DISCOUNTS RATES USED TO VALUE SMALL BUSINESSES AND
THE U.S. CONVERGENCE WITH
INTERNATIONAL FINANCIAL REPORTING STANDARDS
Shawna Mc Laughlin
B.A., Humboldt State University, 1995
PROJECT
Submitted in partial satisfaction of
the requirements for the degree of
MASTER OF SCIENCE
in
ACCOUNTANCY
at
CALIFORNIA STATE UNIVERSITY, SACRAMENTO
SUMMER
2010
© 2010
Shawna Mc Laughlin
ALL RIGHTS RESERVED
ii
DISCOUNTS RATES USED TO VALUE SMALL BUSINESSES AND
THE U.S. CONVERGENCE WITH
INTERNATIONAL FINANCIAL REPORTING STANDARDS
A Project
by
Shawna Mc Laughlin
Approved by:
__________________________________, Committee Chair
Yan Xiong, Ph.D.
____________________________
Date
iii
Student: Shawna Mc Laughlin
I certify that this student has met the requirements for format contained in the University
format manual, and that this Project is suitable for shelving in the Library and credit is to
be awarded for the Project.
_____________________________________________
Monica Lam, Ph.D.
Associate Dean for Graduate and External Programs
College of Business Administration
iv
_____________________
Date
Abstract
of
DISCOUNTS RATES USED TO VALUE SMALL BUSINESSES AND
THE U.S. CONVERGENCE WITH
INTERNATIONAL FINANCIAL REPORTING STANDARDS
by
Shawna Mc Laughlin
In 2002, the U.S. Financial Accounting Standards Board (FASB) and the
International Accounting Standards Board (IASB) entered into The Norwalk Agreement.
This agreement was a Memorandum of Understanding in which the two boards
“…pledged to use their best efforts to (a) make their existing financial reporting standards
fully compatible as soon as is practicable and (b) to coordinate their future work programs to
ensure that once achieved, compatibility is maintained” (FASB, 2002). Over time, it is
expected that U.S. public companies will eventually prepare their financial statements
according to International Financial Reporting Standards (IFRS). Professionals who
appraise small private companies often use data derived from public markets to arrive at
their values. Since it is not likely that small private companies will adopt IFRS at the
same rate, or to the same extent, as publicly traded companies, discount rates derived
from public market data will not be applicable in the valuation of small private
companies without specific adjustments to ensure comparability.
v
In this project, a hypothetical company is used to illustrate the difference in
discount rates when the financial statements are prepared according to U.S. Generally
Accepted Accounting Principles (GAAP) versus when they are prepared according to
IFRS. The discount rate is selected using the buildup method from data published in the
Ibbotson SBBI 2010 Valuation Year Book and applied to the subject company to arrive at
an indicated value. The next step is to convert the GAAP basis financial statements to
IFRS. The value of the subject company and the IFRS financial statements will then be
used to determine and compare the corresponding discount rates. Finally, the adjusted
discount rates will be used to illustrate the importance of matching the benefit streams of
small private U.S. companies that continue to use GAAP to the benefit streams of
publicly traded companies once they have adopted IFRS.
, Committee Chair
Yan Xiong, Ph.D.
______________________
Date
vi
TABLE OF CONTENTS
Page
List of Tables .............................................................................................................. ix
1. INTRODUCTION .................................................................................................. 1
1.1 Purpose of the Project ................................................................................ 1
1.2 Statement of Problem ................................................................................. 1
2. BACKGROUND OF THE PROJECT .................................................................... 3
2.1 Sources of Discount Rates ......................................................................... 3
2.2 The Buildup Method Using Ibbotson Data ................................................ 4
2.3 Capitalization Rates v. Discount Rates ...................................................... 5
2.4 RMA Data Used to Create Subject Company............................................ 6
3. ANALYSIS OF THE DATA ................................................................................... 7
3.1 Derive Representative Company Using RMA Data .................................. 7
3.2 Determine the Discount Rate ..................................................................... 9
3.3 Determine the Capitalization Rate. .......................................................... 11
3.4 Determine the Value of the Representative Company ............................. 12
3.5 Convert Financial Statements to IFRS for SMEs and IFRS .................... 12
3.5.1 Purchased Goodwill .................................................................. 12
3.5.2 Impairment of Assets ................................................................ 13
3.5.3 Research & Development ......................................................... 14
3.5.4 Borrowing Costs for Self-constructed Assets ........................... 15
vii
3.6 Discount Rates Under IFRS for SMEs and IFRS .....................................20
4. FINDINGS AND INTERPRETATIONS .............................................................. 23
Bibliography………...………………………………………………………………..25
viii
LIST OF TABLES
Page
1.
