Fair Value Measurement
Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the
United States. With offices in North America, Europe, Asia, and Australia, Wiley is globally
committed to developing and marketing print and electronic products and services for our
customers’ professional and personal knowledge and understanding.
The Wiley Corporate F&A series provides information, tools, and insights to corporate professionals responsible for issues affecting the profitability of their company, from
accounting and finance to internal controls and performance management.
Fair Value Measurement
Third Edition
Practical Guidance and Implementation
MARK L. ZYLA
© 2020 John Wiley & Sons, Inc. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form
or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as
permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior
written permission of the Publisher, or authorization through payment of the appropriate per-copy fee
to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400,
fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission
should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street,
Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at www.wiley.com/go/
permissions.
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in
preparing this book, they make no representations or warranties with respect to the accuracy or
completeness of the contents of this book and specifically disclaim any implied warranties of
merchantability or fitness for a particular purpose. No warranty may be created or extended by sales
representatives or written sales materials. The advice and strategies contained herein may not be
suitable for your situation. You should consult with a professional where appropriate. Neither the
publisher nor author shall be liable for any loss of profit or any other commercial damages, including
but not limited to special, incidental, consequential, or other damages.
For general information on our other products and services or for technical support, please contact our
Customer Care Department within the United States at (800) 762–2974, outside the United States at
(317) 572-3993, or fax (317) 572-4002.
Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material
included with standard print versions of this book may not be included in e-books or in
print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version
you purchased, you may download this material at http://booksupport.wiley.com. For more
information about Wiley products, visit www.wiley.com.
NOTE: Any views or opinions represented in this work are personal and belong solely to the author and
those quoted or cited. They do not represent those of people, institutions, or organizations that they
may or may not be associated with in any professional or personal capacity, unless explicitly stated.
Library of Congress Cataloging-in-Publication Data is Available:
ISBN 978-1-119-19123-0 (hardback)
ISBN 978-1-119-34891-7 (ePDF)
ISBN 978-1-119-34981-5 (ePub)
Cover Design: Wiley
Cover Image: © bluebay/Shutterstock
Printed in the United States of America
10 9 8 7 6 5 4 3 2 1
To my wife, Jo Ann, and my son, Jack.
You make this all possible …
And to my dad, Larry Zyla,
Thank you … for everything.
Contents
Preface
xiii
Acknowledgments
xix
Chapter 1: The History and Evolution of Fair Value Accounting
Why the Trend Toward Fair Value Accounting?
History and Evolution of Fair Value
Fair Value Accounting and the Economic Crisis
The FASB and IASB Convergence Project
The Future of Fair Value Measurement
Fair Value Quality Initiative for Valuation Specialists
Conclusion
Notes
Appendix 1A: The Mandatory Performance Framework
Performance Requirements
Conclusion
Notes
1
2
5
12
17
23
24
26
26
31
31
33
46
Chapter 2: Fair Value Measurement Standards and Concepts
47
FASB ASC 820, Fair Value Measurement
Disclosures
Fair Value Option
Standards in the Valuation Profession and Fair Value Measurements
Conclusion
Notes
48
67
70
77
79
80
Appendix 2A: Taxes and Fair Value Measurements
Summary of Changes under 2017 TCJA
Chapter 3: Business Combinations
Mergers and Acquisitions
Accounting Standards for Business Combinations—A Brief History
ASC 805, Business Combinations
Other Business Combination Highlights
81
81
85
86
88
90
95
vii
viii
◾ Contents
Subsequent Accounting for Goodwill and Other Intangible Assets
Conclusion
Notes
Chapter 4: The Nature of Goodwill and Intangible Assets
History of Intangible Assets
Intellectual Property
Economic Basis of Intangible Assets
Identification of Intangible Assets
Useful Life of an Intangible Asset
Intangible Assets and Economic Risk
Goodwill
Economic Balance Sheet
Conclusion
Notes
Chapter 5: Impairment
Evolution of Impairment Testing
Applicable FASB Guidance for Impairment Testing
Accounting for the Impairment of Long-Lived Assets
Goodwill Impairment Testing—Public Companies
Goodwill Impairment—One-Step Impairment Loss
Testing Other Indefinite-Lived Intangible Assets for Impairment
Amortization of Goodwill
Conclusion
Notes
Appendix 5A: Example of a Qualitative Impairment
Analysis—PlanTrust, Inc.
Financial Accounting Standards Board ASC 350, Intangibles—
Goodwill and Other
PlanTrust, Inc.
Notes
Chapter 6: The Cost Approach
The Cost Approach under FASB ASC 820, Fair Value Measurement
Economic Foundation for the Cost Approach
Cost versus Price versus Fair Value
The Role of Expected Economic Benefits in the Cost Approach
Reproduction Cost versus Replacement Cost
Components of Cost
Obsolescence
The Relationships Among Cost, Obsolescence, and Value
Physical Deterioration
Functional (Technological) Obsolescence
99
100
101
103
104
105
106
106
111
112
112
114
116
117
119
120
122
123
125
138
139
139
140
140
143
143
144
159
161
162
164
164
166
167
168
169
170
171
172
Contents
◾
ix
Economic (External) Obsolescence
Applying the Cost Approach
Taxes Under the Cost Approach
Limitations of the Cost Approach
Conclusion
Notes
173
174
178
179
179
180
Chapter 7: The Market Approach
183
Applying the Market Approach When Measuring the Fair Value of an Entity or
a Reporting Unit of an Entity
Conclusion
Notes
Chapter 8: The Income Approach
Introduction
Discounted Cash Flow Method
Multiperiod Excess Earnings Method
FASB Concepts Statement 7
Rates of Return Under the Income Approach
The Income Increment/Cost Decrement Method
Profit Split Method
Build-Out, or Greenfield, Method
Weighted Average Cost of Capital Calculation
Conclusion
Notes
Chapter 9: Advanced Valuation Methods for Measuring the Fair Value
of Intangible Assets
Introduction
Limitations of Traditional Valuation Methods
Real Options
Using Option Pricing Methodologies to Value Intangible Assets
Black-Scholes Option Pricing Model
Binomial or Lattice Models
Monte Carlo Simulation
Decision Tree Analysis
Conclusion
Notes
Chapter 10: Measuring the Remaining Useful Life of Intangible Assets
in Financial Reporting
FASB Guidance on Determining the Remaining Useful Life
Considerations in Measuring Useful Lives of Intangible Assets
Practical Guidance for Estimating and Modeling the Useful Life
Conclusion
Notes
184
213
213
215
215
216
223
239
244
245
246
251
251
258
259
261
261
261
263
266
269
272
277
280
281
281
283
283
285
289
295
295
x
◾ Contents
Chapter 11: Fair Value Measurement for Alternative Investments
Introduction
Investments in Certain Entities That Calculated Net Asset Value per Share
AICPA Technical Practice Aid
AICPA Guidance for Determining the Fair Value of Investment
AICPA Accounting and Valuation Guide, Valuation of Portfolio Company
Investments of Venture Capital and Private Equity Funds and Other
Investment Companies
International Private Equity and Venture Capital Valuation Guidelines
Common Valuation Methodologies of Measuring the Fair Value of the Fund’s
Investment Portfolio
Conclusion
Notes
Chapter 12: Contingent Consideration
Contingent Consideration: Earn-outs in Business Combinations
Accounting for Contingent Consideration
Conclusion
Notes
297
297
299
300
301
305
306
307
308
308
311
311
312
324
324
Appendix 12A: Measuring the Fair Value of a Nonfinancial Contingent
Liability—Example of a Loan Guarantee
327
The Jordan Lee Fund Guarantee of Townsend Farm Development, LLC
Notes
328
334
Chapter 13: Auditing Fair Value Measurement
Auditing Standards
The Audit Process
Evolution of Audit Standards for Fair Value Measurements and Disclosures
Auditing Standard 2501, Auditing Accounting Estimates, Including Fair Value
Measurements
Auditing Standards for Auditor’s Use of the Work of Specialists
Proposed International Standard on Quality Management 1
Practical Guidance for Auditors
PCAOB Staff Audit Practice Alert No. 9, Assessing and Responding to Risk in
the Current Economic Environment
AICPA Nonauthoritative Guidance
The Appraisal Foundation
Conclusion
Notes
335
336
338
342
344
349
354
354
356
358
359
359
360
Contents
Appendix 13A: Auditing Fair Value Measurement in a Business
Combination
Auditor Questions
General
Income Approach
Cost Approach
Market Approach—General
xi
363
363
363
364
366
367
Appendix 13B: Auditing Fair Value Measurement in a Goodwill
Impairment Test
General
Income Approach
WACC
The Market Approach
369
369
370
371
372
Chapter 14: Fair Value Measurement Case Study
373
Learning Objectives
Business Background and Facts—Dynamic Analytic Systems, Inc.
Notes
Appendix 14A: Suggested Case Study Solutions
373
374
406
407
Note
437
Appendix 14B: Model Fair Value Measurements Curriculum
Acknowledgments
AICPA Staff
About Us
Preface
Model Fair Value Measurement Curriculum
Appendices and Examples
Note
Glossary of International Business Valuation Terms
Bibliography
About the Author
Index
◾
477
463
475
439
439
440
440
440
440
448
451
453
Preface
F
AIR VAL U E MEASU REMENTS A ND D I SCLO SUR E S continues to be an area of
tremendous interest in financial reporting. Although the Fair Value Measurements
framework is fully converged under U.S. GAAP (ASC 820 Fair Value Measurements)
and IFRS (IFRS 13 Fair Value Measurements), best practices of the measurements themselves
have continued to evolve. Over the past 10 years, organizations such as the AICPA and the
Appraisal Foundation have developed varied guidance on best practices on measuring fair
value for valuation specialists. In December 2018, the PCAOB finalized AS 2501, Auditing
Accounting Estimates, Including Fair Value, and AS 1201, Auditor’s Use of a Specialist, to provide
additional guidance to auditors in auditing fair value. The valuation profession recently
developed a Fair Value Quality Initiative to enhance that profession’s involvement in financial
reporting, resulting in the new Certified in Entity and Intangible Valuation (CEIV) credential
and the Mandatory Performance Framework (MPF).
In December 2018, the International Accounting Standards Board issued a report on
their postimplementation review of IFRS 13, Fair Value Measurements. Both the IASB and
the FASB regularly conduct reviews of newly implemented accounting standards to assess
whether the standards are working as intended. The FASB conducted a postimplementation
review in 2014 and concluded that the then-titled FASB Statement 157 “met its objectives.”1
The IASB concluded that the information required by IFRS 13 is “useful to users of financial
statements.”2
Investor-focused organizations such as the CFA Institute have concluded from a series of
surveys of their members that “where fair value has been implemented over the past 15–20
years there is greater acceptance as to its appropriateness, relevance and reliability.”3 A 2013
CFAI Survey on Fair Value Accounting & Long-Term Investing in Europe summarizes the
importance of fair value measurements in financial reporting to investors across the globe.
Simply put all investors buy, sell, and hold their investments based on fair value information. Fair value information is necessary to judge current financial health, is an
input to predicting future performance, and helps in the judgment of how effectively
management is fulfilling its stewardship function.4
Clearly, fair value measurements enhance the public trust in financial reporting.
The third edition of Fair Value Measurement: Practical Guidance and Implementation, which
includes substantial new discussion material and many new comprehensive examples, is organized as follows:
xiii
xiv
◾ Preface
Chapter 1: The History and Evolution of Fair Value Accounting
◾
Provides a historical look at the development of fair value concepts and accounting
standards.
◾
Includes milestones related to the development of fair value for financial instruments and
fair value measurement of nonfinancial assets and liabilities.
◾
Explains how the economic crisis shaped fair value measurement and how the crisis led
to the refinement of several accounting standards.
◾
Discusses how the proposed convergence of U.S. GAAP with IFRS has shaped fair value
measurement concepts, despite the unlikely full convergence of both standards.
◾
Introduces trends that are likely to continue to affect fair value measurement including
different levels of disclosures for public and privately held entities.
◾
Introduces the Fair Value Quality Initiative and the Mandatory Performance Framework.
◾
Includes, in an appendix, a checklist of items to consider under the Mandatory Performance Framework.
Chapter 2: Fair Value Measurement Standards and Concepts
◾
Presents an overview of fair value measurement in U.S. GAAP and with cross references
to FASB ASC 820, Fair Value Measurement.
◾
Examines important fair value framework concepts such as the principal or most advantageous market, market participants, the highest and best use for nonfinancial assets,
inputs to fair value measurements, and the fair value hierarchy.
◾
Discussed the application of FASB ASC 825, Financial Instruments, which provides the fair
value option for financial instruments.
◾
Includes an explanation of standards in the valuation profession, including a discussion
of Uniform Standards of Professional Appraisal Practice (USPAP) and International
Valuation Standards (IVS).
◾
Provides, in an appendix, the impact of the Tax Cut and Jobs Act (TCJA) of 2017 on fair
value measurements.
Chapter 3: Business Combinations
◾
Discusses the role merger and acquisition transactions play in our economy, including
trends and pitfalls.
◾
Discusses the development of accounting standards for business combinations.
◾
Covers the requirements of ASC 805, Business Combinations.
◾
Discusses private company alternative accounting under ASU 2014-18.
◾
Provides comprehensive examples.
Chapter 4: The Nature of Goodwill and Intangible Assets
◾
Provides a brief overview of intangible assets and intellectual property, including the
increasingly prominent role these assets contribute to the overall business enterprise
value.
Preface
◾
◾
◾
xv
Touches on the criteria for recognizing goodwill and intangible assets in financial reporting and for estimating their useful lives.
Provides the classification and examples of intangible assets from FASB ASC 805, Business
Combination, as well as many other examples.
Chapter 5: Impairment
◾
Discusses the evolution of testing goodwill for impairment under various accounting
standards.
◾
Includes a description of the alternative accounting for private companies under ASU
2014-02.
◾
Includes a discussion of the “one-step” impairment test under ASU 2017-04, Simplifying
the Test for Goodwill Impairment.
◾
Covers the qualitative goodwill impairment test as well as the challenges of the prior
two-step quantitative impairment test.
◾
Discusses the applicable guidance for testing goodwill, intangible assets, and long-lived
assets for impairment and the order of testing.
◾
Provides insight into the discussion about whether goodwill impairment testing should
be at the equity or enterprise level.
◾
Includes an appendix with a comprehensive example of a valuation specialist’s report prepared for a qualitative goodwill impairment analysis.
Chapter 6: The Cost Approach
◾
Discusses the cost approach to fair value measurement, including the economic basis for
the cost approach, the role of expected economic benefits, and economic obsolescence.
◾
Distinguishes between reproduction cost and replacement cost.
◾
Provides examples for applying the cost approach using historical trending, the unit cost
method and the unit of cost method.
◾
Addresses how taxes and other factors may impact the application of the cost approach.
Chapter 7: The Market Approach
◾
Covers measuring the fair value of an entity using a market approach such as the guideline public company method or the guideline transaction method.
◾
Provides insight to control premiums and synergies under this method.
◾
Discusses the development and application of equity and invested capital multiples.
◾
Covers the application of the market approach to measure the fair value of intangible
assets.
◾
Provides updated examples of use of various techniques under the market approach.
Chapter 8: The Income Approach
◾
Examines the workhorse of valuation methods, the discounted cash flow method, including single-period and multiperiod variations.
xvi
◾
◾
◾
◾
◾ Preface
Provides an in-depth look at the multiperiod excess earnings method, including market
participant assumptions in projected financial information and the role of contributory
assets and their required returns.
Provides examples of other income approach methods used in business combinations,
such as the profit split method and the “with and without” method.
Addresses the weighted average cost of capital and its calculation under the build-up
method and the capital asset pricing model.
Provides updated examples of various valuation techniques under the market approach.
Chapter 9: Advanced Valuation Methods for Measuring the Fair Value of
Intangible Assets
◾
Introduces advanced valuation techniques such as the option-pricing methods, Monte
Carlo simulation, and decision tree analysis.
◾
Discusses real options derived from the ownership rights of intangible assets and how to
measure their fair value.
Chapter 10: The Remaining Useful Life of Intangible Assets
◾
Distinguishes between finite-lived assets and indefinite-lived assets.
◾
Provides factors to consider when measuring the useful lives of intangible assets, including the legal, contractual, and useful lives.
◾
Provides examples of various approaches to calculating the remaining useful lives of
intangible assets.
Chapter 11: Fair Value Measurement of Alternative Investments
◾
Discusses authoritative guidance for determining the fair value measurement of alternative investments, including recent AICPA Technical Practice Aids.
◾
Addresses the practical expedient for investments that calculate net asset value per share.
◾
Distinguishes initial due diligence features of an alternative investment from ongoing
monitoring features.
◾
Discusses the new AICPA Accounting and Valuation Guide, Valuation of Portfolio Company
Investments of Venture Capital and Private Equity Funds and Other Investment Companies.
Chapter 12: Contingent Consideration
◾
Discusses the accounting recognition of earn-outs and other contingent consideration in
business combinations.
◾
Discusses the common ways that earn-out clauses are used to resolve price differences
between buyers and sellers in a business combination.
◾
Provides examples of measuring the fair value of contingent consideration using a
probability-weighted expected return method, the Black-Scholes option pricing model,
and Monte Carlo simulation.
Preface
◾
◾
xvii
An appendix to Chapter 12 explains how to measure the fair value of a loan guarantee
using the Black-Scholes option pricing model and includes a case study example to illustrate the concepts.
Chapter 13: Auditing Fair Value Measurement
◾
Discusses the guidance for auditing fair value measurements in AU 328.
◾
Includes a discussion on the PCAOB’s new auditing standards AS 2501, Auditing Accounting Estimates, Including Fair Value, and AS 1201, Auditor’s Use of a Specialist.
◾
Includes important topics from PCAOB Alert No. 2, including auditing fair value
measurements, classification within the fair value hierarchy, and using the work of a
valuation specialist or a pricing service.
◾
Discusses the PCAOB Alert No. 9, Assessing and Responding to Risk in the Current Economic
Environment.
◾
Appendixes A and B provide examples of issues auditors may consider when auditing
business combinations and one-step goodwill impairment tests.
◾
Appendix C examines the results of PCAOB inspection reports in Acuitas, Inc.’s Survey of
Fair Value Audit Deficiencies.
Chapter 14: Fair Value Measurement Case Study
◾
Provides a new streamlined comprehensive business combination case study with valuation models illustrating the measurement of fair value for intangible assets.
◾
Covers important topics such as the acquisition price, contingent consideration, business
enterprise value, the weighted average cost of capital, identifying intangible assets, goodwill, a bargain purchase, and subsequent testing for impairment of goodwill.
◾
Highlights important case study concepts through a question-and-answer format with
suggested solutions.
As I noted in the preface of the first two editions, some have voiced concerns about the
cost-benefit associated with measuring fair value in financial reporting. However, as reported
by the accounting standard setters and the CFA Institute, the benefits of fair value in financial
reporting are clearly evident. Fair value measurements, however, do require a certain amount
of judgment and expertise. Clearly, there are some challenges. However, the benefits to users of
financial statements that include fair value measurements vastly outweigh those challenges.
Hopefully this third edition will continue to help with those challenges.
MARK L. ZYLA
Atlanta, Georgia
May 2019
xviii
◾ Preface
NOTES
1. Response of the Financial Accounting Standards Board on the Post-Implementation Review of
FAS 157, letter from Russ Golden, Chair of the FASB, to the Financial Accounting Foundation,
dated March 10, 2014.
2. Post-Implementation Review of IFRS 13, Fair Value Measurement, December 2018, www
.ifrs.org.
3. “Summary of CFA Institute Member Surveys,” September 2010, www.cfa.institute.org.
4. “Value Accounting & Long-Term Investing in Europe,” CFA Institute, September 2013, www
.cfainstitute.org.
Acknowledgments
M
O S T I M P O R TA N T LY, I want to thank Lynn Pierson for her assistance with this
book. Without Lynn’s efforts, this third edition as well as the first and second,
would not have been completed with nearly the quality and depth.
Finally, thank you to those who provided comments and suggestions on various aspects
of fair value measurements which were instrumental in preparing this third edition as well
as the first and second, including: Bill Kennedy of Duff & Phelps; Julie Delong of Ankura
Consulting Group LLC; Teresa Thamer of Brenau University; Brian Steen of Dixon Hughes
Goodman LLP; Brent Solomon of the University of Maryland; Tara Marino of the CohnReznick
LLP; Mark Edwards of Grant Thornton International Ltd; Michael Blake of Arpeggio Advisors;
John Lin of McKesson Corporation; Adrian Loud of Censeo Advisors LLC.; Tracy Haas of
Roark Capital Group; Harold Martin, Peter Thacker and Brian Burns of Keiter; Bernard
Pump of Deloitte LLP; Jim Dondero of Andersen; Ellen Larson of FTI Consulting; Steve
Hyden of Washington Partners; David Dufendach of Alverez & Marsal; Ed Ketz of Penn State
University; Neil Beaton of Alvarez & Marsal; Tom Ryan of the Leventhal School of Accounting
at University of Southern California and Professor Mauro Bini of Bocconi University and
Chairman of the Management Board of OIV—Organismo Italiano di Valutazione.
These individuals’ comments, as well as those of many others, were invaluable in my
preparation of this book. Any errors, however, are my own.
xix
1
C H A PTER O NE
The History and Evolution
of Fair Value Accounting
F
A I R VA L U E A C C O U N T I N G has changed the way financial information is pre-
sented. Where once financial statements were based primarily on historical costs,
under certain circumstances, fair value is often the basis of measurement for reporting
for both financial and nonfinancial assets and liabilities. Measuring fair value often requires
experience and judgment, and it has the potential to introduce bias into financial statements.
A trend toward increasing the amount of financial statement information presented or
disclosed at fair value persists under U.S. generally accepted accounting standards (GAAP)
and International Financial Reporting Standards (IFRS). The trend away from historical
costs, which has been the bedrock of traditional accounting, toward fair value accounting
has been challenging for preparers, auditors, standards setters, and regulators.
Fair value accounting is a financial reporting approach that requires or permits entities
to measure and report assets at the price assets would sell and liabilities at the estimated price
that a holder would have to pay in order to discharge the liability. The term fair value accounting not only refers to the initial measurement but can also refer to subsequent changes in fair
value from period to period and the treatment of unrealized gains and losses in the financial
statements. Therefore, fair value accounting affects the reported amounts for assets and liabilities in the balance sheet and affects the reported amounts for unrealized gains or losses
shown in the income statement or in the other comprehensive income section of shareholders’ equity. In financial reporting, fair value accounting is often applied to financial instruments such as investments in stocks, bonds, an entity’s own debt obligations, and derivative
instruments like options, swaps, and futures. When unadjusted or adjusted market prices are
the basis for fair value estimates of financial assets and liabilities, the process is often called
mark-to-market accounting.
1
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
◾ The History and Evolution of Fair Value Accounting
2
Fair value accounting is applicable to nonfinancial assets and liabilities as well, but in
more limited circumstances. For instance, when an entity is acquired in a business combination, all balance sheet assets and liabilities are recorded at fair value. Subsequent to the
acquisition date, fair value is the basis for testing acquired goodwill for impairment. Likewise,
fair value is the benchmark when testing property, plant, and equipment and amortizable
intangible assets for impairment.
Fair value measurement is the process for determining the fair value of financial and nonfinancial assets and liabilities when fair value accounting is required or permitted. Therefore,
fair value measurement is broader than mark-to-market accounting. It encompasses estimating fair value based on market prices as well as estimating fair value using valuation models.
The Financial Accounting Standards Boards (FASB) Accounting Standards Codification (ASC)
820, Fair Value Measurement, provides authoritative guidance for measuring the fair value of
assets, liabilities, and equity interests when fair value accounting is required or permitted in
other accounting standards. The International Accounting Standards Board (IASB) has an
identical standard, IFRS 13, Fair Value Measurements.
Advocates of fair value accounting believe that fair value best represents the financial
position of the entity and provides more relevant information to the users of the financial
information. Detractors believe that fair values are unreliable because they are difficult to estimate. Critics also believe that reporting temporary losses is misleading when they are likely to
reverse, and those critics believe that reported losses adversely affect market prices and market
risk.1 In spite of the criticism, fair value accounting has become more prominent in financial statement presentation and will continue to be a fundamental basis for accounting in the
future.
In December 2018, the IASB published a postimplementation review of IFRS 13, Fair
Value Measurements, which is conducted periodically by both the IASB and the FASB to determine whether accounting standards are working as intended. In a summary of their findings,
the IASB concluded the following:
◾
◾
◾
“The information required by IFRS 13 is useful to users of financial statements.
Some areas of IFRS 13 present implementation challenges, largely in areas requiring
judgment. However, evidence suggests that practice is developing to resolve these
challenges.
No unexpected costs have arisen from application of IFRS 13.2
The IASB further concluded that the findings of the postimplementation review on fair
value measurements should be incorporated into the project about better communication in
financial reporting. The Board also concluded that it needed to better liaise with the valuation
profession, including monitoring new developments with valuation specialists.
WHY THE TREND TOWARD FAIR VALUE ACCOUNTING?
In recent years, there has been an increasing trend toward the use of fair value accounting
in financial reporting. Even when fair value accounting is not required and financial statements are prepared using some other measurement basis, there is a likelihood that related
Why the Trend Toward Fair Value Accounting?
◾
3
disclosures will require the presentation of fair value information. Several factors are influencing the trend toward fair value accounting: the growing economic importance of intellectual
property, globalization, and investors’ desire for financial statements that are more relevant
and transparent.
The Changing Economy
The economy in the United States has undergone tremendous changes over the past
quarter-century due to a rapid rate of technological innovation. The explosion in the use of
personal computers and digital media has created whole industries that did not previously
exist. One product of technological innovation that contributed to economic change is the
commercialization of the Internet, which resulted in what some call the information revolution.
The result of this technological and economic change is that a significant portion of the U.S.
economy shifted from bricks-and-mortar businesses to information-based businesses.
This economic change has led to a growing recognition that the value driver of many
business entities lies within their intellectual property, not just in their inventory, plant, and
equipment. Financial statement users also recognize that intellectual property has not been
effectively measured under traditional cost-based accounting practices. The reason is that
existing accounting principles require internally created intellectual property to be expensed
as research and development.
Ocean Tomo, an intellectual capital merchant banking firm, produces an Annual Study
of Intangible Asset Market Value that breaks down the Standard & Poor (S&P) 500’s equity
market value into an implied intangible asset value and a tangible asset value. In 2015,
tangible and financial assets generated approximately 13 percent of the S&P 500’s market
value. While tangible and financial assets are reflected on company balance sheets, the
remaining 87 percent of value attributable to intangible assets is often not recognized at all.3
The market-to-book ratio for the S&P 500 as of December 31, 2018, was approximately 2.944
This ratio indicates that only about a third of the value of the market capitalization on average
is recognized by current accounting standards. This value gap has increased in recent years,
highlighting the increasing importance of intangible assets (including intellectual property)
in the overall market capitalization of publicly traded companies.
Globalization
The International Monetary Fund defines economic globalization as “a historical process; the
result of human innovation and technological process. It refers to the increasing integration of
economies around the world, particularly through the movement of goods, services and capital across borders.” Globalization has accelerated since the 1980s as a result of technological
advances that made international financial and trading transactions easier and quicker.5 This
increasing globalization of business has created a need for consistent accounting standards
across national boundaries.
The FASB and the IASB recognize that users of financial statements would benefit from
having one set of international accounting standards that could be used for domestic and
international, cross-border financial reporting. As a result, both organizations have been
working for several years to jointly create accounting standards and to converge U.S. GAAP
4
◾ The History and Evolution of Fair Value Accounting
with international accounting standards (IAS). According to the FASB, convergence refers to
both the goal of establishing a single set of high-quality international accounting standards
and the path taken to reach that goal, which includes the collaborative efforts “to improve
existing U.S. GAAP and International Financial Standards and eliminate the differences
between them.”6 Historically, IAS have been more principal based, requiring more fair value
measurement than U.S. GAAP, which are considered more rules based, requiring more
cost-based measurement. As the accounting standards converge, U.S. GAAP is requiring
more fair value accounting measures.
The history and evolution of fair value measurement encompasses the recent convergence of U.S. GAAP and IAS pertaining to fair value measurement. The five-year joint FASB
and IASB project was undertaken to improve and align fair value measurement and disclosure
requirements and to respond to the global financial crisis.7 As originally promulgated, the
FASB’s Statement of Financial Accounting Standards (SFAS) 157, Fair Value Measurements and
Disclosures, influenced the development of International Financial Reporting Standard (IFRS)
13, Fair Value Measurement. Convergence has shaped U.S. accounting standards through
updates to FASB ASC 820. The FASB’s Accounting Standards Update (ASU) 2011-04,
Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S.
GAAP and IFRS, which was issued in May 2011, eliminated most of the significant remaining
differences between U.S. and international accounting standards for measuring fair value.
The move and subsequent halting of the Convergence Project as it pertains to fair value
measurements is discussed in greater detail in this chapter.
Relevance and Transparency
An important characteristic of efficient capital markets is that prices are the result of the
market’s correct assessment of all available information. The FASB recognizes that better
financial reporting leads to stronger capital markets by helping investors make informed
decisions. One of the FASB’s stated goals is “to set accounting standards that produce financial
information useful in helping investors decide whether to provide resources to a company,
and whether the management of that company has made good use of the resources it
already has.”8
In an effort to make financial reporting more relevant to investors, the FASB has encouraged investors to participate in the accounting standards process by providing comments on
discussion papers and exposure drafts that are issued at various stages of the FASB’s projects.
The FASB has asked interested investors to provide expert advice to the FASB’s designated “investor liaison” staff members in conjunction with FASB projects. The goal is to improve the
relevance of accounting standards for investors in a cost-effective manner.
Two other investor advisory groups provide input to the FASB from the investor perspective, the Investors Technical Advisory Committee (ITAC) and the Investor Task Force (ITF).
The ITAC is focused on providing technical accounting advice and increasing investor participation in standard setting.9 The ITF is made up of institutional asset managers who analyze various sectors of the economy. The ITF provides advice to the FASB about the impact of
various accounting standards proposals on specific industry sectors.10
History and Evolution of Fair Value
◾
5
The Securities and Exchange Commission (SEC) is equally committed to advancing high
quality accounting standards that are responsive to investors’ needs. In testimony before a
Congressional subcommittee, SEC Director John M. White said,
An open process that allows standards setters to seek and thoughtfully consider the
views of market participants is critical to establishing, maintaining, and continually improving financial accounting and reporting standards. We are committed to
high quality accounting standards and a transparent financial reporting system that
meets the needs of investors and other market participants.11
Transparency in financial reporting is the unbiased, clear, complete presentation of
a company’s financial position. Information in the management discussion and analysis
(MD&A) section of the financial statements about existing risk and uncertainty and about
the likely future impact of risk and uncertainty on the company’s prospects further promotes
transparency. When financial reporting is transparent, investors are better able to make
decisions and avoid surprises. On a macroeconomic scale, transparency leads to more
efficient allocation of capital and stronger capital markets. In the aftermath of the economic
crisis, there was a debate about whether fair value accounting promoted financial statement
transparency or whether it caused the meltdown. In a 2008 report to Congress, the SEC found
that “investors generally believe that fair value accounting increases financial reporting
transparency and facilitates better investment decision-making.”12 The CFA Center for
Financial Market Integrity concurs with the SEC’s view. It supports fair value as “the most
transparent measurement for investors to analyze financial statements,” and it said, “fair
value is being used as a scapegoat by corporations who have made poor decisions or were not
in compliance with accounting standards.”13
The financial crisis has presented a challenge and an opportunity for the SEC and the
FASB to reaffirm their missions and assess their success in achieving their goals. The SEC’s
mission is to “protect investors, provide for efficient markets, and to facilitate capital formation.”14 The FASB’s mission is “to establish and improve standards of financial accounting
and reporting that foster financial reporting by nongovernmental entities that provides
decision-useful information to investors and other users of financial reports.”15 The SEC and
the FASB have renewed their efforts to ensure greater transparency in financial reporting
and its relevance to investors since the financial crisis began and are likely to continue to do
so for the foreseeable future.
HISTORY AND EVOLUTION OF FAIR VALUE
The FASB’s Accounting Standards Codification (ASC) is the single, authoritative source for
U.S. GAAP today. ASC superseded all previously issued U.S. GAAP accounting standards and
reorganized them by topic. ASC became effective for interim and annual period beginning after
September 15, 2009.16 ASC 820, Fair Value Measurement (ASC 820), superseded the original
FASB accounting standard SFAS 157 that was issued in 2006. In addition, any FASB Staff
Positions that amended SFAS 157 have also been superseded by ASC 820. FASB Accounting
6
◾ The History and Evolution of Fair Value Accounting
Standards Updates are included in the Codification once they reach their effective date. Those
that have not reached their effective date are presented in separate “pending content” sections,
adjacent to the subtopic they will replace. ASU 2011-04, Amendments to Achieve Common Fair
Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS, is effective for all entities with reporting periods beginning after December 15, 2011. Since this discussion in this
section pertains to the history of fair value measurements, the references are as the standards
were originally presented under GAAP, much of which has now been codified under the ASC.
Fair value accounting is not a new requirement in financial reporting. Fair value has been
a standard of measurement in financial reporting for decades. The FASB has issued dozens of
statements that use fair value as the measurement of value. The concept of value contained
in these statements is from a market perspective, not from the perspective of the reporting
entity. Therefore, measuring fair value requires financial statement preparers to use judgment and to make assumptions consistent with those made by other market participants. The
FASB has also issued a few statements with fair value–like measurement standards such as
FASB ASC 718, Compensation—Stock Compensation. The main difference between these two
measurement standards is that the fair value–like measurement standard does not incorporate an exit price assumption and fair value does. The assumptions underlying the fair value
measurement framework of ASC 820 are covered in Chapter 2.
In September 2006, the FASB issued SFAS 157 (now codified as ASC 820) to clarify the
concepts related to the measurement of fair value and to provide further implementation
guidance.17 According to the FASB, the reason for issuing SFAS 157 was to define fair
value, establish a framework for measuring fair value, and expand disclosure about fair
value measurements.18 SFAS 157 did not introduce any new accounting requirements.
Instead, it applied to all existing accounting statements that require assets or liabilities to be
presented or disclosed in financial statements at fair value. As originally promulgated, the
FASB intended SFAS 157 to provide one uniform statement under which the concept of fair
value would be more fully explained.
When it was originally issued, SFAS 157 became a source of controversy in the United
States. The banking industry was particularly vocal in its objections to mark-to-market
accounting. Many criticized its application to liabilities, and preparers felt they needed more
guidance to apply the Statement to nonfinancial assets and liabilities. In response to pressures
from financial statement preparers and other constituents, the FASB announced that it would
delay implementation for nonfinancial assets and liabilities for one year. The announcement
came a few days before the Statement’s original scheduled implementation date. The reason
cited by the FASB for the partial implementation was “to allow the Board and constituents
additional time to consider the effect of various implementation issues that have arisen, or
that may arise, from the application of Statement 157.”19
Even the partial implementation did not allay all the controversy. Some critics of fair value
accounting claimed that the credit crisis that began in 2008 was exacerbated by financial
institutions’ implementation of SFAS 157. The Statement became fully effective for fiscal years
beginning after November 15, 2008, for all items, including financial and nonfinancial assets
and liabilities required under existing statements to be measured at fair value.
In order to better understand fair value measurement, this section covers the history and
evolution of fair value measurement in financial reporting. It begins with a historical look
History and Evolution of Fair Value
◾
7
back at the development of fair value concepts. Then it covers some of the more important
milestones related to the development of fair value for financial instruments and fair value
measurement for nonfinancial assets and liabilities. The economic crisis shaped fair value
measurement and led to the refinement of several accounting standards and concepts as regulators and standards setters responded to the crisis. Convergence of U.S. GAAP and IAS has
also shaped fair value measurement concepts. Finally, this section ends by discussing some
trends that are likely to influence the future of fair value measurement.
Development of Fair Value Concepts
The concept of fair value has been evolving for over a century. In an 1898 U.S. Supreme Court
case about railroad rate regulation, Smyth v. Ames, the Court discussed some of the concepts
underlying fair value by saying:
In order to ascertain that value, the original cost of constructions, the amount
expended in permanent improvements, the amount and market value of its stocks
and bonds, the present as compared to the original cost of construction, the probable
earning capacity of the property under particular rates prescribed by statute, and
the sum required to meet operating expenses, are all matters for consideration,
and are to be given such weight as may be just and right in each case. We do not
say that there may not be other matters to be regarded in estimating the value of
the property.20
This reference to fair value alludes to several fair value measurement concepts that
are currently in use, such as a cost approach, a market approach, economic value, and the
application of judgment to weigh the various indications of value.
The FASB initially considered adopting the same definition of fair market value used for tax
reporting requirements, and using it to describe fair value in financial reporting. However,
the FASB ultimately decided on a unique definition for fair value; therefore, the terms fair value
and fair market value are not interchangeable. The fair market value definition found in the
International Glossary of Business Valuation Terms is the same as the tax definition of fair market
value in Revenue Ruling 59-60, which states that it is
the price, expressed in terms of cash equivalents, at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and
able seller, acting at arm’s length in an open and unrestricted market, when neither
is under compulsion to buy or sell and when both have reasonable knowledge of the
relevant facts.21
Fair market value is the standard of value in all federal and state tax matters. It is often used to
value ownership interests in entities, which is consistent with its transaction-based definition.
The term fair market value has a significant body of interpretive case law, which was the primary reason the FASB decided to adopt a different standard of value with a specific definition
for financial reporting.22
Fair value is the standard for financial reporting purposes. Fair value is defined in the FASB
Master Glossary as “the price that would be received to sell an asset or paid to transfer a liability
in an orderly transaction between market participants at the measurement date.”23
8
◾ The History and Evolution of Fair Value Accounting
Although fair market value has a rich history with respect to legal and tax matters, the
application of fair value to financial reporting is a relatively new development. This section
looks at the development of fair value concepts in financial accounting standards from a
historical perspective.
One of the first accounting statements requiring the use of fair value in financial reporting
was Accounting Principles Board (APB) 18, The Equity Method of Accounting for Investments in
Common Stock, which was issued in 1971. APB 18 introduced the equity method of accounting for investments in unconsolidated subsidiaries. Under APB 18, a loss would be recognized
when the investment’s fair value declined below its carrying value and the loss was considered
to be other than temporary.24
APB 29, Accounting for Nonmonetary Transactions, introduced in 1973, outlined ways to
measure the fair value of nonmonetary transactions. It indicates that the fair value of a nonmonetary transaction should be determined by referring to cash transactions for the same or
similar assets, quoted market prices, independent appraisals, and the estimated fair value of
the asset or service received. Any determination of fair value using these methods would also
have to consider whether the estimated value would be realized.25
In 1977, SFAS 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings,
established some important fair value concepts. SFAS 15 specifies that fair value is the amount
determined through a current sale between a willing buyer and a willing seller, other than in
a forced or liquidation sale. It also states,
Fair value of assets shall be measured by their market value if an active market for
them exists. If no active market exists for the assets transferred but exists for similar
assets, the selling prices in that market may be helpful in estimating the fair value of
the assets transferred. If no market price is available, a forecast of expected cash flows
may aid in estimating the fair value of assets transferred, provided the expected cash
flows are discounted at a rate commensurate with the risk involved.26
SFAS 15 established several important criteria for using a market approach and established
the use of a discounted cash flow method for measuring fair value. These important concepts
persist in financial reporting today.
Fair Value of Financial Instruments
The FASB has issued several accounting standards that apply to financial instruments including derivatives. One of the first was SFAS 2, Accounting for Certain Marketable Securities. Issued
in 1975, SFAS 2 required that marketable securities be carried at the lower of cost or market
value. It also established the practice of recording changes in the market value of an entity’s
noncurrent asset portfolio in a separate component of equity. Therefore, it permitted unrealized losses to bypass the income statement.
In 1991, SFAS 107, Disclosures About Fair Value in Financial Instruments, required the fair
value disclosure of an entity’s financial instruments. The requirement included all financial
assets and liabilities, whether recorded or unrecorded in the financial statements.27
SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, was introduced in 1993. It established three categories of investment securities: held-to-maturity
History and Evolution of Fair Value
◾
9
debt securities, trading securities, and available-for-sale securities. SFAS 115 also requires fair
value as the standard of measurement for debt and equity securities classified as either trading
or available-for-sale. Unrealized changes in the fair value of trading securities are recognized
in earnings, whereas the unrealized changes in the fair value of available-for-sale securities
are excluded from earnings and reported in a separate component of shareholders equity.28
In 1994, the FASB issued SFAS 119, Disclosure About Derivative Financial Instruments and
Fair Value of Financial Instruments. It required entities that hold or issue derivative financial
instruments for trading purposes to disclose the average fair value of those instruments. SFAS
119 also required that fair value information be presented without combining, aggregating,
or netting the fair value of derivative financial instruments with the fair value of nonderivative
financial instruments.29
In 2000 the FASB introduced FAS 133, Accounting for Derivative Instruments and Hedging
Activities, which required fair value as the measurement for derivative securities. The accounting treatment for changes in the fair value of derivative instruments depends on their classification as a fair value hedge, a cash flow hedge, a foreign currency hedge, or a derivative
instrument not designated as a hedging instrument.30
With the issuance of SFAS 159, The Fair Value Option for Financial Assets and Financial
Liabilities, in 2007, the FASB expanded fair value measurements for financial instruments,
which was consistent with the Board’s long-term accounting measurement objectives for
financial instruments. The FASB noted in the implementation guidance for SFAS 159 that
the objective of the Statement is to improve financial reporting, “by providing entities with
the opportunity to mitigate volatility in reported earnings caused by measuring related assets
and liabilities differently without having to apply complex hedge accounting provisions.”31
SFAS 159 permits entities to choose whether to measure financial assets and liabilities at
fair value or whether to retain their current basis of measurement; therefore the fair value
option is an election. It can be applied on an instrument-by-instrument basis, and there is no
requirement to apply it to all financial assets or liabilities. Once an election is made to measure an instrument at its fair value under SFAS 159, the election is irrevocable (unless a new
election date occurs). The financial instruments covered by the Statement are fairly broad.
The majority of entities electing the fair value option under SFAS 159 are in the financial services industry, primarily commercial and investment banks.
A business entity electing the fair value option under SFAS 159 is required to report unrealized gains and losses resulting from changes in fair value in earnings at each subsequent
reporting date. SFAS 159 was superseded by FASB ASC 825, Financial Instruments.
Fair Value Measurement for Nonfinancial Assets and Liabilities
During the technology boom in the late 1990s brought on by the initial commercialization
of the Internet, the FASB began a project to update APB 16, Business Combinations. The FASB
observed that during the 1990s, much of the economic value in mergers and acquisitions was
driven by technology and other intangible assets owned by the acquired company. Yet these
valuable assets were not being fairly presented in the financial statements because under APB
16, much of the value of the acquired entity was reported on the balance sheet as goodwill.
And under accounting rules at that time, goodwill could be amortized for up to 40 years.
10
◾ The History and Evolution of Fair Value Accounting
The FASB concluded that purchase price allocation to acquired assets and liabilities under
APB 16 did not fairly represent the economic substance of business combinations, and that
financial statements were not being fairly presented. The Board also concluded that companies had too much leeway in reporting the value of acquired intangible assets. As a result, the
FASB made sweeping changes to the accounting standards for business combinations.
On June 29, 2001, the FASB issued SFAS 141, Business Combinations, which was superseded by SFAS 141 (Revised), Business Combinations (SFAS 141(R)), about six years later as
a result of a joint FASB /IASB project. One of the first steps in the FASB and IASB project to
converge U.S. GAAP with international accounting standards was to harmonize the accounting standards for business combinations; therefore, the FASB revised SFAS 141. The Boards
issued common Exposure Drafts, which became SFAS 141(R) and IFRS 3, Business Combinations. The accounting standard for business combinations is now codified in FASB ASC 805,
Business Combinations, and will be covered in greater detail in Chapter 3.
When it was originally issued in December 2007, SFAS 141(R) introduced the acquisition method, which is based on determining the fair value of all acquired assets and liabilities.
The fair values of identifiable acquired assets and liabilities in total may or may not equal the
purchase price. When the fair value of all identifiable acquired assets and liabilities is less than
the purchase price, the difference represents goodwill. If the fair value of all acquired assets
and liabilities is more than the purchase price, a bargain purchase would be indicated.
SFAS 141(R) contains the requirements for the initial recognition of goodwill and other
intangible assets in business combinations. The Statement also indicates that SFAS 142,
Goodwill and Other Intangible Assets, provides guidance for the subsequent testing of goodwill
for impairment and that SFAS 144, Testing for Impairment of Long-Lived Assets, provides
guidance the subsequent impairment testing for intangible assets subject to amortization.
Accounting standards for the subsequent treatment of goodwill and other intangible assets
recognized in a business combination are currently codified in ASC 350, Intangibles—Goodwill
and Other, and ASC 360, Property, Plant and Equipment.
In 2001, The FASB issued SFAS 142, which provides guidance on determining whether
goodwill recorded in a business combination becomes impaired in subsequent years, and it
sets forth the requirements for the impairment testing. Under SFAS 142, goodwill is tested
for impairment annually using a two-step test. The first step is to estimate the fair value of
the entity or reporting unit by comparing the fair value to its carrying value (book value).
If the fair value is greater than book value, goodwill is not impaired. If the fair value is less than
the carrying value, goodwill may be impaired, and a second step is required.
The second step is to estimate the fair values of all the assets and liabilities of the entity
or reporting unit as of the testing date, including the implied fair value of goodwill. This step
is similar to the allocation of purchase price under SFAS 141(R). The implied fair value of
goodwill is then compared to the carrying value of the goodwill. If the fair value of goodwill
is less than the carrying value of goodwill, it is considered to be impaired, and the difference
must be written off. More recently, the FASB introduced a qualitative impairment test, dubbed
“step zero” in Accounting Standards Update 2011-08, which is covered in Chapter 5.
The application of fair value measurements to nonfinancial assets and liabilities is most
often seen in practice in SFAS 141(R), now FASB ASC 805, Business Combinations, and
SFAS 142, now FASB ASC 350, Intangibles—Goodwill and Other. Since these statements were
History and Evolution of Fair Value
◾
11
introduced, the FASB has issued clarifications and updates, which are covered in subsequent
sections of this chapter, in response to the economic crisis and constituent concerns. In addition, both the accounting profession and the valuation profession have begun projects to
determine the best practices for the application of fair value measurements. Many of these
projects have taken years to develop and some are still in progress. They are also discussed in
later chapters of this book.
Fair Value Measurement
Fair value measurement is discussed from a historical perspective further on in this chapter;
the chapter discusses the original issuance of SFAS 157 and it covers the subsequent
amendments contained in FASB Staff Positions and Accounting Standards Updates. The next
chapter, Chapter 2, “Fair Value Framework from ASC 820,” will cover the more important
concepts and assumptions for measuring fair value. The chapter will follow ASC 820’s
contents’ sequence and it will provide full references to codification subtopics. In addition,
definitions from the FASB’s Master Glossary will be provided for quick reference.
Prior to the implementation of SFAS 157 the application of fair value measurements in
financial reporting varied among three dozen or more of the pronouncements that required a
fair value measurement. These statements referred to different accounting concepts, so over
time inconsistencies developed in applying fair value measurements under different statements. With the introduction of SFAS 141 and SFAS 142, some of the more common applications of fair value measurements were in business combinations and the subsequent testing
of goodwill and other long-lived assets. These statements required the fair value measurements of assets that were not readily measureable by the marketplace. Preparers of financial statements were concerned about measuring fair value in the absence of quoted market
prices. SFAS 157 established a framework for applying fair value measurements. The FASB
believed that the implementation of SFAS 157 would improve financial reporting by increasing
consistency, reliability, and comparability.
When originally issued, SFAS 157 defined fair value as “the price that would be received to
sell an asset or paid to transfer a liability in an orderly transaction between market participants
at the measurement date.”32 Fair value measurement assumes that the asset or liability can be
exchanged in an orderly transaction between market participants who wish to sell the asset or
transfer the liability at the measurement date. Fair value measurements arise from an orderly
transaction, or one in which there has been exposure to the market for a sufficient period prior
to the measurement date to allow for the usual and customary marketing activities for such
assets or liabilities. An orderly transaction is not a forced transaction, such as a forced liquidation or a distress sale.33 By definition a nonactive market is not an orderly market or one in
which there is sufficient exposure to the market for usual and customary marketing activities.
Thus, a price indicated in a nonactive or illiquid market would likely not be an indication of
fair value. SFAS 157 introduced or expanded upon several important topics, as it
◾
◾
◾
Revised definition of fair value
Discussed the issue of price in the measurement
Defined market participants
12
◾
◾
◾
◾
◾
◾ The History and Evolution of Fair Value Accounting
Expanded on the concept of principal market or most advantageous market
Introduced the concept of defensive value
Described valuation technique
Introduced the fair value hierarchy
Expanded required disclosures
These concepts, as updated for convergence with IFRS, are discussed more fully in Chapter 2.
As previously mentioned, SFAS 157’s full implementation was delayed by the FASB. SFAS
157 was originally supposed to be effective for fiscal years beginning after November 15, 2007.
However, on November 12, 2008, a few days before the statement was to become fully effective, the FASB delayed implementation for nonfinancial assets and liabilities.34 These nonfinancial assets and liabilities are related to goodwill, business combinations, and discontinued
operations, as well as to some nonfinancial intangible assets. One of the reasons for delay was
that preparers of financial statements felt they did not fully understand the implications for
the statement’s implementation.
The statement was fully implemented for fiscal years beginning after November 15, 2008.
Although the FASB agreed to adopt the one-year delay, it encouraged the earlier adoption.
FAIR VALUE ACCOUNTING AND THE ECONOMIC CRISIS
Beginning in the latter part of 2006, an increase in the general level of interest rates caused a
sharp rise in the delinquency and default rates by subprime rate mortgage borrowers. Most
of the underlying subprime mortgages were based on adjustable rates. As interest rose, many
borrowers were unable to make the higher interest payments on their mortgages. As a result,
the default rates in subprime mortgages increased dramatically. The rise in interest rates
also contributed significantly to a decline in the overall housing market, which compounded
the impact of the defaults caused by limited options for sale of the underlying real estate by
the defaulter.
As an increasing number of subprime mortgage borrowers began to default, many financial institutions and investment banks holding mortgage-backed securities based on subprime
mortgages began to experience uncertainty about the reliability of cash flows from these
investments, which further eroded their perceived value. As the level of defaults increased,
rating agencies significantly downgraded these subprime mortgage securities. The downgrades caused other investors and lenders to refrain from investing in mortgage-backed
securities. The lack of a secondary market created a “liquidity crisis,” which began to spread
throughout the financial markets. The risk of defaults in the underlying mortgages caused
the secondary markets for securitized mortgages to freeze, which impacted a wide range of
commercial and investment banks that held these securities.
Mark-to-Market Accounting
At the center of this liquidity crisis was an accounting issue: How should the holders of
mortgage securities measure the value of these debt securities for financial reporting?
To complicate matters, many of the entities had already elected the Fair Value Option provided
by SFAS 159, which permitted entities to measure most financial assets and liabilities at their
Fair Value Accounting and the Economic Crisis
◾
13
respective fair values in fiscal years beginning after November 15, 2007. The Fair Value Option
incorporates the definition of fair value as presented in SFAS 157, which includes features
such as the fair value hierarchy, market participant assumptions, and the preference for
observable inputs.
Among the accounting questions at the center of the financial crisis were these two: What
is the fair value of the securitized subprime mortgages that financial institutions and other
entities should report on their balance sheet? When the market is considered distressed, what
is the appropriate level for disclosure in the fair value hierarchy?
Critics of fair value measurement believed that the credit crisis was made much greater
by the mark-to-market accounting of financial institutions that had invested in the securitized subprime debt. The criticism of fair value accounting was based on an apparent difference between the market value of certain securities in distressed markets and the value
indicated by holding the securities to maturity. The central issue was whether the fair value
of these securities would be the depressed price indicated by the market or the value indicated by the securities’ expected future cash flows discounted to the present at a risk-adjusted
rate of return.
Many called for suspension or revision of SFAS 157 during the economic crisis. However, the Center for Audit Quality reaffirmed its position on the relevance of fair value
measurements, saying,
Suspending fair value accounting during these challenging economic times would
deprive investors of critical financial information when it is needed most. Investors
have a right to know the current value of an investment, even if the investment is
falling short of past or future expectations.35
Application of Fair Value Accounting in Illiquid Market
In response to widespread public criticism of mark-to-market accounting, the SEC Office of the
Chief Accountant and FASB Staff released a statement entitled “Clarifications on Fair Value
Accounting” on September 30, 2008.36 The statement responded to several questions raised
by the credit crisis:
◾
◾
Can management’s internal assumptions (e.g., expected cash flows) be used to measure
fair value when relevant market evidence does not exist?
Yes. When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and
include appropriate risk premiums, is acceptable.
Are transactions that are determined to be disorderly representative of fair value? When
is a distressed (disorderly) sale indicative of fair value?
The results of disorderly transactions are not determinative when measuring fair
value. The concept of a fair value measurement assumes an orderly transaction between
market participants. An orderly transaction is one that involves market participants that
are willing to transact and allows for adequate exposure to the market. Distressed or
forced liquidation sales are not orderly transactions, and thus the fact that a transaction
is distressed or forced should be considered when weighing the available evidence.
Determining whether a particular transaction is forced or disorderly requires judgment.
14
◾
◾ The History and Evolution of Fair Value Accounting
Can transactions in an inactive market affect fair value measurements?
Yes. A quoted market price in an active market for the identical asset is most representative of fair value and thus is required to be used (generally without adjustment).
Transactions in inactive markets may be inputs when measuring fair value, but would
likely not be determinative.
On October 10, 2008, the FASB followed the SEC’s lead and issued FASB Staff Position
157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not
Active, which further clarified assumptions to be used in measuring fair value in circumstances
where there may not be a market price. FSP 157-3 reinforced the fair value measurement concepts introduced by SFAS 157 and reinforced the guidance contained in the SEC’s and FASB’s
joint statement clarifying fair value accounting. Its main points include:
◾
◾
◾
Determining fair value in a dislocated market depends on the facts and circumstances
and may require the use of significant judgment about whether individual transactions
are forced liquidations or distressed sales.
The use of the reporting entity’s own assumptions about future cash flows and appropriately risk-adjusted discount rates is acceptable when relevant observable inputs are not
available.
Broker (or pricing service) quotes may be an appropriate input when measuring fair
value but are not necessarily determinative if an active market does not exist for the
financial assets.37
FSP 157-3 was superseded approximately six months later by FSP 157-4, which was one
of the FASB’s Credit Crisis Projects which is covered after the following section.
SEC Study on Mark-to-Market Accounting
The Emergency Stabilization Act of 2008 required the SEC to conduct a study on
mark-to-market accounting and to focus on the provisions of SFAS 157 that apply to
financial institutions. Section 133 of the Act called for a study that would specifically
consider:
◾
◾
◾
◾
◾
◾
The effects of fair value accounting standards on a financial institution’s balance sheet
The impacts of fair value accounting on bank failures in 2008
The impact of fair value standards on the quality of financial information available to
investors
The process used by the FASB in developing accounting standards
The advisability and feasibility of modifications to fair value standards
Alternative accounting standards to those provided in SFAS 157
On December 30, 2008, the SEC’s Office of the Chief Accountant and Division of Corporate Finance delivered a report to Congress recommending against the suspension of fair value
accounting standards. Among key findings, the report notes that investors generally believe
Fair Value Accounting and the Economic Crisis
◾
15
fair value accounting increases financial reporting transparency and facilitates better decision
making. The report also observes that fair value accounting did not appear to play a meaningful role in the bank failures that occurred in 2008. Rather, the report indicated that bank
failures in the United States appeared to be the result to growing credit losses, concerns about
asset quality, and, in certain cases, eroding lender and investor confidence.38
The SEC study on mark-to-market accounting suggested that “additional measures
should be taken to improve the application and practice related to existing fair value requirements.” The SEC study also recommended, “fair value requirements should be improved
through development of application and best practices guidance for determining fair value in
illiquid or inactive markets.”39
The FASB’s Credit Crisis Projects
The FASB added a new project to its agenda in February 2009, in response to the recommendations contained in the SEC study on mark-to-market accounting and based on input from
the FASB’s Valuation Resource Group. The project was intended to improve the application
guidance used to determine fair values and disclosures for fair value estimates. This project
initiative evolved into what the FASB refers to as the Credit Crisis Projects, which include:
◾
◾
◾
FSP 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or
Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly, provided additional guidance for measuring fair value in turbulent markets. It was issued in
April 2009 in an expedited standards-setting process and in response to pressure from the
SEC. The guidance provided by this FASB Staff Position emphasized that the objective of
a fair value measurement is to determine the price that would be received when selling
the asset in an orderly transaction between market participants under current market
conditions. Under FSP 157-4, the preparer first must conclude whether there has been a
significant decrease in the level of volume and activity in the market. If so, the preparer
must then determine whether the transaction is orderly. Prices from orderly transactions
must be considered in the fair value measurement; although adjustments to the price may
be appropriate. If the transaction is not orderly, little weight should be placed on the price
when determining fair value. FSP 157-4 has been incorporated into FASB ASC 820 and
its requirements are covered in more detail in Chapter 2.
FSP 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments, provided the criteria that indicate when a debt security is permanently impaired,
and it contained new provisions for the recognition of the impairment. This expedited
standard was issued simultaneously with FSP 157-4 in April 2009. Current guidance
is available at FASB ASC 320, Investments—Debt and Equity Securities, at 320-10-35-17
to 30.
FSP 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments,
improved the transparency and quality of fair value disclosures and introduced new
requirements for disclosures in interim financial statements. This expedited standard
was also issued in April 2009 and is discussed further in the next section. FSP 107-1 has
been superseded. Current guidance is available at FASB ASC 320, Investments—Debt and
Equity Securities, in the Disclosure subtopic at 320-10-50.
16
◾
◾
◾
◾ The History and Evolution of Fair Value Accounting
ASU 2009-05, Measuring Liabilities at Fair Value, was originally proposed as FSP FAS
157-c, and then as FSP FAS 157-f. This credit crisis issue received a significant amount
of attention and public comment. It addresses one of the more contentious aspects of
fair value measurement—namely, its application to liabilities. The requirements of ASU
2009-05 have been incorporated into ASC 820 and are discussed in Chapter 2.
ASU 2009-12, Investments in Certain Entities that Calculate Net Asset Value per Share (or Its
Equivalent), is discussed in Chapter 11, “Fair Value Measurements of Private Equity and
Other Alternative Investments.”
ASU 2010-06, Improving Fair Value Measurements Disclosures, was issued to improve transparency and to provide more information about the inputs to fair value measurements.
The improvements will be included in the Disclosures section of Chapter 2, “Fair Value
Measurement Standards and Concepts” from ASC 820.
A final credit crisis project with relevance to fair value measurement was Recoveries of
Other-Than-Temporary Impairments (Reversals). The FASB decided to consider whether to
allow an entity to recover, through earnings, a previously recognized other-than-temporary
impairment loss on certain financial instruments. The Board decided to consider this topic
through its work on the joint FASB/IASB project Financial Instruments: Improvement
to Recognition and Measurement.40 The FASB recently issued ASU 2018-03, Technical
Corrections and Improvements to Financial Instruments—Overall, to provide clarification on a
number of issues related to fair value measurement of financial instruments.41
Financial Crisis Advisory Group (FCAG)
In response to the financial crisis, the FASB and IASB formed a Financial Crisis Advisory
Group in early 2009. The group is comprised of senior business leaders both within and outside the accounting profession with broad experience with international financial markets.
The purpose of the group is to advise both boards about standard-setting implications of:
◾
◾
The global financial crisis
Potential changes to the global regulatory environment42
The mission of the group is to provide recommendations to enhance transparency and
reduce complexity in financial reporting in an effort to serve the financial markets and
restore investor confidence in those markets. The group conducted several advisory meetings
throughout 2009 and 2010 to address:
◾
◾
◾
Areas in which financial reporting helped identify issues of concern, or may have created
unnecessary concerns during the credit crisis
Areas in which financial reporting standards could have provided more transparency to
help anticipate the crisis or respond to the crisis more quickly
Whether priorities for the IASB and the FASB should be reconsidered in light of the
credit crisis
The FASB and IASB Convergence Project
◾
◾
◾
◾
◾
◾
◾
17
Potential areas that require future attention of the IASB and the FASB to avoid future
market disruption
The implications of the credit crisis for the interaction between general purpose financial reporting requirements for capital markets and regulatory reporting, particularly for
financial institutions
The relationship between fair value and off-balance-sheet accounting and the current
crisis, both during and leading up to the crisis
The findings and relevance of conclusions of various studies underway, including the U.S.
Securities and Exchange Commission study under the Emergency Economic Stabilization
Act of 2008
The need for due process for accounting standard setters and its implications on resolving
emergency issues on a timely and inclusive basis
The independence of accounting standard setters and governmental actions to the global
financial crisis43
The Group published its recommendations on July 28, 2009. The report is organized
into four main principles, and contains recommendations to improve the functioning and
effectiveness of global standard setting. In his comments about the report, Hans Hoogervorst,
the Co-Chairman of the FCAG, emphasized the importance of broadly accepted accounting
standards that are the result of thorough due process. He said, “The report highlights the
importance but also the limits of financial reporting. Accounting was not the root cause of
the financial crisis, but it has an important role to play in its resolution.”44
THE FASB AND IASB CONVERGENCE PROJECT
For some time, the FASB and IASB (or the “Boards”) have recognized the need for “a single set of high-quality, international accounting standards that companies worldwide would
use for both domestic and cross-border financial reporting.”45 With increasing global economic activity, it was believed that a single set of international accounting standards were
needed to support healthy global capital markets and meet the needs of investors worldwide.
The FASB and IASB had been jointly working on a project to converge U.S. GAAP with IAS
since 2002. Although the Convergence Project was eventually halted due to many outside
factors, the Project did lead to the convergence of standards related to fair value measurement
and business combinations. In addition, the Boards discussed issues related to convergence of
standards on impairments. Since the Convergence Project impacted Fair Value Measurements
under both GAAP and IFRS, it is helpful to understand the milestones.
At a September 2002 meeting in Norwalk, Connecticut, the FASB and IASB agreed
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 work program to ensure
that once achieved, compatibility is maintained.”46 The project has become known as the
Convergence Project.
18
◾ The History and Evolution of Fair Value Accounting
In February 2006, the Boards issued what has become known as a Memorandum of
Understanding (MoU). The MoU was based on three joint principles:
◾
◾
◾
Convergence of accounting standards can best be achieved through the development of
high-quality, common standards over time.
Trying to eliminate differences between two standards that are in need of significant
improvement is not the best use of the FASB’s and the IASB’s resources—instead, a new
common standard should be developed that improves the financial information reported
to investors.
Serving the needs of investors means that the Boards should seek convergence by replacing standards in need of improvement with jointly developed new standards.47
The 2006 MoU also prioritized the joint work into three groups: (1) short-term convergence projects, (2) active agenda projects, and (3) future convergence projects. The
short-term convergence projects focused on eliminating a few major differences between
U.S. GAAP and IFRS and each of the Boards focused on topics regarded as candidates for
improvement. While the FASB examined the fair value option, research and development,
and subsequent events, the IASB examined borrowing costs, joint ventures and segment
reporting, as well as other topics. The FASB and IASB also planned to work jointly to improve
current accounting practices. The active agenda projects included seven projects the Boards
were already working on: business combinations, consolidations, fair value measurement,
distinguishing liabilities and equity, performance reporting, post-retirement benefits, and revenue recognition. The final group included the Boards’ future agenda projects: derecognition,
financial instruments, intangible assets, and leases.48
A significant milestone was achieved by the Boards in 2007 with the first issuance of a
joint standard entitled Business Combinations. Although they are not perfectly identical, SFAS
141(R) and IFRS 3 provide similar guidance for the application of the acquisition method to
business combinations. The Boards’ guidance reflects concurrence on the more significant
issues relating to accounting for business combinations. Codified in ASC 805, SFAS 141(R)
strengthened the fair value measurement focus when accounting for a merger or acquisition. ASC 805 is perhaps the most significant accounting standard requiring fair value
measurement for nonfinancial assets and liabilities, and it is a primary focus of this book. The
application of ASC 820 concepts to business combinations will be discussed in more depth
in Chapter 3, “Business Combinations,” and will be illustrated throughout the remainder
of the book.
In April 2008, the Boards updated the Memorandum of Understanding and noted that a
number of the short-term convergence projects had been completed including the fair value
option, research and development, borrowing costs and segment reporting. Although Business Combinations was the only joint project that had been completed, the Boards noted that
significant progress had been made in a number of other projects. The Boards set a goal of
completing their joint projects by 2011.49
In another milestone, the FASB and IASB completed a joint project on fair value measurement. The FASB issued ASU 2011-04 and the IASB issued IFRS 13, Fair Value Measurement,
in an effort to harmonize the concepts surrounding the measurement of fair value and align
The FASB and IASB Convergence Project
◾
19
disclosure requirements. It is important to note that the guidance does not extend the use of
fair value measurement either in the United States or internationally. Instead, it improves the
guidance on how fair value should be measured and disclosed in situations where it is already
required or permitted in existing accounting pronouncements.50
ASU 2011-04 provides clarifications relating to the concepts of highest and best use,
the measurement of an entity’s equity interest, and qualitative disclosures for unobservable
inputs. It also changes the fair value measurement principles for financial instruments
managed within a portfolio and for the application of premiums and discounts in the fair
value of a reporting unit. In addition, ASU 2011-04 requires additional disclosures for Level
3 measurements, among other disclosures.51
IFRS 13 adopted several important fair value measurement concepts from SFAS 157,
including an exit price assumption, the principal market focus, and the exclusion of blockage discounts. In addition, IFRS 13 includes U.S. GAAP fair market value concepts included
in subsequent FASB fair value measurement guidance for inactive markets and for measuring
liabilities at fair value.52
Perhaps the most interesting change brought about by convergence of fair value measurement and the issuance of ASU 2011-04 is that some disclosures have been eliminated for
nonpublic companies.53 The FASB made these changes in response to constituent feedback
and in an effort to reduce the reporting burden for private companies. The details are covered
in the Disclosure section of Chapter 2.
In an April 2011 joint podcast, David Tweedie, chairman of the IASB, and Leslie Seidman,
chairman of the FASB, summarized the progress that the Boards had made on the convergence
project to date; they discussed the overarching objectives of the project and they announced
an extension of the target deadline. The chairmen emphasized that the goal of convergence is
high quality standards that allow ample time for outreach to constituents. He added that input
from interested parties has allowed the Boards to develop standards in a collaborative manner.
As of April 2011, the Boards had yet to complete their work on leasing, revenue recognition,
financial instruments, and insurance. Therefore, they announced that the original June 2011
target for convergence had been extended to the end of 2011. Although the 2011 target was
not met, convergence efforts continued. However, due to certain external factors, the Project
was eventually put on hiatus. In a speech to the FASB@40 conference on September 12, 2013,
FASB Chairman Russ Golden provided his views on the priorities of the organization. Relating to convergence, Mr. Golden noted that the process for achieving convergence of global
accounting standards “will change.” Mr. Golden further noted that “FASB’s first priority is to
improve the financial reporting for the benefit of investors and other users of financial information in U.S. capital markets.”54 The SEC’s role in deciding whether to accept IFRS for U.S.
financial reporting is discussed in the following section.
The SEC and IFRSs
In 2007, as a result of the progress achieved by the FASB and IASB toward convergence, the
SEC decided that it would no longer require reconciliation of IFRSs based financial statement
to U.S. GAAP for non-U.S. companies registered to issue securities in the United States. In a
parallel move, the European Commission decided in 2008 that listed companies can prepare
20
◾ The History and Evolution of Fair Value Accounting
financial statements using another country’s GAAP, provided that the country’s GAAP is
subject to convergence with IFRS and provided that the country’s GAAP has been deemed
equivalent to IFRS. As of 2008, U.S., Canadian, and Japanese companies can comply with
EU financial reporting requirements using their own countries’ versions of GAAP.55 These
SEC and European Commission developments effectively create two sets of similar, but not
completely convergent standards in the United States and in the European Union. These
changes provide flexibility to foreign companies, however, domestic corporations registered
in the United States and the European Union do not currently enjoy the freedom to choose
between U.S. GAAP and IFRS.
The Original Proposed Roadmap
In 2008 the SEC issued a roadmap to advance the adoption of IFRSs for U.S.-based reporting
entities, saying, “Because IFRSs has the greatest potential to become the global standard of
accounting, we believe it is in the best interest of U.S. investors, U.S. issuers, and U.S. markets
to consider mandating reporting under IFRSs in the United States as well.”56 The roadmap
lists milestones to be achieved toward the goal of requiring that SEC registered companies use
IFRSs for financial reporting purposes.
1. Improvements in accounting standards. Under this first milestone, the SEC will evaluate the
progress made by the boards in developing standards under the Memorandum of Understanding that are “high quality and sufficiently comprehensive.”57
2. Accountability and funding of the IASC Foundation. A new, permanent funding arrangement
is needed for the International Accounting Standards Committee (IASC) because traditionally, participants have provided funding in the capital markets on a voluntary basis.
The new system of funding must be broad based, compelling, open-ended, and country specific. The SEC also believes the IASC should have more oversight from securities
authorities similar to the SEC’s oversight of the FASB in the United States.
3. Improvement in the ability to use interactive data for IFRSs reporting. The SEC recently
required that financial statement filers use eXensible Business Reporting Language
(XBRL) to submit financial information. The SEC wants IFRSs financial statement
preparers to use a similar interactive data format.
4. Education and training. As U.S. GAAP is transitioned into IFRSs, the SEC recognizes that
accountants, investors, auditors, and other users of the financial information will need to
be retrained in IFRS, and the SEC recognizes that this training effort would have to take
place prior to the adoption of IFRSs in the United States.
5. Allowance for limited early use of IFRS where this would enhance comparability for U.S.
investors. The SEC has made several proposals for the early use of IFRS by certain
reporting entities where the adoption of IFRS allows better comparison of financial data.
6. Anticipated timing of future rulemaking by the commission. The SEC plans to perform a comprehensive review of all SEC rules and to make recommendations for amendments to
those rules so that IFRS can be used for registration and reporting under the Exchange
Act and the Securities Act.
The FASB and IASB Convergence Project
◾
21
7. Implementation of the mandatory use of IFRS. The mandatory use of IFRS would be implemented in stages, beginning in 2014. The SEC would require filers to provide three years
of financial information in the first year of implementation. For example, large accelerated
filers would be required to file financial statements using IFRS for the fiscal years 2012
through 2014.58
The Work Plan
In response to public feedback on the Proposed Roadmap and in response to the G-20’s call for
standards setters to increase their efforts to create a single set of high quality, global accounting standards in the wake of the global economic crisis, the SEC directed its staff to formulate a
plan for U.S. financial statement issuers to transition to IFRS. The February 2010 Work Plan
addressed the following areas:
◾
◾
◾
◾
◾
◾
Sufficient development and application of IFRS for the U.S. domestic reporting system
The independence of standard setting for the benefit of investors
Investor understanding and education regarding IFRS
Examination of the U.S. regulatory environment that would be affected by a change in
accounting standards
The impact on issuers, both large and small, including changes to accounting systems,
changes to contractual arrangements, corporate governance considerations, litigation
contingencies
Human capital readiness59
The purpose of the work plan is to provide the SEC with sufficient information to decide
“whether, when and how our current financial reporting system for U.S. issuers should be
transitioned to a system incorporating IFRS.”60
The SEC staff released two papers in late 2011 in connection with the execution of the
work plan. The first addressed whether IFRS is sufficiently developed and of a high enough
quality for application in the United States. The paper, “A Comparison of U.S. GAAP and IFRS,”
is a principle level evaluation organized by ASC Topic that highlights the differences between
the two sets of standards. The staff’s scope excluded joint FASB/IASB projects underway under
the MoU. The second paper, “An Analysis of IFRS in Practice,” summarizes the staff’s analysis
of 183 companies that prepare IFRS financial statements, including some that are SEC registrants. The staff noted two themes from their analysis of financial statements that are prepared
in compliance with IFRS. One is that transparency and clarity could be enhanced through
better disclosures. The other is that diversity in application permitted under IFRS made comparability across countries and industries more challenging.
The SEC made substantial progress on the work plan through the end of 2011; however, there are two significant open items. First, the FASB and IASB have not completed all
the convergence projects.61 The FASB’s technical plan and project update web page indicates
that joint FASB/IASB projects underway include financial instruments, hedging, investment
companies, revenue recognition, leases, and insurance contracts.62 The second open item is
22
◾ The History and Evolution of Fair Value Accounting
a governance strategy for the IASB. The International Accounting Standards Committee’s
Foundation Monitoring Board, which includes representatives from the SEC and the Board of
Trustees of the Financial Accounting Foundation, which oversees the FASB, are both in the
process of reviewing governance strategies for the IASB. The focus of their work is to enhance
the IASB’s structure to promote an independent, accountable-standards-setting body. The
SEC is expected to issue a report in 2012 summarizing the efforts required to complete the
work plan.63
The SEC’s Deputy Chief Accountant Paul A. Beswick delivered a speech to the AICPA on
December 5, 2011, addressing convergence. In his closing remarks he indicated that the goal
of a single set of high-quality global accounting standards may not be achievable if national
standards setters such as the FASB and SEC have the ability to deviate from IASB standards.
Then, he asked, “Would it better to be 90 percent converged and understand the differences,
or should the objective be abandoned?”64
Condorsement
Although the SEC has not reached a final decision whether to incorporate IFRS into the U.S.
financial reporting system, it has begun to explore possible incorporation approaches. One
such approach, dubbed “condorsement,” is discussed in a SEC Staff Paper published May 26,
2011, “Exploring a Possible Method of Incorporation,” and is part of the SEC’s Work Plan
for the Consideration of Incorporating International Financial Reporting Standards into the
Financial Reporting System for U.S. Issuers.
Other jurisdictions have incorporated IFRS into their reporting systems either by full
adoption of IFRS as issued by the IASB without intervention, or by applying a national
incorporation process that considers existing laws and regulations and leads to adoption of
IFRS, or a local variation of IFRS. National incorporation processes can generally be broken
down into convergence approaches or endorsement approaches.
Countries that follow convergence approaches maintain their local standards, but make
efforts to converge those standards to IFRS over time. The United States and China are
currently following convergence approaches. Countries following an endorsement approach
incorporate individual IFRS into their local standards, with varying degrees of modification.
The European Union and Australia generally follow an endorsement approach.
The SEC Staff’s potential framework is basically an endorsement approach with a longer,
phased transition period following a convergence approach; thus “condorsement.” Under the
Staff’s potential framework, the transition plan would begin with the Memorandum of Understanding projects that the FASB and IASB have jointly undertaken and committed to completing in 2011. These projects include financial instruments, revenue recognition, leases, other
comprehensive income, fair value measurement, netting of derivatives, and consolidation of
investment companies.
The second phase would incorporate those standards currently on the IASB’s
standard-setting agenda. The FASB would participate in the standard-setting process,
but current U.S. GAAP would remain in place until the new standards are issued. The third
category includes IASB Standards that are not slated for change in the near future, and would
require further development of a transition plan.
The Future of Fair Value Measurement
◾
23
The SEC Staff believed that following their potential condorsement framework for incorporation would help U.S. constituents manage the transition and would provide the FASB
flexibility to meet constituent needs. Gradual implementation would potentially be less costly
and would permit coordination with ongoing standard-setting activity.
Another important benefit is that the possible SEC Staff method incorporates IFRS into
U.S. GAAP, which preserves U.S. GAAP as the basis for financial reporting in the United States.
It also preserves the SEC’s authority over U.S. accounting standard setting and maintains the
FASB role in protecting U.S. constituent’s interests in the development of high-quality standards. The FASB would provide input and support to the IASB, but would retain the ability to
modify or supplement IFRS to protect U.S. interests.65
In July 2012, the SEC staff issued what it termed its “final” report on the convergence
of U.S. GAAP and IFRS titled, “Work Plan for Consideration of Incorporating International
Financial Reporting Standards into the Financial Reporting System for U.S. Issuers.” In the
report, the staff concluded that there were still a number of unresolved issues of convergences,
including:
◾
◾
◾
◾
◾
the diversity in how accounting standards, including IFRS, are interpreted,
applied and enforced in various jurisdictions around the world;
the potential cost to U.S. issuers of adopting or incorporating IFRS;
investor education;
and governance.66
Although SEC staff noted the differences in their final report there was no recommendation for future plans for the eventual convergence of the standards.
THE FUTURE OF FAIR VALUE MEASUREMENT
Whether full convergence of U.S. GAAP with international standards is ever achieved,
financial reporting standards are likely to continue their parallel courses of harmonized
development. Although the convergence of fair value measurement standards has been
largely completed, there will likely be future clarifications and harmonization of the few
remaining differences.
In contrast, disclosures about fair value measurement will likely take two divergent
paths. Although there has been a consistent trend toward more disclosure for public companies, which is likely to continue, the same cannot be said for nonpublic companies. In
fact, IFRS contain a separate set of reporting standards for private entities entitled International Financial Reporting Standards for Small to Medium-sized Entities (IFRS for SMEs).
The self-contained 230-page set of standards is designed to reduce the financial reporting
burden for nonpublic companies. The FASB has decided to follow the IASB’s lead, and
established a Blue Ribbon Panel to address how accounting standards can best meet the
needs of private company financial statement users in the United States.
The Panel concluded that the current accounting standards-setting system in the
United States is deficient in two significant ways. First, standard setters do not understand
24
◾ The History and Evolution of Fair Value Accounting
decision-useful information from the perspective of private company financial statements
users. Second, standard setters have not weighed the costs and benefits of GAAP for private
company financial reporting. These shortcomings have led to standards that lack relevance
for many users and to standards with a level of complexity that is a burden for private companies and their CPA practitioners. Fair value measurement and goodwill impairment are two
of the current accounting standards cited by the report as contributing to the problem.
The Blue Ribbon Panel’s report considered alternative models and structures for
developing accounting standards for private companies. The Panel considered a model
similar to the IASB’s model that has separate International Financial Reporting Standards
for Small to Medium-sized Entities (IFRS for SMEs), but rejected a ground-up creation of
separate, stand-alone statements for private companies. Instead, the Panel decided upon
and recommended a U.S. GAAP model with exceptions and modifications that respond to
the needs of the private company sector. In addition, the Panel recommended that a new,
separate accounting standards board be created to determine exceptions and modifications
to U.S. GAAP. These new standards will be discussed in subsequent chapters.
Accounting standards setters are also considering whether internally generated
intangible assets should be recognized on the financial statements. IFRS 38 allows for the
recognition of certain internally generated intangible assets in a development phase rather
than research phase, other than “internally generated brands, mastheads, publishing titles,
customer lists and similar items.” Although these limited intangible assets are recognized
at cost initially, IFRS allows for remeasurement at fair value if there is a reference to an
active market.67
The European Financial Reporting Advisory Group (EFRAG) is a “private association
established with the encouragement of the European Commission” and “to promote views in
the field of financial reporting.” EFRAG is undergoing a research project on better information
on intangible assets.68
Research indicates that investors require more complete information in financial reporting. Since current financial reporting does not provide information for almost two-thirds
of the market capitalization of publicly traded companies, perhaps accounting standard
setters will begin to focus on internally generated intangible assets and their contribution
to overall valuations in the interest of providing more complete transparent information for
investors, which should lead to even greater use of fair value as a unit of measurement in
financial reporting.
FAIR VALUE QUALITY INITIATIVE FOR VALUATION SPECIALISTS
Fair value continues to be widely used as a unit of measurement under both U.S. GAAP and
IFRS in financial reporting. Fair value, while providing useful information to the users of financial information, often involves the use of complex financial models, comprehensive valuation techniques, and typically incorporates some form of judgment into the measurement.
Since the fair value measurement techniques are, in certain circumstances, beyond the expertise of management, outside valuation specialists are retained to assist with the fair value
measurement. Management subsequently uses the work product of the outside specialist as
Fair Value Quality Initiative for Valuation Specialists
◾
25
audit evidence in financial reporting. Even though an outside specialist prepares the work,
management still maintains responsibility for the fair value measurement.
In Prepared Remarks for the 2011 AICPA National Conference on Current SEC and
PCAOB Developments, the then–Deputy Chief Accountant of the SEC, Paul Beswick, expressed
concern about the then-existing structure of the valuation profession. Mr. Beswick noted,
“Valuation professionals stand apart from other significant contributors in the financial
reporting process for another reason, their lack of a unified identity.” Mr. Beswick went on
to suggest, “I think one potential solution to consider is whether there should be, similar
to other professions, a single set of qualifications with respect to education level and work
experience, a continuing education curriculum, standards of practice and ethics, and a code
of conduct. One could also contemplate whether a comprehensive inspection program and a
fair disciplinary mechanism should be established to encourage proper behavior and enforce
the rules of the profession in the public interest.”69
In response to Mr. Beswick’s suggestions, the Appraisal Foundation hosted a series
of roundtables for the valuation profession to discuss these concerns. As a result of these
discussions, several organizations, including not-for-profit valuation professional organizations (VPOs), nonmembership VPOs, leaders of valuation practices of international
accounting and consulting firms and others formed what became known as the Fair Value
Quality Initiative to address the concerns of regulators about the profession. The Fair Value
Quality Initiative formed several task forces that developed four workstreams to create an
infrastructure to provide a more unified profession for valuations for financial reporting.
The four workstreams included:
1. Governance and coordination
2. Performance requirements
3. Qualifications
4. Quality control70
There were many significant outcomes of this initiative. The first is the creation of the
Certified in Entity and Intangible Valuations (CEIV) credential, which is a single credential
offered by the American Institute of Certified Public Accountants (AICPA), American Society of Appraisers (ASA), and Royal Institution of Chartered Surveyors (RICS). The CEIV is
intended for valuation professionals who provide valuations for financial reporting purposes.
Although the CEIV can be obtained through one of three VPOs, each organization has a standard education and experience requirements as a pathway to obtain the CEIV. The three VPOs
developed a unified exam in which a candidate from any of the three organizations must pass
in order to ultimately obtain the credential. Additional information about the CEIV can be
obtained at https://ceiv-credential.org/.
The second and perhaps in some ways even more significant outcome of the Fair Value
Quality Initiative is the development of the Mandatory Performance Framework (MPF) and its
companion document, the Application of the Mandatory Performance Framework (AMPF).
The MPF is designed as a performance framework to assist valuation specialists with the determination of “how much” work and documentation needs to be completed for valuations for
financial reporting. The MPF and AMPF are discussed in further detail in Appendix 1A to
this chapter.
26
◾ The History and Evolution of Fair Value Accounting
CONCLUSION
Fair market value is a concept that is widely used in the United States for legal and tax matters
and its measurement has been debated for over a century. Fair value is a standard of measurement that has been permitted or required in certain situations in U.S. GAAP for about
40 years. Fair value is “the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date.”71
Guidance for measuring fair value currently appears in ASC 820.
ASC 820 has evolved since it was originally issued as SFAS 157 in 2006. The economic
crisis forced the FASB to reconsider some SFAS 157’s more controversial aspects such as measuring fair value in inactive markets, measuring liabilities, and the adequacy of disclosures.
The initial process of convergence of U.S. GAAP and IFRS also led to a refinement of many
of the terms associated with fair value measurement such as highest and best use, market
participants, and exit price. In addition, the convergence process shaped required disclosures
by requiring more information about the unobservable inputs to the measurement, but by
reducing the required disclosures for nonpublic companies. The issuance of ASU 2011-04,
which is now codified under ASC 820, marked the end of the FASB’s fair value measurement
refinement project.
The valuation profession with the introduction of the CEIV credential and the issuance
of the Mandatory Performance Framework has led to more consistent, higher-quality fair
value measurements, which should enhance the public trust in financial reporting. The
technical aspects of fair value measurements continue to evolve. While the FASB explores
the cost-benefit of fair value measurements in various circumstances, it appears that the
accounting and reporting requirements for fair value measurement will continue to exist in
their present form for the foreseeable future.
NOTES
1. Stephen G. Ryan, “Fair Value Accounting: Understanding the Issues Raised by the Credit
Crunch,” Council of Institutional Investors, July 2008, p. 1, www.cii.org/UserFiles/file/
resource%20center/correspondence/2008/CII%20Fair%20Value%20Paper%20(final)%20
%20071108.pdf.