Table 1 GAAP Basis Balance Sheet ……………………………………….….. 7
2.
Table 2 GAAP Basis Income Statement..………………………………….…... 8
3.
Table 3 Benefit Stream..……………………………………………………….. 9
4.
Table 4 Buildup Method – Discount Rate ……………………………………..10
5.
Table 5 Capitalization Rate……………………………………………………..11
6.
Table 6 Indicated Value…………………………………………………….…..12
7.
Table 7 Balance Sheet Adjustments...…………………………………….…... 16
8.
Table 8 Income Statement Adjustments.……………………………………….17
9.
Table 9 Notes on Adjustments...……….……………………………………….18
10.
Table 10 Balance Sheets: GAAP, IFRS for SMEs and IFRS.………………….19
11.
Table 11 Income Statements: GAAP, IFRS for SMEs and IFRS.………….…..20
12.
Table 12 Discount Rates: GAAP, IFRS for SMEs and IFRS..…………….…...21
13.
Table 13 Illustration of Overstatement/(Understatement) of Values………..…23
ix
1
Chapter 1
INTRODUCTION
1.1 Purpose of the Project
The purpose of this project is to explore impending changes to methodologies
used to value small private businesses by applying discount rates derived from the public
market. These changes will be required as United States public companies move toward
the use of International Financial Reporting Standards (IFRS) in lieu of U.S. Generally
Accepted Accounting Principles (GAAP). Since adoption of full IFRS by small privately
held business will not be mandatory, it is likely that many will choose to continue using
GAAP. Even after small businesses begin implementing IFRS, they will likely utilize the
standards developed specifically for small and medium sized entities, referred to as IFRS
for SMEs. This project demonstrates the difference in discount rates when financial
statements are converted from GAAP to both IFRS for SMEs as well as to full IFRS.
1.2 Statement of Problem
As U.S. public companies adopt IFRS and U.S. private companies continue to use
GAAP or choose to use IFRS for SMEs, the discount rates derived from the public
market to value small private companies will become inapplicable without certain
adjustments. Once IFRS is fully implemented, the valuation analyst will be required to
add additional steps to income approach valuation methodologies to estimate the value of
a small privately held company. Currently, the appraiser analyzes the financial
2
statements to ensure they are prepared according to GAAP. Once this step is complete,
the discount rates, which are also currently derived from GAAP basis data, can be applied
to the GAAP basis benefit streams. With the U.S. convergence with IFRS for public
companies, it will eventually be necessary to convert financial statements of small private
companies from GAAP, or any other basis of accounting, to IFRS before the discounts
are utilized. Other bases of accounting may eventually include IFRS for small and
medium sized entities. Since the discount rates will be derived from data built from full
IFRS basis financial statements, even differences between IFRS for SMEs and IFRS will
need to be addressed before their application.
In order to opine the most accurate value possible when appraising small
businesses, the valuation analyst must expand analytical procedures in applying income
approach methodologies to account for the growing differences in accounting principles
and standards used.
3
Chapter 2
BACKGROUND OF THE PROJECT
2.1 Sources of Discount Rates
The discount rate is the required rate of return necessary to persuade an investor
to make the investment based on the risk associated with the benefit stream of the
investment (Trugman, 2008). Typically, the more risk associated with receiving the
expected benefit stream, the lower the amount the investor may be willing to invest.
Conversely, the less risk associated with receiving the expected benefit stream, the more
the investor may be willing to invest. The discount rate is also often referred to as the
cost of capital (Ibbotson Associates, 2010).
Discount rates come from the market (Trugman, 2008). If an investor is
considering a particular investment, that investment will be compared to other
investments available in the market to determine how much the investor is willing to pay
based on the risk involved. In other words, if an investor has the choice between a low
risk investment and a high-risk investment, both of which produce the same rate of
return, the investor will not choose the high-risk investment unless the cost of acquiring
the investment is low enough to compensate for the risk assumed. The discount rate
provides the investor with a measure of the risk involved in making a particular
investment in comparison to all possible investments in the market.