2. “Post-implementation Review of IFRS 13 Fair Value Measurement,” IASB, www.ifrs.org,
accessed May 11, 2019.
3. “Ocean Tomo’s Annual Study of Intangible Asset Market Value—2010,” Ocean Tomo Intellectual Capital Equity, March 5, 2015, https://oceantomo.com/blog/2015/03-05-ocean-tomo2015-intangible-asset-market-value/.
4. https://ycharts.com/indicators/sandp_500_price_to_book, accessed May 11, 2019.
5. “Globalization: A Brief Overview,” International Monetary Fund Staff, May 2008, www.imf
.org/external/np/exr/ib/2008/53008.htm.
6. “International Convergence of Accounting Standards – Overview,” Financial Accounting
Standards Board (FASB), accessed September 6, 2011, www.fasb.org/jsp/FASB/Page/
SectionPage&cid=1176156245663.
7. FASB News Release May 12, 2011: “IASB and FASB Issue Common Fair Value Measurement
and Disclosure Requirements,” www.fasb.org.
Notes
◾
27
8. “Investors: Your Views Are Critical in Helping Us Improve Financial Reporting,” FASB, accessed September 7, 2011, www.fasb.org/jsp/FASB/page/SectionPage&cid=1176156441168.
9. Investor Technical Advisory Committee (ITAC), FASB, accessed September 7, 2011, www.fasb
.org.
10. Investor Task Force (ITF), FASB, accessed September 7, 2011, www.fasb.org.
11. John W. White, SEC Director, Division of Corporate Finance, “Testimony Concerning Transparency in Accounting, Proposed Changes to Accounting for Off-Balance Sheet Entities”
(Before the Subcommittee on Insurance, and Investment Committee on Banking, Housing
and Urban Affairs, United States Senate, September 18, 2008), www.sec.gov.
12. “Congressionally-Mandated Study Says Improve, Do Not Suspend, Fair Value Accounting
Standards,” SEC Press Release December 30, 2008, www.sec.gov/news/press/2008/2008307.htm.
13. “Fair Value Being Used as a Scapegoat for Bad Decisions, Lack of Compliance,” CFA Institute
Centre for Financial Market Integrity Press Release, March 17, 2008, http://chainstitute.org.
14. Luis A. Aguilar, SEC Commissioner, “Increasing Accountability and Transparency to
Investors,” remarks at The SEC Speaks in 2009, February 6, 2009, www.sec.gov/news/
speech/2009.
15. Facts about FASB, FASB, accessed September 8, 2011, www.fasb.org.
16. FASB Accounting Standards Codification, About Codification, Notice to Constituents,
accessed February 12, 2012, https://asc.fasb.org/asccontent&trid=2273304&analyticsAsset
Name=_notice_to_constituents.
17. The statement as originally promulgated refers to its historical context.
18. Statement of Financial Accounting Standards No. 157 (SFAS 157), Fair Value Measurements,
paragraph 1.
19. FASB Staff Position (FSP) 157-2, Effective Date of FASB Statement No. 157, February 12, 2008,
paragraph 1, www.fasb.org.
20. “Book Review: What Is Fair Value? by Harleigh H. Hartman,” Weekly Review 3, no. 78
(July–December 1920): 448, digitized at www/books.Google.com.
21. International Glossary of Business Valuation Terms 2001, www.bvresources.com/
FreeDownloads/IntGlossaryBVTerms2001.pdf.
22. Jay E. Fishman, Shannon P. Pratt, and William J. Morrison, Standards of Value: Theory and Applications (Hoboken, NJ: John Wiley & Sons, 2007), 21–23.
23. FASB Master Glossary, accessed 9/19/2011, http://asc.fasb.org/glossary&nav_type=left_
nav&analyticsAssetName=home_page_left_nav_masterglossary.
24. Current Text Accounting Standards as of June 1, 1997 General Standards, Section I82.109h,
Applying the Equity Method, p. 27719.
25. Current Text Accounting Standards as of June 1, 1997 General Standards, Section N35.111,
Nonmonetary Transactions, p. 31985.
26. Statement of Financial Accounting Standard No. 15, Accounting for Debtors and Creditors for
Troubled Debt Restructurings, June 1977, paragraph 13.
27. Summary of Statement No. 107, FASB, accessed July 26, 2011, www.fasb.org/summary/
stsum107.shtml.
28. Summary of Statement No. 115, FASB, accessed July 26, 2011, www.fasb.org/summary/
stsum115.shtml.
29. Summary of Statement No. 119, FASB, accessed July 26, 2011, www.fasb.org/summary/
stsum119.shtml.
30. Summary of Statement No. 133, FASB, accessed July 26, 2011, www.fasb.org/summary/
stsum133.shtml.
28
◾ The History and Evolution of Fair Value Accounting
31. Statement of Financial Standards No. 159, The Fair Value Option for Financial Assets and
Financial Liabilities—Including an Amendment of FASB Statement No. 115, February 2007,
paragraph 1.
32. SFAS 157, paragraph 5.
33. Id., paragraph 7.
34. FASB Staff Position (FSP) 157-2, paragraph 1.
35. “Joint Statement of the Center for Audit Quality, the Council of Institutional Investors and the
CFA Institute Opposing Suspension of Mark-to-Market Accounting,” October 1, 2008.
36. “SEC Office of the Chief Accountant and FASB Staff Clarifications on Fair Value Accounting,
2008-234,” September 30, 2008.
37. FASB Staff Position (FSP) 157-3, paragraph 9.
38. “Congressionally-Mandated Study Says Improve, Do Not Suspend, Fair Value Accounting,”
www.sec.gov/news/press/2008/2008-307.htm.
39. “Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-to-Market Accounting,” SEC (December 30, 2008).
40. “FASB Project Update—Recoveries of Other Than Temporary Impairments (Reversals),”
accessed September 19, 2011, www.fasb.org/otti_reversals.shtml.
41. Financial Accounting Standards Board, Accounting Standards Update 2018-03—Technical
Corrections and Improvements to Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, accessed September 12,
2019,
https://www.fasb.org/cs/ContentServer?c=Document_C&cid=1176170113872&
d=&pagename=FASB%2FDocument_C%2FDocumentPage.
42. Financial Crisis Advisory Group (FCAG), Financial Accounting Standards Board, FCAG Charter, accessed September 19, 2011, www.fasb.org/jsp/FASB/Page/SectionPage&cid=1175801
889213.
43. Id.
44. Financial Crisis Advisory Group, Press Release, 28 July 28, 2009, “FCAG Publishes
Wide-Ranging Review of Standard-Setting Activities Following the Global Financial Crisis,”
www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2F
DocumentPage&cid=1176156365908.
45. International Convergence of Accounting Standards – Overview, Financial Accounting
Standards Board (FASB).
46. The Norwalk Agreement, International Convergence of Accounting Standards—Overview,
FASB, accessed September 19, 2011, www.fasb.org/cs/ContentServer?c=Document_C&
pagename=FASB%2FDocument_C%2FDocumentPage&cid=1218220086560.
47. Memorandum of Understanding between the FASB and IASB 2006–2008, International
Convergence of Accounting Standards—Overview, FASB, www.fasb.org/cs/ContentServer?c=
Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176156245558.
48. Id., 2–4.
49. Completing the February 2006 Memorandum of Understanding: A Progress Report
and Timetable for Completion, September 2008, International Convergence of Accounting Standards—Overview, FASB, www.fasb.org/cs/ContentServer?c=Document_C&
pagename=FASB%2FDocument_C%2FDocumentPage&cid=1175801856967.
50. “IASB and FASB Issue Common Fair Value Measurement and Disclosure Requirements,”
FASB and IASB News Release, May 12, 2011, FASB, www.fasb.org/cs/ContentServer?site=
FASB&c=FASBContent_C&pagename=FASB%2FFASBContent_C%2FNewsPage&cid=11761
58544944.
Notes
◾
29
51. FASB Accounting Standard Update No. 2011-04, Fair Value Measurement (Topic 820), Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and
IFRSs, May 2011, pp. 1–6.
52. IFRS Project Summary and Feedback Statement, IFRS 13, Fair Value Measurement, May 2011,
pp. 16–26, www.ifrs.org/NR/rdonlyres/04E9F096-B1F8-410A-B1E9-2E61003BADFA/0/
FairValueMeasurementFeedbackstatement_May2011.pdf.
53. Podcast: FASB Board Member Russ Golden discusses FASB Accounting Standards Update
No. 2011-04: Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair
Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, May 2011, www
.fasb.org/cs/ContentServer?site=FASB&c=Page&pagename=FASB%2FPage%2FSectionPage
&cid=1176156828276.
54. Deloitte, “Russ Golden Discusses His Priorities as FASB Chairman,” September 13, 2013, www
.iasplus.com/en-us/news/2013/09/fasb-speech.
55. Commission Decision of December 12, 2008 on the use by third countries’ issuers of securities
of certain third country’s national accounting standards and International Financial Reporting Standards to prepare their consolidated financial statements, Official Journal of the European
Union, L 340/112, 19.12.2008.
56. “Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Stands by U.S. Issuers,” Securities and Exchange Commission
Release No. 33-8982, page 33, accessed September 19, 2011, www.sec.gov/rules/proposed/
2008/33-8982.pdf.
57. Id., p. 23.
58. Id., pp. 20–37.
59. Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers, Progress Report October 29,
2010. Office of the Chief Accountant, Division of Corporation Finance, United States Securities and Exchange Commission, p. 1, www.sec.gov/spotlight/globalaccountingstandards/
workplanprogress102910.pdf.
60. Id.
61. Paul A. Beswick, Deputy Chief Accountant, U.S. Securities and Exchange Commission, “Prepared Remarks for the 2011 AICPA National Conference on Current SEC and PCAOB Developments,” December 5, 2011, www.sec.gov/news/speech/2011/spch120511pab.htm.
62. FASB Current Technical Plan and Project Updates, www.fasb.org/jsp/FASB/Page/
SectionPage&cid=1218220137074, accessed February 12, 2012.
63. Beswick, “Prepared Remarks.”
64. Id.
65. Work Plan, 1–24.
66. Comparability in International Accounting Standards—A Brief History, www.fasb.org,
Accessed May 11, 2019.
67. IAS 38 Intangible Assets, www.ifrs.org, accessed May 11, 2019.
68. EFRAG, “EFRAG Research Project on Better Information on Intangible Assets,” www.efrag
.org, accessed May 11, 2019.
69. Beswick, “Prepared.”
70. “Mandatory Performance Framework for the Certified in Entity and Intangible Valuations
Credential,” www.ceiv.org, accessed May 11, 2019.
71. FASB Master Glossary, http://asc.fasb.org, September 9, 2011.
1A
APPE N D IX O N E A
The Mandatory Performance
Framework
I
N RES PONS E TO CONC ERN S BY R E GULATO R S , the valuation profession formed
the Fair Value Quality Initiative to provide a more “a more rigorous and uniform
qualifications, training, accreditation and oversight of individuals conducting fair
value measurements.”1 One outcome of the initiative is the development of performance
requirements for individuals performing valuations for financial reporting.
PERFORMANCE REQUIREMENTS
Financial reporting both within the United States and internationally has developed into a
“mixed model,” in which some measurements are on a historical cost basis while other measurements are at fair value. As discussed in Chapter 1, fair value, although believed to provide better information for the user of the financial information, often requires more complex
modeling and assumptions and incorporates more judgment about the measurement than
traditional historical cost.
The valuation profession, through organizations such as the AICPA and the Appraisal
Foundation, has developed best practices in valuations for financial reporting through the
ACIPA’s Accounting and Valuation Guides and the Appraisal Foundation’s Fair Value Measurement Monographs. The publications of these organizations provide guidance about how
to perform the fair value measurement.
31
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
32
◾ The Mandatory Performance Framework
The Performance Requirements workstream of the Fair Value Quality Initiative developed
a framework about “how much” work should be done in developing the fair value measurement as opposed to “how to” perform the measurement. How much work may include such
factors as the scope of the measurement, the amount of due diligence, the level of rigor, and
the amount of documentation when performing the measurement.
The Mandatory Performance Framework (MPF) and the Application of the Mandatory Performance Framework (AMPF) are differentiated from professional and technical standards promulgated by VPOs. The Mandatory Performance Framework defines each as follows:
◾
◾
◾
Professional standards. Standards that encourage professional behavior. Examples are
codes of ethics and codes of conduct that require acting competently, independently, objectively, and transparently. These can also be considered standards that define the qualities of a professional: ethical, independent, objective, having requisite skills, educated,
experienced, tested, trained, and credentialed or licensed. Professional standards focus
on characteristics of individual professionals and their conduct.
Technical standards. These are standards that address the how to of work that must
be done to prepare a professional work product. These standards address the technical
correctness of the work product by considering appropriate input factors, application of
methods and techniques, and reporting guidelines. Both mandatory standards and voluntary guidance have been developed around technical issues in valuation in general
and, to a lesser extent, around fair value measurement.
Performance framework. Contains requirements that cover how much work should
be performed in order to prepare a professional work product. The performance framework addresses scope of work, extent of documentation and analysis, consideration
of contrary evidence, and documentation in both the report and the supporting
working papers. Alternatively, the performance framework establishes the extent to
which valuation professionals perform their work in terms of depth of analysis and
documentation.2
The Structure of the Mandatory Performance Framework
The Mandatory Performance Framework consists of two documents, the “Mandatory Performance Framework” and a companion document, “The Application of the Mandatory
Performance Framework.” The “Mandatory Performance Framework” is comprised of four
sections:
1. A preamble that describes the scope and purpose of the framework.
2. A section that provides guidance about the levels of documentation that a valuation specialist must adhere to in performing the fair value measurement.
3. A glossary.
4. A list of authoritative and other technical guidance.
Conclusion
◾
33
The “Application of the Mandatory Performance Framework” has three general sections:
◾
◾
◾
A1: Provides additional guidance about areas of fair value measurement where an inconsistency in practice has been previously noted.
A2: Provides additional guidance in the documentation requirements of measuring the
fair value of a business entity.
A3: Provides additional guidance in the documentation requirements of measuring the
fair value of individual assets and liabilities.
The Scope of the Mandatory Performance Framework
The MPF provides guidance for valuation professionals on the underlying support for valuations for financial reporting purposes. The level of support includes the scope of work and the
amount of documentation the valuation specialist should undergo when performing the fair
value measurement. In general, CEIV credential holders are required to adhere to the framework when performing valuations for financial reporting purposes, although there may be
some limited exceptions. The MPF is considered a best practices document for valuation specialists who do not hold the CEIV credential.3
MPF and AMPF Checklist
A checklist (Exhibit 1A.1) is included as part of this Appendix, which was developed from the
MPF and AMPF. The checklist demonstrates the scope of the Framework and its application
in fair value measurements. However, valuation professionals should obtain and understand
the requirements of the Framework through the actual documents themselves. Both the MPF
and AMPF are publicly available at www.ceiv-credential.org.
CONCLUSION
Regulators had expressed concerns about the lack of uniformity in the valuation profession
regarding common education, experience, scope of work, and disciplinary mechanisms in
valuations that are used as audit evidence in financial reporting. In response, the profession
formed a Fair Value Quality Initiative to respond to those concerns. The Performance Requirements workstream of the Initiative developed the Mandatory Performance Framework to provide guidance about how much work should be performed in the fair value measurement in
terms of scope and level of documentation.
34
◾ The Mandatory Performance Framework
EXHIBIT 1A.1 Mandatory Performance Framework—Checklist
Mandatory Performance Framework—Checklist
Comments
Extent of Documentation Requirements
2.10.1 Understand the nature, extent, and results of the
valuation procedures performed.
2.10.2 Understand all approaches and methods used in the
valuation analysis, and, if applicable, understand
why commonly used approaches and methods were
not used in the valuation analysis.
2.10.3 Understand the inputs, judgments, and
assumptions made and the rationale for their use.
2.10.4 Determine who performed the work and their
qualifications (e.g., valuation professional,
subcontractor, management).
2.10.5 Identify the intended users of the valuation report.
2.10.6 Identify the measurement date.
2.11 When considering the extent of documentation to
support a conclusion of value, the valuation professional
should consider:
2.11.1 The significance the data or information has on the
conclusion of value.
2.11.2 The risk of management bias affecting the
conclusion of value.
2.11.3 The risk that insufficient documentation may result
in a misunderstood conclusion of value.
2.11.4 The degree of judgment required by the valuation
professional to prepare information used to
estimate the conclusion of value.
2.11.5 The reasonableness or appropriateness of the
approaches and methods used in to estimate the
fair value of the subject interest.
2.17.1 Emphasizes evidential skepticism. Valuation
professionals must exercise due professional care
that requires the valuation professional to
continuously question and critique information and
data provided by management for bias,
misstatement, or both. The valuation professional
must also consider the experience of management
and the sufficiency of the documentation and
analyses provided by management throughout the
valuation engagement. The valuation professional
should not presume management is biased;
however, the valuation professional should not
accept and rely on less-than-persuasive evidence
because the valuation professional believes
management is unbiased. This requirement extends
to third-party specialists retained by management
and their competence and the sufficiency of their
work product.
Reference
Conclusion
◾
35
EXHIBIT 1A.1 (continued)
Mandatory Performance Framework—Checklist
Comments
Reference
Engagement Letter
Identification of the client
Type of report
Scope of work
Client responsibility
Identification of the intended use of the report
Identification of the intended users and expected recipients
Measurement date for the valuation engagement
Standard of value
Premise of value
Description and (if relevant) listing of the business(es), business
interest(s), intangible asset(s), liabilities, or inventory that are to
be valued
Fee, timing, and deliverable
Assumptions, extraordinary assumptions or hypothetical
assumptions, or limiting conditions
Management Interviews
1. Date of the interview
2. Who conducted the interview
3. Which members of management were interviewed (including
date, time, and location of interview)
4. Notes regarding the questions and related responses (field
notes)
5. Which facilities were visited (if applicable) and their locations
6. Any other relevant content discussed and impressions formed
during the interview
Content of the Final Valuation Report
Client information
Purpose and intended use of the valuation report
Intended users of the valuation report
Measurement date
Valuation report date
Subsequent events (if applicable and appropriate)
Identification of the subject interest
Sources of information
Reliance on client-provided information
Valuation approaches and methods
Alternative approaches and methods.
Limitations on the scope of research and analysis
Disclosure of limitations
Disclosure of scope changes
Nonassured financial statements
Financial information adjustments
Significant assumptions and estimates—documentation
requirements
(continued)
36
◾ The Mandatory Performance Framework
EXHIBIT 1A.1 (continued)
Mandatory Performance Framework—Checklist
Comments
Documentation Requirements
A1.3.4 The valuation professional, at a minimum, must
document in writing within the work file:
1. Where applicable, the process and rationale for
selecting the valuation method(s) or excluding
common valuation methods to estimate the fair value
of the subject interest.
2. The process and rationale for selected weighting (or
emphasis on) each approach and/or method in
reconciling various indications of value to reach the
final conclusion of value (if more than one
approach/method is used).
3. A reconciliation of the results should include, among
other things:
a. A supporting narrative about the applied methods
and their applicability and usefulness to the
valuation assignment; the reliability of the
underlying data used in their preparation; and an
explanation of inputs and assumptions
b. An assessment of the reliability of the results
obtained and whether any of the results used to
reach a conclusion of value are deemed more or
less probative of fair value based on information
gathered throughout the engagement (note: the
extent of documentation should be commensurate
with the level of judgment and qualitative analysis
involved in supporting the positive assertion)
c. A clear explanation discussing any apparent
inconsistencies in the analysis relative to external
or internal documentation and/or data (for
example, contrary evidence). This may then take
the form of arithmetic/mathematical calculations
when using quantitative weighting
4. An explanation, based on the results of items 1–3, that
identifies whether the conclusion of value is based on
the results of one valuation approach and method, or
based on the results of multiple approaches and
methods.
A1.4 Prospective Financial Information (PFI)
Reasonably Objective Basis
In order for the valuation professional to determine if a PFI is
reasonable, he or she must compare it to the expected cash flows
of the subject interest or entity (for example, expected cash flows
might be determined by using probability-weighted scenarios of
possible outcomes).
Understanding Management’s Approach to Developing the PFI
Valuation professionals should understand and document how
the PFI was developed by management.
Reference
Conclusion
◾
37
EXHIBIT 1A.1 (continued)
Mandatory Performance Framework—Checklist
Comments
Valuation professionals should be aware of the purpose for which
PFI is prepared. In addition, valuation professionals should
understand whether the PFI was prepared using market
participant assumptions.
Key Components of the PFI
Base year metrics
Annual revenue forecasts or revenue growth rates
Annual gross margins
Annual EBITDA/EBIT margins
Annual depreciation and amortization
Annual effective tax rate
Annual capital expenditures
Annual debt-free net working capital (DFNWC) requirements
The Valuation Professional’s Assessment of the PFI
Comparison of PFI to expected values of the cash flows:
Frequency of preparation
Comparison of prior forecasts with actual results
Mathematical and logic check
Comparison to historical trends
Comparison to industry expectations
Forecasts that vary from historical performance or industry trends
Check for internal consistency
Documentation Requirements
The identification of the party or parties responsible for
preparation of the PFI
The process used to develop the PFI from the perspective of a
market participant
The explanation of key underlying assumptions utilized in the PFI
such as revenue forecasts, percentage of market share captured
by the entity, or how the projected profit margins compare to
those of other market participants
The steps used in, and results of, testing the PFI for
reasonableness including, but not limited to: (a) a comparison of
the PFI to expected cash flows, (b) a comparison of the PFI to
historical performance, (c) a comparison of prior year’s PFI against
actual historical results (when prior PFIs are available), (d) an
analysis of the forecast relative to economic and industry
expectations
An evaluation of any differences between the PFI and expected
cash flows
An analysis of any evidence that contradicts management’s
assumptions or conclusions used in their PFI
The rationale for any adjustments made to management’s PFI
Evidence that a mathematical and logic check was performed
The components of the prospective balance sheet, and if
available, cash flow statements
The prospective capital structure
Reference
(continued)
38
◾ The Mandatory Performance Framework
EXHIBIT 1A.1 (continued)
Mandatory Performance Framework—Checklist
Comments
A2.2 Discount Rate Derivation
Documentation Requirements
Cost of Equity
The rationale for the selection of a model.
The source of the risk free rate used (when applicable) in the
calculation and explain the rationale for its selection.
The source or calculation of the equity risk premium (when
applicable) and the rationale for its use.
An explanation of the calculation of beta of the guideline
companies and the rationale for the method used (or rationale for
the use of another source of beta) when using CAPM.
The rationale for selecting the specific beta when using CAPM,
including “adjusted betas.”
The amount of size premium, the source of the premium data (if
applicable), and the rationale for selecting the concluded
premium (even if that premium is zero) when applicable.
The amount of company-specific risk adjustment, if any, the
rationale for application of the adjustment, and the objective and
quantitative data sets used to develop the specific concluded
adjustment. Qualitative factors may be considered in determining
whether a company-specific risk adjustment should be applied;
however, quantitative support must also be provided to support
the amount of the adjustment (note: this type of support should
not include the valuation professional’s judgment of the level of
company-specific risk premiums observed in other valuations).
This is typically the most subjective part of the derivation of the
cost of equity capital and, therefore, documentation related to
this feature should be the most extensive. Comparisons to IRR
calculations or to the results of other discount rate models may
aid in supporting a company-specific risk adjustment. In certain
instances it may be appropriate for the valuation professional to
explain why no company-specific risk premium was used.
The amount of country-specific risk adjustment (if applicable),
the source of the adjustment data (if applicable), and the
rationale for selecting the concluded adjustment (even if that
adjustment is zero).
Other significant assumptions should be clearly explained and
documented as well as other inputs that may apply depending on
the models chosen by the valuation professional.
Cost of Debt
The source(s) of data used and the rationale for use of the
source(s) (for example, yields based on interest expense divided
by debt balance, or interest rates cited in the guideline
company’s annual reports).
Reference
Conclusion
◾
39
EXHIBIT 1A.1 (continued)
Mandatory Performance Framework—Checklist
Comments
The rationale to support the selection of the pretax cost of debt
and any additional source documents.
The rationale for the effective tax rate used to adjust the pretax
rate to an after tax rate.
Capital Structure
The capital structures of the guideline companies and rationale
for selection of the time frame over which they are measured.
The capital structure selected in the calculation of the WACC and
rationale for its selection.
A2.3 Growth Rates
Documentation Requirements
The rationale, support, and reasonableness assessment for the
selected growth rate(s) used in the analysis.
The rationale for all inputs that comprise the terminal or
long-term GR.
When estimating the valuation of an entity, the rationale to
capitalize into perpetuity a particular GR at the point in time
where the business had achieved a steady state of operation. For
instance, if company management provides a five-year forecast,
the valuation professional should not assume the terminal GR is
appropriate after the forecasted period without performing
additional analysis.
Consideration of other models (for example, the H-model, also
referred to as the “fading growth” model) when growth at the
end of the projection period is not expected to be sustainable.
A2.4 Terminal Value Multiple Methods/Models
Documentation Requirements
The rationale for selecting the appropriate terminal exit
multiple(s) or model(s).
The rationale and support for each key assumption used in the
terminal method or model such as, as applicable:
Reference
a. The discount rate
b. Terminal or perpetual growth rate
c. Second-stage or high-growth growth rate for the H-Model
and two-stage model
d. High-growth stage duration/life for the H-Model and
two-stage model
e. Terminal market multiple (exit multiple)
A2.5 Selection of, and Adjustments to, Valuation Multiples
Documentation Requirements
The market multiples of the guideline companies and the source
of the data used. The exhibit should include the numerators and
denominators used in each multiple. Include a discussion of any
assumptions necessary for these calculations.
(continued)
40
◾ The Mandatory Performance Framework
EXHIBIT 1A.1 (continued)
Mandatory Performance Framework—Checklist
Comments
The process used to select a multiple based on a consideration of
all the comparative analyses performed, and the rationale for
judgments along the way. This should include, but not be limited
to, discussion of: (a) the decision regarding equity versus invested
capital multiples, (b) the decision regarding the time frame of
earnings or other metrics, (c) analysis of the comparative
performance measures and how it affected the selection of the
multiples applied to the subject entity, (d) the comparative
qualitative and quantitative analysis that affected the selection of
the multiples applied to the subject entity, (e) the selection of the
starting point of the multiples within the range, and (f) the
rationale for adjustments, if any, to the starting point multiples to
determine multiples applicable to the subject entity.
The identification of each significant accounting difference and
adjustments made, if any, for better comparability.
The calculation of the multiples of the entire company (if
reporting units are being analyzed in a publicly traded company)
and the rationale for differences in the multiples used.
The calculation of multiples implied in a recent transaction and
the rationale for differences in the multiples used.
A2.6 Selection of Guideline Public Companies or Comparable
Company Transactions
Documentation Requirements
The understanding of the subject entity, including identification of
which characteristics are appropriate for selection of guideline
public companies or comparable company transactions.
The process used in the selection of the guideline public
companies or comparable company transactions, and an
indication of specific criteria used in that selection. This would
include the rationale for the inclusion or exclusion of specific
guideline public companies or comparable transactions if that
selection was based on subjective factors (instead of specific
criteria such as SIC code, transaction date, or existence of a
certain level of profitability).
The identification and description of the selected guideline public
companies or comparable company transactions.
A2.7 Discounts and Premiums
Documentation Requirements
The understanding of the subject company’s capital structure and
concomitant rights and obligations of, and restrictions on, each
class of capital.
The rationale for why a premium or discount is appropriate for the
subject interest with proper references to supporting
documentation (for example, executed contracts, registration
statements, corporate documents, state law, and so forth).
Reference
Conclusion
◾
41
EXHIBIT 1A.1 (continued)
Mandatory Performance Framework—Checklist
Comments
The rationale for selection of methodology used to determine the
appropriate magnitude of premium or discount.
A discussion of how market evidence/data is used and adjusted
for application to the subject interest.
How the discount or premium was applied to the valuation
method (for example, to the equity component of the TIC
multiple, the entire multiple or value indication, and so forth).
Identification, and description where necessary, of each
significant input used to arrive at the applied premium or
discount. This should include, at a minimum:
Reference
a. Resources used to determine input (for example, companyspecific data, commercial or governmental databases, and
so forth)
b. Clear description of how inputs into a model were calculated
(for example, inputs used to determine volatility, adjustments
made for survivorship bias, and so forth)
c. Any other quantitative and qualitative considerations
A3.2 Identified Assets and Liabilities
Documentation Requirements
Analyses and discussions with management that identify key
value drivers and related assets associated with those value
drivers, including the rationale for the transaction
The description in sufficient detail of all the assets and liabilities
being valued such that an experienced professional not
associated with the valuation engagement could identify the
assets and liabilities by accounting groupings, segment/reporting
units, and so forth (note: the identification of assets and liabilities
is the responsibility of management and so the valuation
professional should ask management for properly documented
support)
The analyses showing how each intangible asset met the
separability criteria in ASC 805, if applicable
The analyses showing how each intangible asset met the
legal/contractual criteria
The rationale for the inclusion in the valuation analysis of the
selected assets and liabilities
The rationale of why certain assets and liabilities (that might
otherwise be considered reasonable for inclusion) were excluded
from the valuation analysis
The extent to which the valuation professional used or relied on
information contained in valuation reports with earlier
measurement dates (particularly as it may relate to calibration)
The description of the identified principal market and market
participant assumptions
(continued)
42
◾ The Mandatory Performance Framework
EXHIBIT 1A.1 (continued)
Mandatory Performance Framework—Checklist
Comments
A3.4 Life for Projection Period
Documentation Requirements
The rationale for the selected projection period
Support for the steady-state cash flow to be used for the
estimated cash flows beyond the discrete cash flow period
(for example, comparisons to industry margins, growth rates,
and so forth)
Support for ongoing growth or decline after the steady-state
cash flow is reached
The process and rationale for selecting the economic life of the
intangible asset, including consideration of market participant
assumptions
The rationale for selection of the specific threshold or truncation
point used in the analysis
If applicable, discussions with company management and
company’s auditors about materiality considerations
A3.5 Attrition
Documentation Requirements
The process and rationale for the methods used to determine
historical and future attrition patterns applied to the attrition
analysis
The source and description of the data used to determine
historical and future attrition estimates
The quantitative and qualitative impact of any relevant macroor microeconomic influences, or both, incorporated into the
attrition analysis
A3.6 Royalty Rates
Documentation Requirements
The criteria used to search for third-party licensing agreements
and the rationale for using or excluding an initial list of data in
the analysis
The lists and data produced during the search
The process used in analyzing the third-party licensing
agreements and support for the selection of the royalty rate used
If applicable, the rationale for using or excluding licensing
arrangements of the subject entity when determining a
reasonable royalty rate
The reasonableness of all rules of thumb methods considered
and used in estimating or supporting a royalty rate to value the
subject asset
Identify sufficient excess earnings or cash flow to provide
economic support for the selected royalty rate
Reference
Conclusion
◾
43
EXHIBIT 1A.1 (continued)
Mandatory Performance Framework—Checklist
Comments
A3.7 Contributory Asset Charges
Documentation Requirements
The following specifics should be provided, along with rationales
for their selection when appropriate:
◾
◾
◾
◾
◾
Reference
Working Capital:
The appropriate level
The required rate of return
The working capital charge, as a percentage of revenue, for
each projected period
Land:
The appropriate market participant level of land and its
associated fair value
The required rate of return
The land charge, as a percentage of revenue, for each
projected period
Fixed Assets (not including land):
The appropriate market participant level of fixed assets and
the economic life for each fixed asset category
The required rate of return
The return “on” fixed asset charge, as a percentage of
revenue, for each projected period
The return “of” fixed asset charge, as a percentage of
revenue, for each projected period (if not otherwise
reflected in the depreciation/amortization or in the
expense structure of the entity)
Any practical expedient method used (for example,
“smoothed” percent of revenues)
Intangible Assets valued using the Relief-From-Royalty
Method
The appropriate royalty rate
An explanation should be provided for instances:
When the royalty rate “charge” is different from the
royalty rate used to estimate the fair value of the
intangible asset, such as a trademark/trade
name, or
When an intangible asset such as a trademark/trade name
is not valued but a royalty rate charge is still applied in
the valuation analysis
Assembled Workforce and Other Intangible Assets
The assumptions used to estimate the fair value of the
assembled workforce and other intangible assets
An exhibit showing the calculation of the value of the
assembled workforce or other intangible asset
The required rate of return
The intangible asset charge, as a percentage of revenue,
for each projected period
(continued)
◾ The Mandatory Performance Framework
44
EXHIBIT 1A.1 (continued)
Mandatory Performance Framework—Checklist
Comments
A3.8 Tax Amortization Benefits (TAB)
Documentation Requirements
The valuation professional’s understanding of the market
participant tax jurisdiction requirements to determine:
◾
◾
◾
◾
The appropriateness of the TAB.
The amortization method, whether a straight-line
amortization method or an accelerated amortization method
can be utilized.
The tax amortization life of the intangible asset. Under US tax
law, 15 years is often used to calculate the TAB of the
intangible asset and goodwill; however, an explanation
should be provided when an assumption other than 15 years
is used.
The rationale for the market participant tax rate.
The rationale for selecting the discount rate used to estimate the
TAB—whether it is the discount rate used to estimate the fair
value of the intangible asset, the WACC, or another rate to
estimate the TAB
The consideration of the TAB in either a taxable or nontaxable
transaction when performing a discounted cash flow or internal
rate of return analysis
The interaction with the WARA analyses (for example, pre-TAB vs.
post-TAB)
The consideration of the TAB in circumstances where foreign
transactions are conducted and the TAB may or may not be
applicable
A3.9 Reconciliation of Intangible Asset Values
Documentation Requirements
The aggregate projections and cash flows of the entity with a
description of who prepared them (for example, management,
subcontractor, third-party specialist, valuation professional)
In a business combination, an IRR analysis, comparison to the
WACC, and any changes to PFI resulting from this analysis
The WACC, its derivation, and sources of information
The results of the WARA compared to the results of the WACC,
including any commentary about significant or relevant
observations based on the valuation professional’s professional
judgment
Reconciliation of the results of the WARA and results of the
WACC reconciliation, if applicable
Evaluation of a subject’s goodwill value as a percentage of the
purchase price to comparable market data (if available) provides
an indication of whether or not the subject company’s asset
values are in line with broad marketplace expectations. This
should include a narrative about the results and whether the
results are contrary to or supportive of the analysis.
Reference
Conclusion
◾
45
EXHIBIT 1A.1 (continued)
Mandatory Performance Framework—Checklist
Comments
Discussions of any apparent underpayments or overpayments for
the entity. In the event of an underpayment, valuation
professionals should document their discussion with the company,
and auditor if relevant, confirming that it is management’s
responsibility to assess whether a bargain purchase exists.
A3.10 Discount Rate/IRR/WARA
Documentation Requirements
A rationale for the applicable market participant tax rate used to
estimate rates of return for each asset
A rationale for the after-tax rates of return for each asset used in
the WARA calculation
An explanation of any discrepancies between the WARA, IRR, and
WACC
All adjustments in the WARA calculation under a nontaxable
transaction
A3.11 Contract Liabilities
Documentation Requirements
The rationale for selecting one of the two methods described
previously to value contract liabilities
When utilizing the bottom-up approach, clearly indicate all the
costs necessary to fulfill the contract liability and how the
“normal” profit margin was estimated
When utilizing the top-down approach, provide market data and
support for each assumption for related selling costs and profits
thereon
The life of the contract liability in case discounting is applied
The rationale for the rate of return used to estimate the fair value
of the contract liabilities
A3.12 Inventory
Documentation Requirements
The nature and characteristics of the inventory being valued
The process used in, and rationale for, selecting the methods
used in the valuation analysis(es)
If commonly used approaches and methods were not used in the
valuation analysis(es), document reasons as to why
As applicable, information regarding obsolescence, discontinued
product lines, operations to be sold, and other factors
When management has asserted a zero step-up in basis for
inventory value or limited the scope of the engagement not to
include inventory, or both, the final valuation report must disclose:
◾
◾
◾
The inventory was not valued in accordance with the MPF.
Management has asserted a zero step-up in basis for
inventory value or limited the scope of the engagement not
to include inventory, or both.
This assertion or scope limitation may impact other
conclusions of value within the final report.
Reference
46
◾ The Mandatory Performance Framework
NOTES
1. “Mandatory Performance Framework,” www.ceiv-credential.org, p. iii, accessed May 12,
2019.
2. Id., p. iv, accessed May 12, 2019.
3. Preparers of financial information as well as valuation specialists should refer to the MPF itself
to determine when the Framework applies to particular situations.
2
C HAPTE R TW O
Fair Value Measurement Standards
and Concepts
T
H E F I N A N C I A L A C C O U N T I N G S TA N D A R D S Bo a rd (FASB) Accounting Stan-
dards Codification (ASC) 820, Fair Value Measurement, as amended and updated by
Accounting Standards Update (ASU) 2011-04, Amendments to Achieve Common Fair
Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS, is the latest FASB
guidance on measuring fair value whenever fair value accounting is required or permitted
in other accounting standards. The fair value measurement and disclosure requirements
amendments contained in ASU 2011-04 are effective for all entities with reporting periods
beginning after December 15, 2011. The amended guidance in ASC 820 encompasses all
the fair value credit crisis projects that the FASB undertook in the wake of the financial crisis.
It encompasses the FASB and the IASB’s converged guidance for measuring fair value. The
FASB has completed all fair value projects on its project list; therefore, it is unlikely that there
will be any significant changes to ASC 820 in the foreseeable future.
This chapter provides the reader with an overview of fair value measurement in U.S.
GAAP as provided in ASC 820 and amended for convergence by ASU 2011-04. The overview
will provide a foundation for understanding the application of fair value measurement,
which is covered in the remainder of this book. This chapter also briefly covers some of the
more important concepts relating to the fair value option from FASB ASC 825, Financial
Instruments. ASC references are provided in parenthesis throughout this chapter to help
readers locate the FASB’s authoritative guidance on fair value measurement.
47
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
48
◾ Fair Value Measurement Standards and Concepts
FASB ASC 820, FAIR VALUE MEASUREMENT
ASC 820 explains how to measure fair value when it is required or permitted in other ASC
topics. It does not establish any new requirements for fair value to be used in financial reporting. ASC 820 states that the objective of a fair value measurement is “to estimate the price
at which an orderly transaction to sell the asset or to transfer the liability would take place
between market participants at the measurement date under current market conditions.”
The FASB emphasizes that fair value is a market-based measurement regardless of whether
observable market-based transaction information is available. When observable market prices
are not available, fair value is measured using a valuation technique that maximizes the use
of observable inputs. Fair value pricing assumptions are from the perspective of market participants who are selling an asset or transferring a liability; therefore, the price is assumed to be
an exit price. ASC 820 provides a definition of fair value, introduces the fair value framework,
and sets out fair value measurement disclosure requirements (ASC 820-10-05-1).
Definition of Fair Value Measurement
According to the FASB’s Master Glossary (the Glossary), fair value is “the price that would be
received to sell an asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date.” This definition of fair value is to be applied in all other
accounting standards that call for measurement or disclosure at fair value.
The FASB definition is similar to the definition of fair market value as promulgated in tax
reporting under Revenue Ruling 59-60. The IRS defines fair market value as “the price at
which property would change hands between a willing buyer and a willing seller when the
former is not under any compulsion to buy and the latter is not under any compulsion to sell
and both parties having reasonable knowledge of relevant facts.”
The FASB actually considered using this definition of fair market value as the definition
of fair value in financial reporting. However, the FASB acknowledged the extensive tax case
law relating to this definition and did not want to inadvertently introduce case law into financial reporting.1 Even though it is similar to the IRS definition, the FASB definition of fair value
introduced by ASC 820 includes additional concepts such as the principal or most advantageous market and the concept of market participant assumptions, which creates differences
between the two definitions.
The objective of a fair value measurement is to estimate a transaction price for the subject
asset, liability, or equity instrument. The transaction price is from the perspective of a market
participant that owns the asset or owes the liability; therefore, it is considered an exit price. The
transaction price must be the result of an orderly transaction between market participants,
and it must be the result of current market conditions prevailing at the measurement date.
Market information from observable market transactions may or may not exist for the
subject asset or liability. Regardless of the availability of market information, fair value is
considered a market-based measurement, not an entity-specific measurement. Therefore, the
entity’s intent to hold the asset or sell the liability is irrelevant.
If an observable market price is not available for an identical asset or liability, another
valuation technique can be used. The goal would be to measure fair value using the same
FASB ASC 820, Fair Value Measurement
◾
49
assumptions that a market participant would use to price the asset or liability, including the
market participant’s assessment of risk. Any valuation technique should maximize the use of
observable inputs and minimize the use of unobservable inputs (ASC 820-10-05-1B and 1C).
ASC 820, Scope and Scope Exceptions
ASC 820 applies to the measurement of fair value whenever it is required or permitted by
another Topic. In some situations, it may not be practical to measure fair value. When it
is not practicable to measure the fair value of a financial instrument, the financial instrument is exempt from the requirement. ASC 820 also permits practicability exceptions to fair
value measurements for nonmonetary assets, asset retirement obligations, restructuring obligations, and participation rights when their fair value cannot be reasonably determined. As a
practical expedient, the fair value of a guarantee can be measured using its transaction (entry)
price. The Topic also provides an exception for certain not-for-profit entity transactions when
fair value cannot be measured with sufficient reliability (ASC 820-10-15-3).
Initial Measurement
Fair value measurement is based on an exit price assumption. When an entity enters into
a transaction to purchase an asset or assume a liability, the price is an entry price. There
are some important distinctions between entry prices and exit prices. Sometimes a business
may pay more for an asset because it can utilize that asset in a way other businesses cannot. For example, when a business acquires proprietary technology that it can use to enhance
its own product line, the proprietary technology may be worth more to the acquirer than to
other market participants, and the acquisition price may reflect a potential synergistic use
by the acquirer. Subsequently, the entity may not be able to sell the proprietary technology
at the same price it paid to acquire the technology; therefore, the exit price would not equal
the entry price.
However, since the buyer and seller are market participants, in many cases, the transaction price will equal the exit price. Therefore, the transaction price may represent the fair
value of the asset or liability at initial recognition. In determining whether a transaction price
represents the fair value of the asset or liability at initial recognition, the reporting entity
must consider factors specific to the transaction and to the asset or liability. Situations where
the transaction price may not equal the fair value include forced sales, transactions between
related parties, circumstances where transactions costs are included as part of the price, and
transactions that take place outside the principal or most advantageous market. When the
initial price is required or permitted to be measured at fair value, and when the fair value does
not equal the transaction price, a gain or loss is recognized in earnings (ASC 820-10-30-2, 3,
and 6).
Fair Value Framework
The fair value framework is presented in ASC 820-10-35, under a subtopic entitled Subsequent Measurement. The subtopic provides guidance for the fair value measurement of assets
and liabilities in periods after initial measurement. However, the fair value framework also
50
◾ Fair Value Measurement Standards and Concepts
applies to the initial measurement as well as to any subsequent measurement of fair value
(ASC 820-10-35-1).
The first section of the fair value framework provides further guidance and clarification
about the elements of the fair value definition, including the asset or liability, the transaction,
market participants, the price, and application to nonfinancial assets and to liabilities and
equity. The fair value framework also covers valuation techniques, inputs to the valuation
techniques, and the fair value hierarchy (ASC 820-10-35-2).
Asset or Liability
A fair value measurement under ASC 820 is for a particular asset or liability. The reason
provided by the FASB is that assets and liabilities are a primary subject of accounting
measurement.2 The definition of fair value also applies to interests that are considered part
of invested capital of the enterprise. Invested capital, or enterprise value, is considered to
be shareholder’s equity plus interest-bearing debt. Invested capital includes the sources of
enterprise financing over the long term. The fair value of net assets, equity, or invested capital
of a reporting unit can be the basis of comparison when testing goodwill of the reporting unit
for impairment.
An example of the application of fair value measurement to individual assets or liabilities is
in a business combination, where the assets and liabilities of the acquired entity are measured
at individual fair values as of the date of the change of control in the acquisition. An example of
the application of fair value measurement to an enterprise value is the fair value measurement
of a reporting unit under ASC 350, Intangibles—Goodwill and Other, which is used for testing
goodwill for impairment.
When measuring fair value, the characteristics of a particular asset or liability should be
considered if a market participant would also consider those characteristics when deciding on
a price. The condition and location of the asset and any restrictions on the sale or use of the
asset are characteristics that must be considered (ASC 820-10-35-2B).
For example, if an entity owns a share of restricted stock, the restriction is a characteristic of the asset. If the restriction cannot be removed, it would be transferred to other market
participants. The fair value of the share would be measured based on the price for an identical, unrestricted share with an adjustment equal to the amount market participants would
demand in exchange for accepting the risk associated with the restriction. The amount of
the adjustment would depend on the restriction’s nature, duration, and impact on market
participants (ASC 820-10-55-52).
When considering how restrictions on the use of an asset impact fair value, the key is to
determine whether the restriction is specific to the owner or specific to the asset. If a restriction
is specific to the owner, it would not be transferred to the market participant. The fair value
of the asset would be determined based on its highest and best use, which may be maximized
through a transfer to a market participant for use without the restriction. If the restriction
stays with the asset, however, the fair value would take the restriction into account (ASC
820-10-55-54).
FASB ASC 820, Fair Value Measurement
◾
51
Another consideration is whether the asset or liability should be measured on a
stand-alone basis or in a group of assets or liabilities. The group can be a reporting unit or a
business. Whether the fair value measurement should be made on a stand-alone basis or as
part of a group depends on the asset or liability’s unit of account. According to the Glossary,
a unit of account is “the level at which an asset or liability is aggregated or disaggregated
in a Topic for recognition purposes.” The appropriate unit of account is determined in
accordance with the ASC Topic that requires or permits the fair value measurement (ASC
820-10-35-2D).
Transaction
Fair value measurement assumes the transaction to sell the asset or transfer the liability is
an orderly transaction between market participants. It also assumes that the transfer occurs
under current market conditions on the measurement date (ASC 820-10-35-3). Under the
acquisition method, the fair values of assets acquired and liabilities assumed are measured
on the balance sheet at each of their respective values as of the date of change in control in a
business combination.
Principal (or Most Advantageous) Market
One of the assumptions underlying any fair value measurement is that the price is the result
of a sale in the principal market, which is defined in the Glossary as “the market with the greatest volume and level of activity for the asset or liability.” The principal market is generally
presumed to be the same market that the entity usually uses to sell similar assets or transfer similar liabilities, unless there is evidence to the contrary. Because the entity also must
have access to the principal market at the measurement date, different entities may have different principal markets. If there is a principal market, the fair value is the price in the principal
market, even if there is another market with a better price.
If there is not a principal market for the asset or liability, the fair value measurement is
assumed to be the result of a transaction in the most advantageous market. According to the
Glossary, the most advantageous market is “the market that maximizes the amount that would
be received to sell the asset or minimizes the amount that would be paid to transfer the liability,
after taking into account transaction costs and transportation costs.” The most advantageous
market is also considered from the perspective of the reporting entity.
Two additional clarifications are applicable to the principal (or most advantageous)
market assumptions. One is that the reporting entity must be able to access the market
in order to measure fair value using a price from that market. That does not mean the
entity has to be able to sell the asset or transfer the liability in that market. The second is
that there does not have to be an observable market that provides pricing information in
order to measure the fair value of an asset or liability. The fair value measurement can be
based on an assumed transaction from the perspective of hypothetical market participants
(ASC 820-10-35-5 and 6).
52
◾ Fair Value Measurement Standards and Concepts
Market Participants
According to the Glossary, market participants are “buyers and sellers in the principal (or most
advantageous) market for the asset or liability that have all the following characteristics:
◾
◾
◾
◾
They are independent of each other, that is, they are not related parties
They are knowledgeable
They are able to enter into a transaction for the asset or liability
They are willing to enter into a transaction for the asset or liability, that is, they are
motivated but not forced or otherwise compelled to do so.”
Fair value is based on the assumptions market participants would use to determine the
price for an asset or liability. One of those key assumptions is that the market participant is acting in its own best interest. There is no need to identify specific market participants. Instead,
the entity should focus on identifying characteristics that distinguish market participants and
consider attributes specific to the asset or liability, the principal (or most advantageous) market, and the market participants in that market with whom the reporting entity would likely
transact (ASC 820-10-35-9).
SEC Guidance for Determining Market Participant Assumptions in Inactive
Markets Evan Sussholz, who was at the time the Professional Accounting Fellow, Office
of the Chief Accountant of the U.S. Securities and Exchange Commission, provided guidance
for determining how to apply the market participant assumption when markets are inactive
during a speech to the American Institute of Certified Public Accountants in December
2009. He acknowledged that the economic crisis has created situations in which observable
pricing information may not be available, or that it may not be available without undue
cost and effort. In those situations, he suggested that an entity start by looking at their own
assumptions, including the expected use of the asset, the asset’s life, and the expected cash
flows from the asset’s use or sale. Then the entity should apply reasonable judgment in considering whether the entity’s own assumptions represent market participant assumptions, by
answering four questions.
1. What are the potential exit markets for an asset and what is the asset’s principal or most
advantageous market?
While the principal or most advantageous market may be relatively easy to determine for a financial asset, such markets may not exist for nonfinancial markets. Therefore, observable pricing information may not be readily available for some assets. When
analyzing potential exit markets, the entity should consider the following attributes for
each market.
◾
Whether the market is active, inactive, or recently inactive.
◾
Whether there are distinct groups of market participants (strategic vs. financial
buyers).
◾
Whether there are clusters within the groups (small vs. large, profitable vs.
unprofitable).
◾
The competitive nature of the market (perfect competition vs. monopoly, fragmented
vs. unfragmented).
FASB ASC 820, Fair Value Measurement
◾
53
2. What is the highest and best use for the asset?
In order to answer this question, the entity must identify all the potential uses for the
asset within each potential exit market. The potential uses for the asset should be consistent with the asset’s highest and best use. The highest and best use concept is discussed
in further detail in a subsequent section of this chapter.
3. Who are the potential market participants and what are their distinguishing characteristics?
After reiterating that ASC 820 does not require the identification of specific market participants, Mr. Sussholz suggested that identifying characteristics that distinguish
market participants helps the entity understand the asset’s use and value. Examples of
characteristics attributable to market participants are:
◾
Financial versus strategic buyers
◾
National or regional competitors
◾
Financial capacity
◾
Acquisition strategy
◾
Marketplace synergies
◾
Market share
◾
Complementary assets
◾
Management capabilities
4. How do the market participant characteristics compare to the reporting entity’s own
characteristics?
To answer the final question, the entity should reconcile market participant characteristics to the entity’s characteristics to determine whether the entity’s assumptions
are representative of market participant assumptions. This reconciliation should consider
quantitative as well as qualitative information. If the entity’s assumptions are not representative of market participant assumptions, then it will be necessary to adjust the entity’s
assumptions in order to measure the fair value of the asset.3
Price
Price is the key word in the FASB’s definition of fair value. It is an exit price based on an
orderly transaction in the principal (or most advantageous) market. Price is specific to
the measurement date, and it incorporates the current market conditions on that date.
Transaction costs cannot be included in the price; however, transportation costs can be
included in the measurement. The FASB’s decision not to include transaction cost is based on
the concept that transaction costs are not part of the asset or liability. Transaction costs are
typically unique to the specific transaction and may differ depending on the transaction, not
the asset or liability. When location is a characteristic of an asset, however, it is appropriate to
include the cost of transportation to the principal (or most advantageous) market in the price
(ASC 820-10-35-9A to C).
Highest and Best Use for Nonfinancial Assets
The Glossary defines the highest and best use for a nonfinancial asset as “the use of a nonfinancial asset by market participants that would maximize the value of the asset or group of assets
and liabilities (for example, a business) within which the asset would be used.”
54
◾ Fair Value Measurement Standards and Concepts
Highest and best use is an economic concept that is based on the market participant’s ability
to generate economic benefits in such a way that it would maximize the value of the asset. The
value can be maximized by using the asset on a stand-alone basis, by using it with a group of
assets, by using it in a business, or by selling it. A sale assumes that the highest and best use
would be maximized by another market participant.
The highest and best use concept encompasses several assumptions for the underlying
asset, including a use that is physically possible, legally permissible, and financially feasible.
Therefore, when pricing the asset, market participants would consider the physical characteristics of the asset, any legal restrictions on the use of the asset, and whether the asset would
produce the required investment return. Highest and best use is always considered from a
market participant’s perspective when measuring fair value, even when the entity’s use is different. An entity’s current use of a nonfinancial asset is generally presumed to be its highest
and best use, unless there is evidence to the contrary (ASC 820-10-35-10A to C).
An interesting concept recognized by ASC 820 is that a defensive value can be a nonfinancial asset’s highest and best use. Defensive value results when acquisitions are made
in order to eliminate a competitor or a competing product. The value to the acquirer is the
competitive enhancement of its own products and resulting incremental cash flow, not the
use of the acquired asset itself. ASC 820 recognizes that value from a defensive acquisition
should be measured at the fair value, taking into consideration market participants’ highest
and best use. Market participants may conclude that the highest and best use would be a defensive use that prevents competitors from gaining access to it. Therefore, defensive value is not
inconsistent with a highest and best use assumption (ASC 820-10-35-10D).
The assumption about a nonfinancial asset’s highest and best use determines the valuation premise used to measure the asset. The valuation premise applied to the asset can be
either on a stand-alone basis or in combination with other assets. If the asset’s highest and
best use is on a stand-alone basis, then the price would be the amount received to transfer the
asset to a market participant who would also use the asset on a stand-alone basis. If the asset’s
highest and best use is in combination with other assets, the price is based on the asset’s sale
as part of the group of assets to market participants. The group may be a group of assets or a
group of assets and liabilities (e.g., a business) (ASC 820-10-35-10E).
Some examples will help clarify these concepts.
Example: Highest and Best Use for an Asset Group Assume that a strategic buyer
of a technology consulting company acquires another similar company in a business combination and that the acquired entity has only three assets: (1) developed technology, (2) a trade
name, and (3) customer relationships. The developed technology was created by the acquired
entity for its own use in conjunction with providing services to its customers. Under the acquisition method of accounting, the acquiring company measures the fair value of each of the
assets individually, taking into consideration the unit of account for the assets. The acquiring
company assumes that each of the three assets would provide the most value to market participants as part of a group of assets. In other words, the highest and best use would be based on
a valuation premise that the asset is used in combination with the other assets in the group.
The acquiring company assumes that the market in which the assets could be sold is the
same market in which the assets were acquired. The exit price under the definition of fair value
FASB ASC 820, Fair Value Measurement
EXHIBIT 2.1
◾
55
Strategic versus Financial Buyers
Asset
Strategic Buyer
Financial Buyer
Customer relationships
$1,250
$800
Developed technology
2, 000
1,750
500
750
$3,750
$3,300
Trade name
Totals
(the price at which the assets could be sold to a market participant) may be the same as the
entry price (the price at which the assets were acquired). However, the acquiring company
would have to consider the most likely market participants to which the assets could be sold.
The acquiring entity determines that there are two broad groups of potential market participants for these assets: financial buyers, such as private equity or venture capital firms that do
not have complementary investments, and strategic buyers, or competitors.
The acquiring company performs an analysis to measure the fair value of each of the
assets within the group from the perspective of likely market participants, strategic buyers
and financial buyers. The results of their analysis are presented in Exhibit 2.1.
The total fair value of the three assets to a strategic buyer is $3,750 but only $3,300 to
a financial buyer. What is the fair value of the three assets that the acquiring entity should
record on its balance sheet?
First, what would be likely to create differences in fair values for each asset from the
perspective of the two groups of market participants? The fair value of the technology and
customer relationships may be worth more to strategic buyers because market participants
within this group would be likely to integrate the technology and customer relationships
into their own business. The customer relationships and technology would be worth less to a
financial buyer who may not have an existing business with similar product lines. However,
the fair value of the trade name may be less from the perspective of a strategic buyer because
the strategic buyer may already have an established trade name while a financial buyer
may not.
Second, what is valuation premise for the fair value measurement, combined use with
other assets or stand-alone? The fair value of these particular assets is likely to be enhanced
in conjunction with the use of the other two assets. For example, the value of customer
relationships on its own would likely not be as great as it is with developed technology and
an established trade name. The acquiring company’s analysis indicates that the fair value
of these three assets is maximized by strategic market participants who would use them in
combination with the other assets; therefore, combined use is the premise of value.
The fair value of the three assets under the acquisition method and recorded on the
balance sheet would be:
Customer relationships
$1,250
Developed technology
2,000
Trade name
500
56
◾ Fair Value Measurement Standards and Concepts
Even though the fair value of the trade name is higher to a financial buyer, the maximum value of these assets would be in combined use with other assets in the group from the
perspective of a strategic buyer (ASC 820-10-55-26 to 29).
Example: Highest and Best Use of Real Estate Assume a pharmaceutical company
acquires a similar pharmaceutical in a business combination. The acquired pharmaceutical
company owns a building, which it uses as both its headquarters and a manufacturing plant
to produce its product. The building is considered state of the art and was built by a developer
so that it could have multiple uses. Similar buildings nearby have recently been developed for
commercial use as sites for high-end shopping centers. The acquiring pharmaceutical company determines that the building could easily be converted for use as a retail shopping center.
The highest and best use of the building is presumed to be its current use unless market or
other factors suggest a different use. Since there are high-end shopping centers nearby, there
is an indication that the building’s highest and best use may be an alternative use. Fair value
would be determined by having a real estate appraiser estimate (a) the value of the building in
its current use as a headquarters and manufacturing facility, and (b) the value of the building
as converted to a retail shopping center, considering the costs to convert. If the highest and
best use would result from the building’s conversion to a retail shopping center, then market
participants would likely consider that information when pricing the asset and the fair value
would be based on the building’s use as a retail shopping center.
Application to Liabilities and Instruments Classified in a Reporting
Entity’s Shareholders’ Equity
The fair value measurement of a financial or nonfinancial liability rests on the assumptions
that the liability is transferred to a market participant on the measurement date, the liability
would remain outstanding, and the transferee would fulfill the obligation. Likewise, the fair
value measurement of a financial or nonfinancial equity instrument is based on the assumptions that the equity instrument is transferred to a market participant on the measurement
date, the instrument would remain outstanding, and the transferee would take on the rights
and responsibilities associated with the equity instrument. Therefore, fair value measurement
is not made assuming the liability is settled with the counterparty or assuming the equity
instrument is canceled.
Observable market information may not exist for liabilities and equity instruments, and
contractual or other legal restrictions may prevent their transfer. When that is the case, it is
possible that observable market information may exist for the same liability or equity when it is
traded as an asset. Corporate bonds are examples of liabilities that trade in observable markets
as assets. When measuring fair value, the use of observable market observations should be
maximized and the use of unobservable inputs should be minimized (ASC 820-10-35-16).
Liabilities and Instruments Classified in a Reporting Entity’s Shareholders’ Equity
Held by Other Parties as Assets
The best indication of a liability’s or an equity’s value is a quoted market price for an identical
instrument in an active market. If a quoted price for an identical liability or equity instrument
FASB ASC 820, Fair Value Measurement
◾
57
is not available, the next best indication of value is a quoted market price in an active market
for an identical instrument that is held by another party as an asset. The fair value of the
instrument would then be measured from the perspective of the market participant that
holds the debt or equity instrument as an asset. In the absence of an active market, a quoted
market price in an inactive market for an identical liability or equity traded as an asset
can be used. In the absence of observable market prices for identical instruments traded as
assets, the fair value of liabilities and equity instruments can be measured using an income
approach, such as a discounted cash flow method, or a market approach using quoted market
prices for similar instruments traded as assets. The fair value would be determined from the
perspective of a market participant who holds the liability or equity instrument as an asset
(ASC 820-10-35-16B to BB).
When using the quoted market price of liability or equity instruments held by another
party as an asset to measure fair value, it may be necessary to make adjustments to the quoted
market price. Adjustments compensate for factors specific to the asset that are not represented
in the liability or equity instrument being measured. Typically adjustments are needed when
the quoted price is for a similar but not identical asset, or when the unit of account is not the
same. For instance, when the credit quality of the instrument held as an asset is not identical to the credit quality of the issuer of the liability being measured, an adjustment would
be needed. A liability with a third-party credit enhancement would not have the same unit of
account as an otherwise identical asset, and an adjustment would be required. It is interesting
to note that the quoted market price of the asset should be adjusted to reflect restrictions on
the transfer of the asset when measuring the fair value of the liability (ASC 820-10-35-16D).
The converse is not true. Restrictions on the transfer of a liability do not create the need to
adjust the transaction price of an identical asset. Those restrictions are assumed to be factored
into the transaction price (ASC 820-10-35-18C).
Liabilities and Instruments Classified in a Reporting Entity’s Shareholders’ Equity
Not Held by Other Parties as Assets
When quoted market prices are not available for similar or identical liabilities and equity
instruments, and when they are not available for identical instruments when traded as
an asset, fair value of the liability or equity instrument can be measured using another
valuation method. The fair value measurement of a liability would be from the perspective of
the market participant that owes the liability and the fair value measurement of an equity
instrument would be from the perspective of the entity that has issued it. Although the
following paragraphs discuss the fair value measurement of liabilities, the principles are
equally applicable to the fair value measurement of equity instruments.
A discounted cash flow method can be applied from one of two perspectives. The fair value
can be measured from the perspective of a market participant that fulfills the obligation, or it
can be measured from the perspective of a market participant that issues an identical liability. When assuming the obligation is fulfilled, the discounted cash outflows would include the
direct costs to fulfill the obligation and would include compensation for taking on the obligation. The compensation would include a risk premium to compensate for the risk inherent in
the cash flows and an amount to cover opportunity costs (i.e., profit). When measured from
58
◾ Fair Value Measurement Standards and Concepts
the perspective of a market participant that issues an identical liability, the fair value would
equal the proceeds that a market participant would expect to receive for issuing an instrument with identical terms (i.e., cash flows) and the same credit characteristics (i.e., discount
rate) (ASC 820-10-35-16I to J).
Other Factors That Impact the Fair Value of a Liability
Nonperformance risk has a direct impact on the fair value measurement of a liability. According to the Glossary, nonperformance risk is “the risk that an entity will not fulfill an obligation. Nonperformance risk includes, but is not limited to, the reporting entity’s own credit
risk.” Credit risk is the risk that the entity will experience a change in its creditworthiness
(ASC 820-10-35-17 to 18).
Credit enhancements, which are third-party guarantees, also impact the nonperformance risk and thus may impact the fair value of the liability. The key to measuring the fair
value of a liability with a credit enhancement is to determine the unit of account. If the unit
of account excludes the credit enhancement, the liability’s fair value would reflect the entity’s
own credit standing. If unit of account includes the credit enhancement, the fair value would
reflect the third party’s credit standing (ASC 820-10-35-18A).
Example: Measuring the Fair Value of Debt Assume Debt Co. issued $10 million of
10-year 5.8 percent fixed interest private placement debt on December 31, 20X1. Debt Co.’s
credit rating at the time was Aaa. Proceeds from the private placement were $10,186,200,
indicating a 5.75 percent yield to maturity. Debt Co. decides to account for this debt under
the fair value option using a discounted cash flow method as of December 31, 20X2.
The company’s credit rating has fallen from Aaa to Baa as of December 31, 20X2.
The two inputs to the discounted cash flow are the contractual terms of the debt and
the discount rate. The private placement memorandum stipulates the amount and timing of
coupon interest payments and the principal repayment. One method to determine the discount rate is to decompose the yield to maturity from the original issuance to understand how
market participants priced the issue. Then, the level of market rates and spreads can then be
analyzed considering the change in Debt Co.’s credit rating and the relative market spreads
for each credit rating. The decomposition of the original yield to maturity and the analysis of
market rates as of the valuation date are shown in Exhibit 2.2.
On the original issue date, the 10-year Treasury rate was 3.82 percent, and the market
required an additional 1.56 percent for Aaa-rated corporate bonds. The original yield to maturity indicates that the market required an additional 0.37 percent premium over the Aaa rate
for risks specific to Debt Co. and/or to that particular debt issuance. One year later, the 10-year
Treasury rate had decreased, but the market spread for Aaa corporate bonds had increased to
1.62 percent. There is no information to indicate that specific issue risk of 0.37 percent present
at original issuance has changed; therefore, the discounted cash flow model is calibrated at the
valuation date, and this amount is included in the discount rate. Debt Co.’s change in credit
rating to Baa would also be factored into the discount rate. The spread between Aaa and Baa
10-year corporate bonds of 1.08 percent as of December 31, 20X2, would also be included
in the discount rate. Therefore, the remaining contractual cash flows would be discounted at
6.5 percent to determine the fair value of Debt Co.’s debt as of December 31, 20X2.
FASB ASC 820, Fair Value Measurement
EXHIBIT 2.2
◾
59
Fair Value of Debt
Original
YTM
Market Rates
12/31/X2
10-Year Treasury Rate1
3.82
3.43
Spread for Moody’s Aaa2
1.56
1.62
Specific Issue Risk
0.37
0.37
Change to Baa3
N/A
1.08
Yield to Maturity / Market Rate
5.75
6.50
1 Federal Reserve Statistical Release H.15.
2 Difference between Moody’s Aaa Corporate Bond Rate and the 10-year Treasury rate, Release H.15.
3 Difference between Moody’s Aaa and Baa Corporate Bond Rates, Release H.15.
Valuation Techniques
The guidance for applying valuation techniques to measure fair value emphasizes that the
objective “is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under
current market conditions.” The selection of appropriate valuation techniques requires judgment and depends on the particular circumstances, including the availability of sufficient
data. Appropriate valuation techniques will maximize the use of observable inputs and minimize the use of unobservable techniques. In some circumstances, it is appropriate to rely
on just one valuation technique, particularly if quoted prices in active markets are available.
In other situations, multiple valuation techniques can be used to determine multiple indications of value. When assessing multiple indications of value, the reasonableness of the range of
values must be considered. “The fair value measurement is the point within that range that is
most representative of fair value in the circumstances.” Three valuation techniques are widely
used to measure fair value: the cost approach, the market approach, and the income approach
(ASC 820-10-35-24).
Cost Approach
According to the Glossary, the cost approach is “a valuation technique based on the amount
that currently would be required to replace the service capacity of an asset (often referred to
as current replacement cost).”
The notion behind the cost approach is that the fair value of an asset is estimated by the
current replacement cost of the asset less any adjustments for obsolescence related to the subject asset. The replacement cost of the asset would equal the amount that it would cost to
replace the asset with another asset of comparable utility, as of the measurement date. The cost
approach is often used to estimate the value of specific assets, such as a building or machinery
and equipment, or certain intangible assets, such as customer relationships or an assembled
workforce. Because of its nature, the cost approach is difficult to apply when estimating the
fair value of an entire operating business; however, it is not impossible to do so. In financial reporting, the cost method is most often used to estimate of the fair value of intangible
60
◾ Fair Value Measurement Standards and Concepts
assets acquired in a business combination under FASB ASC 350. The cost approach is the
subject of Chapter 6.
Market Approach
According to the Glossary, the market approach is “a valuation technique that uses prices and
other relevant information generated by market transactions involving identical or comparable (that is, similar) assets, liabilities, or groups of assets and liabilities, such as a business.”
The market approach estimates fair value by comparing a financial measurement such as
an earnings or cash flow for the subject entity to an earnings or cash flow multiple for a similar guideline entity whose shares are transacted in the marketplace. Commonly used financial
metrics are multiples of prices to earnings (P/E ratio) or multiples of invested capital to earnings before depreciation and amortization (EBITDA). Conceptually, the market approach is
easy to understand because it estimates fair value based on market transactions for similar
assets or business interests. The difficulty in applying the market approach to measure fair
value, particularly to intangible assets, is in identifying guideline assets or business interests
similar enough to support a determinative comparison. The market approach is the subject
of Chapter 7.
Income Approach
The Glossary says that the income approach includes “valuation techniques that convert
future amounts (for example, cash flows or income and expenses) to a single current (that
is, discounted) amount. The fair value measurement is determined on the basis of the value
indicated by current market expectations about those future amounts.”
Methods under the income approach can be applied to estimate the fair value of an
entire entity or reporting unit, or they can be applied to estimate the fair value of a specific
asset, particularly an intangible asset. The income approach is generally used to estimate
the fair value of a business or an asset of the business, such as an intangible asset based on
the risk-adjusted cash flows that the entity or specific intangible asset is expected to generate
over its remaining useful life. Several common methods can be used to estimate fair value
under the income approach and are based on a discounted cash flow analysis. These methods
measure fair value by estimating expected future cash flows that the entity or intangible
asset will generate. The sum of these expected cash flows over the life of the entity or asset is
discounted to the present at a risk-adjusted rate of return. The discount rate selected for use
is commensurate with the risk of actually receiving the cash flows. The income approach is
covered in Chapter 8.
Multiple Valuation Techniques
As a general rule, once valuation techniques are selected, they should be used consistently
from period to period. However, there may be circumstances in which a change in valuation
technique is warranted, such as when new markets develop, when market conditions change,
when the availability of information changes, or when valuation techniques improve. There
may also be circumstances that indicate a need to change the weights applied to multiple
FASB ASC 820, Fair Value Measurement
◾
61
valuation techniques. Or there may be a reason to change the application of adjustments to
valuation techniques. These changes are acceptable as long as the objective is to produce a
fair value measurement that is equally or more representative of fair value. Changes in valuation techniques or their application are considered to be changes in accounting estimates
(ASC 820-10-35-24 to 26).
Calibration
A relatively new fair value measurement concept brought about by convergence with IFRS
is the calibration of subsequent measurements with the initial measurement. Calibration is
applicable for situations in which the fair value of the initial measurement is the transaction
price (i.e., no gain or loss at initial measurement), and when remeasurement in subsequent
periods relies on unobservable inputs. At initial measurement, the valuation technique should
be calibrated so that the resulting fair value equals the transaction price. Doing this ensures
that current market conditions are reflected in the valuation technique and illuminates situations when adjustments may be needed to capture unique characteristics of the asset or
liability that are missed by the valuation technique. Calibration creates a more accurate fair
value measurement in subsequent periods because past relationships among unobservable
market inputs and observable transaction prices are preserved (ASC 820-10-35-24C).
Inputs to Valuation Techniques
Inputs to valuation techniques are either observable or unobservable. Observable inputs are
objectively determined price data from exchange markets, dealer markets, brokered markets
or principal-to-principal markets. Unobservable inputs are subjective assumptions about how
market participants make pricing decisions. According to ASC 820, “Valuation techniques
used to measure fair value shall maximize the use of relevant observable inputs and minimize
the use of unobservable inputs.” Inputs and any adjustments to inputs must be consistent
with the characteristics of the asset or liability being measured and consistent with its unit
of account. Adjustments such as a control premium or a discount for the lack of control may
be needed if a market participant would consider them relevant. A blockage factor, or a discount to reflect the price impact of trading a large block of stock, is not permitted in fair value
measurements. As a general rule, quoted prices in active markets are not adjusted when measuring fair value. When market prices are quoted as a bid/ask spread, the price within the
range that is most representative of fair value shall be selected. Using a bid price for an asset,
an ask price for a liability, a midmarket price convention, or another practical expedient used
by market participants are all permitted (ASC 820-10-35-36 to 36D).
Fair Value Hierarchy
ASC 820’s fair value hierarchy categorizes the inputs to the fair value measurement into three
levels. Level 1 inputs are unadjusted prices in active markets for identical assets or liabilities,
and they are given the highest priority within the hierarchy and within the fair value measurement itself. Level 2 inputs are observable market inputs that fail to quality as Level 1 inputs,
and Level 3 inputs are unobservable assumptions. Level 3 inputs have the lowest priority.
62
◾ Fair Value Measurement Standards and Concepts
For situations in which the fair value measurement of a particular asset or liability is based
on inputs from more than one level, the measurement is categorized at the lowest level input
that is significant to the overall measurement of the value.
When determining the appropriate fair value hierarchy level, the focus should be on the
inputs. Generally, adjustments to inputs should not be taken into consideration when determining the hierarchy level. However, if an observable input is adjusted using an unobservable
input and that adjustment is significant to the overall value, the measurement should be categorized in Level 3. It should also be noted that the valuation technique does not determine the
hierarchy level. Although the availability and reliability of relevant inputs would be considered
when selecting a valuation method, it is the inputs, not the valuation method that determines
the hierarchy level. For example, a fair value measurement determined using a discounted
cash flow method could be classified as Level 2 or Level 3. The selection of the appropriate
level requires judgment and depends on identifying which inputs are more significant to the
measurement and where those inputs fall within the hierarchy (ASC 820-10-35-37 to 38).
Level 1 Inputs According to the Glossary, Level 1 inputs are “quoted prices (unadjusted)
in active markets for identical assets or liabilities that the reporting entity can access at the
measurement date.” As a general rule, when Level 1 inputs are available, they should be used
without adjustment because they provide the most reliable evidence about the fair value of
a particular asset or liability. The fair value of Level 1assets or liabilities would be equal to
the quoted price times the quantity held or owed by the entity. Blockage discounts for large
positions should not be applied (ASC 820-10-35-40, 41, and 44).
Level 1 inputs exist for many financial assets and liabilities, and sometimes inputs are
available from multiple markets. When there is more than one active market for an asset or
liability, the reporting entity must select inputs from the principal market, which is the market with the greatest volume and level of activity for that particular asset or liability. In the
absence of a principal market, the entity can select inputs from the most advantageous market.
However, the entity must be able to access the market in order to use the inputs in a fair value
measurement. Access means that it would be possible for the entity to enter into a transaction
for that particular asset or liability at that input price, in that market, on the measurement
date (ASC 820-10-35-41B).
Example: Principal or Most Advantageous Market To illustrate these points, assume
that Enterprise Company sells a commodity in two active markets, its local market and a neighboring market. Enterprise transacts in both of these markets on a regular basis and can access
the prices in both markets on the measurement date. The costs and fair values in the principal
and most advantageous market are presented in Exhibit 2.3.
The fair value would equal the market price less transportation costs in the principal market, which is the market with the greatest volume and level of activity for the asset. If the local
market is the principal market, then the fair value of the commodity is $97. If the neighboring
market is the principal market, then the fair value is $95.
Now assume the principal market for the commodity is in a distant city, and that
Enterprise cannot access that market because transportation costs would be prohibitive.
Since Enterprise does not have access to the principal market, the fair value is measured
FASB ASC 820, Fair Value Measurement
EXHIBIT 2.3
◾
63
Principal and Most Advantageous Market
Market Price
Local
Market
Neighboring
Market
$ 107
$ 106
Transaction Cost
(7)
(4)
Transportation Cost
(10)
(11)
Net Price
$
90
$
91
in the most advantageous market. Enterprise determines the most advantageous market
based on the net price, which is the price to sell less all costs, including transaction costs
and transportation costs. The neighboring market is the most advantageous market for
Enterprise because the net price is maximized at $91. But the net price is not the fair value;
it is calculated solely for the purpose of determining the most advantageous market. The fair
value would be measured using the price in most advantageous market less transportation
costs, or $95 (820-10-55-46 to 49).
Several interesting observations can be drawn from this example. One observation is that
the principal market is determined from the perspective of all market participants. Therefore,
different sellers of a particular asset would likely reach the same conclusion when identifying
the principal market and the market price. However, they may not reach the same conclusion
about the fair value of the asset because fair value is market price less transportation costs. The
Glossary defines transportation costs as “the costs that would be incurred to transport an asset
from its current location to its principal (or most advantageous) market.” Therefore, transportation costs are unique costs to the selling entity; they are not determined based on market
participant assumption.
Another observation is that the most advantageous market is determined from the perspective of the individual seller. In the absence of a principal market, fair value is determined
in the most advantageous market. Therefore, different sellers of a particular asset would
likely reach different conclusions when identifying the most advantageous market and the
market price.
It should also be noted that the most advantageous market does not necessarily yield the
most advantageous fair value measurement. In our illustration, the neighboring market is
the most advantageous market, but the fair value in the local market would be higher. The
most advantageous market is determined by looking at net price, after subtracting all costs.
Fair value is the market price less transportation costs only; transaction costs are not deducted.
Level 1 Input Adjustments As previously stated, Level 1 inputs should be used without
adjustment whenever they are available. However, there are a few exceptions to this general
rule. One exception is for entities that use matrix pricing as a practical expedient to price a
large number of similar assets, such as investments in bonds. Although prices for identical
assets are available, they are not readily accessible. This alternative pricing method results in
a measurement that is lower than Level 1. Another exception would be in situations where
a quoted price in an active market is not indicative of fair value because of the occurrence
64
◾ Fair Value Measurement Standards and Concepts
of a significant event. For instance, if a publicly traded company makes an announcement
after the close of the market, but before the measurement date, the market input may not be
indicative of the company’s fair value. Any adjustment to the quoted market price would result
in a measurement lower than Level 1. A final exception may occur when using the quoted
price of an identical instrument traded as an asset to measure the fair value of a liability or
equity instrument. Any adjustments required for factors specific to the asset but not present
in the liability would result in a measurement lower than Level 1 (ASC 820-10-35-41C).
Level 2 Inputs Level 2 inputs are defined in the Glossary as “inputs other than quoted prices
included within Level 1 that are observable for the asset or liability, either directly or indirectly.” Quoted prices for identical assets or liabilities can be categorized as Level 1 or Level 2,
depending on whether the market is active (Level 1) or not active (Level 2). Quoted prices for
identical assets or liabilities are considered directly observable inputs. Quoted prices for similar
assets are always categorized as Level 2 and are considered indirectly observable inputs. Level
2 also includes other inputs that are indirectly observable in markets such as interest rates,
yield curves, implied volatilities and credit spreads. One caveat is that the Level 2 input must
be observable for the asset or liability’s full contractual term (ASC 820-10-35-47 to 48).
Examples of Level 2 inputs for specific assets are:
◾
◾
◾
◾
◾
◾
Swaps. The reference rate, such as the London Interbank Offering Rate (LIBOR), a specific
yield curve, or a bank prime rate.
Options. The implied volatility rates for the underlying share prices.
Licensing agreements acquired in a business combination. Royalty rates for similar agreements
with unrelated parties.
Inventory acquired in a business combination. Retail market prices and wholesale market
prices.
Buildings. Valuation multiples based on observable market data such as price per square
foot.
Reporting units. Valuation multiples such as earnings or revenue multiples based on transaction prices for similar businesses (ASC 820-10-55-21).
Level 2 Input Adjustments When measuring the fair value of an asset or liability, it may
be necessary to adjust Level 2 inputs for factors specific to the asset or liability, such as its condition or location. Adjustments may also be needed when the asset or liability is not comparable.
For instance, a restriction on the transfer of an asset or a different unit of account may affect
an asset’s comparability. Adjustments may also be needed or based on the volume or level of
activity in the market from which the inputs are observed. When adjustments are significant
to the fair value measurement of the particular asset or liability, the measurement would be
categorized as Level 3 (ASC 820-10-35-50 to 51).
Level 3 Inputs Unobservable inputs are defined by the Glossary as “inputs for which market
data are not available and that are developed using the best information available about
FASB ASC 820, Fair Value Measurement
◾
65
the assumptions that market participants would use when pricing the asset or liability.”
Relevant observable inputs may not be available because there is little to no market activity
for the asset or liability as of the measurement date. All unobservable inputs are categorized
as Level 3 inputs.
Unobservable inputs are intended to represent an exit price from the perspective of a market participant who owns the asset or owes the liability. They reflect the assumptions that a
market participant would use to price the asset or liability. A market participant’s assumptions
about risk are integral to fair value measurement and include risks inherent in the valuation technique, risks associated with the inputs to that technique, and risks associated with
measurement uncertainty.
Unobservable inputs should be developed using the best information available, which
may include an entity’s own data. When using the entity’s own data as a starting point, it
would be adjusted when market participants would use different data. Additional adjustments
would be necessary for entity-specific synergies not available to other market participants.
A reporting entity must consider all information about market participant assumptions that
is reasonably available, but it need not undertake exhaustive efforts (ASC 820-10-35-52
to 54A).
Measuring Fair Value When the Volume or Level of Activity for an
Asset or Liability Has Significantly Decreased
When there has been a significant decrease in the volume or level of activity relative to the
normal market activity for an asset or liability, the objective of the fair value measurement does
not change. Fair value is an exit price in an orderly market between market participants at the
measurement date under current market conditions. When the volume or level of activity has
significantly decreased, further analysis must be undertaken to determine whether the quoted
market price represents fair value and whether the transaction is orderly.
If the reporting entity determines that a quoted market price does not represent fair value,
an adjustment to the quoted market price would be necessary, and the adjustment may be
significant. Other adjustments may also be required when assets are not comparable or when
market prices are stale. When a market participant demands a risk premium as compensation
for bearing the uncertainty relating to the cash flows of the asset or liability, an adjustment for
risk would be needed (ASC 820-10-35-54D to E).
Another factor to consider when the volume or level of activity has changed is whether
the entity should change the valuation method for measuring fair value. The entity may also
consider whether to add a second technique for measuring fair value. Whenever an entity uses
more than one valuation technique, the goal is to determine the point within the range that
is the most representative of fair value (ASC 820-10-35-54F).
Identifying Transactions That Are Not Orderly
Generally, transactions from forced liquidations or distressed sales are not considered to be
orderly. When there has been a significant decrease in the volume or level of activity relative
66
◾ Fair Value Measurement Standards and Concepts
to the normal market activity, it does not always mean that the transaction is not orderly. The
particular situation must be evaluated further to determine whether the transaction is not
orderly after weighing all available evidence. Circumstances that may indicate a transaction
is not orderly include:
◾
◾
◾
◾
◾
Inadequate exposure to the market that does not allow an ample period of time for usual
and customary marketing activities for the asset or liability
A seller that markets the asset or liability to a single market participant
A distressed seller that is in or near bankruptcy or in receivership
A forced sale for regulatory or legal reasons
A transaction price that is an outlier compared to other recent transactions
(ASC 820-10-35-54H to I)
When a transaction is not considered to be orderly, little to no weight should be placed on
the transaction price, and other indications of fair value should receive more emphasis when
measuring fair value. If the transaction is considered to be orderly, the transaction price should
be considered. The amount of weight given to the transaction price would depend on such factors as the volume of transactions in the market, the comparability of the market transaction to
the subject asset or liability, and the amount of time that has elapsed between the transaction
and measurement date.
When the entity cannot conclude whether the transaction is orderly because of insufficient information, the transaction price must be considered. However, less weight would be
placed on transaction with inconclusive evidence about whether the transaction is orderly,
and more weight would be placed on transactions considered to be orderly. When making its
assessment about whether a transaction is orderly, an entity cannot ignore information that
is reasonably available, but it need not undertake exhaustive efforts (ASC 820-10-35-54J).
Using Quoted Prices Provided by Third Parties
Entities may use quoted prices provided by third parties when measuring fair value if the
entity has determined that the third-party prices have been developed in accordance with
ASC 820. Pricing services and brokers are typical third-party sources of quoted prices.
The entity should consider whether the third-party price represents a binding quote or
whether it is an indicative price. More weight would be afforded to a binding quote in the fair
value measurement.
When there has been a significant decrease in the volume or level of activity relative to
the normal market activity, the entity must evaluate the third-party quotes further. The entity
must determine that prices are developed using current information that reflects orderly transactions. Or the third-party could develop prices using a valuation technique that reflects market participant assumptions, including risk premiums. The entity should place more weight
on third-party prices that reflect transaction prices, and less weight on those developed using
other valuation techniques (ASC 820-10-35-54K to M).
Disclosures
◾
67
DISCLOSURES
The objective of fair value measurement disclosures is twofold:
1. Disclosures are provided to help financial statement users to assess the valuation techniques and inputs applied to all assets and liabilities measured at fair value after initial
recognition.
2. Additional disclosures are presented for recurring measurements made using unobservable, Level 3 inputs so that users can assess the effect of those measurements on earnings
and other comprehensive income.
Financial statement preparers must disclose sufficient information to meet those objectives. In determining whether disclosures are sufficient, preparers must consider all of these
issues:
◾
◾
◾
◾
The appropriate level of detail
How much emphasis should be placed on various requirements
The appropriate level of aggregation or disaggregation
Whether additional information is needed to permit the evaluation of quantitative information (ASC 820-10-50-1 to 1A)
Required disclosures should be presented for each class of asset and liability measured at
fair value in the balance sheet after initial recognition. Determining the appropriate classes
of assets and liabilities requires judgment and should consider the nature, characteristics,
and risks of the class as well as the hierarchy level where the class would be categorized.
As a general rule, asset and liability classes require greater disaggregation than their balance sheet counterparts. Disclosures should also include sufficient information to allow the
financial statement user to reconcile the disclosures by class to balance sheet line items (ASC
820-10-50-2B and C).
Another item that entities must disclose is their policy for determining when transfers
between levels of the fair value hierarchy occur. The policy should be the same for transfers into
a level and for transfers out and should be followed consistently. Some companies recognize
transfers on the date of event or change in circumstances. Others recognize all transfers at the
beginning or end of the reporting period (ASC 820-10-50-2C).
Required Disclosures
Quantitative fair value measurement disclosures are required to be presented for all assets
and liabilities measured at fair value after their initial measurement. Additional information is required to be presented for assets and liabilities measured at fair value that fall
into Levels 2 and 3. Exhibit 2.4 provides a graphical summary of the disclosure requirements in ASC 820-10-50-2. The left side shows the hierarchy level to which the disclosure
68
EXHIBIT 2.4
Required Disclosures
Fair Value Measurement Disclosure Summary
Topic 820-10-50
Recurring or Nonrecurring
Recurring
Nonrecurring
All Assets & Liabilities
Description of valuation technique
Transfers between Levels 1 and 2∗
Reason for FVM
(i.e., circumstances)
Measured at Fair Value
Inputs used in FVM
Reason for transfers∗
After initial recognition
Disclosures for each class of asset/liability
Entity’s policy for determinig transfers∗
FVM at end of reporting period
Transfers in separated from transfers out∗
Levels 1, 2, & 3
Level of hierarchy FVM is categorized
If highest and best use differs from current
use and why.
Level 2
Any change in valuation technique
Use of additional valuation technique
Reason for change or addition
Level 3
Any change in valuation technique
Effect of measurement:
Use of additional valuation technique
on earnings
Reason for change or addition
on OCI
Quantitative info about unobservable
inputs
Description of the valuation process
including policies and proceedures
Reconciliation of opening & closing
balances:
Including: gains/losses, recognized in
earnings gains/losses in OCI
Purchases, sales, issues & settlements
(seperately)
Transfers in or out of level 3, separately
69
Income statement line item of gain/loss
OCI line item where recognized
Reason for transfers in or out of level 3
Company policy for determining transfers
Sensitivity analysis of FVM to changes in
inputs∗
Interrelationships among inputs, including
their mitigating/magnifying effects on
FVM∗
Assets & liabilities disclosed
but not measured at FV
Level of hierarchy FVM is categorized
Description of valuation technique
Inputs used in FVM
Any change in valuation technique
Use of additional valuation technique
Reason for change or addition
If highest and best use differs from current
use and why.
Note: All required quantitative disclosures should be presented in tabular format.
∗ Disclosure not required for nonpublic entities.
Additional disclosures are required for derivative assets and liabilities, liabilities with inseparable third-party credit enhancements, and FVM of investments
that calculate net asset value per share.
70
◾ Fair Value Measurement Standards and Concepts
requirements apply. Many disclosures are required regardless of level, and there are additional
requirements for Level 2 and Level 3 measurements. When an asset or liability is measured
using a measurement basis other than fair value, such as historical cost, the asset or liability
may be disclosed in the footnotes at fair value. When that is the case, additional information,
such as the hierarchy level, valuation technique, and inputs used in the fair value measurement, must be disclosed as well. Determining which disclosures are required also depends
on whether the asset or liability is measured at fair value on a recurring or nonrecurring
basis. Many disclosures are required for both recurring and nonrecurring measurements.
Exhibit 2.4 shows whether disclosures are required for both recurring and nonrecurring, for
recurring measurements only, or nonrecurring measurements only across the top.
Exhibit 2.5 provides an example of disclosures required for all assets measured at fair
value. The tabular format shows recurring fair value measurements in the top portion,
and nonrecurring measurements in the bottom. In the past, recurring and nonrecurring
disclosures were presented in separate disclosures.
The example in Exhibit 2.6 provides more detail about Level 3 measurements in a
roll-forward format. It shows an opening balance and a closing balance for all assets measured at fair value on the reporting dates, and it shows all activity that impacts the fair value
measurements during the period. Additional information about the fair value measurement
impact on earnings and other comprehensive income appears at the bottom of the disclosure.
Exhibit 2.7 provides an example of some relatively new disclosures for Level 3 assets.
It provides additional information about valuation techniques and inputs used to measure
fair value.
Private Companies
In an effort to respond to constituents’ appeal to reduce the reporting burden for smaller companies, the FASB has decided that many fair value measurement disclosures will no longer
be required for nonpublic companies. Generally, disclosures relating to transfers between fair
value hierarchy levels and disclosures about the sensitivity of measurements to changes in
inputs have been eliminated. Exhibit 2.4 indicates the disclosures that have been eliminated
for nonpublic companies in a footnote.
FAIR VALUE OPTION
ASC 825, Financial Instruments, contains the accounting guidance for the fair value option.
The fair value option is an election that companies can make to measure certain items at
fair value for financial reporting purposes, which was originally issued in 2006 as SFAS
159, Fair Value Option. The guidance in ASC 825 outlines the requirements for making the
election and for the presentation and disclosure of accounting information under the election
(ASC 825-10-05-5). The objective of the fair value option is to improve financial reporting.
The fair value option is intended to mitigate volatility in earnings caused by companies
that previously reported their assets and liabilities under different measurement basis
(ASC 825-10-10-1).
71
EXHIBIT 2.5
Disclosures for Assets Measured at Fair Value
Example Company
Disclosure—Assets Measured at Fair Value
Fair Value Measurements at the End of the Reporting Period Using
12/31/X1
Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)
Significant
Other
Observable
Inputs
(Level 2)
Significant
Unobservable
Inputs
(Level 3)
Total Gains
(Losses)
Recurring fair value measurements:
Trading securitiesa
Healthcare industry
$ 4,500,000
$ 4,500,000
Real estate industry
3,900,000
2,750,000
925,000
925,000
$ 9,325,000
$ 8,175,000
Other
Total trading securities
1,150,000
$ 1,150,000
Available-for-sale debt securities
Mortgage-backed securities
U.S. Treasury securities
Total available-for-sale debt securities
$ 13,575,000
$ 13,575,000
5,235,000
5,235,000
$ 18,810,000
$ 5,235,000
$ 13,575,000
Investmentsb
Private equity fund
Venture capital
$ 2,135,000
$ 2,135,000
1,450,000
1,450,000
$ 3,585,000
$ 3,585,000
(continued)
72
EXHIBIT 2.5
(continued)
Example Company
Disclosure—Assets Measured at Fair Value
Fair Value Measurements at the End of the Reporting Period Using
12/31/X1
Total recurring fair value measurements
$ 31,720,000
Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)
Significant
Other
Observable
Inputs
(Level 2)
Significant
Unobservable
Inputs
(Level 3)
$ 13,410,000
$ 1,150,000
$ 17,160,000
Total Gains
(Losses)
Nonrecurring fair value measurements:
Long-lived assets held and usedc
$ 20,000,000
$ 35,000,000
Goodwilld
2,000,000
Long-lived assets held for salee
1,000,000
16,000,000
$ 23,000,000
$ 51,000,000
Total nonrecurring fair value measurements
$ (15,000,000)
6,000,000
(4,000,000)
(15,000,000)
$ 6,000,000
$ (34,000,000)
Notes:
a On the basis of its analysis of the nature, characteristics, and risks of the securities, the reporting entity has determined that presenting them by industry is
appropriate.
b On the basis of its analysis of the nature, characteristics, and risks of the securities, the reporting entity has determined that presenting them as a single class
is appropriate.
c In accordance with Subtopic 360-10, long-lived assets held and used with a carrying amount of $50 million were written down to their fair value of $35
million, resulting in an impairment charge of $15 million, which was included in earnings for the period.
d In accordance with Subtopic 350-20, goodwill with a carrying amount of $10 million was written down to its implied fair value of $6 million, resulting in an
impairment charge of $4 million, which was included in earnings for the period.
e In accordance with Subtopic 360-10, long-lived assets held for sale with a carrying amount of $25 million were written down to their fair value of $16 million,
less costs to sell of $6 million (or $10 million), resulting in a loss of $15 million, which was included in earnings for the period.
73
EXHIBIT 2.6
Level 3 Disclosures
Example Company
Disclosure—Reconciliation of Fair Value Measurements Categorized within Level 3 of the Fair Value Hierarchy
Investments
Opening balance
MortgageBacked Securities
Private Equity
Fund
Venture
Capital
Total
$ 36,500,000
$ 4,000,000
$ 1,575,000
$ 42,075,000
Transfers into Level 3
125,000a,b
125,000
Transfers out of Level 3
(6,000,000)b,c
(6,000,000)
Total gains or losses for the period
Included in earnings (or changes in net assets)
(865,000)
Included in other comprehensive income
500,000
(365,000)
(7,050,000)
(7,050,000)
Purchases, issues, sales, and settlements
1,000,000
1,000,000
Purchases
Issues
Sales
(10,000,000)
(625,000)
(10,625,000)
$ 2,135,000
$ 1,450,000
$ 17,160,000
Closing balance
$
$
$
(2,000,000)
(2,000,000)
Settlements
$ 13,575,000
Change in unrealized gains or losses for the period included in
earnings (or changes in net assets) for assets held at the end of the
reporting period
Trading
Revenues
(165,000)
500,000
335,000
Other
Revenues
Total gains or losses for the period included in earnings (or changes
in net assets)
$
350,000
$ 15,000
Change in unrealized gains or losses for the period included in
earnings (or changes in net assets) for assets held at the end of the
reporting period
$
280,000
$ 55,000
Notes:
a Transferred from Level 2 to Level 3 because of a lack of observable market data, resulting from a decrease in market activity for the securities.
b The reporting entity’s policy is to recognize transfers into and out of Level 3 as of the date of the event or change in circumstances that cause the transfer.
c Transferred from Level 3 to Level 2 because observable market data became available for the securities.
74
◾ Fair Value Measurement Standards and Concepts
EXHIBIT 2.7
Disclosures about Valuation Techniques
Example Company
Disclosure—Information about Fair Value Measurements Categorized within Level 3
of the Fair Value Hierarchy
Mortgage-backed
securities
Venture capital
Fair Value
at 12/31/X1
Valuation
Technique(s)
Unobservable Input
$ 13,575,000
Discounted
cash flow
Constant prepayment
rate
1,450,000
Discounted
cash flow
Guideline
companies
Range (Weighted
Averages)
4%–8% (6%)
Loss severity
40%–100% (70%)
Default rate
9%–40% (20%)
Weighted-average cost
of capital
12%–16% (15%)
Long-term growth rate
4%–5% (4%)
Pretax operating
margin
3%–20% (15%)
Discount for lack of
marketabilitya
10%–25% (20%)
Discount for lack of
controla
10%–20% (15%)
EBITDA multipleb
6%–12% (9%)
Revenue multipleb
1%–3% (2%)
Discount for lack of
marketabilitya
10%–25% (20%)
Discount for lack of
controla
10%–20% (15%)
Notes:
a Represents discounts used when the reporting entity has determined that market participants would take
into account these premiums and discounts when pricing investment
b Represents amounts used when the reporting entity has determined that market participants would use
such multiples when pricing the investments
The fair value option is applicable to financial instruments, which, according to the
Glossary, encompass both financial assets and liabilities. The Glossary definition also includes
the concept that several financial instruments can be linked in a chain under a contract
that qualifies as a financial instrument and that the chain ends in the payment of cash
or an equity ownership interest. The Glossary defines financial assets as “cash, evidence
of an ownership interest in an equity, or a contract that conveys to one entity a right to
do either of the following: (1) receive cash or another financial instrument from a second
Fair Value Option
◾
75
entity, or (2) exchange other financial instruments on potentially favorable terms with the
second entity.” Financial assets arise from contractual agreements between two parties
and cannot be imposed by a third party. The definition of a financial liability is the opposite,
and the Glossary defines it as “a contract that imposes on one entity an obligation to do
either of the following; (1) deliver cash or another financial instrument to a second entity,
or (2) exchange other financial instruments on potentially unfavorable terms with the
second entity.”
Any entity can elect to measure financial assets and financial liabilities at fair value. The
election is available to a number of other items such as firm commitments, loan commitments, some insurance contracts, and some warranties. The fair value option is not available for consolidated investments in subsidiaries, consolidated variable interest entities, benefit
plan obligations, leases, demand deposits, or the issuer’s convertible debt (ASC 825-10-15-4
and 5).
Entities can make a fair value election on election dates, which generally occur on the
date the entity first recognizes the item or the date the entity enters into a firm commitment.
Election dates may also occur if there is an event or change of status, such as when an asset
reported at fair value is transfers to another subsidiary, when investments become subject
to equity accounting, when subsidiaries or variable interest entities are consolidated or
deconsolidated, when debt is significantly modified, or when a business combination occurs
(ASC 825-10-25-4 and 5).
The fair value election can be made on the election date on an instrument-by-instrument
basis (with some exceptions as outlined in ASC 825-10-25-7), or it can be made through an
existing accounting policy applicable to specific types of financial instruments. Once the election is made, it is irrevocable. The fair value option is applied to entire instruments and never
to portions of instruments. A fair value election made by the parent company and applied
in consolidation does not have to be applied into separate company financial statements for
the subsidiary. However, if the fair value option is elected by the subsidiary, it is required in
separate company financial statements. When several financial instruments are acquired in
a single transaction, the fair value option does not have to be applied to all of the financial
instruments (ASC 825-10-25-2, 6, and 10).
When there is a change in fair value for an item measured at fair value under the fair
value election, the unrealized gain or loss must be reported in earnings (825-10-35-4). In
the statement of financial position, assets and liabilities should be reported so that those measured at fair value are separated from those measured using other measurement attributes.
This can be accomplished by presenting them in a separate line item or by presenting them
in the same line item and parenthetically disclosing the amount measured at fair value
(ASC 825-10-45-1 and 2).
Additional disclosures are required for items measured under the fair value option and for
derivatives measured at fair value. The disclosures are not required for financial instruments
classified as trading securities, life settlement contracts, or servicing rights. The objectives of
fair value option disclosures are to promote financial statement comparability between entities that choose different measurement basis for similar assets and liabilities and between the
76
◾ Fair Value Measurement Standards and Concepts
assets and liabilities for a particular entity recorded at different measurement basis. Fair value
option disclosures are expected to provide this information:
◾
◾
◾
◾
Management’s reasons for electing or partially electing the fair value option
How changes in fair value impact earnings for the period
How certain items would have been measured if the fair value election had not been made,
(e.g., disclosures about equity investments and nonperforming loans)
Differences between fair values and contractual cash flows
Disclosures for financial instruments measured at fair value under the fair value election
are over and above those required in other ASC Topics such as ASC 820. Financial statement
preparers are encouraged but not required to combine the fair value option disclosures with
other fair value disclosures (ASC 825-10-50-24 to 27).
These disclosures are required for each date that a balance sheet is presented in interim
or annual financial statements:
◾
◾
◾
◾
◾
◾
Management’s reasons for electing fair value, by item or group of similar items.
If the fair value option is elected for some but not all items within a group of similar items,
disclosures should include a description of the items, the reason for the partial election,
and how the group of similar items relates to the balance sheet line item.
For each balance sheet line item that includes fair value option items, disclose how each
balance sheet line item relates to major classes of assets and liabilities presented in accordance with disclosures for ASC 820 and disclose the carrying amount of items in that line
that are not eligible for the fair value option.
The difference between the aggregate fair value and the aggregate unpaid principal
balance for loans, long-term receivables, and long-term debt instruments.
For loans held as assets, disclose the aggregate fair value of those over 90 days past due,
the aggregate value of loans in nonaccrual status, and the difference between the fair
value and aggregate unpaid principle on loans over 90 days or in nonaccrual status.
For investments measured at fair value that would be equity investments absent the fair
value option, disclose information about the item as though it were an equity investment
(ASC 825-10-50-28).
Additional disclosures are required for each period an annual or interim income statement is presented, including:
◾
◾
◾
For each income statement line item, the amount of gains and losses included in earnings
from changes in fair value.
How interest and dividends are measured and where they are reported in the income
statement.
For loans and other receivables held as assets, the gain or loss attributable to changes in
instrument specific credit risk and how such gains or losses were determined.
Standards in the Valuation Profession and Fair Value Measurements
◾
◾
77
For liabilities with significant changes in instrument specific credit risk, the gain or loss
attributable to the change in credit risk, qualitative information about the reason for the
change, and how gains and losses attributable to changes in credit risk were determined
(ASC 825-10-50-30).
Entities must also disclose the methods and significant assumptions used to estimate fair
value for fair value option items annually. At the time a fair value election is made, the entity
must disclose qualitative information about the nature of the event. Quantitative information
about the earnings impact of the initial election on each balance sheet line item must also be
disclosed (ASC 825-10-50-31 and 32).
STANDARDS IN THE VALUATION PROFESSION AND FAIR
VALUE MEASUREMENTS
Regulators have expressed concerns about the lack of uniformity within the valuation profession in regard to education, common best practice, discipline, and standards. The profession
responded with the Fair Value Quality Initiative, which led to the development of the CEIV
credential and the Mandatory Performance Framework. The MPF is a performance framework about how much work and documentation should be performed with the fair value
measurement, however the MPF is technically not a professional standard.
Professional standards for valuation specialists generally are issued by the VPO, in
which the valuation professional holds a credential. Valuation professionals who hold an
Accredited in Business Valuation (ABV) from the AICPA are required to follow the Statements
on Standards for Valuation Services (VS). Valuation specialists who hold an Accredited
Senior Appraiser under the American Society of Appraisers (ASA) must follow the ASA’s
business valuation standards. Valuation specialists who are members of the Royal Institute
of Chartered Surveyors (RICS) must follow the Red Book, which are that organization’s
standards. Although each of these organizations promulgates professional standards, the
standards are for general valuation practice. There are currently no valuation standards
specific to valuations in financial reporting.
Uniform Standards of Professional Appraisal Practice
The Uniform Standards of Professional Appraisal Practice (USPAP) are issued by the Appraisal
Foundation. The Appraisal Foundation, which was authorized by Congress in the 1989
as a result of the Savings and Loan crisis, originally authorized standards and qualifications
for real estate appraisers. The Foundation expanded its authority to develop qualifications
for personal property appraisers and provides voluntary guidance on recognized valuation methods and techniques for all valuation professionals.4 USPAP is generally recognized as the
overarching body of ethical and professional standards for the valuation profession in the
United States.
78
◾ Fair Value Measurement Standards and Concepts
The Appraisal Foundation has also taken a leading role in the profession in developing best
practices in valuations for financial reporting. The Foundation has issued guidance on various
topics such as best practices in contributory asset charges, valuation of customer relationships, valuation of contingent consideration, and the development of the Market Participant
Acquisition Premium (MPAP).
International Valuation Standards Council
The International Valuation Standards Council (IVSC) is an independent and not-for-profit
global valuation standards-setting organization. The IVSC provides standards for all areas
of valuation including tangible assets, businesses and interests in businesses, and financial
instruments. The IVSC through its member VPOs also is instrumental in developing the valuation professional around the world.
The IVSC is a member and sponsor-based organization with member VPOs in over
100 different countries. Sponsors include, among others, the six largest international
accounting firms, international consulting firms, the CFA Institute, the Appraisal Foundation, the Royal Institute of Chartered Surveyors, the AICPA, the ASA, OIV in Italy, INDAABIN
in Mexico, and the International Finance Corporation of the World Bank.
The IVSC’s primary objective is “to build confidence and public trust in valuation.”5
IVSC accomplishes this objective through a set of multidisciplinary professional valuation
standards that are referred to as International Valuation Standards or IVS. The IVSC’s
standards-setting process is inclusive and transparent. The standards-setting process is led by
a Standards Review Board, which oversees and provides guidance in standards development.
The Standards Review Board refers the actual development of standards to one of three
technical boards, the Tangible Assets Board, the Business Valuation Board, and the Financial
Instruments Board. The Standards Review Board then consults with the technical boards as
part of the standards development to ensure that the standards are harmonized across all
disciplines and meet the Board’s strategic directives.
The Standards Review Board frequently issues inquiries to constituents in the development of standards and carefully considers comments from interested parties. Each of the
technical boards as well as the Standards Review Board opens sections of their in-person
meetings to the public. Any proposed revision to IVS, either in the form of a new standard
or technical revision, is also open for public comments for a period of time prior to any
formal adoption.
IVSC’s technical boards regularly consult with other standards-setting organizations,
including the International Accounting Standards Board (IASB) and the International
Auditing and Assurance Standards Board (IAASB) about matters concerning valuations in
financial reporting.
IVS is incorporated as professional standards in some form by VPOs in more than
100 different countries. IVS is also included by statute in several countries as a required set
of valuation standards.
Conclusion
◾
79
IVS is structured as follows:
◾
◾
◾
◾
◾
◾
Introduction
Glossary
IVS Framework
General Standards
◾
IVS 101 Scope of Work
◾
IVS 102 Investigation and Compliance
◾
IVS 103 Reporting
◾
IVS 104 Bases of Value
◾
IVS 105 Valuation Approaches and Methods
Asset Standards
◾
IVS 200 Businesses and Business Interests
◾
IVS 210 Intangible Assets
◾
IVS 300 Plant and Equipment
◾
IVS 400 Real Property Interests
◾
IVS 410 Development Property
◾
IVS 500 Financial Instruments
Index6
Fair Value Measurements is a global concept in financial reporting. The FASB and the
IASB have developed nearly identical accounting standards for fair value measurement and
business combinations, as well as very similar standards in other areas of fair value accounting. International valuation standards provide consistency and comparability in the actual
fair value measurements in financial reporting across all markets, enhancing public trust in
the capital markets.
CONCLUSION
The objective of financial reporting is to provide information about a company’s net assets
and operating performance that investors and other stakeholders find useful. Traditionally,
accounting in the United States has been based on historical costs. However, financial
reporting has been evolving toward fair value measurement based on current values rather
than historical costs. Fair value has been required in financial reporting for some time now,
albeit on a relatively limited basis. Fair value has become the standard of measurement for
business combinations and for subsequent impairment testing of goodwill and intangible
assets acquired in the business combination. The FASB issued FASB ASC 820, Fair Value
Measurement (originally SFAS 157), to clarify the concepts for measuring fair value in all of
financial reporting.
ASC 820 is not without controversy, however. The application of fair value measurement
requires judgment, which is a fundamental change for those trained in historical cost-based
measurements. This subjective aspect of fair value measurement also creates a new dynamic
80
◾ Fair Value Measurement Standards and Concepts
among the preparer, the entity’s external auditor, and the outside valuation specialist who
may be engaged to perform the measurement. ASC 820 was issued by the FASB to provide
clearer direction for the measurement of fair value in financial reporting.
NOTES
1. Exposure Draft Proposed Statement of Financial Accounting Standards—Fair Value Measurements, June 23, 2004, paragraph C27, www.fasb.org.
2. Statement of Financial Accounting Standard No. 157, Fair Value Measurement, footnote 4.
3. Speech by SEC Staff Evan Sussholz: Remarks before the 2009 AICPA National Conference on
Current SEC and PCAOB Developments, Washington DC, December 7, 2009, www.sec.gov/
news/speech/2009/spch120709es.htm.
4. www.appraisalfoundation.org, accessed May 11, 2019.
5. International Valuation Standards 2017, IVSC, www.IVSC.org.
6. Id.
2A
APPE N D IX TW O A
Taxes and Fair Value Measurements
T
H E 2 0 1 7 TAX C U T S and Jobs Act (“the TCJA” or “the Act”) became effective on
December 22, 2017. The provisions of the TCJA have far reaching implications on
fair value measurements in financial reporting. The provisions impact not only U.S.
companies, but U.S. companies with foreign subsidiaries, as well as international companies
operating in the United States. The provisions impact not only the expected cash flow of
various entities but also perhaps their cost of capital as well.
The provisions of the TJCA perhaps require more extensive modeling in measuring
fair value of entities and various identified intangible assets. Since estimating the taxes is
much more facts-and-circumstances based under the TCJA, as a practical expedient, we have
assumed a blended rate of 26 percent in the examples throughout the book.
SUMMARY OF CHANGES UNDER 2017 TCJA
◾
◾
◾
Corporate tax rate is a flat 21 percent for tax years after December 31, 2017.
◾
State and local taxes are still deductible.
Treatment of capital expenditures
◾
100 percent of bonus depreciation is deductible through 2022.
• May apply to assets acquired in 4Q 2017.
◾
Limit of $1 million on a single item (total of $2.5 million).
◾
Applies to Sec. 179 property (vehicles, machinery, and equipment).
◾
Phased out by 20 percent a year from 2023 through 2026.
Limitation on deductibility of interest expense
◾
Limited to 30 percent of adjustable taxable income (ATI).
• (30 percent of EBITDA through 2021, 30 percent of EBIT beginning in 2022).
◾
Adjustable taxable income = Income excluding depreciation, amortization and
depletion.
81
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
◾ Taxes and Fair Value Measurements
82
◾
◾
◾
◾
Limitation does not apply to companies with annual gross receipts of $25 million
or less.
◾
Nondeductible portion can be carried forward.
Net operating losses (NOLs)
◾
Carry-forwards utilization is limited to 80 percent of taxable income.
◾
Carry-backs are eliminated.
◾
No change to SEC 382 Limitations.
Caps on executive compensation deductions.
Research and experimental expenditures
◾
Amortized over five years rather than immediately expensed ( begins 2022).
◾
Applies to capitalized software as well.
Impact on Fair Value Measurements
Since fair value is an exit notion from a market participant viewpoint, the valuation specialist should consider how a market participant would view taxes in pricing in the unit of
account. Changes in taxes under the TCJA may require more extensive modeling of prospective financial information. As a first step, the valuation specialist should consider whether the
prospective financial information provided by management is prepared on a book or tax basis.
If prepared on a book basis, the specialist may inquire of management to adjust the prospective
information for the impact of the TCJA.
As a second step, the valuation specialist may have to extend the prospective information beyond the explicit forecast period. For example, the applicable percentage of expense for
certain business assets (bonus depreciations) extends through 2026. Consequently, valuation
specialists may have to analyze the impact on the prospective financial information originally
provided by management to reflect the changes in deductibility of certain acquired assets or
create a separate depreciation schedule.
Additionally, previous practical expedients may not be appropriate any longer. Valuations
specialists sometimes assumed that tax depreciation equals book depreciation. Under the
TCJA, that assumption may no longer be appropriate. Also, the valuation specialist should
determine whether or not historical information is still a reasonable proxy for future. Interest
expense deductions may have to be modeled to properly measure the limitations of the
deductions (30 percent of EBITDA versus 30 percent of EBIT). However, this limitation may
not impact many entities.
Finally, the valuation specialist should consider consulting with management as to their
expectation as to changes in the marginal tax rates. Also, the valuation specialist should consult with management as to the proper determination of estimates of future depreciation and
amortization expense as well as any research and experimental expenditures. Depreciation in
the prospective financial information may have to be separated as to depreciation expense of
assets acquired prior to and post effective dates of the TCJA.
Although marginal tax rates appear to decrease under the TCJA, the impact upon value
may be muted due to changes in capital investment, changes in research and experimental
expenses, changes in debt structure, and greater focus on capital structure management.
Summary of Changes under 2017 TCJA
◾
83
Impact on Cost of Capital
The TCJA also may have an impact on the cost of capital in a fair value measurement.
The change in interest deductibility may cause a shift away from debt to more equity
financing since the tax shield may be more limited. Also, international companies may
employ a strategy of placing debt in more tax-favored jurisdictions, which may impact market
participant assumptions. Some observers believe that the changes in the deductibility of
interest will not only increase the after-tax cost of debt, but also will increase risk of equity
holders, increasing the overall cost of capital. Any increase in the cost of capital, of course,
will limit any increase in valuations from the tax saving from the provisions of the TJCA.
3
C HAPTE R THR E E
Business Combinations
B
U S I N E S S CO M B I N AT I O N is a financial reporting term that refers to a broad range
of transactions in which one company acquires another. The FASB Master Glossary
defines a business combination as “a transaction or other event in which an acquirer
obtains control of one or more businesses. Transactions sometimes referred to as true mergers
or mergers of equals are also business combinations.” The terms merger and acquisition refer
to the most common forms of business combinations. Mergers and acquisition transactions
are frequently described simply as M&A in the business community.
Mergers occur when two separate companies combine to form a single surviving entity.
Mergers are usually accomplished through the exchange of shares, where the shareholders
of one company surrender their shares in exchange for shares of the other company. Mergers
often occur between companies of relatively equal sizes. When mergers involve companies
of unequal sizes, the larger one takes control of the smaller company’s assets and liabilities,
and the smaller one ceases to exist. In contrast, acquisitions occur when one company buys
another company. Acquisitions are accomplished when one company purchases a controlling
number of the target company’s shares directly from the shareholders in exchange for cash,
for shares, or for a combination of both.
Although merger transactions may exist from a legal perspective, they do not exist in
financial reporting. All merger and acquisition transactions are considered to be business
combinations for financial reporting purposes. In a business combination, one company buys
another; therefore, one of the parties to the transaction is always identified as the acquirer and
the other is the acquiree.
The application of fair value measurement to business combinations and to the subsequent impairment testing of acquired assets is the primary focus of this book. The evolution
of fair value measurement concepts and the fair value measurement framework from ASC
820, Fair Value Measurement, were covered in Chapters 1 and 2. This chapter will provide an
overview of business combinations. The first section of the chapter will cover the role M&A
85
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
86
◾ Business Combinations
transactions play in our economy. It will begin with a look at recent M&A trends and factors
that motivate companies to undertake business combinations. Although the overriding goal
of an M&A transaction should be to increase shareholder wealth, not all transactions are successful. Therefore, the first section of the chapter will also address M&A pitfalls. The second
section of this chapter will cover accounting for business combinations. It will begin by briefly
discussing the development of accounting standards for business combinations from a historical perspective, and then it will cover the requirements of ASC 805, Business Combinations, in
greater detail.
Private companies have the option to elect alternative accounting treatment for business
combinations as provided by the FASB and the Private Company Council in ASU 2014-08,
Accounting for Intangible Assets in a Business Combination. The private company alternatives
for business combinations are discussed in Appendix 3A.
MERGERS AND ACQUISITIONS
M&A activity has rebounded since the Great Recession, with $4.7 trillion in global deals signed
in 2015, a level that eclipsed the previous record from 2007.1 Although 2016 global M&A of
$3.9 trillion fell short of the 2015 record, the M&A market remained vibrant amidst political
and economic uncertainty from the U.S. election, Brexit, and volatility in oil prices.2 Global
M&A volume of $705 billion for the first quarter of 2017 was the highest since 2007 and
was driven by cross-border acquisitions.3 The technology sector saw the highest level of M&A
activity in 2016,4 but the oil and gas sector has experienced the highest volume in the first
quarter of 2017.5
Motives for Mergers and Acquisitions
M&A transactions are completed for many reasons, but the single most important driver is the
desire to profit from opportunities represented by attractive target valuations. Acquirers may
believe the market has mispriced a publicly traded company. Or in the case of a privately owned
company, the perceived economic value of the company may be more than its price. Acquirers
hope to convert any mispricing to profit and shareholder value by holding or reselling the
target company.
In order to improve performance and shareholder value, many companies employ M&A
strategies designed to diversify risk, to achieve operating synergies, or to achieve financial
synergies. When the goal is diversification to reduce company-specific risk, acquiring companies in other industries, markets, or geographical areas can reduce earnings volatility and
increase value. Many acquisitions are undertaken in order to achieve operating synergies
such as economies of scale, increased pricing power, complementary functional efficiencies,
higher growth, and new markets. Operating synergies have the potential to improve profits
and growth, which drive company value. Financial synergies attributable to excess cash,
increased debt capacity, and tax benefits have the potential to increase cash flows or reduce
the company’s cost of capital, which can also lead to higher valuation.6
Mergers and Acquisitions
◾
87
During the financial crisis, distressed companies were often M&A targets because access
to capital was severely restricted and companies that needed cash to survive became targets
in a buyers’ market. Companies also shed underperforming operating units in order to shore
up operating results and focus on core businesses.7
The recent trend toward increased M&A, which is expected to continue in 2019, has
been driven by the need for growth as companies pursue new products and markets through
strategic acquisition in order to supplement organic growth.8 The Tax Cut and Jobs Act
(TCJA) of 2017 continues to fuel growth in M&A activity. Cross-border acquisition activity
has increased, particularly due to outbound deal volume from China.9,10 Other significant
factors contributing to increased volume are the low cost of capital to fund deals, high
corporate cash reserve balances, solid consumer spending, and the stabilization of oil prices.
The recent international climate has proven to be favorable with economic recovery in the
Eurozone in spite of Brexit uncertainty and with a relatively smooth transition in China
toward a more service-oriented economy, despite recent trade issues with the United States.11
M&A Pitfalls
Improving shareholder wealth is the overarching goal for both the acquiring entity and the
selling entity in M&A transactions. Acquisitions are more likely to be successful when there
are unique, significant synergies, when a low acquisition premium is paid, when the target
is a subsidiary or division, when the target is a smaller entity in a related business, and when
the acquirer is an industry leader. Evidence suggests that the sellers benefit disproportionately
from M&A transactions, especially when the takeover is hostile. Acquirers, on the other hand,
often fail to cover their cost of capital, which results in dilution of shareholder value. The primary reasons that M&A transactions fail from the acquirer’s perspective are that the acquirer
pays too high a price for the target and the acquirer underestimates the effort required to
successfully integrate the target company.
The acquirer may overpay for a variety of reasons, including overoptimistic appraisals,
overestimated synergies, overlooked problems, and overbidding. Overoptimistic appraisals
include assumptions that the market will rebound from a slump, that the company will turn
around, or that rapid growth will continue indefinitely. Overestimating positive synergies and
ignoring negative synergies can result in postmerger results that do not meet expectations.
When an acquirer pays a higher acquisition price based on the synergies it brings to the
table, there is potential for double counting the synergistic benefits. Overlooking problems
can occur because of faulty due-diligence due to insufficient information or inappropriate
conclusions. Problems with due diligence are more likely to occur when the target is larger or
when it operates in a different industry or multiple industries. When problems are identified,
they may be overlooked. Those conducting the investigation may be reluctant to bring bad
news to management’s attention for fear of being blamed for killing the deal. Overbidding
often occurs when the acquirer loses sight of the cost–benefit equation in the heat of the deal.
Due to human nature, the more time and effort that goes into a deal, the more difficult it
becomes to abandon the deal if the bidding gets out of line.12
88
◾ Business Combinations
ACCOUNTING STANDARDS FOR BUSINESS
COMBINATIONS—A BRIEF HISTORY
The early accounting history for business combinations is dominated by the debate about
whether the purchase method or the pooling method would be used to account for M&A transactions. The purchase method assumed that one entity acquired another for cash or a combination of cash and securities. The purchase method resulted in the recognition of acquired assets
and liabilities at fair market value. Under the purchase method, premerger, historic operating
results are not combined, and postmerger, historic income statements represent the acquiring
company’s operating results alone.
The pooling method assumed that two similar sized companies combined through an
exchange of securities. The pooling method recognized the combined assets and liabilities by
adding the companies’ respective book values together. Historic operating results of the two
companies were also combined. The pooling method was created through a Federal Power
Commission ruling in the 1940s in response to utility companies that attempted to justify
higher rates after writing acquired assets up to their fair market value.13
The American Institute of Certified Public Accountants (AICPA) Committee on Accounting Procedures (CAP), the predecessor to the Accounting Principles Board (APB), issued
Accounting Research Studies 5 and 10 that were opposed to the pooling method. However,
when the CAP issued ARB 40 in 1950, pooling was an acceptable method assuming the
previous ownership methods continued, companies were of comparable size, companies were
in similar businesses, and management continued. ARB 48, Business Combinations, which
was issued in 1957, loosened the criteria and permitted companies to choose between the
purchase and pooling methods.14
The Accounting Principles Board’s (APB) 16, Business Combinations, was issued in 1970
as a result of pressure from the Securities and Exchange Commission (SEC) and eliminated
the option to choose between the purchase and pooling methods when accounting for a
merger or acquisition. Instead, APB 16 created 12 criteria that had to be met in order for
a transaction to qualify for pooling accounting treatment; otherwise, the purchase method
was required.15 The financial reporting of a business combination that met the requirements
for pooling was materially different from one that was recorded under the purchase method.
Pooling was favored by companies because it permitted accounting for merged assets at
their older book values, which led to lower depreciation charges, and since goodwill was not
recognized under the pooling method, amortization expense was not recognized.16 Because
there were two methods permitted under APB 16, accounting for business combinations
was inconsistent in the United States and it was not comparable worldwide. Critics felt the
12 pooling criteria were arbitrary and ignored the substance of the merger transaction.17
It also became common for companies to structure transactions so that they would qualify
for pooling accounting treatment.
In its business combinations deliberations, the FASB concluded that the purchase method
under APB 16 had a number of deficiencies. The FASB observed that in many business combinations, the acquired company’s intangible assets accounted for most of the transaction’s
economic value. The use of the purchase accounting method under APB 16 resulted in much,
Accounting Standards for Business Combinations—A Brief History
◾
89
or most, of the transaction’s value being recorded on the balance sheet as goodwill, which
could then be amortized for up to 40 years. Since transactions are made for reasons other
than the acquisition of goodwill, the purchase method did not fairly represent the economic
substance of business combination.18
In order to correct these financial reporting deficiencies and inconsistencies, the FASB
issued SFAS 141, Business Combinations, on June 29, 2001, to replace APB 16, which had
been in effect for 31 years.19 SFAS 141 introduced two significant changes to accounting for
business combinations. First, it eliminated the pooling of interests’ method and required purchase accounting for all business combinations. The FASB believed that the purchase method
of accounting provided a better representation of the true economic substance of the underlying transaction and was therefore more relevant. Second, SFAS 141 placed more stringent
requirements for the recognition of acquired intangible assets in the acquiring company’s
financial statements. Paragraph 39 in SFAS 141 required that:
An intangible asset shall be recognized as an asset apart from goodwill if it arises from
contractual or other legal rights or, if not contractual, only if it is capable of being
sold, transferred, licensed, rented or exchanged. An assembled and trained workforce, however, is not valued separately from goodwill.20
SFAS 141 also provided guidance for applying the purchase method, which included identifying the acquiring and acquired entities, determining the total cost of the acquired entity,
and accounting for contingent consideration. Because business combinations accounted for
under the purchase method often resulted in the recognition of goodwill, which raised another
host of accounting issues, the FASB issued SFAS 142, Goodwill and Other Intangible Assets, concurrently with the issuance of SFAS 141. (Goodwill and other intangible assets are covered in
Chapter 4 and the impairment testing is covered in Chapter 5.)
In spite of the improvements to business combination accounting under SFAS 141, purchase accounting still had some limitations. One significant shortcoming that SFAS 141 did
not completely resolve was inconsistency with international accounting standards. The FASB
resolved this problem by issuing a revised statement on business combinations as part of the
convergence project with the IASB in December 2007. SFAS No. 141(R), Business Combinations, was a joint effort of the FASB and the International Accounting Standards Board (IASB)
and was the first statement issued under the convergence project between the FASB and the
IASB. The IASB issued a similar revised statement on accounting for business combinations,
IFRS 3, Business Combinations.
According to the FASB, another fundamental reason for revising the accounting guidance for business combinations was to improve financial reporting transparency and provide
investors with a more accurate representation of the true costs of mergers and acquisitions
through financial statement recognition and measurement of “identifiable assets acquired,
liabilities assumed, and any non-controlling interest in the acquiree.”21 The FASB also wanted
to improve financial statement disclosure requirements and provide sufficient information
to enable financial statement users to evaluate the nature and resulting financial effect of
business combinations.22 Finally, the FASB wanted to eliminate the recognition of negative
goodwill, as required in SFAS 141. Instead, SFAS 141(R) introduced the concept of a bargain
90
◾ Business Combinations
purchase price for situations when the fair values of the assets acquired are greater than the
consideration given up, which results in the acquirer recognizing a gain equal to the excess
fair value.
The FASB and the IASB issued almost identical statements that require the acquiring
entity in a business combination to recognize all, and only, those assets acquired and liabilities assumed in the transaction. The revised statement establishes an acquisition date fair
value measurement for all assets acquired and liabilities assumed as the measurement objective. The statement also requires disclosure of additional information that investors and other
users might need to evaluate and understand the nature and financial effect of the business
combination.23 Under SFAS 141(R), accounting for a business combination was no longer
considered to be purchase accounting. Instead, the revised statement introduces the Acquisition Method of accounting, which has broader application to all transactions where one entity
gains control over another.
ASC 805, BUSINESS COMBINATIONS
The requirements of SFAS 141(R) are codified in the FASB’s Accounting Standards Codification (ASC) under Topic 805, Business Combinations. The codification also includes subsequent
changes to SFAS 141(R) made by the FASB through FSP FAS 141(R)-1, Accounting for Assets
Acquired and Liabilities Assumed in a Business Combination that Arise from Contingencies, and
Accounting Standards Update (ASU) 2010-09, Disclosure of Supplementary Pro Forma Information for Business Combinations. The ASC is the single source of authoritative generally accepted
accounting principles in the United States (U.S. GAAP). ASC references are provided in parenthesis throughout this chapter to help the reader locate the FASB’s authoritative guidance for
business combinations.
The Acquisition Method
Business combinations are required to be accounted for by applying the acquisition method,
which requires all of the following four steps:
1. Identifying the acquirer.
2. Determining the acquisition date.
3. Recognizing and measuring the identifiable assets acquired, the liabilities assumed, and
any noncontrolling interest in the acquiree.
4. Recognizing and measuring goodwill or a gain from a bargain purchase (805-10-05-4).
Identifying the Acquirer
ASC 805 provides definitive guidance for identifying the acquirer, which is important because
the acquisition method does not permit “mergers of equals” in a business combination. Under
ASC 805, Business Combinations
◾
91
the acquisition method, one entity acquires another, and a business combination occurs when
one business entity gains control over another business entity. The entity that gains control of
the other is considered to be the acquirer.
Control generally means a controlling financial interest in another entity, which is usually indicated by the ownership of a majority voting interest (810-10-25-1, Consolidation).
The acquirer is usually the entity that transfers the cash or other assets or is the entity that
incurs the liabilities in order to affect the business combination. When business combinations
are affected by exchanging equity interests, the acquirer is usually the entity that issues its
equity interests (805-10-55-11 and 12).
Identifying the acquirer may not be as easy as it seems, particularly in situations in which
a business combination transpires through the exchange of equity interests. In an exchange
of equity transaction, one of the ways to identify the acquirer is to look at the relative voting rights in the combined entity after the combination. Examining relative voting rights is
particularly useful when there is no controlling group. The acquirer will be the group with
the largest voting interest after the combination. Another way to determine the acquirer is
to look at the composition of the combined organization’s governing body. The acquirer will
be the entity with the ability to elect the largest number of members to the combined entity’s
board of directors. The acquirer is also usually the entity that pays a premium over the precombination fair value of the other entity’s equity interest. Generally, the acquiring entity is
relatively larger based on assets, revenues, or earnings, and is the entity that initiates the business combination (805-10-55-12 to 14).
The 2017 merger between The Dow Chemical Company and E.I. du Pont de Nemours
and Company is an example of a typical business combination. The footnote disclosures
from DowDuPont, Inc. 2018 10-K relating to the merger between Dow Chemical and
DuPont clearly illustrate the four steps in the acquisition method as well as other business
combination concepts.
DowDuPont, Inc.: Identifying the Acquirer In September 2017, DowDuPont issued
a press release that said in part:
MIDLAND, Mich., and WILMINGTON, Del., Sept. 1, 2017—DowDuPont™
(NYSE:DWDP) today announced the successful completion of the merger of equals
between The Dow Chemical Company (“Dow”) and E.I. du Pont de Nemours
& Company (“DuPont”), effective Aug. 31, 2017. The combined entity is
operating as a holding company under the name “DowDuPont™” with three
divisions—Agriculture, Materials Science, and Specialty Products.
Shares of DuPont and Dow ceased trading at the close of the New York Stock
Exchange (NYSE) on Aug. 31, 2017. Beginning today, DowDuPont will start trading
on the New York Stock Exchange under the stock ticker symbol “DWDP.” Pursuant
to the merger agreement, Dow shareholders received a fixed exchange ratio of 1.00
share of DowDuPont for each Dow share, and DuPont shareholders received a fixed
exchange ratio of 1.282 shares of DowDuPont for each DuPont share.24
92
◾ Business Combinations
Based on the press release, it is difficult to determine which entity is the acquirer. However,
determining the acquirer is the first step of the acquisition method for a business combination.
Based on the facts and circumstances of the business combination, Dow was considered the
acquirer for business combination accounting purposes, even though the combination was
described as a merger. DowDuPont’s 2018 10-K describes it as follows:
Historical Dow was determined to be the accounting acquirer in the Merger. As a
result, the financial statements of Historical Dow for the periods prior to the Merger
are considered to be the historical financial statements of DowDuPont.25
Acquisition Date
The second step in the acquisition method is determining the acquisition date, which is the
date on which the acquirer obtains control of the acquired company. Control is typically
demonstrated when the acquirer transfers consideration, acquires the assets, and assumes
responsibility for the acquired liabilities, which usually occurs on the closing date of the
transaction. However, this may not necessarily always be the case. There may be situations
when the acquirer obtains effective control prior to the closing date, later than the closing
date, or without transferring consideration (820-10-25-6 to 11).
DowDuPont, Inc.: Change of Control The DowDuPont. Inc. press release provided
additional information about the combined company’s change control structure resulting
from the August 31, 2017, merger by saying:
Shares of DuPont and Dow ceased trading a the close of the New York Stock Exchange
(NYSE) on Aug. 31, 2017. Beginning today, DowDuPont will start trading on the New
York Stock Exchange under the stock ticker symbol “DWDP.”26
Recognize and Measure the Identifiable Assets Acquired, the Liabilities
Assumed, and Any Noncontrolling Interest in the Acquiree
To qualify for recognition under the acquisition method, identifiable assets acquired and liabilities assumed must meet the definition of assets and liabilities in FASB Concepts Statement
No. 6, Elements of Financial Statements, as of the acquisition date. As a result of the business
combination, some assets may be recognized that were not previously recognized by the
acquired company because they were developed internally and the costs to develop the assets
were expensed. In other situations, costs the acquirer expects to incur but is not obligated
to incur are not recognized when applying the acquisition method. Therefore, restructuring
costs related to the business combination such as the costs associated with exiting an activity
and terminating or relocating employees are recognized in the post-combination financial
statements (805-20-25-1 to 4).
ASC 805, Business Combinations
◾
93
Under ASC 805, the acquirer is required to recognize identifiable intangible assets
separate from goodwill. However, due to the recent issuance of ASU 2014-08 by the Private
Company Council (PCC) and the FASB, private companies can elect an alternative to recognize
fewer identifiable intangible assets. A summary of the PCC alternative for intangible asset
recognition appears in Appendix 3A. Recognition criteria for public companies and those
private entities that have not made the PCC election are covered in this section.
Generally, an intangible asset is considered to be identifiable if it meets either the separablity criterion or the contractual-legal criterion contained in the Master Glossary’s definition
of identifiable. According to the Master Glossary, an asset is identifiable if it meets either of the
following criteria:
1. It is separable, that is, capable of being separated or divided from the entity and sold,
transferred, licensed, rented, or exchanged, either individually or together with a
related contract, identifiable asset, or liability, regardless of whether the entity intends
to do so.
2. It arises from contractual or other legal rights, regardless of whether those rights are
transferable or separable from the entity or from other rights and obligations.
Identifiable acquired assets assumed liabilities and any noncontrolling interest are
measured at their acquisition-date fair values. The application of fair value measurement
applies to assets with uncertain cash flows that normally have valuation allowances such
as accounts receivable and loans, to assets subject to operating leases, to defensive assets, to
assets and liabilities arising from contingencies, and to contingent consideration arrangements. There are some limited exceptions to the application of fair value measurement
to the assets and liabilities acquired in business combinations. Income taxes, employee
benefits, share-based payment awards, and assets held for sale are notable exceptions
(805-20-30-1 to 12).
DowDuPont, Inc.: Fair Value of Assets and Liabilities Identifiable intangible assets
acquired as part of a business combination are recorded at their respective fair value as of the
measurement date. DowDuPont’s 10-K provides an example of this process:
Based on an evaluation of the provisions of Accounting Standards Codification
(“ASC”) 805, “Business Combinations” (“ASC 805”), Historical Dow was determined
to be the accounting acquirer in the Merger. DowDuPont applied the acquisition
method of accounting with respect to the assets and liabilities of DuPont, which
were measured at fair value as of the date of the Merger. Historical DuPont’s assets
and liabilities were measured at estimated fair values at August 31, 2017, primarily
using Level 3 inputs. Estimates of fair value represent management’s best estimate
and require a complex series of judgments about future events and uncertainties.
Third-party valuation specialists were engaged to assist in the valuation of these
assets and liabilities.27
94
◾ Business Combinations
The following table summarizes the identifiable intangible assets acquired as shown in
DowDuPont, Inc.’s Form 10-K for the year ending December 31, 2018 (in millions):
Merger Intangible Assets (Amounts in millions)
Intangible assets with finite lives:
Developed technology
$ 4,239
Trademarks/trade names
1,045
Customer-related
9,215
Microbial cell factories
400
Other
461
Total other intangible assets
$ 15,360
Intangible assets with indefinite lives:
IPR&D
660
Germplasm
6,263
Trademarks/trade names
4,788
Total other intangible assets
$ 27,071
Source: DowDuPont, Inc. Form 10-K; www.sec.gov.
Recognize and Measure Goodwill or a Gain from Any Bargain Purchase
Generally, goodwill is recognized when the fair value of the consideration transferred exceeds
the sum of the fair value of assets acquired and liabilities assumed. However, the fair value
of any noncontrolling interest in the acquiree and the acquisition date fair value of the
acquirer’s previously held equity interest, if any, must also be added to the consideration
transferred when calculating goodwill (805-30-30-1). Consideration can take many forms
including cash, other assets, a business or subsidiary of the acquirer, contingent consideration, common or preferred equity instruments, options, warrants, and member interests
of mutual entities. Consideration transferred must also be measured at fair value as of the
acquisition date (805-30-30-1, 7, and 8).
If the sum of the fair value of assets acquired and liabilities assumed is greater than the fair
value of the consideration transferred, then the business combination is considered a bargain
purchase, and a gain is recognized. If it initially appears that the business combination resulted
in a bargain purchase, then the acquirer is required to reassess whether the assets acquired
were correctly identified and the resulting fair value measurement was properly performed.
The purpose of the reconsideration is to ensure that all available information is appropriately considered, as of the date of the business combination (805-30-30-4 and 5). Prior to
the issuance of SFAS 141(R), a bargain purchase did not result in the recognition of a gain.
Instead a bargain purchase resulted in some acquired assets being recorded at amounts less
than fair value.
Other Business Combination Highlights
◾
95
DowDuPont, Inc.: Fair Value of the Consideration Transferred The DowDuPont,
Inc.’s 2018 Form 10-K summarizes the determination of the fair value of the consideration
transferred, or acquisition price to effect the merger between Dow and DuPont:
The total fair value of consideration transferred for the Merger was $74,680 million.
Total consideration is comprised of the equity value of the DowDuPont shares at
August 31, 2017, that were issued in exchange for Historical DuPont shares, the
cash value for fractional shares, and the portion of Historical DuPont’s share awards
and share options earned at August 31, 2017.28
DowDuPont, Inc.: Recognition and Measurement of Goodwill or a Gain from a
Bargain Purchase ASC 805 indicates that:
It is required that the acquirer recognizes goodwill as of the acquisition date,
measured as the excess of the consideration transferred plus the fair value of any
non-controlling interest in the acquiree at the acquisition date over the fair values of
the identifiable net assets acquired.
On the other hand, a bargain purchase occurs in a business combination in
which the total acquisition-date fair value of the identifiable net assets acquired
exceeds the fair value of the consideration transferred plus any non-controlling
interest in the acquire. When there is a bargain purchase, the acquirer must
recognize the excess fair value of acquired net assets in earnings as a gain.
DowDuPont recognized goodwill from the 2017 business combination of
$45,497,000,000:29 The addition of the goodwill resulting from the business combination with DuPont resulted in an adjustment that “included a $392 million increase in
goodwill.”
In April 2019, DowDuPont announced that the company would be breaking up into three
separate chemical companies: Dow, which will be dedicated to the production of commodity
chemicals; DuPont, which will produce specialty chemicals; and Corteva, which will focus on
agricultural chemicals.
OTHER BUSINESS COMBINATION HIGHLIGHTS
Some of the more important guidance for accounting for business combinations in financial
reporting under ASC 805 is highlighted in this section.
Definition of a Business
The guidance in ASC 805 applies to all transactions that meet the definition of a business combination, which, according to the Master Glossary, is “a transaction or other event in which an
acquirer obtains control of one or more businesses.” The Master Glossary defines a business
as “an integrated set of activities and assets that is capable of being conducted and managed
96
◾ Business Combinations
for the purpose of providing a return in the form of dividends, lower costs, or other economic
benefits directly to investors or other owners, members or participants.”
In January 2017, the FASB issued ASU 2017-01, Clarifying the Definition of a Business.
The ASU created an initial screening test, which asks whether substantially all the gross assets
acquired are concentrated in a single (or group of similar) identifiable assets. If yes, then the
acquisitions are deemed asset acquisitions rather than business combinations. If no, then the
acquisition may be a business if it includes an input and has substantive processes.
The screening process further asks if there are outputs in addition to inputs and processes.
If there are outputs and they include an organized workforce that produces outputs and has a
unique process, then the acquisition may be a business combination. If there are no outputs
but the acquisition includes employees and the inputs could be converted to outputs, then that
acquisition may be considered a business combination.30
The net result of this clarification of the definition of a business is that it is expected
that more transactions will be considered acquisitions of assets rather than a business
combination.
Pending content to ASC 805 further clarifies that a business consists of inputs and
processes applied to those inputs that have the ability to contribute to the creation of
outputs. However, outputs are not required for the entity to be defined as a business
(ASC 805-10-55-4).
It is important to note that the acquisition can be structured as a purchase of equity
interests or as the purchase of assets. A group of acquired assets that meets the definition of
a business would be accounted for as a business combination regardless of the legal form of
the transaction.
ASC 805 provides accounting and reporting guidance for the acquisition of a business
and for the acquisition of assets or groups of assets that do not meet the definition of a business. The guidance in ASC 805 relating to the acquisition of a business does not apply to joint
ventures, acquisitions of assets or groups of assets that do not meet the definition of a business,
or to combinations of entities under common control.
ASC 805-50, Business Combination, Related Issues, provides separate guidance for the
acquisition of assets rather that do not meet the definition of a business. Acquired assets are
recognized based on their cost to the entity, including any transaction costs. When the fair
value of the non-cash consideration is different than the fair value of the assets acquired, the
acquiring entity would recognize a gain or loss. The acquiring entity should allocate the cost
to acquired assets and liabilities based on their fair values and there should be no allocation
to goodwill (805-50-30-1 to 3).
The Measurement Period
The measurement period is the period after the acquisition date during which the acquirer
can adjust provisional amounts recognized from the business combination or recognize
additional assets or liabilities as information becomes available. It provides the acquirer
reasonable time to obtain information necessary to identify and measure the identifiable
assets acquired, liabilities assumed, any noncontrolling interest, consideration transferred,
the equity interest previously held, and goodwill or a gain on a bargain purchase. The measurement period ends as soon as the acquirer receives information it was seeking about facts
Other Business Combination Highlights
◾
97
and circumstances that existed on the acquisition date. It also ends if the acquirer determines
that additional information is not obtainable. During the measurement period, adjustments
to provisional amounts are recognized retroactively, and the offsetting adjustment is to
goodwill. After the measurement period ends, adjustments are recognized in the income
statement. The measurement period cannot exceed one year from the acquisition date
(805-10-25-13 to 15).
Business Combinations Achieved in Stages
Sometimes an acquirer obtains control of an acquiree in stages. It may own a noncontrolling
equity interest prior to gaining a controlling interest. When a controlling interest is acquired,
the acquirer must remeasure its previously held equity interest at fair value on the acquisition
date. Any gain or loss from remeasurement is recognized in earnings, and any previously recognized other comprehensive income is reclassified and included in the calculation of gain or
loss (805-10-25-9 and 10).
Fair Value of the Contingent Consideration Transferred
The acquisition price under ASC 805, Business Combinations, is generally the fair value of the
consideration transferred for the acquirer’s interest in the acquired company. In many transactions, the terms of the merger agreement are structured to provide additional consideration
to the business’s former owners if the entity meets specified financial targets after the acquisition. This contingent consideration is beneficial to both parties in the business combination
when the parties are unable to fully agree on an acquisition price. If a business combination
has contingent consideration (sometimes referred to as an earn-out), it is recorded at fair value
as of the acquisition date (805-30-30-7).
Changes in the fair value of contingent consideration can be the result of additional information about facts and circumstances that existed at the acquisition date, which would result
in a measurement period adjustment to goodwill. However, changes in the fair value of contingent consideration resulting from events after the acquisition date such as meeting earnings targets or milestones are not measurement period adjustments. Adjustments outside the
measurement period have the potential to impact earnings (805-30-35-1).
Because changes in the fair value of contingent consideration in subsequent periods can
lead to earnings volatility, measuring the fair value accurately within the measurement period
is critical. Contingent consideration and its fair value measurement are covered in depth in
Chapter 12.
Acquisition-Related Costs
Acquisition-related costs are costs incurred to affect the business combination such as finder’s
fees; advisory, legal, accounting, and valuation fees; other professional fees; and general
and administrative costs, including the costs of maintaining an acquisitions department.
Acquisition-related costs must be expensed in the period incurred and cannot be capitalized.
The cost of registering and issuing debt and equity securities is considered an exception, and
these costs are recognized in accordance with other GAAP (805-10-25-23).
98
◾ Business Combinations
Acquired Contingent Assets and Liabilities
Contingent assets and liabilities generally fall within the scope of ASC, 450 Contingencies,
unless they are acquired and fall within the scope of ASC 805, Business Combinations, which
stipulates that an acquisition date asset or liability shall be recognized if the acquisition date
fair value can be determined before the end of the measurement period. If the acquisition
date fair value cannot be determined before the end of the measurement period, then an
asset or liability should be recognized at the acquisition date if both of the following criteria
are met:
1. Information available before the end of the measurement period indicates that it is
probable that an asset existed or a liability had been incurred at the acquisition date.
2. The amount of the asset or liability can be reasonably estimated.
If both criteria are not met, the acquirer should not recognize the asset or liability as of
the acquisition date.
Further application guidance in Topic 450 also applies to acquired contingencies
(805-20-25-18A to 20A).
In-Process Research and Development (IPR&D)
IPR&D is technology that is under development as of the acquisition or measurement date,
that is not currently feasible, and that is without any alternative future use. Under generally
accepted accounting principles (GAAP), the potential viability of technology under development is considered to be uncertain; therefore, costs of research and development are expensed
as incurred. Prior to SFAS No. 141(R), this conservative reasoning was extended to business
combinations, which required IPR&D to be written off as of the date of the acquisition.
However, in their deliberations for SFAS No. 141(R), the FASB “concluded that in-process
research and development acquired in a business combination generally will satisfy the definition of an asset because the observable exchange at the acquisition date provides evidence that
the parties to the exchange expect future economic benefits to result from that research and
development. Uncertainty about the outcome of an individual project is reflected in measuring fair value.”31 This treatment has continued under ASC 805, Business Combinations. The
acquirer is required to recognize the fair value of IPR&D as an identifiable asset apart from
goodwill, similar to any other acquired asset.
GAAP contains some interesting accounting inconsistencies in the treatment of IPR&D.
Specifically, while IPR&D acquired in a business combination would be recognized as an asset
apart from goodwill, subsequent expenditures for research and development would still be
expensed. In addition, if IPR&D were purchased as an asset apart from a business combination,
the cost of the IPR&D would be expensed.
Additional inconsistencies exist in impairment testing of IPR&D. Acquired IPR&D measured and recorded at fair value in a business combination is considered an indefinite-lived
intangible asset until the project has been completed or abandoned. Consequently, any test
for impairment is based on IPR&D’s fair value and is performed in accordance with ASC 350,
Intangibles—Goodwill and Other. After the acquisition date, any additional costs to further
develop the IPR&D are expensed until there is a determination that the project is developed
Subsequent Accounting for Goodwill and Other Intangible Assets
◾
99
or is to be abandoned. Once IPR&D is considered to be developed, then a life is assigned to the
technology. The project is amortized over its remaining life. The developed technology would
then be tested for impairment under ASC 360, Property, Plant and Equipment. Inconsistencies
relating to the accounting treatment of IPR&D may or may not be resolved by the FASB at a
future date.
Private Company Alternative Accounting Under ASU 2014-18
In December 2014, the FASB issued ASU No. 2014-18, Business Combinations (Topic 805):
Accounting for Identifiable Intangible Assets in a Business Combination (a Consensus of the Private
Company Council).
ASU No. 2014-18 is designed to reduce the cost and complexity of accounting for
intangible assets acquired by private companies in business combinations. Private companies
may elect the alternative accounting treatment in business combinations but there is no
requirement to do so.
Under the alternative accounting, private companies would not have to recognize two
otherwise identified intangible assets in a business combination. The first group of assets that
would not have to be separately recognized are noncompete agreements. The second group of
assets that would not have to be separately recognized are customer-related intangible assets
unless they are capable of being sold or licensed independently of other assets. Examples of
these types of customer assets that may have a secondary market and are still required to
be recognized under the alternative accounting are mortgage servicing rights, commodity
supply contracts, bank core deposits, and other customer information that may be regularly
sold. Otherwise any customer-related assets would not have to be separately recognized apart
from goodwill.
The PCC reasoning for excluding recognition of these particular assets in a business
combination is because these assets may not be relevant to the users of the financial
statements of certain private companies. These users may only have interest in assets that
may have value in the secondary market if something goes wrong with their investment.
Noncompetition agreements and customer relationships generally do not have value in
distressed situations.
SUBSEQUENT ACCOUNTING FOR GOODWILL
AND OTHER INTANGIBLE ASSETS
The purpose of ASC 805, Business Combinations (previously SFAS 141(R)), and ASC 350,
Intangibles—Goodwill and Other (previously SFAS No. 142), was to improve financial reporting
by recognizing the fair values of goodwill and other intangibles arising from transactions and
by reflecting the underlying economics of the acquisition more completely and accurately.
Constituents including company management, financial statements users, and analysts
recognized that intangible assets are an increasingly important economic resource and
that an increasing proportion of the value of assets acquired relates to intangible assets.
As a result, better information about intangible assets was needed in financial reporting for
business combinations.32
100
◾ Business Combinations
Because of goodwill impairment testing under ASC 350, users of financial information are
better able to understand the subsequent performance of acquired intangible assets. Impairment testing provides users with a better understanding about changes in expectations for the
entity’s performance over time, thereby improving users’ ability to assess future profitability
and cash flows.33 Although annual impairment testing is no longer required for some privately held entities, ASC 350 requires that goodwill of a public entity must be tested for impairment at least annually, or more frequently, if impairment is indicated. Impairment Testing is
the subject of Chapter 5.
CONCLUSION
Accounting for business combinations under ASC 805, Business Combinations, improves
financial reporting by eliminating inconsistencies previously allowed under APB 16’s pooling
and purchase methods of merger accounting. The acquisition method of accounting for
business combinations provides for the identification of all assets acquired and liabilities
assumed in a merger and it establishes the acquisition date fair value as the measurement
objective. It also improves the international comparability of financial statements through
convergence with the International Accounting Standards Board and the simultaneous
release of IFRS 3, Business Combinations.
Some of the more significant provisions of ASC 805 are the requirement to identify the
acquirer; to identify all assets and liabilities, including intangible assets; to recognize a gain
on a bargain purchase; to recognize contingent consideration; and to measure the fair value
of in-process research and development. ASC 805 also addresses whether to recognize contingent assets and liabilities existing on the acquisition date, in guidance similar to that provided
in ASC 450, Contingencies.
Private companies may elect alternative accounting for business combinations under
ASU 2014-18.
Impairment testing for goodwill and other intangible assets is covered in ASC 350,
Intangibles—Goodwill and Other, or in ASC 360, Property, Plant and Equipment. Goodwill and
intangible assets with indefinite lives fall under ASC 350 and the goodwill of publicly held
entities is subject to impairment testing, annually, or sooner if indicated by a triggering
event. Such events generally occur when there has been an adverse change in the business
climate or a significant reorganization. For privately held entities that have elected the Private
Company Council’s alternative accounting, goodwill is amortized. Intangible assets with
defined lives are subject to amortization and fall under ASC 360.
Goodwill can be assessed for impairment through a qualitative test. If it is more likely that
goodwill is not impaired, based on the totality of events and circumstances, then no further
testing is necessary. If impairment is indicated, then a quantitative impairment test is required
to determine the amount of impairment.
Entities also have the option of performing the quantitative test to determine whether
goodwill is impaired. The quantitative test is a straightforward comparison of the entity’s fair
value to its carrying value. If the carrying value exceeds the fair value, the amount of the
impairment loss is equal to the excess carrying value.
Notes
◾
101
NOTES
1. “U.S. Executives on M&A: Full Speed Ahead in 2016; 2016 Survey Findings,” New York: Fortune Knowledge Group and KPMG.
2. J.P. Morgan, “2017 M&A Global Outlook: Finding Opportunities in a Dynamic Market.”
3. Olga Tarabrina, “Global M&A Breaks through the $700 Billion Mark at the Quickest Pace in
a Decade,” Dealogic, March 21, 2017, www.dealogic.com/insight/global-ma-breaks-700bnmark/.
4. J.P. Morgan.
5. Tarabrina.
6. Aswath Damodaran, “How Has M&A Changed Since the Economic Crisis?,” http://pages.stern
.nyu.edu/~adamodar/New_Home_Page/invfables/adqmotives.htm, accessed September 29,
2011.
7. Rich Jeaneret, “Why 2011 Outlook for M&A Is Uncertain,” Forbes, December 14, 2010, www
.forbes.com/2010/12/14 mergers-acquisitions-outlook-leadership-2010.
8. “The State of the Deal: M&A Trends 2019,” Deloitte, www.deloitte.com.
9. J.P. Morgan.
10. “2017 Global Transactions Forecast: From Apprehension to Appetite,” Baker McKenzie and
Oxford Economics, https://www.bakermckenzie.com/-/media/images/newsroom/2017/01/
gtfinfographic-final.pdf.
11. Id.
12. Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of
Companies, 3rd ed. (New York: John Wiley & Sons, 2000), 103–108.
13. Michael Davis, “APB 16: Time to Reconsider; Acquisitions Disguised as Poolings Can
Lead to Misleading Improvements in Earnings,” Journal of Accountancy, October 1, 1991,
www.thefreelibrary.com/APB+16%3A+time+to+reconsider%3B+acquisitions+disguised+
as+poolings+can … -a011394227.
14. Brian W. Carpenter and Daniel P. Mahoney, “Closing the GAAP Gap,” CPA Journal, December
2008, http://findarticles.com/p/articles/mi_qa5346/is_200812/ai_n31171180/.
15. Davis, “APB 16.”
16. Id.
17. Id.
18. SFAS 142, paragraph B28.
19. Carpenter and Mahoney.
20. SFAS 141, paragraph 39.
21. SFAS 141(R), Business Combinations, paragraph 1, December 2007.
22. Id.
23. “FASB issues FASB Statements No. 141(R), Business Combinations, and No. 160, Noncontrolling
Interests in Consolidated Financial Statements,” news release, December 4, 2007, www.fasb.org.
24. “DowDuPont Merger Successfully Completed,” www.dow-dupont.com, accessed May 15,
2019.
25. DowDupont Form 10-K, December 31, 2018, 38.
26. “DowDuPont Merger Successfully Completed.”
27. DowDupont Form 10-K, December 31, 2018, 105.
28. Id.
29. Id., 107.
30. ASU 2017-01 Clarifying the Definition of a Business, www.fasb.org.
31. FASB FAS 141(R), Business Combinations, Basis for Conclusions, paragraph B152.
32. Summary of Statement No. 142, www.fasb.org.
33. Id.
4
C HAPTE R F O U R
The Nature of Goodwill
and Intangible Assets
T
H E R E C O G N I T I O N O F I N TAN G I B L E AS S E T S at fair value is a relatively recent
development in financial reporting that typically occurs because of business combinations. As a result, there has been an increased awareness that intangible assets
contribute value to business entities. Every entity, large and small, is made up of both tangible and intangible assets that work in conjunction to create value for the entity. Tangible
assets are easily understood; they are assets with physical characteristics that are typically
observable. Inventory, machinery, and real estate are tangible assets that usually represent
a significant portion of the business enterprise’s operating assets. Intangible assets also can
significantly contribute to the profitability of business enterprises. Intangible assets are distinguished by their lack of physical substance; they generally cannot be observed or touched.
Even so, intangible assets provide valuable rights and privileges. Estimating the fair value of
these intangible assets creates challenges for those engaged in financial reporting.
The International Glossary of Business Valuation Terms defines intangible assets as
“non-physical assets such as franchises, trademarks, patents, copyrights, goodwill, equities,
mineral rights, securities, and contracts (as distinguished from physical assets) that grant
rights and privileges and have value for the owner.”1 This definition of intangible assets in
general includes both intellectual property and goodwill. When measuring the fair value
created from intangible assets, it is important to understand what distinguishes intellectual
property from goodwill, which is covered in this chapter.
The Dictionary of Finance and Investment Terms has a similar view of intangible assets, defining them as a “right or nonphysical resource that is presumed to represent an advantage to the
firm’s position in the marketplace. Such assets include copyrights, patents, trademarks, goodwill, computer programs, capitalized advertising costs, organization costs, licenses, leases,
franchises, exploration permits, and import and export permits.”2 The accounting definition
103
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
104
◾ The Nature of Goodwill and Intangible Assets
provided by the Financial Accounting Standards Board (FASB) refers to intangible assets as
“assets (not including financial assets) that lack physical substance.”3 The FASB’s definition
of intangible assets excludes goodwill while the definition used by traditional corporate finance
and valuation professionals includes goodwill in the broader definition of intangible assets.
HISTORY OF INTANGIBLE ASSETS
Intangible assets represent the intellectual capital of an entity. As such, intangibles represent
knowledge. Human history is predicated on development of knowledge. Intangible assets
are not new phenomena; they have existed throughout human history. Changes in communications technology from the invention of the printing press in the fifteenth century and
the telegraph in the nineteenth century, to the telephone, television, and the Internet in
the twentieth century, provide an example of how changes in technology impact mankind’s
advancement. The development of new technologies and legal protections such as patents
and copyrights afforded those new technologies creates significant value for the intangible
assets’ owners.
As discussed previously, both the U.S. and global economies have undergone a tremendous shift, from “bricks and mortar” businesses to information-based businesses that require
less investment in tangible assets such as machinery and buildings. Additionally, the globalization of international trade and the development of new information-based technologies in
the past 20 years have contributed to recent recognition that intangible assets add value to an
entity. As a consequence, a much greater percentage of global market capitalization is derived
from intangible assets.
Governments have long protected ownership rights of intangible assets, particularly intellectual property. Governments realize that to encourage innovation, the inventor’s work has
to be protected. One of the first declarations granting rights to inventors was the Statute of
Monopolies declared by the King of England in 1623. The statute was written to promote competition and still reward the inventor. Written in the language of the time, the statute provides
protection for the inventor for 14 years.
Provided alsoe That any Declaracion before mencioned shall not extend to any tres
Patents and Graunt of Privilege for the tearme of fowerteene yeares or under, hereafter to be made of the sole working or makinge of any manner of new Manufactures
within this Realme, to the true and first Inventor and Inventors of such Manufactures,
which others at the tyme of makinge such tres Patents and Graunts shall not use, soe
as alsoe they be not contrary to the Lawe nor mischievous to the State, by raisinge
prices of Commodities at home, or hurt of Trade, or generallie inconvenient: the said
fourteen yeares to be from the date of the first res Patents or Grant of such privilidge
hereafter to be made, but that the same shall be of such force as they should be if this
Act had never byn made, and of none other.4
The Constitution of the United States grants the U.S. Congress the authority to “promote
the progress of science and useful arts, by securing for limited times, to authors and inventors, the exclusive right to their respective writings and discoveries.” Under this power, one
Intellectual Property
◾
105
of the first acts of the new Congress in 1790 was to adopt both patent and copyright laws.
Originally, protection for trademarks was left to the individual states; however, Congress began
passing the first federal trademark laws in 1870. Since then, Congress has amended the intellectual property statutes frequently in response to changes in technology and to advances in
international commerce. Both houses of Congress have committees that are responsible for
keeping intellectual property laws up to date.5
Although intellectual property creates economic advantages for its owner, the value
of intellectual property is often difficult to quantify. An article on the World Intellectual
Property Organization website quotes Sir William Thompson, Lord Kelvin, who spoke
in the nineteenth century about the difficulty in measuring knowledge by saying, “When
you measure what you are speaking about and express it in numbers, you know something about it, but when you cannot (or do not) measure it, when you cannot (or do not)
express it in numbers, then your knowledge is of a meager and unsatisfactory kind.”6
Expressing similar thoughts, Galileo Galileli suggested, “Measure what is measurable, and
make measurable what is not so.”7 Quantifying the economic benefit that specific assets
contribute to a business enterprise is the fundamental purpose for fair value measurements in
financial reporting.
INTELLECTUAL PROPERTY
Intellectual property refers to creations of the mind such as inventions, literary and artistic
works, and symbols, names, images, and designs used in commerce. Intellectual property can
be protected legally.8 Common legal protections for intellectual property are patents, copyrights, trademarks, trade names, service marks, and trade secrets. These legal protections
prevent the use of the intellectual property by others.
The U.S. Patent and Trademark Office (USPTO) describes a patent as “a property right
granted by the Government of the United States of America to an inventor to exclude others
from making, using, offering for sale, or selling the invention throughout the United States or
importing the invention into the United States for a limited time in exchange for public disclosure of the invention when the patent is granted.”9 Currently the term is 20 years from the
date of application.
The USPTO distinguishes a trademark from a patent by describing a trademark as
“protect(ing) words, names, symbols, sounds, or colors that distinguish goods and services
from those manufactured or sold by others and to indicate the source of the goods. A service
mark is “a word, name, symbol or device that is to indicate the source of the services and
to distinguish them from the services of others. A service mark is the same as a trademark
except that it identifies and distinguishes the source of a service rather than a product.
The terms ‘trademark’ and ‘mark’ are often used to refer to both trademarks and service
marks.”10 Trademarks, unlike patents, can be renewed forever, as long as they are being used
in commerce.11
A copyright “protect[s] works of authorship, such as writings, music, and works of art that
have been tangibly expressed. The Library of Congress registers copyrights which last for the
life of the author plus 70 years.”12
106
◾ The Nature of Goodwill and Intangible Assets
ECONOMIC BASIS OF INTANGIBLE ASSETS
Intangible assets create value for an entity in a number of ways. If intangible assets represent a knowledge advantage through proprietary know-how, relationships with important
customers, or expertise held by key employees, then the entity should be able to exploit that
knowledge to achieve a competitive advantage in the marketplace. The knowledge advantage
becomes an economic advantage through enhanced margins. For example, if an entity develops technology internally, then it does not have to license similar technology from an outside
source and it does not have to pay licensing or royalty fees. Similarly, if the entity already has
relationships with key customers, it will not have to incur marketing and selling expenses to
attract as many new customers. Additionally, if the entity already has a trained workforce,
then it will not have to incur as many hiring and training expenses. Although the extent of the
economic benefits provided by intangible assets varies by asset, the economic benefit generated
by each intangible asset contributes to the value to the entity as a whole.
In Intangibles: Management, Measurement, and Reporting, Baruch Lev describes fundamental value drivers that are unique to intangible assets. He calls them nonrivalry scalability and
networking. Nonrivalry scalability refers to the ability to accommodate a multitude of users
at any given time. Tangible assets, such as laptop computers, have a limit to the number of
simultaneous users. Intangible assets, however, can be used by multitudes at once. Only one
person at a time can use a laptop, but millions can simultaneously access eBay’s website and
use eBay’s proprietary software technology. The use of an intangible asset typically does not
have any physical limitations. The only limitation is the size of the market for that asset. Therefore, nonrivalry scalability described by Lev is a primary value driver for intangible assets.13
Another value driver described by Lev is the network effect of intangible assets. A network effect is simply that the value of the intangible asset increases as the number of users
increases.14 Adobe Systems Incorporated owns software that bridges the gap between computer images and print images. One of the most widely used Adobe products is Acrobat software, which allows the interface of electronic computer images with a printer. The Adobe
Flash Player that utilizes this software is installed on 98 percent of Internet-connected desktops.15 The widespread use of Flash Player makes this software the de facto industry standard
and creates a competitive advantage for Adobe in marketing its other products.
The economic investment in intangible assets is substantial as the investment in specific
intangible assets often creates a competitive advantage for the owner. A 2001 working paper
by the Federal Reserve Bank of Philadelphia estimates that $1 trillion is spent annually on
developing intangible assets in the United States alone. The $1 trillion annual investment
equals the investment in tangible assets by those same businesses. The investment in intangible assets is likely to be even higher today. The same working paper also estimates that the
capital stock of intangibles in the United States had an equilibrium market value of at least
$5 trillion as of the year 2000.16
IDENTIFICATION OF INTANGIBLE ASSETS
While economic benefits provide evidence as to the existence of intangible assets, the FASB provides specific criteria for recognizing an intangible asset in financial reporting. In a business
combination, an intangible asset should be recorded on the balance sheet as of the acquisition
Identification of Intangible Assets
◾
107
date if it is considered identifiable. According to the FASB Master Glossary, an intangible asset is
considered identifiable if it is either:
◾
◾
Separable, that is, capable of being separated or divided from the entity and sold,
transferred, licensed, rented, or exchanged, either individually or together with a
related contract, identifiable asset, or liability, regardless of whether the entity intends
to do so
Arises from contractual or other legal rights, regardless of whether those rights are
transferable or separable from the entity or from other rights and obligations
According to the FASB, an intangible asset has substance that should be recognized in a
company’s financial statements if the intangible can be monetized or if it is created by legal
rights. An intangible asset can be monetized by selling or licensing the asset to a market participant. A favorable contract is an example of a legal obligation that provides substance to an
intangible asset.
Examples of Specific Intangible Assets
To understand how an intangible asset creates value within an entity, it may be helpful
to examine the asset’s place in the FASB’s general classification of intangible asset. The
FASB classifies intangible assets with similar characteristics into groups in order to provide
examples of identifiable intangible assets. The FASB’s groups include marketing-related,
customer-related, artistic-related, contract-based, and technology-based intangible assets.17
Marketing-Related Intangible Assets
A number of intangible assets are used to create market awareness for an entity’s products or
services. Trade names and trademarks distinguish a company’s products and services from
competitors’ products and services. An apple is generally thought of as a fruit; however, when
the logo of an apple with a bite taken out of it is attached to a laptop computer, the apple takes
on an entirely different meaning. That logo represents the unique features of Apple’s products and provides a competitive advantage for Apple Inc. by creating brand awareness in the
marketplace.
Trade dress is another marketing-related intangible asset. Trade dress is a distinctive
feature incorporated into the product or its packaging that identifies the company that
produces the product. Tiffany & Company uses a turquoise color called “Tiffany Blue” in its
advertising and on boxes and shopping bags used in its stores. Tiffany describes the color by
saying, “Glimpsed on a busy street or resting in the palm of a hand, Tiffany Blue boxes and
shopping bags epitomize the jeweler’s great heritage of elegance, exclusivity and flawless
craftsmanship.”18
A marketing-related intangible asset that has become increasingly important in the Internet age is the Internet domain name. A domain name that is obvious and easy to remember
increases Internet traffic, and it is more valuable than a name that is difficult to remember.
If you are wondering whether to bring an umbrella to work today, weather.com is an example
of a domain name that certainly meets this criterion.
Another example of a marketing-related intangible asset is one that may not be apparent to a customer or consumer. A noncompete agreement is a marketing-related intangible
108
◾ The Nature of Goodwill and Intangible Assets
asset that preserves market share by legally limiting potential competition from current or past
employees. Noncompetition employment agreements are often executed when an employee
is hired and when one company acquires another. They are usually restricted to the specific
industry within which the company operates. Trade names, trademarks, trade dress, and noncompete agreements enhance the value of a firm by supporting its marketing activities and by
creating or preserving a competitive advantage.
Customer-Related Intangible Assets
Another group of intangible assets that adds value to an entity are those related to the
development of customer relationships. Established customer relationships are a vital asset
because the customers are a business entity’s lifeblood, providing cash that the business needs
to survive and grow. Often customer relationships consist of both a contractual component
and an additional relationship component. The value derived from the contract component
is fairly self-evident. The value of the relationship component is derived from the possibility that the contract will be renewed, preserving the relationship and providing a future
income stream.
Customer relationships are physically represented in customer lists. A customer list is
typically a database that includes information about the customers, such as their name,
address, e-mail address, phone numbers, and contact names. It may also contain order
histories and demographic information. Although a customer list generally doesn’t provide
any contractual or other legal rights, customer lists are often monetized through the sale
of contact information to another party. Therefore, a customer list acquired in a business
combination normally meets the separability criterion for identification and recognition in
the financial statements.19
How many of us have had a phone call as we are about to sit down to dinner from someone wanting to sell us something? It is likely that our telephone number and other contact
information were sold to the dinner interrupter by another entity in order to monetize our
contact information.
Artistic-Related Intangible Assets
Artistic-related intangible assets such as works of art, books, plays, and musical scores derive
value from their copyright protection. Since a copyright provides a legal protection, the copyright is considered identifiable and it meets the criteria for recognition in financial reporting. In addition, the holder of an artist-related intangible asset can transfer the copyright to
another party through various means. It can be transferred in whole by assigning the right,
or transferred in part through a licensing agreement that gives another party the right to use
the asset for a specific period. Artistic-intangible assets can be recognized individually or recognized in conjunction with similar or related assets. When recognized in conjunction with
other assets, the group of assets should have similar useful lives.20 Artistic-related intangible
assets are generally owned by entities that produce or use artistic works, such as those in the
music or publishing industries.
The NBC television and radio network started using a three-note chime to identify
itself in the 1920s, and it continues to use its famous chime today. The chime was the
first audio service mark registered with the U.S. Patent Office.21 The familiar NBC chime
is a valuable artistic intangible asset that is currently owned by the General Electric
Corporation.
Identification of Intangible Assets
◾
109
Contract-Related Intangible Assets
Contract-related intangible assets such as customer contracts, license agreements, franchise
rights, and operating rights create value for an entity by allowing the entity to do something
it otherwise would not be able to do, or by allowing the entity to do something with more
favorable terms than current market conditions would allow. These types of intangible assets
are inherently considered identifiable for financial reporting purposes because they meet the
legal/contractual provision for recognition.
A favorable lease would be an example of a contract-related intangible asset. If an entity
holds a long-term lease for a headquarters facility with a lease rate that is less than current
market rates for similar facilities, then the lease is considered an intangible asset. The value of
the intangible asset would be measured by determining the present value of the lease savings
over the life of the lease.
A supply contract that provides for the conveyance of materials at lower than market rates
is another example of a contract-related intangible asset. Sometimes the value of a supply contract is derived from the assurance of an uninterrupted supply of materials when there are
shortages in the market.
A franchise agreement would also be a contract-based intangible asset. Franchise
agreements grant the right to distribute products, techniques, or trademarks in exchange for
royalty payments or a share of revenues. Franchise agreements outline the obligations of the
franchisor and franchisee and often include a geographical restriction or exclusivity clause.
An example of a franchise agreement would be the arrangement between an automobile
dealership and the automobile manufacturer.
Technology-Related Intangible Assets
Technology-related intangible assets create value by applying technological innovation to an
entity’s products or services. Technological innovation often provides unique benefits to the
entity or to the entity’s customers. Technology-related intangible assets include proprietary
technology, such as patented and unpatented software, databases, trade secrets, and formulas. Technology-related intangible assets can be transferred and licensed, and increasingly are
licensed as entities attempt to monetize their intellectual property. This transferability permits technology-related intangible assets to be considered identifiable and to be recognized in
financial reporting.