There are various models used to estimate the discount rate, including the buildup
method, the capital asset pricing model (CAPM) and the Fama-French three-factor model
4
(Ibbotson Associates, 2010). When analysts appraise small businesses, they typically use
the buildup method, which involves discount rates derived from market data compiled in
the Morningstar Associates, Inc. Ibbotson SBBI Valuation Yearbook or in the Duff &
Phelps LLC Risk Premium Report (Trugman, 2008). This project will use the data
compiled by Ibbotson Associates.
2.2 The Buildup Method Using Ibbotson Data
The discount rate is built by summing up four basic components: the risk-free
rate of return, the common stock equity risk premium, the smaller size premium and the
industry specific risk premium (Trugman, 2008).
The risk free rate of return is the minimum return the investor expects on a risk
free investment. This is the pure cost of money plus the rate of inflation. Since U.S.
Government Treasury Bonds are considered a “riskless” investment, their rates are often
used as a proxy for a risk free investment. As of December 2009, the annual average rate
of return on a twenty-year U.S. Government Treasury Bond was 4.1%; therefore, 4.1% is
used in this project to represent the risk free rate of return (Ibbotson Associates, 2010).
The equity risk premium is the rate of return investors require over and above the
risk free rate of return for investing in common stocks. Ibbotson estimates the equity risk
premium using historical market information they compiled annually for every year since
1926. The use of historical information is based on the assumption that the future will
resemble the past. As such, Ibbotson’s long-horizon expected equity risk premium based
5
on the analysis of historical data as of December 2009 was 6.7% (Ibbotson Associates,
2010).
The small stock risk premium accounts for the additional risk inherent in the
investment in small company stocks. As of December 2009, Ibbotson published the
small stock risk premium for the 10th decile as 6.28% (Ibbotson Associates, 2010).
The industry specific risk premium provides an adjustment for the difference in
risk inherent within an industry as compared to the market as a whole. The hypothetical
company that will be used in this project is a grape vineyard named Private Hill
Vineyard. Ibbotson’s data provides for an adjustment of -2.2% for businesses classified
under the SIC 01: Agricultural Production—Crops as of December 2009. For the
purpose of this study, -2.2% will be accepted as an appropriate adjustment to the discount
rate to accurately reflect the risk involved in operating a grape vineyard (Ibbotson
Associates, 2010).
2.3 Capitalization Rates v. Discount Rates
If the company’s earnings are expected to continue to grow at the same rate as the
earnings from which the current benefit stream is derived, the expected benefit stream
can be capitalized to determine the value of the company. The capitalization rate is the
discount rate minus the growth rate (Trugman, 2008). For the purposes of this project, it
is assumed that the subject company has reached a steady rate of growth of 3% that is
expected to continue into perpetuity.
6
2.4 RMA Data Used to Create a Subject Company
To demonstrate the differences in discount rates when financial statements of a
company are prepared according to GAAP and to IFRS, a hypothetical example of a
company will be used. Risk Management Association (RMA) compiles financial data by
industry and publishes it in its Annual Statement Studies. The RMA industry data for
businesses classified under SIC 0172 for grape vineyards is used to create the
hypothetical company named Private Hill Vineyards.
Private Hill Vineyards is a small privately held grape vineyard that produces
grapes in demand by local wine makers. In 2004, Private Hill Vineyards was created by
the combination of two adjacent vineyards, one of which contributed a new, increasingly
popular varietal of grape; the other contributed prime vineyard acreage. In 2010, Private
Hill Vineyard attracted the attention of a French company with its new varietal. The
French company owns land in an area of France situated in the ideal climate for
production of Private Hill’s varietal and is interested in introducing it into the French
wine making community. In order to prepare financial statements suitable for use by its
French associates, and to explore its prospective international expansion, Private Hill
Vineyard adopted IFRS for SMEs for its financial reporting.
In addition to converting the Private Hill Vineyardfinancial statements to IFRS
for SMEs, the financial statements will also be converted to full IFRS to illustrate the
difference in discount rates used in the appraisal of small, privately held companies.
7
Chapter 3
ANALYSIS OF THE DATA
3.1 Derive Representative Company Using RMA Data
Table 1 includes the GAAP basis balance sheet for Private Hill Vineyard. This
hypothetical company is based on the 2009 RMA data that includes vineyards with assets
of more than $500,000 but less than $2,000,000.
Table 1 GAAP Basis Balance Sheet
Balance Sheets Derived from RMA Data
RMA
2009
Subject
2009
ASSETS
Cash
Accounts Receivable
Inventory
Other Current
Total Current Assets
Fixed Assets (Net of Depreciation)
Net Intangible
All Other Non-Current
Total Assets
13.10%
7.30%
0.30%
3.10%
23.80%
59.30%
0.40%
16.60%
100.10%
165,307
92,118
3,786
39,119
300,330
748,300
5,048
208,212
1,261,890
LIABILITIES & EQUITY
Accounts Payable
Short Term Notes Payable
Current Portion of LT Debt
Other Current Liabilities
Total Current Liabilities
Long Term Debt
All Other Non-Current Liabilities
Total Liabilities
Total Equity
TOTAL LIABILITIES & EQUITY
1.20%
9.90%
2.60%
6.50%
20.20%
65.80%
15.40%
101.40%
-1.40%
100.00%
15,143
124,927
32,809
82,023
254,902
830,323
194,331
1,279,556
(17,666)
1,261,890
Risk Management Association, Philadelphia, PA
ANNUAL STATEMENT STUDIES, (TM) RMA THE RISK MANAGEMENT ASSOCIATION, (TM) and
the RMA Logo are trademarks of the Risk Management Association. RMA owns the copyright
in the ANNUAL STATEMENT STUDIES(TM) data. The data is used under license from RMA.
8
The net fixed assets consist of 40 acres of land, vineyard improvements, vehicles
and farming equipment. The net intangibles consist of the goodwill purchased in 2004
when the two adjacent vineyards combined, as well as costs associated with intangibles
generated internally since 2004.
The GAAP basis income statement for Private Hill Vineyards is shown in table 2.
Table 2 GAAP Basis Income Statement
Income Statements Derived from RMA Data
RMA
2009
Revenue
Cost of Goods
Gross Profit
Total Operating Expenses
Depreciation/Amortization Expense
Operating Profit
Other Income/(Expense) Net
Income Tax Expense
Net Income
100.00%
0.00%
100.00%
76.90%
9.20%
14.10%
-7.02%
-1.88%
5.20%
Subject
2009
1,250,111
0
1,250,111
958,835
115,010
176,266
(87,750)
(23,510)
65,006
Risk Management Association, Philadelphia, PA
ANNUAL STATEMENT STUDIES, (TM) RMA THE RISK MANAGEMENT ASSOCIATION, (TM) and
the RMA Logo are trademarks of the Risk Management Association. RMA owns the copyright
in the ANNUAL STATEMENT STUDIES(TM) data. The data is used under license from RMA.
When valuation analysts appraise businesses using income approach methods, it
is common that they do so using pre-tax earnings as the benefit stream (Ibbotson
Associates, 2010). For this reason, the expected benefit stream used in establishing a
value for Private Hill Vineyard is the company’s earnings before taxes cash flow (EBT
cash flow). This benefit stream is determined by adding back expenses for depreciation,
amortization and taxes to net income as seen in Table 3.
9
Table 3 Benefit Stream
Benefit Stream
EBT Cash Flow
Net Income
Add Back Depreciation and Amortization
Add Back Taxes
Selected Ongoing Capacity
Dec
2009
65,006
115,010
23,510
203,526
203,500
Private Hill Vineyard’s 2009 EBT cash flow when financial statements are
prepared according to GAAP is $203,500.
3.2 Determine the Discount Rate
The next step in determining the value of Private Hill Vineyard is to select the
discount rate. The method chosen in this project is the buildup method using the
Ibbotson data. Table 3 illustrates how the components of the discount rate are summed
up to arrive at the discount rate used to value a grape vineyard.
10
Table 4 Build Up Method - Discount Rate
Discount Rate
Cost of equity
Risk-free Rate of Return
Common Stock Equity Risk Premium
Small Stock Risk Premium
Plus/Minus Industry Risk Premium
Net discount rate
Adjust from After Tax Rate to Pretax Economic Stream
Selected Discount Rate
4.6%
6.7%
6.3%
-2.2%
15.4%
7.9%
23.3%
The net discount rate of 15.4% is the discount rate applicable to agricultural
operations involving the production of crops. For the purpose of this project, it is
assumed that the risk associated with operating a vineyard is equivalent to risk involved
in growing crops in general.