Amazon recently introduced the Kindle Fire, an improved version of its electronic book
reader. Kindle’s proprietary technology makes the wireless downloading of electronic books,
music, and apps possible using either a standard Wi-Fi connection or through its own Whispernet cloud technology that eliminates the need for connection to a computer. 22 Developed
originally by Amazon for the Kindle2, the Whispernet technology used in Kindle products
gave Amazon a substantial advantage by allowing it to create and dominate the electronic
book reader market.
Other Examples of Identifiable Intangible Assets
The general classification of intangible assets into the five major categories and specific
example of intangible assets within those categories cited in ASC 805 are summarized in
Exhibit 4.1.23 The exhibit also includes additional examples of intangible assets even though
they are not specifically cited in the FASB guidance.
110
◾ The Nature of Goodwill and Intangible Assets
EXHIBIT 4.1
Identifiable Intangible Assets
Marketing-Related Intangible Assets
Trademarks
Trade names
Service marks
Collective marks
Certification marks
Trade dress
Newspaper mastheads
Internet domain names
Noncompetition agreements
Brand names
Distribution rights∗
Distribution networks∗
Retail shelf space∗
Subscription lists∗
Supplier relationships∗
Cooperative ventures∗
Customer-Related Intangible Assets
Customer lists
Order backlogs
Customer contracts
Customer relationships
Noncontractual
relationships
Medical charts and records∗
Artistic-Related Intangible Assets
Plays
Operas
Ballets
Books
Magazines
Newspapers
Literary works
Musical compositions
Song lyrics
Advertising jingles
Pictures
Photographs
Videos
Audiovisual material
Motion pictures
Films
Music videos
Television programs
Architectural drawings∗
Blueprints∗
Product designs∗
Drawings∗
Manuscripts∗
Publications∗
Slogans∗
Film libraries∗
Contract-Based Intangible Assets
License agreements
Royalty agreements
Standstill agreements
Advertising contracts
Construction contracts
Management contracts
Service contracts
Supply contracts
Lease agreements
Construction permits
Franchise agreements
Broadcast rights
Operating rights
Servicing contracts
Employment contracts
Drilling rights
Water rights
Air rights
Timber rights
Route authorities
Airport gates∗
Development rights∗
Exploration rights∗
FCC licenses∗
Management contracts99
Mineral rights99
Permits99
Technology-Based Intangible Assets
Patented technology
Computer software
Computer mask works
Unpatented technology
Databases
Title plants
Trade secrets
Secret formulas
Processes
Recipes
In-process R&D∗
Laboratory notebooks∗
Patent applications∗
Proprietary processes∗
Technological documentation∗
∗ Other examples not specifically mentioned in FASB ASC 805, Business Combinations.
Useful Life of an Intangible Asset
◾
111
USEFUL LIFE OF AN INTANGIBLE ASSET
The useful life of an intangible asset is an important consideration when estimating the fair
value of the asset. The value of economic benefits generated by an intangible asset is directly
related to the asset’s useful life. The FASB Master Glossary defines the useful life as “the period
over which an asset is expected to contribute directly or indirectly to future cash flows.”
FASB ASC 350 further describes the importance of useful life to the recognition of intangible
assets, saying:
The accounting for a recognized intangible asset is based on its useful life to the
reporting entity. An intangible asset with a finite useful life shall be amortized; an
intangible asset with an indefinite useful life shall not be amortized. The useful life
of an intangible asset to an entity is the period over which the asset is expected to
contribute directly or indirectly to the future cash flows of that entity. (350-30-35-1
and 2)
The FASB further clarifies the description of useful life, saying:
The useful life is not the period of time that it would take that entity to internally
develop an intangible asset that would provide similar benefits. However, a reacquired right recognized as an intangible asset is amortized over the remaining
contractual period of the contract in which the right was granted. If an entity subsequently reissues (sells) a reacquired right to a third party, the entity includes the
related unamortized asset, if any, in determining the gain or loss on the reissuance.
(350-30-35-2)
The useful life of the asset is a component of each of the three valuation techniques that
are used to measure fair value under ASC 820, Fair Value Measurement. Under the income
approach, the useful life of the intangible asset is directly related to the forecast of future
cash flows that the asset is expected to generate. Under the market approach, the useful life
of the intangible asset is inherently factored into the market prices for comparable guideline
assets. Under the cost approach, the useful life of the asset is a concern when estimating
its obsolescence.
FASB ASC 350 also describes several important factors that should be considered when
estimating the useful life of an intangible asset for financial reporting purposes:
◾
◾
◾
◾
◾
◾
Expected use of the asset by the entity
The expected useful life of another asset or group of assets to which the useful life of the
intangible asset may relate
Legal, regulatory, and contractual provisions that may limit the useful life
The entity’s own historical experience in renewing or extending similar arrangements
regardless of whether those arrangements have explicit renewal provisions
The effects of obsolescence, demand, competition, and other economic factors
Required future maintenance expenditures (350-30-35-3)
Estimating the useful life of an intangible asset is discussed further in Chapter 10.
112
◾ The Nature of Goodwill and Intangible Assets
INTANGIBLE ASSETS AND ECONOMIC RISK
Intangible assets often have economic benefits such as nonrival scalability and network
effects, but they are also characterized by a high level of risk. Intangible assets often have
high development costs and low incremental costs once the intangible asset is developed.
For example, a software program may take years to develop at a relatively high cost. Yet once
developed, the software can be reproduced at a low marginal cost. High development costs
create risk because there is no assurance that the initial investment will be recovered.
High development costs with unknown benefits are risky.
The ease with which software can be reproduced is both a benefit and a detriment to the
developer. The benefit is derived from low incremental costs and high profit margins as more
units of the software are produced and sold. The detrimental impact arises from lost revenue
due to illegal use or copying of the software (piracy). Ease of reproduction can also be detrimental when it allows competitors to reengineer the product and produce similar software.
The level of risk associated with intangible assets typically declines as the innovation process
moves forward. Development stage intangible assets are far more risky than commercially
developed intangible assets that benefit from legal protection through a patent or copyright.24
GOODWILL
Sometimes the term goodwill is used to describe all of an entity’s intangible assets as a group,
whether they are separately identifiable or not. However, goodwill also has an economic basis
as a stand-alone asset. Goodwill represents the future economic benefits arising from all assets
acquired in a business combination that are not individually identified and separately recognized. Goodwill is used specifically in accounting to refer to the excess price paid to acquire a
business over and above the value of the acquired tangible and identifiable intangible assets.
The Dictionary of Finance and Investment Terms describes goodwill as an “intangible asset representing going concern value in excess of asset value paid by a company for another company
in a purchase acquisition.”25
Exhibit 4.2 provides a graphical representation of the sources of company value for a
hypothetical technology company. In the graph, the area between the goodwill line and the
IPR&D line represents goodwill’s contribution to value. Similarly, the area between the IPR&D
line the intangible asset line represents, IPR&D’s contribution to company value, and so forth.
Over time, the relative contribution of tangible assets to company value declines, whereas
the relative contribution of all intangible assets increases. Mature companies often have significant going concern value over and above the value of their identifiable assets. Identifiable intangible assets and research and development efforts also have the potential to make
significant contributions to a company’s long-term success.
Nature of Goodwill
Unlike most identifiable intangible assets, goodwill is not subject to amortization. Instead,
it is subject to impairment testing annually or more frequently if events and circumstances
◾
113
TOTAL CASH FLOW VALUE
Goodwill
TIME
VALUE FROM GOODWILL
VALUE FROM TANGIBLE ASSETS
VALUE FROM INTANGIBLE ASSETS
IN PROCESS R&D
EXHIBIT 4.2 Sources of Company Value
indicate that it may be impaired. Impairment testing is covered more extensively in Chapter 5.
In order to understand why the FASB requires that goodwill be tested for impairment, it is
important to understand the economic attributes of goodwill.
The International Glossary of Business Valuation Terms, which was developed with input
from representatives of the major North American business valuation societies and organizations, describes goodwill as “that intangible asset arising as a result of name, reputation,
customer loyalty, location, products, and similar factors not separately identified.”26 Goodwill
is a slightly different concept in financial accounting. Goodwill is defined in the FASB’s ASC
Master Glossary as “an asset representing the future economic benefits arising from other
assets acquired in a business combination or an acquisition by a not-for-profit entity that are
not individually identified and separately recognized.”
In early exposure drafts for Business Combinations, the FASB listed six components of goodwill that had been commonly recognized in accounting practices under existing authoritative
guidance. The Board’s views about the conceptual components of goodwill remain unchanged
from early exposure drafts. The IASB’s Business Combinations also recognizes similar, but not
identical components of goodwill. The six FASB goodwill components are:
1. The excess of the fair values over the book values of the acquiree’s net assets at the date of
acquisition.
2. The fair value of other net assets that the acquiree had not previously recognized.
They may not have been recognized because they failed to meet the recognition criteria
114
◾ The Nature of Goodwill and Intangible Assets
(perhaps because of measurement difficulties), because of a requirement that prohibited
their recognition, or because the acquiree concluded that the costs of recognizing them
separately were not justified by the benefits.
3. The fair value of the “going-concern” element of the acquiree’s existing business. The
going-concern element represents the ability of the established business to earn a higher
rate of return on an assembled collection of net assets that would be expected if those net
assets had to be acquired separately. That value stems from the synergies of the net assets
of the business, as well as from other benefits (such as factors related to market imperfections, including the ability to earn monopoly profits and barriers to market entry—either
legal or because of transaction—by potential competitors).
4. The fair value of the expected synergies and other benefits from combining the acquirer’s
and the acquiree’s net assets and businesses.
5. Overvaluation of the consideration paid by the acquirer stemming from errors in valuing
the consideration tendered.
6. Overpayment or underpayment by the acquirer.27
In a business combination, the recognition of goodwill on the balance sheet of an acquired
entity can result from any or all of the six components previously mentioned. The FASB and
IASB provide insight about the nature of goodwill from a conceptual standpoint and agree
that the third and forth components are conceptually part of goodwill. The third component
relates to the excess value of the acquiree’s assembled assets and represents preexisting goodwill at the time of the business combination. The fourth component relates to the excess value
created by the synergies of the business combination. The Boards refer to the third and fourth
components of goodwill as core goodwill.
In their basis for conclusions to the original business combination accounting standard,
the Boards indicate that the intent is to reduce the amount of goodwill recognized in the financial statements to the amount of core goodwill. Specifically, component 1, the excess fair value
over book value would be reduced or eliminated by recognizing identifiable acquired assets
at their fair values rather than their carrying amounts. Component 2, the fair value of previously unrecognized assets would be reduced or eliminated by identifying and recognizing
all acquired intangible assets. And component 5, the overvaluation of the consideration paid
would be reduced or eliminated by measuring consideration accurately.28
ECONOMIC BALANCE SHEET
Preparing an adjusted economic balance sheet can be a useful tool when analyzing a company’s intangible assets. It helps determine the magnitude or aggregate value of all of the
intangible assets owned by an entity. It also provides a structure to analyze the company’s
cost of capital and estimate the required rates of return for intangible assets.
The first step in preparing an adjusted economic balance sheet is to restate all the assets
and noninterest-bearing liabilities recorded on the historic cost balance sheet and record them
at their fair values. The second step is to subtract the fair value of current noninterest-bearing
liabilities from the fair value of the current assets. The resulting fair value of debt-free working
Economic Balance Sheet
Historic Cost Balance Sheet
Assets
Liabilities and
Owners’ Equity
Current
Assets
Current
Liabilities
Net Fixed
Assets
Long-Term
Debt
Equals
Owners’
Equity
Other
Assets
Economic Balance Sheet
Business
Enterprise Value
Invested
Capital
Net
Working
Capital
Weighted
Average
Return
on Assets
Interest bearing Debt
Tangible
Assets
Weighted
Average
Cost of
Capital
Equals
Intangible
Assets
Owners’
Equity
Goodwill
Fair Value Balance Sheet
Fair Value
Assets
Fair Value Liabilities
& Owner’s Equity
Current
Assets
Current
Liabilities
Tangible
Assets
Equals
Intangible
Assets
Goodwill
EXHIBIT 4.3 Developing an Economic Balance Sheet
Long-Term
Debt
Owners’
Equity
◾
115
116
◾ The Nature of Goodwill and Intangible Assets
capital appears on the asset side of the balance sheet. The third step is to determine the fair
value of the entity’s invested capital (usually consisting of interest-bearing debt and equity).
The fair value is estimated through traditional valuation methods such as the discounted cash
flow method or the guideline company method, a market approach methodology.
Once the value of invested capital is established, the value of the company’s goodwill and
intangible assets can be calculated in total. The difference between the fair value of invested
capital on the right-hand side of the balance sheet and the sum of net working capital and
tangible assets on the left side of the balance sheet equals the aggregate fair value of goodwill
and intangible assets. After the fair values of all intangible assets have been identified and
recorded, the remaining fair value is attributable to goodwill.
The economic balance sheet also provides the appropriate weights to be used in the calculation of the weighted average cost of capital. Since the weighted average cost of capital for
the right side of the balance sheet should equal the weighted average return on assets for the
left side of the balance sheet, the economic balance sheet provides information for calculating
the required rates of return for individual classifications of assets. This topic will be covered in
more depth in Chapter 8 in the discussion about the income approach to valuation.
The top portion of Exhibit 4.3 shows a historic cost balance sheet and the middle
section shows a fair value balance sheet. The economic balance sheet in the lower portion of
Exhibit 4.3 highlights two important concepts. The entity’s business enterprise value is equal
to the amount of invested capital, and the weighted average return on assets required by the
company’s investors is equal to the cost of capital. The economic balance sheet is also based
on the fair value of assets and liabilities.
CONCLUSION
Although they lack physical substance, intangible assets are capable of contributing significant value to a business enterprise. Globalization and advances in technology have
contributed to a shift in the relative value of many entities from tangible assets to intangible
assets. Legal protections such as copyrights and patents allow developers of intellectual
property to benefit from their efforts, which also contribute to the shift in value to intangible
assets. Intangible assets derive value from their ability to generate a competitive advantage
in the form of higher profits. Nonrivalry scalability, or the ability to accommodate multiple
users, and networking, a direct relationship between the number of users and value, are
economic drivers of the value of intangible assets.
In a business combination, intangible assets should be recognized in financial reporting
if they meet either the separable or the contractual criteria. To help preparers identify intangible assets, the FASB introduced five broad categories for their classification. The categories are
(1) marketing-, (2) customer-, (3) artistic-, (4) contractual-, and (5) technology-related intangible assets. For financial accounting and reporting purposes, goodwill has a specific meaning.
It is the excess purchase price paid over and above the fair value of the company’s tangible and
intangible assets in a business combination. As such, goodwill has an economic basis equal
to the future benefits arising from all assets acquired in a business combination that are not
individually identified and separately recognized.
Notes
◾
117
Ascertaining an intangible asset’s useful life is a fundamental step in determining the
fair value of the asset. The useful life is the period over which the asset will contribute cash
flows to the business entity. Clearly understanding the economic factors affecting the particular intangible asset is essential in determining the asset’s useful life. Therefore an assessment
of the competitive environment would include an assessment of the intangible asset’s uses,
substitutes, supply and demand factors, obsolescence, economic risks, and legal, regulatory,
or contractual provisions.
An economic balance sheet is another tool that may provide insight when determining
the value of an intangible asset. The economic balance sheet allows the preparer to calculate
the value of a company’s intangible assets and goodwill in total. The economic balance sheet
also helps calculate the required rate of return for tangible and intangible assets by using the
company’s weighted average cost of capital as a reference point.
NOTES
1. International Glossary of Business Valuation Terms, www.bvresources.com/FreeDownloads/
IntGlossaryBVTerms2001.pdf accessed February 21, 2012.
2. Dictionary of Finance and Investment Terms, 6th ed. (New York: Barron Educational Services,
2003).
3. FASB Glossary, www.fasb.org, accessed February 21, 2012.
4. Statute of Monopolies 1623, “The UK Statute Law Database Office of Public Sector Information,” www.statutelaw.gov, accessed April 21, 2009.
5. “Intellectual Property,” Microsoft Encarta Online Encyclopedia 2009, 1997–2009 Microsoft
Corporation, http://encarta.msn.com, accessed April 19, 2009.
6. “Intangible Asset & Intellectual Property Valuation: A Multidisciplinary Perspective,” World
Intellectual Property Organization, www.wipo.int.
7. “Modern Metrix Measurement and Analytics in Marketing, Media and Political Research in
XXI Century,” http://mmx.typepad.com/mmx/.
8. “What Is Intellectual Property?” World Intellectual Property Organization, www.wipo.int,
accessed April 16, 2009.
9. Glossary USPTO website, www.uspto.gov, accessed April 18, 2009.
10. Id.
11. Id.
12. Id.
13. Baruch Lev, Intangibles: Management, Measurement, and Reporting (Washington, DC: Brookings
Institution Press, 2001), 22.
14. Id., page 26.
15. Adobe Systems Incorporated Corporate Overview, www.adobe.com, accessed April 21, 2009.
16. Leonard I. Nakamura, Working Paper No. 01-15, “What Is the U.S. Gross Investment in Intangibles? (at least) One Trillion Dollars a Year!” Federal Reserve Bank of Philadelphia, October
2001.
17. ASC 805-20-55.
18. “Tiffany Blue: A Color of Distinction,” www.tiffany.com.
19. ASC 805-20-55-21.
20. ASC 805-20-55-30.
118
◾ The Nature of Goodwill and Intangible Assets
21. John Schneider, “The NBC Chimes Machine,” www.bayarearadio.org/schneider/chimes
.shtml.
22. “Wireless Access with Whispernet,” www.amazon.com, accessed April 16, 2009.
23. ASC 805-20-55-11 to 51.
24. Lev, Intangibles, 37–45.
25. Dictionary of Finance and Investment Terms.
26. International Glossary of Business Valuation Terms.
27. FASB SFAS No. 141(R), paragraph B313.
28. Id., paragraphs B314 to B 316.
5
C HAPTE R F IV E
Impairment
I
MPAIRMENT, A C C O R D I N G TO the FASB Master Glossary, is the condition that exists
when the carrying amount of a long-lived asset or asset group exceeds its fair value.
Goodwill must be tested for impairment annually, or sooner if events and circumstances
indicate the asset may be impaired. If testing indicates that goodwill or an intangible asset
is impaired, it must be written down to fair value immediately. Under U.S. GAAP, once
goodwill and intangible assets are written down, they cannot be written back up when
conditions improve.
The financial crisis gave rise to a sharp spike in U.S. goodwill impairment losses that
peaked at $188 billion in 2008. Since then, impairment losses dropped to a more normal
level. For 2013 and 2014, impairments were $22 and $26 billion dollars, but in 2015 U.S.
goodwill impairment losses jumped to $57 billion, the highest level since the financial crisis.
Several industries have been particularly hard hit. The energy and information technology
sectors account for $18.2 billion and $12.9 billion of 2015’s impairment losses. The high
level of impairments in 2015 is partially the result of several high-dollar impairment events.
Notable companies with significant impairment losses in 2015 are Microsoft Corporation
with $5.1 billion in losses, Yahoo!, Inc. with $4.5 billion, ConAgra Foods, Inc. with $2 billion,
and several more with approximately $1.5 billion in goodwill impairment losses: MGM
Resorts, International, NRG Energy, Inc., National Oilwell Varco, Inc., and Hess Corporation.1
Impairment can exist in any long-lived asset or group of assets whether the assets
are tangible or intangible. The guidance for testing intangible assets for impairment is
found in two different sections of the FASB’s Accounting Standards Codification; ASC 350,
Intangibles—Goodwill and Other, and ASC 360, Property, Plant and Equipment. The impairment
testing guidance in ASC 350 applies to intangible assets that have indefinite useful lives
and are not subject to amortization. Goodwill is also tested for impairment under ASC 350.
The requirements of ASC 360 apply to both tangible assets subject to depreciation and intangible assets subject to amortization. Therefore, intangible assets with finite, determinable
lives are tested for impairment under ASC 360.
119
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
120
◾ Impairment
The focus of this chapter is impairment testing for goodwill and intangible assets.
However, since the impairment of tangible assets often occurs simultaneously with the
impairment of intangible assets, a section of this chapter, dedicated to the order of testing, will
help practitioners understand when and how to apply the respective impairment tests in ASC
350 and ASC 360. Another section, entitled “Accounting for the Impairment of Long-Lived
Assets,” covers impairment testing for long-lived assets using the net realizable value test
under ASC 360. It also discusses other important topics related to impairment testing under
ASC 360, including triggering events, asset groups, and disclosures.
A section entitled “Goodwill Impairment Testing” covers the qualitative and quantitative goodwill impairment tests under ASC 350. Because impairment testing under ASC 350
is done at the reporting unit level, the section discussing reporting units and the best practice
guidance for allocating assets and liabilities to reporting units is provided. The section also
covers other topics related to goodwill impairment testing such as control premiums, deferred
taxes, and disclosures. A final section covers testing other indefinite-lived intangible assets for
impairment.
In order to fully understand the current requirements for impairment testing, it is helpful
to understand the development of impairment accounting standards from a historical perspective; therefore, this chapter begins with the evolution of impairment testing.
EVOLUTION OF IMPAIRMENT TESTING
The development of accounting standards for impairment testing of goodwill and other
intangible assets is closely linked to the development of accounting standards for business
combinations. Prior to the FASB’s issuance of SFAS 141, Business Combinations, in 2001,
goodwill from a business combination was recognized under APB 16 and amortized over its
useful life, which was capped at 40 years. Other intangible assets were rarely given financial
statement recognition under APB 16, but if they were recognized, they were amortized over
their useful lives up to 40 years.
SFAS 142, Goodwill and Other Intangibles (now FASB ASC 350), was an offshoot of
the FASB’s business combinations project that resulted from constituent comments to the
exposure draft. The FASB originally intended for the fair value of goodwill to be measured
in a business combination and amortized over its remaining life, and incorporated this
intention into the exposure draft for business combinations. However, respondents’ comments indicated that they were concerned about the difficulty of measuring the fair value
of goodwill and determining a remaining life. Financial analysts also indicated that they did
not regard goodwill amortization expense as providing useful information when analyzing
investments.2 As a result, the FASB reached a compromise. The requirement for goodwill
amortization was eliminated in the final version of SFAS 141, Business Combinations. Instead
of amortization, goodwill impairment testing was introduced in SFAS 142, which required
that goodwill recorded in a business combination be tested for impairment at least annually
or more frequently, if necessary.
The FASB also explained that a primary reason for issuing SFAS 141 and 142 was that
analysts and other users of financial statements, as well as company management, recognized
Evolution of Impairment Testing
◾
121
that intangible assets were an increasingly important economic resource for many entities and
that intangible assets represented an increasing proportion of the value of assets acquired in
business combinations.3 The Sources of Company Value graph in Chapter 4 at Exhibit 4.2
illustrates this economic relationship. As a result of their increased economic value, the FASB
recognized that better information about intangible assets was needed in financial reporting
for business combinations.4
SFA 141 and 142 improved financial reporting by recognizing the fair values of goodwill
and other intangibles arising from transactions and by reflecting the underlying economics
of acquisitions more completely and accurately. As a result, users of the financial information
are better able to understand the investments made in intangible assets and the subsequent
performance of those investments. Subsequent disclosures provide users with a better understanding about any changes in expectations for goodwill and intangibles over time, thereby
improving users’ ability to assess the probability of future cash flows.5
The requirements of SFAS 141, which were revised by SFAS 141(R), and of SFAS 142
are incorporated into the FASB’s codified accounting standards at ASC 305, Business Combinations, and ASC 350, Intangibles—Goodwill and Other. Together they cover the financial
accounting and reporting for goodwill and other indefinite-lived intangible assets that are
acquired individually or with a group of other assets as the result of a business combination
and the subsequent accounting treatment of goodwill and other intangible assets after they
have been initially recognized in the financial statements. One important clarification is that
ASC 350 applies only to goodwill and other intangible assets with indefinite, undeterminable
lives. The subsequent accounting treatment of intangible assets with definite lives subject to
amortization falls within the guidance of ASC 360, Property, Plant and Equipment.
Since the original goodwill and intangible asset accounting standards were codified at
ASC 350, several Accounting Standards Updates have been issued by the FASB that apply to
goodwill impairment testing. These updates were issued in an effort to address constituents’
concerns about the cost and complexity of performing goodwill impairment testing as
previously required by Topic 350. ASU 2011-08, Testing Goodwill for Impairment, introduced
qualitative goodwill impairment testing, which is broadly applicable to all companies, and it
gives companies more flexibility in testing goodwill for impairment. ASU 2012-08, Testing
Indefinite-Lived Intangible Assets for Impairment, extends the qualitative impairment test to
intangible assets that fall under ASC 360 because they are not subject to amortization. The
qualitative impairment test is discussed in greater detail in the Goodwill Impairment section
of this chapter.
The FASB issued ASU 2014-02, Accounting for Goodwill—A Consensus of the Private
Company Council, to provide an accounting alternative for the subsequent measurement
of goodwill for private companies. If the election is made, private companies can amortize
goodwill over a period of time not to exceed ten years. Testing of goodwill for impairment is
required only when a triggering event occurs that indicates a reporting unit’s value may be
below its carrying value. The entity may then perform a qualitative assessment or quantitative test to determine whether impairment is likely. If impairment is likely, the quantitative
test is used to determine whether goodwill is impaired and to determine the amount of the
goodwill loss. The loss is simply the difference between the reporting unit’s carrying value
and fair value; however, the loss is limited to the amount of goodwill.
122
◾ Impairment
ASU 2017-04, Simplifying the Test for Goodwill Impairment, extended some of the changes
from ASU 2014-02 to public companies. It also applies to entities that have not made the
private company election provided in ASU 2014-02. ASU 2017-04 does not eliminate the
annual goodwill impairment test for public companies and it does not provide for amortization of goodwill. Instead, it simplifies the goodwill impairment test by eliminating Step 2,
which was previously required to quantify the amount of the goodwill impairment loss. Under
ASU 2017-04, the calculation of the goodwill impairment loss is the same as provided in
ASU 2014-02. It is simply the difference between the reporting unit’s carrying value and fair
value; however, the loss is limited to the amount of goodwill. The guidance in this chapter
incorporates the pending changes in ASU 2017-04 because early adoption is permitted for
impairment tests performed after January 1, 2017, and because early adoption is considered
to be likely.
APPLICABLE FASB GUIDANCE FOR IMPAIRMENT TESTING
The guidance for testing goodwill for impairment is found in FASB ASC 350 under subtopic
20-35, Goodwill—Subsequent Measurement. The guidance for testing intangible assets for
impairment is found in two different sections of the Codification; ASC 350 under subtopic
30-35, General Intangibles Other than Goodwill—Subsequent Measurement, and ASC 360 under
subtopic 10-35, Overall—Subsequent Measurement. ASC 350 applies to impairment testing for
intangible assets that are not subject to amortization while ASC 360 applies to impairment
testing for all long-lived assets, including both intangible assets and tangible assets subject
to depreciation or amortized. When there is indication that goodwill or an intangible asset
is impaired, testing should be immediate. When no impairment is indicated, goodwill and
intangible assets with indefinite lives must be tested annually, at a minimum. Because
intangible assets with definite lives are subject to amortization, there is no requirement for an
annual impairment test. Exhibit 5.1 summarizes the requirements for impairment testing.
Order of Testing
According to the provisions set forth in FASB ASC 350, Intangibles—Goodwill and Other, if
goodwill and another asset (or asset group) of a reporting unit are tested for impairment at
the same time, the other asset (or asset group) is to be tested for impairment before goodwill.
EXHIBIT 5.1
Guidance for Impairment Testing
Guidance for Testing
for Impairment
Long-Lived Asset
Frequency of Testing
Goodwill
Annually or if events occur or
circumstances change
FASB ASC 350-20
Intangible assets with
indefinite lives
Annually or if events occur or
circumstances change
FASB ASC 350-30
Assets subject to amortization
or depreciation
If events occur or circumstances
change
FASB ASC 360-10
Accounting for the Impairment of Long-Lived Assets
◾
123
Therefore, long-lived assets and asset groups including property, plant, and equipment, and
intangible assets that are subject to amortization are tested first under FASB ASC 360. After
tangible and definite-lived intangible assets have been tested and any impairment loss has been
recorded, goodwill and other intangible assets are tested for impairment under ASC 350.6
ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS
Most long-lived assets are tangible assets including property, plant, and equipment that are
originally recorded at cost and depreciated over the useful life of the asset. However, intangible assets with definite useful lives acquired in a business combination are also considered
long-lived assets and are recorded at their respective fair values as of the acquisition date.
Theses intangible are amortized over their remaining lives. Accounting standards relating to
the recognition of intangible assets are inconsistent. Acquired intangible assets are recorded
on the balance sheet, but the internal costs associated with creating intangible assets are
expensed when incurred.
When to Test Long-Lived Assets for Impairment
Under FASB ASC 360, a long-lived asset that is currently being depreciated or amortized
should be tested for impairment if there is a “triggering event” such as:
◾
◾
◾
◾
◾
◾
A significant decrease in the market value of the long-lived asset (asset group)
A significant change in the extent or manner in which the long-lived asset (asset group)
is used or in its physical condition
A significant adverse change in legal factors or in the business climate that could affect
the value of a long-lived asset (asset group), including an adverse action or assessment by
a regulator
An accumulation of costs significantly in excess of the amount originally expected to
acquire or construct a long-lived asset (asset group)
A current period operating or cash flow loss combined with a history of operating or cash
flow losses or a projection or forecast that demonstrates continuing losses associated with
a long-lived asset (asset group)
A current expectation that, more likely than not, a long-lived asset (asset group) will be
sold or otherwise disposed of significantly before the end of its previously estimated useful life. The term more likely than not refers to a level of likelihood that is more than 50
percent.7
Impairment Testing at the Asset Group Level
Under FASB ASC 360, Property, Plant and Equipment, impairment exists when the carrying
amount of a long-lived asset or asset group that is subject to amortization exceeds its fair value
and when the carrying value is not recoverable. The test for recoverability is whether the carrying value of the asset or asset group exceeds the sum of the undiscounted cash flow expected
to result from the use and eventual disposition of the asset or asset group.
124
◾ Impairment
Under ASC 360, long-lived assets are tested for impairment at the asset group level,
which is the lowest level for which cash flows are independently identifiable. In limited
circumstances, assets such as corporate headquarters do not have identifiable cash flows,
and in those cases, the asset group would include all the assets and liabilities of the entire
entity. Goodwill is excluded from the asset group unless the asset group is a reporting unit.8
The expected cash flows associated with an asset group are determined using the entity’s
own assumptions about the use of the asset group.9 Assumptions must be reasonable and
consistent with assumptions used for other purposes. When there are alternative courses of
action, or when there is a range of possible future cash flows for the likely course of action,
it is appropriate to assess the likelihood of possible outcomes and use a probability-weighted
approach to determine expected future outcomes. Expected cash flows should cover the time
frame associated with the asset group, which is determined based on the expected useful life for
the asset group’s primary asset. Expected cash flows should also be determined based on the
existing service potential for the asset group as of the date of testing. Costs of maintaining the
existing service potential would be included in expected cash flows, but capital expenditures
to increase the service potential would be excluded from expected cash flows.10
The impairment loss is recognized if the carrying amount of the asset or asset group
exceeds its fair value and is not recoverable. According to ASC 360, an expected present value
technique is appropriate to measure fair value when there are uncertainties associated with
the asset group. The impairment loss recognized is the amount by which the asset or asset
group’s carrying amount exceeds its fair value.11
When an impairment loss is recognized for a long-lived asset group, the impairment loss
should only be applied to the carrying values of assets within the group. The impairment loss
is allocated on a pro rata basis to the individual assets within the group, except that the allocated impairment loss should not reduce the carrying amount of an individual asset below its
fair value.12
Disclosure Example: Staples, Inc.—Impairment of Long-Lived Assets
The following footnote disclosure for Staples, Inc. describes the testing and impairment of the
company’s long-lived assets, as required by ASC 360.
Long-Lived Assets
The Company recorded long-lived asset impairment charges related to continuing operations of $35 million, $37 million, and $59 million in 2016, 2015, and
2014, respectively. The following is a summary of these charges:
The $35 million of charges in 2016 primarily relate to the impairment of fixed
assets at North American retail stores.
The $37 million of charges in 2015 include $22 million related to the disposal
of information technology assets related to the Company’s North American retail
stores, and $15 million related to the impairment of fixed assets, primarily at North
American retail stores.
The $59 million of charges in 2014 primarily relate to the impairment of fixed
assets at North American retail stores.
Goodwill Impairment Testing—Public Companies
◾
125
These charges related to retail store assets were based on measurements of the
fair value of the impaired assets derived using the income approach, specifically the
DCF method, which incorporated Level 3 inputs as defined in ASC 820. The Company
considered the expected net cash flows to be generated by the use of the assets through
the store closure dates, as well as the expected cash proceeds from the disposition of
the assets, if any.13
GOODWILL IMPAIRMENT TESTING—PUBLIC COMPANIES
The guidance for goodwill impairment testing in this section discusses the requirements for
public business entities and other entities that have goodwill reported in their financial statements and have not elected the private company alternative for the subsequent measurement
of goodwill. The guidance for entities that have elected the private company alternative is provided in a later section of this chapter.
The FASB’s ASC 350 is the authoritative source of accounting standards and guidance for
goodwill impairment testing. In addition, the AICPA’s Impairment Task Force (the Task Force)
was formed to provide guidance and illustrations for goodwill impairment testing for valuation specialists, financial statement preparers, and auditors. Although the Task Force’s guidance is nonauthoritative, it is a rich source of accounting and valuation guidance specifically
targeted to applying the requirements of FASB ASC 820, Fair Value Measurement, to goodwill impairment testing. The Task Force published The AICPA Accounting and Valuation Guide:
Testing Goodwill for Impairment in 2013. Since then, the FASB has substantially changed the
requirements for determining the amount of a goodwill impairment loss by eliminating Step 2
of the impairment test. Even so, much of the information in Testing Goodwill for Impairment is
still relevant.
When to Test Goodwill for Impairment
FASB ASC 350 provides guidance for determining when goodwill impairment testing is
indicated. Goodwill should be tested for impairment at the reporting unit level at least
annually.14 An entity may first assess qualitative factors to determine whether it is necessary to perform a quantitative impairment test. If the results of the qualitative assessment
indicate that it is unlikely that the fair value of the reporting unit is less than its carrying
value, then the quantitative impairment test is unnecessary.15 If the qualitative impairment
factors indicate that impairment is likely, then the quantitative impairment test is performed
to determine the amount of the goodwill impairment loss to be recognized.16 An entity
also has the option to bypass the qualitative assessment and perform the quantitative
impairment test.17
The relevant events and circumstances to be considered in the qualitative assessment of
goodwill were introduced by ASU 2011-08, Testing Goodwill for Impairment. (The qualitative
goodwill impairment test is discussed in the next section.) These triggering events also apply
to other indefinite-lived intangible assets under ASC 350.
126
◾ Impairment
Examples of events and circumstances that may indicate goodwill impairment include
the following:
◾
◾
◾
◾
◾
◾
◾
Macroeconomic conditions such as a deterioration in general economic conditions, limitations on accessing capital, fluctuations in foreign exchange rates, or other developments
in equity and credit markets.
Industry and market considerations such as a deterioration in the economic environment, increased competition, a decline in market multiples, a change in the market for
the entity’s products and services, or a regulatory or political development.
Cost factors such as an increase in raw materials, labor, or other costs that have a negative
impact on earnings.
Overall financial performance such as negative or declining cash flows or a decline in
actual or planned revenue or earnings compared with actual and projected results.
Other entity-specific events such as a change in management, key personnel, strategy, or
customers; bankruptcy or litigation.
Events affecting a reporting unit such as a change in the composition or carrying amount
of its assets, disposing of a portion or all of a reporting unit, an impairment test for a significant asset group within a reporting unit, or recognition of a goodwill impairment loss
of a subsidiary that is a component of a reporting unit.
A sustained decrease in share price, both in absolute terms and relative to peers.18
Qualitative Assessment—Additional Considerations
If, after assessing the totality of events and circumstances just listed, management concludes
that the entity’s fair value is greater than its carrying value using a more likely than not
criterion (>50 percent), then no further testing is required. If the entity chooses to use a qualitative goodwill impairment test, it must consider how events and circumstances could affect
the comparison of the reporting unit’s carrying value and fair value, and it must weigh the
relative effects of those events and circumstances on the comparison. The FASB provides further guidance on considering and weighing the events and circumstances that may indicate
impairment, which includes the following:
◾
◾
◾
◾
◾
◾
◾
The totality of events and circumstances should be considered.
The examples of events and circumstances provided by the FASB are not considered to be
all-inclusive.
All relevant events and circumstances that affect the fair value of the reporting unit
should be considered.
The extent to which each adverse event or circumstance identified impacts the comparison of carrying value to fair value should be considered.
More weight should be placed on events and circumstances with the greatest effect on
carrying value or fair value.
Positive and mitigating events and circumstances should be considered.
The results of any recent fair value calculations for reporting units and the difference
between the fair value and carrying amount should be considered.19
Goodwill Impairment Testing—Public Companies
◾
127
The final point means that the results of the most recent quantitative, step-one impairment test should be considered. The difference between a reporting unit’s fair value and its
carrying value at the last quantitative impairment test date would be one of the circumstances
considered. The size of this difference or cushion relative to the reporting unit’s carrying value
would provide information about the amount of weight to be placed on this circumstance.
Therefore, a reporting unit with a large cushion as a percentage of carrying value from its
previous calculation may place more weight on this circumstance in its current qualitative
impairment test.
The AICPA’s Impairment Task Force believes that the annual qualitative impairment test
should be more than a roll-forward of the previous quantitative impairment test, and that it
should serve as a standalone, independent evaluation of relevant events and circumstances.
In reaching this opinion, the Task Force considered the FASB’s decision to eliminate the
carry-forward of impairment testing as previously permitted under ASC 350. And the Task
Force took into account the FASB’s guidance that recent fair value calculations should be a
factor when considering events and circumstances that indicate goodwill is impaired.20
The Task Force suggests that the qualitative goodwill impairment test be performed using
the following process:
◾
◾
◾
◾
Identify inputs and assumptions that most affect fair value.
Identify relevant events and circumstances that impact the inputs.
Weigh the events and circumstances.
Conclude on the totality of events and circumstances.21
The first step in the Task Force’s process is the only one not specifically provided by ASC
350. The Task Force believes that an entity must first understand the method used to calculate
a reporting units fair value and then identify the key inputs and assumptions that affect the
fair value under that method. Therefore, the relevant drivers of fair value depend upon the
method(s) used to measure fair value and the inputs to those methods.22
The Task Force also added some addition examples of events and circumstances that may
require consideration:
◾
◾
◾
◾
◾
Market reaction to new product or service
Technological obsolescence
A significant legal development
Contemplation of a bankruptcy proceeding
An expectation of a change in the risk factors or risk environment influencing the
assumptions used to calculate the fair value of a reporting unit, such as discount rates or
market multiples23
An example of a qualitative impairment test is provided in Exhibit 5.2.
Quantitative Impairment Test and Measurement of an Impairment Loss
An entity has the option of performing a quantitative impairment test instead of a qualitative
assessment. If the entity chooses to perform a qualitative assessment of goodwill and if the
totality of events and circumstances indicate that it is likely that goodwill is impaired, then
128
EXHIBIT 5.2 Transcontinental Transportation, Inc. Qualitative Goodwill Impairment Test, Intermodal Ports Reporting Unit
(December 31, 20X2)
Section 1: Most Recent Fair Value Calculation
Date: 12/31/X1
Factor Weights for Events and Circumstances:
Company Stock Price: $43.25/share
Market Capitalization: $ 384,925,000
XXX—Relatively higher weight due to direct effect on fair value or carrying
value of reporting unit.
Fair Value of Reporting Unit: $132,500,000
XX—Average weight due to indirect effect on fair value or carrying value of
Carrying Value of Reporting Unit: $96,850,000
reporting unit.
Fair Value Margin: $35,650,000
X—Low weight due to lack of specific effect on fair value or carrying value of
Fair Value Margin Percentage: 36.8%
reporting unit.
0—No weight.
Substantial
Section 2: Events and Circumstances
Negative Impact
No Impact or
Negative Impact
Not Applicable
Substantial
Positive Impact
Macroeconomic Conditions
General economic conditions
XXa
Access to capital
XXb
Fluctuations in foreign exchange rates
0
Xc
Developments in equity and credit markets
Other negative factors—Uncertain outlook
XXd
Other mitigating factors
0
Industry and Market Considerations
Changes in the operating environment
Changes in competition
An absolute change in market multiples or metrics
0
Xe
0
A change in market multiples relative to peers
0
A change in the market for products or services
0
Positive Impact
129
A regulatory development
0
A political development
0
Other negative factors
0
Other mitigating factors—New B to B marketing
campaign
0
Xf
Cost Factors with Negative Impact on Earnings and Cash Flows
Changes in raw material costs
0
XXg
Changes in labor costs
Changes in other costs—fuel costs
XXh
Other negative factors
0
XXi
Other mitigating factors—fuel cost hedges
Overall Financial Performance
XXXj
Cash flows and trend in cash flows
A change in actual revenues or earnings
XXXk
0
A change in forecasted revenues or earnings
XXl
A shortfall/surplus from budgeted revenues or
earnings
Other negative factors
0
Other mitigating factors
0
Substantial
No Impact or
Substantial
Negative Impact Negative Impact Not Applicable Positive Impact Positive Impact
Entity-Specific Events
Changes in management
0
Loss of key personnel
0
Change in strategy
0
Change in customers
XXXm
(continued)
130
EXHIBIT 5.2
(continued)
Contemplation of bankruptcy
Litigation
0
Xn
Other negative factors
0
Other mitigating factors
0
Events Affecting Reporting Unit
Change in the composition of net assets
XXXo
Change in the carrying amount of net assets
0
A more-likely-than-not expectation of selling or
disposing all or a portion of a reporting unit
0
The testing for recoverability of a significant asset
group within a reporting unit
0
Recognition of a goodwill impairment loss in the
financial statements of a subsidiary that is a
component of a reporting unit
0
Other negative factors
0
Other mitigating factors
0
Change in Share Price
XXXp
A sustained change in share price in absolute terms
A sustained change in share price relative to peers
Other negative factors
0
Other mitigating factors—Increase in S&P
0
Xq
Section 3: Explanations of events and circumstances with positive or negative impact.
a Gross domestic product is up 2% from 20X1. Import/export intermodal volume and reporting unit revenues are highly correlated with GDP.
b Access to capital markets has improved as bank lending has eased. Transcontinental borrowed $40,000,000 with floating rate tied to LIBOR to finance
capital improvements.
131
c The prime rate has remained relatively low with decreases in the risk-free rate offset by increases in risk premiums.
d Continued economic uncertainty with high unemployment and very modest improvements in near-term growth prospects.
e A competitor in the Southeastern United States has expanded its operations into four ports located in North Carolina and Virginia, which will
potentially reduce revenues at these ports through pricing pressures.
f New business-to-business marketing campaign with focus on customized transportation solutions expected to enhance competitive position.
g Labor costs have declined due to continued high unemployment rate. Payroll taxes have also decreased.
h Fuel costs have increased by 7%, and increased unrest in the Middle East creates uncertainty about long-term future prices. Transcontinental has been
able to pass some of these increased costs on to customers through higher prices.
i Transcontinental actively manages its fuel cost risk through futures and options contracts. Approximately 80% of price exposure for upcoming year is
hedged.
j Cash flows from operations were $19.3 million in 20X2, a 12% increase over 20X1. Overall, cash declined by $10.7 million in 20X2 primarily due to
significant capital expenditures.
k Revenues increased by 3% over 20X1, and net income increased by 1% to $16.7 million.
l Revenues exceeded budgeted revenues by 2%, and earnings exceeded budgeted earnings by 12%.
m SantaCal, a significant new customer serving agricultural consumers in California, New Mexico, and Arizona, signed a three-year contract. Projected
revenues are $18 million over the three-year term.
n Litigation with former owner is expected to be settled with minimal impact to company.
o Transcontinental completed projects at three port locations, making $50 million in infrastructure improvements.
p Transcontinental shares closed at $48.50 on 12/31/20X2, a 12% increase over 12/31/X1. The average price for the year was $46.25. The Intermodal
Port reporting unit contributes approximately 25% of the company profits. Its largest division, rail contributes 60% of profits.
q The S&P 500 increased by 15% in 20X2, which indicates that the stock market sees more value than it did at 12/31/X1.
Section 4: Conclusion
Based on a consideration of all relevant events and circumstances, it is more likely than not that the fair value of Transcontinental Transportation’s
Intermodal Port reporting unit exceeds its carrying value.
COO Signature
CFO Signature
132
◾ Impairment
the quantitative impairment test is required. The quantitative impairment test is used to determine whether goodwill impairment exists and to determine the amount of the impairment.
Impairment of goodwill is the condition that exists when the carrying amount of the
reporting unit including goodwill exceeds its fair value. Therefore, the quantitative impairment test compares the reporting unit’s carrying amount, or book value, to its fair value. If the
reporting unit’s fair value is greater than its carrying amount, the reporting unit’s goodwill is
not considered to be impaired.
If the unit’s fair value is less than its carrying amount, then goodwill is impaired and
a goodwill impairment loss is recognized. The amount of the loss is equal to the difference
between the reporting unit’s fair value and carrying amount; however, the loss is limited to
the amount of the reporting unit’s goodwill.24
Performing the quantitative impairment test requires a number of preliminary steps
including defining reporting units and assigning goodwill to reporting units. When measuring the fair value of the reporting unit, management must determine an appropriate
valuation approach and consider whether a control premium is applicable and whether the
value is determined assuming the underlying transaction is taxable or nontaxable. The entity
must also decide whether the impairment test will be conducted using an equity basis or
an enterprise value basis. The FASB guidance related to these preliminary considerations is
provided in the following sections.
Reporting Units
Goodwill impairment testing is performed at the reporting unit level. According to the FASB
Master Glossary, a reporting unit is an operating segment or one level below an operating segment (also known as a component). An operating segment is a component of a public entity
that engages in business activities from which it earns revenues and incurs expenses, that has
operating results that are reviewed by management, and that has discrete financial information.25 Operating segments of public companies are reported separately in accordance with
ASC 280, Segment Reporting.
A component of an operating segment can be a reporting unit. However, if two or more
components have similar economic characteristics, they should be combined into one reporting unit. Economic characteristics refer to the operating segment’s products and services,
production processes, customers, distribution channels, and the regulatory environment. An
operating segment can also be a reporting unit if all of its components are similar. In addition,
the entity as a whole can have a single reporting unit.26 Judgment is required when determining what constitutes a reporting unit because multiple factors must be considered, including
how an entity is managed internally, the number of businesses the entity owns, and the degree
of comparability of those businesses.
Assigning Goodwill to Reporting Units
For the purpose of goodwill impairment testing, acquired assets and assumed liabilities are
assigned to a reporting unit, and goodwill is assigned to one or more reporting units as of
the business combination date. The assignment of acquired assets and assumed liabilities to
reporting units applies to those acquired individually and to those acquired as a group of assets
Goodwill Impairment Testing—Public Companies
◾
133
in business combination. FASB ASC 350 indicates that acquired assets and assumed liabilities
are initially assigned to a reporting unit when both of the following two criteria are met:
1. The asset will be employed in or the liability relates to the operations of a reporting unit.
2. The asset or liability will be considered in determining the fair value of the reporting
unit.27
Certain assets or liabilities serve corporate functions rather than operating functions.
Nevertheless, if both of the preceding criteria are met, they should be assigned to a reporting
unit. Examples of corporate items that might be assigned to a reporting unit are pension
liabilities and obligations related to noncompetition agreements with former owners. Pension
liabilities and noncompetition agreements both relate to operations of specific reporting
units; therefore they would be included in the calculations of the carrying values and the fair
values of the reporting unit when testing goodwill for impairment.28
If corporate assets or liabilities do not meet both of the preceding criteria, then they are
not assigned to an individual reporting unit. Instead, if a reporting unit benefits from a corporate asset or liability, then the corporate asset or liability should be allocated to reporting
units in proportion to the benefits received. The allocation method should be reasonable, supportable, and consistent from period to period.29 An example of a corporate asset that benefits
multiple reporting units would be corporate headquarters facility.
When testing goodwill for impairment, acquired goodwill must be assigned to one or
more reporting units as of the acquisition date. The assignment to reporting units is based on
the relative benefit that arises from the business combination synergies. Therefore, goodwill
can be assigned to preexisting reporting units of the acquiring entity, to new reporting units
of the acquired entity, and/or to reporting units that combine acquiring and acquired entity
operations. And, goodwill can be assigned to preexisting reporting units of the acquiring
entity even though other acquired assets and liabilities are not assigned to that particular
reporting unit.30
The amount of goodwill assigned to a particular reporting unit would be determined in
a manner similar to how goodwill is recognized in a business combination. The difference
between the fair value of the acquired business to be included in a reporting unit and the
fair value of the individual assets and liabilities assigned to the reporting unit represents the
reporting unit’s goodwill. The goodwill allocation method must be reasonable, supportable,
and consistent from period to period.31
Determining the composition of a company’s reporting units for goodwill impairment
testing requires judgment. Any misidentification has the potential to change the outcome of
the impairment test and the dollar amount of the impairment loss. When reporting units are
more broadly defined, cash flows from a larger pool of assets may be sufficient to counterbalance any impaired value. Under a narrow definition of the reporting unit, the impaired
goodwill would stand out and require recognition in the financial statements.
The AICPA’s Accounting and Valuation Guide, Testing Goodwill for Impairment is an excellent
source of guidance for allocating assets and liabilities to reporting units. Numerous examples
illustrate different methodologies that are used in practice to assign shared assets and liabilities
to reporting units. It also addresses how to allocate corporate debt, deferred taxes, cumulative
translation adjustments, contingent consideration, and goodwill to reporting units.
134
◾ Impairment
Measuring the Fair Value of a Reporting Unit
The fair value hierarchy should be considered when measuring the fair value of a reporting
unit for impairment purposes. According to FASB ASC 350, “The fair value of a reporting unit
refers to the price that would be received to sell the unit as a whole in an orderly transaction
between market participants at the measurement date. Quoted market prices in active markets
are the best evidence of fair value and should be used as the basis for the measurement, if
available.”32 However, ASC 350 goes on to say that “the quoted market price of an individual
equity security need not be the sole measurement basis of the fair value of a reporting unit.”33
Control Premium
FASB ASC 350 states that the market capitalization of a reporting unit derived from the market
price of an individual security may not represent the fair value of a reporting unit when there
are benefits of owning a controlling interest. Including a control premium in the reporting
units fair value measurement may be appropriate if a controlling interest would provide the
ability to take advantage of synergies or other benefits.34
FASB ASC 350 describes control premiums in testing for impairment of goodwill by saying that:
The market price of individual security may not be representative of the fair value of
the reporting unit as a whole. Substantial value may arise from the ability to take
advantage of the synergies and other benefits that flow from control over another
entity. Consequently, measuring the fair value of a collection of assets and liabilities
that operate together in a controlled entity is different from measuring the fair value
of that entity’s individual equity securities. An acquiring entity often is willing to pay
more for equity securities that give it a controlling interest than an investor would
pay for a number of equity securities representing less than controlling interest. That
control premium may cause the fair value of the reporting unit to exceed its market
capitalization. The quoted market price of an individual equity security, therefore,
need not be the sole measurement basis of the fair value of the reporting unit.35
Applying a control premium to the preliminary fair value of an entity has the potential to
change the outcome of a goodwill impairment test; therefore, control premiums have received
considerable attention from regulators and the valuation profession in recent years. The
Appraisal Foundation’s Working Group on Control Premiums has been developing guidance
for measuring the fair value of control premiums for financial reporting purposes since 2013.
The Working Group refers to control premiums as market participant acquisition premiums.
Although the guidance is not authoritative, the September 1, 2015, Exposure Draft, The
Measurement and Application of Market Participant Acquisition Premiums, is considered to be
best practice guidance.
The guidance focuses on identifying prerogatives of control and determining how they
give rise to potential incremental economic benefits in the form of enhanced cash flows and/or
risk reduction. This concept is closely aligned with the FASB guidance from ASC 350 outlined
in the preceding paragraph. The guidance from the Appraisal Foundation’s exposure draft is
covered in more detail in Appendix 5A to this chapter.
Goodwill Impairment Testing—Public Companies
◾
135
Valuation Approaches to Measuring the Fair Value of a Reporting Unit
When quoted market prices are not available, the fair value of the reporting unit should
be based on the best information available. FASB ASC 350-20-35-24 says, “a valuation
technique based on multiples of earnings or revenue, or a similar performance measure may
be used if that technique is consistent with the objective of measuring fair value.” The use of
earnings or revenue multiples to determine the fair value of a reporting entity is appropriate
when multiples are available from comparable companies. Comparability is determined based
on the nature, scope, and size of the entities’ operations and other economic characteristics.36 Therefore, the guideline company method and guideline transaction method under
the market approach can be used to measure the fair value of a reporting unit.
A discounted cash flow analysis based on the forecasted financial data from the acquiring
company is often the best indication of fair value. The background information and basis for
conclusions to the original goodwill accounting standard provides the FASB’s rationale for this
conclusion:
The Board noted that in most instances quoted market prices for a reporting unit
would not be available and thus would not be used to measure the fair value of a
reporting unit. The Board concluded that absent a quoted market price, a present
value technique might be the best available technique to measure the fair value of a
reporting unit.37
In reviewing the assumptions underlying a discounted cash flow analysis used for impairment testing under FASB ASC 350, it may be helpful to review Chapter 7 of the AICPA’s Guide
for Prospective Financial Information, which covers the attributes of prospective financial information prepared using a reasonably objective basis and appropriate assumptions. The highlights of the AICPA’s guide are discussed in Chapter 8, “The Income Approach.”
Carrying Value: Equity Value versus Enterprise Value
Whether impairment testing should be performed on an equity basis or enterprise basis has
been the topic of debate within the accounting and valuation professions because the choice
of which basis to use can impact the outcome of the impairment test. To compute carrying
value using an equity basis, the carrying value of debt is subtracted from the fair value of net
operating assets. The FASB considered requiring an equity basis for impairment testing in its
deliberations prior to issuing ASU 2010-28 (which has since been superseded). However, due
to diversity in practice, the FASB decided not to mandate a particular basis for calculating the
carrying amount of a reporting unit for the purposes of Step 1 of the goodwill impairment
test. Therefore, management must decide whether the quantitative goodwill impairment test
should be conducted using an equity or enterprise basis.
Quantitative Impairment Test—An Apples-to-Apples Comparison
Recent PCAOB inspection reports noted several audit deficiencies that resulted from mismatches between the assets and liabilities in the reporting unit’s calculation of fair value
136
◾ Impairment
and carrying value. When comparing a reporting unit’s fair value to its carrying value,
it is important to make the comparison on an apples-to-apples basis. However, the Task
Force acknowledges that in some situations, a reporting unit may benefit from assets or
is burdened by unrecognized items that have not received accounting recognition in the
financial statements, and it believes that the fair value measurement should consider these
unrecognized items.38
Disclosure Example: Essendant, Inc. Goodwill Impairment Charge39
The following example of a footnote disclosure for a goodwill impairment test and resulting recognition of an impairment loss for Essendant, Inc. under the simplified goodwill
impairment test provided by the FASB in ASU 2017-04, which was subject to early adoption
for interim and annual goodwill impairment tests performed after January 1, 2017.
Essendant, Inc. tests goodwill for impairment annually as of October 1 and whenever
triggering events or circumstances indicate that an impairment may have occurred,
such as a significant adverse change in the business climate, loss of key personnel or
a decision to sell or dispose of a reporting unit, among others. Determining whether
an impairment has occurred requires a comparison of the carrying value of the net
assets of the reporting unit to the fair value of the respective reporting unit.
During the quarter ended March 31, 2017, given a sustained decrease in the
Company’s share price and related market capitalization, the Company determined
that a triggering event had occurred for all of its reporting units, requiring an interim
impairment test of goodwill. During this assessment, the Company determined that
the carrying value of net assets for three of the four reporting units of the Company
exceeded fair value. In consideration of the Company’s adoption of ASU 2017-04
(refer to Note 1 – “Basis of Presentation”) the Company recognized goodwill impairment of $198.8 million in aggregate based on the difference between the carrying
value of net assets and fair value as determined based on the combination of prices
and merger and acquisitions (“M&A”) transactions of comparable businesses and
forecasted future discounted cash flows.
The carrying amount of goodwill by reporting unit and impairment recognized
is noted in the table below (in thousands):
Goodwill Balance
as of December 31,
2016
For the Three Months
Ended March 31,
2017
Goodwill Balance
as of March 31,
2017
Impairment
Currency
Translation
Adjustments
$224,683
$(185,704)
$–
$38,979
13,067
–
11
13,078
Automotive
45,234
(12,220)
122
33,136
CPO
14,922
(904)
–
14,018
$297,906
$(198,828)
$133
$99,211
Office and Facilities
Industrial
Goodwill Impairment Testing—Public Companies
◾
137
Deferred Tax Considerations in Goodwill Impairment Testing
When the accounting standards for goodwill impairment testing were first introduced, practitioners raised questions about how to account for deferred taxes, which were created by
differences between the book and tax bases of assets and liabilities. Specifically, constituents
sought guidance about how deferred taxes would be treated when determining the fair value
of a reporting unit and the reporting unit’s carrying value. In 2002, the FASB issued EITF
Issue No. 02-13, Deferred Income Tax Considerations in Applying the Goodwill Impairment Test in
FASB Statement No. 142, to clarify some of the goodwill impairment issues relating to deferred
tax assets and liabilities. The EITF’s guidance has been incorporated into ASC 350.
EITF 02-13 identified three issues related to deferred tax assets and liabilities. The two
issues that continue to be relevant since the issuance of ASC 2017-04 are:
Issue 1. Whether the fair value of a reporting unit should be estimated by assuming that
the unit would be bought or sold in a nontaxable transaction versus a taxable transaction.
Issue 2. Whether deferred income taxes should be included in the carrying amount of a
reporting unit in the goodwill impairment test.40
The EITF guidance for Issue 1 clarified that the assumption is a matter of judgment that
depends upon specific facts and circumstances to be evaluated on a case-by-case basis. The
assumption about whether the transaction is taxable or nontaxable should be consistent with
the assumptions that market participants make when estimating fair value. A market participant would consider the feasibility of the tax structure and whether a prudent seller would
utilize the particular tax structure to maximize value. Additional considerations about the
feasibility of the tax structure would include whether the reporting unit could actually be sold
in a nontaxable transaction and whether tax laws, regulations, and corporate governance
requirements would limit the entity’s ability to treat the sale of the reporting unit as a nontaxable transaction. Therefore, when performing a goodwill impairment test, management
should make an assumption about the tax structure based on whether the economic value
would be maximized on an after-tax basis, from the seller’s perspective.41
In its guidance for Issue 2, the EITF recommends that deferred taxes should be included
in the carrying value of the reporting unit regardless of whether the fair value of the reporting unit will be determined by assumption of a taxable or nontaxable transactions structure.
Therefore, the reporting unit’s carrying value should include deferred taxes when performing
step one of the goodwill impairment test.42
Example of Tax Assumptions in a Goodwill Impairment Test
Blue Company is performing its annual goodwill impairment test as of June 30, 20X1. Blue
has one reporting unit and the following fact pattern:
◾
◾
◾
◾
◾
Carrying value of total assets of $235
Tax basis of assets excluding goodwill and deferred income taxes of $125
Goodwill of $75
Net deferred tax liabilities of $15
Corporate tax rate of 26 percent
138
◾ Impairment
Management of Blue believes that the entity could be sold and the transaction could be
structured as either a stock sale (nontaxable) or an asset sale (taxable). The fair value of the
entity assuming a stock sale is $230, and due to tax ramifications, the fair value of the entity
assuming an asset sale is $240. Therefore, if the entity were sold in a nontaxable transaction, the tax impact would be approximately $15 as indicated by the deferred tax liability. If
the entity were sold in a taxable transaction, the tax impact would be approximately $30 or
[($240 – 125) * 26%].
Using the guidance in ASC 350, Blue analyzes the economic impact of a nontaxable structure compared to a taxable structure as follows:
Nontaxable
Taxable
Fair value
$230
$240
Less taxes paid
(15)
(30)
Economic value
$215
$210
Blue concludes that the entity’s highest economic value would result from a nontaxable
transaction, so management estimates the carrying value for the quantitative goodwill
impairment test under FASB ASC 350, as:
Net assets (without goodwill and deferred taxes)
$175
Goodwill
75
Deferred taxes
(15)
Carry value
$235
Impairment is indicated for Blue because the entity’s fair value of $230 is less than its
$235 carrying value. The goodwill impairment loss is equal to the $5 difference between fair
value and carrying value.
GOODWILL IMPAIRMENT—ONE-STEP IMPAIRMENT LOSS
The FASB’s issuance of ASU 2017-04 effectively eliminated the need to perform step two of
the goodwill impairment test for public companies. Step two of the goodwill impairment test
required companies to determine the amount the goodwill impairment loss through an onerous process that is similar to the allocation of purchase consideration to identified assets and
liabilities acquired in a business combination. The update modifies the process for determining the amount of the goodwill impairment by providing a simplified one-step procedure that
compares the fair value of a reporting unit to the carrying value of the unit. The amount of a
reporting unit’s goodwill impairment loss is equal to the excess carrying value over fair value
and is limited to the amount of goodwill.
The update will have a negligible impact to private companies that were already eligible for
similar treatment following the release of ASU 2014-02. The update also makes no changes
to the existing option for private or public companies to elect a qualitative assessment test
Amortization of Goodwill
◾
139
to evaluate goodwill impairment. Public company U.S. Securities and Exchange Commission
filers are required to implement the provisions of the update for all periods following December
15, 2019. Early adoption is permitted for all companies that elect to implement the updated
provisions in financial statements issued after January 1, 2017.
TESTING OTHER INDEFINITE-LIVED INTANGIBLE ASSETS
FOR IMPAIRMENT
Historically, intangible assets that were not subject to amortization had to be tested for impairment at least annually under FASB ASC 350. Although the test for impairment was a rather
straightforward comparison of the intangible asset’s fair value to its carrying value, many
financial statement preparers felt that determining the fair value on an annual basis was a
burdensome requirement.
In response to constituents’ concerns about the cost and complexity of impairment
testing and in an effort to resolve inconsistencies between goodwill and long-lived intangible
asset impairment testing, the FASB has issued ASU 2012-02, Testing Indefinite-Lived Intangible
Assets for Impairment, which provided qualitative impairment testing for other indefinite-lived
intangible assets. The update permits entities to make a qualitative assessment about whether
events and circumstances indicate that an indefinite-lived intangible asset has been impaired.
The qualitative assessment would consider the effect of events and circumstances on the fair
value of the indefinite-lived intangible asset, both individually and in the aggregate. Positive
and mitigating events and circumstances would also be evaluated. Examples of events and
circumstances provided by the FASB for use in the qualitative goodwill impairment test also
apply to the qualitative impairment test for intangible assets.
When performing the qualitative impairment test, the entity would consider the change
in fair value and any change in the carrying amount of the intangible asset since the last
assessment. If the entity has a recent quantitative test to use as a benchmark, the size of the
prior cushion would be considered, as well. If the entity concludes that the intangible asset
is not impaired using a more likely than not (>50 percent) criterion, then no further testing
is necessary. Otherwise, the entity must perform a quantitative impairment test as previously
required by ASC 350.
AMORTIZATION OF GOODWILL
Since the FASB issued ASU 2014-02, Accounting for Goodwill—A Consensus of the Private
Company Council, to provide an accounting alternative for the subsequent measurement of
goodwill for private companies, which allowed amortization over a period of up to 10 years,
the Board has issued Invitation to Comment (ITC) to solicit feedback about extending
amortization of goodwill to public companies. The IASB also is considering issuing a similar
query to constituents. As a consequence, if ever promulgated, the testing of goodwill for
impairment may be limited to extreme circumstances similar to long-lived assets under
ASC 360.
140
◾ Impairment
CONCLUSION
The accounting standards for testing goodwill and intangible assets for impairment are provided in FASB ASC 350, Intangibles—Goodwill and Other, and in FASB ASC 360, Property, Plant
and Equipment. Goodwill and intangible assets with indefinite lives are tested annually under
ASC 350. They must be tested between annual tests when events and circumstances indicate that impairment may have occurred. Events and circumstances may indicate impairment
if there has been an adverse change in the business climate or a significant reorganization.
Intangible assets with finite lives that are amortized are tested under ASC 360.
Determining whether goodwill has been impaired can be accomplished using a qualitative or quantitative assessment. The optional qualitative impairment test is based on a more
likely than not test about whether goodwill is impaired after assessing all pertinent events and
circumstances. If it is more likely than not that goodwill is not considered impaired under
the qualitative test, then no further testing is required. On the other hand, if it appears that
goodwill might be impaired, the entity must perform a quantitative goodwill impairment test,
which compares a reporting unit’s carrying value to its fair value to identify the existence of a
potential impairment. Because the qualitative impairment test is optional, an entity can forgo
the qualitative test and simply perform the quantitative test. If impairment is indicated by the
quantitative test, then a goodwill impairment loss must be recognized.
Impairment testing for property, plant and equipment and intangible assets subject to
amortization under ASC 360 is done at the asset group level. Impairment exists if the carrying amount of a long-lived asset or asset group exceeds its fair value and if the carrying value
is not recoverable. The asset group is not considered recoverable if the carrying value exceeds
the sum of the undiscounted cash flow expected to result from the use and eventual disposition of the asset group. Impairment testing under ASC 350 and ASC 360 has nuances that
include determining the order of testing under applicable accounting standards, proper identification of asset groups and reporting units, assigning goodwill to reporting units, assessing
any control premium, and considering the impact of deferred taxes on impairment testing.
NOTES
1. Duff & Phelps, 2016 U.S. Goodwill Impairment Study, November 2016.
2. Statement of Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets,
Paragraph B90—Decision Usefulness, FAS 142-50.
3. Id., FAS 142-3.
4. Summary of Statement No. 142, www.fasb.org.
5. Id.
6. Financial Accounting Standards Board’s Accounting Standards Codification (ASC)
350-20-35-31.
7. ASC 360-10-35-21.
8. ASC 360-10-35-23 to 26.
9. ASC 360-10-35-30. These assumptions may differ from market participant assumptions used
in the original fair value measurement.
Notes
◾
141
10. ASAC 360-10-35-29 to 31.
11. ASC 360-10-35-17.
12. ASC 360-10-35-18.
13. Sony, Inc. Form 10-K, filed March 9, 2017.
14. ASC 350-20-35-1, Pending Content.
15. ASC 350-20-35-3D.
16. ASC 350-20-35-3, Pending Content.
17. ASC 350-20-35-3B, Pending Content.
18. ASC 350-20-35-3C.
19. ASC 350-20-35-3D to 3G, Pending Content.
20. AICPA Accounting and Valuation Guide, Testing Goodwill for Impairment, Sections 2.05
and 2.06.
21. AICPA Accounting and Valuation Guide, Testing Goodwill for Impairment, Section 3.02.
22. Id., 3.03 to 3.06.
23. Id., 3.09
24. ASC 350-20-35-1 to 2, Pending Content.
25. ASC 280-10-50-1.
26. ASC 350-20-35-34 to 37.
27. ASC 350-20-35-39.
28. Id.
29. ASC 350-20-35-40.
30. ASC 350-20-35-41.
31. ASC 350-20-35-41 to 42.
32. ASC 350-20-35-22.
33. ASC 350-20-35-23.
34. Id.
35. ASC 350-20-35-22 to 23.
36. ASC 350-20-35-24.
37. SFAS 141(R), Business Combinations, paragraph 1. December 2007.
38. AICPA Accounting and Valuation Guide, Testing Goodwill for Impairment, Section 2.27.
39. Essendant, Inc. Form 10-Q, filed with the SEC April 27, 2017.
40. EITF 02-13, paragraph 3.
41. ASC 350-20-35-26 and 27.
42. ASC 350-20-35-7.
5A
APPE N D IX F IV E A
Example of a Qualitative Impairment
Analysis—PlanTrust, Inc.
FINANCIAL ACCOUNTING STANDARDS BOARD ASC 350,
INTANGIBLES—GOODWILL AND OTHER
Under ASC 350, Intangibles—Goodwill and Other, goodwill is not amortized. Rather, goodwill is
assessed for impairment at a level referred to as a reporting unit. Impairment is the condition
that exists when the carrying amount of goodwill exceeds its implied fair value.1 In September
2011, the FASB issued Accounting Standards Update 2011-08 (ASU 2011-08), Testing Goodwill for Impairment. The update permits an entity to qualitatively assess whether the fair value
of a reporting unit is less than its carrying amount. Or, the entity has the option to forgo the
qualitative assessment and simply perform step one of the two-step goodwill impairment test.
The FASB’s amendments apply to public as well as nonpublic entities, are subject to early adoption, and are effective for fiscal years beginning after December 15, 2011. Based on a qualitative assessment, if the entity determines that events and circumstances indicate that its fair
value is not less than its carrying value using a more likely than not criterion (>50 percent),
then no further testing is required. If the entity determines that it is more likely than not that
the fair value of the reporting unit is less than the carrying value, then the entity must perform step one of the two-step goodwill impairment test, as previously provided under ASC 350.
A two-step impairment test is used to identify potential goodwill impairment and to measure
the amount of a goodwill impairment loss to be recognized, if any.
143
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
144
◾ Example of a Qualitative Impairment Analysis—PlanTrust, Inc.
ASU 2011-08 (ASC350-20-35-3C) provides examples of events and circumstances that
may indicate a reporting entity’s goodwill is impaired. The qualitative factors include:
◾
◾
◾
◾
◾
◾
◾
Macroeconomic conditions such as a deterioration in general economic conditions, limitations on accessing capital, fluctuations in foreign exchange rates, or other developments
in equity and credit markets.
Industry and market considerations such as a deterioration in the environment in which
an entity operates, an increased competitive environment, a decline in market-dependent
multiples or metrics, a change in the market for an entity’s products or services, or a
regulatory or political development.
Cost factors such as increases in raw materials, labor, or other costs that have a negative
effect on earnings and cash flows.
Overall financial performance such as negative or declining cash flows or a decline in
actual or planned revenue or earnings compared with actual and projected results of
relevant prior periods.
Other relevant entity-specific events such as changes in management, key personnel,
strategy, or customers; contemplation of bankruptcy; or litigation.
Events affecting a reporting unit such as a change in the composition or carrying amount
of its net assets, a more-likely-than-not expectation of selling or disposing all, or a portion, of a reporting unit, the testing for recoverability of a significant asset group within
a reporting unit, or recognition of a goodwill impairment loss in the financial statements
of a subsidiary that is a component of a reporting unit.
If applicable, a sustained decrease in share price (consider in both absolute terms and
relative to peers).
PLANTRUST, INC.
The following is an example of a valuation specialist’s report prepared for a qualitative goodwill impairment analysis.2 PlanTrust, Inc. is a fictitious company. The example is for illustrative purposes only and is not intended to be used for any other purpose. Alternative facts
and circumstances may require other assumptions and methodologies. Although the example
has been prepared using commonly accepted methods, there is variation among practitioners
within the profession. Others may choose different methods and assumptions other than the
ones presented in this example.
Valuation, Inc. was retained to prepare a qualitative assessment to determine whether
the fair value of PlanTrust, Inc. is “more likely than not” less than its carrying value. In our
qualitative assessment, we have considered the examples of relevant events and circumstances
provided by ASC350 as well as other relevant factors that may indicate a reporting entity’s
goodwill is impaired.
In this report, we included an overview of the Company and the Reporting Unit and
described the most recent goodwill impairment analysis dated September 30, 20X5, which
was the starting point for our analysis. We then described any changes in the strategy,
operations, customer mix, and market share since the most recent goodwill impairment
PlanTrust, Inc.
◾
145
analyses. We analyzed the current economy and industry in which PlanTrust operates and
identified the Reporting Unit’s value drivers. We considered PlanTrust’s historical financial
results, comparing the financial results of the most recent 12 months with both the prior
actual financial results and the previously projected financial results. Our financial analysis
also included a comparison of the forecasts prepared for this analysis to the forecasts prepared
in conjunction with the most recent impairment analysis. Because the most recent goodwill
impairment analysis relied on the income approach, we also considered whether changes
in the weighted average cost of capital might negatively impact the reporting unit’s value.
In addition, we considered whether the carrying value of the reporting unit changed significantly. Our conclusion summarizes the factors considered in this analysis and the impact of
these factors on the qualitative assessment of goodwill.
The Company and Reporting Unit
The Fiduciary Trust Group, Inc. began offering pension benefit investment and consulting
services in 1968 in the New York metropolitan area. Over the past 40-plus years, the company has grown dramatically into a family of companies providing employee benefit plan
administrative services, investment management, and asset custodial services throughout the
United States and Canada. The Fiduciary Trust Group, Inc. now has 3,200 employees and over
$450 million in revenue. The Company is organized into two groups: Fiduciary Assurance,
Inc. and Benefit Plan Consulting, Inc., which consists of two reporting units: PlanTrust, Inc.
and PlanPlus, Inc.
PlanTrust, Inc., one of the nation’s largest third-party 401k plan administrators, was
acquired in 2007. It provides 401k and employee pension benefit administration to a broad
range of clients including public retiree plans and company sponsored plans. Revenue for the
20X5 calendar year was $155.3 million. PlanTrust, Inc. has five administrative and customer
service offices in the United States and one in Canada. Its products include:
◾
◾
◾
◾
◾
◾
◾
◾
◾
An online personal 401k investment management system that allows clients’ employees
to select investment funds, make payroll deductions, and monitor their accounts
Online investment advice designed to educate employees about investment choices and
empower them to begin saving for retirement
A 1-800 number staffed by PlanTrust investment counselors
A broad menu of investment funds for employers to select for their sponsored 401k plans
Quarterly plan performance reporting for employees and employers
Tax and benefit plan compliance reporting for employers
The option to add a self-directed investment choice to employer plans
Outsourcing of transactional processing for human resources departments
Retiree benefit administration
Prior Impairment Analysis
Management prepared PlanTrust’s prior quantitative goodwill impairment test, as of September 30, 20X5, which indicates that both income and market approaches were considered, but
146
◾ Example of a Qualitative Impairment Analysis—PlanTrust, Inc.
the conclusion relied only upon the income approach. Publicly traded guideline companies
and the guideline transactions were not considered to be comparable to PlanTrust.
Management’s valuation analysis relied on the results of the discounted cash flow
method, which indicated that the fair value of the Reporting Unit was $92,250,000.
A difference, or cushion, of $58,017,000 existed when compared to PlanTrust’s carrying
value of $34,233,000, resulting in a passing margin for the impairment test of approximately 170 percent. Therefore, management’s conclusion was that the Reporting Unit
was not impaired. The size of the “cushion” as of September 30, 20X5, indicates that a
significant amount of negative evidence (i.e., adverse operating changes or events) could
be absorbed before goodwill would be considered impaired using a more-likely-than-not
assessment.
Analysis of Events
There have been no significant changes in the company’s recent operations, in management,
or key personnel and no changes in strategy, operations, product mix, or customers. The only
significant change was a positive change in the competitive environment. One of PlanTrust’s
primary competitors in the Northeast was acquired by a large international financial
institution. Since then, PlanTrust has hired several of their top salesmen and has been able
to attract some of their core customers and increase its business by 10 percent. This increase
in market share is reflected as an increase in 20X6 revenues in the forecasts prepared
by management.
Industry Overview
As a pension and retirement plan consultant, PlanTrust falls into SIC 6411—Insurance
Agents, Brokers, and Services. Although this industry is still in its growth stage, growth was
somewhat slower over the past five years, increasing at an average annual rate of 2.8 percent.
The industry is expected to benefit from the rebound in the general economy and the stock
market. Higher GDP growth will result in greater demand for employee benefit-related
services. Revenue for the industry in 20X6 is expected to grow approximately 4.0 percent as
individuals and businesses begin to expand benefit coverage in an improving economy. Over
the five years to 20X6, industry revenue is projected to increase at an average annual rate of
5.5 percent.
Key value drivers include:
◾
◾
◾
An increase in the value of assets under management
An increase in enrollment in employee benefit funds
A decline in unemployment
We concluded that the general economic and industry outlook would have a positive
impact on PlanTrust’s fair value.
PlanTrust, Inc.
◾
147
Guideline Company Trends
We analyzed the publicly traded guideline companies identified by management as similar to
PlanTrust.
◾
◾
◾
◾
Arlington Benefit Plan Advisors, Inc. (ABPA)
Boston Benefit Plan Consultants, Inc. (BBPC)
Capital Consulting Corporation (CCC)
Diversified Financial Administrators (DFA)
Although management stated that the guideline companies are not similar enough to
PlanTrust to apply the multiples to PlanTrust’s financial metrics, we consider trends in the
multiples of the guideline companies to be an indication of how the industry is performing as
a whole. (See Exhibit 5A.1.)
Based on the change in multiples for the four publicly traded guideline companies from
September 30, 20X5, to September 30, 20X6, we conclude that the value of the industry had
declined. The decline in value is most apparent by the change in the median MVIC/EBITDA
and MVIC/EBIT multiples, which declined by 1.23 and 2.70, respectively. The decline in value
was most severe for CCC, whereas BBPC had the best performance of the group. Although the
decline in guideline company multiples is an indication of industry performance and expectations, we believed that it is not a significant indication of fair value of PlanTrust due to the lack
of comparability as described by management in the prior impairment analysis. In addition,
overall industry performance is expected to improve.
General Economic Outlook3
We considered the general economic climate that prevailed in the first half of 20X6. The economic recovery in the United States has slowed of late. However, it is likely that the economy
will avoid a double-dip recession. Following an anemic 0.8 percent growth rate in the first
half of 20X6, real gross domestic product (GDP) is expected to contract 0.3 percent in the
third quarter of 20X6 as consumers curtail spending habits in the face of stock market volatility and subpar labor market conditions. The economy is expected to rebound in the fourth
quarter by 1.2 percent.
As shown in Exhibit 5A.2, for all of 20X6, real GDP growth is expected to be 1.3 percent, rising to a 1.5 percent growth rate in 2012. In 2013, real GDP is expected to expand
2.4 percent as both consumer and business confidence improves.
The labor market created 117,000 jobs in July. Although this number is well below
what one would expect for a proper recovery, it was certainly a big improvement over
the previous two months when the economy created a total of 99,000 jobs. Private sector
employment grew by 154,000 in July for a total of 333,000 jobs over the last three months.
Although the unemployment rate eased to 9.1 percent in July, corporate layoffs affected
nearly 60 percent more workers than last year.
148
◾ Example of a Qualitative Impairment Analysis—PlanTrust, Inc.
EXHIBIT 5A.1 Plantrust, Inc., Guideline Company Trend, September 30, 20X5 TO
September 30, 20X6
Guideline Companies
As of September 30, 20X6
MVIC/
Revenue
MVIC/
EBITDA
MVIC/
EBIT
Equity
Price/Net
Income
Equity
Price/Book
Value
ABPA
1.30
9.45
12.42
21.00
4.92
BBPC
2.34
13.95
20.92
20.63
2.68
CCC
NA
0.56
0.38
NA
0.77
DFA
0.34
3.38
4.51
4.78
1.91
Maximum
2.34
13.95
20.92
21.00
4.92
Average
1.33
6.83
9.56
15.47
2.57
Median
1.30
6.41
8.47
20.63
2.29
Minimum
0.34
0.56
0.38
4.78
0.77
As of September 30, 20X5
ABPA
1.43
9.02
11.33
19.14
5.28
BBPC
1.87
10.12
13.86
22.55
3.08
CCC
0.20
6.27
11.00
14.60
1.26
DFA
0.34
4.07
6.49
6.82
1.35
Maximum
1.87
10.12
13.86
22.55
5.28
Average
0.96
7.37
10.67
15.78
2.74
Median
0.89
7.65
11.17
16.87
2.22
Minimum
0.20
4.07
6.49
6.82
1.26
ABPA
(0.13)
0.43
1.09
1.86
(0.36)
BBPC
0.47
3.83
7.06
(1.92)
(0.40)
CCC
NA
(5.71)
(10.62)
NA
(0.49)
DFA
(0.00)
(0.69)
(1.98)
(2.04)
0.56
Change in Maximum
0.47
3.83
7.06
(1.55)
(0.36)
Change in Average
0.37
(0.54)
(1.11)
(0.31)
(0.17)
Change in Median
0.42
(1.23)
(2.70)
3.76
0.08
Change in Minimum
0.14
(3.51)
(6.11)
(2.04)
(0.49)
Change
As indicated by the S&P 500 Index, the overall equity market was at approximately
the same level on September 30, 20X6, as it was on September 30, 2010. The September 30,
20X6, closing price of $1,131.42 represents a decline of less than 1 percent from the previous
year. However, to conclude that the S&P’s performance was flat would be incorrect. The
S&P 500 gradually increased from $1,141.2 on September 30, 2010, to its $1,363.61 peak
on April 29, 20X6. It generally fluctuated within the $1,250 to $1,350 range until July 22,
PlanTrust, Inc.
◾
149
Historical & Projected Real GDP Growth
(% change from a year ago)
4.0%
3.0%
2.0%
1.0%
0.0%
−1.0%
2005 2006 2007 2008 2009
2010
2011
2012
2013
−2.0%
−3.0%
−4.0%
EXHIBIT 5A.2 Historical and Projected Real GDP Growth (percent change from a year ago)
20X6, and then dropped dramatically to its low of $1,119.38 on August 5. The S&P 500
was extremely volatile for the remainder of the September 30 fiscal year, never sustaining a
recovery and ending at $1,131.42.
Economic and Industry Conclusion
The industry is expected to benefit from the rebound in the general economy. Higher GDP
growth will result in greater demand for insurance products, insurance-related services, and
higher enrollment in employee benefit plans. Additionally, the industry should benefit from
a rise in demand for health and medical insurance as the U.S. population ages, as well as an
increase in assets under management as the Baby-Boomer generation prepares for retirement.
Over the five years to 2016, industry revenue is projected to increase at an average annual rate
of 5.5 percent. As the industry is expected to benefit from the economic rebound, a positive
impact on PlanTrust’s fair value is expected.
Financial Analysis of the Reporting Unit
We were provided with PlanTrust’s internally prepared financial statements for each of the
prior five years and for the nine months ended September 30, 20X6. The income statements
are presented in Exhibit 5A.3 and balance sheets are presented in Exhibit 5A.4.
Income Statement Analysis
PlanTrust’s revenues were $156,213,400 for the calendar year ended December 31,
20X4, and $155,301,000 for the calendar year ended December 31, 20X5. Most of the
revenue is generated by benefit plan administration service and fees for investment management. Revenue for the nine months ended September 30, 20X6, was $126,063,000.
PlanTrust’s net operating expenses primarily consist of salaries, printing, depreciation, and
other office charges. Net operating expenses were $144,207,000 in calendar year 20X4
and $139,041,000 in calendar year 20X5. Earnings before interest and taxes (EBIT) was
150
EXHIBIT 5A.3 Plan Trust, Inc., Historical Income Statement Summary
Year Ending December 31,
Revenues
20X0
20X1
20X2
20X3
20X4
20X5
YTD 9/30/20X6
$ 151,411,500
$ 188,940,000
$ 183,409,500
$ 169,429,500
$ 156,213,000
$ 155,301,000
$ 126,063,000
162,759,000
204,003,000
193,161,000
169,054,500
154,377,000
151,324,500
116,959,500
-
-
-
-
-
3,919,500
3,556,000
4,972,500
3,151,500
Operating Expenses:
Total Expenses
Less: Allocated Expense Adjustment
Less: Depreciation Expense
9,840,000
9,481,500
12,226,500
7,374,000
6,123,000
Less: Amortization Expense
3,631,500
8,317,500
5,752,500
4,795,500
4,047,000
3,391,500
2,181,000
Net Operating Expenses
149,287,500
186,204,000
175,182,000
156,885,000
144,207,000
139,041,000
108,071,000
EBITDA
2,124,000
2,736,000
8,227,500
12,544,500
12,006,000
16,260,000
17,992,000
Less: Depreciation Expense
9,840,000
9,481,500
12,226,500
7,374,000
6,123,000
4,972,500
3,151,500
Less: Amortization Expense
3,631,500
8,317,500
5,752,500
4,795,500
4,047,000
3,391,500
2,181,000
(11,347,500)
(15,063,000)
(9,751,500)
375,000
1,836,000
7,896,000
12,659,500
EBIT
Source: Management provided internal financial statements.