The net discount rate of 15.4% is an after tax discount rate. Since we are using a
pre-tax benefit stream, it is necessary to adjust the discount rate to a pre-tax basis. The
adjustment of 7.9% is calculated using the equation
=
After Tax Discount Rate - Sustainable Growth Rate
(1 - Tax Rate) + Sustainable Growth Rate
- After Tax Discount Rate
in which the sustainable growth rate is 3% and the tax rate is 43.84% (federal and
California corporate income tax rates combined) (Ibbotson Associates, 2010). The result
is the selected pre-tax discount rate of 23.3%.
11
3.3 Determine the Capitalization Rate
As mentioned in section 2.3, the subject company is assumed to have reached a
steady and continuous growth rate of 3%. This makes it possible to use the capitalization
rate to capitalize the company’s current benefit stream to present day value without
making complex forecasts of operations. To determine the capitalization rate, the
expected growth rate is subtracted from the discount rate. Table 4 shows the calculation
that derives the capitalization rate from the discount rate.
Table 5 Capitalization Rate
Capitalization Rate
Selected Discount Rate
Less Sustainable Growth
Next Year Capitalization Rate
Current Year Capitalization Rate*
23.3%
3.0%
20.3%
19.7%
Selected Capitalization Rate
19.7%
* = Next Year Capitalization Rate/(1 + Sustainable Growth Rate)
Since the discount rate derived from Ibbotson data is forward looking, when the
growth is subtracted, the result is next year’s capitalization rate. The capitalization rate in
Table 5 is converted from next year’s capitalization rate to this year’s capitalization rate
by dividing next year’s capitalization rate by one plus the sustainable growth rate to
arrive at the current year capitalization rate of 19.7%. The current year capitalization rate
will then be applied to the current year benefit stream to determine the value of the
company.
12
3.4 Determine the Value of the Representative Company
The value of the company is determined by dividing the EBT cash flows by the
capitalization rate as illustrated in Table 6.
Table 6 Indicated Value
Indicated Value
EBT Cash Flow
Divide By
Capitalization Rate
Indicated Value
203,500
19.7%
1,032,995
Selected Value (Rounded)
1,033,000
After rounding, the selected value of Private Hill Vineyard is $1,033,000.
3.5 Convert Financial Statements to IFRS for SMEs and IFRS
In order for Private Hill Vineyard to proceed with discussions that might lead to
their expansion into France, the financial statements must be converted from GAAP basis
accounting to a form of IFRS. In doing so, there are four changes required.
3.5.1 Purchased Goodwill. The first difference is the treatment of the carrying
value of the goodwill purchased during the business combination that occurred in 2004.
Under GAAP, the purchased goodwill is reported on the balance sheet at its cost of
$3,786. At the time in which the financial statements are being prepared, there is no
13
impairment. Purchased goodwill is not amortized under GAAP (Fitzpatrick & Frank,
2009).
In converting the financial statements from GAAP to IFRS for SMEs, Private Hill
Vineyard applies the principle in IFRS for SMEs §19.23(a) which states that the useful
life of goodwill shall be presumed to be ten years unless the useful life can be determined
to be otherwise (IASB, 2009). Goodwill under IFRS for SMEs is reported on the balance
sheet, net of amortization, from 2004 through 2010 using the straight-line, half-year
convention. The adjustments necessary to convert the GAAP basis financial statements
to IFRS for SMEs are presented in Note “a” Table 9.
IFRS 3 conforms with GAAP in that the carrying costs of unimpaired purchased
goodwill are not amortized and, therefore, no adjustment is necessary when converting
GAAP basis financial statements to full IFRS (IASB, 2010).
3.5.2 Impairment of Assets. In 2007, impending state environmental regulations
prohibiting the use of older diesel powered machinery and equipment resulted in the
shortened remaining useful life and reduced residual value of an entire class of
equipment. As a result, Private Hill Vineyards wrote down an impairment loss under
GAAP.
In 2009, the delay of the state environmental regulations caused the remaining
useful life to be extended as well as a small increase in residual value. Despite the
potential to recover a portion of the earlier write down, GAAP does not allow for the
reversal of a previously recognized impairment loss (Doupnik & Perera, 2008).
14
In converting the 2009 GAAP basis financial statements to IFRS for SMEs,
Private Hill Vineyards applies the principles in IFRS for SMEs §27.28-27.30 in which
the carrying cost of the assets on the balance sheet are increased by the recoverable
amount of the previous impairment write down (IASB, 2009). The adjustments to
reverse the impairment loss as allowed by IFRS for SMEs are presented in Note “b” in
Table 9.