151
EXHIBIT 5A.4
Plan Trust, Inc., Historical Balance Sheet Summary
As of December 31,
20X2
20X3
20X4
20X5
As of
As of
9/30/20X5
9/30/20X6
20X0
20X1
Cash and Cash Equivalents
$ 963,000
$ 10,269,000
Due from PlanPlus
6,016,500
-
136,500
-
-
Due from Affiliates
-
-
70,500
63,000
-
78,000
-
-
Prepaid Expenses
4,596,000
3,790,500
3,579,000
2,298,000
3,363,000
3,522,000
2,281,500
2,999,800
Accounts Receivable
15,004,500
13,090,500
13,687,500
Assets
Current Assets
Deferred Tax Asset Current
301,500
Federal Income Tax Recoverable
-
4,843,500
$ 7,236,000 $ 11,223,000
$ 5,016,000
$ 7,402,500 $ 12,631,500 $ 14,525,800
2,020,500
-
-
13,003,500
10,878,000
8,469,000
8,145,000
10,521,100
-
-
-
-
-
-
-
756,000
-
-
-
-
243,000
-
-
-
-
-
26,881,500
31,993,500
24,952,500
27,343,500
19,257,000
21,492,000
23,058,000
28,046,700
-
-
1,758,000
1,609,500
-
1,141,500
-
-
Goodwill, Net
20,976,000
28,011,000
30,157,500
33,841,500
35,556,000
35,451,000
35,451,000
35,551,800
Value of Business Acquired
13,609,500
26,542,500
21,075,000
16,426,500
12,390,000
8,997,000
9,846,000
6,816,200
-
441,000
156,000
9,000
-
-
-
-
-
1,948,800
Other Current Assets
Total Current Assets
Deferred Tax Asset
Other Intangibles
-
-
Notes Receivable
-
-
-
-
246,000
1,948,500
Investments—Bonds
372,000
364,500
373,500
439,500
366,000
387,000
424,500
Furniture and Equipment, Net
18,597,000
23,034,000
17,172,000
5,436,000
4,236,000
5,859,000
5,370,000
5,178,100
Software, Net
14,907,000
6,354,000
2,824,500
9,646,500
6,676,500
8,704,500
5,611,500
11,926,000
Real Estate
-
-
625,500
-
-
-
-
Total Assets
-
451,800
$ 95,343,000 $ 116,740,500 $ 98,469,000 $ 95,377,500 $ 78,727,500 $ 83,980,500 $ 79,761,000 $ 89,919,400
(continued)
152
EXHIBIT 5A.4 (continued)
As of December 31,
20X0
20X1
20X2
20X3
20X4
20X5
As of
As of
9/30/20X5
9/30/20X6
Liabilities and Stockholders’ Equity
Current Liabilities:
Accrued Salaries
$ 9,480,000
$ 7,537,500
$ 9,702,000
$ 8,770,500 $ 11,688,800
Accrued Expenses
11,602,500
12,900,000
9,880,500
11,559,000
11,070,000
13,939,500
12,372,000
-
-
-
289,500
-
-
-
Amounts Held for Customers
Due to PlanPlus
Due to Fiduciary Trust Group
Due to Affiliates
7,059,000
6,000,000
$ 10,845,000 $ 12,447,000 $ 11,316,000
826,500
-
4,047,000
3,583,500
3,888,000
13,810,400
-
-
8,250,000
-
-
-
2,530,500
-
-
705,000
364,500
49,500
3,180,000
Short-term Contingency Payment
-
3,030,000
2,907,000
2,881,500
7,092,000
Deferred Revenue
-
4,119,000
4,035,000
3,162,000
3,000,000
3,570,000
4,500
54,000
72,000
3,289,500
3,016,500
1,941,000
2,940,000
74,000
34,146,000
36,526,500
33,289,500
36,435,000
34,896,000
40,012,500
25,933,500
33,465,800
Other Liabilities
Total Current Liabilities
Deferred Tax Liabilities
(378,000)
5,076,000
-
-
(1,611,000)
Long-term Note
Payable—PlanPlus
41,250,000
41,250,000
41,250,000
33,000,000
24,750,000
Long-term Note
Payable—Pension Trust Co.
11,421,000
2,550,000
-
2,250,000
-
Long-term Note
Payable—Pension Services Co
-
2,887,500
-
-
-
NGS Long-term Note Payable
-
-
-
-
Escrow Account
-
-
-
-
Other Long-term Debt/Liabilities
79,500
-
-
1,851,000
4,722,200
-
-
-
3,170,400
(333,000)
2,040,600
20,625,000
12,375,000
-
-
-
-
-
-
-
-
-
-
-
-
-
-
8,250,000
-
8,808,000
8,368,500
7,776,000
811,500
4,773,000
619,500
4,148,800
Total Liabilities
86,439,000
97,098,000
82,908,000
79,461,000
58,846,500
53,035,500
46,845,000
52,030,200
Total Stockholders’ Equity
8,904,000
19,642,500
15,561,000
15,916,500
19,881,000
30,945,000
32,916,000
37,889,000
Total Liabilities and
Stockholders’ Equity
$ 95,343,000 $ 116,740,500 $ 98,469,000 $ 95,377,500 $ 78,727,500 $ 83,980,500 $ 79,761,000 $ 89,919,200
Source: Audited historical financial statements.
PlanTrust, Inc.
◾
153
$1,836,000 in calendar year 20X4 and $7,896,000 in calendar year 20X5. Operating
expenses were $108,071,000 for the nine months ended September 30, 20X6, and EBIT
was $12,659,500. Based on a comparison to the calendar year ended December 31, 20X5,
PlanTrust appears to be more profitable in the nine months ended September 30, 20X6, with
higher revenues and lower expenses.
Comparison of Actual Results to Forecasted Results
Actual results for the 20X5 calendar year were slightly better than projections prepared
as of September 30, 20X5, for the full 20X5 calendar year. Projected revenue for the
20X5 calendar year was $154,779,000, which practically mirrored the actual revenue of
$155,301,000. Net operating expenses of $139,041,000 were slightly higher than projected
expenses of $138,820,500. However, actual EBIT of $7,896,000 were slightly higher than
projected $7,633,500.
The occurrence of actual results surpassing projected results is a positive factor in the
impairment analysis. See Exhibit 5A.5 for a comparison of actual results to forecasted results.
Comparison of Current Five-Year Forecast with Prior Five-Year Forecast
As part of the qualitative assessment, we were provided with a five-year forecast as of September 30, 20X6 (the 20X7 Plan) and compared it to the five-year forecast used in connection
with the September 30, 20X5, impairment analysis (the 20X6 Plan).
EXHIBIT 5A.5 Plan Trust, Inc., as of September 30, 2016, Comparison of Actual 20X5
to Forecasted 20X5
Historical
September 30, 20X5
Forecast for
Year Ending
December 31,
Year Ending
December 31,
20X5
20X5
Increase/
(Decrease)
$ 155,301,000
$ 154,779,000
$ 522,000
151,324,500
151,072,500
252,000
Less: Allocated Expense Adjustment
3,919,500
3,927,000
(7,500)
Less: Depreciation Expense
4,972,500
4,933,500
39,000
Less: Amortization Expense
3,391,500
3,391,500
-
Net Operating Expenses
139,041,000
138,820,500
220,500
16,260,000
15,958,500
301,500
4,972,500
4,933,500
39,000
Revenues
Operating Expenses:
Total Expenses
EBITDA
Less: Depreciation Expense
Less: Amortization Expense
EBIT
3,391,500
$
7,896,000
$
3,391,500
-
7,633,500
$ 262,500
Source: Management provided internal historical financial statements and forecast.
154
◾ Example of a Qualitative Impairment Analysis—PlanTrust, Inc.
Comparing the 20X7 Plan to the 20X6 Plan, projected revenues have increased over
the five years of the projected period. Total revenues for the five-year period increased by
$193,387,800, from $636,686,700 to $830,074,500. Projected net operating expenses
also increased, but to a lesser extent, over the same period by $122,384,100. EBIT increased
over the projected period from $81,803,400 to $154,896,000.
The comparison of the forecasts is consistent with the expected increase in revenues
resulting from new customers. The expectation for better performance in the 20X7 Plan is a
positive factor in the impairment analysis. (See Exhibit 5A.6.)
Comparison of Weighted Average Cost of Capital
Because the income approach to value was the primary method used to indicate fair value in
the prior goodwill impairment analysis, we considered how changes in the weighted average
cost of capital (WACC) can affect this qualitative assessment of goodwill. Exhibit 5A.7 compares the development of the WACC as of September 30, 20X5, to the WACC as of September
30, 20X6. As of the latter date, the beta, market premium, and size premium each increased
compared to the previous date resulting in a higher cost of equity. The cost of debt remained
similar between the two dates, and the capital structure remained the same. The overall WACC
increased from 12 percent to 13 percent. And, although an increase in WACC indicates more
risk and would have an adverse affect on the fair value of PlanTrust, we concluded the increase
in the discount rate would not be significant enough to deplete the cushion that resulted from
the comparison of fair value to carrying value in the September 30, 20X5, goodwill impairment analysis.
Comparison of the Carrying Value
Finally, we considered whether the carrying value of the reporting unit had changed significantly. The carrying value of the reporting unit is equal to the book value of shareholders’
equity. The carrying value of the reporting unit increased from $32,916,000 as of September
30, 20X5, to $37,889,000 as of September 30, 20X6, an increase of $4,973,000 (see
Exhibit 5A.4). When assessing the excess fair value of the reporting unit over the carrying
value, an increase in carrying value is a negative factor. However, we concluded that because
the roughly $5 million increase in carrying value represents less than 9 percent of the
$58,017,000 cushion from the previous year’s quantitative impairment test, the negative
factor was not significant.
Conclusion of Qualitative Assessment
We prepared a summary of the factors considered in the analysis and weighed the impact of
these factors on the qualitative assessment of goodwill. We weighted the factors low, medium,
or high based on their relevance to PlanTrust and based on the relative objectivity or subjectivity of the evidence. In total, we believed the negative factors appear to have less of an impact
than the positive factors. Our summary of the qualitative impairment analysis is shown in
Exhibit 5A.8.
155
EXHIBIT 5A.6
Plan Trust, Inc., as of September 30, 20X6, Forecast Comparison
Forecast (20X6 Plan)
Revenues
20X6
20X7
20X8
20X9
20Y0
Total 20X6-Y0
$ 150,877,500
$ 124,389,600
$ 120,937,200
$ 119,986,800
$ 120,495,600
$ 636,686,700
% Increase/(Decrease)
Operating Expenses:
Total Expenses
144,375,000
114,453,600
106,740,000
103,591,200
103,681,200
572,841,000
Less: Allocated Expense Adjustment
5,242,500
3,276,000
3,210,000
3,146,400
3,082,800
17,957,700
Less: Depreciation Expense
3,867,000
3,858,000
3,858,000
3,858,000
3,858,000
19,299,000
Less: Amortization Expense
2,908,500
1,999,200
944,400
771,600
631,200
7,254,900
Net Operating Expenses
132,357,000
105,320,400
98,727,600
95,815,200
96,109,200
528,329,400
18,520,500
19,069,200
22,209,600
24,171,600
24,386,400
108,357,300
Less: Depreciation Expense
3,867,000
3,858,000
3,858,000
3,858,000
3,858,000
19,299,000
Less: Amortization Expense
2,908,500
1,999,200
944,400
771,600
631,200
7,254,900
11,745,000
13,212,000
17,407,200
19,542,000
19,897,200
81,803,400
% Increase/(Decrease)
EBITDA
% Increase/(Decrease)
EBIT
156
EXHIBIT 5A.6 (continued)
Forecast (20X7 Plan)
Revenues
% Increase/(Decrease)
20X6
20X7
20X8
20X9
20Y0
Total 20X6-Y0
$ 170,049,000
$ 167,941,500
$ 165,553,500
$ 163,167,000
$ 163,363,500
$ 830,074,500
13%
35%
37%
36%
36%
Operating Expenses:
Total Expenses
163,113,000
143,067,000
133,425,000
129,489,000
129,601,500
698,695,500
Less: Allocated Expense Adjustment
4,314,000
4,947,000
4,848,000
4,751,000
4,657,000
23,517,000
Less: Depreciation Expense
3,520,500
3,603,000
3,000,000
3,000,000
3,000,000
16,123,500
Less: Amortization Expense
2,908,500
2,499,000
1,180,500
964,500
789,000
8,341,500
Net Operating Expenses
152,370,000
132,018,000
124,396,500
120,773,500
121,155,500
650,713,500
15%
25%
26%
26%
26%
17,679,000
35,923,500
41,157,000
42,393,500
42,208,000
-5%
88%
85%
75%
73%
% Increase/(Decrease)
EBITDA
% Increase/(Decrease)
179,361,000
Less: Depreciation Expense
3,520,500
3,603,000
3,000,000
3,000,000
3,000,000
Less: Amortization Expense
2,908,500
2,499,000
1,180,500
964,500
789,000
8,341,500
11,250,000
29,821,500
36,976,500
38,429,000
38,419,000
154,896,000
-4%
126%
112%
97%
93%
89%
EBIT
% Increase/(Decrease)
Source: Management provided forecasts.
16,123,500
157
EXHIBIT 5A.7
Plan Trust, Inc., WACC Comparison, as of September 30, 20X6
As of
As of
September 30, 20X51
September 30, 20X6
Modified CAPM Method, Cost of Equity: Ke = Rf + ( β x RPm ) + RPs + RPu
2.70%2
Risk-Free Rate (Rf)
2.75%
Beta (β)
0.92
1.073
Market Premium (RPm)
5.60%
5.80%4
Size Premium (RPs)
4.80%
5.36%5
Company-Specific Risk Premium (RPu)
5.00%
5.00%1
17.70%
19.27%
ke =
After Tax Cost of Debt: kd = Kb(1-t)
Borrowing Rate (Kb)
5.55%
5.55%6
Tax Rate (t)
26.00%
26.00%1
4.11%
4.11%
kd =
(continued)
158
EXHIBIT 5A.7 (continued)
Weighted Average Cost of Capital (WACC)
Weighted
Capital
Structure
Capital
Cost
Cost
Structure7
Cost
Weighted
Equity
60.00%
17.70%
10.62%
60.00%
19.27%
Debt
40.00%
40.00%
Cost
11.56%
4.11%
1.64%
4.11%
1.64%
WACC =
12.26%
WACC =
13.20%
Rounded =
12.00%
Rounded =
13.00%
Notes:
1 As presented in management’s September 30, 20X5, Goodwill Impairment Analysis.
2 20-Year Treasury Bond as of September 30, 20X6; Federal Reserve Statistical Release.
3 Based on the levered adjusted betas for the guideline publicly traded companies.
4 Duff & Phelps Valuation Handbook: Guide to Cost of Capital; industry premium for SIC 6411.
5 Duff & Phelps 20X7 Valuation Handbook: Guide to Cost of Capital (Long-Term Returns in Excess of CAPM Estimations for Decile Portfolios of the
NYSE/AMEX/NASDAQ 10th Decile).
6 Moody’s Baa rate as of September 30, 20X6; Federal Reserve Statistical Release.
7 Based on an analysis of guideline companies, the industry and the company’s own capital structure.
Notes
◾
159
EXHIBIT 5A.8 Plan Trust, Inc., Summary of Factors, as of September 30, 20X6
Date of prior goodwill impairment analysis
September 30, 20X6
Fair value of equity as of September 30, 20X5
$
92,250,000
Carrying value of equity as of September 30, 20X5
$
37,889,000
Margin of passing
140%
Factor
Impact
Weight
Nature of Evidence
Proximity in time to last quantitative goodwill
impairment test
Positive
High
Objective
Magnitude of passing margin for last quantitative
goodwill impairment test
Positive
High
Objective
Increase in market share
Increase in the value of assets under management
Positive
Increase in enrollment in employee benefit funds
Positive
Decline in unemployment
Change in guideline company multiples
Negative
Positive
Medium
Low
Subjective
Low
Subjective
Positive
Low
Low
Objective
Expected higher GDP growth
Positive
Medium
Surpassing 20X5 projections
Positive
Medium
Improved five-year forecast
Positive
High
Comparison of WACC
Negative
Medium
Medium
Objective
Increase in carrying value of equity
Negative
Based on the qualitative impairment analysis performed, we concluded there does not
appear to be deterioration in the fair value of PlanTrust, which supports management’s assertion that goodwill is not impaired as of September 30, 20X6.
NOTES
1. ASC 350, “The fair value of goodwill can be measured only as a residual and cannot be measured directly. Therefore, this Statement includes a methodology to determine an amount that
achieves a reasonable estimate of the value of goodwill for purposes of measuring an impairment loss. That estimate is referred to herein as the implied fair value of goodwill.”
2. Accredited valuation specialists should consult the development and reporting requirements
under applicable professional standards to determine what additional information, if any,
should be included as part of the work product.
3. Georgia State University’s Forecast of the Nation, August 2011.
6
C HAPTE R S IX
The Cost Approach1
T
H E C O S T A P P R O A C H is one of the three valuation approaches used to measure
fair value in financial reporting. The cost approach is often referred to as the asset
approach, and the terms are used interchangeably. For instance, the American
Society of Appraisers (ASA) Business Valuation Standards say that “in business valuation, the asset-based approach may be analogous to the cost approach of other appraisal
disciplines.”2
However, the International Glossary of Business Valuation Terms has separate definitions for
the cost approach and asset approach. The Glossary defines the cost approach as “a general way
of estimating a value indication of an individual asset by quantifying the amount of money
that would be required to replace the future service capability of that asset.” Conversely, the
Glossary defines the asset approach as “a general way of determining a value indication of a
business, business ownership interest or security by using one or more methods based on the
value of the assets of that business net of liabilities.”3
The difference between the two definitions is that the cost approach is more often used
to describe the measurement of fair value of an individual asset, whereas the asset approach
is used to measure the fair value of a business, ownership interest, or security. Under the
definition of the cost approach, fair value is measured as the cost to replace the service
capacity of the asset. Under the definition of asset approach, fair value measurement of an
entity is the summation of individual asset and liability values determined by various other
valuation methods.
According to the ASA Business Valuation Standards, using the asset approach to measure the fair value of an entity may not always be appropriate. Under most circumstances, the
asset approach should not be the sole appraisal approach to value an operating entity that is
a going concern. The asset approach is more appropriately used to value real estate holding
companies or companies in liquidation.4 The reason for this caution is that the basic form
161
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
162
◾ The Cost Approach
of the asset approach typically does not consider the fair value of unidentified assets, such
as goodwill.
In the real estate profession, the cost approach is defined as “a set of procedures through
which a value indication is derived for the fee simple interest in a property by estimating the
current cost to construct a reproduction of, or replacement for, the existing structure plus any
profit or incentive; deducting depreciation from the total cost; and adding the estimated land
value.”5 This definition from the real estate profession is interesting in that it includes a “profit
or incentive” as part of the costs included in the analysis.
In Intellectual Property, Valuation, Exploitation, and Infringement Damages, the authors
Gordon Smith and Russell Parr describe the use of the cost approach to measuring fair value,
which can be extended to intangible assets, by saying:
The cost approach seeks to measure the future benefits of ownership by quantifying
the amount of money that would be required to replace the future service capacity
of the subject intellectual property. The assumption underlying this approach
is that the cost to purchase or develop new property is commensurate with the
economic value of the service that the property can provide during its life …
Using a cost approach to develop an indication of market value, however, requires
consideration of economic obsolescence, and in this instance the appraiser must
decide to what extent future economic benefits will support an investment at the
indicated value.6
THE COST APPROACH UNDER FASB ASC 820, FAIR VALUE
MEASUREMENT
The valuation concepts in FASB ASC 820, Fair Value Measurement (ASC 820), are similar
to those previously described. For financial reporting purposes, the FASB defines the cost
approach as:
The cost approach reflects the amount that would be required currently to replace
the service capacity of an asset (often referred to as current replacement cost). From
the perspective of a market participant seller, the price that would be received for
the asset is determined based on the cost to a market participant buyer to acquire or
construct a substitute asset of comparable utility, adjusted for obsolescence. That is
because a market participant buyer would not pay more for an asset than the amount
for which it could replace the service capacity of that asset. Obsolescence encompasses physical deterioration, functional (technological) obsolescence, and economic
(external) obsolescence and is broader than depreciation for financial reporting purposes (an allocation of historical cost) or tax purposes (using specific service lives). In
many cases, the current replacement cost method is used to measure the fair value
of tangible assets that are used in combination with other assets or with other assets
and liabilities.7
The first element in the definition of the cost approach under ASC 820 is the concept of
replacing the service capacity, or utility, of an asset. The AICPA’s Consulting Services Practice
The Cost Approach under FASB ASC 820, Fair Value Measurement
◾
163
Aid 99-2, Valuing Intellectual Property and Calculating Infringement Damages, although not
directly related to measuring fair value, still provides insight to this concept by saying,
Replacement cost contemplates the cost to recreate the functionality or utility of the
subject discrete intangible asset, but in a form or appearance that may be quite different from the actual intangible asset subject to appraisal. Functionality is an engineering concept that means the ability of the subject intangible asset to perform the
task for which it was designed. Utility is an economics concept that means the ability
of the subject intangible asset to provide an equivalent amount of satisfaction.8
In economics, utility is a measure of happiness or relative satisfaction. Utility can also
be thought of as a measure of economic returns that the investor expects the investment to
generate.9 Therefore, two very different assets could provide the same expected return on
investment and thus the same utility.
The principle of substitution is a second element in the definition of the cost approach
under ASC 820. Fair value is an exit price to a market participant. Under the principle of substitution, a seller can receive a price no higher than the price a buyer is willing to pay. The
price a buyer is willing to pay is capped by what it would cost to purchase or construct a substitute asset of equal utility. This principle of substitution is also found in real estate appraisal.
In The Appraisal of Real Estate, the Appraisal Institute describes the principle of substitution as:
The principle of substitution states that when several similar or commensurate commodities, goods or services are available, the one with the lowest price attracts the
greatest demand and widest distribution. This principle assumes rational, prudent
market behavior with no undue cost to delay. According to the principle of substitution, a buyer will not pay more for one property than for another that is equally
desirable. Property values tend to be set by the price of acquiring equally desirable
substitute property. The principle of substitution recognizes that buyers and sellers of
real property have options; i.e., other properties are available for similar uses.10
A third element in the definition of the cost approach under ASC 820 describes the potential obsolescence adjustments to reconcile the price of the substitute asset to the value of the
subject asset. If the substitute asset provides greater utility, the buyer would pay more to purchase it. The replacement cost of the subject asset would be equal to the price a buyer would
pay for a better substitute less an adjustment for the subject asset’s obsolescence. The obsolescence factor would be equal to the excess utility of the replacement plus any other obsolescence
in the subject asset. The AICPA’s Practice Aid further describes the replacement concept under
the cost approach by noting that:
Although the replacement intangible asset performs the same task as the subject
intangible asset, the replacement asset is often better in some way than the subject
asset. In that case, the replacement property may yield more satisfaction than the
subject property. If this is true, the analyst should be careful to adjust this factor in
the obsolescence estimation of the replacement cost analysis.11
Obsolescence is a state that can be described as worn out, no longer in use, or outmoded
in style, design, or construction.12 The existence of obsolescence generally causes a reduction
in the value of an asset. The three types of obsolescence mentioned specifically in ASC 820
◾ The Cost Approach
164
are (1) physical deterioration, (2) functional obsolescence, and (3) economic obsolescence.
Physical deterioration results from physical wear and tear caused by the asset’s use or its aging.
Functional obsolescence results when an asset is unable to perform the function for which it
was originally intended. Advances in technology create technological obsolescence, which is
a type of functional obsolescence. Economic obsolescence occurs when the asset is still able to
function as it was originally intended, but not profitably. Economic obsolescence occurs when
competitive market forces external to the entity reduce the asset’s ability to earn a satisfactory
return, thereby decreasing its value.13,14
One final point to emphasize about the definition of cost approach under ASC 820 is that
the goal is to measure the fair value of an asset. The fair value is the price agreed on by market
participants acting in their own self-interests. It is based on the assumptions that each market
participant would use to price the asset. Under the cost approach, the seller assumes that the
price cannot exceed an amount that the buyer is willing to pay. The buyer assumes that he will
only pay an amount that is less than or equal to what it would cost to purchase or construct
a similar asset. Therefore, under the cost approach, the price is a market price, the price at
which the asset could be sold to a market participant.
ECONOMIC FOUNDATION FOR THE COST APPROACH
Although the economic foundation of the cost approach was discussed in the previous
section, it was not specifically identified. The economic foundation for the cost approach
is concisely summarized in the AICPA’s Practice Aid 99-2, Valuing Intellectual Property and
Calculating Infringement Damages. According to the AICPA:
The theoretical underpinnings of the various cost approach valuation methods for
valuing discrete intangible assets relate to the economic principles of substitution,
supply and demand, and externalities.
◾
◾
◾
Substitution. This principle affirms that no prudent buyer would pay more for
a discrete intangible asset than the cost to construct an intangible of equal
desirability and utility.
Supply and demand. Shifts in supply and demand cause costs to increase and
decrease and cause changes in the need for supply of different kinds of discrete
intangible assets.
Externalities. Gains or losses from external factors may accrue to intangible
assets. External conditions may cause a newly constructed discrete intangible
to be worth more or less than its original cost.15
COST VERSUS PRICE VERSUS FAIR VALUE
Assuming that fair value is measured by the market price that a market participant would
receive when selling an asset, and assuming that fair value is limited to the amount it would
cost a buyer to purchase or construct a similar asset, then one might be tempted to conclude
that cost equals price equals fair value. The conclusion may be appropriate, but first one must
Cost versus Price versus Fair Value
◾
165
understand what distinguishes each of these terms and what other factors influence their
relationship before concluding that cost can be used to measure fair value.
Cost refers to either the historic costs spent to create an asset or the amount that would
be spent to re-create the asset as of the measurement date. Cost has a factual basis. Price also
has a factual basis and is the amount paid to purchase an asset. Price is determined through a
market transaction at a specific point in time. But the cost to create an asset under traditional
cost approach methods and the price paid to purchase a similar asset would not be the same
unless profitability and the cost of capital employed were also included as inherent costs of the
asset under the cost approach.
When an entity develops an asset internally, it incurs direct costs for materials and labor.
Other indirect costs such as employee benefits, administration, and utilities are typically
allocated to the project, but the cost of capital and expected profit are not typically allocated
to the project. However, when an entity purchases an asset, the acquisition price typically
takes into consideration all the direct and indirect costs of producing the asset plus a markup.
The markup provides the seller a reasonable profit and includes the seller’s opportunity
cost of capital. Entrepreneurial profit provides an incentive for the seller to be in business.
The opportunity cost of capital provides the seller an incentive to direct resources to produce
that specific asset to the exclusion of all other possible products. So the difference between
the price to purchase an asset and the cost to create a similar asset can often be attributed to
entrepreneurial profit and opportunity cost.
One of the shortcomings of the cost approach to measuring fair value is that traditionally entrepreneurial profit and opportunity costs have not often been included. There are two
reasons for this. First, the historic costs on which the cost approach is based often tend not to
measure entrepreneurial profit and incentive. This is particularly true for intangible assets as
they are typically created or developed internally. Second, many valuation specialists do not
adjust historic costs to include profit and incentive before using historic cost as the basis for the
application of the cost approach to the measurement of fair value. There are inconsistencies
in practice among valuation specialists and there is a lack of clear, authoritative guidance on
the subject.
In a speech delivered at the 2005 AICPA National Conference on Current SEC and PCAOB
Developments, Pamela Schlosser, at the time the Professional Accounting Fellow for the Office
of the Chief Accountant of the U. S. Securities and Exchange Commission, briefly touched on
the shortcomings of the cost approach to measure fair value while discussing customer-related
intangibles. She said:
We are aware of questions regarding what valuation methodology should be used to
estimate the fair value of intangible assets. Although the appropriateness of any valuation technique is highly dependent on individual facts and circumstances, I believe
an income approach is generally the most appropriate method for estimating the fair
value of customer-related intangible assets. Under this approach, the future benefits
of those relationships can be quantified in the form of cash flows expected to be generated from incremental sales to those customers. On the other hand, the use of the cost
approach has generally been challenged since, in the staff’s experience, the models
failed to capture all associated costs that would be necessary to rebuild that customer
relationship and the resultant value was not deemed sufficient when compared to
values derived by other approaches.16
166
◾ The Cost Approach
In essence, Schlosser is appropriately saying that the traditional cost approach methods
generally fail to capture certain costs such as entrepreneur’s profit and incentive. This limitation not only applies to measuring the fair value of customer relationships, but other assets
using these methods as well. A potential solution to this problem is to adjust replacement costs
by adding entrepreneur’s profit and opportunity cost. If the entrepreneur’s profit and incentive are included in the cost to create an asset, then the fully burdened historic cost would
more closely resemble a historic market price and would serve as a better base from which to
measure fair value under the cost approach. The resulting fair value measurement would be
a close approximation of the fair value measurements using methods under the market and
income approaches.
Some have asserted that the income approach is more appropriate to measure the fair
value of certain intangible assets because it better captures the incremental future benefits
associated with those intangibles. Although it is true that the income approach is preferred
for the measurement of fair value when the asset is the primary asset associated with the generation of the entity’s revenues, it would be incorrect to conclude that the cost approach to fair
value measurement ignores future economic benefits, particularly if those methods consider
entrepreneurial profits and the opportunity cost of capital.
THE ROLE OF EXPECTED ECONOMIC BENEFITS IN THE
COST APPROACH
Although the cost approach to valuation traditionally does not directly measure the expected
future benefits, the cost approach relies on an underlying assumption that future economic
benefits are sufficient to cover the cost of the investment.17 Economic benefits would take the
form of an expected sales price, or future cash flows from revenues or reduced expenses. Entities often perform a cost-versus-benefit financial analysis to decide whether an investment in
an entire entity, operating unit, or asset would be profitable. The cost of purchasing or creating the asset is compared to expected future benefits discounted at a project-specific rate of
return, or hurdle rate. The rate of return would cover the cost of capital plus a risk premium
specific to the asset, plus an amount to provide profit. The cost of capital is typically the entity’s
weighted average cost of capital. However, the valuation specialist may consider how the asset
is typically financed when selecting the appropriate mix of debt and equity. The considerations
are similar to those when calculating a required return under the income approach. If the
expected future benefits discounted at the cost of capital exceed the cost of constructing or
purchasing the asset, then the investment is considered worthwhile.
The relationship between the price to purchase the asset or the cost to develop the asset
and its expected future benefit is relatively straightforward when the decision is made to invest
in the subject asset. However, future economic benefits are also considered when determining
the cost to reproduce or replace the subject asset on the valuation date. If future economic
benefits are not sufficient to cover the cost to reproduce or replace the asset, then the subject
asset is considered to be obsolete, and the subject asset’s fair value is reduced by an amount
equal to the shortfall in economic benefits. Economic obsolescence is covered in subsequent
sections of this chapter.
Reproduction Cost versus Replacement Cost
◾
167
REPRODUCTION COST VERSUS REPLACEMENT COST
Although ASC 820 specifically says that “the cost approach is based on the amount that
currently would be required to replace the service capacity of an asset (current replacement
cost),”18 understanding reproduction cost will provide a good foundation for understanding
replacement cost. Reconciling reproduction cost to replacement cost will also provide a key to
understanding and quantifying obsolescence.
The definitions of reproduction and replacement cost in Valuing Intangible Assets by Robert
Reilly and Robert Schweihs are widely cited among valuation specialists, because they so completely describe and differentiate the two concepts. According to Reilly and Schweihs, the
valuation specialist must clearly understand the two approaches and decide which type of
cost will be estimated from the start of the analysis.
Reproduction cost is the estimated cost to construct, at current prices as of the
date of the analysis, an exact duplicate or replica of the subject intangible asset,
using the same materials, production standards, design, layout, and quality of
workmanship as the subject intangible asset. The reproduction intangible asset will
include the same inadequacies, super-adequacies, and obsolescence as the subject
intangible asset.
Replacement cost is the estimated cost to construct, at current prices as of
the date of the analysis, an intangible asset with equivalent utility to the subject
intangible, using modern materials, production standards, design, layout, and
quality workmanship. The replacement intangible asset will exclude all curable
inadequacies, super-adequacies, and obsolescence that are present in the subject
intangible asset.19
Reproduction cost is the cost of creating an exact replica in today’s dollars, and it is commonly referred to as “cost of reproduction new (CRN).” The cost of replacement (COR) is the
cost of purchasing or constructing an asset with equal utility in today’s dollars. It is usually less
expensive to replace an asset than it is to reproduce an asset. And the replacement is usually
functionally superior to the original.
An important point to emphasize is that both reproduction and replacement cost are
measured as of the valuation date. They are current costs, not historic costs. When calculating reproduction or replacement costs, any changes in the prices of labor or materials since
the original asset was created would be incorporated into current costs. Efficiencies in the
utilization of materials and labor would also be reflected in current costs.
The difference between the current cost to reproduce a replica and the current cost to
replace it with a better substitute relates to obsolescence present in the original. Replacement
cost is generally considered the most meaningful basis of value for fair value measurement
under the cost approach. However, whether the starting point of a valuation analysis is
from the cost of reproduction or from the cost of replacement, properly considering obsolescence will lead to the same value conclusion. The relationship can be summarized in
the formula:
Cost of Reproduction New (CRN) − Obsolescence = Cost of Replacement (COR)20
168
◾ The Cost Approach
To illustrate the difference between reproduction cost and replacement cost, suppose
a sixteenth-century European castle has been destroyed by fire. Even if it were possible to
rebuild the castle using historic materials and similar craftsmanship, the cost in today’s
dollars would be staggering. Its modern replacement would be different in design and
appearance, and would probably be a home or museum instead of a castle. The replacement
would provide similar or superior utility and would have all the modern conveniences, such
as running water, electricity, and central heat and air. The cost to build a lavish modern
replacement would be significantly less than the cost to reproduce the castle. All the difference in materials, craftsmanship, and functionality would be attributable to the castle’s
obsolescence.
COMPONENTS OF COST
Whether determining reproduction cost or replacement cost, the valuation specialist should
consider all relevant component costs associated with the subject asset. Relevant component
costs may not be those incurred when constructing or creating the original asset, but would
be those currently required to re-create or replace the asset. Reilly and Schweihs describe common component costs as material, labor, overhead, developer’s profit, and entrepreneurial
incentive.
Material costs generally represent a significant portion of a tangible asset’s total costs.
For a building project, material costs would include everything from the cost of the land to
the cost of incidental supplies used in construction. Material costs are typically incidental to
the creation of intangible assets and would include items such as data storage units, planning
documents, laboratory notebooks, patterns, and technical documentation. All material costs
relating to the subject asset, from the design phase to installation, would be included in the
analysis of cost.
Labor costs would include all salaries and wages paid to employees while working on
the project. Labor costs would also typically include payments to contractors involved in
the project. Labor costs are usually the most significant component cost in the creation of
intangible assets and they are often significant to tangible assets, as well.
Overhead costs such as payroll taxes and fringe benefits for development personnel, and
utilities and operating expenses indirectly contribute to the production or development of the
subject asset. An allocation of management and support personnel salary and wages would
also be included in overhead costs. Project overhead allocations are commonly based on the
percentage of time an employee dedicates to the project. Overhead costs are a component in
the measurement of reproduction or replacement cost under the cost approach.
Entrepreneur’s profit is essential to a smoothly functioning economy. It underlies the production of goods, the delivery of services, and the development of new products and intellectual property. A developer would not undertake a project unless he expected to receive a return
sufficient to cover all the costs of the project and to make a profit on the project. The development of intangible assets is similar to the development of real estate with respect to developer’s
profit. In The Appraisal of Real Estate, the definition of entrepreneurial profit incorporates the
Obsolescence
◾
169
concept that a profit component is needed to compensate the developer for risk associated with
the development of the project.21
However, developer’s profit has not traditionally been considered a component cost for
intangible assets. Under the cost approach, entrepreneur’s profit can be included in the fair
value measurement by estimating a percentage markup on material, labor, and overhead, or
by estimating a fixed dollar markup.22 Developer’s profit can be quantified as the profit that the
developer would require if the project were sold to a market participant. Although developer’s
profit traditionally has not always been included in the measurement of fair value under a cost
approach, its omission may understate the value, depending on the facts and circumstances
of the measurement.
Opportunity costs are another component of cost that must be recovered in order to
compensate a developer for undertaking a specific project. The time and effort devoted to a
particular project are unavailable for profitable use elsewhere for the duration of the project.
The developer forgoes the return from the next most attractive investment opportunity.
Opportunity cost is sometimes quantified by determining the cost of capital incurred in
funding the project. Similar to entrepreneurial profit, opportunity cost must be recovered
in order to compensate for the risk associated with the project. Omitting opportunity cost
from the cost analysis may result in an understatement of fair value.
The consideration of developer’s profit and opportunity cost appears to have achieved
relatively widespread acceptance within appraisal of real estate. In fact, the analysis of cost
for real estate goes even further to distinguish between project profit, contractor’s profit,
developer’s profit, entrepreneurial profit, and entrepreneurial incentive (opportunity cost).23
Within the valuation profession, the treatment of developer’s profit and entrepreneurial
incentive has been inconsistent in practice. However, these costs should be considered in the
measurement of fair value under the cost approach. Entrepreneur’s profit and opportunity
cost should be considered regardless of whether the subject asset is purchased or developed
internally and regardless of whether the subject asset is real estate, a tangible asset, or an
intangible asset. Omitting these costs could understate fair value.
OBSOLESCENCE
In previous sections, obsolescence was cited as the reason the subject asset is worth less
than the cost of a modern replacement. Obsolescence is equal to the excess utility of the
modern replacement. The difference between the cost to reproduce a replica and the cost of
the modern replacement was attributed to the existence of obsolescence.
These general concepts can be expanded to improve understanding of the relationships
between reproduction cost, replacement, and value and to introduce more specific forms of
obsolescence. Understanding the types of obsolescence and how to measure them is critical
in the fair value measurement of the subject asset. According to ASC 820-10-55-3E, all
forms of obsolescence should be considered, including physical deterioration, functional
(technological) obsolescence, and economic obsolescence. The following sections will discuss
how each type of obsolescence relates to value, and how to recognize and quantify each form
of obsolescence.
170
◾ The Cost Approach
THE RELATIONSHIPS AMONG COST, OBSOLESCENCE,
AND VALUE
Obsolescence is both curable and incurable from an economic perspective. An asset’s deficiencies are curable if the expected economic benefits from the improvements exceed the current cost of improvements. Deficiencies are incurable if costs exceed benefits. The following
formula is more specific about the types of obsolescence that distinguish reproduction and
replacement cost:
Reproduction Cost New − Curable Functional and Technological
Obsolescence = Replacement Cost New
An additional formula provides the key to understanding how the cost of a new replacement can be used to measure fair value:
Replacement Cost New − Physical Deterioration − Economic Obsolescence
− Incurable Functional and Technical Obsolescence = Fair Value
Whether the starting point for the valuation is reproduction cost or replacement cost,
the valuation specialist will arrive at the same fair value when all forms of obsolescence are
adequately considered and measured.24
To illustrate various forms of obsolescence, the example of the sixteenth-century castle
will be expanded. Suppose the sixteenth-century castle was being used as a museum to house
a collection of early armaments when it was destroyed. Although the layout of the castle
was not ideal for use as a museum, improvements had been made, including the additions
of heat, electricity, restroom facilities, and emergency exits. Although most of the castle was
in extraordinary condition considering its age, the northern wing had been permanently
closed because it needed extensive structural work. The castle was surrounded by a moat and
located in the heart of a medieval village. Historic preservation laws protect the castle and the
village. In the event a historic building is destroyed, the laws specify that any new building
must conform to the footprint of the original building and any surviving structure must
be preserved. Even though the museum is a popular tourist destination, it fails to cover its
operating expenses.
In this example, reproduction costs would include all costs to rebuild a replica of the castle
by using original historic materials and similar craftsmanship. The cost of any improvements
made to date, such as the additions of electricity, heat, restrooms, and emergency exits, would
also be included in the reproduction costs. All reproduction costs would be in today’s dollars.
The original historic materials, antiquated craftsmanship, poor layout, and energy inefficiency are all examples of functional and technological obsolescence found in the original
castle. Because these deficiencies would not be replicated in the modern replacement, they
are considered curable. Therefore, curable obsolescence represents the difference between
the cost of the castle’s replica and the cost of a new modern replacement, calculated in
today’s dollars.
Physical Deterioration
◾
171
The modern replacement would be made of contemporary materials using the latest
building technology. The museum’s layout would be improved to provide more display space,
a better flow from room to room, and better accessibility. And the replacement would be more
energy efficient. However, the cost of a new replacement museum does not equal the fair
value of the original castle. Additional adjustments are necessary to measure the fair value of
the original castle, which is the subject asset in this example.
First, the castle’s physical deterioration must be considered. The replacement is new, but
the original is quite old. And a portion of the castle was not being used because of structural deficiencies. Both age and condition are elements of physical deterioration that must
be deducted from the new replacement cost when measuring the original castle’s fair value.
If it does not make economic sense to replace the castle with a modern replacement, then
economic obsolescence is indicated. In this example, the museum’s failure to cover its operating expenses is a sign of economic obsolescence. Economic obsolescence would equal the
portion of the castle’s replacement cost that would not be recovered over its economic life as a
museum. Economic obsolescence must also be deducted from the new replacement cost when
measuring the original castle’s fair value.
In this example, incurable functional and technological obsolescence are present in
the new replacement because historic preservation laws require that it be rebuilt following
the same footprint as the original. Had the historic preservation laws not been in effect, the
museum might be larger, smaller, or a different shape than the original. Because the moat
survived the fire, according to law, it has to be incorporated into the replacement’s design.
A moat is functionally and technologically obsolete, and these incurable forms of functional
and technological obsolescence are incorporated into the castle’s replacement. The castle’s
replacement cost must be reduced by incurable obsolescence to arrive at the fair value of the
original castle.
Although understanding the relationships among reproduction cost, replacement
cost, obsolescence, and fair value is important, being able to quantify each element is
equally important when measuring fair value. Quantifying obsolescence is the subject of the
next section.
PHYSICAL DETERIORATION
Decreases in an asset’s value due to age or due to physical wear and tear are causes of physical deterioration. Physical inspection of tangible assets will help identify wear and tear, and
examination of accounting records will help identify the age of the subject asset.
Physical deterioration can be estimated by determining the cost to cure the deficiency
or based on observed depreciation.25 Another common method to quantify physical deterioration is to calculate the percent of physical deterioration (%PD) based on the age and life
expectancy of the asset, as follows:
%PD = [EA∕(EA + RUL)] × 100 assuming:
EL = EA + RUL
172
◾ The Cost Approach
where
EA is Effective Age = the age of the asset relative to a new asset of like kind, considering
rebuilding and maintenance that will extend its service life
RUL is Remaining Useful Life = the estimated period during which an asset is expected to
be profitably used for its intended purpose
EL is Economic Life = the estimated total life of the asset26
For example, suppose a sports drink manufacturer uses a mobile marketing trailer to
promote its products at major sporting events. When it was originally built, the trailer was
expected to have a 10-year life. Five years later, the company unveiled a new advertising
campaign with new logos, colors, and slogans. As part of the new campaign, the trailer was
redesigned and refurbished. The company plans to use the refurbished trailer for eight more
years. What is the trailer’s percentage of physical deterioration?
RUL = 8 years, as the company plans to use the trailer for eight more years
EL = 10 years, because the estimated total life of a new trailer is 10 years
EA = 2 years, because the refurbished trailer service life has been extended to eight years,
which compares to a 10-year life for a new trailer %PD = [2∕(2 + 8)] × 100 = 20%
Although it is not impossible for intangible assets to experience physical deterioration,
this form of obsolescence is not usually applicable to intangible assets,27 because they rarely
have physical form. And any deterioration in an intangible asset due to age would most likely
be attributable to functional or economic obsolescence rather than physical deterioration.
FUNCTIONAL (TECHNOLOGICAL) OBSOLESCENCE
Functional obsolescence is a decrease in the subject asset’s value due to its inability to perform
the function for which it was designed. The intended function does not change; the subject
asset’s ability to perform the function has declined. Technological obsolescence is a type of
functional obsolescence. It results when the function itself has become obsolete. Even though
the function is obsolete, the subject asset is still able to perform the function.28 For example,
software in need of modification or enhancement might be considered functionally obsolete.
But if the software were to be rewritten in a different programming language, using different
hardware, operating systems, or utilities on the valuation date, then technological obsolescence would be indicated.29
Physical inspection is one method used to identify functional obsolescence. It is most effective for identifying functional obsolescence for tangible assets. Inefficient facility layout, structural deficiencies, excess capacity, and deficient capacity are all physical manifestations of
functional obsolescence.
Comparative analysis is the other commonly used method to identify functional obsolescence, and it applies to technological obsolescence as well. To assess whether functional
obsolescence exists, the subject asset is compared to a new version of itself. To assess whether
Economic (External) Obsolescence
◾
173
technological obsolescence exists, the subject asset is compared to a new, ideal replacement.
If continued use of the subject asset results in excess operating costs, maintenance costs, usage
costs, or excess capital costs compared to a new replica or replacement, then obsolescence
is indicated.
Measuring functional or technological obsolescence can be accomplished in a number
of ways. One method is to calculate the cost to cure the functional or technical deficiency.
The cost-to-cure method is most often used to measure obsolescence resulting from physical
structural or capacity deficiencies. When there is excess capacity, a second method can be
used to calculate the pro rata portion of capital costs attributable to the excess capacity.
The pro rata excess capital costs would be a measure of obsolescence. A final method
is to quantify excess operating costs attributable to the subject asset over its remaining
useful life. This can be accomplished by using a one-period capitalization model30 or a
multiperiod discounted cash flow model. Capitalized or discounted excess costs would be a
measure of the amount of obsolescence. The capitalized or discounted excess cost method is
appropriate for calculating functional and technological obsolescence for both tangible and
intangible assets.
ECONOMIC (EXTERNAL) OBSOLESCENCE
Economic obsolescence is the decrease in the value of an asset due to influences that are external to the subject asset. Economic obsolescence exists when the subject asset is unable to
generate a sufficient rate of return over its expected remaining life based on its indicated value.
Economic obsolescence is generally considered to be incurable.31 Economic obsolescence typically cannot be determined through physical inspection, and it is broadly the same for tangible
and intangible assets.
The American Society of Appraisers lists common external causes of economic
obsolescence as
◾
◾
◾
◾
◾
◾
◾
◾
A declining industry
Inability to get financing
Loss of material or labor sources
New legislation or ordinances
Increases in the price of inputs without the ability to increase product prices
Reduced demand for the product
Increased competition
Inflation or high interest rates32
In Intellectual Property, Smith and Parr describe four forms of economic obsolescence that
can occur in trademarks: (1) event obsolescence, (2) technological obsolescence, (3) product
obsolescence, and (4) cultural obsolescence. Each form of economic obsolescence prohibits
the trademark from achieving its full potential because it reduces the trademark’s capacity to
contribute to the entity’s earnings. All are considered economic obsolescence, because they
reflect factors external to the trademark itself.33
174
◾ The Cost Approach
Smith and Parr further discuss the four forms of obsolescence by providing examples of
each one. Event obsolescence occurs when unusual events reduce the potential value of a
trademark. Product tampering might have caused the Tylenol trademark irreparable damage
had the company not responded quickly and effectively. When a company’s products become
technologically obsolete, its trademark may also be damaged. The Betamax trademark has
little value today because it is associated with obsolete home videocassette recording devices
from the 1970s. Product obsolescence occurs when the value of a trademark associated with a
product diminishes as the product goes out of use or is diminished in importance. In the 1940s
and 1950s, automobile automatic transmissions were trademarked because they were highly
prized and touted in company advertisements. Today, automatic transmissions are standard
equipment and the trademarks have lost their value. Finally, cultural obsolescence occurs
when religious, ethnic, or gender-related sensibilities inhibit the use of a trademark. The controversy over the use of Native American images and names in sports organizations is an
example of cultural obsolescence.34
In order to determine whether economic obsolescence exists, a comparative analysis is
helpful. The subject asset’s economic performance is compared to its historical performance,
to its budgeted performance, to a similar asset, or to an industry average. Common points
of comparison are profit margins, returns on investment, unit selling price, unit cost of
goods sold, and unit sales volume. Deficiencies in the comparative analysis would indicate
that there is an economic shortfall with respect to the subject asset. Once identified, the
economic shortfall is projected over the subject asset’s remaining useful life and discounted
to the present value. The present value of the economic shortfall is equal to economic
obsolescence.
Another method to measure economic obsolescence is to compare the entity’s business
enterprise value to the total fair value of all its underlying assets, less liabilities. If the business enterprise value or fair value of the business is less than the sum of working capital,
fixed assets, intangible assets, and other assets at fair value, the difference is attributable to
economic obsolescence.35
APPLYING THE COST APPROACH
The cost approach is most often used to measure the fair values of both tangible and intangible
assets that are not direct sources of cash flow generation for the entity. These contributory
assets tend to be less significant to the entity’s overall value. The cost approach is also
used when the market or income approaches are not feasible. The cost approach is the
preferable approach when the asset is readily replaceable and when the cost of reconstructing or replacing the subject asset with a similar asset can be reasonably determined.36
The cost approach may also be preferable when valuing entities with heavy investments
in tangible assets or when operating earnings are insignificant relative to the value of the
underlying assets.37
Although the application of the cost approach is more common in the valuation of tangible assets, the cost approach can be applied to intangible assets as well. The cost approach
is more successfully applied to intangible assets when they are newer, when substitutes
Applying the Cost Approach
◾
175
exist, and when estimating the fair value from the perspective of the current owner under
an in-use premise. The cost approach is less applicable to unique intangibles that benefit
from legal protection, such as trademarks and copyrights. It is also less applicable when
estimating the value of intangibles using an in-exchange premise.38 The American Society of
Appraisers suggests that the cost approach is appropriately used to measure the fair values of
the following intangible assets:
◾
◾
◾
◾
◾
Assembled workforce
Internally developed and used software
Mailing lists
Engineering drawings
Packaging designs39
In Intellectual Property, Valuation, Exploitation, and Infringement Damages by Smith and
Parr, the authors describe three methods for applying the cost approach: historical cost trending, the unit cost method, and the unit of production method.
Historical Cost Trending
Historical cost trending is possible when the business entity has maintained records from the
purchase, creation, or development of the subject asset. If the subject asset was purchased
from another party in a market transaction, a historic price is available. The valuation
specialist should consider whether market conditions existing on the historic transaction
date are similar to market conditions existing on the valuation date. Market conditions
would include market efficiency, the parties’ relative negotiating strength, and the terms and
conditions of the transaction such as price, timing, and other considerations.40 If conditions
are similar on the valuation date, then historic prices are suitable for cost trending. When
the subject asset is created or developed internally, labor force market conditions would
be applicable.
The historic prices for purchased assets and the historic costs of developed assets are
expressed as current reproduction costs by applying an appropriate price index. Because
the current costs represent the cost to reproduce a new replica of the subject asset and
because the subject asset is not new, the current cost must be reduced by an amount equal
to the subject asset’s physical deterioration and functional and economic obsolescence, as
appropriate.
For internally developed assets, the valuation specialist must also consider whether a similar amount of effort would be required to replicate the subject asset or whether new technology
would permit a more efficient deployment of effort. The difference in the number of hours originally required to produce an asset and the number of hours required on the valuation date
would indicate functional obsolescence in the original. The required number of hours required
to replace the subject asset on the valuation date times the trended historical cost would result
in an indication of the asset’s fair value under the cost approach.
Exhibit 6.1 shows the fair value of customer order processing software measured using
the replacement cost based on trending historic cost.
◾ The Cost Approach
176
EXHIBIT 6.1 XYZ Company Customer Order Processing Software, Replacement Cost
Based on Historic Cost Trending, as of June 30, 20X9
Year Cost Incurred
Price
Indexa
Historic
Costb
Index
Adjustment
Factor
Cost
20X0
168.9
1,237,280
210.3/168.9
$ 1,540,556
20X1
173.5
1,499,161
210.3/173.5
1,817,139
20X2
175.9
1,361,140
210.3/175.9
1,627,332
Trended Original Cost
4,985,027
Opportunity Cost: 15%, 24 months to re-createc
1,495,508
Entrepreneur’s Profit: 4%, 24 months to re-createc
398,802
Reproduction Cost
6,879,338
Less: Obsolescence of 30%c
(2,063,801)
Before-Tax Replacement Cost
4,815,536
Less: Tax @38%
(1,829,904)
After-Tax Replacement Cost
2,985,633
Amortization Benefit Multiplier
Fair Value of Customer Order Processing Software, rounded
1.16
$ 3,463,000
Notes:
a Bureau of Labor Statistics—Urban Wage Earners
Base year—1984
20X0
20X1
20X2
Mid-year—20X9
100.0
168.9
173.5
175.9
210.3
b Historic costs include materials, direct labor, employment benefits, and overhead.
c Per management.
The Unit Cost Method
The unit cost method is simply a direct estimate of all the costs that would be incurred to create
a similar replacement for the subject asset. The replacement would include improvements necessary to cure any functional or economic obsolescence in the subject asset. The replacement
cost would be an aggregate of all applicable costs, such as:
◾
◾
◾
◾
◾
Salaries and benefits of employees involved in the project
Amounts paid to outside consultants, engineers, and so on
An allocation for the salary and benefits of managers and support personnel
Materials
Overhead costs including office space, utilities, and computer time
◾
Applying the Cost Approach
177
EXHIBIT 6.2 XYZ Company Inventory Control Software, Replacement Cost Based on the
Unit Cost Method, as of June 30, 20X9
Estimate
Hours to
Replace
Hourly
Rate
Materials
Direct
Labor
Benefits,
Overhead
Profit, and
Opportunity
Costsa
550
$82.10
—
45,155
32,512
3,300
65.00
—
214,500
154,440
Specification Development
Project Management
Total Costs
$
77,667
368,940
Analyst
13,420
49.50
—
664,290
478,289
1,142,579
Programmer
19,525
45.40
1,887
886,435
639,592
1,527,914
Documentation
2,530
39.50
740
99,935
72,486
173,161
Testing
1,650
35.20
—
58,080
41,818
99,898
Before-Tax Replacement Cost
3,390,158
Less Tax @ 38%
(1,288,260)
After-Tax Replacement Cost
2,101,898
Amortization Benefit Multiplier
Fair Value of Inventory Control Software, rounded
1.16
$ 2,438,000
Note:
a Benefits of 33% overhead of 20% opportunity costs of 15% and entrepreneur’s profit of 4%.
◾
◾
◾
Costs to create pilots, prototypes, or models
Testing costs
Documentation and implementation costs41
The unit cost method can be used to estimate the costs of tangible assets such as buildings and production lines and intangible assets such as a company’s operating software, its
customer relationships, or its assembled workforce.
Exhibit 6.2 provides an example of fair value measured using the unit cost method to
calculate the replacement cost for XYZ Company’s inventory control software.
The Unit of Production Method
The unit of production method is another replacement cost method. Within certain industries,
rules of thumb exist for determining costs. The current unit cost to construct certain types of
assets is well known, relatively standard, and widely used to estimate a project’s total cost.
For example, certain types of software can be developed within a specific range of cost per line
of code, or employees in certain industries can be hired and become fully trained within a certain range of costs per employee. Within the beverage industry, franchise rights give the owner
exclusive rights to bottle and distribute products within a certain geographic area. These franchise rights are often valued using rules of thumb based on the number of cases of product sold
within the bottling territory in the most recent year.
◾ The Cost Approach
178
EXHIBIT 6.3 XYZ Company Auto Rental Franchise, Replacement Cost Based on the Unit of
Production Method, as of June 30, 20X9
Franchise Location
Number of
Automobiles
Replacement
Cost per Autoa
Gainesville, Florida
108
1,000
Total
Replacement
$
108,000
Jacksonville, Florida
363
1,000
363,000
Tallahassee, Florida
185
1,000
185,000
Augusta, Georgia
81
1,000
81,000
Brunswick, Georgia
46
1,000
46,000
Savanna, Georgia
127
1,000
127,000
Charleston, South Carolina
273
1,000
273,000
Columbia, South Carolina
191
1,000
191,000
Hilton Head, South Carolina
252
1,000
252,000
Replacement Cost Before Obsolescence Adjustment
1,626,000
Less: Obsolescence of 10%b
(162,600)
Before-Tax Replacement Cost
1,463,400
Less: Tax @ 38%
(556,092)
After-Tax Replacement Cost
907,308
Amortization Benefit Multiplier
Fair Value of Auto Rental Franchise, rounded
1.16
$ 1,052,000
Notes:
a Per Business Reference Guide, 17th Edition, automobile rental companies have of $1,000 per auto.
b Management estimate of overcapacity within local markets.
The replacement cost for XYZ Company’s franchise rights are measured using the unit of
production method in Exhibit 6.3. The value of the auto rental franchise is based on a $1,000
per automobile rule of thumb commonly used in the industry.
Applying each of these three methods results in an estimate of the subject’s replacement
cost, assuming it is new. Any physical depreciation in the subject must be measured and
deducted from the cost of replacement. Similarly, any incurable functional or economic
obsolescence in the subject must be measured and deducted from the cost of replacement.
The resulting amount would measure the subject asset’s fair value.
TAXES UNDER THE COST APPROACH
In the past, the cost approach was prepared either prior to the consideration of taxes or on
an after-tax basis due to divergence in practice among valuation professionals with respect to
this issue. However, a trend has emerged that valuation specialists tend to agree that the cost
approach is more appropriately prepared without the consideration of taxes.
Conclusion
◾
179
The cost approach captures expenditures that would be incurred to create an asset of similar utility. Because income taxes are not incurred when developing an asset of similar utility,
then taxes should not be included as part of the cost analysis. When there is no tax provision included in the replacement or reproduction costs under the cost approach, the future
tax benefit from depreciation or amortization should also be excluded from the conclusion of
fair value.
LIMITATIONS OF THE COST APPROACH
The cost approach has some limitations that make its application challenging. First, the
approach is not as comprehensive as the other two approaches. Many of the factors that
generate economic benefit and are important drivers of value are not directly incorporated
into the technique. Information about the amount, timing, and trend of the subject asset’s
economic benefits is not considered. The risk associated with the realization of economic
benefits is traditionally not factored into the measurement of cost. Second, the estimates
used to develop reproduction and replacement costs are often subjective. As more time
elapses between the date the subject asset is created and the date reproduction costs are
estimated, the estimates become even more subjective. For a replacement asset, as the form
of the replacement becomes more unlike the original asset, the replacement cost becomes
more a matter of judgment. A third limitation is that obsolescence is sometimes difficult to
quantify. Finally, there is divergence in practice among valuation specialists with regard to
the treatment of developer’s profit and entrepreneurial incentive.
CONCLUSION
Even though it has limitations, the cost approach is often used to measure the fair value. It
is the preferred method when the asset is readily replaceable and when the cost of reconstructing or replacing the subject asset with a similar asset can be reasonably determined.
And it is often used to measure the value of assets with indirect contribution to an entity’s
earning’s stream, or when using other methods is not practical. The cost approach is
sometimes used as a starting point or as a check for the value measured under the market or
income approach.
The cost method provides a reasonable indication of value when all cost components
are considered (materials, labor, overhead, developer’s profit, and opportunity cost) and
when cost is reduced for all forms of obsolescence (physical deterioration, functional or
technological obsolescence, and economic obsolescence). Fair value can be measured under
the cost approach using either a reproduction cost or a replacement cost as a starting point.
The cost approach rests on the economic principles of substitution, supply and demand, and
externalities. Substitution refers to the replacement of an asset’s future service capability
with another that provides similar utility. The cost of a substitute can indicate the fair value
of an asset after considering whether future economic benefits will support investment in
the replacement.
180
◾ The Cost Approach
NOTES
1. Thanks to Lynn Pierson for her assistance in writing this chapter.
2. American Society of Appraisers, “ASA Business Valuation Standards,” 2008, 9.
3. American Institute of Certified Public Accountants, American Society of Appraisers, Canadian Institute of Chartered Business Valuators, National Association of Certified Valuation
Analysts, and the Institute of Business Appraisers, International Glossary of Business Valuation
Terms, 2001, 2 and 4.
4. American Society of Appraisers, 9.
5. Appraisal Institute, The Appraisal of Real Estate, 12th ed. (2001), 349.
6. Gordon V. Smith and Russell L. Parr, Intellectual Property, Valuation, Exploitation and Infringement Damages (Hoboken, NJ: John Wiley & Sons, 2005), 156.
7. Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 820,
Fair Value Measurement, ASC 820-10-55-3D to 3E.
8. Joseph A. Agiato, Jr. and Michael J. Mard, Valuing Intellectual Property and Calculating Infringement Damages, American Institute of Certified Public Accountants Consulting Services
Practice Aid 99-2, 1999, 38–39.
9. Robert F. Reilly and Robert S. Schweihs, The Handbook of Business Valuation and Intellectual
Property Analysis (New York: McGraw-Hill, 2004), 282.
10. Appraisal Institute, 38–39.
11. Agiato and Mard, 39.
12. Webster’s II New College Dictionary (Boston: Houghton Mifflin, 1995), 755.
13. American Society of Appraisers, Valuation of Intangible Assets for Financial Reporting Purposes,
Business Valuation 301 Course Materials, 225–232.
14. Agiato and Mard, 40.
15. Id., 38.
16. Pamela R. Schlosser, “Statement by SEC Staff: Remarks before the 2005 AICPA National Conference on Current SEC and PCAOB Developments,” December 5, 2005, www.sec.gov/news/
speech/spch120505ps.htm,.
17. Smith and Parr, 156.
18. FASB ASC 820-10-55-3D.
19. Robert F. Reilly and Robert S. Schweihs, Valuing Intangible Assets (New York: McGraw-Hill,
1999), 122.
20. Agiato and Mard, 40–41.
21. Appraisal Institute, 360.
22. Reilly and Schweihs, Valuing Intangible Assets, 124–126.
23. Appraisal Institute, 362.
24. Agiato and Mard, 40–41.
25. Willamette Management Associates, Property Tax Valuation White Papers: Economic Obsolescence Is an Essential Procedure of a Cost Approach to Valuation of Industrial or Commercial Properties, www.propertytaxvaluation.com/economic_obsolescence_essential_procedure.html,
accessed April 16, 2009, 4-5.
26. James R. Hitchner, Financial Valuation Application and Models, 2nd ed. (Hoboken, NJ: John Wiley
& Sons, 2006), 365.
27. Michael J. Mard, “Financial Factors: Cost Approach to Valuing Intellectual Property,” Licensing
Journal (August 2000): 27.
28. Willamette Management Associates, 4–7.
Notes
◾
181
29. Reilly and Schweihs, The Handbook of Business Valuation and Intellectual Property Analysis, 486.
30. Willamette Management Associates, 4–7.
31. Agiato and Mard, 40.
32. American Society of Appraisers, 225.
33. Smith and Parr, 236–237.
34. Id.
35. American Society of Appraisers, 230.
36. Id., 151.
37. Loren Garuto and Oliver Loud, “Taking the Temperature of Health Care Valuations,” Journal
of Accountancy (October 2001): 4.
38. Reilly and Schweihs, Valuing Intangible Assets, 120.
39. American Society of Appraisers, 153.
40. Reilly and Schweihs, Valuing Intangible Assets, 121–122.
41. Smith and Parr, 161–162.
7
C HAPTE R S E V E N
The Market Approach
T
HE MARKET APPROACH MEASURES the fair value of an entity by using market
prices and value indications from actual transactions for the same or similar entities.
The most common market approach methods apply earnings multiples or cash flow
multiples from market transactions to the earnings or cash flows for the subject entity. Applying the market approach to measure the fair value of an intangible asset is appropriate when
market prices or rates for similar intangible assets can be identified.
The market approach is one of the three basic valuation techniques specified for the measurement of fair value by FASB ASC 820, Fair Value Measurement (ASC 820). Additionally,
the market approach is often used to measure the fair value of a reporting unit when testing
goodwill for impairment under FASB ASC 350, Intangibles—Goodwill and Other. This chapter
describes various market approach methods for estimating the fair value of an entity or a
reporting unit. The latter part of the chapter also discusses various market approach methods for measuring the fair value of individual intangible assets acquired through mergers and
acquisitions, as required by FASB ASC 805, Business Combinations.
According to the FASB:
The market approach uses prices and other relevant information generated by
market transactions involving identical or comparable (that is, similar) assets, liabilities, or a group of assets and liabilities, such as a business. For example, valuation
techniques consistent with the market approach often use market multiples derived
from a set of comparables. Multiples might lie in ranges with a different multiple
for each comparable. The selection of the appropriate multiple within the range
requires judgment, considering qualitative and quantitative factors specific to the
measurement. Valuation techniques consistent with the market approach include
matrix pricing. Matrix pricing is a mathematical technique used principally to
value some types of financial instruments, such as debt securities, without relying
exclusively on quoted prices for the specific securities, but rather relying on the
securities’ relationship to other benchmark quoted securities.1
183
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
184
◾ The Market Approach
The International Glossary of Business Valuation Terms (IGBVT) defines the market approach
as “a general way of determining a value indication of a business, business ownership interest,
security, or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been
sold.”2 The market approach is most often applied to the measurement of a reporting unit’s fair
value unit using one of two common methods: (1) the guideline public company method, or
(2) the guideline transaction method. The IGBVT describes the guideline public company method
as “a method within the market approach whereby market multiples are derived from market
prices of stocks of companies that are engaged in the same or similar lines of business and
that are actively traded on a free and open market.”3 The Glossary also describes the guideline
transaction method as a “merger and acquisition method within the market approach whereby
pricing multiples are derived from transactions of significant interests in companies engaged
in the same or similar lines of business.”4 The distinction between the two methods is that
the guideline public company method uses multiples derived from the market trading price of
similar publicly traded companies, whereas the transaction method derives multiples from the
acquisition price of similar companies that were recently acquired.
Conceptually, the market approach is easy to understand and consists of five basic steps:
(1) identify comparable guideline companies or transactions, (2) select an appropriate earnings metric, (3) calculate multiples using the market prices of the guideline companies or
transaction prices in the numerator and the selected earnings metric in the denominator,
(4) select an appropriate multiple or multiples from the range of guideline company multiples, and (5) apply the multiple(s) to the subject company’s earnings metric to estimate the
fair value of the subject entity.
A multiple is simply the ratio of a market price to another metric such as an earnings
metric. Multiples can be expressed on a per-share basis or in aggregate for the entity as a
whole. A price/earnings ratio (P/E) is an example of a commonly used market multiple that
is expressed on a per-share basis. The multiple, market value of invested capital to earnings
before interest, taxes, depreciation, and amortization (MVIC/EBITDA), is an example of a multiple that is based on aggregate values for the company. Market multiples are typically classified
as either equity multiples or invested capital multiples, depending on the ownership perspective for the underlying earnings used in the multiple. These ownership perspectives will be
discussed in greater detail in a subsequent section.
APPLYING THE MARKET APPROACH WHEN MEASURING THE FAIR
VALUE OF AN ENTITY OR A REPORTING UNIT OF AN ENTITY
In financial reporting, the market approach is often used to measure the fair value of an entire
entity or a reporting unit when testing goodwill for impairment under ASC 350. The guideline public company method and guideline transaction method are both commonly used for
goodwill impairment testing. The following sections describe the application of the guideline
public company and guideline transaction methods to measure the fair value of an entire
entity. Applying the methods to measure the fair value of an entity’s reporting units, although
equally valid, is not presented.
Applying the Market Approach When Measuring the Fair Value
◾
185
Guideline Public Company Method
The guideline public company method uses multiples developed from similar publicly traded
companies and is the most common method used in estimating the fair value of an entity. The
first step in applying the guideline public company method is to select a group of companies
that are comparable. Comparable companies should be similar enough to the subject entity
to provide an indication about the multiple(s) that the subject entity would be likely to trade,
if it were also publicly traded. Once the analyst has selected a preliminary group of guideline
companies, they should be analyzed to determine the relative degree of business and financial
risk compared to the subject entity. Ratio analysis is commonly used to perform the analysis
and refine the group of guideline companies. The analyst then selects market multiples from
one or more guideline companies to provide an indication of the fair value for the subject entity.
Selecting Guideline Companies
One of the advantages of using the guideline public company method is that there is an
abundance of information about publicly traded companies from SEC filings and from the
analysts who follow these companies. Guideline companies can be identified by relying on
Standard Industrial Classification (SIC) or North American Industrial Classification System
(NAICS) codes, which classify companies by their primary line of business. Comparable
guideline companies are typically those that file governmental reports using the same SIC or
NAICS code as the subject company. SIC codes can be found by searching the Securities and
Exchange Commission’s website at www.sec.gov. SIC codes are used when companies file
SEC reports through its Electronic Data Gathering Analysis and Retrieval System (EDGAR).
NAICS codes are used by the United States, Canada, and Mexico for collecting and publishing
statistical economic data and can be found by searching the U.S. Census Bureau’s website at
www.census.gov.
Guideline public companies can also be identified through other means. Management of
the subject company is usually knowledgeable about significant competitors and major players within the industry. Industry publications such as IBISWorld typically identify companies
that are prominent industry participants including those that are public companies. Once one
potential guideline company has been identified, public information about that company can
lead to the identification of similar comparable companies. For instance, when looking up a
price quote for a particular public company, Yahoo! Finance will display a summary page that
includes a list of similar companies that it says People Also Watch. Standard & Poors’ Capital IQ
database has a function called quick comps. In addition to generating a list of potentially
comparable companies, Capital IQ can generate a report that provides multiples and ratios
for each company for use in company selection. If a database is available for use, a key-word
search based on the subject company’s business description may yield additional potential
guideline public companies. Finally, when they are publicly traded, the subject company’s
suppliers and customers may be appropriate for consideration as a guideline company since
they are participants in the same industry. There are no strict criteria for determining comparability for guideline companies. Accordingly, an analyst may consider companies outside
the subject entity’s primary line of business. The overarching consideration should simply be
that the guideline companies’ operations are subject to the same or similar macroeconomic
186
◾ The Market Approach
factors. In other words, guideline public companies are those that face similar risks in
the marketplace.
Advent Assurance Inc. Example The market approach concepts presented in this
chapter will be illustrated using an insurance industry software company, Advent Assurance
Inc. The data sources that are referenced in the example are appropriate sources of information when measuring fair value under the market approach. However, the data, companies,
and transactions provided in the example are not real. They are provided for illustrative
purposes only.
Advent Assurance Inc. is a privately held company that provides claims management software to the insurance industry using the domain name Adventassure.com. Another industry
software service provider, Independent Indemnity Inc., acquired Advent Assurance two years
ago. The company is profitable, but its operating results have fallen short of premerger expectations. Advent Assurance expects $65.0 million in revenues and $8.5 million in EBITDA in
the year 20X1. The management of Advent Assurance is testing its goodwill for impairment
under FASB ASC 350 as of December 31, 20X0. A valuation specialist has been hired to measure the fair value of the Advent Assurance Inc. entity and to determine whether its goodwill
is impaired. Company management provided historical and prospective financial statements
for the analysis.
The valuation specialist decides to use the guideline public company method to measure
Advent Assurance’s fair value. The valuation specialist asks management for a list of similar
companies and includes the publicly traded companies as potential comparable companies.
The analyst also has access to Capital IQ and uses quick comps to generate a list of potential
comparable companies for the subject company. Finally, the analyst uses a database screening tool to search SIC codes in the software industry using the key word “insurance” as a
secondary screen. The valuation specialist uses additional screens to select companies with
market capitalizations in the $50 million to $750 million range that currently have profitable
operations in North America. The valuation specialist reviews each potential company’s business description and eliminates those that do not appear to be comparable. Capital IQ also
contains more detailed information about the guideline companies’ market capitalization,
key financial information, and analysts’ views. A summary of the potential guideline publicly
traded companies’ financial information and multiples are presented in Exhibit 7.1.
Analyzing Guideline Companies for Comparability
Once a set of potential guideline companies has been selected, each one should be analyzed
for comparability. The goal of the analysis is to determine whether the prospective guideline
company is indeed subject to the same macroeconomic factors as the company being valued.
The analysis usually involves a comparison of financial performance between the prospective
guideline companies and the entity. Ratio analysis typically compares liquidity, working capital activity, leverage, and profitability for each prospective guideline company relative to the
subject entity. Financial performance ratios and their trends over time are also used to assess
the subject entity’s relative risk as compared to the guideline companies.
187
EXHIBIT 7.1
Advent Assurance, Inc. Guideline Publicly Traded Company Multiples
$ in Thousands, except stock price and multiples
Company Name
Ticker Symbol
SIC Code
Archive Cloud
Storage, Inc.
Bravo System
Solutions, Inc.
Guardian Health
Systems, Inc.
Millenial Care
Networks, Inc.
Respondent
Information
Systems, Inc.
ACS
BSS
GHS
MCN
RIS
Median
7379
7379
7379
7379
7379
12/31/20XX
12/31/20XX
9/30/20XX
12/31/20XX
9/30/20XX
Price/Earnings
11.11
34.76
22.28
19.13
37.07
Price/Book Value
12.04
2.46
1.25
8.14
0.50
2.46
MVIC/Revenue
1.28
1.36
0.81
1.66
2.23
1.36
Valuation Multiples
22.28
MVIC/EBITDA
9.21
9.29
9.19
10.34
12.17
9.29
MVIC/EBIT
21.69
15.25
15.75
13.11
18.00
15.75
Market Capitalization
Stock Price
2.86
22.29
15.55
15.40
16.43
Shares Outstanding
38,466.0
16,204.0
40,720.0
4,858.0
9,692.0
Market Value of Common Equity
110,089.7
361,235.8
633,053.5
74,827.8
159,244.4
Preferred Stock
159,244.4
—
300.0
—
—
—
—
Total Debt
315,413.8
115,000.0
113,579.0
1,909.9
1,310.3
113,579.0
Market Value of Invested Capital
425,503.4
476,535.8
746,632.5
76,737.6
160,554.7
425,503.4
Cash
118,360.2
92,120.6
107,827.5
2,580.0
40,617.0
92,120.6
(Continued)
188
EXHIBIT 7.1
(continued)
$ in Thousands, except stock price and multiples
Archive Cloud
Storage, Inc.
Bravo System
Solutions, Inc.
Guardian Health
Systems, Inc.
Millenial Care
Networks, Inc.
Respondent
Information
Systems, Inc.
Median
307,143.2
384,415.2
638,805.0
74,157.6
119,937.7
307,143.2
102.7%
29.9%
17.8%
2.6%
1.1%
17.8%
0.84
0.70
0.92
1.56
1.74
0.92
Revenue
240,433.8
282,982.5
790,524.0
44,643.0
53,872.8
240,433.8
EBITDA
33,362.3
41,389.3
69,500.2
7,173.0
9,856.4
33,362.3
Operating Income (EBIT)
14,157.6
25,206.7
40,559.6
5,657.1
6,665.0
14,157.6
Net Income
9,910.3
10,392.8
28,418.0
3,911.0
4,296.0
9,910.3
Total Book Value of Equity
9,143.1
147,091.1
504,934.4
9,193.0
320,722.8
147,091.1
Prior Year’s Revenue
224,443
184,595
794,128
27,264
23,239
7.1%
53.3%
-0.5%
63.7%
131.8%
53.3%
Sales Growth—Next Year
1.9%
10.8%
6.9%
21.2%
20.4%
10.8%
EPS Growth— Next Year
5.4%
23.4%
11.8%
24.3%
100.0%
23.4%
Company Name
Market Value of Invested Capital
Excluding Cash
Debt to MVIC
Beta
Key Financial Information
Growth %
Analyst Estimates:
Source: The information in this exhibit is typically available from Yahoo! Finance and the SEC’s Edgar database. However, neither the companies nor the
information presented in this exhibit is real.
Applying the Market Approach When Measuring the Fair Value
◾
189
The expectation for cash flow growth for the subject company compared to the guideline
public companies is another important consideration when analyzing guideline companies
for comparability because market multiples for publicly traded companies reflect investors’
long-term growth expectations. Generally, publicly traded companies with higher growth
expectations trade at higher multiples. Other factors such as the public company’s relative
profitability and relative risk are also reflected in its market multiples.
Advent Assurance Ratio Analysis The valuation specialist analyzes the prospective
guideline companies’ financial statements by looking at key operating, profitability, liquidity,
leverage, and activity ratios. Since these prospective guideline companies are publicly traded,
financial statements are readily available at SEC.gov in the EDGAR database. Based on
the financial ratios in the summary, the valuation specialist concludes that the guideline
companies are indeed comparable and that they are suitable for use in measuring Advent
Assurance’s enterprise value.
Invested Capital versus Equity Multiples
As discussed briefly in a previous section, there are two broad types of market multiples suitable for use when measuring the fair value of an entity: equity multiples and invested capital
multiples. They differ with respect to the ownership perspective for the underlying earnings.
Equity multiples provide an indication of the fair value of the entity from the perspective of
the equity shareholders and are based on earnings available to common shareholders after
the payment of interest and preferred dividends. The applicable market value is either the
market capitalization of common shares (total outstanding shares × the price per share)
or the price of one common share. The applicable earning parameter represents residual
cash flows that belong to the common shareholders. Net income less preferred dividend and
free cash flow, or earnings per share and free cash flow per share, are examples of earnings
parameters after interest and preferred dividends have been deducted. A P/E multiple is perhaps the most widely recognized example of a market multiple that indicates the fair value of
common equity.
Invested capital multiples are based on earnings available to both debt holders and equity
shareholders. The applicable market value is market value of invested capital (MVIC), which
includes the market capitalization of common shares plus preferred shares and debt. MVIC is
usually expressed in aggregate dollars. The applicable earnings parameter would be earnings
before any deduction for interest expense or preferred dividends. Examples of these earnings
parameters are earnings before interest, taxes, depreciation, and amortization (EBITDA),
earnings before interest and taxes (EBIT), and debt free cash flow (DFCF). Therefore, an
EBITDA, EBIT, or DFCF multiple indicates the fair value of invested capital.
An entity’s fair value can be estimated under the market approach using either invested
capital or equity multiples. In order to reconcile the two valuation perspectives, deduct the
fair value of preferred equity and the fair value of interest-bearing debt from the fair value of
invested capital to arrive at the fair value of common equity.
190
◾ The Market Approach
Common Invested Capital Multiples
◾
MVIC/EBITDA
◾
MVIC/EBIT
◾
MVIC/DFCF
◾
MVIC/DFNI (debt-free net income)
◾
MVIC/Revenue (sales)
Common Equity Multiples
◾
Market value of equity/earnings (price/earnings ratio)
◾
Market value of equity/free cash flow (net income plus noncash charges less capital expenditures less working capital additions)
◾
Market value of equity/carry value of equity (price/book value of equity)
◾
Market value of equity/net asset value (price/adjusted book value)
A valuation specialist should use judgment in selecting the appropriate multiple(s) for a
particular entity. The most commonly used multiples are MVIC/EBITDA, MVIC/DFCF, and P/E.
However, other multiples may be appropriate in other circumstances. For example, technology start-up and Internet application software entities are often priced based using revenue
multiples.
Selecting the Appropriate Multiples
After analyzing the guideline companies using ratio analysis and calculating the appropriate
equity and invested capital multiples for each of the guideline companies, the next step is
to select appropriate multiples to apply to the subject company’s earnings parameters. The
selection process generally considers four significant criteria; profitability, growth, risk, and
size. Comparing the key criteria of the subject entity to the key criteria for guideline public
companies provides important information for the multiple selection process. Each multiple
will provide an indication of the fair value of the entity. Although judgment is required when
selecting an appropriate multiple, there are certain statistical measures that may provide
information to simplify the selection process.
Statistical Methods
When measuring the fair value of an entity using the guideline company method, statistical
analysis may provide information about the quality and potential usefulness of available
market multiples. A valuation specialist will often begin analyzing prospective guideline
company multiples by calculating the mean and the median. The mean and median are
measures of central tendency. A simple or arithmetic mean is the sum of the observations
divided by the number of observations. For example, assume that four guideline companies
have price/earnings multiples of 9, 10, 10.5, and 12. The mean would be 10.375, which
equals (9 + 10 + 10.5 + 12)/4. The median is simply found by arranging a list of numbers
from highest to lowest and selecting the one in the middle. If there is an even number of
Applying the Market Approach When Measuring the Fair Value
◾
191
observations, then the median is the average of the two middle numbers. The median P/E
multiple in this example is 10.25.
Another statistical measure of central tendency is the harmonic mean. The advantage of
the harmonic mean is that it gives equal weight to each of the observations, as opposed to the
simple mean that gives more weight to observations with higher values.5 The formula for the
harmonic mean is:
∑
1∕Hy = 1∕n
1∕Yi
where
H = harmonic mean, and 1/H is the inverse of the harmonic mean
n = number of observations, and 1/n is the inverse of the number
Σ = statistical symbol for summarization
Y = the value of each observation, and 1/Y is the inverse of the value
Calculating the harmonic mean for the four observations from the previous example:
1∕H = 1∕4 (1∕9 + 1∕10 + 1∕10.5 + 1∕12)
1∕H = .25 (.111 + .1 + .095 + .083)
1∕H = .097
H = 10.265
Note that the harmonic mean of 10.265 is less than the simple mean of 10.375. This is always
the case.
Another statistical measure, the coefficient of variation, is used to measure the degree
of dispersion of a group of observations around their mean. It is often used in fair value
measurement to assess the degree of dispersion for potential market multiples for a group
of guideline companies. For instance, an analyst can use the coefficient of variation to
determine the relative strength of the MVIC to revenue, MVIC to EBITDA, and MVIC to EBIT
multiples for a group of guideline companies. Or the analyst could use the coefficient of
variation to determine the relative strength of the MVIC to EBITDA multiple between the auto
manufacturing industry and the auto parts industry. The degree of dispersion for multiples
for a set of guideline public companies depends on market focuses within the industry and
can vary widely from industry to industry. Consequently, when industry multiples are more
tightly clustered (have less dispersion) they may be more indicative of value than multiples
from industries that have wider dispersion. Tightly clustered multiples generally indicate
that the market prices of companies within a particular industry are based to some extent on
market participants’ reliance on that multiple.6 When that is the case, industry multiples are
a valuable tool for measuring the fair value of a subject entity under the market approach.
For a group of guideline companies, each multiple’s coefficient of variation can be
calculated by dividing the standard deviation of the multiple by its mean. A low coefficient
of variation indicates a lower degree of dispersion, and it indicates that the market multiple would be appropriate to use in the guideline company method. A detailed discussion
of standard deviation and the formula for calculating it are available in any statistics
192
◾ The Market Approach
book; therefore, they are not presented in this chapter. Instead, understanding how the
coefficient of variation is used to measure the dispersion of multiples and to select among
potential multiples is the focus of this section.
Advent Assurance: Selecting the Appropriate Multiple and a Preliminary
Measure of Fair Value This example uses invested capital multiples to estimate the fair
value of invested capital for Advent Assurance Inc. Three multiples are considered: (1) MVIC
to sales, (2) MVIC to EBITDA, and (3) MVIC to EBIT. Statistical analysis of the coefficient of
variation (standard deviation divided by mean) to assess the dispersion of the three multiples
is employed to select the most appropriate multiple. Analysis of the three invested capital
multiples, their coefficients of variation, and the selected multiple is shown in Exhibit 7.2.
The EBITDA multiple is the best multiple for measuring the entity’s fair value because
it has the lowest coefficient of variation and the tightest dispersion around the mean. The
calculation of a preliminary fair market value is also shown in Exhibit 7.2. Advent Assurance’s expected $8.5 million EBITDA for the upcoming year is simply multiplied by the median
MVIC/EBITDA multiple of 9.3. A preliminary fair value of $78.9 million for Advent Assurance’s invested capital is indicated by the analysis.
Advent Assurance—Using Regression Analysis to Select a Revenue Multiple
Although a full discussion of least squares regression is beyond the scope of this book,
Exhibit 7.3 provides an example of the use of regression analysis to select a revenue multiple
for Advent Assurance. Least squares regression analysis is an appropriate tool to use when
selecting multiples because it quantifies relationships among the guideline companies’
market values and their operating metrics. The strength of the relationship is represented
by an R-square statistic. The R-square indicates the percentage of change in the dependent
variable that is explained by a change in the independent variable. A strong relationship
between the independent variable (the operating metric) and the dependent variable (the
market value) is indicated by an R-square that is closer to 1.0, whereas a weak relationship is
closer to 0.0.
Regression analysis is easily performed in Excel by putting the independent variable (X
variable) guideline company operating data in a column on the left and the dependent variable (Y variable) guideline company market price data in an adjacent column on the right. In
the Advent Assurance example, the independent variable is the guideline companies’ EBITDA
margins (%) and the dependent value is the guideline companies’ MVIC/Revenue multiples.
Highlighting both data columns and then inserting a scatter graph will produce a graph that
shows the relationship between the independent variable and the dependent variable. The
graph layout menu allows the user to add trend line data including the R-square statistic
and the regression equation to the graph. When the strength of the relationship indicated
by the R-square is relatively strong (perhaps over 50 percent), the regression equation can
be used to calculate a MVIC/Revenue multiple for the subject company. The multiple is
calculated by substituting the subject company’s 13.1 percent expected EBITDA percent as
the independent X variable in the regression equation and solving for the Y value. The 1.29
MVIC/Revenue multiple can then be used to estimate a preliminary fair value of invested
capital for Advent Assurance. The 1.29 MVIC/Revenue multiple times the expected revenue of
193
EXHIBIT 7.2
Advent Assurance, Inc. Guideline Company Method Summary (as of December 31, 20X0)
Numbers in $000s
Guideline Companies
MVIC to
Revenue
EBITDA
EBIT
Revenue
EBITDA
EBIT
EBITDA%
EBIT%
Debt/MVIC
Archive Cloud Storage, Inc.
1.28
9.21
21.69
240,434
33,362
14,158
13.9%
5.9%
102.7%
Bravo System Solutions, Inc.
1.36
9.29
15.25
282,983
41,389
25,207
14.6%
8.9%
29.9%
Guardian Health Systems, Inc.
0.81
9.19
15.75
790,524
69,500
40,560
8.8%
5.1%
17.8%
Millenial Care Networks, Inc.
1.66
10.34
13.11
44,643
7,173
5,657
16.1%
12.7%
2.6%
Respondent Information Systems, Inc.
2.23
12.17
18.00
53,873
9,856
6,665
18.3%
12.4%
1.1%
58,500
7,800
6,240
13.3%
10.7%
Advent Assurance, Inc.—20X0
Maximum
2.23
12.17
21.69
790,524
69,500
40,560
18.3%
12.7%
Average
1.47
10.04
16.76
282,491
32,256
18,449
14.3%
9.0%
30.8%
Median
1.36
9.29
15.75
240,434
33,362
14,158
14.6%
8.9%
17.8%
44,643
7,173
5,657
8.8%
5.1%
1.1%
Minimum
0.81
9.19
13.11
Standard Deviation
0.52
1.28
3.26
Coefficient of Variation
0.36
0.13
0.19
Selected Multiple
Expected 20X1 EBITDA
Preliminary Fair Value of Business
Enterprise, roundeda
9.3
8,500
$78,900
a A valuation specialist may also consider whether the circumstances warrant the addition of a control premium.
102.7%
194
◾ The Market Approach
EXHIBIT 7.3 Advent Assurance, Inc. Regression Analysis for Revenue Multiple Selection
(as of December 31, 20X0)
Guideline Companies
EBITDA%
MVIC/Revenue
Archive Cloud Storage, Inc.
13.9%
1.28
Bravo System Solutions, Inc.
14.6%
1.36
Guardian Health Systems, Inc.
8.8%
0.81
Millenial Care Networks, Inc.
16.1%
1.66
Respondent Information Systems, Inc.
18.3%
2.23
MVIC / Revenue
y = 14.185x ‒ 0.5666
R2 = 0.9126
2.50
2.00
1.50
MVIC / Revenue
1.00
0.50
–
0.0%
5.0%
10.0%
15.0%
20.0%
Regression equation—X coefficient
14.185
Times: Advent Assurance’s Expected EBITDA % for 20X1
13.1%
1.8550
Plus: Y intercept
−0.5666
Revenue Multiple
1.29
Times: Expected 20X1 Revenue (in thousands)
Indicated Fair Value of Invested Capital, rounded (in thousands)
65,000
$83.7 million
$65.0 million provides an $83.7 million indication of value for Advent Assurance, Inc.’s total
invested capital.
Growth rates are another independent variable commonly used in regression analysis
to select multiples for the subject company. Companies that experience high growth rates
typically trade at higher multiples than those with stable or declining growth. Revenue
growth rates and EBITDA growth rates are potential independent variables and revenue
multiples and EBITDA multiples are potential dependent variables. Although the strength of
regression relationships with growth as the independent variable does not tend to be as strong
Applying the Market Approach When Measuring the Fair Value
◾
195
as the regression relationship between profitability (EBITDA percent) and revenue multiples,
it may be worthwhile to perform the regression analysis to quantify the relationship. When
the statistical relationship between guideline company growth rates and multiples is not
strong, the consideration of growth in the selection of a multiple will require more judgment.
Statistical analysis is useful when selecting a multiple under the guideline company
method; however, the selection still requires some judgment. A valuation specialist should
not simply pick the mean guideline company multiple as the multiple to use when measuring
the fair value of an entity without considering the entity’s risks, growth prospects, and size
compared to those for the guideline companies. A valuation specialist should understand
each of the guideline companies’ business models as well as the subject entity’s business
model. The focus of business model analysis and of any ratio and trend analysis should be on
comparing the profitability, risk, growth prospects, and size of the guideline companies to the
prospects of the subject entity.
Risk and size are closely related. Public companies tend to be much larger and more diversified than the privately held companies that are typically subject companies in a valuation
analysis. The public company’s size and diversification result in lower risk and a lower cost of
capital compared to private companies. Therefore, when selecting a multiple for a private subject company based on guideline publicly traded company multiples, adjusting for differences
in size and risk may be necessary.
One method to adjust for size and risk is based on the relative weighted average costs of
capital (WACCs) for the guideline companies and the subject company. Developing a WACC
for the subject company is discussed in Chapter 6. The same principles can be used to develop
a WACC for the median guideline public company. The primary differences between the subject private company’s WACC and the median guideline public company’s WACC relate to the
size premium, beta, company-specific risk, capital structure, and the cost of debt. A multiple adjustment factor equal to the median guideline company WACC divided by the subject
company WACC can be applied to a preliminary multiple to adjust for additional risk related
to the subject company. The multiple adjustments for Advent Assurance are illustrated in
Exhibit 7.4.
EXHIBIT 7.4
Advent Assurance, Inc. Multiple Adjustment (as of December 31, 20X0)
Preliminary Multiples
EBITDA
Multiple
Revenue
Multiple
9.3
1.29
Adjustment Factor
Median Guideline Public Company WACC
11%
Divided by Subject Company WACC
16%
0.69
0.69
Adjusted Multiples
6.4
0.89
Operating Metric
8,500
65,000
Indicated Fair Value, rounded
54,300
57,600
196
◾ The Market Approach
Market Participant Acquisition Premium
The guideline publicly traded company method is typically regarded as indicating the equity
value on a minority, marketable basis because it is based on valuation date stock prices that
represent a small fraction of the entity’s total shares outstanding. Minority owners have no
control over the company and have higher investment risk as a result. According to ASC 350,
“An acquiring entity often is willing to pay more for equity securities that give it a controlling
interest than an investor would pay for a number of equity securities representing less than
a controlling interest. That control premium may cause the fair value of a reporting unit to
exceed its market capitalization.”7
Empirical evidence for control premiums is published quarterly and annually by FactSet/
Mergerstat and is available through a searchable database at BVResources.com. Mergerstat’s
control premiums are based on transactions for controlling interests in public traded companies. Mergerstat calculates the premium offered for control by dividing the offer price per
share by the seller’s closing market price per share five days prior to the announcement of the
transaction. For the third quarter of 2017, the median domestic control premium was 28.7
percent and the median international control premium was 23.2 percent. Mergerstat excludes
negative premiums from the median calculation.8
When estimating the fair value of an entity, the valuation specialist should consider
adding a control premium to the preliminary estimate of fair value derived from the guideline
publicly traded company method. In contrast, a control premium is not usually applied to the
value indication from the guideline merged and acquired company method. The reason is that
these transactions are typically for the acquisition of 100 percent of the entity’s outstanding
shares. Therefore, the transaction price already reflects the price of a controlling interest.
The Appraisal Foundation’s Valuations in Financial Reporting Valuation Advisory 3, The
Measurement and Application of Market Participant Acquisition Premiums, provides best practice
guidance for measuring market participant acquisition premiums (MPAPs), a concept that
replaces control premiums.9 A MPAP is defined as the difference between (1) the pro rata fair
value of the subject controlling interest and (2) its foundation. The foundation is considered
to be the pro rata fair value of marketable, noncontrolling interests in the enterprise. For publicly traded companies, the foundation is equal to the quoted market price for the company’s
shares. Best practices require that the application of an MPAP should be supported by reference to incremental economic benefits that market participants would realize. Incremental
economic benefits would take the form of enhanced cash flows or a lower required return. Market participants are typically categorized into three categories; strategic acquirers, financial
acquirers, and conglomerate acquirers. One of the Appraisal Foundation’s Advisory 3 Working Group’s conclusions is that incremental economic benefits will not always be reflected in
the price paid by market participants for control due to the competitive dynamics of the sales
process.10 Another of the Working Group’s concluding observations is that in many instances
incremental economic benefits “will not be reliably identifiable, resulting in either no, or a
small, premium.”11
◾
Advisory 3 emphasizes that incremental economic benefits stemming from exercising
the prerogatives of control are the source of the MPAP. Enhanced cash flows may be
derived from superior revenue growth, increased operating margins, working capital
efficiencies, and reduced capital expenditures. Incremental economic benefits may also
be derived from a lower cost of capital that results from an optimized capital structure,
Applying the Market Approach When Measuring the Fair Value
◾
◾
◾
◾
◾
◾
◾
◾
◾
◾
◾
197
increased company size, and reduced operating risks. Advisory 3 also provides influencing factors that should be considered from the perspective of a market participant
when estimating the price a market participant would pay for a controlling interest. The
following factors influence the MPAP:
Acquisition activity in the industry—A high or increasing number of transactions may
indicate that market participants perceive opportunities for economic benefits. Competition among buyers generally increases the fair value of the controlling interest resulting
in higher MPAPs. Regulatory changes or economic turmoil may also lead to consolidation
within industries.
Life cycle stage—MPAPs are generally higher for growth-stage companies due to greater
potential to realized economic benefits.
Market participant attributes—The acquirer’s attributes and acquisition strategy are an
indication of the types of economic benefits it is likely to achieve. Strategic acquirers operate within the same industry as the target entity as competitors, suppliers, or customers.
Potential revenue synergies and cost savings tend to be the most important economic
benefits for strategic buyers. Financial acquirers such as private equity funds are more
likely to achieve synergies in the form of reduced costs of capital. Conglomerate acquirers
purchase other entities in order to diversify their operations and reduce risk. While conglomerate acquirers may realize reduced administrative costs, reduced risk that results in
a lower cost of capital is typically the primary economic benefit.
Relative size of market participant acquirers—Generally the size of the MPAP is positively
related to the size of the acquirer. Greater size provides economic benefits in the form of
favorable access to capital, better access to existing distribution networks, superior negotiating leverage with suppliers and customers, and administrative capacity.
Balance of information—Asymmetrical information available to controlling interests
that is not available to noncontrolling interests may come to light as a result of the due
diligence process and may result in a higher MPAP.
Capital structure of the subject entity—Because one of the prerogatives of control is the
ability to change the capital structure, the further the subject entity’s capital structure is
from the optimal capital structure, the greater the potential MPAP.
Management objectives—Because privately held companies are often managed with
different objectives than publicly held companies, the MPAP for a private company
would likely be higher. The MPAP would arise from specific future economic benefits
that would result from reducing compensation to market levels, reducing lease rates to
reflect market rates, including debt in an optimal capital structure and reducing excess
cash levels.
Quality of management—Poor quality of management will likely result in a higher MPAP
due to opportunities to improve cash flows. Benchmarking techniques provide objective
measures to evaluate growth, profitability, asset utilization, and the cost of capital in order
to identify potential economic benefits.
Regulatory factors—Legal, regulatory, and industry factors that serve to limit acquisition
activity or the number of potential bidders will reduce the MPAP.
Corporate by-laws—The subject entity’s own governing documents may serve to impose
restrictions on the controlling shareholder’s ability to assert control, which will reduce
the MPAP.
198
◾
◾ The Market Approach
Transaction structure—The tax structure of a transaction impacts the price paid for
a controlling interest. In addition, the valuation specialist must carefully consider the
impact that contingent consideration has on the price. Analysis of transaction multiples
may be useful when estimating the impact that the transaction structure and contingent
consideration have on the MPAP.12
The Appraisal Foundation’s Advisory 3 provides best-practice guidance for analyzing and
calculating the MPAP. The analysis compares the pro rata fair value of the foundation to the
pro rata fair value of the subject controlling interest. The foundation’s fair value is estimated
assuming that the prerogatives of control will continue to reside with the existing controlling
shareholder group. The foundation represents a pro rata marketable, noncontrolling interest
and is equal to the quoted market price of publicly traded company shares. The pro rata fair
value of the subject controlling interest is estimated assuming that one of the prerogatives of
control is the ability to pursue an orderly sales process; therefore, the Appraisal Foundation
believes that in most cases sellers would have access to a market to transact. However, diversity
in practice exists with respect to the application of a discount for lack of marketability for the
subject interest.13
Advisory 3 illustrates a side-by-side comparison of cash flows for the foundation and for
the controlling interest in order to identify and to quantify the economic benefits of control.
The difference between the fair value of invested capital for the foundation and the subject
controlling interest represents the fair value of the economic benefits of control. The MPAP is
preferably expressed as a percentage of pro rata total invested capital for the foundation.
The final step is to assess the MPAP for reasonableness from a market participant’s perspective in order to support the conclusion. This assessment would compare revenue and
EBITDA multiples to guideline publicly traded companies and to guideline transactions. Multiples based on total invested capital are more reliable to use in the comparison. In addition, the
MPAP should be compared to observed control premiums. FactSet Mergerstat/BVR Control
Premium Study is a source of information about control premiums that is available quarterly
and annually for broad industry groups.14
Guideline Transaction Method (Merger and Acquisition Method)
The guideline transaction method is similar to the guideline public company method except
that instead of using share prices of publicly traded companies in the multiple’s numerator,
acquisition prices for guideline acquired companies are used to develop an acquisition
multiple. When the acquisition target is a public company, the multiple can be expressed on
a per-share basis; however, when the acquisition target is a private company, the multiple is
typically based on the total acquisition price. Another difference is that the guideline publicly
traded company method relies on stock prices on or near the valuation date while transaction
prices for the guideline transaction method can be derived from transactions that cover
several recent years. The guideline transaction method is often used to estimate the fair value
of an entity or reporting unit when data from a sufficient number of relevant transactions for
similar companies is available.
The first step in the guideline transaction method is to select a group of transactions for
target companies that are similar enough to the subject entity or reporting unit to provide
Applying the Market Approach When Measuring the Fair Value
◾
199
guidance about the multiple(s) and price that the subject entity might expect if it were acquired
in an arm’s-length transaction. Once guideline transactions are selected, they must be analyzed to decide whether sufficient information is available to determine the relative business
and financial risks for these guideline companies compared to the subject entity or reporting
unit. If the business and financial risks of the guideline and subject entity are considered comparable, then one or more multiples from the guideline company can be selected to provide an
indication of the subject entity’s fair value. The entity or reporting unit’s fair value can then be
estimated by multiplying the guideline company multiple times the subject entity’s earnings
parameter.
One of the challenges of the guideline transactions method is that available information
may be limited. The exception is when one public company acquires another publicly traded
entity. In that situation, information will be readily available. Due to the prevalence of acquisitions by private equity firms in recent years, the number of public company transactions has
decreased. Available information about private company transactions is also generally limited. Even when the acquisition price is publicly available, other details about the transaction
may not be.
Because detailed financial information for most privately held company transactions is
not generally available to the public, valuation specialists typically subscribe to data services
such as Bizcomps, Pratt’s Stats, the Institute of Business Appraisers’ Market Database, or
MergerShark that primarily report on private transactions. The databases are not considered
as reliable as audited financial information reported to the SEC. In addition, the data points
provided and the calculations and definitions of certain data points vary by data service;
therefore additional effort must be made when using these sources. In spite of the drawbacks,
private company transaction databases can provide additional insight in a valuation analysis.
However, many valuation specialists do not consider the guideline transaction method
to be the primary method for measuring fair value. Instead, they use this method as a
reasonableness check for fair value measured using other methodologies.
Example—Guideline Transaction Method (SK)
Buddy’s Snack Foods Inc. Example Application of the guideline transaction method in
this chapter is illustrated with the example of a hypothetical snack food company.
Buddy’s Snack Foods Inc. is a privately held, family-owned business located on the East
Coast. Formed in 1990, the Company specializes in the production of snack crackers and
potato chips primarily for the consumer market including grocery stores, cafeterias, and convenience stores. Total sales of “Buddy’s” snack products peaked in 2015 at about $45 million
and have been stagnant for the past few years. The Company has been profitable historically
with operating margins generally in the range of 5 to 10 percent. The CEO believes the Company still has potential and would like to expand operations in the Midwest but lacks the
necessary financial resources to invest in new production facilities and equipment. Buddy’s
founder and controlling shareholder is nearing retirement age and there are no other family
members interested in becoming involved in the business. Thus, the family is contemplating
a sale of its ownership interest and has engaged a valuation specialist to estimate the value of
the Company. Audited financial statements and other pertinent data were provided as part of
the initial information gathering process.
200
◾ The Market Approach
Selecting Guideline Transactions
Because the interest being valued represents a controlling interest in the Company, the valuation specialist has decided to use a guideline transaction method. The MergerShark transaction database has been used as the primary source for M&A transaction evidence.15 Several
search criteria were used to identify relevant transactions for purposes of deriving pricing
data. The valuation specialist is primarily interested in guideline transactions involving companies engaged in a line of business similar to that of Buddy’s. However, she is concerned that
searching only for merged or acquired snack food companies may not result in enough transactions to make meaningful comparisons and derive relevant pricing information. As a result,
the search was broadened to include all acquired companies within the larger food industry.
The valuation specialist notes the importance of making sure the pricing evidence is timely,
thus the search is performed only for transactions completed during the 2013–2017 time
period. Finally, the search screened only for those companies that had available financial metrics such as revenue, EBITDA, and book value. Based on these search parameters, 15 potential
guideline transactions were identified and considered in the transaction method. A summary
of the potential guideline transactions financial information and multiples are presented in
Exhibit 7.5.
Analyzing Guideline Transactions for Comparability
As with the guideline public company example discussed earlier, the valuation specialist must
consider the comparability of the identified merged and acquired companies with the subject
company. In this case, only two of the 15 transactions involved target companies engaged in
the snack food industry (Diamond Foods and Snyder’s-Lance). The balance of the merged or
acquired companies operates in other segments of the more broadly defined food industry. The
valuation specialist will consider this as part of her overall analysis. It is noteworthy, however,
that there does not appear to be a discernable difference in the pricing for the snack food companies as compared to the other food companies and thus this difference may not be extremely
critical to the overall analysis.
The valuation specialist will also note differences in size, which is generally a reflection
of risk that should be considered in any comparative analysis. Buddy’s Snack Foods is clearly
much smaller than the guideline target companies, only one of which (Willamette Egg Farms)
exhibits revenue of less than $1 billion. It is also noteworthy that some transactions involve
large, well-recognized food brands (e.g., Kraft). Pricing for these target companies may be less
relevant when compared to a small niche brand such as Buddy’s.
Selecting the Appropriate Multiples
The selection of multiples in the guideline transaction method involves consideration of the
same four criteria (profitability, growth, risk, and size) used in the guideline public company
method. However, it should be noted that there is often less information available for guideline transactions than for guideline public companies because in many cases the acquired
companies are themselves privately held or the transactions are too small to require extensive
reporting from the buyer. Thus, a detailed ratio analysis is normally not possible, and certain
201
EXHIBIT 7.5
Buddy’s Snack Foods Inc. Guideline Transaction Method (as of December 31, 2017)
Transaction
Target
MVIC/
MVIC/
MVIC
Revenue
Revenue
EBITDA
EBITDA%
A privately held marketer and
distributor of premium protein
beverages and foods
183,900,000
135,000,000
1.36
9.9
13.7%
Canada Bread
Company,
Limited
Manufacturer and marketer of
value-added flour-based
products, including fresh bread,
rolls, bagels, and frozen
partially baked products.
1,664,377,680
1,425,453,081
1.17
11.0
10.7%
Post Holdings,
Inc.
Willamette Egg
Farms, LLC
A privately held producer,
processor, and wholesale
distributor of eggs and egg
products
95,400,000
80,000,000
1.19
NA
NA
Shuanghiu
International
Smithfield
Foods, Inc.
The world’s largest pork
processor and hog producer
7,085,545,880
13,094,300,000
0.54
7.3
7.4%
General Mills,
Inc.
Annie’s, Inc.
A natural and organic food
company that offers
great-tasting products in large
packaged food categories
820,000,000
204,104,000
4.02
29.2
13.7%
Post Holdings,
Inc.
MOM Brands
Company
Privately held company known
for selling lower priced cereals
that are often similar to bigger,
better-known brands
1,388,800,000
747,200,000
1.86
11.6
16.1%
Ferrero
International SA
Thorntons plc
An industrially scaled chocolate
maker in the United Kingdom
with 242 stores and 158
franchised outlets
172,194,165
351,972,520
0.49
6.6
7.4%
Buyer
Target (Seller)
Target Description
Post Holdings,
Inc.
Premier
Nutrition Corp.
Grupo Bimbo,
S.A.B. de C.V.
(Continued)
202
EXHIBIT 7.5
(continued)
Transaction
Target
MVIC/
MVIC/
MVIC
Revenue
Revenue
EBITDA
EBITDA%
A producer, marketer, and
distributor of food products to
the retail, foodservice, and food
ingredient markets. Its principal
products are specialty egg
products, refrigerated potato
products, cheese and other
dairy products
3,705,060,000
1,948,283,000
1.90
13.9
13.6%
Kraft Foods
Group, Inc.
One of North America’s largest
consumer packaged food and
beverage companies with
iconic brands—Kraft, Capri Sun,
Jell-O, Kool-Aid, Maxwell
House, Oscar Mayer,
Philadelphia, Planters, and
Velveeta
62,458,500,935
18,205,000,000
3.43
26.4
13.0%
Snyder’s-Lance,
Inc.
Diamond
Foods, Inc.
A snack food and culinary nut
company focused on making
innovative, convenient snacks
as well as culinary nuts
1,914,073,470
864,165,000
2.21
16.7
13.2%
Pinnacle Foods,
Inc.
Boulder
Brands, Inc.
Manufactures a portfolio of
health and wellness brands,
including Udi’s and Glutino
gluten-free products, EVOL
natural frozen meal offerings,
and Smart Balance and Earth
Balance refrigerated and
shelf-stable spreads businesses
975,000,000
516,631,000
1.89
13.5
14.0%
Buyer
Target (Seller)
Target Description
Post Holdings,
Inc.
Michael
Foods, Inc.
H.J. Heinz
Company
203
Danone SA
WhiteWave
Foods Company
A leading consumer packaged
food and beverage company
that manufactures, markets, and
sells branded plant-based
foods and beverages, coffee
creamers and beverages,
premium dairy products, and
organic produce
12,445,626,467
3,866,295,000
3.22
25.5
12.6%
Reckitt
Benckiser Group
plc
Mead Johnson
Nutrition
Company
A global leader in pediatric
nutrition, develops,
manufactures, markets, and
distributes more than 70
products in over 50 markets
worldwide
17,825,094,957
3,742,700,000
4.76
17.8
26.7%
Cooke, Inc.
Omega Protein
Corporation
A nutritional product company
that develops, produces, and
delivers healthy products such
as fish oils, specialty proteins,
and dietary supplements and
animal feeds
486,054,000
390,831,000
1.24
17.7
7.0%
Campbell Soup
Company
Snyder’s-Lance,
Inc.
A leading snacking company
that manufactures and markets
snack food throughout the
United States, such as Kettle
Chips, Cape Cod, Lance
crackers, Snyders of Hanover,
Pop Secret, and Emerald
6,092,685,164
2,109,227,000
2.89
20.2
14.3%
(Continued)
204
EXHIBIT 7.5
Buyer
(continued)
Target (Seller)
Target Description
Transaction
Target
MVIC/
MVIC/
MVIC
Revenue
Revenue
EBITDA
EBITDA%
High
4.76
29.2
Low
0.49
6.6
26.7%
7.0%
First Quartile
1.22
11.1
11.2%
Third Quartile
3.05
19.6
14.0%
Mean
2.15
16.2
13.1%
Median
Subject Co. Metric
Selected Multiple Rationale
1.89
15.3
13.4%
$ 45,200,000
$ 4,339,200
9.6%
[A]
[B]
1.22
13.2
Indicated MVIC (Rounded)
55,060,000
57,380,000
Concluded MVIC (Rounded)
$56,200,000
Selected Multiple
Notes:
N/A = Not Applicable / Available.
[A] The selected MVIC/Revenue multiple reflects the 1st quartile multiple based on the subject company EBITDA margin relative to the guideline transactions
and size considerations.
[B] The selected MVIC/EBITDA multiple reflects the midpoint between the 1st quartile multiple and the median multiple to reflect the smaller size and lower
growth potential of the subject company.
Sources: MergerShark Database, and Acuitas, Inc. calculations.
Applying the Market Approach When Measuring the Fair Value
◾
205
key metrics such as historical growth rates may not be available. In such cases, the valuation
specialist works with the available evidence and considers the overall viability of the method
given the data constraints.
In the case of Buddy’s Snack Foods, the valuation analyst has already identified differentials in size between the guideline target companies and the subject company. Size may
represent a proxy for risk since smaller companies often have reduced access to management
talent and may lack the financial resources necessary to make capital investments and achieve
higher rates of growth. Such qualitative considerations should factor into the selection of multiples. The valuation specialist would consider the smaller size of Buddy’s as a negative factor
and likely reduce the selected multiple on that basis.
In addition, as noted earlier, measuring guideline target company growth and comparing
it to the subject company may be difficult or impossible. The valuation analyst should consider
the historical growth pattern for the subject company and may factor this into the multiple
selection process on a qualitative basis. As noted earlier, Buddy’s growth has plateaued, and
future growth is constrained by its size. Thus, the valuation specialist may view this as a negative factor for purposes of multiple selection, or at best, neutral.
Based on these considerations, an EBITDA multiple of 13.2× was selected, representing
the midpoint between the first quartile and median multiples of the guideline transactions.
This selection reflects the Company’s greater perceived risk (due to its smaller size) and lower
growth expectations. The indicated enterprise value based on this selected multiple is $57.4
million.
Generally, profitability data is available for the valuation specialist to make meaningful
comparisons. As noted in the earlier discussion related to the guideline public company analysis, higher profitability is usually associated with higher revenue multiples. The valuation
specialist may run a regression analysis to determine the degree of correlation, but timing differences in the transaction data may distort this analysis to some extent. The food industry
profitability data in Exhibit 7.5 appears to exhibit a weak correlation with revenue multiples
(smaller target companies priced at lower revenue multiples, and vice versa). The Company’s
indicated EBITDA margin of 9.6 percent is at the lower end of the range exhibited by the
guideline target companies and relatively close to the first quartile of companies (11.2 percent margin). In this case, the valuation specialist has selected a revenue multiple of 1.22×,
equal to the first quartile multiple for the guideline transactions, in order to reflect the lower
profitability and perceived greater overall risk of Buddy’s relative to the guideline target companies. The indicated enterprise value derived from the revenue metric is $55.1 million.
The final step for the valuation specialist is to consider both indications of value and determine a final concluded value estimate from the guideline transaction method. The indications
of value are relatively close together in this case, and there does not appear to be a strong
basis for selecting one value metric over the other. An equal weighting of both the revenue
and EBITDA indications results in a concluded enterprise value from the guideline transaction
method of $56.2 million. Note that this value reflects a 100 percent control ownership interest in the Company. Valuation of a minority interest would require consideration of a discount
for lack of control.
206
◾ The Market Approach
The Application of the Market Approach in Measuring the Fair Value
of Intangible Assets
Using the market approach to measure the fair value of intangible assets is somewhat more
difficult than using the market approach to measure the fair value of an entity. Although
information about the market price of guideline companies and guideline transactions is
often readily available, information about transactions for individual intangible assets is
more difficult to obtain. The P/E multiple of publicly traded company can be easily obtained
through various sources on the Internet such as Bloomberg or Yahoo! Finance, or by simply
looking it up in the Wall Street Journal. Information about license agreements for a patent
or a trade name is not readily available from these sources. Fortunately, market approach
methods can be adapted to make use of the limited market information available for specific
intangible assets.
Relief from Royalty Method
The relief from royalty method contains assumptions from both market and income
approaches. The theory behind the relief from royalty method is that an entity that owns
an intangible asset has a valuable right since the entity does not have to pay a royalty fee
to a third party for the right to use that intangible asset. The fair value of that right can be
measured through an analysis of license agreements and the royalty rates charged by third
parties for the use of similar intangible assets. Since the entity already owns the intangible
asset, the entity is “relieved from” having to pay a third party a royalty for the use of the
intangible asset.
The fair value of the intangible asset is measured as the present value of hypothetical royalty payments that the entity is relieved from paying by not having to license the use of the
intangible asset from a third party.
The application of the relief from royalty method for measuring the fair value of an intangible asset involves three steps.
1. Analyze publicly available information from license agreements to determine royalty
rates for similar intangible assets.
2. Analyze the industry in which the entity owning the intangible asset operates.
3. Estimate the value of the subject intangible asset by applying an appropriate royalty rate
to the subject entity’s prospective financial information (PFI). An appropriate royalty rate
takes industry conditions and the terms of publicly available license agreements into consideration.
In applying the relief from royalty method to measure the fair value of an intangible asset,
the first step is to analyze license agreements for the use of similar intangible assets. There are
several commercially available sources of information about license agreements. The terms
of the license agreements should be analyzed, which includes considering the royalty rate,
the economic measure to which the royalty rate is applied, the geographic region to which
the agreement applies, whether the agreement is exclusive or nonexclusive, and the length
of time the agreement is in effect. The purpose of the analysis is to determine whether the
Applying the Market Approach When Measuring the Fair Value
◾
207
licensed intellectual property is subject to similar risks and would have a similar required rate
of return as the subject intangible asset under consideration. If not, then any differences in
risk should be considered by adjusting the selected royalty rate.
The second step is to analyze the industry in which the parties to the license agreements
operate. An understanding of the industry is important to provide a framework for determining a royalty rate that is appropriate to apply to the intangible asset being valued. There may
be industry factors that influence the royalty rate the market would support if the intangible
asset under consideration was licensed to a hypothetical third party. A topic that will be discussed further in Chapter 8, “The Income Approach,” is a rule of thumb for determining an
appropriate royalty for intangible assets, which is 25 to 30 percent of operating income. The
rule of thumb, known as the profit split method, is rooted in actual license transactions and
indicates that a royalty rate for a group of intangible assets would likely fall between 25 and 33
percent of operating income. It is important to consider normal industry margins in order to
determine whether payment of a royalty is even feasible. A common error in the application of
the relief from royalty method is the selection of a rate that cannot be supported by the industry’s or entity’s actual operating margins. Also, the analyst should understand the potential
impact of substitute assets that would replace the intangible asset under consideration.
The third step in the relief from royalty method is to apply the selected royalty rate to
applicable operating parameter in the subject entity’s PFI. Most royalty rates found in license
agreements are based on net sales; therefore, the subject entity’s prospective revenues are used
to estimate the fair value of the intangible asset. Prospective revenue would be multiplied by
the royalty rate for each future year of the intangible asset’s estimated remaining useful life.
The results would be adjusted for the impact of tax expense and discounted at an appropriate
rate, consistent with the entity’s cost of capital and the relative risk of the intangible asset. The
present value of the after-tax royalties would be a measure of the intangible asset’s fair value.
Advent Assurance: Relief from Royalty Method The valuation specialist has also
been asked to measure the aggregate fair value of Advent Assurance Inc.’s trade names
including the company name, the AdAssure, and VentSure product line names as well as the
Internet domain name Adventassure.com. The specialist decides to use the relief from royalty
method and finds guideline royalty rates for the business services sector of the software
industry in Royalty Source. Exhibit 7.6 summarizes guideline royalty rates and shows the
1 percent selected royalty rate. The selected royalty rate is applied to Advent Assurance’s
expected revenues as provided by management over the domain name’s 10-year expected
useful life. The present value of the royalty payments that Advent Assurance is relieved
from paying indicates that the aggregate fair value of the trade names is $3.087 million.
Exhibit 7.7 contains the analysis.
Royalty Source’s intellectual property transaction database is available at www
.royaltysource.com. Consor Intellectual Asset Management provides similar information at
www.consor.com, as do RoyaltyStat at www.royaltystat.com and Royalty Connection at
www.royaltyconnection.com.
Another source of rate information, ktMINE, offers access to thousands of intellectual
property agreements and provides the ability to locate relevant agreements using search filters
based on intellectual property agreement attributes. In addition to allowing a user to search
208
◾ The Market Approach
EXHIBIT 7.6 Advent Assurance Inc., Royalty Rates—Valuation of Trade Names as of
December 31, 20X0
Royalty
Licensor
Licensee
Date
Terms
Low
High
Business Plans, Inc.
Forecast Nation,
LLC
May-16
International
1.00%
5.00%
Adjustors Agents,
Inc.
Missouri Regional
Administrators, Inc.
Dec-16
Nontransferable
1.00%
2.00%
Smart Tech, Corp.
Bella Industries, Inc.
Sep-14
North America
0.25%
0.50%
Business Pro
Technologies, Inc.
Central Timeframe,
Corp.
Jul-13
NA
0.25%
1.00%
Payroll Systems, Inc.
Knickerbochs
GMBH
Apr-13
International
2.00%
4.00%
ASP Integrated
Controls, LLC
Loridan, Inc.
Nov-12
Exclusive
1.00%
1.00%
Integrated Decision
Systems, Inc.
Skyler, Davis,
Jackson & May LLC
Jun-12
Non-exclusive
0.25%
1.50%
High
2.00%
5.00%
3rd Q
1.00%
3.00%
Mean
0.82%
2.14%
Median
1.00%
1.50%
2nd Q
0.25%
1.00%
Low
0.25%
0.50%
Mode
1.00%
1.00%
Selected
Royalty Rate:
1.00%
Source: The royalty rates in this exhibit are an example of typically available data from several sources.
However, neither the companies nor royalty rates presented in this exhibit are real.
the database using key words, ktMINE has search filters for the licensor, licensee, filing company, effective date, SIC Code, territory, exclusivity, agreement type, industry, and royalty rate.
Searches can easily be refined, and the pool of applicable agreements narrowed. Once the
search has been completed, a results summary shows key licensing terms and royalty rates
for each agreement. The user can view the agreements and quickly jump to the bookmarked
royalty rate information.
Guideline Transaction Method for Intangible Assets
A guideline transaction method is sometimes used to measure the fair value of an intangible
asset when there is sufficient market information. The application of the guideline transaction
method to an intangible asset is similar to the guideline transaction method when it is used
to measure the fair value of the equity or invested capital of an entity. A valuation multiple
selected from guideline transactions for similar intangible assets is applied to a parameter of
209
EXHIBIT 7.7
Advent Assurance Inc., Valuation of Trade Names, as of December 31, 20X0
20X1
Revenue
20X2
20X3
20X4
20X1 +10
20X5
$65,000,000 100% $68,250,000 100% $73,027,500 100% $78,139,000 100% $83,609,000 100% $96,925,746 100%
Growth
5%
7%
7%
6%
3%
Pre-Tax Royalty Savings
650,000
1%
682,500
1%
730,275
1%
781,390
1%
836,090
1%
969,257
Less: Taxes
(169,000)
0%
(177,450)
0%
(189,872)
0%
(203,161)
0%
(217,383)
0%
(252,007)
0%
After-Tax Royalty Savings
481,000
1%
505,050
1%
540,404
1%
578,229
1%
618,707
1%
717,251
1%
Partial Period
0.06
1.00
1.00
1.00
1.00
Period
0.03
0.56
1.56
2.56
3.56
8.56
Present Value Factor
0.995
0.911
0.772
0.654
0.554
0.242
30,152
460,112
417,220
378,325
343,058
173,838
PV of After-Tax Royalty Savings
Sum of PV of Savings
Amortization Benefit Multiplier
2,790,850
1.11
Preliminary Value
3,086,774
Concluded Value, Rounded
3,087,000
Assumptions
Discount Rate
18.0%
Long-Term Growth Rate
3.0%
Tax Rate
26.0%
Royalty Rate
Remaining Useful Life
1.00%
10 years
1.00
1%
210
◾ The Market Approach
the subject intangible asset. Given its market-based nature, this method can be one of the most
compelling indicators of value. Unfortunately, the lack of information about guideline transactions for specific assets makes the guideline transaction method one of the more difficult
methodologies to apply in practice.
The application of the guideline transaction method begins with an analysis of each
individual transaction to understand its terms and conditions. This analysis is important to
determine whether any adjustments should be made to the guideline multiples to maximize
comparability. After adjustments are made, the valuation multiples are applied to the subject
intangible assets’ parameters.
Advent Assurance: Guideline Transaction Method
The valuation specialist also decides to consider information from the guideline transaction
method when measuring the fair value of the “Adventassure.com” domain name. Fortunately, there are several entities that provide transaction services to buyers and sellers of
Internet domain names, and these entities are a source of information about potential selling
prices for similar names. The process is rather simple. Enter the domain name in the search
engine on one of the service providers’ websites and it will provide list prices for similar names.
The drawback of using these sources of information is that the domain name transactions
are for limited timeframes and they do not convey full ownership to the buyer. Therefore, the
guideline transaction information can best be used as a floor when measuring fair value of the
subject domain name. The specialist also takes into consideration that these prices are offering
prices not consummated by third-party transactions; therefore, the prices should be viewed
as an “asking” price. The fair value indicated by these prices may require an adjustment
since an asking price may not be the price that a market participant would be willing to pay
for a particular asset.
The results of the valuation specialist’s research on the name “Adventassure.com” is presented as:16
Domain Name
Price
InsureMe.com
$4,000
AssuranceAssociates.net
$2,850
AdventureGroup.com
$3,500
ClaimStream.com
$3,975
AdjustersExpress.net
$2,500
Comparable domain names seem to be offered for sale between $2,500 and $4,000. The
valuation specialist also researches actual transactions for recent sales of similar domain
names to determine whether actual sales between third parties are at or below their offer
prices. The specialist notes that domain names with the .com extension appear to sell at a
higher price. Since AdventureGroup.com appears to be the most similar name, the specialist
concludes that the floor fair value estimate for the identified domain name is approximately
$3,500.
Applying the Market Approach When Measuring the Fair Value
◾
211
Sources of Information
One of the challenges in using market approach methods to measure the fair value of intangible assets is that there are no public exchanges. Without public exchanges, there is little
readily available information about guideline transactions. Another complicating factor is
that most intangible assets are purchased or sold as part of a group of other assets. Exchanges
of intangible assets usually occur through business combinations, rather than through individual purchases or sales. Consequently, finding appropriate information about transactions
for individual intangible assets to provide a basis for measuring fair value is more difficult than
finding information about transactions for an entire entity.
Although it is difficult to find transaction information for individual intangible assets, it
may not be impossible as there are several alternative ways to search for information. Many
intangible assets are licensed. As discussed in the relief from royalty section of this chapter,
there are commercially available sources of license data. Also, if one or both parties to the
agreement is a publicly traded company, information about the licensing of intangible assets
may be found in SEC filings or in summaries of transactions compiled and sold by commercial
organizations.
SEC Filings
SEC filings for similar publicly traded companies or competitors may contain information
that describes licensing arrangements. The reports may provide enough information so that
a guideline royalty rate can be determined and can be used when applying the relief from
royalty method.
Information about royalty rates for the use of the Westin and Sheraton brands was found
in an 8-K filed by Starwood Hotels and Resorts Worldwide, Inc. on October 28, 2015. The
disclosure about the license agreement says,
Interval Leisure Group (Nasdaq:IILG) (“ILG”), and Starwood Hotels and Resorts
Worldwide, Inc. (NYSE:HOT), (“Starwood”) today announced that the Boards of
Directors of both companies have unanimously approved a definitive agreement
under which a wholly owned subsidiary of ILG will acquire and then merge with
and into Vistana Signature Experiences (“Vistana”). In connection with the transaction Vistana will enter into an 80-year exclusive global license agreement for
the use of the Westin and Sheraton brands in vacation ownership in addition to
the non-exclusive license for the existing St. Regis and The Luxury Collection of
vacation ownership properties. Under the terms of the license agreement, Starwood
will receive an annual base royalty fee of $30 million plus 2% of vacation ownership
interest sales.17
Court Cases
Information about royalty rates and about intellectual property transactions may become
public as a result of intellectual property disputes. Reviewing decisions from certain U.S. tax
court cases, particularly those involving transfer pricing issues, can yield valuable information. Civil cases involving patent and trademark infringement are also good sources of information when the case involves an intangible asset within the same or similar industry as the
212
◾ The Market Approach
subject intangible asset. Court cases relating to a specific industry can be particularly useful
when analyzing guideline transactions within that industry,
A recent example of a patent infringement court case that establishes a royalty rate is
I/P Engine v. Google. In the suit, I/P Engine alleged that a Google subsidiary, AdWords, had
infringed two of its patents related to search and filtering technology used to place ads among
Internet content. In its 2014 decision, the U.S. District Court for the Eastern District of Virginia
set an ongoing royalty rate of 6.5 percent that will apply to a royalty base of 20.9 percent of
AdWords revenues, which the court decided was the portion of revenues attributable to the
infringing features.18
The indicated royalty rate derived from a court case should be used with caution. Royalty
rates from court cases may reflect a compromise reached by the court and may not be based
on market participant assumptions.
Intellectual Property Auctions
Many companies have intellectual property rights that they are not exploiting. The intellectual
property rights may have been created as a by-product of another development effort. Or, while
the technology covered by the intellectual property may still be viable, the company may no
longer produce any products using the technology. When the owner of an intellectual property
is not currently exploiting the property, the intellectual property may have value to another
company. Companies are beginning to recognize that these dormant intellectual properties
may have value and they are seeking ways to monetize intellectual property rights through
sales to other parties.
Ocean Tomo, an intellectual capital merchant bank specializing in intellectual property,
assists companies that would like to monetize intellectual property portfolios by providing
auction services through its trademarked Bid-Ask Market. A hallmark of the Bid-Ask Market
is that it transparently posts all offers to sell, offers to buy, and all final transaction prices.
In addition, Ocean Tomo offers private auction services and live open-cry auctions via
telepresence remote access. Ocean Tomo’s first formal intellectual property rights auction
took place in San Francisco in April 2006. The results of the first auction were mixed, but
promising. Ocean Tomo organized the intellectual property into 78 lots of similar intellectual
properties. Of the 78 lots, 26 sold for a total more than $3 million. The results of this first
auction persuaded Ocean Tomo to proceed with the development of the intellectual property
auction market.19 Since then, Ocean Tomo has held regular auctions in Europe and the
United States with over $750 million in transactions through 2017.20
The Mandatory Performance Framework—Applying the Market
Approach
Best practice guidance for a valuation specialist’s application of the market approach to
estimate the fair value of an entity or intangible assets is outlined in the Mandatory Performance Framework, which is required for those with the Certified in Entity and Intangible
Valuations Credential. Guidance applicable to the valuation of an entity includes selecting
guideline public companies, selecting guideline transactions, selecting multiples, and adjusting multiples. The Mandatory Performance Framework also covers guidance applicable to
Notes
◾
213
selecting a royalty rate for use in the relief from royalty method to estimate the fair value of
an intangible asset. These best practices applicable to the market approach are covered in
Appendix 1A—The Mandatory Performance Framework.
CONCLUSION
The market approach is one of the three basic approaches to measuring fair value. Methods
under the market approach, such as the guideline public company method or the guideline
transaction method, are often used to measure the fair value of both an entity and a reporting
unit of an entity. Other methods under the market approach, such as the relief from royalty
method and the guideline transaction method, are often used to measure the fair value of
identified intangible assets such as technology, trade names, or domain names.
NOTES
1. FASB ASC 820-10-55-3A to 3C.
2. International Glossary of Business Valuation Terms, Business Valuation Resources, https://sub
.bvresources.com/FreeDownloads/IntGlossaryBVTerms2001.pdf (accessed December 19,
2017).
3. Id.
4. Id.
5. Shannon Pratt, The Market Approach to Valuing Businesses (New York: John Wiley & Sons,
2001), 133.
6. Id.
7. ASC 350 Intangibles—Goodwill and Other, 350-20-35-23.
8. Control Premium Study 3rd Quarter 2017, FactSet Mergerstat Global Mergers and Acquisition Information, www.mergerstat.com, accessed through BVResources.com December 27,
2017.
9. The Appraisal Foundation’s Valuations in Financial Reporting Valuation Advisory 3: The Measurement and Application of Market Participant Acquisition Premiums, September 6, 2017.
10. Id., 7.
11. Id., 12.
12. Id., 19–25.
13. Id., 10.
14. www.bvresources.com/products/factset-mergerstat-bvr-control-premium-study.
15. https://mergershark.com/.
16. Although the information presented in this example is fictitious, the pricing of domain names
can be found by Internet service companies such as Godaddy.com.
17. Starwood Hotels and Resorts Worldwide, Inc. Form 8-K, filed October 28, 2015, capitaliq.com.
18. John Riberio, “Google Ordered to Pay Royalty on AdWords Revenue to Vringo,” CIO, January
29, 2014, www.cio.com.
19. “On the Block,” Inside Counsel, July 2006, www.insidecounsel.com.
20. www.oceantomo.com/intellectual-property-auctions.html, accessed December 20, 2017.
8
C HAPTE R E IG HT
The Income Approach
INTRODUCTION
T H E I NC OM E APPROACH TO FA I R VA LU E measurement estimates the fair value of an
entity, intangible assets, or other assets and liabilities by calculating the present value of future
cash flows that the entity or asset is expected to generate over its lifetime. The cash flows are
discounted to the measurement date at a rate of return that is required to compensate for the
risk associated with receipt of the future cash flows.
The income approach is one of the three basic valuation techniques to measure fair value
described in the Financial Accounting Standards Board’s Accounting Standards Codification
820, Fair Value Measurements and Disclosures (ASC 820). This chapter presents various
methods used to estimate the fair value under the income approach. Although the income
approach can be used to measure the fair value of entities, tangible assets, intangible assets,
and liabilities, the focus of the chapter is on measuring the fair value of intangible assets
that are recognized through business combinations. The chapter also includes a section on
determining appropriate rates of return (discount rates) for those intangible assets.
The Financial Accounting Standards Board’s (FASB) Master Glossary defines the
income approach as “the use of valuation techniques to convert future amounts (cash flows
or earnings) to a single present amount (discounted). The measurement is based on the
value indicated by current market expectations about those future amounts.”1 ASC 820
further describes several valuation techniques under the income approach. These valuation techniques or methods include present-value models, option-pricing models, and the
multiperiod excess earnings method. The Black-Scholes-Merton formula is an example of
an option-pricing model that incorporates present value techniques. The multiperiod excess
earnings method is a present value technique that is commonly used to measure the fair
value of certain intangible assets.2
215
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
216
◾ The Income Approach
The International Glossary of Business Valuation Terms (IGBVT) defines the income approach
as “a general way of determining a value indication of … an intangible asset using one or
more methods that convert anticipated benefits into a present single amount.”3 Both the FASB
and IGBVT income approach definitions described the conversion of expected future cash flows
to a single present amount, using various methods as a means to measure fair value.
Income approach methods fall into one of two categories. They are either single-scenario
methods or multiscenario methods. Single-scenario methods are based on the entity’s
expected cash flows, whereas multiscenario methods incorporate many different sets of
possible cash flow outcomes. Single-scenario methods are the most common methods
used to determine fair value measurements in financial reporting. The advantage of using
single-scenario methods in fair value measurements is that these methods are more universally understood than multiscenario methods. Single-scenario methods are also easier to audit
since the results of the analysis are directly correlated to the underlying assumptions used
in the analysis. The focus of this chapter will be on common single-scenario methods under
the income approach, including the Discounted Cash Flow analysis (DCF), the Multi-Period
Excess Earnings Method (MPEEM), the Incremental Income/Cost Decrement Method, the
Profit Split Method, and the Build-Out Method. Multiscenario methods include Real Option
Techniques, Decision Tree Analysis, Monte Carlo Simulation, and DCF models using multiple
forecasts.4 Chapter 9 will focus on more advanced multiscenario valuation methods.
Future cash flows are typically estimated using management’s prospective financial
information (PFI) as a starting point. PFI is a general term for forward-looking financial information. PFI comes in many forms including complete financial statements, elements of
financial statements such as financial statement line items or accounts, break-even analyses,
feasibility studies, forecasts or projections. PFI is commonly prepared in connection with
obtaining external financing, for budgetary purposes, and for decision-making purposes.5
Best practices for a valuation specialist’s analysis of the entity’s PFI are outlined in the
Mandatory Performance Framework, which is required for those with the Certified in Entity
and Intangible Valuations credential. Best practice PFI analysis is covered in Appendix 1A.
DISCOUNTED CASH FLOW METHOD
The basis for valuation methods under the income approach is a discounted cash flow analysis. Other valuation methods under the income approach are derived from this fundamental
method. The DCF is simply defined in the International Glossary of Business Valuation Terms as
“The present value of future expected net cash flows calculated using a discount rate.”6 The
present value formula for the discounted cash flow analysis using a midyear convention is:
Fair Value = Cash flow year 1∕(1 + Discount rate) 0.5 +
Cash flow year 2∕(1 + Discount rate)1.5 + n +
[Normalized cash flows year n∕(Discount rate-long-term growth rate)]∕
(1 + Discount rate)n−0.5
The DCF method of estimating fair value requires three basic inputs: (1) the expected cash
flows to be received over the explicit forecast period, (2) the terminal value or perpetuity value
Discounted Cash Flow Method
◾
217
that captures the value after the explicit forecast period, and (3) the discount rate, adjusted
for the risk of actually receiving the cash flows. The exponents 0.5, 1.5 through n – 0.5 are
the number of years using a midyear convention assuming that cash flows are received evenly
over the year.
The DCF is commonly used to measure the fair value of an entity when it is the acquisition
target in a business combination. The DCF is used to determine the acquisition price and it
becomes the foundation for recording the business combination under the acquisition method
of accounting. The DCF is also used to measure the fair value of an entity or a reporting unit
when testing goodwill for impairment.
There are two most common forms of the DCF that are distinguished by the ownership
perspective of the underlying cash flows. One is discounted cash flows to equity holders, and
the other is debt-free cash flows to all holders of invested capital. This form includes equity and
debt holders. As a result, there are variations in the specific income items to be considered as
cash flows and variations in the selection of an appropriate discount rate for each form of DCF.
In the cash flows to equity form, relevant cash flows to equity holders are discounted back
to the present at an equity rate of return. The formula to calculate each year’s forecasted cash
flows to equity holders in the DCF analysis is:
Net Income (including a deduction for interest expense)
Plus: Depreciation and amortization and other noncash expenses
Less: Capital expenditures required to support growth in revenue
Less: Change in working capital required to support growth in revenue
Plus: Additional borrowings
Less: Repayment of debt principal
Equals: Cash flows to equity holders
The cash flows to equity holders are discounted back to the present at the cost of
equity, which is typically developed using a modified version of the Capital Asset Pricing
Model (CAPM) or a variation of the CAPM commonly referred to as the build-up method.
(These models are discussed later in the chapter.) Discounting cash flows to equity holders at
the appropriate cost of equity results in a present value that represents the fair value of the
entity’s equity ownership. The advantage of the equity form of the DCF is that it inherently
uses the entity’s own capital structure in measuring fair value. The disadvantage is that
the entity’s actual capital structure may not be similar to the hypothetical capital structure
under a market participant assumption.
To illustrate the equity form of the DCF, assume that Titan Technology, Inc. is acquired
for $17.5 million on August 31, 20X1. The acquisition price consists of $15.0 million in cash
and $2.5 million in debt with a 10 percent annual rate, due June 30, 20X5. A preliminary
estimate of the fair values for the acquired asset and liabilities indicates that the fair value of
intangible assets and goodwill is approximately $11.6 million. Based on the acquirer’s projections for operating profit margins, depreciation expense, working capital requirements, capital
expenditures, and taxes, the fair value of the equity holders’ interest in Titan Technology, Inc.
is $17.793 million as presented in Exhibit 8.1. The DCF to equity holders is calculated using
218
EXHIBIT 8.1
Titan Technology, Inc., as of August 31, 20X1, Discounted Cash Flow Analysis to Equity Holders
20X1
Sales
Growth
$16,371,000
20X2
100.0%
5.0%
$17,225,000
20X3
100.0%
5.2%
$18,395,000
20X4
100.0%
6.8%
$19,695,000
Terminal
Value
20X5
100.0%
7.1%
$20,475,000
100.0%
4.0%
$21,089,000
100.0%
3.0%
Cost of Sales
10,150,000
62.0%
9,991,000
58.0%
10,669,000
58.0%
11,423,000
58.0%
11,876,000
58.0%
12,232,000
58.0%
Gross Profit
6,221,000
38.0%
7,234,000
42.0%
7,726,000
42.0%
8,272,000
42.0%
8,599,000
42.0%
8,857,000
42.0%
SG&A Expenses
3,274,200
20.0%
3,100,500
18.0%
3,311,100
18.0%
3,545,100
18.0%
3,685,500
18.0%
3,796,020
18.0%
EBITDA
2,946,800
18.0%
4,133,500
24.0%
4,414,900
24.0%
4,726,900
24.0%
4,913,500
24.0%
5,060,980
24.0%
Less: Depreciation
2.2%
516,750
3.0%
551,850
3.0%
590,850
3.0%
614,250
3.0%
632,670
3.0%
EBIT
2,588,221
15.8%
3,616,750
21.0%
3,863,050
21.0%
4,136,050
21.0%
4,299,250
21.0%
4,428,310
21.0%
Less: Interest Expense
(200,000)
−1.2%
(200,000)
−1.2%
(200,000)
−1.1%
(200,000)
−1.0%
(100,000)
−0.5%
−
0.0%
EBT
358,579
2,388,221
14.6%
3,416,750
19.8%
3,663,050
19.9%
3,936,050
20.0%
4,199,250
20.5%
4,428,310
21.0%
Less: Taxes
(620,937.46)
−3.8%
(888,355)
−5.2%
(952,393)
−5.2%
(1,023,373)
−5.2%
(1,091,805)
−5.3%
(1,151,361)
−5.5%
Net Income
1,767,284
10.8%
2,528,395
14.7%
2,710,657
14.7%
2,912,677
14.8%
3,107,445
15.2%
3,276,949
15.5%
Plus: Depreciation
358,579
2.2%
516,750
3.0%
551,850
3.0%
590,850
3.0%
614,250
3.0%
632,670
3.0%
Less: Capital
Expenditures1
(358,579)
−2.2%
(516,750)
−3.0%
(551,850)
−3.0%
(590,850)
−3.0%
(614,250)
−3.0%
(632,670)
−3.0%
Less: Incremental
Working Capital6
(102,658)
−0.6%
(128,100)
−1.0%
(175,500)
−1.0%
(195,000)
−1.0%
(117,000)
−1.0%
(92,100)
−1.0%
Less: Repayment of
Debt Principal7
−
0.0%
−
0.0%
−
0.0%
−
0.0%
(2,500,000)
−12.2%
−
0.0%
Cash Flows to Equity
Holders
1,664,626
10.2%
2,400,295
13.9%
2,535,157
13.8%
2,717,677
13.8%
490,445
2.4%
3,184,849
15.1%
219
Terminal Value
19,905,309
Partial Period
−
1.00
1.00
1.00
1.00
1.00
Period
−
0.50
1.50
2.50
3.50
3.50
Present Value Factor
1.000
0.917
0.770
0.647
0.544
0.544
Present Value of Cash
Flows to Equity
−
2,200,347
1,952,920
1,759,262
266,794
10,828,157
11,600,000
Assumptions
/ 15
Discount Rate
19.0%2
Internal Rate of Return
19.5%3
Sum of PV of DFCF (20X1–20X5)
6,179,322
Fair Value of Intangible
Assets and Goodwill
PV of Terminal Value
10,828,157
15-Year Amortization Period
PV of Tax Benefit—Amortization of Intangibles8
1,270,528
Tax Amortization per Year
18,278,007
Tax Rate
Preliminary Value
Fair Value of Equity, Rounded
$18,278,000
Annual Amortization Benefit
Sum of PV Factors 20X1 to 20Y6
Present Value of
Amortization Benefit
773,333
X 26%
201,067
6.32
Tax Rate
26%4
Long-Term Growth Rate
3%5
Debt-Free Working Capital %
15%6
$1,270,528
Notes:
1 Makes the simplifying assumption that capital expenditures are equal to depreciation expense.
2 Cost of equity capital per Exhibit 8.11.
3 Implied rate, which reconciles the future expected cash flows to equity holders to the fair value of the acquisition price less acquisition debt.
4 Estimated corporate tax rate.
5 Based on Management’s projections, the growth prospects of the industry, and the overall economy.
6 Based on analysis of historical and industry levels.
7 This example assumes the repayment of all debt as a simplification. Any future borrowing would be added to cash flows to equity holders in the applicable
period.
8 Assumes the acquisition is an asset purchase.
220
◾ The Income Approach
a 19 percent cost of equity for the discount rate. (The calculation of the cost of capital will be
addressed in a later section.)
The cash flows to invested capital form of the DCF method is also referred to as the debt-free
method. Under the debt-free method, cash flows to all investors, both debt holders and equity
holders, are discounted back to the present at the weighted average cost of capital (WACC).
When measuring fair value, the WACC is based on market participant assumptions. The formula to calculate each year’s forecasted cash flows to investors under the debt-free form of the
discounted cash flow is:
Net income
Plus: Tax affected interest expense
Plus: Depreciation and amortization and other noncash expenses
Less: Capital expenditures required supporting growth in revenue
Less: Working capital additions required to support growth in revenue
Equals: Debt-free cash flows (cash flows to holders of both debt and equity)
Debt-free cash flows are discounted back to the present using the WACC, and the resulting value represents the fair value of debt holders’ and equity holders’ interest in the entity, in
other words, the fair value of invested capital. The fair value of the equity interest can be measured by subtracting the fair value of current interest-bearing debt from the total fair value
of invested capital. The advantage of the debt-free method is that it can be used to measure
fair value under a market participant assumption about capital structure. The disadvantage
is that the measurement fair value depends on the calculation of WACC, which is often based
on many assumptions. Deriving a WACC will be discussed later in the chapter.
An example of the invested capital form of the DCF is shown in Exhibit 8.2, using the same
Titan illustration and assumptions from Exhibit 8.1.
The Weighted Average Cost of Capital (WACC) Compared to the
Internal Rate of Return on the Investment (IRR)
One of the first steps in measuring the fair value of individual assets acquired in a business
combination under FASB ASC 805, Business Combinations, is to measure the fair value of the
entire acquired entity. This fair value is also known as the business enterprise value (BEV). As
mentioned, the most common method to measure the fair value of the acquired entity is the
discounted cash flow method under the income approach. The entity’s fair value indicated by
the DCF can also be corroborated by other valuation techniques, such as the guideline company method under the market approach.
The BEV or the fair value of invested capital is measured by discounting debt-free cash
flows to the present at the WACC. The fair value of the entity’s equity is then measured by
subtracting the fair value of debt from the BEV. A corollary to measuring the fair value of the
equity using a DCF method at the WACC is to calculate the implied internal rate of return (IRR)
on the investment. The IRR is the discount rate that makes the present value of the acquired
entity’s expected future debt-free cash flows to be equal to the acquisition price.
In financial theory, the IRR should approximate the WACC. However, in practice there is
often a difference, sometimes a substantial difference. If the WACC is greater than the acquired
entity’s IRR, then the acquirer may have paid more than the sum of the fair values of the
221
EXHIBIT 8.2
Titan Technology, Inc., as of August 31, 20X1, Discounted Cash Flow Analysis—Total Invested Capital
20X1
Sales
Growth
20X2
20X3
20X4
Terminal
Value
20X5
$16,371,000 100.0% $17,225,000 100.0% $18,395,000 100.0% $19,695,000 100.0% $20,475,000 100.0% $21,089,000 100.0%
5.0%
5.2%
6.8%
7.1%
4.0%
3.0%
Cost of Sales
10,150,000
62.0%
9,991,000
58.0%
10,669,000
58.0%
11,423,000
58.0%
11,876,000
58.0%
12,232,000
58.0%
Gross Profit
6,221,000
38.0%
7,234,000
42.0%
7,726,000
42.0%
8,272,000
42.0%
8,599,000
42.0%
8,857,000
42.0%
SG&A Expenses
3,274,200
20.0%
3,100,500
18.0%
3,311,100
18.0%
3,545,100
18.0%
3,685,500
18.0%
3,796,020
18.0%
EBITDA
2,946,800
18.0%
4,133,500
24.0%
4,414,900
24.0%
4,726,900
24.0%
4,913,500
24.0%
5,060,980
24.0%
Less: Depreciation
358,579
2.2%
516,750
3.0%
551,850
3.0%
590,850
3.0%
614,250
3.0%
632,670
3.0%
2,588,221
15.8%
3,616,750
21.0%
3,863,050
21.0%
4,136,050
21.0%
4,299,250
21.0%
4,428,310
21.0%
Less: Taxes
(672,937)
−4.1%
(940,355)
−5.5%
(1,004,393)
−5.5%
(1,075,373)
−5.5%
(1,117,805)
−5.5%
(1,151,361)
−5.5%
Debt-Free Net Income
1,915,284
11.7%
2,676,395
15.5%
2,858,657
15.5%
3,060,677
15.5%
3,181,445
15.5%
3,276,949
15.5%
EBIT
Plus: Depreciation
358,579
2.2%
516,750
3.0%
551,850
3.0%
590,850
3.0%
614,250
3.0%
632,670
3.0%
Less: Capital Expenditures1
(358,579)
−2.2%
(516,750)
−3.0%
(551,850)
−3.0%
(590,850)
−3.0%
(614,250)
−3.0%
(632,670)
−3.0%
Less: Incremental
Working Capital6
(102,658)
−0.6%
(128,100)
−1.0%
(175,500)
−1.0%
(195,000)
−1.0%
(117,000)
−1.0%
(92,100)
−1.0%
Cash Flows to
Invested Capital
1,812,626
11.1%
2,548,295
14.8%
2,683,157
14.6%
2,865,677
14.6%
3,064,445
15.0%
3,184,849
15.1%
Terminal Value
Partial Period
Period
Present Value Factor
Present Value of Cash
Flows to Inv. Capital
21,232,329
−
1.00
1.00
1.00
1.00
1.00
−
0.50
1.50
2.50
3.50
3.50
1.000
0.921
0.780
0.661
0.560
0.560
−
2,345,896
2,093,260
1,894,620
1,716,978
11,896,265
(Continued)
222
EXHIBIT 8.2
(continued)
20X1
20X2
20X3
20X4
Sum of PV of DFCF (20X1–20X5)
8,050,754
Fair Value of Intangible
Assets and Goodwill
PV of Terminal Value
11,896,265
15-Year Amortization Period
/15
Pv of Tax Benefit—Amortization of Intangibles
1,313,140
Tax Amortization per Year
773,333
Preliminary Value
21,260,159
Less: Debt
Fair Value of Equity, Rounded
26%
Tax Rate
Annual Amortization Benefit
Value of Invested Capital, Rounded
11,600,000
21,260,000
Sum of PV Factors 20X1 to 20Y6
(2,500,000)
Present Value of Amortization
Benefit
201,067
6.53
$1,313,140
$ 18,760,000
Notes:
1 Makes the simplifying assumption that capital expenditures are equal to depreciation expense.
2 Discounted at the weighted average cost of capital per Exhibit 8.11.
3 Implied rate, which reconciles the future expected cash flows to the fair value of the acquisition price.
4 Estimated corporate tax rate.
5 Based on Management’s projections, the growth prospects of the industry and the overall economy.
6 Based on analysis of historical and industry levels.
20X5
Terminal
Value
Assumptions
Assumptions
Discount Rate
18.0%2
Internal Rate of Return
18.6%3
Tax Rate
26%4
Long-Term Growth Rate
3%5
Debt-Free Working Capital %
15%6
Multiperiod Excess Earnings Method
◾
223
identifiable assets. This situation results in the recognition of goodwill at a higher value than
would otherwise be expected if the WACC were equal to the IRR. If the WACC is lower than the
implied IRR, it is probable that the acquirer made a cost-effective acquisition and the resulting
fair value of goodwill would be substantially lower than would otherwise be expected if the
WACC were equal to the IRR.
Valuation specialists often compare the entity’s IRR to the WACC to gain insight about the
prospective fair value of goodwill in an acquisition. The BEV in Exhibit 8.2 is calculated based
on an 18 percent WACC. The IRR is 18.6 percent, based on a $17.5 million acquisition price.
In the Titan example, the difference between the implied IRR and the WACC is insignificant.
When a significant difference between the two percentages exists, further analysis is needed.
A significantly higher IRR may indicate the existence of a bargain purchase price that would
potentially result in a gain. A significantly lower IRR may indicate the payment of a synergistic
premium by the acquirer.
MULTIPERIOD EXCESS EARNINGS METHOD
The Multiperiod Excess Earnings Method (MPEEM) is a variation of the discounted cash flow
analysis that is often used to measure the fair value of certain intangible assets. Unlike the DCF,
which measures fair value by discounting cash flows for an entire entity into perpetuity, the
MPEEM measures fair value by discounting expected future cash flows attributable to a single intangible asset over the asset’s remaining useful life. Typically, the single intangible asset
is the primary generator of cash flows for the entity. Customer relationships and technology
are examples of intangible assets that are primary generators of cash flows and are therefore
suitable for fair value measurement using the MPEEM.
When measuring the fair value of a specific intangible asset using the MPEEM, the starting
point is estimating prospective financial information (PFI), or future cash flows, for a group of
assets. Then a contributory asset charge (CAC) is deducted from total cash flows. The CAC
represents the portion of cash flows attributed to all other operating assets such as working
capital, fixed assets, and other intangible assets that contribute to the generation of total cash
flows. The present value of remaining cash flows over the life of the specific intangible assets
represents the fair value of that asset.
The CAC is a form of economic rent for the use of the other operating assets. The CAC
consists of two components, the required return for use of all other operating assets plus an
amount necessary to replenish the fair value of certain contributory intangible assets. For
working capital and fixed assets, the amount necessary to replenish the fair value is generally
already taken into consideration in the total cash flows. The return on and return of concepts
imbedded in contributory charges are similar to the investment analysis concepts of a return
on investment in the form of earnings and the return of capital. The Appraisal Foundation’s
The Identification of Contributory Assets and Calculation of Economic Rents is part of a series
entitled Best Practices for Valuations in Financial Reporting: Intangible Asset Working
Group (Contributory Assets). The Appraisal Foundation’s Contributory Assets is the most
comprehensive guidance within the valuation profession about contributory charges under
the MPEEM.7
224
◾ The Income Approach
The origins of the MPEEM can be traced back to a formula approach found in the Internal
Revenue Service’s Committee on Appeals and Review Memorandum (ARM) 34, which was
introduced in the 1920s when breweries and distilleries faced substantial losses due to their
closure during Prohibition. The IRS issued ARM 34 to provide guidance to determine the value
of intangible assets, including goodwill so that the owners of breweries and distilleries could
be compensated for the closure of their businesses. ARM 34 presented formulas to determine
the aggregate value of goodwill and intangible assets. The aggregate value was determined
by deducting an economic charge on the value of working capital and tangible assets from
the normalized net income of the entity. The residual earnings were called excess earnings.
The residual excess earnings were assumed to be attributed to the entity’s intangible assets.
These earnings were capitalized according to a formula using suggested capitalization rates.
The capitalized aggregate value of goodwill and intangible assets was then added to the value
of the entity’s tangible assets to determine the entity’s total value. Revenue Ruling 68-609
issued in 1968 provides additional guidance in estimating the value of an entity’s intangible
assets for tax reporting requirements.8 Although they have many significant limitations, the
methodologies presented in IRS ARM 34 and revised in Revenue Ruling 68-609 formed the
basis for contributory charges under the MPEEM.
The AICPA issued an updated practice aid entitled Assets Acquired to Be Used in Research
and Development Activities in 2013. The practice aid and its predecessor, which are commonly
referred to as the IPR&D Practice Aid, identifies best practices for defining, accounting for, disclosing, valuing, and auditing acquired assets to be used in R&D activities, including specific
In-Process Research & Development (IPR&D) projects.9 Although the practice aid only specifically covers acquired research and development, the concepts and methodologies provided in
the practice aid are widely applied to other acquired assets.
The MPEEM is one of the primary methods to estimate the fair value of IPR&D in a business combination covered by the practice aid. Expanding on the concepts introduced in ARM
34 and refined by RR 68-609 and by others, the practice aid provides a detailed description of
the excess earnings methodology. It extends the single-period capitalization method found in
the IRS ruling by applying the concept to a multiperiod analysis. The practice aid also provides
improved guidance for calculating contributory charges so that the excess earnings methodology can be used to estimate the fair value of a single intangible asset instead of the aggregate
value of all intangible assets. Guidance for determining appropriate rates of returns for various
classes of assets can also be found in the IPR&D practice aid.
The fair value of Titan Technology, Inc.’s patented technology is measured using the multiperiod excess earnings method in Exhibit 8.3. The charge for the required return on contributory assets shown in Exhibit 8.3 (4.5 percent for 20X1, 4.3 percent for 20X2, and so on) is
based on the fair values of contributory assets measured at either appraised value, replacement cost, or a DCF model, and is based on the required return calculations contained in
Exhibit 8.4. Contributory charges are fully discussed in a subsequent section.
Applying the MPEEM
When applying the MPEEM to estimate a specific intangible asset’s fair value, there are numerous complexities that must be addressed. The first is to develop a fundamental understanding
of the entity’s operations and its value drivers. Although obtaining this insight may seem to be
straightforward, it is sometimes difficult to achieve in practice. For example, the fair value of
225
EXHIBIT 8.3
Titan Technology, Inc., as of August 31, 20X1, Valuation of Patented Technology
20X5
Projected Companywide Revenue
20X1
20X2
20X3
20X4
20X5
Plus 10 Years
$16,371,000
$17,225,000
$18,395,000
$19,695,000
$20,475,000
$27,515,000
Growth
5.0%
5.2%
6.8%
7.1%
4.0%
3.0%
Decay Factor3
0.97
0.85
0.69
0.57
0.46
0.06
Surviving Company Revenues
15,832,849
14,577,985
12,746,154
11,173,171
9,510,109
1,729,586
EBITDA
2,849,932
3,498,293
3,058,707
2,681,237
2,282,150
415,050
18.0%
24.0%
24.0%
24.0%
24.0%
24.0%
346,792
437,340
382,385
335,195
285,303
51,888
2,503,140
3,060,954
2,676,322
2,346,042
1,996,847
363,163
316,657
291,560
254,923
223,463
190,202
34,592
2,186,483
2,769,394
2,421,399
2,122,578
1,806,645
328,571
Average EBITDA Margin
Less: Depreciation7
EBIT
Less: Charge for Use of Tradename
Adjusted EBIT
Less: Taxes
(568,486)
(720,042)
(629,564)
(551,870)
(469,728)
(85,428)
Debt-Free Net Income Before
Contributory Charge
1,617,998
2,049,352
1,791,835
1,570,708
1,336,917
243,143
Less: Contributory Asset Charge
(707,620)
(624,080)
(516,389)
(427,728)
(351,673)
(54,463)
Contributory Asset Charge as a
Percentage of Revenue5
4.5%
4.3%
4.0%
3.8%
3.7%
3.1%
Debt-Free Cash Flow to Patented
Technology
188,680
910,378
1,425,272
1,275,446
1,142,979
985,244
Partial Period
0.33
1.00
1.00
1.00
1.00
1.00
Period
0.17
0.83
1.83
2.83
3.83
13.83
Present Value Factor
Present Value of Debt-Free Cash
Flows
0.971
0.865
0.727
0.611
0.513
0.090
295,572
1,232,744
927,023
698,103
505,683
17,006
(Continued)
226
EXHIBIT 8.3
(continued)
20X5
20X1
Cumulative DFWC
Cumulative Percentage of PV of
DFCF
Sum of PV of DFCF
Amortization Benefit Multiplier6
Preliminary Value
Concluded Value Patented
Technology, Rounded
20X2
20X3
20X4
20X5
Plus 10 Years
295,572
1,528,316
2,455,338
3,153,442
3,659,125
4,920,667
6%
31%
50%
64%
74%
100%
4,913,161
1.10
5,412,132
$5,412,000
Assumptions
Discount Rate1
Tax Rate2
Remaining Useful Life3
Royalty Rate4
19%
26%
5 years
2%
Notes:
1 Cost of equity per Exhibit 8.11.
2 Estimated corporate tax rate.
3 Based on 5-year life and the applicable decay factor with analysis truncated after 15 years. 100% of cash flows are captured in the first fifteen years.
4 Based on industry royalty rates.
5 Charge for the use of the remaining assets that contribute to the cash flow forecast. See Contributory Asset Analysis on Exhibit 8.4.
6 Represents the present value of the estimated tax benefit derived from the amortization of the intangible asset, over the tax life (15 years) of the asset.
7 Tax depreciation may be forecasted based on MACRS.
227
EXHIBIT 8.4
Titan Technology, Inc., as of August 31, 20X1, Required Return on Contributory Assets
(’000s)
Total Revenue
Growth
Total Revenue
Multiplied by: DFWC %
Debt-Free Working Capital Balance
Required Return on Working Capital
4.4%1
20X1
20X2
20X3
20X4
20X5
Thereafter
$ 16,371,000
$ 17,225,000
$ 18,395,000
$ 19,695,000
$ 20,475,000
$ 21,089,000
5.0%
5.2%
6.8%
7.1%
4.0%
3.0%
16,371,000
17,225,000
18,395,000
19,695,000
20,475,000
21,089,000
15.0%
15.0%
15.0%
15.0%
15.0%
15.0%
2,455,650
2,583,750
2,759,250
2,954,250
3,071,250
3,163,350
140,453
109,031
114,719
122,511
131,169
136,364
Capital Expenditures2
358,579
516,750
551,850
590,850
614,250
632,670
Depreciation
358,579
516,750
551,850
590,850
614,250
632,670
$ 1,527,760
1,527,760
1,527,760
1,527,760
1,527,760
1,527,760
1,527,760
Required Return on Capital
Investment3
Net Fixed Assets Balance
6.6%3
100,832
100,832
100,832
100,832
100,832
100,832
Noncompetition Agreement
Beginning Value
$ 522,300
Noncompetition Agreement
Required Return
19.0%4
99,237
99,237
99,237
99,237
99,237
−
172,250
172,250
172,250
172,250
172,250
Assembled Workforce Beginning
Value
$ 689,000
Assembled Workforce Required
Return
25.0%5
172,250
(Continued)
228
EXHIBIT 8.4
(continued)
(’000s)
Customer Relationships Beginning
Value
$ 1,038,000
Customer Relationships Required
Return
24.0%6
Required Return on Contributory
Assets (as a % of Revenue)
20X1
20X2
20X3
20X4
20X5
Thereafter
249,120
249,120
249,120
249,120
249,120
249,120
4.5%
4.3%
4.0%
3.8%
3.7%
3.1%
Notes:
1 Assumes the asset would be financed with 100% debt per Exhibit 8.11.
2 Valuation specialists may make the simplifying assumption that capital expenditures are equal to depreciation expense, otherwise based on management’s
forecasted capital expenditures and related tax depreciation.
3 Assumes that capital expenditures would be financed with 15% equity and 85% debt.
4 Assumes the asset would be financed with 100% equity per Exhibit 8.11.
5 Cost of equity plus a 1% premium.
6 Cost of equity plus a 2% premium.
Multiperiod Excess Earnings Method
◾
229
a technology-based entity may be driven by customer relationships, a trade or domain name,
or by the technology itself. The task of identifying the entity’s primary value drivers falls to the
management of the acquiring entity.
Other complexities in applying the MPEEM are isolating the actual cash flows that are
attributable to the specific subject intangible asset and developing contributory charges.
Understanding the difference between a return of the contributory asset and a return on that
contributory asset is important to the successful development of contributory charges.
Returns on and Returns of Contributory Assets
An entity is composed of a group of tangible and intangible assets that contribute to the generation of its total cash flows. The MPEEM isolates cash flows attributable to the subject intangible asset by deducting contributory charges for all of the other assets that contribute to
the entity’s cash flows. After deducting these charges, the remaining residual cash flows are
assumed to be attributable to the subject intangible asset.
The first component of the contributory charge represents a return on contributory assets.
The return on contributory assets is based on the assumption that the entity pays a hypothetical economic rent or royalty for the use of the asset. It is a required rate of return on the fair
value of all the contributory assets to compensate for the entity’s use of those assets to produce
economic benefits. The return on contributory assets is analogous to a royalty paid for the use
of a technology in a product owned by another entity. The contributory charge includes a
return on all contributory assets, including working capital, fixed assets, and intangible assets,
excluding the subject intangible asset.
The second portion of the contributory asset charge is a return of contributory assets
and is analogous to the return of principal that is part of each mortgage payment. However,
deducting a return of contributory charge is not appropriate for all contributory assets. It is
only applicable to assets when the cost to replenish the asset is not already part of the cash
flow analysis. For example, the costs to replace internally generated intangible assets such
as assembled workforce and trade names are included in the cash flow analysis as expenses
on the income statement. Similarly, a significant portion of the return of fixed assets is also
already included as depreciation expense. When calculating initial cash flows prior to contributory asset charges, depreciation expense is therefore not added back as a noncash item
since it reflects a return of the investment in fixed assets.
Classification of Contributory Assets
There are four types of contributory assets that have distinct treatment when calculating contributory charges under the MPEEM. They differ with respect to how return of capital and
return on capital are incorporated into the MPEEM.
1. Nonwasting assets replenish themselves indirectly through normal company operations.
Working capital is an example of a nonwasting asset that replenishes itself through normal operations. Working capital will increase or decrease with the growth or decline in
company revenues. Nonwasting assets do not require a contributory charge for the return
of the asset. However, a company does require a return on its working capital. Therefore,
a contributory charge for a return on a nonwasting asset is appropriate.
230
◾ The Income Approach
2. Assets that are capitalized and deteriorate over time are considered wasting assets. Buildings, machinery, and equipment are examples of wasting assets that physically deteriorate
over time. The physical deterioration is recognized in financial reporting as depreciation
expense. Wasting assets must be replenished so that they can continue to support the
expected cash flows of the entity. The return-of-capital charge should reflect the amount
needed to maintain the viability of these assets throughout the MPEEM forecast period.
There are two methods commonly used to capture the return of capital charge on wasting
assets. One is to use depreciation expense as a proxy for the capital charge and the other
is through the use of a hypothetical lease charge.
1. Depreciation Expenses as a Proxy. In most DCF models, depreciation expense is added
back to cash flows from operations because it is a noncash operating expense.
Planned capital expenditures are then subtracted to arrive at expected cash flows.
An alternative treatment is based on the assumption that depreciation expense is a
reasonable proxy for, or is equal to, the costs required to replenish the capital asset.
Noncash depreciation expense would not be added back to operating cash flows as is
typically done for other noncash expenses. Instead, the cash flows analysis would be
burdened with depreciation expenses to fully reflect the return of capital charge for
these assets. There would be no capital expenditures for the replenishment of these
wasting assets in the MPEEM. Under this alternative, contributory charges would
exclude a return of capital charge. However, wasting capital assets requires a return
on capital contributory charge to account for their contribution to the entity’s cash
flows. Therefore, the contributory charge under this alternative is a simple return on
capital charge.
2. Hypothetical Lease Payment. The other method is to treat wasting assets as though they
are leased. The hypothetical lease payment is similar to payment of a royalty rate for
an intangible asset. Since the assets are leased under this method, there is no depreciation expense. The return of and return on capital charges are incorporated into the
hypothetical lease payment and fully reflected in the contributory charge.
3. The costs to develop some assets are expensed when incurred. They receive recognition as
assets through the acquisition method in a business combination. Examples of this type of
asset would be an assembled workforce or existing customer relationships. After they are
recognized as assets, any future costs to maintain the asset would be a normal part of operating expense. For example, hiring and training costs to maintain the workforce would be
expensed as usual. Similarly, sales and marketing costs required to maintain existing customer relationships or to replace lost customers with new ones would be expensed. Since
these costs flow through the income statement, the return-of charge is already considered in operating cash flows that form the base for the MPEEM analysis. Therefore, the
return-of charge would not be included as a contributory asset charge. However, because
all companies expect to earn a return on any costs incurred to train and hire a workforce
or to build and maintain customer relationships, contributory charges would include a
return-on charge for these types of assets.
4. The contributory charge for some assets is more appropriately captured through
market-based royalty rates. A trade name is a common example of this type of contributory assets. The value of the trade name may be disproportionate to the costs incurred
Multiperiod Excess Earnings Method
◾
231
to develop or maintain it. In this case, a market-based charge is more appropriate.
Contributory charges for this type of asset can be reflected through a market royalty
payment to a hypothetical owner of the asset. Both return-of and return-on charges are
captured in the royalty rate since the hypothetical owner of the asset would have to be
compensated for both of these charges.10
When using the MPEEM to measure the fair value of an entity’s primary, revenuegenerating asset, contributory charges should be calculated for all other operating assets
that contribute to the entity’s operating cash flows. The contributory asset charge includes a
return on charge for all contributory assets. Sometimes the return of capital charge is included
in the contributory asset charge and sometimes it flows through MPEEM’s operating cash
flows. One must also consider the asset’s remaining useful life when calculating contributory
asset charges. For example, the contributory charge for a noncompetition agreement should
be taken for the period of time the company expects to benefit from the agreement. Other
assets such as fixed assets may require additions to the return of portion beyond depreciation
expense if additional capacity is required to support forecasted revenue growth.
Goodwill
When measuring the fair value of a subject asset under the MPEEM, contributory charges
are calculated for intangible assets that are typically recognized using the acquisition method
to account for the business combination. With exceptions provided to private companies
explained in the next section, the FASB generally requires the recognition of an asset in
a business combination if it is identifiable. Recall that an intangible asset is considered
identifiable if it meets one of two criteria:
1. It is separable, that is, capable of being separated or divided from the entity and
sold, transferred, licensed, rented, or exchanged, either individually or together
with a related contract, identifiable asset, or liability, regardless of whether the
entity intends to do so.
2. It arises from contractual or other legal rights, regardless of whether those
rights are transferable or separable from the entity or from other rights and
obligations.11
Goodwill does not meet these criteria. Goodwill represents the contribution of future
assets and does not currently contribute to the entity’s cash flows. When using the MPEEM
to measure the fair value of the subject asset, a contributory charge is not typically taken
for goodwill as a contributory asset. However, there are some exceptions. Some elements of
goodwill are considered contributory assets and a contributory charge is appropriate. One
example is an assembled workforce. An assembled workforce is not specifically recognized
as an identifiable intangible asset under ASC 805. The assembled workforce is included in
goodwill. However, from an economic perspective, the workforce obviously contributes to the
generation of cash flows. So the contribution of the assembled workforce should be considered
when calculating contributory charges under the MPEEM.
232
◾ The Income Approach
In some industries, such as telecommunications and cable, there may be circumstances
when some element of goodwill should be recognized as a contributory asset. This might be
appropriate even when these assets do not meet the identifiably criteria under FASB ASC 805.