Similar to IFRS for SMEs, IAS 16 also allows for the reversal of previously
recognized impairment losses (IASB, 2010). The adjustment in Note “b” in Table 9 to
convert the GAAP basis financial statement is identical to the adjustment required to
convert to IFRS for SMEs.
3.5.3 Research & Development. During 2009, Private Hill Vineyards incurred
research & development expenditures related to the continued search for new varietals.
The goal was to create healthy, productive vines that could be used to produce popular
but affordable wines. Under GAAP, all research and development costs are required to
be expensed (Lindsey & Rutledge, 2005).
IFRS for SMEs conforms to GAAP in the all research and development costs are
required to be expensed (Fitzpatrick & Frank, 2009). For this reason, no change is made
to the IFRS for SMEs financial statements with respect to research and development
expenditures.
Under IAS 38, it is possible to capitalize the portion of research and development
that is attributable to development of the Private Hill Vineyards’ new asset provided that:
15
1. The technical feasibility exists that the vines, or more specifically the grapes from
the vines, will eventually be available for use or sale.
2. The intent is to complete the development of the new varietal for use or sale.
3. There will be the ability to use or sell the new varietal.
4. The probable future economic benefits can be demonstrated.
5. There are adequate technical, financial and other necessary resources to complete
the development of the varietal.
6. It is possible to measure the expenditure attributable to the development of the new
varietal.
Since all six factors apply to the development of the new vines, Private Hill Vineyards is
able to capitalize the 2009 expenditures for development of the asset (Doupnik & Perera,
2008). The adjustments to the GAAP basis financial statements to reclassify the expense
to an asset are included in Note “c” in Table 9.
3.5.4 Borrowing Costs for Self-constructed Assets. In order to ensure the success
of the development of the new varietal, Private Hill Vineyards financed part of the cost of
the research & development expenditures. Under GAAP, the borrowing costs associated
with the self-construction of a new asset are generally capitalized and amortized
(Fitzpatrick & Frank, 2009).
Under IFRS for SMEs §25, borrowing costs for the production of selfconstructed assets are instead expensed (IASB, 2009). Note “d” in Table 9 provides the
16
adjustments to reclassify the capitalized asset to an expense, per the principles included in
§25 of IFRS for SMEs.
Full IFRS conforms to GAAP regarding borrowing costs for self-constructed
assets according IAS 23 (IASB, 2010). Therefore, no adjustment to the GAAP basis
financial statements for borrowing costs was necessary to convert the financial statements
to IFRS.
Table 7 shows the adjustments made to the GAAP basis balance sheet to convert
it to the IFRS for SMEs balance sheet and to the full IFRS balance
sheet.
Table 7 Balance Sheet Adjustments
Balance Sheet Adjustments
IFRS (SME)
2009
ASSETS
Cash
Accounts Receivable
Inventory
Other Current
Total Current Assets
Fixed Assets (Net of Depreciation)
Net Intangible
All Other Non-Current
Net Increase/(Decrease) to Total Assets
LIABILITIES & EQUITY
Accounts Payable
Short Term Notes Payable
Current Portion of LT Debt
Other Current Liabilities
Total Current Liabilities
Long Term Debt
All Other Non-Current Liabilities
Total Liabilities
Total Equity
Net Increase/(Decrease) to Liabilies & Equity
0
(64,286)
2,083
IFRS
2009
b
a,d
(62,203)
b
c
(99,286)
0
0
(62,203)
(62,203)
0
(64,286)
(35,000)
0
a,b,d
0
(99,286)
(99,286)
b,c
17
Table 8 shows the adjustments made to the GAAP basis income statement to
convert it to the IFRS for SMEs income statement and to the full IFRS income statement.
Table 8 Income Statement Adjustments
Income Statement Adjustments
IFRS (SME)
2009
IFRS
2009
Revenue
Gross Profit
Total Operating Expenses
Depreciation/Amortization Expense
Operating Profit
Other Income/(Expense) Net
Income Tax Expense
Net Increase/(Decrease) to Net Income
0
1,514
10,840
(12,354)
(4,420)
(7,935)
d
a,b
a, b,d
0
(35,000)
10,714
24,286
9,816
14,470
c
b
b,c
Table 9 notes the adjusting entries for each line item that changed in the
conversion from GAAP to IFRS for SMEs and/or full IFRS as they are described in
§3.5.1 - 3.5.4 of this project.