The distinguishing characteristic of these industries is that their operations are dependent on
the grant of a license or other similar authorization. SEC Staff Announcement Topic D-108,
Use of the Residual Method to Value Acquired Assets Other Than Goodwill, describes the features
of these assets and the difficulty in measuring their fair value using traditional valuation
methods.12 Examples of this type of asset are a nuclear power plant license, a cellular spectrum, a radio frequency license, and cable franchises. When applying the acquisition method,
many SEC registrants allocated the entire residual amount from the business combination
to these indistinguishable assets. In Topic D-108, the SEC staff discusses the identification
criteria under SFAS 141 (now ASC 805) and the residual nature of goodwill. D-108 requires
that a direct valuation method be used to measure the fair value of these license types of
assets and says that the residual method should only be used to measure goodwill.13
When calculating contributory charges under the MPEEM, there may be circumstances
when a component of goodwill, such as a license, can be measured separately from goodwill.
If so, a contributory charge can be taken for this component of goodwill in the MPEEM similar
to the contributory charge for the economic contribution of an assembled workforce. However,
these circumstances are rare given the difficulty in directly measuring the fair value of these
indistinguishable assets.
Private Company Council Elections
Using the MPEEM to estimate the fair value of an intangible asset for an entity that has elected
the accounting alternative provided by the FASB’s Private Company Council through ASU
2014-008, Accounting for Identifiable Intangible Assets in a Business Combination, can present
unintended consequences. The accounting alternative provides exceptions to the recognition
requirement for customer-related intangible assets and noncompetition agreements. Instead,
private companies can recognize these intangible assets as a component of goodwill. The FASB
indicated that one reason for providing the accounting alternative was to reduce the cost and
complexity associated with the measurement of certain intangible assets.
Unfortunately, customer-related intangible assets and noncompetition agreements
are still considered contributory assets. When the MPEEM is being used to estimate the
fair value of the entity’s primary intangible asset, it may be necessary to estimate the fair
value of the customer-related asset and noncompetition agreement in order to determine
an appropriate contributory charge. For example, when the primary intangible asset being
valued using the MPEEM is technology, the fair value of customer-related assets may have
to be estimated using an alternative method. However, if the primary intangible asset is
a customer-related asset, the MPEEM should not be used for other intangible assets because
it would likely overstate the value. Finally, it may be possible to use qualitative factors to
determine that the fair value of a noncompetition agreement is immaterial. Otherwise, its
fair value must also be measured in order to determine an appropriate charge for use in the
MPEEM. Therefore, although the FASB intended to reduce the cost and complexity associated
with business combinations for private entities, all private companies may not experience the
intended benefits.
Multiperiod Excess Earnings Method
◾
233
Titan Technologies Example
The contributory asset charge calculation for Titan Technology is shown in Exhibit 8.4 to
illustrate the application of these concepts. Note that the contributory charge percentages
from Exhibit 8.4 are used in the fair value measurement of Titan’s patented technology under
the multiperiod excess earnings method in Exhibit 8.3.
This example includes the simplifying assumption that Titan would not require an
increased level of fixed assets, such as a new plant. The simplifying assumption means that
capital expenditures are equal to depreciation expense in Exhibit 8.4. As a result, contributory
charge percentages are relatively stable from year to year. If an additional investment in new
assets is required during the life cycle of the technology, there would be a “stairstep” effect
resulting in an increase of the contributory charge in the year of the investment.
Prospective Financial Information
Another important step in estimating the fair value of an intangible asset using the MPEEM
is to determine the prospective financial information (PFI) that is appropriate to use in the
analysis. Appropriate PFI are the revenue, expenses, and resulting cash flows associated with
the subject intangible asset, and they should be directly tied to the remaining useful life of the
subject intangible asset. Management typically provides PFI for the entire entity, which serves
as a starting point for identifying the subject asset’s PFI. Best practices for a valuation specialist’s analysis of the entity’s PFI are outlined in the Mandatory Performance Framework and
are covered in Appendix 1A. Although the best practice concepts for analyzing PFI are from
the perspective of the entire entity, they are equally applicable to the PFI of intangible assets.
Some valuation analysts prefer to analyze PFI by breaking out fixed and variable expenses.
The proportion of fixed to variable expense often is a reflection of the industry in which the
company operates. Variable expenses tend to be more operational in nature and fixed expenses
tend to be based on management’s operating, investing, and financing decisions. Therefore, a
thorough understanding of the entity’s variable and fixed-cost structure leads to better identification of the PFI attributable to the subject intangible asset.
Since most intangible assets are wasting assets, the subject intangible asset’s contribution
to the entity’s overall PFI typically declines over time. Therefore, the entity level PFI must be
adjusted to reflect the economic life of the subject intangible asset. The resulting PFI for the
subject intangible asset is used in the MPEEM.
Market Participant Assumptions in the PFI
In a business combination measurement of fair value, the PFI should reflect those assumptions
that a market participant would make rather than the assumptions that are specific to the
acquiring entity. Recall that the FASB defines fair value as “the price that would be received to
sell an asset or paid to transfer a liability in an orderly transaction between market participants
at the measurement date.”14 When the acquiring entity is a frequent market participant, its
assumptions may be similar to those assumptions made by market participants. ASC 820 goes
on to say that “a reporting entity shall measure the fair value of an asset or a liability using
the assumptions that market participants would use in pricing the asset or liability, assuming
234
◾ The Income Approach
that market participants act in their economic best interest.”15 When developing fair value
measurements, the FASB did not intend to identify specific individual market participants.
ASC 820 provides guidance about the market participant assumption by saying that the entity
“shall identify characteristics that distinguish market participants generally, considering factors specific to (a) the asset or liability, (b) the principal (or most advantageous) market for the
asset or liability, and (c) market participants with whom the reporting entity would enter into
a transaction in that market.”16
When developing the PFI, the market participant assumption should be made after considering the likely buyers for the entity or reporting unit. For example, likely buyers might be a
small group of strategic buyers or a group of financial acquirers. If the business combination
has many potential acquirers, each with similar bids, then the PFI prepared in conjunction
with the acquisition would be more likely to reflect market participant assumptions and
exclude synergies. Conversely, if the business combination has a limited group of potential
strategic acquirers, then the assumptions underlying the PFI would be more entity-specific
and be more likely to include synergies. If the market participant assumption incorporates
synergies, then value of the synergies would be reflected in the value of the individual
acquired intangible assets. If the market participant assumptions exclude synergies, the value
of the entity-specific synergies would not be reflected in the value of the individual acquired
assets, but would fall to goodwill. Although ASC 820 does not require the identification of
specific market participants, if they can be identified without undue cost or effort, then the
assumptions used by these specific entities should be considered.
Analyzing PFI for Market Participant Assumptions
Fair value is measured under the MPEEM using prospective financial information with market participant assumptions. However, market participant assumptions are often difficult to
observe, leaving management with the difficult task of making assumptions appropriate for a
hypothetical market participant. ASC 820 describes the process determining market participant assumptions for unobservable inputs when management is developing PFI:
A reporting entity shall develop unobservable inputs using the best information
available in the circumstances, which might include the reporting entity’s own data.
In developing unobservable inputs, a reporting entity may begin with its own data,
but it shall adjust those data if reasonably available information indicates that other
market participants would use different data or there is something particular to the
reporting entity that is not available to other market participants (for example, an
entity-specific synergy). A reporting entity need not undertake exhaustive efforts
to obtain information about market participant assumptions. However, a reporting
entity shall take into account all information about market participant assumptions
that is reasonably available. Unobservable inputs developed in the manner described
above are considered market participant assumptions and meet the objective of a fair
value measurement.17
One of the important assumptions that management must make in developing the PFI
using market participant assumptions is whether the market participant is a strategic or a
Multiperiod Excess Earnings Method
◾
235
financial acquirer. The choice is significant since market participant assumptions may be
different for potential strategic and financial acquirers. Strategic acquirers have potential
operating synergies related to revenue, expenses, and cost of capital. Revenue synergies may
be experienced by using the acquirer’s existing distribution channels to sell the acquired
entity’s products. Additional revenue synergies may be found by combining complementary
products within existing channels. Potential synergies relating to cost reductions are the
result of economies of scale and the elimination of duplicate costs. Examples of cost-reduction
synergies would be the elimination of redundant workforces and a reduction in fixed costs
from combining manufacturing and distribution facilities. Finally, there may be synergies
related to the reduced cost of capital of the combined entities. For example, a start-up may
gain access to capital at a lower rate as part of a larger, more stable entity.
If there are synergies that can be realized by all market participants, then the synergies
should be reflected in the PFI and in the fair value of the assets of the acquired entity. If synergies are specific to the business combination, and can only be realized by a few potential
acquiring entities, then the PFI should be adjusted to exclude any market synergies unavailable to other market participants. The resulting fair value of the acquired assets would exclude
synergies. Instead, any value resulting from synergies would appear in goodwill.
Economic Life of the Intangible Asset in the PFI
Adjustments to the entity-wide PFI provided by management may be necessary because the
time frame that the PFI encompasses might not correspond to the subject asset’s economic
life. The economic life of the subject asset is the appropriate valuation timeframe when measuring the fair value of the specific intangible asset. The assumption about the economic life of
a specific intangible asset depends on the nature of the intangible asset. There are two ways to
estimate the economic life of an intangible asset when measuring its fair value. The American
Society of Appraisers refers to these two methods as lifecycle analysis and attrition analysis.18
The lifecycle analysis is normally used for intangible assets that have an estimated product
life such as developed technology sold to third parties. The economic life of an intangible asset
is typically one of the considerations in the remaining useful life of the asset. FASB ASC 350,
Intangibles—Goodwill and Other, provides guidance about which factors should be considered
when estimating the remaining life of the asset. The statement says that useful life shall be
based on an analysis of all pertinent factors, with no one factor being more presumptive than
the others. The six factors are:
1. The expected use of the asset by the entity.
2. The expected useful life of another asset or a group of assets to which the useful life of the
intangible asset may relate.
3. Any legal, regulatory, or contractual provisions that may limit the useful life.
4. The entity’s own historical experience in renewing or extending similar agreements
(consistent with the intended use of the asset by the entity), regardless of whether those
arrangements have explicit renewal or extension provisions. In the absence of that
experience, the entity shall consider the assumptions that market participants would
use about renewal or extensions (consistent with the highest and best use of the asset by
market participants), adjusted for entity-specific factors in this paragraph.
236
◾ The Income Approach
5. The effects of obsolescence, demand, competition, and other economic factors (such as
the stability of the industry, known technological advances, legislative action that results
in an uncertain or changing regulatory environment, and expected changes in distribution channels).
6. The level of maintenance expenditures required to obtain the expected future cash flows
from the asset (for example, a material level of required maintenance in relation to the
carrying amount of the asset may suggest a very limited useful life).19
The economic life of the asset takes into consideration these factors and how they impact
the expected positive cash flows specifically related to the use of the asset.
Attrition analysis is a statistical process for estimating the historical turnover rate for
the subject intangible analysis. The historic turnover rate is applied to the subject asset
to estimate the future rate of loss due to the use of the intangible asset. An example of
attrition analysis is examining historical customer turnover to estimate the likely turnover
of customers in the future. In order for this method to provide reliable results, the analyst
must consider whether historical patterns of attrition would be expected to continue over the
foreseeable future.
Issues in the Application of the MPEEM
Due to the large number and complex nature of assumptions incorporated into the MPEEM,
divergent practices exist in the application of the method among valuation specialists. The
Appraisal Foundation’s Best Practices for Valuations in Financial Reporting: Intangible Asset
Working Group—Contributory Assets publication entitled The Identification of Contributory
Assets and Calculation of Economic Rents (Contributory Assets) recognizes these divergent
practices and, where applicable, provides guidance about the best of the practices. Within the
valuation profession, the more prevalent divergent practices relate to the use of contributory
cross charges, the application of revenue splits, the selection of an appropriate level of fixed
assets, and the inclusion of deferred revenue in the working capital contributory charge.
Contributory Asset Cross-Charges Typically, the MPEEM is used to measure the fair
value of the intangible asset that is the primary value driver for the entity. The reason is that
in most situations, the entity-wide set of PFI can only be adjusted to reflect the cash flows
for one specific intangible asset. However, if these cash flows are generated by more than one
significant intangible asset, it may be difficult to determine which asset is the primary asset.
For example, suppose a software company sells prepackaged software that is acquired in a
business combination. The entity has two identifiable intangible assets: developed software
and existing customer relationships.
A common method to determine which asset is the primary asset would be through discussions with management. The primary asset would be the subject asset whose fair value is
determined using the MPEEM. Other methods such as a cost approach method or the relief
from royalty method would be used to estimate the fair value of the second intangible asset.
The fair value of the secondary asset would then be considered a contributing asset in the
MPEEM.
Multiperiod Excess Earnings Method
◾
237
The Appraisal Foundation’s Contributory Assets discusses the diversity in practice for
the simultaneous application of the MPEEM to measure the fair value of two separate
intangible assets. The simultaneous measurements can be accomplished by taking contributory cross-charges in each MPEEM. For example, when measuring the fair value of the
technology, a charge would be taken for the contribution of the customer relationships and
when measuring the fair value of the customer relationships a charge would be taken for
the contribution of the technology. There are some valuation specialists who believe the
simultaneous application of the MPEEM using cross-charges would measure the fair value
of both intangible assets. Others believe this methodology is difficult to implement and is
prone to overvaluation. Valuation specialists believe the simultaneous application of the
MPEEM should be limited to situations where it is possible to identify distinct sets of cash flows
generated by each intangible asset. Because of the problems associated with implementation
of simultaneous MPEEM fair value measurements, Contributory Assets recommends against
using this type of methodology.20
Splitting Revenues or Profits Under the MPEEM A simple way to avoid the difficulties
associated with using the MPEEM to simultaneously measure the fair value of two identified
intangible assets is to split the entity’s revenue and cash flows. The revenues and cash flows
attributable to each of the two subject assets would be identified separately. For example, if the
entity has two unique technologies that are used in two separate products, then the MPEEM
can be used to measure the fair value of each technology by separating the cash flows by
product line. Isolating the cash flows attributable to each technology avoids the problems associated with cross-charges. The contributory assets would be those assets used exclusively with
the subject technology to generate cash flows for the company. Contributory assets used in the
generation of cash flows for both technologies would be allocated on a pro rata basis based on
revenues. Thus, it would not be appropriate to take a charge for the other technology or any
other asset exclusively used to produce the other product. If it is not possible to separate cash
flows into those attributable to the two identified intangible assets, then the fair value of the
primary assets can be measured using the MPEEM, but the fair value of the secondary asset
must be measured by some other method.
Appropriate Level of Working Capital As discussed previously, working capital is considered a nonwasting asset that is replenished through the entity’s normal operating cycle.
However, an increased level of working capital would be required to support revenue and cash
flow growth. When this is the case, a return on the increased level of working capital should be
included as a contributory charge under the MPEEM. The return on working capital contributory charge should be based on a normalized level of working capital that a market participant
would require to support the cash flow–generating ability of the subject asset.
Deferred Revenue Deferred revenue is recorded when an entity receives cash for future
products or services. The earnings process is not complete; therefore, the entity has an obligation to deliver additional products or services and revenue cannot be recognized. Examples of
deferred revenues include a software vendor’s maintenance obligation on prepaid maintained
contracts, an airline’s obligation to provide travel when tickets are purchased in advance,
238
◾ The Income Approach
and magazine publisher’s obligation to deliver magazines when subscriptions payments are
received in advance. Sometimes, deferred revenues are included as a component of working
capital when calculating contributory charges, and sometimes they are not. The Appraisal
Foundation’s Intangible Asset Working Group on Contributory Assets (the Working Group)
provides guidance about when deferred revenue should be included in the computation of
working capital as a contributory asset. Their conclusion is that deferred revenue should be
included as a current liability in working capital if the PFI is developed using an accrual basis
because the deferred revenue is a part of ongoing operations. Deferred revenue that is not considered part of ongoing operations may or may not be included as a component of working
capital depending on the circumstances.21
Appropriate Level of Fixed Assets When calculating contributory asset charges for
fixed assets, the first thing to consider is the appropriate level of fixed assets. The entity’s stage
in its life cycle may influence the required level of fixed assets. A normal level of fixed assets
would be the level required to support the level of operations contained in management’s
prospective financial information. The valuation specialist must also consider how the normal
level of fixed assets changes over time as the entity grows.
Contributory Assets describes two methods for calculating fixed asset contributory
charges; one is the Average Annual Balance method and the other is the Level Payment
method. The fixed asset contributory charge using the Average Annual Balance method is
calculated as:
Debt-free net income
Plus: Tax depreciation
Less: Return of the fixed assets (economic depreciation of fair value which may be accounting or tax depreciation as a proxy)
Less: Return on the average balance of the fixed assets (at fair value)
Less: Contributory asset charges on all other contributory assets
Equals: Excess cash flow to individual asset
As previously discussed, depreciation is often used as a proxy for the return of the fixed
asset. Tax depreciation is the preferred proxy, but accounting depreciation is also used. This
simplifying assumption may be appropriate in most circumstances; however, the valuation
specialist should consider whether the level of fixed assets would remain constant throughout
the forecast period of the MPEEM.22
The Level Payment method assumes that the contributory fixed asset is leased and the
entity pays a market royalty for the use of the asset. The assumed lease or rent payment would
include both a return of and return on the fixed asset because the hypothetical owner would
charge an amount to cover the use of the fixed asset and to cover the cost to replenish the
fixed asset.
The contributory charge using the Level Payment assumption is calculated as:
Debt-free net income
Plus: Tax depreciation
FASB Concepts Statement 7
◾
239
Less: Level payment contributory asset charge, which covers both return of and return
on the assets at fair value
Less: Contributory asset charges on all other contributory assets
Equals: Excess cash flow to individual asset23
The Level Payment assumption is similar to the relief from royalty method used to measure the fair value of certain intangible assets. An advantage of the Level Payment assumption
is that it may do a better job of including market participant assumptions when comparable
market rent data is available for similar assets. A disadvantage is that it may be difficult to
obtain appropriate data.
FASB CONCEPTS STATEMENT 7
FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting
Measurements (CON 7), provides guidance for using present value techniques to measure fair
value, and it provides a framework for using estimated future cash flows in an accounting measurement. Uncertainties about the amount and timing of estimated future cash flows impact
the measurement of an asset or a liability.
Typically, when an entity’s management prepares PFI, they provide their best estimate
of the future cash flows. CON 7 describes a best estimate as “the single most-likely amount
in a range of possible estimated amounts.” In statistics, this would be the mode. In the past,
accounting pronouncements have used the term best estimate in a variety of contexts that
range in meaning from “unbiased” to “most likely.”24 CON 7 also describes the expected
amount as an alternative to the best estimate. The best estimate is the single most likely
amount, whereas the expected amount refers to the sum of probability-weighted amounts in
a range of possible estimated amounts. It is the estimated mean or average.25
Under CON 7, there are two present value methodologies: (1) the traditional method and
(2) the expected present value method. The traditional method uses the best estimate of the
single most likely set of cash flows. This traditional method is the most common method for
forecasting cash flows in PFI and is also commonly used in DCF methods to estimate the fair
value of an entity. Under the traditional method, the risk associated with receiving estimated
future cash flows is reflected in the risk-adjusted discount rate. A risk premium is added to
the risk-free rate to account for the specific risk associated with estimated future cash flows.
According to CON 7, the expected cash flow is probably a more effective method than the
traditional method. The expected cash flow method incorporates all of the expected outcomes
for possible future cash flows instead of just a single, most-likely stream of cash flows. Although
theoretically preferable, the expected cash flow methodology is more difficult to implement in
practice. Estimating all possible cash flow outcomes and assigning relative probabilities is a
daunting task. However, in practice, the application of the expected cash flow approach is subject to cost-benefit constraints. The cost of obtaining additional information must be balanced
against the additional reliability of that information. Therefore, it is not always necessary to
apply the expected cash flow method using all possible cash flows. Instead, the expected cash
flow method is often applied to a relatively small number of cash flow outcomes (or scenarios)
using probabilities that capture the range of possible cash flows.
◾ The Income Approach
240
There are two basic versions of the expected cash flow method. They are similar in that
both versions start with a set of expected cash flows determined using scenario analysis. The
focus of scenario analysis is on direct analysis of the possible variations in the amount and timing of cash flows and on the underlying assumptions used in the development of the scenario.
It is also necessary to estimate the likelihood or probability of each scenario. The expected set
of cash flows is the probability weighted average of all the scenarios.
To illustrate the calculation of expected cash flows, assume that Custom Couture, Inc.
has recently agreed to license a trademarked logo to Fab Fashions, Inc., an unrelated third
party. In exchange for exclusive rights to use the logo, Fab Fashions, Inc. has agreed to pay
3 percent of net revenues. The term of the agreement is through the end of 20X6, which corresponds with the remaining statutory life of the trademark protection. Fab Fashions, Inc. has
provided the revenue projections in Scenario 1. Custom Couture’s management believes the
projections are optimistic. Custom Couture’s estimate of most likely revenues is included in
Scenario 2. Management acknowledges that Fab Fashion’s strategic marketing plan has the
potential to succeed and that revenues could be higher. The most optimistic projections are
included in Scenario 3. Custom Couture’s management assesses the probability of Scenario 1
at 30 percent, Scenario 2 at 60 percent, and Scenario 3 at 10 percent. Assume in this example
that these are the only potential outcomes. In reality, the outcomes may be much broader and
require the use of statistical models such as Monte Carlo simulation. Expected license revenue
is calculated in Exhibit 8.5.
The two versions of the expected cash flow method differ with respect to the method used
to adjust for the systematic (market) risk associated with the expected cash flows. In the direct
cash flow adjustment version, cash flows are directly adjusted for systematic market risk using
market risk data. If market data is unavailable, a market premium from an asset-pricing model
can be used in the following formula to calculate the market risk adjustment:
MRA = CF − (CF × (1 + Rf ∕1 + D)∧P)
where
MRA = market risk adjustment
CF
= cash flow
Rf
= risk-free rate
D
= total discount rate, including the risk-free rate and a market risk premium
P
= period
The market risk adjustment is deducted from expected cash flows. The resulting
risk-adjusted expected cash flows are discounted at the risk-free rate to determine the fair
value of the underlying asset. The fair value of the trademark using the direct adjustment
version of the expected cash flow method is presented in Exhibit 8.6.
The other version of the expected cash flow method takes market risk into account
through the discount rate. Expected cash flows are simply discounted at a discount rate that
includes the risk-free rate and a market risk premium. Exhibit 8.7 shows the discount rate
version of the expected cash flow method. Note that the resulting fair value for the trademark
241
EXHIBIT 8.5
Custom Couture, Inc., as of December 31, 20X1, Calculation of Expected License Revenues
20X2
20X3
20X4
20X5
20X6
$42,465,000
$44,588,000
$46,817,000
$49,158,000
$51,616,000
30%
30%
30%
30%
30%
12,739,500
13,376,400
14,045,100
14,747,400
15,484,800
39,120,000
41,076,000
42,308,000
43,577,000
44,884,000
60%
60%
60%
60%
60%
23,472,000
24,645,600
25,384,800
26,146,200
26,930,400
46,712,000
49,048,000
51,500,000
54,075,000
56,779,000
10%
10%
10%
10%
Scenario 1: Optimistic
Expected Revenue
Probability
Scenario 1 Probability-Weighted Revenue
Scenario 2: Most Likely
Expected Revenue
Probability
Scenario 2 Probability-Weighted Revenue
Scenario 3: Most Optimistic
Expected Revenue
Probability
10%
Scenario 3 Probability-Weighted Revenue
4,671,200
4,904,800
5,150,000
5,407,500
5,677,900
Scenario 1 Probability-Weighted Revenue
12,739,500
13,376,400
14,045,100
14,747,400
15,484,800
Scenario 2 Probability-Weighted Revenue
23,472,000
24,645,600
25,384,800
26,146,200
26,930,400
Scenario 3 Probability-Weighted Revenue
4,671,200
4,904,800
5,150,000
5,407,500
5,677,900
Expected Fab Fashions, Inc.
40,882,700
42,926,800
44,579,900
46,301,100
48,093,100
Royalty Rate
Expected License Revenue to Custom Couture, Inc.
3.0%
3.0%
3.0%
3.0%
3.0%
$1,226,481
$1,287,804
$1,337,397
$1,389,033
$1,442,793
242
EXHIBIT 8.6
Adjustment
Custom Couture, Inc., as of December 31, 20X1, Valuation of Trademark, Expected Cash Flow Method—Cash Flow
20X2
20X3
20X4
20X5
20X6
$1,226,481
$1,287,804
$1,337,397
$1,389,033
$1,442,793
Less: Taxes
(318,885)
(334,829)
(347,723)
(361,149)
(375,126)
Expected License Cash Flows
907,596
952,975
989,674
1,027,884
1,067,667
Expected License Revenue
Market Risk Adjustment1
58,286
118,470
178,688
239,680
301,534
Expected Risk-Adjusted License Cash Flows
849,310
834,505
810,985
788,205
766,133
Period
1.00
2.00
3.00
4.00
5.00
Present Value Factor
0.980
0.961
0.942
0.924
0.906
832,657
802,100
764,210
728,179
693,910
PV of Risk-Adjusted License Cash Flows
Sum of PV of License Cash Flows
Amortization Benefit Multiplier2
Preliminary Value
Value of Trademark, rounded
Assumptions
3,821,056
1.17
4,473,626
$4,474,000
Note
Discount Rate3
2.0%
Tax Rate4
26.0%
Remaining Useful Life
5 years
Notes:
1 Adjustment for systematic (market risk): Adjustment = CF – (CF × (1+RF/1+D)^P), where CF is cash flow, RF is the risk-free rate, D is the total discount rate
including the risk-free rate plus a market risk premium, and P is the period. This example incorporates a 2% risk-free rate and a 7% market risk premium.
The market risk adjustment is the amount of change in cash flow to equate the risk-free rate and the risk adjusted discount rates.
2 Represents the present value of the estimated tax benefit derived from the amortization of the intangible asset, over the tax life (15 years) of the asset.
The amortization benefit multiplier is based on the 2% discount rate plus a 7% market risk premium.
3 Risk-free rate of 2%.
4 Estimated corporate tax rate.
243
EXHIBIT 8.7
Adjustment
Custom Couture, Inc., as of December 31, 20X1, Valuation of Trademark, Expected Cash Flow Method—Discount Rate
20X2
20X3
20X4
20X5
20X6
$1,226,481
$1,287,804
$1,337,397
$1,389,033
$1,442,793
Less: Taxes
(318,885)
(334,829)
(347,723)
(361,149)
(375,126)
Expected License Cash Flows
907,596
952,975
989,674
1,027,884
1,067,667
Expected License Revenue
Period
1.00
2.00
3.00
4.00
5.00
Present Value Factor
0.917
0.842
0.772
0.708
0.650
832,657
802,100
764,210
728,179
693,910
PV of License Cash Flows
Sum of PV of License Cash Flows
Amortization Benefit Multiplier1
Preliminary Value
Value of Trademark, rounded
Assumptions
3,821,056
1.17
4,473,626
$4,474,000
Note
Discount Rate2
9.0%
Tax Rate3
26.0%
Remaining Useful Life
5 years
Notes:
1 Represents the present value of the estimated tax benefit derived from the amortization of the intangible asset, over the tax life (15 years) of the asset.
2 Risk-free rate of 2.0% plus a 7.0% market risk premium.
3 Estimated corporate tax rate.
244
◾ The Income Approach
is the same under both methods. The version selected for use depends on the facts and
circumstances in the situation, including the asset or liability being measured, the availability
of data, and the application of judgment.26
RATES OF RETURN UNDER THE INCOME APPROACH
Chapter 4 introduced the concept of an adjusted economic balance sheet where the business
entity value equals the business’s invested capital. In the adjusted economic balance sheet,
net working capital on a debt-free basis appears on the left-hand side with the fair value of
all assets. The right side of the economic balance sheet shows how these assets are owned
or financed. There is usually some combination of debt (both short term and long term) and
equity. A simple adjusted economic balance sheet is presented in Exhibit 8.8.
The economic balance sheet is a useful tool for demonstrating how the entity finances its
assets. It is also useful in determining appropriate required rates of return (or discount rates)
for individual assets, particularly intangible assets. If the business enterprise value equals
the invested capital and the weighted average cost of capital is the required rate of return
on invested capital, then the weighted average required return on the assets must equal the
weighted average cost of capital.
Examples of Required Returns on Contributory Assets
The required rates of return for individual assets should reflect the relative risk of that asset.
The required return for individual assets can often be determined based on market-derived
Business
Enterprise Value
Invested
Capital
Net
Working
Capital
Weighted
Average
Return
on Assets
InterestBearing Debt
Tangible
Assets
Weighted
Average
Cost of
Capital
Equals
Intangible
Assets
Goodwill
EXHIBIT 8.8 Economic Balance Sheet
Owners’
Equity
The Income Increment/Cost Decrement Method
◾
245
rates of return and based on the way the asset is typically financed. The required rate of return
is the basis for the contributory charge under the MPEEM. The following chart provides an
example of required rates of return for specific classes of contributory assets.
Asset
Basis of Contributory Charge
Debt-free working capital
After-tax short-term rates, which would be available to market
participants. Examples include bank prime rates, commercial paper
rates, and 30- to 90-day U.S. Treasuries. Each should be adjusted
for entity-specific risk. Consideration should also be given to the
mix of debt and equity financing required to fund working capital.
Fixed assets
Rates of return on would include financing rates for similar assets
for market participants. Examples include observed vendor
financing and bank debt available to fund a specific fixed asset.
Consideration should be given to a blended mix of debt and equity
financing if market participants typically fund these assets with a
mixture of debt and equity.
Workforce, customer lists,
trademarks, and trade
names intangible assets
Weighted average cost of capital for market participants,
particularly entities with single-product assets, adjusted for the
relevant mix of debt and equity. Most intangible assets are 100
percent funded with equity; therefore, an equity rate of return
should be considered for those assets.
Technology-based
intangible assets
Since most technology-based assets are funded with equity, the
cost of equity is considered the base. It is adjusted upward for the
increased relative risk of the technology-based asset compared to
other company assets.
Other intangibles,
including IPR&D assets
Rates should be consistent with the relative risk of the subject
intangible asset. When market participant inputs are available, that
information should be used in calculating a required rate of return.
Riskier assets such as IPR&D should require higher rates of return.27
THE INCOME INCREMENT/COST DECREMENT METHOD
The Income Increment/Cost Decrement method is an income approach that focuses on incremental cash flows attributable to the subject intangible asset. Incremental cash flows resulting
from the use of the asset are estimated over the asset’s remaining useful life and discounted to
arrive at a present value. The incremental cash flow can be in the form of additional revenues
or can be related to cost saving from the use of the assets. This method is sometimes referred
to as the scenario method because it compares the operating results under two scenarios to
measure the incremental cash flow benefit attributable to the use of the subject asset. The first
scenario incorporates the assumption that the subject intangible asset is being used by the
entity to generate incremental cash flows. The second scenario projects cash flows assuming
the subject intangible asset is not available for use by the entity. The difference in the present
value of cash flows from the two scenarios is the fair value of the subject intangible asset. The
incremental income/cost decrement method is most often used to measure the fair value of
noncompetition agreements and is sometimes referred to as the with versus without method.
246
◾ The Income Approach
The Titan Technology, Inc. enterprise value, calculated using the total invested capital
form of the discounted cash flow analysis from Exhibit 8.2, will be used as a basis for
illustrating the “with versus without” method of measuring the fair value of a noncompete
agreement. Assume that Titan’s business enterprise value in Exhibit 8.2 includes the benefits
from the previous owner’s agreement not to compete. It is the “with” scenario. The new
owners of Titan believe that without the agreement, they could potentially lose 20 percent of
revenues in the remainder of 20X1, declining to a 10 percent revenue loss in 20X5. The new
owners assess the probability of competition at 30 percent in all years.
Exhibit 8.9 reflects the adjustments for lost revenue due to competition and shows Titan’s
enterprise value “without” the noncompete agreement. The difference between the enterprise
value “with” and “without” the noncompete agreement represents the preliminary value of
the noncompete agreement. It is adjusted for the tax amortization benefit resulting from the
recognition of the noncompete agreement as an intangible asset for tax purposes. The adjustment is made with an amortization benefit multiplier.
PROFIT SPLIT METHOD
Another income approach method for measuring the fair value of an intangible asset is the
profit split method. The theoretical basis for the profit split method is similar to the premise
underlying the relief from royalty method under the market approach. The relief from royalty method assumes that the fair value of the subject intangible asset is based on what the
company would have to pay a hypothetical third party to license the subject intangible asset
if it were not already owned. The profit split method assumes that the fair value of the subject
intangible asset is based on what the company would receive when licensing the subject intangible asset to a hypothetical third party. Under the profit split method, the company’s revenues
and profits are split into two groups: (1) revenues and profits attributable to the intangible
asset based on a hypothetical license, and (2) revenues and profits from the company’s other
operating assets. The percentage split profits depends on the relative contribution the intangible asset makes to the entity’s profitability.
To illustrate this method, assume that EcoThrive, Inc. produces and sells microchips
used in hybrid and electric vehicles. The company markets its products under the trade name
“EVolve,” which is widely recognized within the electronic vehicle industry. Management
of EcoThrive, Inc. believes that it could license the trade name for an amount equal to 25
percent of profits. The company’s projected annual revenues are $42.480 million. The fair
value measurement of EcoThrive’s trade name is presented in Exhibit 8.10.
The profit split method was developed years ago from guidelines used by independent parties when negotiating the use of intellectual property. Negotiations typically centered on determining an appropriate amount of consideration to pay based on the intellectual property’s
contribution to the development of a viable, commercial product. These guidelines recognized
four steps in bringing a technology to market. The first step is to develop the technology itself.
The second step is to incorporate the technology into a product that would have market acceptance. The third step is to manufacture the product. The fourth step is to sell the product in
the market place.28
247
EXHIBIT 8.9
Titan Technology, Inc., as of August 31, 20X1, Analysis of Noncompetition Agreement
20X1
20X2
20X3
20X4
20X5
Revenue
$16,371,000
$17,225,000
$18,395,000
$19,695,000
$20,475,000
Growth
5.0%
5.2%
6.8%
7.1%
4.0%
Revenue Lost to Competition1
× Probability of Competition1
Adjusted Revenue
3,274,200
20.0%
3,961,750
100.0%
$16,036,475
30%
$15,388,740
23.0%
3,679,000
100.0%
$17,291,300
30%
20.0%
3,151,200
100.0%
$18,749,640
30%
16.0%
2,047,500
100.0%
$19,860,750
30%
10.0%
30%
100.0%
Cost of Sales
9,541,000
62.0%
9,301,621
58.0%
10,028,860
58.0%
10,874,696
58.0%
11,519,720
58.0%
Gross Profit
5,847,740
38.0%
6,734,854
42.0%
7,262,440
42.0%
7,874,944
42.0%
8,341,030
42.0%
SG&A Expenses
3,077,748
20.0%
2,886,566
18.0%
3,112,434
18.0%
3,374,935
18.0%
3,574,935
18.0%
EBITDA
2,769,992
18.0%
3,848,289
24.0%
4,150,006
24.0%
4,500,009
24.0%
4,766,095
24.0%
337,064
2.2%
481,094
3.0%
518,739
3.0%
562,489
3.0%
595,823
3.0%
2,432,928
15.8%
3,367,194
21.0%
3,631,267
21.0%
3,937,520
21.0%
4,170,273
21.0%
Less: Taxes
−5.5%
Debt-Free Net Income
Depreciation
EBIT
(632,561)
−4.1%
(875,471)
−5.5%
(944,129)
−5.5%
(1,023,755)
−5.5%
(1,084,271)
1,800,367
11.7%
2,491,724
15.5%
2,687,138
15.5%
2,913,765
15.5%
3,086,002
Plus: Depreciation
337,064
2.1%
481,094
2.8%
518,739
2.8%
562,489
2.9%
595,823
2.9%
Less: Capital Expenditures
(337,064)
−2.2%
(481,094)
−3.0%
(518,739)
−3.0%
(562,489)
−3.0%
(595,823)
−3.0%
Less: Incremental Working
Capital
(109,211)
−0.6%
(137,594)
−1.0%
(186,702)
−1.0%
(204,832)
−1.0%
(120,619)
−1.0%
Debt-Free Cash Flows—With
Competition
1,691,156
2,354,130
2,500,435
2,708,933
2,965,383
Debt-Free Cash
Flows—Without
Competition
1,812,626
2,548,295
2,683,157
2,865,677
3,064,445
121,470
194,165
182,722
156,744
99,062
Cash Flows Attributable to
Noncompete Agreement
15.5%
(Continued)
248
EXHIBIT 8.9
(continued)
20X1
Cash Flows Attributable to
Noncompete Agreement
Partial Period
194,165
1.00
−
Period
Present Value Factor
20X2
121,470
20X3
182,722
1.00
20X4
156,744
1.00
20X5
99,062
1.00
−
0.50
1.50
2.50
3.50
1.000
0.917
0.770
0.647
0.544
−
177,991
140,757
101,467
53,888
Present Value of Cash Flows to
Invested Capital
Amortization Benefit Assumptions
Preliminary Value of Noncompete Agreement
Amortization Benefit Multiplier2
Concluded Value of Noncompetition Agreement, rounded
Discount Rate
19%
1.10
Estimated Effective Tax Rate
26%
522,252
Life of Tax Benefit (in years)
474,103
522,300
15
Present Value Annuity Factor (mid-period)
5.319
Amortization Benefit Factor
1.102
Assumptions:
Discount Rate3
19%
Tax Rate4
26%
Long-Term Growth Rate5
3.0%
Term of Benefit from Noncompete Agreement6
4 years
Notes:
1 Based on discussions with Management, direct competition would cause a 20% loss in revenue in 20X1, declining to 10% by 20X5, and would have no effect
thereafter. Management estimates a 30% probability of competition for applicable years.
2 Represents the present value of the estimated tax benefit derived from the amortization of the intangible asset, over the tax life (15 years) of the asset.
3 Cost of equity per Exhibit 8.11.
4 Estimated corporate tax rate.
5 Based on Management’s projections, the growth prospects of the industry, and the overall economy.
6 Per Non-competition Agreement dated August 31, 20X1.
249
EXHIBIT 8.10 Ecothrive, Inc., as of December 31, 20X1, Valuation of Trade Name Using the Profit Split Method
Revenue
$ 42,480,000
Operating Margin
x 40%1
Profit Before Tax
16,992,000
Less: Taxes @ 26%
(4,417,920)
Profit After Tax
12,574,080
Percentage Split
25%3
3,143,520
Capitalization Rate
Concluded Value, Rounded
Assumptions:
Operating Margin1
40%
Tax Rate2
26%
Estimated Profit Split3
25%
Long-Term Growth Rate1
5%
Discount Rate5
20%
Projected Life of Trade Name
Indefinite
Notes:
1 Based on management projections.
2 Estimated corporate tax rate.
3 Based on management estimate of a hypothetical royalty rate of 5.4% of revenues.
4 Discount rate less the long-term growth rate.
5 Equals the weighted average cost of capital.
15%4
$20,957,000
250
◾ The Income Approach
In negotiations for licensing the technology, each of these steps would be considered
equally risky and would be weighted equally when considering the contribution to a profitable
product. Therefore, the development of the technology contributes 25 percent of the profit
margin from the sale of the product.
The profit split method is commonly used in the valuation of intellectual property such
as patented technology. Under this method, the intellectual property’s fair value is calculated
based on 25 percent of the company’s before-tax gross profits from sales of company’s products
in which the asset is used.29 The fair value of the technology is estimated over the life of the
technology assuming normal maintenance. Twenty-five percent of applicable profits are discounted back to the present at a risk-adjusted rate of return, or discount rate. The 25 percent
rule and a 33 percent variation have emerged as commonly cited rules in articles on license
agreements and in court cases involving intellectual property disputes. Therefore, the profit
split method is widely recognized in the licensing and legal communities.
Although the profit split method is basically a rule of thumb, it does have a foundation
based in economic realities. A licensee would be willing to pay a percentage of profits
attributable to the successful commercialization of the licensed intangible asset. But the
percentage would have an upper limit. The challenge for the valuation specialist is to estimate
an appropriate gross profit “split” that would compensate the owner of the technology for its
use. A 25 percent gross profit may be a good starting point. The percentage would be adjusted
up or down based on the facts and circumstances unique to the measurement of fair value for
the subject intellectual property. The adjustment would be based on the relative risk borne by
the parties in the commercialization of the intellectual property.
The risks encountered in the commercialization of intellectual property are unique to the
stage of development:
◾
◾
◾
◾
◾
Research and development risk. Is the technology viable?
Manufacturability risk. Can the technology be included in a commercially viable product?
Marketing risk. Is there a market for the product?
Competitive risk. How will competitors react to the introduction of the new technology?
Legal risk. Does the new technology infringe upon any third-party rights?30
Several papers provide empirical support for the 25 percent profit split method. Kemmerer
and Jiaqing’s article entitled “Profitability and Royalty Rates across Industries: Some Preliminary Evidence” notes that although royalty rates across industries do not directly converge
at the 25 percent rule, the rates generally fall between 25 percent of gross profit margins and
25 percent of operating profit margins. They conclude that the EBITDA (earnings before interest, taxes, depreciation, and amortization) margin seems to be a “more reasonable base upon
which to apply the 25 percent rule compared to the gross margin and EBIT margin.”31 In
another study published in les Nouvelles, Goldscheider, Jarosz, and Mulhern analyzed licensee
agreements from 347 companies and concluded that the median royalty rate applied to operating profit margins converged with the implied royalty rate from the 25 percent rule.32
Although the 25 percent rule appears to have an empirical basis, the profit split method is
commonly used as a reference point when evaluating the reasonableness of a market royalty
rate for use of comparable intellectual property. Because the profit split method is grounded in
Weighted Average Cost of Capital Calculation
◾
251
economic theory and is commonly used in practice, the percentage suggested by this method
has implications for the range of royalty rates that would be viewed as reasonable. The profit
split method can be used to support a royalty rate in the relief from royalty method under
the market approach. The relief from royalty method is discussed in Chapter 7, “The Market
Approach.”
BUILD-OUT, OR GREENFIELD, METHOD
Even though the ASC 805 considers certain intangible assets identifiable, it may be difficult
to measure their fair value. Recall that an intangible asset is considered identifiable if it meets
either the separable or contractual criteria.
In industries that require a government license or permit to operate, such as telecommunications, radio and television, or power generation, there has been a debate about appropriate
methods to measure fair value. Recall that SEC Topic D-108 suggests that the residual method
only applies to goodwill and that these types of licensed intangible assets should be measured
using a direct valuation method.
One such method is the build-out method, or “Greenfield method.” The Greenfield method
is an income approach method that is based on the assumption that the entity commences
operations on the measurement date. Cash flows are forecasted assuming that the existing
competitive situation continues within each market. The exception is that the subject entity’s
forecasted cash flows assume a start-up of operations. By assuming a start-up scenario, the
analysis excludes any potential goodwill and going-concern value. This allows the analyst to
isolate the fair value of the licenses or permit to operate, and to measure the fair value of the
license or permit directly.
WEIGHTED AVERAGE COST OF CAPITAL CALCULATION
As discussed previously, the weighted average cost of capital (WACC) is the appropriate rate for
discounting debt-free cash flows. The WACC is the rate of return required by all investors, both
debt and equity, to compensate them for the risk associated with their investment. The WACC
is typically used to discount an entity’s debt-free cash flows and to measure the fair value of
the entity’s invested capital.
In the WACC calculation, the required rate of return for each type of investor is weighted
based on the fair value of the investment to derive a weighted average required rate of return.
The formula for calculating the weighted average cost of capital (WACC) is:
WACC = ke × We + kd × Wd
where
ke = Cost of equity (both common and preferred)
We = Equity weight (value of equity/total invested capital)
kd = After-tax cost of debt (cost of debt × (1 – tax rate))
Wd = Debt weight (interest-bearing debt/total invested capital)
◾ The Income Approach
252
Capital Structure
Theoretically, when measuring the fair value of an entity, a market participant’s capital structure would be used to determine the relative weights of debt and equity in the calculation of the
WACC. Estimating a hypothetical market participant’s capital structure is often difficult due to
limited information available for non–publicly traded market participants. Consequently, valuation specialists typically rely on the capital structures of public companies as a proxy for the
hypothetical market participant’s capital structures. The weighting in the capital structure
should be based on the market value rather than carrying value.
Equity Rate of Return (ke )
Appropriate rates for publicly traded preferred equity capital and debt can be objectively identified based on market yields and interest rates, but the identification of an appropriate cost
of capital for privately held preferred and common equity is more subjective. Both rates are
calculated based on empirical market data and required rates of return for investments with
similar risk. Yields on privately held preferred equity are typically adjusted from market yields
on similar, publicly traded shares. The cost of common equity is typically calculated using one
of two models: (1) the Capital Asset Pricing Model or (2) a Build-Up Method. Another relatively
new method is to estimate a required rate of return for equity by referring to studies on rates
of return for venture capital investments.
Capital Asset Pricing Model
One method for estimating the cost of equity (ke ) is by using the Capital Asset Pricing Model
(CAPM). The formula for a modified version of the CAPM is:
ke = Rf + (RPm × 𝛽) + RPs + RPu
where:
= Rate of return on a risk-free security
Rf
RPm = Equity risk premium for the market
𝛽
= Sensitivity of the specific asset return compared to the market returns
RPs = Size risk premium over and above RPm
RPu = Risk premium for unsystematic risk attributable to the specific
company (company-specific risk premium)
Risk-free rate of return (Rf ). By analyzing the yields of U.S. Treasury securities, the rate of
return on a risk-free security is typically developed. Ideally, the duration of the risk-free security selected should match the projected cash flow horizon of the subject asset or entity. One
proxy for the risk-free rate is the yield on 20-year Treasury Constant Maturities as this is the
duration that best approximates the duration of an entity.
Weighted Average Cost of Capital Calculation
◾
253
Equity risk premium for the market (RPm ). The required return above the risk-free rate to
reflect the additional risk associated with holding equities over a long horizon. Theoretically,
the market risk premium is the rate of return for a market portfolio containing every possible equity investment in proportion to its relative market capitalization less the risk-free rate.
In practice, the market risk premium is often based on the returns from a broad stock index
such as the S&P 500 Composite Index less the risk-free rate. The Stocks, Bonds, Bills and Inflation Valuation Edition Yearbook published by Ibbotson Associates and Duff and Phelps, LLC Risk
Premium Report are two excellent sources of equity risk premium data.
Beta (𝛽). Beta is a measure of a specific security’s sensitivity to the market. It is estimated
using regression analysis to compare the security’s historic excess returns over the risk-free
rate to the historic market risk premium. Beta is the slope of the regression equation. Beta is
also a measure of the security’s systematic risk. Another method to estimate beta is based on
published betas for publically traded guideline companies. Because published betas are based
on overall market risks, they include operating and financial risks. Published, leveraged betas
can be adjusted to remove the effects of financing decisions. Information about guideline
companies’ capital structures and tax rates is contained in their financial statement filed with
the SEC. Using the formula following, an unlevered 𝛽 can be calculated for each guideline
company:
βU = βL ∕(1 + (1–t) × (D∕E)),
where
𝛽 U = unlevered beta
𝛽 L = published levered 𝛽
D = total debt
E = total equity capitalization
t = marginal tax rate
After selecting an appropriate unlevered 𝛽, the unlevered guideline 𝛽 can be relevered to
reflect the target company’s capital structure using another version of the same formula:
where
βL = βU β (1 + (1–t) × (D∕E))33
Size risk premium (RPs ). The risk premium associated with the required return on certain
smaller size stocks above the required return on large capitalization stocks. Small company
stocks typically have returns in excess of those that can be explained by their betas. These
small company excess returns may occur when 𝛽 is calculated using a broad stock index such
as the S&P 500 Composite Index. The market capitalization of the typical S&P 500 stock may
be significantly larger than the market capitalization of the subject company. Size risk premiums can be calculated based upon empirical data published by Duff and Phelps in its annual
Valuation Handbook.
Company-specific (unsystematic) risk (RPu ). The risk premium for unsystematic risk is
designed to account for additional risk factors specific to the subject entity.
254
◾ The Income Approach
Firm-specific risk factors may include:
◾
◾
◾
◾
◾
Small size relative to size premium group
Leverage
Industry risks
Volatility of returns
Other company-specific factors
◾
Concentration of customer base
◾
Key person dependence
◾
Key supplier dependence
◾
Abnormal present or pending competition
◾
Pending regulatory changes
◾
Pending lawsuits
◾
Strengths/weaknesses of company management34
The Build-Up Method
The other commonly used method to estimate the cost of equity (ke ) is the build-up method.
It is similar to the modified version of the CAPM in that it seeks to estimate the cost of equity
by starting with the risk-free rate and adding premiums for risks associated with the security.
The formula for the build-up method is: 35
ke = Rf + RPm + RPs + RPu
The risk premium variables in the build-up formula are essentially the same as those found
in the CAPM. The build-up method is flexible and can be customized for the attributes of the
specific company being analyzed. Some versions of the build-up method use 𝛽-adjusted risk
premiums and others incorporate industry risk premiums.
Debt Discount Rate (kd )
The required return or cost of debt is usually defined as a market participant’s marginal borrowing rate, less the tax benefit associated with the deductibility of interest expense. As a
practical matter, the marginal borrowing rate can be identified by examining existing lending agreements, by interviewing current or prospective lenders, or by observing the current
market rate for entities with similar credit ratings. The formula for the required rate of return
for debt is:
kd = Marginal borrowing rate × (1 − Marginal tax rate)
The calculation of Titan Technology’s WACC is presented in Exhibit 8.11 to illustrate several of the concepts within this section. The cost of equity used in the WACC calculation is an
average of the amounts derived from the build-up method and the CAPM. The cost of debt is a
market rate for debt with a similar credit rating, adjusted for the tax benefit. Finally, the capital structure is an industry average for similar-sized companies. Thus, the WACC is calculated
from the perspective of a market participant.
Weighted Average Cost of Capital Calculation
◾
255
EXHIBIT 8.11 Titan Technology, Inc., as of August 31, 20X1, Weighted Average Cost of
Capital (WACC)
Ten Decile
Analysis
Twenty-Five
Portfolio Rank
Analysis
Risk-Free Rate (Rf)
1.99%1
1.99%1
Market Premium (RPm)
6.90%2
n/a9
Industry Risk Premium (RPi)
2.49%2
1.78%11
Size Premium (RPs)
5.60%3
12.11%10
Company Specific Risk Premium (RPu)
4.00%4
4.00%4
20.98%
19.88%
Ten Decile
Analysis
Twenty-Five
Portfolio Rank
Analysis
Risk-Free Rate (Rf)
1.99%1
1.99%1
Beta (β)
1.058
1.058
Market Premium (RPm)
6.90%2
4.93%12
Size Premium (RPs)
5.60%3
5.42%10
Company Specific Risk Premium (RPu)
4.00%4
4.00%4
ke =
Modified CAPM Method, Cost of Equity: Ke = Rf + ( b x RPm ) + RPs + Rpu
ke =
18.84%
16.34%
Range of ke =
16.34%
20.98%
Concluded ke =
19.00%
After Tax Cost of Debt: kd = Kb(1-t)
Borrowing Rate (Kb)
6.00%5
Tax Rate (t)
26.00%6
kd =
4.44%
Weighted Average Cost of Capital (WACC)
Capital
Structure7
Equity
90.00%
Debt
10.00%
Weighted
Cost
19.00%
Cost
17.10%
4.44%
0.44%
WACC =
17.54%
Rounded =
18.00%
Notes:
1 20-Year Treasury Bond as of Valuation Date; Federal Reserve Statistical Release as of the valuation date.
2 Duff & Phelps 20X1 Valuation Handbook: Guide to Cost of Capital
3 Duff & Phelps 20X1 Valuation Handbook: Guide to Cost of Capital (Long-Term Returns in Excess of CAPM Estimations
for the 10th Decile Portfolio of the NYSE/AMEX/NASDAQ).
4 Based on discussions with Management and analysis of similar stage investments.
5 LIBOR plus 5% (proxy for marginal borrowing rate).
6 Estimated corporate tax rate.
7 Based on an analysis of guideline companies and the industry.
8 Based on the leverage adjusted beta for the guideline public company and relevered for the Company’s optimal
capital structure.
9 Market Premium, Duff & Phelps included as part of the size-specific equity risk premium.
10 Size-specific equity risk premiums over CAPM are based on comparison of the Company to risk premium groups
presented in the Duff & Phelps Risk Premium Report 2016 (Smoothed Average Premium over CAPM).
11 Market Premium, Duff & Phelps Risk Premium Report 20X1.
256
◾ The Income Approach
Venture Capital Rates of Return
An alternative way of determining an early stage entity’s overall cost of capital is to use venture capital rates of return as a proxy for equity investor’s required rate of return as there is
often considerable risk and uncertainty associated with the products and target earnings for
venture capital investments. This approach may also be appropriate for entities in high-risk
industries or those with unproven technology, products, or operations. Venture capital rates
may be the most appropriate comparable rates available when estimating the discount rate to
apply to the anticipated cash flows of a high-risk entity.
Two early, ground-breaking studies about the cost of capital for early-stage and high-risk
investments were the QED Report on Venture Capital Financial Analysis, published in 1987 by
QED Research, Inc., and A Method for Valuing High-Risk Long Term Investments: The Venture
Capital Method, published in 1987 by the Harvard University Business School Press.
Although it is a bit dated, the QED Report was a widely used source of data for determining an appropriate discount rate for investments in venture capital companies. The QED study
is relatively comprehensive and includes information supplied by hundreds of venture capital investors.36 For each stage in a start-up company’s development, the report provides a
range of required returns on investment. The QED study describes the stages that an entity goes
through from start-up to harvest through an IPO or acquisition by another entity. Although
the data is dated, the report is still relevant to understand the relationships between an entity’s
stage of development and the relative required return that an investor might demand.
Start-up. Start-up investments are typically less than one year old. A start-up entity initially needs capital for product development, prototype testing, and test marketing (in
experimental quantities to selected customers). This stage covers studying potential market penetration, bringing together a management team, and refining the business plan.
The required rate of return for the start-up phase would be quite high, between 50 percent
and 70 percent.
First stage. Investment proceeds through the first stage if prototypes are successfully developed and technical risk is considered minimal. Likewise, market studies must indicate that
the product is viable and potentially profitable. The entity must have a modest manufacturing facility capable of producing and shipping the product in commercial quantities.
First-stage entities are unlikely to be profitable; therefore, they would have a required
return in the 40 percent to 60 percent range.
Second stage. A second-stage entity has shipped product to customers and has received
real feedback from the market. Management is beginning to understand the time frame
required to access markets but may not fully know the limits to potential market penetration. The entity is probably still unprofitable, or only marginally profitable. It probably needs capital to finance equipment purchases, inventories, and receivables financing.
An appropriate required rate of return would be between 35 percent and 50 percent.
Third stage. Third-stage companies experience rapid growth in sales and positive profit
margins. Downside investment risk is minimal. However, rapid expansion means more
working capital is required than can be generated from internal cash flows. New venture
capital investments would be used for the expansion of manufacturing facilities, expanded
Weighted Average Cost of Capital Calculation
◾
257
market reach, or for product enhancements. At this stage, banks may be willing to supply
credit to the extent that fixed assets or receivables can secured it. Although credit may be
more available at this stage, the required rate of return is still quite high in the 30 percent
to 50 percent range.
Fourth stage. Entities at the fourth stage of development may still need outside cash to
sustain rapid growth, but they are successful enough and stable enough so that the risk to
outside investors is significantly reduced. The owners may prefer to finance growth with
debt in order to prevent the dilution of their equity ownership. Commercial bank credit
will play a more important role. Although the goal of many venture capital investors is to
harvest their investment through a sale, public offering, or leveraged buyout, the timing
of the potential cash-out for stage-four venture capital investors is still uncertain. A drop
in the required rate of return to between 30 percent and 40 percent would be indicative
of this stage of development.37
The Harvard Study recognizes the same stages of development and reaches similar conclusions about appropriate rates for each stage of investment. The Harvard Study notes that
venture capital rates of return are extremely high, especially when compared to historical
returns realized on a variety of other investments, including stocks, real estate, foreign stocks,
and gold. The Harvard Study cites several reasons for the high rate of return required by venture capitalists, which are still relevant.
Venture capitalists perceive a high level of systematic risk associated with venture
capital investments. Their investments are particularly vulnerable to market conditions
when the time comes to liquidate the investment through a public offering or buyout by a
larger company. Venture capitalists expect to receive a higher return to compensate for this
high level of systematic risk. Another factor contributing to a venture capital investment’s
risk and high required return is its illiquidity. Venture capital investments are often private
companies with legal restrictions on the sale of their unregistered securities. Information
about these companies is limited and the pool of potential buyers is small. A premium is
needed to compensate for the illiquidity associated with venture capital investments. Another
theory is that venture capitalists expect to be compensated for providing services to the
portfolio company. A typical venture capitalist is an active investor who provides expertise
and oversees management of the company. The return premium compensates the venture
capitalist for the value he adds. The final reason cited by the Harvard Study for the high
venture capitalist risk premium is that the return on a successful venture capital investment
is offset by losses on other unsuccessful investments. Only about 25 percent of venture capital
investments meet or exceed their forecasts. The venture capitalist expects this outcome.
The high-risk premium is demanded to compensate for the fact that earnings forecasts
are often unmet.38
Although the Harvard Study and the QED Study can be used by a valuation specialist to
understand relative required rates of return for various stages of company development and
the reasons that investors require those returns, other sources provide more recent data. The
AICPA’s Accounting and Valuation Guide: Valuation of Privately-Held-Company Equity Securities Issued as Compensation includes an appendix that provides information about venture
capital rates of return. Its Appendix B provides a range of recent returns based on a study by
258
◾ The Income Approach
Venture Economics with data through December 31, 2002, and a study by Thomson Reuters
with data through December 31, 2008. The selection of these timeframes is intended to illustrate that rates of return vary significantly over a market cycle. The data also illustrates the
relationship between the stage of development and the rate of return. The AICPA chart is
reproduced as follows:
5-Year Return
Type of Fund
2002
2008
10-Year Return
2002
2008
20-Year Return
2002
2008
Seed stage
51.4%
3.0%
34.9%
25.5%
20.4%
22.1%
Balanced
20.9%
7.5%
20.9%
12.0%
14.3%
14.6%
Later stage
10.6%
8.1%
21.6%
7.3%
15.3%
14.7%
All ventures
28.3%
5.7%
26.3%
13.4%
16.6%
17.2%
Pepperdine University’s Graziadio School of Business and Management publishes an
annual Private Capital Markets Report that is available online. The report is a survey of senior
lenders, asset-based lenders, investment bankers, business brokers, limited partnerships,
and business appraisers that provides information by private capital market group about
benchmarks that must be met for investors to qualify for capital, how much capital is
accessible, and what the required returns are for accessing capital.
For example, the 2017 report indicates that private equity groups have a median required
return of 27.5 percent for investments in entities with $1 million in EBITDA and a median
required return of 20.5 percent for entities with $100 million in EBITDA. Similarly, venture
capital firms have a median required return of 35 percent for seed stage investments and a 25
percent median required return for later stage companies. At over 100 pages in length, the
Pepperdine Private Capital Markets Report provides a wealth of information about all facets of
the private debt and equity markets on an annual basis.
Thus, the valuation specialist should determine which stages of development the entity
has passed through. The current stage of development will indicate an approximate range of
returns that a hypothetical investor would expect for investing in a developing entity at that
particular stage. The rate would be refined after considering the specific risk characteristics of
the subject entity as of the measurement date.
CONCLUSION
The income approach is one of the three basic valuation techniques described in ASC 820
to measure fair value. The income approach measures fair value as the present value of the
expected future cash flows that the entity generates or an intangible asset generates as part of
an entity discounted for the risk of receiving those cash flows. The income approach provides
a great deal of flexibility in measuring the fair value of an entity or a specific intangible asset
in an entity. However, the reliability of the value derived from an income approach method is
dependent on the quality of prospective financial information used in its development.
Notes
◾
259
NOTES
1. Master Glossary, Financial Accounting Standards Board (FASB), Accounting Standards Codification (ASC), www.fasb.org.
2. FASB ASC 820-10-55-3G.
3. International Glossary of Business Valuation Terms (International Glossary), www.aicpa.org,
accessed August 24, 2017.
4. “Valuation of Intangible Assets for Financial Reporting Purposes,” BV 301, American Society
of Appraisers Course.
5. Application of the Mandatory Performance Framework for the Certified in Entity and Intangible
Valuations Credential, Corporate and Intangibles Valuation Organization, LLC, 2017, 5–6.
6. International Glossary.
7. The Appraisal Foundation, Best Practices for Valuations in Financial Reporting: The Identification of Contributory Assets and the Calculation of Economic Rents, May 31, 2010, www
.appraisalfoundation.org.
8. Gary Trugman, “Evolution of Business Valuation Services,” A CPA’s Guide to Valuing a Closely
Held Business AICPA, www.fvs.aicpa.org, accessed May 17, 2009.
9. AICPA Accounting & Valuation Guide: Assets Acquired to be Used in Research and Development (2013).
10. “Valuation of Intangible Assets for Financial Reporting Purposes,” BV 301, American Society
of Appraisers Course, 448–454.
11. FASB ASC 805, Business Combinations (SFAS 141(R)), paragraph 3k.
12. Use of Residual Method to Value Acquired Assets Other Than Goodwill, Topic No. D-108, EITF
Discussion Dates: September 29–30, 2004, www.fasb.org.
13. Id.
14. FASB Master Glossary.
15. FASB ASC 820-10-35-9.
16. Id.
17. FASB ASC 820-10-35-54A.
18. “Valuation of Intangible Assets for Financial Reporting Purposes,” American Society of
Appraisers Course BV301, 422.
19. FASB ASC 350, Intangibles—Goodwill and Other (SFAS No. 142), paragraph 11.
20. The Appraisal Foundation, Contributory Assets, paragraphs 3.5.05–3.5.07.
21. Id., paragraph 2.2.07.
22. Id., paragraphs 3.4.06–3.4.08.
23. Id., paragraphs 3.4.10–3.4.11.
24. Statement of Financial Accounting Concepts No. 7, Using Cash Flow Information and Present
Value in Accounting Measurements, www.fasb.org.
25. Id.
26. FASB ASC 820-10-55-13 to 19.
27. The Appraisal Foundation, Contributory Assets, paragraphs 4.2.05–4.2.09.
28. Richard Razgaitis, Valuation and Pricing of Technology-Based Intellectual Property (Hoboken, NJ:
John Wiley & Sons, 2003), 151.
29. Jody C. Bishop, “The Challenge of Valuing Intellectual Property Assets,” Northwestern Journal
of Technology and Intellectual Property 1, no. 1 (Spring 2003).
30. Simon Rowell, “Strategic Tips for Adding Value to Licensing Transactions,” Current Partnering,
www.currentpartnering.com/articles/1488, accessed June 15, 2009.
260
◾ The Income Approach
31. Jonathan E. Kemmerer, and Jiaqing Lu, Profitability and Royalty Rates Across Industries: Some
Preliminary Evidence, 2012 KPMG International, kpmg.com, accessed December 1, 2017.
32. R. Goldscheider, J. Jarosz, and C. Mulhern, “Use of the 25 Per Cent Rule in Valuing IP,”
les Nouvelles (December 2002):123–133.
33. Shannon P. Pratt and Roger J. Grabowski, Cost of Capital: Applications and Examples, 4th ed.
(Hoboken, NJ: John Wiley & Sons, 2010), 189.
34. Id., 95–98
35. 2017Valuation Handbook: US Guide to Cost of Capital, Duff & Phelps.
36. QED Report on Venture Capital Financial Analysis, QED Research, Inc., 1987.
37. Id.
38. Daniel R. Scherlis and William Sahlman, A Method for Valuing High-Risk, Long Term Investments: The Venture Capital Method (Boston: Harvard Business School Publishing, 1987).
9
C HAPTE R N IN E
Advanced Valuation Methods for
Measuring the Fair Value
of Intangible Assets
INTRODUCTION
B ES T PRAC TIC ES FOR MEASU RI NG the fair value of intangible assets continue to evolve.
Professional organizations such as the American Institute of Certified Public Accountants
(AICPA), the American Society of Appraisers, and the Appraisal Foundation have taken the
lead in providing best practice guidance. The guidance extends to fair value measurement
of intangible assets in financial reporting. Because of the unique nature of intangible assets,
advanced financial theory can be applied to their fair value measurement.
Advanced valuation techniques such as option-pricing methods, Monte Carlo simulations, and decision tree analysis are becoming more accepted as reliable tools for measuring
the value of intangible assets. These methods may also be useful in measuring the fair value
of contingent assets, contingent liabilities, and contingent consideration in a business combination. The purpose of this chapter is to explain several advanced methods for estimating
fair value, particularly those methods that can be used in measuring the fair value of certain
identified intangible assets.
LIMITATIONS OF TRADITIONAL VALUATION METHODS
Previous chapters describe traditional valuation methods under the cost, market, and
income approaches that are commonly used to measure the fair value of intangible assets in
261
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
262
◾ Advanced Valuation Methods for Measuring the Fair Value of Intangible Assets
financial reporting. Although each of these methods is theoretically sound and widely
accepted, they have limitations.
As discussed in Chapter 6, cost-approach methods may be limited because they often do
not capture the opportunity costs and profit associated with measuring fair value. Also, costapproach methods may not fully capture the risk of developing a particular asset. Additional
adjustments may have to be made to capture these factors.
Chapter 7 discusses the market approach, including its limitations. One salient issue in
using market approach methods to measure fair value is that information about guideline
intangible assets may be limited. Even if relevant information exists, it is often necessary to make adjustments to increase comparability between the guideline and subject
intangible asset.
The application of FASB Concepts Statement No. 7, Using Cash Flow Information and
Present Value in Accounting Measurements (CON 7), to fair value measurements is discussed
with income approach methods in Chapter 8. One of the more significant limitations is
that the discounted cash flow (DCF) method traditionally uses most likely cash flows from
management’s prospective financial information (PFI) as the basis for the analysis. The most
likely future cash flow scenario is discounted to the present at an adjusted rate of return
that reflects the uncertainty associated with the receipt of the cash flows. The most likely set
of prospective cash flows and the required return are static, meaning that the PFI does not
provide for future changes in assumptions once additional information becomes known.
The static assumptions in a traditional DCF reflect normal, noncontingent PFI expectations as of the measurement date. Although a traditional DCF model is appropriate in many
circumstances, it may be inappropriate in other circumstances because it fails to consider all
of the factors that impact fair value. First, in the real world, cash flows are not static over
the time horizon covered by PFI. Management receives information and makes decisions on a
daily basis that impact cash flows. Second, uncertainty and risk are reduced with the passage
of time as management receives information that either confirms or contradicts expectations.
Over time, management is better able to optimize future decisions as more information
becomes known. Management’s flexibility to react to incoming information when making
decisions has a positive impact on the entity’s value over time. For example, certain companies employ a second to market business strategy in which the company relies on a competitor
to develop and introduce a product. The company will wait to see whether the market accepts
the product before making a decision to invest in a similar product.
This strategy can have advantages because the commercialization of a technology is capital intensive and risky. The competitor assumes all the risks of achieving market acceptance.
The company will have insight about the market’s positive and negative perceptions of the
product before it decides to undertake the development and commercialization of a similar
product. The disadvantage of this strategy is that the initial product may have such overwhelming acceptance that future products have difficulty obtaining a foothold in the marketplace. The second-to-market strategy is common in the computer industry when manufacturers of desktop and laptop computers add new features in response to market acceptance
of competitors’ innovations.
Flexibility in management decision making gives management the right, but not
the obligation, to pursue the commercialization of a product. Having the right but not the
Real Options
◾
263
obligation to do something is similar to owning a financial option on an underlying share
of stock. A financial option gives the holder the right, but not the obligation, to buy (or sell)
an underlying financial instrument. A call provides the option holder the right to buy the
underlying equity shares at a certain price over a certain period of time. Conversely, a put
provides the option holder the right to sell the underlying equity shares at a certain price over
a certain period of time. The principles underlying the valuation of financial options can be
extended and applied to situations where management’s decision-making flexibility impacts
the value of an intangible asset.
REAL OPTIONS
Real options are often derived from the ownership rights of intangible assets; therefore,
intangible assets are sometimes referred to as real options. They have many of the same
characteristics as a financial option, including the right but not the obligation to do something. Options methodologies have the potential to capture the value created from this
decision-making flexibility. Advanced valuation techniques such as option-pricing models
can be used to estimate the fair value of certain intangible assets whose value is derived
from, and therefore contingent on, actions by management. This methodology is sometimes
referred to as a “real” option because the methodology measures the value resulting from
specific operating decisions, rather than financial decisions. Real option valuation methods
can be used to measure the fair value of certain intangible assets.
Although the application of options valuation techniques to assess the impact of managerial decision making is a relatively new topic in financial theory, its acceptance is becoming more widespread. The advantage of these methodologies is that they utilize models that
more accurately reflect real-world decision making. Option pricing methodologies cannot only
be used to quantify the additional value created from flexibility in decision making but they
are useful tools for assessing the economic impact of contingent events. These techniques are
applicable to the valuation of capital investments, specific tangible and intangible assets, to
liabilities, and to the entity itself. Options valuation techniques are likely to assume a more
prominent role in the measurement of fair value for financial reporting purposes in the future.
Option Basics
An option1 is a contract that gives the owner the right to buy (or sell) an underlying asset from
(to) the counterparty to the contract, at a certain price over a certain period of time. The option
contract creates a right but it does not impose any obligation to buy or sell the underlying
asset. Calls and puts, described in the previous section, are the most common types of options.
Options are considered derivative securities because the value of the option is derived from
the value of the underlying asset. Options are also considered contingent claims because the
value of the option is contingent on the underlying asset achieving a certain benchmark value.
The benchmark value is known as the exercise price. If the underlying asset fails to meet the
exercise price, the option is worthless. The value of financial options is derived from the market
prices of the underlying financial instruments or securities.
264
◾ Advanced Valuation Methods for Measuring the Fair Value of Intangible Assets
The value of an option is equal to the sum of its intrinsic value and its time value. The
intrinsic value is equal to the difference between the price of the underlying share of stock
and the exercise price of the option. Assume that an entity owns a call option on one share
of PublicCo with an exercise price of $75 per share that expires in six months. If PublicCo is
trading at $80 per share, then the intrinsic value of the call option is $5 per share. However,
the intrinsic value is not necessarily the fair value of the option. If the option itself is publicly
traded, then its fair value is most likely equal to the option’s market price. The fair value of the
option may be greater than its intrinsic value. This is most often the case when the option has
a significant length of time before its expiration date. The value in excess of the intrinsic value
is due to the time value of the option.
Suppose the entity wished to exercise the call option. The entity would have to pay the
$75 exercise price to the option counterparty, and it would receive one share of stock from
the counterparty. If the stock has a market value of $80, the entity would earn a profit of
$5. However, the entity has six months to decide whether to exercise the option. It is possible
that the price of the underlying share could increase even further, increasing the entity’s
profit. The value of the option related to the ability to wait to exercise the option is the time
value of the option. Typically, options trade at a price higher than their intrinsic value when
there is time remaining before the option expires. The difference between the market value
of the option and its intrinsic value decreases as the measurement date approaches the
expiration date.
There are three factors that determine the time value of an option: (1) the volatility of the
option, (2) the risk-free interest rate, and (3) the amount of time remaining until the option
expires. Evaluating these three time value factors and the two intrinsic factors (the underlying
share price and the exercise price) will provide sufficient information to determine the option’s
fair value.
For publicly traded stocks, the underlying share price is equal to the closing price on the
option’s measurement date. If the underlying shares are restricted shares, then the closing
price must be adjusted for their lack of marketability. If the shares are in a privately held or
thinly traded company, the value of the underlying shares is measured using one of the three
traditional approaches to value (cost, market, and income approaches). Option-pricing models
assume that the underlying share price is the same whether the stock is being bought or sold.
The underlying share price is not necessarily a bid or ask price. Option-pricing models also
assume that an unlimited number of shares can be bought or sold at the prevailing stock price
without impacting the market price of the stock.
The exercise or strike price is the option’s contract price. In the case of a call option, it is
the price that the option holder can pay in exchange for the underlying shares of stock. In a
put option, the exercise price is the amount of money that the option holder can receive in
exchange for the underlying shares of stock. The intrinsic value of a call option is the underlying stock price minus the exercise price. If the underlying stock price is less than the exercise
price, the option holder would have no reason to exercise the option. In that case, the option
would be worthless. The intrinsic value of a put option is the exercise price minus the underlying price. If the exercise price is less than the underlying stock price, the option holder would
have no reason to exercise the option and it is worthless.
Real Options
◾
265
The time remaining until expiration is the time from the option measurement date to the
expiration date. In a financial option pricing model, the time remaining until expiration is
expressed as a fraction with the number of days remaining until expiration in the numerator
and 365 days in the denominator. Options pricing models are based on a 365-day year, as
opposed to most financial models, which round to 360 days.
Volatility in a financial option is equal to the expected standard deviation of the underlying stock over the period of time until the option’s expiration. As volatility increases, it is more
likely that the price of the underlying stock will exceed the exercise price. Therefore, as volatility increases, so does the value of a call option. Similarly, as volatility increases it is more likely
that the price of the underlying stock will be less than the option’s exercise price. Therefore, as
volatility of the underlying stock increases, so does the value of a put option.
When measuring the fair value of an option, volatility is calculated as the standard deviation of the underlying shares. Standard deviation is calculated for a period of time just before
the measurement date. That period of time would be equal to the number of days between the
measurement and expiration dates. For example, if the option has 30 days to expiration, then
the standard deviation of the underlying shares is calculated for the 30 days just prior to the
measurement date. Volatility experienced just prior to the measurement date is expected to
persist over the next 30 days. However, if the option has a long-term expiration, then using
volatility from a previous period may not be appropriate. If recent share prices reacted to some
condition that is not expected to continue in the future, then recent volatility would not be
representative of future volatility expectations. The standard deviation should be adjusted to
reflect expectations for future performance when past experience is not considered relevant.
If the option’s underlying shares are in a privately held or thinly traded company, then
the implied volatility from publicly traded stock options of comparable companies can be used
as a proxy. The implied volatility in publicly traded options can be calculated by solving for
volatility using the Black-Scholes Options Pricing Model (discussed later in this chapter). The
resulting measure of volatility represents the market’s assumption about the volatility of the
underlying shares of the publicly traded options.
The average volatility of guideline companies can also be used as a proxy for privately
held companies. When using a group of guideline companies within the same industry as a
proxy, caution should be exercised before drawing conclusions about the volatility of a single
company based on the standard deviation of the guideline companies. For example, in modern portfolio theory, the standard deviation of the portfolio will reflect the diversification of
the stocks in the portfolio and will likely result in a lower measurement of volatility than the
average of the volatilities of individual shares that comprise the portfolio. This same limitation applies to the measurement of volatility in guideline companies. The lower volatility of a
group of comparable companies in the same industry would not be indicative of the anticipated
volatility of an individual stock.
The risk-free rate is the last component of an option’s value. The risk-free rate represents
the opportunity cost of capital assuming that the funds used to purchase the option could
be used productively in other investment opportunities. The risk-free rate is the proxy for the
opportunity cost of capital. A zero-coupon treasury bill with the same maturity as the option
would be an appropriate rate.
266
◾ Advanced Valuation Methods for Measuring the Fair Value of Intangible Assets
USING OPTION PRICING METHODOLOGIES TO VALUE
INTANGIBLE ASSETS
Although option pricing methodologies were originally developed to measure the value of
financial options, they can be used to measure the fair value of intangible assets. Option pricing methods are often better than traditional valuation models based on the cost, market,
and income approaches to measure fair value because they capture the fair value of all the
intangible asset’s elements more fully, particularly the value added by their flexibility. In other
words, the option pricing models are better for estimating the fair value of intangible assets
that have real options. Authors such as Chance and Peterson, and Kodukla and Papudesu,
describe seven types of real options that have potential to add value to specific intangible assets.
The real options described below are seven aspects of managerial decision making related to
intangible assets. These real options may not be captured in traditional valuation methods but
can be captured using option pricing models.
1. Abandonment. Management can choose to abandon a project before significant losses are
incurred. This option is akin to the ability to discontinue an intellectual property research
and development project if it appears the technology is not economically feasible.
2. Expansions. Management can choose to expand a product offering at a later date. This
option is common in high-growth technology companies. For intangible assets, the decision may be whether to incorporate existing developed technology into new products.
3. Contractions. Management can choose to outsource certain functions such as manufacturing a product. For intangible assets, an example of this type of option would be licensing a technology or trade name from another party.
4. Interactions. These are options that are connected to other options. Examples of interacting intangible assets are those that are considered to be in use, such as a trade name,
customer relationships, and technology. They interact with other intangibles to create
value for the entity.
5. Timing of entrances or exits. Value may be created as a result of management’s decision
to wait to make an investment until market conditions become more certain. Waiting
may reduce decision risk. An example of a timing option for intangible assets would be
delaying the introduction of an intellectual property product until market acceptance is
more readily determinable.
6. Flexibility to switch. Management can choose to abandon or expand depending on current
market conditions. Incremental fixed costs can be avoided when a project is abandoned.
And, the ability to abandon a project reduces the risk of a project. Management’s flexibility to change the course of action, or to switch strategies in response to evolving business
conditions, provides a real option that provides value over and above the option to abandon or expand.
7. Barrier option. This is an option in which the decision is made not solely on the underlying asset value but on some other predetermined value. This option may be useful in the
analysis of certain intangible assets such as a favorable lease where the terms may be fixed
contractually. The “barrier” is the contractual obligation under the lease.2,3
Using Option Pricing Methodologies to Value Intangible Assets
◾
267
Using Financial Option Models to Measure the Fair Value
of Intangible Assets
When using financial option models to measure the fair value of intangible assets, the input
parameters must be defined. Exhibit 9.1 shows the inputs to financial option models, the definition of the input parameter as it relates to a financial option, and the definition as it relates
to a real option.
Example of Using Option Pricing Methods to Estimate the Fair Value
of an Intangible Asset
Suppose an entity is in the process of developing a new technology related to voice-activated
cell phones.4 The entity believes that this technology will be embraced as municipalities
increase regulation and fines for the use of cell phones while driving. The entity is budgeting
$2 million to develop the technology, which it estimates will take a year. Once the technology
is developed, efforts to commercialize the technology would begin in the second year. However, because of uncertainties relating to commercialization of the product, management is
uncertain about whether the initial $2 million investment would be recovered and whether
it would generate positive returns.
Management initially calculates the return on the investment based on costs in the
second year. Management is willing to incur the costs to develop the technology but is
uncertain about incurring the costs for commercialization of the technology. The costs of
commercialization are dependent on the degree of success achieved from the technology
development phase. Management believes that the cost of commercialization will fall into one
of three scenarios. In the first scenario, commercialization would cost $10 million because the
technology development would result in exclusive rights and widespread use of the technology. In the second scenario, commercialization would cost $2 million because of nonexclusive
EXHIBIT 9.1
Comparison of Financial Options to Real Options
Input
Parameter
Financial Option
Real Option or Intangible Asset
S
The price of the underlying share of
stock
The present value of the cash flows from
the intangible asset
X
The strike or exercise price of the option
The present value of the opportunity cost
from either the delayed capital
expenditure or future cost savings
R
The risk-free rate of interest that most
closely matches the time horizon of
the option
The risk-free rate or interest that most
closely matches the time horizon of the
decision
Σ
The volatility of the underlying share of
stock
A proxy for the relative volatility of the
intangible asset
T
Time to expiration of the option
The expected duration of the time period
for the decision (i.e., expand, abandon)
268
◾ Advanced Valuation Methods for Measuring the Fair Value of Intangible Assets
rights to the technology and competing products. In the final scenario, commercialization
would cost nothing because the entity would be unable to develop a viable technology.
The probabilities of the scenarios are 30 percent, 60 percent, and 10 percent, respectively.
The cost of commercialization is a probability weighted average of the outcomes from the three
scenarios, discounted from the second year back to the present. Assuming a 5 percent discount rate, management’s analysis indicates the costs of developing and commercializing the
technology would be equal to the $2 million initial cost to develop the technology plus the
probability weighted average of the outcomes discounted at 5 percent, or:
$2,000, 000 + ((.30 × $10, 000,000) + (.60 × $2, 000,000) + (.10 × $0)∕1.05)
= $2,000, 000 + ((3,000, 000 + 1, 200, 000 + 0)∕1.05)
= $2,000, 000 + (4,200, 000∕1.05)
= $2,000,000 + 4,000,000
= $6,000,000
Since management has already decided to invest $2 million to develop the technology,
the development costs are considered sunk costs, and the only relevant costs in the commercialization decision are the costs that would be incurred in the second year. Management has
the luxury of waiting until the end of the first year to make a decision about investing in the
commercialization of the technology.
Assume the revenues from the commercialization of the technology are estimated to be
120 percent of the commercialization cost. If the commercialization of the technology is wildly
successful, then the return would be much greater than it would be under the scenario with
competition. Under the unsuccessful technology development scenario, there is no commercialization investment and, therefore, no return. The increase in revenue would be $12 million
if the technology is widely successful, $2.4 million if there is competition, and $0 if the technology is not successful. The present value of the expected revenue is $4.8 million, calculated
as follows:
Incremental Revenue
Probability
Expected Revenue
$12,000,000
30%
$3,600,000
2,400,000
60%
1,440,000
$0
10%
0
$5,040,000
The present value of $5,040,000 discounted at 5 percent for one year is 5,040,000/1.05
= $4,800,000. The incremental benefit of undertaking just the commercialization investment for the new technology is $4,800,000 less $4,000,000, or $800,000. Although the
return is positive, it intuitively seems that the decision whether to invest is too close to call.
Perhaps something is missing from this particular analysis. Is there additional value that
Black-Scholes Option Pricing Model
◾
269
management can achieve by waiting to decide whether to invest in the commercialization
of the technology? Since management has the right but not the obligation to commercialize
the technology assuming its development is successful, is there additional value that may be
better captured through the use of a real option analysis?
The value of management’s option to wait and decide whether to commercialize the technology can be estimated through real options analysis. The inputs into a real option pricing
model are the same as the inputs when valuing a financial option.
◾
◾
◾
◾
◾
The value of the underlying asset is the incremental $5,040,000 revenue in year 2.
The variance in the asset is expected to be 0.82. The variance is based on using a proxy for
the variance of venture capital investments or the variance of the stock prices of smaller
publicly traded companies, which have one significant technology.
The time to expiration, which is the one-year development time frame.
The exercise price is the $4,200,000 cost of development.
The risk-free rate of return of 5 percent.
Inputting these variables into the Black-Scholes Option Model indicates that the option to
wait a year before deciding to commercialize this product is worth approximately $2 million.
BLACK-SCHOLES OPTION PRICING MODEL
There are two widely used option pricing models: the Black-Scholes Option Pricing Model and
the Binomial Pricing Models, or Lattice Model. Of these two, the Black-Scholes Model is the
more widely used model. It is commonly known simply as the Black-Scholes Model. Developed in 1973 by Fischer Black and Myron Scholes, and expanded on by Robert Merton, the
Black-Scholes Model was the first model to simplify the calculation of an option price. Myron
Scholes and Robert Merton received the 1997 Nobel Prize for their work in developing the
option pricing model.5
The model uses the five key factors just described in pricing an option: (1) the underlying
stock price, (2) the exercise price, (3) volatility of the underlying stock, (4) time to expiration, and (5) the risk-free rate. The Black-Scholes model measures the fair value of European
options. European options are similar to American options except European options can only
be exercised on the exercise date, whereas American options can be exercised any time before,
or on, the exercise date. The Black-Scholes model’s measurement of European options instead
of American options can be thought of as a simplifying assumption. Since American options
are more flexible than European options, they may be worth a little more. Therefore, the value
of a European option can be thought of as a floor value for a similar American option. The
Black-Scholes formula for a European call option is:
V = SN(d1 ) − Xe−r(T−t) N(d2 )
270
◾ Advanced Valuation Methods for Measuring the Fair Value of Intangible Assets
where:
d1
= ln(S/X) + (r + (𝜎 2 /2))(T – t)/ 𝜎 ((T – t)^1/2)
= d1 – 𝜎 ((T t)^1/2)
d2
V
= Value of call option
S
= Market price of underlying stock
X
= Exercise price
e
= Base of natural logarithms
N(d) = Cumulative density function (area under normal curve)
Ln = Natural logarithm
r
= Current risk-free investment/maturity same as expiration of option
T – t = Time to option’s expiration, in years
𝜎
= Standard deviation of the underlying stock
A Black-Scholes model can be accessed through a Microsoft Excel spreadsheet using the
built-in Excel function. In addition, versions of the Black-Scholes models are available for use
from many different sources on the Internet. Many of these Internet sites have expanded the
model to cover the valuation of real options.6 Of course, a bit of caution should be exercised
when using models provided by others. It may be prudent to use two or three versions of the
Black-Scholes model as a cross-check for the results.