18
Table 9 Notes on Adjustments
NOTES
a. Purchased Goodwill
IFRS for SMEs
Amortization Expense
Net Intangible (Accumulated Amortization)
Equity
Income Tax Expense
Net Intangible
IFRS
No adjustment
b. Impairment of Assets
IFRS for SMEs
Fixed Assets (Equipment)
Depreciation Expense
Income Tax Expense
Fixed Assets (Accumulated Depreciation)
Equity
IFRS
Fixed Assets (Equipment)
Depreciation Expense
Income Tax Expense
Fixed Asset (Accumulated Depreciation)
Equity
126
693
393
50
1,262
75,000
10,714
4,268
10,714
79,268
75,000
10,714
3,901
10,714
78,901
c. Research & Development
IFRS for SMEs
No adjustment
IFRS
Net Intangible (Development Expenditures)
35,000
Equity
13,717
Operating Expense (Development Expenditures)
Income Tax Expense
d. Borrowing Costs for Self-constructed Assets
IFRS for SMEs
Operating Expense (Borrowing Costs)
Equity
Income Tax Expense
Net Intangible (Development Expenditures)
IFRS
No adjustment
35,000
13,717
1,514
102
102
1,514
19
The resulting balance sheets under GAAP, IFRS for SMEs and full IFRS are each
presented in Table 10.
Table 10 Balance Sheets: GAAP, IFRS (SME) and IFRS
Comparative Balance Sheets
GAAP
2009
IFRS (SME)
2009
IFRS
2009
ASSETS
Cash
Accounts Receivable
Inventory
Other Current
Total Current Assets
Fixed Assets (Net of Depreciation)
Net Intangible
All Other Non-Current
TOTAL ASSETS
165,307
92,118
3,786
39,119
300,330
748,300
5,048
208,212
1,261,890
165,307
92,118
3,786
39,119
300,330
812,586
2,965
208,212
1,324,093
165,307
92,118
3,786
39,119
300,330
812,586
40,048
208,212
1,361,176
LIABILITIES & EQUITY
Accounts Payable
Short Term Notes Payable
Current Portion of LT Debt
Other Current Liabilities
Total Current Liabilities
Long Term Debt
All Other Non-Current Liabilities
Total Liabilities
Total Equity
TOTAL LIABILITIES & EQUITY
15,143
124,927
32,809
82,023
254,902
830,323
194,331
1,279,556
(17,666)
1,261,890
15,143
124,927
32,809
82,023
254,902
830,323
194,331
1,279,556
44,537
1,324,093
15,143
124,927
32,809
82,023
254,902
830,323
194,331
1,279,556
81,620
1,361,176
Table 11 includes the income statements as prepared according to GAAP, IFRS
for SMEs and full IFRS.
20
Table 11 Income Statements: GAAP, IFRS (SME) and IFRS
Comparative Income Statements
GAAP
2009
IFRS (SME)
2009
IFRS
2009
Revenue
1,250,111
1,250,111
1,250,111
Gross Profit
Total Operating Expenses
Depreciation/Amortization Expense
Operating Profit
Other Income/(Expense) Net
Net Income Before Taxes
Income Tax Expense
Net Income
1,250,111
958,835
115,010
176,266
(87,750)
88,516
(23,510)
65,006
1,250,111
960,349
125,851
163,912
(87,750)
76,162
(19,090)
57,072
1,250,111
923,835
125,724
200,552
(87,750)
112,802
(33,325)
79,476
Add Back Depreciation/Amortization
Add Back Taxes
115,010
23,510
125,851
19,090
125,724
33,325
EBT Cash Flow
203,526
202,012
238,526
The most important result of this analysis is that the EBT cash flows are different under
each accounting basis.
3.6 Discount Rates Under IFRS for SMEs and IFRS
Even though the EBT cash flows have changed as result of the application of
IFRS, the company is still the same company. The risk associated with the expected
future benefit stream has not changed and, therefore, the value of the company has not
changed. However, because the EBT cash flows have changed due to the difference in
accounting bases, the discount rates have consequently changed. Table 12 illustrates how
the value is used to arrive at the discount rates applicable to each basis of accounting.
Since, to arrive at the value of a company the earnings stream is divided by the
capitalization rate, the inverse is also true: to arrive at the capitalization rate, the value is
21
divided by the earnings stream. Because the company is the same under each accounting
basis in Table 12, the value is also the same. What have changed are the benefit streams.
When the values are divided by the different benefit streams that result from the use of
GAAP, IFRS for SMEs and full IFRS, the outcome is three different current year
capitalization rates for the same company. The current year capitalization rates are then
multiplied by one plus the sustainable growth rate of 3% to arrive at the forward-looking
discount rates a valuation analyst expects to obtain from market data.
Table 12 Discount Rates: GAAP, IFRS (SME) and IFRS
Adjusted Discount Rates
Value
EBT Cash Flow
Current Year Capitalization Rate
GAAP
2009
IFRS (SME)
2009
IFRS
2009
1,033,000
203,526
1,033,000
202,012
1,033,000
238,526
19.7%
19.6%
23.1%
Next Year Capitalization Rate*
Plus Sustainable Growth Rate
20.3%
3.0%
20.1%
3.0%
23.8%
3.0%
Discount Rate
23.3%
23.1%
26.8%
* = Current Year Capitalization Rate * (1 + Sustainable Growth Rate)
In the case of Private Hill Vineyards, the difference between GAAP and IFRS for
SMEs is not significant. On the other hand, the difference between GAAP and IFRS
provides more of a disparity. If the public markets were already using IFRS and the
market data provided a discount rate of 26.8%, application of this rate to a GAAP basis
benefit stream may cause an understatement of value for Private Hill Vineyards by as
much as 15%. If Private Hill Vineyards was involved in negotiations with their French
22
associates, they might be undercompensated for the value of their company because of
their valuation analyst applied a discount rate based on IFRS to the GAAP basis benefit
stream.
While the differences in discount rates in this scenario are not immense, the point
still stands that the analysis must be performed to ensure that proper comparisons are
being made. The valuation analyst will need to match the subject company’s benefit
stream to the accounting basis of the market as a whole before discounts from the market
can be accurately applied in appraising the subject company.
23
Chapter 4
FINDINGS AND INTERPRETATIONS
Once the expected convergence of U.S. GAAP with IFRS is complete, and IFRS
is adopted by U.S. public companies, the financial statements of these companies will
change. As a result, discount rates derived from the market will come from data based on
IFRS instead of GAAP. Since convergence with IFRS by small private companies will
not be required, it will be more important than ever for the valuation analyst to determine
what differences exist between the subject company’s and the publicly traded companies’
benefit streams and what adjustments to the subject company’s financial statements are
necessary before applying the selected discount rate. This assertion can be best
demonstrated by applying the selected discount rates developed in this project to a
hypothetical unadjusted GAAP basis benefit stream as shown in Table 13.
Table 13 Illustration of Overstatement/(Understatement) of Values
GAAP
2009
IFRS (SME)
2009
IFRS
2009
Discount Rate
Less Sustainable Growth
Next Year Capitalization Rate
Current Year Capitalization Rate*
23.3%
3.0%
20.3%
19.7%
23.1%
3.0%
20.1%
19.6%
26.8%
3.0%
23.8%
23.1%
Selected Capitalization Rate
19.7%
19.6%
23.1%
Hypothetical Benefit Stream
Divide By
Capitalization Rate
Indicated Value
Overstatement/(Understatement) of Value
% Overstatement/(Understatement) of Value
1,000,000
1,000,000
1,000,000
19.7%
5,076,142
19.6%
5,102,041
23.1%
4,329,004
0
0
25,899
0.5%
(747,138)
-14.7%
24
When the benefit streams are not adjusted from GAAP basis, the discount rate
derived from IFRS for SMEs does not produce a material difference in value. On the
other hand, when the discount rate derived from full IFRS data is applied to the
hypothetical unadjusted GAAP basis benefit stream, the value is understated by 14.7%.
This finding demonstrates that the accounting basis of the subject company must be
matched to the accounting basis of the market data from which the discount rate is
derived.
As widespread use of IFRS by public companies becomes a reality, it will be less
likely that the financial statements of the small, privately held company will match the
market data. Valuation procedures will need to be refined to ensure that differences in
accounting bases are considered and adjusted for in order to arrive at accurate estimates
of values for small, privately held companies.
25
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Fitzpatrick, Mark & Frank, Fred. (2009). IFRS for SMEs: The Next Standard for U.S.
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International Accounting Standards Board (IASB). (2010). Standards (IFRSs).
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Trugman, Gary R. (2008). Understanding Business Valuation: A Practical Guide to
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