Example of a Real Option Measured with the Black-Scholes Options
Pricing Model
Assume Sunrise Corporation (Sunrise) has a patent to develop a product that will harness
wind energy more efficiently than other products on the market. The product is called
Windergy. The product will be developed if the expected cash flows from the product will
significantly exceed the cost of the development. If the costs of development exceed the
expected cash flows, then management can decide to shelve the patent and not incur
any further costs. Therefore, the patent can be viewed as a call option on the underlying
product.
Based on an analysis of the market today, the present value of the cash flows that this
new product is expected to yield is $100 million, before any consideration of the initial
development cost. However, many analysts predict energy prices will rise dramatically within
the next five years. The cost of developing the Windergy for commercial use is estimated to
be $125 million. Sunrise has a patent on the product for the next five years. The current
five-year Treasury bond rate is 3 percent, and the average earnings variance for publicly
traded energy companies is 30 percent. The fair value measurement of the Windergy patent
using the Excel version of the Black-Scholes Options Pricing Model is presented in Exhibit 9.2.
Black-Scholes Option Pricing Model
◾
271
EXHIBIT 9.2 Sunrise Corporation, Valuation of Patents—Black-Scholes Options Pricing
Method, as of December 31, 20X0
(USD$)
Assumptions
Current Patent Value (Present Value of Expected Cash Flows)
$ 100,000,000
Cost to Develop (Exercise Price)
125,000,000
Volatility
30%
Risk-Free Rate
3%
Time to Expiration of Patent
5 years
Exercise Price
$ 125,000,000
Years to Expiration
5
Days to Expiration
1,825
Volatility
30%
Risk-Free Rate—r
3.00%
d1 (1)
0.2264
N(d1 )
0.5895
N(–d1 ) or [1 – N(d1 )]
0.4105
d2 (1)
(0.4444)
N(d2 )
0.3284
N(–d2 ) or [1 – N(d2 )]
0.6716
Quarterly Dividend Rate
–
Dividend Yield
#VALUE!
Call Value (2)
$ 23,626,720
Notes:
1 N(d) = Cumulative density function (area under the normal curve) and d and d is as follows:
1
2
d1 =
ln(Market price/Exercise price) + (r + (Volatility2∕2 )) ∗ years to expiration
Volatility ∗ (years to expiration)1∕2
d2 = d1 − ((volatility) ∗ (years to expiration)1∕2 )
2 Call Price = Market Price * N(d ) − [Exercise Price * e−r(time to expiration) N(d )]
1
2
Note that the cost to develop the Windergy product is greater than the present value of
the projected cash flow benefits that it will generate. Yet the patent still has value. The real
option value is derived by the possibility that the patent could be used profitably in the future.
The value of the patent is $23,676,720.
272
◾ Advanced Valuation Methods for Measuring the Fair Value of Intangible Assets
BINOMIAL OR LATTICE MODELS
The Black-Scholes Model is widely used because the resulting option price has been shown
to be reliable. When comparing the theoretical option price generated by the Black-Scholes
Model to an actual trading price of a publicly traded option, the Black-Scholes results are
similar to the publicly traded price in most situations. However, the Black-Scholes has some
limitations and it has some simplifying assumptions.
Many financial instruments have complexities that exceed the capability of the model. In
order to deal with more complexity, John Cox, Stephen Ross, and Mark Rubinstein developed
a more robust option valuation model in 1979. Also used to price stock options, their model
became known as the binomial model. The binomial model is similar to a decision tree
where there are only two possible outcomes at each decision node. In spite of the limited
number of outcomes for each period of time, the binomial model is considered more flexible
than the Black-Scholes Model because more decision points or factors can be modeled. The
binomial model’s flexibility is also an advantage when using it to measure the fair value of
intangible assets.
A binomial model is commonly used to price financial options such as calls or puts.7
Binomial models are graphically represented as binomial trees. Exhibit 9.3a shows what a
binomial tree looks like before any of the values have been filled in.
Suuu
Suu
Su
S0
Suud
Sud
Sd
Sddu
Sdd
Sddd
t0
EXHIBIT 9.3a Binomial Tree
t1
t2
t3
Binomial or Lattice Models
◾
273
The valuation date is on the left-hand side of the binomial tree at t0 or time zero. S0 represents the value of the underlying asset on the valuation date, at time zero. At the first branch,
the value of the underlying asset can either go up to Su or down to Sd. Each branch represents
a time interval, or time step. Each node is associated with new values for S, at a specific point
in time (t1 , t2 , etc.). At the next branch, Su can go up to Suu or down to Sud , and likewise Sd can
go up to Sdu or down to Sdd at t2 . One of the model’s simplifying assumptions is that at t2 , the
values of Sud and Sdu are the same.8
The up and down changes in the value of the underlying asset are a result of the asset’s
expected volatility. The volatility factor used in the equations for an up or down move is the
standard deviation of the logarithmic returns for the underlying asset. The volatility factor
must be based on the same time interval as those used in the model. Volatility is represented
by the 𝜎 symbol. A time step refers to the period of time over which one change in underlying
value occurs. Historic returns are often used as the basis for expected volatility. U represents
the upward change in value and D represents a downward change in value.
Each branch of the binomial tree also has a probability associated with it. An underlying assumption of the model is that the probabilities are risk neutral. The symbol for the
risk-neutral probability of an upward movement is Pu, and the symbol for the risk-neutral
probability of a downward movement is Pd . The formulas required to build a binomial
model are:
√
U = eσ T
D = 1∕U
Pu = eRf T − D∕U − D
Pd = 1 − Pu
where
e = log exponential function
𝜎 = standard deviation of the underlying asset’s logarithmic returns
T = the portion of a year in each time step (three months = .25)
Rf = the annual risk free rate9
Example of a Real Option Measured with a Binomial Model
Suppose a movie producer is considering whether to purchase a screenplay. The screenplay
is an adaptation of a recently released novel by a popular crime writer. The producer knows
that the value of the screenplay is primarily dependent upon prospects for the novel’s success.
Owning the screenplay is similar to owning a call option on the movie. If the novel is successful,
the producer can exercise his option to produce the movie. If the novel is unsuccessful, the
producer can choose not to make the movie. The producer will make his decision after the
novel has been in bookstores for one year.
274
◾ Advanced Valuation Methods for Measuring the Fair Value of Intangible Assets
The following assumptions are also part of this example. The binomial model input
parameters are in parenthesis, where applicable. Many of these input parameters are similar
to those for financial option models.
◾
◾
◾
◾
◾
◾
◾
◾
◾
◾
The novel was released on January 1, 20X1.
200,000 copies were sold prior to March 31, 20X1. (S0 )
An analysis of recent movies based on books indicates that expected movie revenues are
$100 per copy of book sold in the fourth quarter after the book’s release.
It costs $20 million to produce a crime movie. (X)
The screenplay is being offered for $1 million (C0 ) on March 1, 20X1. (t0 )
The producer will decide whether to invest in the movie on January 1, 20X2. (t3 )
Industry research indicates that the standard deviation of the incremental number of
crime novel copies sold during a quarter using a log scale is 40 percent. (𝜎)
The applicable time frame for the binomial model is three-quarters. Each time step is
one-quarter of a year. (T = 0.25)
The annual risk-free rate is 4 percent. (Rf )
If the movie producer decides not to produce a movie on January 1, 20X2, the ownership
of the screenplay reverts to the author (it is worthless).
In this example, the producer will decide whether to purchase the screenplay for
$1 million. He will make his decision based on the value of the screenplay determined using
a binomial model.
The first step in building a binomial tree is to solve for the upward change (U) and downward change (D) in the number of book copies.
√
√
U = eσ T = e.4∗ .25 = 1.2214
D = 1∕U = 1∕1.22 = 0.8187
The second step is to build the binomial tree by calculating the value of the underlying
asset at each node. Recall that S0 is 200,000 copies. Therefore Su = 200,000 × 1.2214 =
244,280, and Sd = 200,000 × 0.8187 = 163,740. In the next time step, Suu = 244,280 ×
1.2214 = 298,364, and so on. The binomial tree shown in Exhibit 9.3b includes the possible
values for the underlying asset, which are number of book copies in this example. Based on
the calculations in the binomial tree, the number of copies sold in the fourth quarter of 20X2
will be between 109,750 and 364,421.
The third step is to calculate each of the possible options values on the exercise date, which
is December 31, 20X1. There are four possible binomial tree outcomes for S at t3 . Recall that
expected movie revenues are $100 times the number of book copies sold in the fourth quarter
after release, and that it costs $20 million to produce a movie. The value of the screenplay,
assuming 364,421 copies are sold (Suuu ), is $16,442,100 (364,421 copies × $100 less $20
million). Likewise, if 244,720 (Suud ) copies are sold, the screenplay value is $4,427,000.
At (Sddu ), book sales of 163,733 copies indicate that the movie would probably lose
$3,626,700. The producer would decide not to make the movie. In other words, he would
not exercise his option. Therefore, the value of the screenplay is $0 at (Sddu ). At (Sddd ), the
Binomial or Lattice Models
◾
275
Suuu 364,421
Suu 298,364
Su 244,280
S0 200,000
Suud 244,270
Sud 199,992
Sd 163,740
Sddu 163,733
Sdd 134,054
Sddd 109,750
t0
t1
t2
t3
March 31, 20X1
June 30, 20X1
Sept. 30, 20X1
Dec. 31, 20X1
EXHIBIT 9.3b Binomial Tree with Underlying Values
movie would lose even more money. The value of the screenplay is also $0 at this node. It is
important to note that the option decision is made on the exercise date at t3 , and at no other
time in this analysis.
At this point, the terminal call option values (C’s) at t3 can be added to the binomial tree.
They are displayed directly underneath the S values. (See Exhibit 9.3c.)
The last step is to work backward from the option values at t3 , to find the option value at
t2 , and to keep working backward to t0 . To do so, the risk-neutral probability formulas Pu and
Pd for an upward and downward move will be used. The values for Pu and Pd are:
Pu = eRf T − D∕U − D
= e(0.04×.25) − .8187∕1.2214 − .8187
= 1.010 − .8187∕.4027 = .4752
Pd = 1 − Pu = 1 − .4752 = .5258
276
◾ Advanced Valuation Methods for Measuring the Fair Value of Intangible Assets
S uuu 364,421
Cuuu $16,442,129
Suu 298,364
Su 244,280
S0 200,000
S uud
Cuud
244,270
$4,427,027
Sud 199,992
Sd 163,740
S ddu
Cddu
163,733
S ddd
Cddd
109,750
$0
Sdd 134,054
$0
t0
t1
t2
t3
March 31, 20X1
June 30, 20X1
Sept. 30, 20X1
Dec. 31, 20X1
EXHIBIT 9.3c Binomial Tree with Terminal Values
The value of the option at any node is simply the probability weighted average of the up
and down options values in the next time step, discounted at the risk-free rate using a log
function. The formula to calculate the value of the option is:
Ct = ((Pu × Cu,t+1 ) + (Pd × Cd,t+1 ))∕eRf T
The value of the option at node Suu at t2 is the probability-weighted average of the option
values Cuuu and Cuud at t3 , discounted at the risk-free rate using a log function.10 The value
of the option Cuu is $10,035,744, which equals ((($16,442,129 × .4752) + ($4,427,027
×.5248))/1.01). The value of each node in the binomial tree is calculated in a similar manner.
The binomial tree with all the screenplay options values filled in is shown in Exhibit 9.3d.
According to the binomial tree analysis, the value of the screenplay is $3,239,612 on
March 31, 20X1. Therefore, the movie producer will purchase the screenplay for $1 million.
Monte Carlo Simulation
◾
277
S uuu 364,421
Cuuu $16,442,129
Suu 298,364
Cuu $10,035,744
S u 244,280
Cu $5,803,707
S0 200,000
C0 $3,239,612
S uud 244,270
Cuud $4,427,027
Sud 199,992
Cud $2,082,791
Sd
Cd
163,740
$979,894
S dd
Cdd
S ddu
Cddu
163,733
S ddd
Cddd
109,750
$0
134,054
$0
$0
t0
t1
t2
t3
March 31, 20X1
June 30, 20X1
Sept. 30, 20X1
Dec. 31, 20X1
EXHIBIT 9.3d Binomial Tree with Real Option Values
MONTE CARLO SIMULATION
The traditional DCF is a deterministic method, which means there is a single set of assumptions
with one outcome. Monte Carlo simulations are stochastic techniques, which means there are
ranges of assumptions and outcomes. Monte Carlo simulation is useful in measuring fair value
because the simulation allows for more complex scenarios with a greater number of variables
than other valuation techniques.
Monte Carlo simulation is an advanced valuation method that can be used to measure the
fair value of an intangible asset. Monte Carlo simulation is a statistical technique used to calculate the likely statistical distribution of possible outcomes based on multiple simulations, or
trial runs. Each simulation uses random variables generated from statistical distributions of
possible values for each of the variables. The model is also capable of considering correlations
among variables.
278
◾ Advanced Valuation Methods for Measuring the Fair Value of Intangible Assets
Monte Carlo simulation is most commonly used for isolating one assumption, or variable,
and estimating the range of probable outcomes and based on the distribution pattern for that
particular assumption. Commercially available software products such as @Risk from Palisade Corporation and Crystal Ball from Oracle are two of the more widely used products that
are available to run Monte Carlo simulations.11
Using commercially available software to run a Monte Carlo simulation is relatively
straightforward. The first step in the analysis is to identify the assumptions, which are the
input parameters. The assumptions can be growth rates, margin levels, or the remaining
useful life of the intangible asset, to name a few. The second step is to determine the appropriate probability distribution for each assumption or variable. Probability distributions for
assumptions can be a normal bell curve type of distributions, or they can be some other
distribution pattern. Historical data is often used to determine the statistical properties of
assumptions. In the third step, the software will run 1,000 or more times to simulate various
outcome scenarios. Each trial uses a different value for the defined input assumption based
on its statistical distribution in the model. Each trial has a different conclusion, and the
conclusions are statistically summarized. The conclusion of the Monte Carlo simulation is a
distribution of outcomes with a confidence level and with a most likely outcome.
Monte Carlo simulation can be applied to the measurement of fair value for intangible
assets by quantifying uncertainties for assumptions in a discounted cash flow analysis that
may not be captured through the use of a traditional discount rate. For example, when
measuring the fair value of in-process research and development, the eventual unit sale price,
the market demand, selling costs, and many other factors are all unknown. The traditional
DCF makes the most likely assumption for these variables, but in reality they often have a
wide range of possible outcomes. Sometimes assumptions like market demand and selling
costs are interrelated. Monte Carlo simulations can be run for these types of complicated,
interdependent assumption scenarios. Because it has the benefit of incorporating real-world
complexities into assumptions and because it generates a thousand or more possible
outcomes, the analysis is quite robust.
Monte Carlo Simulation Example
Assume that New Ideas, Inc. has a patent with a remaining useful life of six years. A valuation
specialist has been asked to measure the fair value of the patent. Management has provided
information about the company’s market share and the valuation specialist has researched
the U.S. market and appropriate royalty rates. The information is summarized in the top portion of Exhibit 9.4.
The valuation specialist has calculated the net present value of the forecasted cash flows
for the patent. Based on this discounted cash flow model, the valuation specialist estimates
that the fair value of the patent is $1.5 million.
To support this value, the valuation specialist runs a Monte Carlo simulation, which provides a distribution of possible outcomes based on the assumptions input into the model and
on 10,000 trial runs. In this simulation, the valuation specialist achieves a 95 percent confidence level (measured as two standard deviations from the mean) that the net present value
falls within the range of $1.1 million to $2 million. The most likely result is $1.5 million.
The output from the Monte Carlo simulation is presented in the lower portion of Exhibit 9.4
(output from Crystal Ball Software).
k
Trim Size: 7in x 10in
Zyla191230 c09.tex V1 - 11/23/2019 10:41am Page 279
279
EXHIBIT 9.4 New Ideas, Inc., Forecasted Royalty Income—Static View
$ in millions
U.S. Market
Subject IP’s Market Share
Subject IP’s U.S. Sales
Royalty Rate
Forecasted Royalty Income
Net Present Value—Royalty Income
20X1
20X2
20X3
20X4
20X5
20X6
$ 100,000,000
$ 108,000,000
$ 118,800,000
$ 133,056,000
$ 146,361,600
$ 158,070,528
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
$ 5,000,000
$ 5,400,000
$ 5,940,000
$ 6,652,800
$ 7,318,080
$ 7,903,526
6.0%
6.0%
6.0%
6.0%
6.0%
6.0%
$ 300,000
$ 324,000
$ 356,400
$ 399,168
$ 439,085
$ 474,212
$ 1,522,904
k
k
280
◾ Advanced Valuation Methods for Measuring the Fair Value of Intangible Assets
DECISION TREE ANALYSIS
Decision Tree Analysis can also be used to measure the fair value of various intangible assets.
Decision Tree Analysis is easy to understand because it creates a pictorial example of the decision process. The name decision tree comes from its visual resemblance to the branches of a
tree. A decision tree analysis incorporates the discounted cash flows for all possible outcomes
and it assigns a probability to each outcome.
Example of a Decision Tree Analysis
The following example of a decision tree analysis is based on the fictitious company Florida
Coastal Restaurants (FCR). FCR has a secret spice recipe for preparing fresh stone crab that is
currently under development. FCR envisions developing the U.S. market for stone crabs prepared with secret spices by shipping the crabs via overnight delivery. Prior to investing in this
marketing effort, management wants to estimate the value of its secret spice recipe. Since there
are many possible future outcomes, a decision tree analysis is used to measure the value of the
secret spice recipe.
FCR’s management first identifies all the possible outcomes and the probabilities associated with them. Then it calculates the discounted cash flows for each of the possible outcomes.
Management believes that there is a 50 percent chance that its efforts to develop a U.S. market for stone crab prepared with the secret spices will be successful. Management is aware of
another seafood restaurant based in the Northeast that has investigated overnight delivery
for its lobsters. FCR expects successful outcomes and their probabilities to be no competition
(30 percent probability), some competition (50 percent), and limited market acceptance (20
percent). If the project is unsuccessful, any investment made up to that date is lost. Management believes there are two potential unsuccessful scenarios: one in which the project is
abandoned halfway through development (65 percent probability), and another where the
project is abandoned right before it is ready to hit the market (35 percent).
FCR’s management believes that a decision tree analysis would best measure the potential value of the market acceptance of stone crabs prepared with its secret recipe. Analysis of
the potential market indicates expected future cash flows of $5 million assuming little to no
competition, $2.5 million assuming some competition, and $1 million assuming a limited
market for the overnight delivery of stone crab. The first node (reading from right to left in this
particular example) represents the decision whether the secret recipe is successful enough to
market nationwide. Management will have invested $500,000 to develop the secret recipe. If
FCR continues with its marketing plans but abandons the project at later date just prior to
product introduction, FCR will have invested a total of $1 million. After the present value
of the cash flows is measured for each unsuccessful scenario, the resulting cash flows are
multiplied by their respective probabilities. The result of the decision tree analysis indicated
the fair value of the secret recipe as part of a plan to market the stone crabs nationwide is
approximately $1,137,500. Florida Coastal Restaurants’ decision tree analysis is presented
in Exhibit 9.5.
Notes
◾
281
Values estimated using discounted cash flow analysis
$5,000,000 with few competing trade secrets
(30% probability)
$2,500,000 with many competing trade secrets (50%)
$ 2,950,000
50%
$1,000,000 with limited market acceptance (20%)
$ 1,137,500
50%
($500,000) project abandoned soon (65%)
$ (675,000)
($1,000,000) project abandoned late (35%)
EXHIBIT 9.5 Florida Coastal Restaurants, as of December 31, 20X0, Decision Tree Analysis
CONCLUSION
Options valuation techniques can be applied to assess the impact of managerial decisions.
Known as real options, these elements create value by providing management flexibility. Real
options include decisions relating to abandonment, expansions, contractions, interactions,
timing of entrances and exits, flexibility to switch, and barrier options. They are similar to
owning a financial option in that they give the owner a right to pursue a course of action,
but they impose no obligation to do so; therefore, real options often have many of the same
attributes as financial options. Real options are often derived from the ownership rights of
intangible assets, and intangible assets are sometimes referred to as real options.
Valuation methods using advance valuation techniques are being increasingly used to
measure the fair value of certain intangible assets. Models based on advanced valuation theory such as option pricing models or real options, Monte Carlo simulations, and decision tree
analysis can be readily applied to measuring the fair value in financial reporting. These methods may capture elements of value that are inherent in the intangible asset that traditional
valuation methods may not recognize.
NOTES
1. The fair value of financial options is measured in financial reporting under ASC 718. Note
that ASC 718 expressly does not fall under the requirements of ASC 820. The measurement
standard under ASC 718 is considered “fair value like,” but not necessarily as fair value as
defined under ASC 820.
2. Prasa Kodukla and Chandra Papudesu, Project Valuation Using Real Options (Ft. Lauderdale,
FL: J. Ross Publishing, 2006), 101–140.
3. Don M.Chance and Pamela P. Peterson, Real Options and Investment Valuation, The Research
Foundation of the AIMR (Charlottesville, VA: CFA Institute, 2002).
4. Jeffery A. Cohen, Intangible Assets: Valuation and Economic Benefit (Hoboken, NJ: John Wiley &
Sons, 2005), 85–87.
282
◾ Advanced Valuation Methods for Measuring the Fair Value of Intangible Assets
5. Fischer Black had died in 1995 and was ineligible for the award (see Chance and
Peterson, 9).
6. An excellent source of valuation models is Aswath Damodaran’s website, Damodaran Online,
http://pages.stern.nyu.edu/∼adamodar/.
7. John C. Cox, Stephen Ross, and Mark Rubinstein, “Option Pricing: A Simplified Approach,”
Journal of Financial Economics, September 1979, 2.
8. Don M. Chance, Analysis of Derivatives for the CFA Program (Charlottesville, VA: Association
for Investment Management and Research, 2003), 200–207.
9. Kodukula and Papudesu, 74.
10. Id., 79.
11. www.palisade.com/risk/ and www.oracle.com/crystalball/index.html.
10
C HAPTE R TE N
Measuring the Remaining Useful Life of
Intangible Assets in Financial Reporting
E
S T I M ATI N G TH E R E M A I N I N G useful life of an intangible asset is an important
element in measuring the fair value of the asset for financial reporting and disclosure
purposes. The length of the useful life is a significant assumption that has potential
to materially impact the fair value measurement. Intangible assets with longer lives typically
have greater economic returns and higher values than similar, shorter-lived assets. The
useful life of an intangible asset is also the principal factor for selecting the period over which
the intangible asset is amortized.
FASB GUIDANCE ON DETERMINING THE REMAINING USEFUL LIFE
The Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC)
820, Fair Value Measurement, describes the three basic valuation techniques (approaches)
for measuring the fair value of an intangible asset. As discussed in previous chapters, useful
life is a key consideration when measuring fair value using all three techniques. When
measuring fair value using the income approach, the period of time covered by prospective
financial information (PFI) for a specific asset should be equal in length to the asset’s useful
life. Under the market approach, the comparable intangible asset’s useful life is one of the
principle considerations when determining whether the asset is in fact comparable. The
length of time covered by PFI is also a consideration for some market approach methods.
In the cost approach, the useful life of the asset is a consideration when measuring the
obsolescence of the asset.
283
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
284
◾ Measuring the Remaining Useful Life of Intangible Assets in Financial Reporting
FASB ASC 350, Intangibles—Goodwill and Other, provides the following guidance about
the useful life of an intangible asset:
The accounting for a recognized intangible asset is based on its useful life to the
reporting entity. An intangible asset with a finite useful life is amortized; an intangible asset with an indefinite useful life shall not be amortized. The useful life of
an intangible asset to an entity is the period over which the asset is expected to
contribute directly or indirectly to the future cash flows of that entity. The useful
life is not the period of time that it would take that entity to internally develop an
intangible asset that would provide similar benefits. (350-30-35-1 and 2)
ASC 350 also provides examples of factors that can impact the useful life of an intangible
asset for financial reporting purposes. When analyzing the useful life of an intangible asset,
all pertinent factors should be considered; however, no one factor is more indicative than the
other. The FASB’s factors are:
◾
◾
◾
◾
◾
◾
Expected use of the asset by the entity
The expected useful life of another asset or group of assets to which the useful life of the
intangible asset may relate
Legal, regulatory, and contractual provisions that may limit the useful life
The entity’s own historical experience in renewing or extending similar arrangements
regardless of whether those arrangements have explicit renewal provisions
The effects of obsolescence, demand, competition, and other economic factors
The level of future maintenance expenditures required to obtain the expected future cash
flows from the asset (350-30-35-3)
Considering these factors provides guidance when estimating the useful life of an intangible asset, but it must be emphasized that the primary consideration is the period over which
positive economic benefits flow from the intangible asset.
Indefinite-Lived Assets
Certain intangible assets such as trade names, domain names, airport routes, and taxi cab
medallions may not be limited by contractual or other legal limitation, nor limited by economic factors. When that is the case, the intangible asset is considered to have an indefinite
life. An indefinite life asset does not mean the life is perpetual, or that the useful life is indeterminable. It simply means that the life of the asset exists beyond the foreseeable time horizon as
a contributor to the cash flow of the entity.1 The lack of objective information about an asset’s
useful life would indicate that the intangible asset has an indefinite life. Indefinite-lived assets
are relatively rare in financial reporting. Although intangible assets such as trade names seem
to have indefinite lives, a look at Fortune 100 companies from 1980 would indicate otherwise.
Several Fortune 100 companies such as LTV, International Harvester, and Sperry have trade
names that no longer enjoy widespread recognition.2
Considerations in Measuring Useful Lives of Intangible Assets
◾
285
The Useful Life of an Intangible Asset with Renewals
The FASB provided clarifying guidance in ASC 350 about how contracts with renewal clauses
and other contract extensions impact the useful life of an intangible asset. Prior to the issuance
of SFAS No. 142, Goodwill and Other Intangible Assets, in 2001, there was variation in practice
with respect to how renewal provisions for contractual intangible assets were treated when
estimating the asset’s useful life. For example, a one-year contractual customer relationship
with a year-to-year renewed provision covering four additional years created confusion about
whether the one-year contractual life or the five-year extended life should be considered the
intangible asset’s useful life. The guidance from SFAS No. 142, which has been codified in ASC
350, provides clarification about what should be considered when estimating the useful life of
an intangible asset. Of particular significance is that the entity’s own experience and assumptions with respect to renewals or extensions of contractual arrangements can be considered.
ASC 350 describes the process for determining useful life when renewals or extensions
are a factor, as follows. (Subtopic 30, paragraph 35-3 factors are listed in a previous section.)
In developing assumptions about renewal or extension used to determine the useful
life of a recognized intangible asset, an entity shall consider its own historical experience in renewing or extending similar arrangements; however, these assumptions
should be adjusted for the entity-specific factors in subtopic 30, paragraph 35-3 of
ASC 350. In the absence of that experience, an entity shall consider the assumptions
that market participants would use about renewal or extension (consistent with
the highest and best use of the asset by market participants), adjusted for the
entity-specific factors in subtopic 30, paragraph 35-3 of ASC 350.3
The entity must disclose any intent to renew the contractual arrangement that has an
impact on the useful life of the intangible asset. ASC 350 stipulates that “for a recognized
intangible asset, an entity shall disclose information that enables users of financial statements
to assess the extent to which the expected future cash flows associated with the asset are
affected by the entity’s intent or ability (or both intent and ability) to renew or extend the
arrangement.”4
CONSIDERATIONS IN MEASURING USEFUL LIVES
OF INTANGIBLE ASSETS
Assessing the useful life of an intangible asset requires considering several determinants of
useful life. These determinants are independent of one another, so they should be considered
individually when estimating an asset’s useful life. In some situations, these determinants
are interrelated with one another. A conclusion about the most appropriate useful life for the
intangible asset is typically based on the determinant with the shortest remaining useful life.
This results in a more conservative measurement of the intangible asset’s fair value. Common
determinants of useful life for typical intangible assets are provided in the following list.
286
◾ Measuring the Remaining Useful Life of Intangible Assets in Financial Reporting
Determinants to
Consider in Useful Lives
of Intangible Assets
Examples of Application to Intangible Asset
Legal Life of the Asset
Legal life of patents, trademarks, copyrights, and other intellectual
property.
Contractual Life
Contracts with customers, franchise agreements, and favorable leases.
Economic Life
The period of time over which intangible assets, such as developed
technology or trade names, generate a positive cash flow.
Functional and Technological
Obsolescence
Functional obsolescence occurs when the asset is no longer able to
efficiently perform the function for which it was intended. Technical
obsolescence is a type of functional obsolescence caused by advances
in technology. Obsolescence is a consideration for patents.
Analytics
Analytics are a statistical measure of useful life based on actual
historical data. Historical turnover can be used to determine the useful
life of customer relationships.
Legal Lives
The legal life of intellectual property is an important determinant in measuring the fair value
of intangible assets such as patents, trade names, trademarks, copyrights, and other intellectual property. The legal life is the term over which legal protection from competition is
provided. Although national governments have local jurisdiction, legal protection of industrial
intellectual property falls under the World Intellectual Property Organization of the United
Nations (WIPO) as administrator of roughly 20 international treaties and conventions governing intellectual property.
Patents
Patent protection can be granted for inventions, machines, tools, manufacturing processes,
business processes, and new compositions of matter such as new drugs. However, for a patent
application to be successful, several conditions of patentability must be met. First, the subject
matter must be patentable. Examples of subject matter that cannot be patented are discoveries
of materials already in nature; scientific theories or mathematical methods; plants, animals or
microorganisms; schemes, rules, or methods of doing business; and methods of treatment or
diagnostic methods. An important second requirement for patentability is that the invention
must be novel and not anticipated in all prior existing knowledge. And, the inventive step from
previous knowledge cannot be obvious. The patent application must demonstrate industrial
applicability, which means that the invention must have a practical use. Finally, the patent
must be fully disclosed in the patent application. When granted, the legal life of the patent
depends on the type, and is either 14 years or 20 years. After the expiration of the patent, the
invention becomes part of the public domain.
Trademarks5
A trademark is a name, word, symbol, brand name, device, or any combination intended
to be used to identify and distinguish the goods/services of one seller/provider from others
and to indicate the source of the goods/services. The registration process requires the clear
Considerations in Measuring Useful Lives of Intangible Assets
◾
287
identification of the mark and the specific goods and services to which it applies. Registration
of the trademark provides exclusive right to use the mark in connection with specified
goods/services. The registration serves to notify the public that the registrant claims ownership of the mark and it provides a presumption of ownership on a nationwide basis.
In the United States, registration is through the U.S. Patents and Trademark Office. The
life of a trademark is presumed to be perpetual; however, the right must be maintained
through actual lawful use. Rights will lapse if the trademark is not actively used for a
period of five years. In addition, it is the responsibility of the recipient to enforce or defend
the trademark.
Copyrights
A copyright provides legal protection from unauthorized copying of original works of authorship that have been fixed in any tangible medium of expression. In the United States, there are
eight protected categories of expression, including literary works; musical works; dramatic
works; pantomimes and choreographic works; pictorial, graphic, and sculptural works;
motion picture and other audiovisual works; sound recordings; and architectural works.6
Copyrights can be protected through registration. However, under the Berne Convention,
copyrights do not have to be asserted or declared; they exist when the work is created.
Copyrights enjoy the longest legal protection of all intellectual property. A copyright lasts for
the life of the author plus another 70 years. For anonymous works, pseudonymous works, or
works made for hire, a copyright lasts for 95 years after the work’s first publication or 120
years from its original creation. Typically the economic life of copyrighted software is much
shorter than its legal life.
Other Legal Protections7
Industrial design is the creative activity of achieving a formal or ornamental appearance for a
mass-produced item. Industrial design satisfies the need to appeal visually to potential customers and it must perform its intended function efficiently. Registrants must demonstrate
the novelty or originality of the design. Successful registration can provide protection for 10
to 25 years, depending upon the country jurisdiction.
Utility models are mechanical inventions where the inventive step is typically smaller than
what is required by a patent. The legal life depends on the jurisdiction, and is typically shorter
than a patent. Three-dimensional topographies for integrated circuits are protected by World
Trade Organization treaties for 10 years from the first commercial use.
Trade secrets are industrial or commercial secrets that typically do not meet the novelty
requirement to achieve patent status. In some situations the intellectual property may meet
the patentability requirements but the owner may want to avoid disclosing the trade secret in a
patent application. In the United States, the Uniform Trade Secrets Act protects trade secrets;
however, the owner must demonstrate an intention to keep the intellectual property secret.
The owner’s efforts to keep the information secret are considered to be of primary importance
in enforcement litigation. One such mechanism is employment agreements with nondisclosure clauses.
Although the remaining time to the expiration of legal protections is one determinant
of the asset’s useful life, other factors such as the asset’s potential economic benefit should also
288
◾ Measuring the Remaining Useful Life of Intangible Assets in Financial Reporting
be considered. The duration of the asset’s economic benefit is typically shorter than applicable
legal protections, particularly for intangible assets in the technology sector.
Contractual Lives
Contractual lives are similar to legal lives in that both are limited by agreement. A contractual agreement between two parties forms the basis of contractual lives while an agreement
between a government and the registrant forms the basis for legal lives under statutory laws.
Contractual lives can be a determinant of an intangible asset’s useful life, particularly if the
intangible asset ceases to exist at the agreement’s termination. Examples of intangible assets
whose useful life may coincide with its contract life include favorable leases, favorable supplier agreements, and customer contracts. However, all the facts and circumstances relating
to the agreement should be considered, including contract terms, industry practices, and previous arrangements between the parties. As discussed previously, ASC 350 acknowledges that
some contracts are likely to be renewed and permits the use of the entity’s own experience in
measuring the useful life of the intangible asset, including the probability of renewal.
Economic Lives
The economic life of an intangible asset is an important determinant in measuring its useful
life. Economic life is a valuation concept, whereas useful life is an accounting concept. The
economic life is the period over which the intangible asset contributes to an entity’s cash
flows. “While the useful life determination is an entity specific determination, the economic life relates to market participant assumptions contained in a valuation model. The
economic life ends when the discounted cash flows occurring after the economic life are
immaterial to the fair value conclusion.”8 The fair value of an intangible asset is directly
related to its economic life. An intangible asset with a longer economic life will have a higher
fair value than a similar intangible asset with a shorter life.
Economic benefits attributable to a specific intangible asset can be estimated using one of
the methods from the income approach to valuation (Chapter 8). The multiperiod excess earnings method (MPEEM) is particularly useful for this type of economic benefit analysis because
it captures factors that influence the economic benefits derived from the subject intangible
asset. If there is a contractual relationship, the MPEEM cash flows would reflect the length of
the contract and the probability of renewal. If the intangible asset is subject to certain functional or technological obsolescence, the MPEEM cash flows would include incremental costs
associated with maintaining the intangible asset. The MPEEM cash flows reflect benefits and
costs of the intangible asset over its useful life which may differ from its legal or contractual life.
A nuance that should be considered when measuring the economic life of an intangible
asset using the MPEEM is how fixed and variable costs are treated. As a simplifying assumption, many valuation specialists treat all costs as though they are variable costs. This approach
may be appropriate in many circumstances. However, this simplifying assumption tends to
result in longer economic lives than would be indicated if expenses were divided between fixed
and variable costs. The relationship between total operating expense and the company’s cost
structure can be estimated statistically through a simple regression analysis,9 where:
Forecasted Operating Expense
= Total Fixed Costs + (Variable Cost per Unit × #Units of Output)
Practical Guidance for Estimating and Modeling the Useful Life
◾
289
Functional and Technological Limitations
One factor that limits an intangible asset’s useful life is obsolescence. Functional obsolescence
occurs when the intangible asset is not able to perform the function for which it was designed.
Technological obsolescence occurs when the function itself has become obsolete. Various factors, both internal and external to the entity, may cause the intangible assets to become obsolete. Rapid technological change is a common cause of obsolescence that may decrease the
intangible asset’s useful life.
Statistical Analysis (Historical Turnover)
ASC 350 makes clear that it is appropriate to use the entity’s own experience to measure the
useful life of an intangible asset for financial reporting purposes. Statistical analysis of the
entity’s own historical trends is one way to identify the appropriate useful life. For example,
customer turnover is often used to estimate the useful life of customer relationships. Statistical
analysis can be performed using either customer revenue data or customer count data. The
time frame for analysis should be at least as long as the average length of time that current
customers have been customers.
One statistical tool commonly used to measure useful lives of customer-related intangible
assets is a survivor curve. Survivor curves rely on the analysis of two forms of data to measure
useful lives. First, the historical attrition rate of the customer base is measured by comparing
the number of customers that exists at the beginning of the period to the number remaining
at the end of the period. Then, several periods are examined to determine an average attrition
rate over time. The attrition rate is then compared to standard curves and fit to a survivor
curve. The survivor curve is a standard statistical measurement based on observations from
other assets with similar attrition characteristics.
Commercially available statistical software that uses this methodology can be employed
to measure the useful life of a variety of intangible assets. Two common software programs
available for estimating useful lives are the Iowa curve studies and the Weibull function.10
These programs are based on statistical studies that were originally developed to measure the
remaining useful life of fixed assets for tax-reporting purposes. The underlying statistical studies have been used for decades and have achieved widespread acceptance for tax-reporting
purposes. Consequently, these statistical methods are valid for use in measuring useful lives of
certain intangible assets in financial reporting.
PRACTICAL GUIDANCE FOR ESTIMATING AND MODELING
THE USEFUL LIFE
Guideline Useful Lives
Useful life is a market participant assumption; therefore, another way to measure the useful
life of intangible assets is based on useful lives reported by similar market participants. Publicly
available information from SEC Form 10-K filings can serve as useful guidelines to estimate the
remaining useful life of the subject intangible asset. The benefit of this guideline approach is
that useful lives reported in public company filings have received SEC scrutiny.
290
◾ Measuring the Remaining Useful Life of Intangible Assets in Financial Reporting
Useful life information is typically disclosed in three financial statement footnotes: significant accounting policies, intangible assets, and acquisitions. The significant accounting
policies footnote may describe the amortization policy for different types of intangible assets,
including the amortizable life. The intangible asset footnote may provide a table showing the
dollar amount and remaining useful life for each type of asset. It may also be possible to calculate the amortization period based on the gross amount of the intangible and the change in
the accumulated amortization for the year. The acquisition footnote may provide information
about recently acquired companies, including the dollar amount recognized for each category
of intangible asset and the estimated remaining useful life. Each public company discloses
slightly different information in their financial statement footnotes; therefore, information
may be inconsistent from one company to the next.
An example of guideline information for intangible asset’s useful lives can be found in
a recent AT&T’s annual report. Footnote 7—Goodwill and Intangible Assets—describes the
amortization of certain intangible assets based on the asset’s useful lives.
Amortized intangible assets are definite-life assets, and, as such, we record amortization expense based on a method that most appropriately reflects our expected cash
flows from these assets, over a weighted-average life of 8.5 years (9.2 years for customer lists and relationships and 4.2 years for trade names and other). Amortization
expense for definite-life intangible assets was $5,186 for the year ended December
31, 2016, $2,728 for the year ended December 31, 2015, and $500 for the year
ended December 31, 2014. Amortization expense is estimated to be $4,612 in 2017,
$3,573 in 2018, $2,516 in 2019, $2,038 in 2020, and $1,563 in 2021.11
The information contained in this footnote and in the footnotes of other market participants provides a source of information about the useful life of similar assets. A summary of
guideline information similar to the one provided in Exhibit 10.1 can be used as a basis for
determining an appropriate market participant assumption for the useful lives of the subject
company’s intangible assets.
Turnover Analysis
A turnover analysis is most often associated with customer relationships. The subject
company may have an internally prepared analysis of customer turnover. In business combinations, the acquiring company typically prepares an analysis of customer turnover as part of
the due diligence process. Although due diligence information typically tracks turnover rates
for the top 20 customers, this information may not be sufficient to estimate the useful life of
customer relationships. In such cases, supplemental analysis of customer attrition is required.
Customer attrition rates incorporate two factors: the level of growth that comes from existing customers and the level of revenue lost to customer attrition. The analysis of customer
attrition can be prepared using either an aggregate approach or a disaggregated approach.
The Aggregate Approach12
The aggregate approach measures attrition and growth together by measuring the level of revenue attributable to customers on the measurement date. A vintage-year analysis arranges
historical customer date by year, starting with the oldest year (see Exhibit 10.2).
291
EXHIBIT 10.1 Guideline Companies Remaining Useful Lives
NYSE:GFI
Good
Foods, Inc.
NasdaqGS: MCK
McKinney
Foods, Inc.
ENXTPA:GFC
Greenville
Farms Co.
AMEX:PCH
Primicia
Cheese Co.
NasdaqGS: PLP
Pulp
Drinks, Inc.
NYSE:JCK
Jackson
Soups, Inc.
Range
Median
Software
8–10
10
15
13–15
12
7
7–15
11
Databases
13–15
15
12–15
9
10
8–10
8–15
12
Technology
8
10
15
11–14
12–14
13
11–15
13
Trade Secrets
5
8–10
7–10
4
9
6
5–10
7
Trademarks
10
15
30
20
5–8
30
8–30
18
Customer Lists
12
7-9
9
6–9
5
4
4–12
8
Customer Relationships
10
15
12
15
11
13
10–15
13
Distributor Relationships
7
5
3–5
9
3
6
3–9
6
292
◾ Measuring the Remaining Useful Life of Intangible Assets in Financial Reporting
EXHIBIT 10.2 Historical Customer Revenue
Vintage Years
Customer #
20X1
20X2
Current Year
20X3
20X4
20X5
A
70,965
68,674
74,542
76,405
77,932
B
36,254
29,441
35,475
—
—
C
20,425
22,833
21,042
20,621
—
D
7,633
7,710
7,554
7,857
8,093
E
13,182
13,842
—
—
—
F
12,958
—
—
16,846
—
G
32,063
38,025
33,355
31,688
32,320
H
20,412
17,821
21,237
21,874
22,749
I
1,382
—
—
—
—
J
16,197
14,577
—
17,492
17,142
K
13,798
10,523
13,117
13,219
—
L
12,467
9,090
13,352
13,219
—
M
3,884
17,039
4,161
4,243
4,285
N
17,756
11,288
18,655
19,215
19,790
O
6,880
8,948
7,087
7,017
6,735
P
—
19,022
8,395
3,250
5,678
Q
—
—
16,885
18,941
15,551
R
—
—
—
32,115
35,940
S
—
23,684
27,237
28,598
—
T
—
30,128
32,538
32,864
33,850
U
—
—
20,354
—
20,761
V
—
—
—
—
—
W
—
33,345
34,012
—
34,692
X
—
—
8,600
8,771
—
Y
—
—
—
22,618
—
Z
—
—
—
28,481
36,408
$ 286,255
$ 375,990
$ 397,596
$ 425,333
$ 371,928
286,255
269,811
249,575
249,694
189,048
Revenue Loss with Attrition
−5.74%
−7.50%
0.05%
−24.29%
Average
−9.37%
Median
−6.62%
Total Revenue:
Revenue from 20X1 Customers
The starting point is a listing of 15 customer and their related revenues from five years ago.
Each column tracks revenues in subsequent years and it adds new customers. Note that total
revenue by customer should reconcile to total revenues in the income statement. Revenue
for the original 15 customers is calculated each year. Attrition is calculated as the geometric average over the four-year period. In this example, approximately 9.4 percent of customer
revenue is lost each year.
Practical Guidance for Estimating and Modeling the Useful Life
◾
293
EXHIBIT 10.3 Using Historical Revenue Attrition—Aggregated Components
Prior Year Annual Revenue
20X5
20X6
20X7
$ 371,928
$ 337,074
$ 305,486
Aggregate Revenue Attrition
9.4%
9.4%
9.4%
Current Year Annual Revenue
$ 337,074
$ 305,486
$ 276,858
The attrition rate is applied to projected annual revenues from customers existing on the
valuation date. The results exclude revenue growth from new customers, but include revenue
growth from existing customers. (See Exhibit 10.3.)
The Disaggregated Approach
The disaggregated approach uses separate estimates for customer revenue growth rates and
for customer attrition rates. Note that both estimates relate to customers existing on the valuation date, excluding new customers. Although the methodology is different than the aggregate
approach, the results are similar.13 (See Exhibit 10.4.)
Exhibit 10.5 uses the disaggregate approach to analyze customer count data. A disaggregated analysis of customer count examines the number of new customers gained each year
and the number lost. An advantage of using the disaggregated approach for both customer
count and revenue data is that it provides a more robust analysis of the customer base.
Decay Curve
An economic decay curve is a statistical technique used to determine the economic benefits
from an intangible asset. The decay factor is applied to revenues attributable to a certain intangible asset in an MPEEM analysis. It quantifies the portion of economic benefit that is lost each
year with the passage of time. The formula for the decay factor is:
e(period-remaining useful life)
EXHIBIT 10.4 Using Management Provided Revenue Attrition
20X5
20X6
20X7
Prior Year Annual Revenue
$ 371,928
$ 332,727
$ 297,658
Attrition per Management
16.0%
16.0%
16.0%
Growth in Sales from Existing Base
6.5%
6.5%
6.5%
$ 332,727
$ 297,658
$ 266,285
Current Year Annual Revenue
Management Attrition Rate
16.0%
Growth in Sales from Existing Base
6.5%
294
◾ Measuring the Remaining Useful Life of Intangible Assets in Financial Reporting
EXHIBIT 10.5 Analysis of Customer Turnover
Customer Count
20X1
20X2
20X3
20X4
20X5
Average
15
17
18
20
15
18
Customers Gained
n/a
4
3
5
2
Customers Lost
n/a
2
2
3
7
Net Change
n/a
2
1
2
−5
Customers Gained %
n/a
26.7%
17.6%
27.8%
10.0%
Customers Lost %
n/a
−13.3%
−11.8%
−16.7%
−35.0%
−19.2%
Net Change
n/a
13.3%
5.9%
11.1%
−25.0%
1.3%
#DIV/0!
For example, if you assume a remaining useful life of 15 years, the decay factor for the
first year is 0.9355, calculated using the following steps and a calculator with logarithmic
functions: (1) divide 1 by negative 15 to get negative 0.0667; (2) depress the 2nd and the ex
buttons on a logarithmic calculator to get 0.9355. The decay factors for years two and three
are calculated in a similar manner and the results are 0.8752 and 0.8187, respectively.
It is interesting to note that although the remaining useful life is 15 years, revenues
attributable to a particular intangible asset using this decay factor will continue for approximately 30 years. For practical purposes, the economic benefits in the distant future can be
truncated in the analysis because they are immaterial. Typically the economic life is the time
that the intangible has significant positive cash flows under the MPEEM. An example of an
MPEEM showing the application of an exponential decay curve is shown in Exhibit 8.3.
Benchmarking Studies
In 2015, BVResources published the second edition of Benchmarking Identifiable Intangibles and
Their Useful Lives in Business Combinations. It is a compilation of reported data from over 6,000
purchase-price allocations gleaned from public filings. With an emphasis on the useful lives
and the relative allocations of intangible assets, the publication provides useful benchmarking
information by broad NAICS code groupings for a significant number of intangible assets. It
provides overall data slices by identifiable intangible asset category and by industry. The data
slices are average and median useful lives, value as a percentage of total identifiable intangible
assets, and value as a percentage of total intangible assets. Therefore, in addition to providing
insight into an appropriate market participant assumption for useful life, it provides insight
about the overall reasonableness of the allocation of value to the subject entities’ intangible
assets and goodwill.
Useful Life Conventions
Some entities measure useful life using an 80 percent or some other (85 or 90 percent) convention. The useful life is considered to be 80 percent of the intangible asset’s economic life.
Although the convention allows the entity to standardize the measurement, it also gives the
Notes
◾
295
estimate of fair value a conservative bias because the fair value of an intangible asset is directly
related to the intangible asset’s economic life.
Resources
A detailed discussion of applying statistical analysis and survivor curves can be found in the
American Society of Appraisers publication Business Valuation Review, in an article titled “Retirement Behavior and Customer Life Expectancy.”14
CONCLUSION
The determination of an intangible asset’s useful life is an important consideration in measuring the fair value of the asset in financial reporting. Intangible assets with longer lives typically
have greater economic returns than shorter-lived assets, which creates a higher fair value. The
intangible asset’s useful life usually coincides with its financial statement amortization period.
The FASB outlined several determinants that should be considered when measuring the
useful life of an intangible asset. Among these considerations are the entity’s intended use for
the asset, the useful lives of the group of assets with which the intangible may be used, legal or
regulatory constraints on the use of the asset, the entity’s own experience with the asset, the
impact of obsolescence on the asset’s ability to produce economic returns for the entity, and
the level of maintenance required to retain the asset’s functionality.
The useful lives of intangible assets can be measured using statistical analysis of the
entity’s own historical data, which is applied to the expectations of future use. Other statistical
methods such as survivor curves can also be used.
Another method to measure the expected useful life of an intangible asset is to analyze
how other market participants measure the useful life of similar assets. Useful guideline information about how other market participants measure the useful lives of similar assets can
often be found in public filings and benchmarking studies.
NOTES
1. FASB ASC 350-30-35-4.
2. http://money.cnn.com/magazines/fortune/fortune500_archive/snapshots/1980/3547
.html, accessed July 30, 2009).
3. FASB ASC 350-30-35-3d.
4. FASB ASC 350-30-50-4.
5. Trademark Basics, United States Patent and Trademark Office, www.uspto.gov/trademarks,
accessed April 5, 2017.
6. Roman L. Weil, Daniel G. Lentz, and David P. Hoffman, Litigation Services Handbook: The Role of
the Financial Expert, 5th ed. (Hoboken, NJ: John Wiley & Sons, 2012), Chapter 18.
7. WIPO Intellectual Property Handbook, World Intellectual Property Organization, www.wipo
.int.
296
◾ Measuring the Remaining Useful Life of Intangible Assets in Financial Reporting
8. Appraisal Practices Board VFR Valuation Advisory 2: The Valuation of Customer-Related
Assets, The Appraisal Foundation, June 2016.
9. G. William Kennedy, “Using Statistical Measures in BVFLS Engagements,” unpublished
presentation to CPAAI, July 20–21, 2009.
10. William M. Stout, “A Comparison of Component and Group Depreciation for Large Homogeneous Groups of Network Assets,” presentation to the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants, August 28, 2002, www
.aicpa.org/download/members/div/acctstd/general/PPE.pdf.
11. AT&T 2016 Annual report page 60, SEC Form 10-K, filed February 17, 2017.
12. Appraisal Practices Board VFR Valuation Advisory 2, 84–85.
13. Id., 87.
14. Richard K. Ellsworth, “Retirement Behavior and Customer Life Expectancy,” Business Valuation Review 28, no. 1 (Spring 2009): 36–38.
11
CHA P T E R E L E V E N
Fair Value Measurement for
Alternative Investments
INTRODUCTION
Fair value measurement for alternative investments is a topic that received attention from the
Financial Accounting Standards Board (FASB) and the American Institute of Certified Public Accountants (AICPA) shortly after the issuance of the fair value measurement accounting
standards now codified as FASB Accounting Standards Codification 820, Fair Value Measurement (ASC 820). Alternative investments are unregistered investment funds that are classified
as investment companies for financial reporting purposes by the FASB. According to the FASB
Master Glossary:
An investment company is a separate legal entity whose business purpose and activity comprise all of the following:
◾
◾
◾
Investing in multiple substantive investments
Investing for current income, capital appreciation, or both
Investing with investment plans that include exit strategies
The FASB further clarifies that an investment company does not acquire or hold
investments for operating purposes. Investment companies share similar attributes such
as investment activity as the primary business activity, unit ownership, and the pooling
of owners’ funds for management by investment professionals.1 Accounting standards for
investment companies codified in ASC 946, Financial Services—Investment Companies, require
that investments exceeding one percent of assets be reported at fair value.
297
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
298
◾ Fair Value Measurement for Alternative Investments
Investment companies generally fall into two categories: those that are registered with the
Securities and Exchange Commission under Regulation S-X and those that are unregistered.
Alternative investments are unregistered investments such as hedge funds, venture capital
funds, real estate funds, commodity funds, funds of funds, and other similar types of investments. Alternative investment companies typically raise funds from accredited investors, as
defined by the Securities and Exchange Commission (SEC). Accredited investors include institutional investors such as banks, insurance companies, investment companies and pension
funds, and individuals with a high net worth or high annual earnings.2
One of the challenges facing management of alternative investment funds is the appropriate measurement of fair value for financial reporting to the fund’s investors. There are
two salient issues in financial reporting related to the fair value measurements of alternative
investments. The first issue is the fair value measurement of the fund’s investments. These
investments are recorded on the fund’s financial statements as assets. The second issue is the
fair value measurement of the investors’ interests in the fund.
In the past, alternative investment funds reported investments at historic cost and made
adjustments to the cost basis if there was an additional third-party transaction such as an
add-on investment at different cost. The FASB’s accounting guidance for investment companies and fair value measurement significantly changed how investment managers measure
and report the value of their investments. Fair value measurement provides more relevant
information to investors about their investments and they are prepared on a consistent basis.
However, in addition to providing consistent, relevant information, fair value measurement
also creates challenges for the financial reporting of alternative investments.
The FASB and AICPA have both issued specific guidance about applying fair value
measurement to alternative investments. The FASB issued Accounting Standards Update
2009-12, Investments in Certain Entities That Calculated Net Asset Value per Share (or Its
Equivalent) (ASU 2009-12), in September 2009, which is now codified in ASC 820. The
AICPA published Technical Practice Aids Sections 2000.18–.27 (TPA) in December 2009
to provide additional, nonauthoritative guidance to auditors and preparers to help them
implement the FASB guidance in ASU 2009-12 and to provide guidance for measuring the
fair value of alternative investments in situations where ASU 2009-12 is not applicable.
The AICPA has also provided additional accounting technical guidance for measuring fair
value in alternative investments:
◾
◾
◾
TIS Sections 2220.18–28 provide guidance to reporting entities when measuring the fair
value of an interest in a fund that reports net asset value. This section provides guidance
on the application of ASC 820. Under certain circumstances, net asset value may be used
as an indication of fair value as a practical expedient.
TIS Section 6910.34, Application of the Notion of Value Maximization for Measuring Fair
Value of Debt and Controlling Equity Positions, provides guidance to reporting entities about
the fair value of debt when the entity has a controlling interest in the equity.
TIS Section 6910.35, Assessing Control When Measuring Fair Value, provides guidance to reporting entities in measuring fair value when the interest is a controlling
position.3
Investments in Certain Entities That Calculated Net Asset Value per Share
◾
299
INVESTMENTS IN CERTAIN ENTITIES THAT CALCULATED NET
ASSET VALUE PER SHARE
The net asset value (NAV) of an investment fund is the difference between the sum of the assets’
fair values less the sum of the liabilities’ fair values. NAV is often measured on a per-share or
per-unit basis, and it is often used as a proxy for the fair value of the investment by investors.
Investment funds’ net asset values are often difficult to measure because the fund’s underlying
investments are often illiquid and because the investments may change over time. Investment companies and other alternative investment funds typically calculate net asset value per
share based on the underlying assets’ fair values. The AICPA’s Investment Companies Guide
describes net asset value per share as follows:
Net asset value per share is the amount of net assets attributable to each share of capitals stock (other than senior equity securities, that is, preferred stock) outstanding at
the close of the period. It excludes the effects of assuming conversion of outstanding
convertible securities, whether or not their conversion would have a diluting effect.4
However, this measurement of net asset value is not necessarily the fair value as defined
by ASC 820. The FASB’s former Valuation Resource Group (VRG) described the relationship
of net asset value to fair value as follows:
After the adoption of Statement 157(now ASC 820), one might conclude that the net
asset value (NAV) of a fund (per unit) may not be appropriate for subsequent measurements of investments in funds. Even though NAV is based on fair value of the
underlying assets in the fund, it may not necessarily represent the price that would
be received to sell an ownership interest in the fund in a transaction between market
participants the measurement date.5
In other words, the FASB’s VRG acknowledged that the net asset value may not necessarily be the fair value. However, as a practical expedient, the FASB permits owners of investments
in entities that calculate net asset value per share in accordance with the measurement principles in ASC 946 to measure the fair value of the investment based on the reported net asset
value. In its summary of ASU No. 2009-12, the FASB emphasized that permitting the use of
net asset value per share as a practical expedient to measure the fair value of the investment
“reduces complexity and improves consistency and comparability in the application of Topic
820, while reducing the costs of applying Topic 820.”6
The guidance for measuring the fair value of investments in entities that calculate net
asset per share applies to investments measured or disclosed at fair value that do not have a
readily determinable fair value and meet the criteria of an investment company. The guidance
also extends to entities such as real estate investment funds that may not meet all the requirements of an investment company, but that follow industry reporting practices similar to those
of investment companies (820-10-15-4).
Reporting entities are permitted to use investment companies’ reported net asset value,
proportionate share of partners’ capital, or members’ units to estimate the fair value of their
300
◾ Fair Value Measurement for Alternative Investments
investment, if the investment company follows the accounting standards in ASC 946. When
the reporting entity’s reporting date and the investment company’s reporting date do not coincide, then adjusting the net asset value may be necessary (820-10-35-59 to 60). However, if
it is probable that the reporting entity will sell the interest in the alternative investment at an
amount different from its NAV, then using NAV as a practical expedient to measure fair value
would not be appropriate (820-10-35-62).
AICPA TECHNICAL PRACTICE AID
In order to provide additional guidance for estimating the fair value of alternative investments,
the AICPA’s issued Technical Practice Aid Sections 2220.18 to .27 (TPA), which applies to
fair value measurements under the practical expedient for investments in certain entities that
calculate NAV. It also provides guidance for measuring the fair value of alternative investments
when the practical expedient is not available or when it is not used.
The unit of account is an important concept when measuring the fair value of alternative
investments. The appropriate unit of account is the interest in the investment fund, not necessarily the underlying assets of the fund. The investor owns an interest in the equity of the
fund, not an interest in the actual portfolio of assets and liabilities. The investor usually does
not have the ability to sell or dispose of individual assets of the fund, just as an investor in an
operating entity lacks the ability to dispose of any particular operating asset.7
Determining Whether NAV Is Calculated Consistent
with FASB ASC 946
According to the AICPA, a reporting entity is responsible for independently evaluating
whether an alternative investment’s NAV is calculated at fair value in accordance with ASC
946 and ASC 820. Therefore, the fund manager’s internal controls and process for measuring
NAV must be considered. The AICPA suggests that the evaluation should take place during
the initial due diligence stage and on an ongoing basis, and might cover the following factors
and any changes in the factors:
◾
◾
◾
◾
◾
◾
◾
◾
◾
◾
The estimation process and control environment
Policies and procedures for estimating fair value of the underlying investments
The use of independent third-party valuation experts
The portion of underlying investments traded on active markets
The professional reputation and standing of the fund’s auditor
Qualifications in the fund’s financial statements
Whether there is a history of significant adjustments to the NAV as a result of an audit
Any adverse findings in reports of controls on service organizations
Whether NAV has been appropriately adjusted for clawbacks and carried interest
A comparison of historical realizations to the last reported fair value8
When assessing whether a fund of fund’s NAV is calculated in accordance with ASC
946 and ASC 820, the reporting entity is not required to look through to the underlying
AICPA Guidance for Determining the Fair Value of Investment
◾
301
investment funds. Instead, the assessment would be limited to considering the fund of funds
manager’s process for assessing the NAV from the underlying fund managers.9
Adjusting the NAV
When the reporting entity’s reporting date does not coincide with the investment’s NAV
reporting date, the reporting entity has two options. First, the reporting entity can request
that the investment manager provide a supplemental NAV calculation as of the entity’s
reporting date. If that is not a workable solution, the entity can adjust the reported NAV. The
adjustment may consider any or all of the following factors.
◾
◾
◾
◾
◾
Additional investments or capital contributions
Distributions or principle redemptions
Changes in the value of the underlying investments since the calculation of NAV
Market or economic changes that impact the value of the investment
Changes in the composition of the underlying portfolio of assets
The AICPA suggests that a roll forward analysis of the investment from the last reported
NAV by the investment fund to the entity’s reporting date is an appropriate format to analyze
the NAV adjustment.10
A reporting entity may also adjust the investment’s reported NAV if it concludes that the
NAV is not calculated at fair value. This typically occurs if the NAV is reported on a cash basis or
if the reported NAV utilizes blockage discounts, which is inconsistent with fair value measurement under ASC 820. Another situation that may require adjusting NAV is when the general
partners’ unrealized carried interest has not been reflected in NAV.11
AICPA GUIDANCE FOR DETERMINING THE FAIR VALUE
OF INVESTMENT
Due to the nature of alternative investments, measuring the fair value is challenging
both for the investment manager and for the entity that owns the alternative investment.
The investment fund manager is responsible for the fair value measurement of the underlying
assets, which can include alternative investments without readily determinable fair values.
It is increasingly common for investment managers to retain the services of an outside
valuations specialist to assist them with the measurement of the fund’s underlying assets and
to determine the net asset value for financial reporting to the funds’ investors.
For the reporting entity that owns an alternative investment, other than initial investment by third parties, there is often little market evidence as to the fair value of the interest.
Even when there are transactions for the same alternative investment, fund management may
not provide transparent information about the transaction. Valuation specialists also provide
expertise to owners of alternative investments by measuring the fair value of the entity’s interest in the funds.
When entities cannot or choose not to use NAV as a practical expedient to report the fair
value of an alternative investment or when the reported NAV cannot be adjusted to estimate
302
◾ Fair Value Measurement for Alternative Investments
the fair value of the alternative investment at the entity’s reporting date, the fair value of
the alternative investment should be measured using the general principles outlined in FASB
820.12 The AICPA’s Technical Practice Aid provides guidance for measuring the fair value
of alternative investments when the practical expedient is not used. The Practice Aid provides
guidance for distinguishing between two basic types of investments, for understanding market
participant inputs, and for considering initial due diligence investment features and ongoing
monitoring features.
Redeemable versus Nonredeemable Investments
The AICPA’s TPA indicates that alternative investments can be classified into two types of
investments: (1) those investments that have redeemable interests and (2) those investments
that do not have redeemable interests. Investments with redeemable interests are those that
allow investors opportunities to redeem their interests at certain times. These types of investments typically include hedge funds and bank trust funds. They often have lock-up periods for
certain specified periods when the investor may not redeem the investment.
If an interest in a fund is redeemable, then any potential market participant would have
the ability to redeem the interest once it was acquired. In that case, the net asset value of
the fund is a key starting point to the measurement of fair value of the interest in the fund.
If there are restrictions about the time period in which the interest may be redeemed, then
that restriction should be considered when measuring fair value. Restrictions increase the
investment’s risk since they limit the ability to liquidate the investment. Thus, all other factors being equal, the fair value of an investment with restrictions would most likely be less
than the investment’s NAV.
Investments with nonredeemable interests are typical of investments in private equity
funds, venture capital funds, and real estate partnerships. These nonredeemable investments
are illiquid and have long lock-up periods. They typically require the investor to provide additional capital contributions as investments are made and make distributions to investors when
underlying investments are sold.13
The fair value of a nonredeemable interest in alternative investments is even more difficult
to measure. Even if there is a limited market for interests in nonredeemable funds, transactions in these limited markets may be somewhat problematic and may not be an indication
of fair value. The reason is that information arising from the transaction may not be transparent or that information about the transaction may not be available to determine whether
the transaction can be used as a relevant indication of fair value. Many of these transactions
are a result of distressed sales, which are inappropriate for the use in the measurement of
fair value.
Market Participant Inputs
Alternative investments are unique in that most are not transferable without special permission from the fund management. Even if permission to transfer the investment is forthcoming,
the market for alternative investments is limited since the investments are not registered
with the SEC. Most alternative investments can be transferred only to accredited investors
under SEC regulations. Additionally, the investor may be restricted from selling his interest
AICPA Guidance for Determining the Fair Value of Investment
◾
303
in the investment fund either because the terms of the investment agreement prohibit such a
transaction or because general market conditions limit the transferability of the interest.
These limitations increase the risk of the investment beyond the risk incorporated into the
measure of the fair value of the individual assets and liabilities. When measuring the fair value
of alternative investments under ASC 820, the investor or reporting entity would consider the
inputs that market participants would use in pricing the investment. If there are no actual
market participants for the interest in the alternative investment, then the inputs should be
based on the reporting entity’s own assumptions about inputs that market participants would
use in pricing the investment.
The TPA reminds us that the FASB considers market participants to be knowledgeable
with an understanding of the investment transaction, which includes information obtained
through normal due diligence efforts. Therefore, it is assumed that the market participant
would be aware of the alternative investment’s restrictions and would understand the inherent limitations in converting the investment to cash. The market participant would also be
presumed to be familiar with the investment manager’s track record and the fund’s investment
opportunities.14
Inputs to measuring alternative investments typically include net asset value, transactions in external markets, and features specific to the investment. When measuring the fair
value of alternative investments that do not use NAV as a practical expedient, the AICPA
provides examples of factors to consider, such as:
◾
◾
◾
◾
◾
◾
NAV
Transactions in principal-to-principal or brokered markets
Market conditions
Features of the alternative investment
Discounted expected future cash flows
Whether there has been a significant decrease in the volume and level of activity for
the asset
The factors considered depend on the valuation technique and other facts and circumstances specific to the investment. The weighing of factors would be determined using a market
participant view.15
Net asset value may be an appropriate starting point for the measurement of fair value,
but all relevant factor and attributes of the interest should be considered, which may require
adjusting the net asset value of the alternative investment. When using this approach, the
reported net asset value should be analyzed first to determine if the underlying assets and
liabilities have been measured at their respective fair values. Then the attributes of the specific
interest in the net asset value should be considered to determine whether any adjustments
should be made to the NAV.
Features of the investment include the structure of the investment, the rights associated
with the investment, and the rights of other investors and lenders to the entity. Other factors that a market participant may consider are the ability to redeem the investment, any
lock-up periods, additional required investments (capital calls), and restrictions on the transfer of the investment. In reviewing these features, a market participant may have the view
304
◾ Fair Value Measurement for Alternative Investments
that these features increase the relative risk of the investment and would therefore take them
into consideration when pricing the investment.
If net asset value is a starting point to measure the fair value of an interest in an alternative investment, then the unique features of the investment determine whether the fair
value of the investment is equal to the net asset value or at a premium to net asset value
or at a discount from net asset value. The AICPA Practice Aid segregates these features into
two categories: (1) features that are considered in the initial due diligence investigation for
the investment and (2) those that are considered during the ongoing monitoring phase of
the investment.
Initial Due Diligence Features of Alternative Investments
The features that a market participant would consider prior to making an alternative
investment are called due diligence features by the AICPA (see the following table). When these
features are incorporated into an alternative investment’s structure, they alter the market
participant’s investment risk. Market participants consider these due diligence features both
individually and collectively when determining the amount they would pay for a particular
investment and whether the price would be equal to, at a premium to, or at a discount from
net asset value. Since the initial transaction price is presumed to be fair value, information
about due diligence features and their impact on fair value at inception would be used to
calibrate the fair value in subsequent periods. In future periods, any changes in the due
diligence features would likely result in an adjustment to the investment’s fair value.
Lock-Up Periods and
Redemption Fees
Lock-up periods and redemption fees are sometimes included as
part of the investment in an alternative. Lock-up periods are the
amount of time that the investor must wait before redeeming the
investment. The longer the lock-up period, the greater the risk to the
market participant investor. Some funds allow an investor to redeem
shares during a lock-up period if a fee is paid for the ability to
redeem during this period.
Notice Periods
Notice period is the amount of time that any investor must give to
the fund prior to redeeming shares in an alternative investment.
Holdbacks
During redemption, the fund may retain the right to hold back a
certain percentage of the redemption amount.
Suspension of Redemptions
or Gates
Some funds retain the right to suspend or defer redemptions. This
right may impact fair value if it is likely the right will be exercised.
No Redemption Feature
Certain types of funds that invest in long-term assets with little
liquidity, such as private equity, venture capital, and some real estate
partnerships, may not allow investors to redeem their interest due to
the lack of liquidity of the underlying assets of these funds.
Fund Sponsor Approval to
Transfer Interests
In many funds, investors may not transfer their interest without the
written consent of the fund’s management.
Use of Side
Pockets
Side pockets are a device for redeemable funds to make investments
in illiquid assets. Side pockets are separate accounts to hold the
investment in these illiquid assets. Any amount in the side pocket
account cannot be redeemed until the illiquid asset is sold.16
Venture Capital and Private Equity Funds and Other Investment Companies
◾
305
Ongoing Monitoring Features
Many events and circumstances that influence the fair value of an investment in an alternative
investment occur after the initial investment. The AICPA’s Practice Aid refers to these features
as ongoing monitoring features. Ongoing features are specific to each type of investment and
may change as market conditions change. In addition, a change in the application of a due
diligence feature imposed by the fund’s manager many change the fair value of the investment.
For example, the actual imposition of a gate (not just the ability to impose one) may
change how a market participant would view the fair value of the investment. Or, for example,
if there are excessive redemptions, the fund may be viewed by a market participant as having
increasing risk since additional redemptions have the potential to create liquidity problems.
Changes in general economic conditions are another factor that may impact how market
participants view the fair value of an alternative investment. Changes in general economic
conditions may cause the fund to be unable to make additional profitable investments.
Other changes such as the closure of the fund to new subscribers, the loss the investment
manager’s key personnel, or allegations of fraud would change a market participant’s
perception of risk and would likely impact the measurement of the alternative investment’s
fair value.17
Factors Related to Control of Investments
In February 2013, the AICPA released two new technical practice aids (TPAs), TIS Section
6910.34 and TIS Section 6910.35, both of which provide additional guidance about the
impact of control on certain alternative investments.
1. TIS Section 6910.34, Application of the Notion of Value Maximization for Measuring Fair
Value of Debt and Controlling Equity Positions. This section provides guidance for circumstances in which a fund may hold both debt and a controlling equity position in the same
investment. From an accounting perspective, the debt and equity may have to be separately reported. From an economic perspective, the fund may view these investments in
aggregate, or on an enterprise basis.
2. TIS 6910.35, Assessing Control when Measuring Fair Value. This section applies for situations in which control may be divided between two or more related funds. From the fund’s
perspective, these investments are managed in aggregate or on a controlling basis. From
an accounting perspective, each fund’s position is on a minority interest basis.18
AICPA ACCOUNTING AND VALUATION GUIDE, VALUATION
OF PORTFOLIO COMPANY INVESTMENTS OF VENTURE CAPITAL
AND PRIVATE EQUITY FUNDS AND OTHER INVESTMENT
COMPANIES
In May 2018, the AICPA’s PE/VC Task Force issued a new AICPA Accounting and Valuation
Guide, Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and
Other Investment Companies. The AICPA’s task force consists of a cross-section of professionals
306
◾ Fair Value Measurement for Alternative Investments
working either for alternative asset funds or as advisors by providing valuation consulting or
accounting services to those funds.
The guide provides the views of the task force as to the application of fair value measurements for investments held by investment companies under the FASB’s ASC 946. The scope of
the guide includes investment held by private equity and venture capital funds, hedge funds,
and business development companies.
Some of the information included in the guide are the views of the task force where there
previously may have been a divergence in practice. Some of the accounting and valuation
information includes:
◾
◾
◾
◾
◾
◾
The proper application of ASC 820 Fair Value Measurements framework under ASC
946-320-35-1, which says, “An investment company shall measure investments in debt
and equity securities subsequently at fair value.”
Chapter 3 of the Guide provides information about market participant assumptions in
measuring the fair value of investments of investment companies.
Chapter 4 of the Guide provides information about the determination of the unit
of account of the investment, such as measuring the fair value of a single investment or potentially combining a group of investments, which may have valuation
implications.
The Guide discusses the use of the three standards of valuation approaches—cost, market,
and income—about valuing investments held by these funds as well as the consideration
of factors such as control and marketability on those investments. The guide also provides
additional information as to measuring the fair value of debt and equity instruments in
complex capital structures.
Chapter 10 of the Guide discusses the concept of calibration in measuring the fair value
of alternative investments.
The Appendix to the Guide provides research and case studies about fair value measurements.
The Guide is expected to be issued in final format either by the end of 2019 or early 2020.
INTERNATIONAL PRIVATE EQUITY AND VENTURE CAPITAL
VALUATION GUIDELINES
The objective of the International Private Equity and Venture Capital Guidelines is to
“provide high-quality, uniform, globally-acceptable, best practice, principles-based valuation guidelines for private equity and venture capital practitioners in order to assist their
compliance with accounting and regulatory requirements, in a form that is simple for all
practitioners, regardless of size, to implement.”19 IPEV is an association-based membership
comprised of founding, endorsing, and associate member organizations that wish to promote
“best practices for private capital valuations.”20
In December, 2018, IPEV issued the latest version of their Valuation Guidelines. The
purpose of the guidelines is to “articulate best practices with respect to valuation of all debt
Common Valuation Methodologies of Measuring the Fair Value of the Fund’s Investment Portfolio
and equity Investments of Investment Entities/Companies.”21 The guidelines discuss both
accounting and valuation concepts related to fair value measurement and are generally
consistent with the AICPA guidance.
COMMON VALUATION METHODOLOGIES OF MEASURING
THE FAIR VALUE OF THE FUND’S INVESTMENT PORTFOLIO
Most alternative investments funds such as private equity and venture capital funds invest in
entities that are illiquid and considered by the fund to be a relatively long-term investment.
When making the investment in a portfolio company, the fund’s expectation is to provide
the capital to support company growth to a point where the portfolio company can be sold
through an initial public offering or in a private sale to another entity. The goal is to transform
the portfolio company into an attractive acquisition target so that the investment fund exits
profitably and is rewarded for the risk of the investment. The fair value of a portfolio investment
company’s fund can be measured through methodologies under the three basic approaches
to value: the cost, market, and income approaches discussed in previous chapters. However,
due to the nature of portfolio investments and because portfolio investments are often in the
early stage of their life cycle, certain valuation methodologies may be more appropriate than
others when measuring fair value of the investment.
If there is an active industry market for the portfolio company, one method that may be
appropriate for measuring the fair value is the guideline transaction method under the market approach. This method measures fair value through transactions of similar companies or
investments in similar companies by unrelated third parties. The method uses the implied multiple from the pricing of the third-party transaction to some economic performance measure
such as revenue or earnings before interest taxes, depreciation, and amortization (EBITDA),
and applies the multiple to the same economic performance measure of the portfolio company
as a measurement of its fair value.
Another method that may be used is the guideline public company method under the market
approach. It is similar to the transaction method. Under this method, multiples of price to
a certain economic performance measure of publicly traded companies are calculated. The
multiples are then applied to the portfolio company to derive indications of the fair value of the
investment. Under both transaction and public market methods, adjustments to the indicated
multiple should be considered for differences in performance and relative risk of the fund’s
portfolio company.
Another commonly used method to estimate the fair value of an investment in a portfolio company is the discounted cash flow method (DCF) under the income approach. The DCF
is often used in conjunction with one or both of the methods under the market approach or
for circumstances in which there may not be any comparable transactions or guideline public companies. The DCF is a particularly appropriate method in measuring the fair value of
early-stage entities, because the value from any future growth in cash flows is captured in the
PFI. The discount rate used to discount the cash flows to the present should reflect the relative
risk of the investment.
◾
307
308
◾ Fair Value Measurement for Alternative Investments
CONCLUSION
The application of fair value measurements to private equity and alternative investments
requires careful planning and attention to many different factors. There are two primary
areas in which fair value measurements impact investment funds. The first is in measuring
the fair value of the portfolio assets themselves. Typically, traditional valuation methods
under the three approaches can be used to measure the fair value of the portfolio investments.
The second area is measuring the fair value of the investors’ interest in the fund.
The net asset value of an investment fund is the difference between the sum of the assets’
fair values and the sum of the liabilities’ fair values. NAV is often measured on a per-share or
per-unit basis. The FASB provides a practical expedient for measuring the fair value of investments in entities that calculate NAV per share. The practical expedient applies to investments
measured or disclosed at fair value that do not have a readily determinable fair value and meet
the criteria of an investment company. Reporting entities are permitted to use investment companies’ reported net asset value, proportionate share of partners’ capital, or members’ units
to estimate the fair value of their investment.
The AICPA’s Technical Practice Aid provides guidance for measuring the fair value of
alternative investments when they meet the criteria for using NAV as the basis for the measurement and when the practical expedient is not appropriate. When the practical expedient
is not appropriate, the AICPA Technical Practice Aid notes that the investment’s NAV may
still be a good starting point for estimating fair value. The AICPA goes on to say that when
measuring the fair value of an investor’s interest in an alternative investment, the features
of the investment should be considered from the perspective of a market participant. These
features may include such provisions as redemption rights, additional capital calls, lock-up
periods, and others. The features of the particular investment affect investment risk, thus its
fair value. The Technical Practice Aids also provide guidance when the fund’s investment has
control over the investment entity
The AICPA recently issued a working draft of an Accounting and Valuation Guide,
Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other
Investment Companies, which provides fairly extensive guidance on the both accounting and
valuation issues related to the fair value measurement of investments held by investment
companies.
Finally, in addition to the accounting guidance, there are several organizations, such
as International Private Equity and Venture Capital that issued guidelines about the measurement of the value of underlying portfolio companies. The guidelines issued by the
group typically conform to the FASB’s requirements under ASC 820 as well as AICPA
best practices.
NOTES
1. AICPA Investment Companies Guide, May 2010, paragraph 1.08.
2. Securities and Exchange Commission, Accredited Investors, www.sec.gov/answers/accred
.htm.
Notes
◾
309
3. Working draft of the AICPA Accounting and Valuation Guide Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies.
4. AICPA Investment Companies Guide, May 2010, paragraph 7.39.
5. Valuation Resource Group, July 2008, www.fasb.org.
6. FASB Accounting Standards Update No. 2009-12, Fair Value Measurements and Disclosures:
Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent), 4.
7. AICPA Technical Practice Aids Section 2220.19—Unit of Account.
8. Id., 2220.20.
9. Id.
10. Id., 2220.22.
11. Id., 2220.23.
12. Id., 2220.27.
13. Id.
14. Id.
15. Id.
16. Id., 2220.27.
17. Id., 2220.27.
18. www.appraisers.org/docs/default-source/discipline_bv/aicpa-pe-vc-task-force-update.pdf,
accessed May 16, 2019.
19. www.privateequityvaluation.com, accessed May 16, 2019.
20. Id.
21. “International Private Equity and Venture Capital Valuation Guidelines,” 8, www
.privateequityvaluation.com, accessed May 16, 2019.
12
C HAPTE R TW E LV E
Contingent Consideration
C
from earn-out clauses in
mergers and acquisitions (M&A) transaction agreements receives accounting
recognition in accordance with FASB ASC 805, Business Combinations. Earn-out
clauses provide for future adjustments to the acquisition price based on the target company’s
performance or based on the occurrence of future events. A well-thought-out plan for measuring contingent consideration is important because it helps protect future earnings from
swings caused by changes in the fair value of the earn-out. This chapter will cover common
earn-out structures and features, as well as the accounting requirements for the initial and
subsequent measurement of contingent consideration. The chapter will also provide guidance
for measuring the fair value of contingent consideration using three different methods: the
probability-weighted expected return method, the Black-Scholes options pricing model, and
Monte Carlo simulation.
O N T I N G E N T C O N S I D E R AT I O N T H AT A R I S E S
CONTINGENT CONSIDERATION: EARN-OUTS
IN BUSINESS COMBINATIONS
The application of fair value measurements to business combinations may require the
evaluation and measurement of contingencies, which the FASB Master Glossary defines as
“an existing condition, situation or set of circumstances involving uncertainty as to possible
gain or loss … that will ultimately be resolved when one or more future events occur or fail
to occur.” In business combinations, one of the more common contingencies is an earn-out
provision that calls for an adjustment to the acquisition price at a future date. According
to the Master Glossary, contingent consideration is “usually an obligation of the acquirer to
transfer additional assets or equity interests to the former owners of an acquire … if specified
future events occur or conditions are met. However, contingent consideration also may
311
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
312
◾ Contingent Consideration
give the acquirer the right to the return of previously transferred consideration if specified
conditions are met.”
Contingent Consideration Facilitates M&A Transactions
Earn-outs are a commonly used device to help the buyer and seller bridge a price gap during
negotiations. A potential acquirer may be reluctant to offer a higher price due to concerns that
the target company’s earnings are inflated or that they would be unsustainable in the future.
To resolve this issue, the parties could decide to make future adjustments to the acquisition
price based on the company reaching revenue or earnings targets.1
When the seller has specific knowledge or expertise, the purchaser may want to provide
an incentive for the seller to cooperate during the management transition period. An earn-out
could be structured to provide the seller incentive to ensure a smooth transition. In this situation, the contingent consideration serves as a mechanism to align the buyer’s and seller’s
future interests.
Contingent consideration can also be used to alter the structure of the transaction for
purely financial reasons. When the seller wants to structure the transaction so that gains are
recognized in more than one tax year, the contingent consideration serves as a mechanism
to provide tax deferral. Or, if the purchaser wants to make payments over an extended future
period, the earn-out serves as an alternative form of financing.2
Finally, contingent consideration can be used to address postacquisition uncertainties.
Postacquisition uncertainties can arise from ongoing operations or from circumstances that
can have a material impact on the company’s operations, such as the successful launch of a
product, the receipt of regulatory approval, or the outcome of litigation. Earn-outs based on
an operating metric such as revenues, profits, or earnings before interest and taxes are most
often used to bridge postacquisition uncertainties in ongoing operations. Earn-outs based on
material events can either be triggered based on the achievement of the milestone or they can
be based on an operating metric.
Measuring the fair value of earn-out provisions, or contingent consideration, requires
rigorous analysis and professional judgment. And the accurate measurement of contingent
consideration is important to protect future earnings and prevent earnings volatility.
ACCOUNTING FOR CONTINGENT CONSIDERATION
The accounting requirements for the initial recognition of contingent consideration and the
subsequent remeasurement are found in FASB ASC 805 (formerly SFAS 141(R)). Because
the subsequent remeasurement of earn-outs has the potential to impact future earnings, it
is important for those structuring the merger to consider the accounting ramifications during
the negotiation phase.
Contingent consideration is recognized as of the acquisition date and is classified either
as a liability or as equity, depending on whether the obligation is certain. Certainty relates
to the obligation’s existence, rather than the amount of the obligation. In other words, a certain obligation is an unconditional obligation. If the obligation is certain (unconditional) at
Accounting for Contingent Consideration
◾
313
inception, it is classified as a liability. This type of earn-out is generally settled with cash or
a variable number of the buyer’s shares (fixed dollar amount). If the obligation is not certain
(conditional) at inception, it is classified as equity. The obligation is triggered if the acquired
entity meets certain performance targets or if certain milestones are met. Settlement is generally a fixed number of the buyer’s shares (variable dollar amount). Regardless of whether the
earn-out provision is classified as a liability or as equity, contingent consideration is measured
at fair value.3
Contingent consideration classified as a liability is subject to remeasurement at each
reporting date until its ultimate settlement date. Any change in the fair value of the liability
due to events that occur after the acquisition date would be recognized in earnings (except
for hedging activities that flow through other comprehensive earnings.) However, contingent
consideration classified as equity is not subject to remeasurement. Instead, any gain or loss
at settlement is recorded as an adjustment to equity through other comprehensive income.
Because companies generally try to avoid earnings volatility, there is an incentive to structure
business combination transactions so that earn-outs will be conditional and, therefore, not
subject to remeasurement.4
One interesting side effect of remeasurement is that it tends to buffer earnings. When
an acquired entity has better than expected operating performance, there is a greater likelihood that earn-out performance targets will be met, which increases the fair value of the
earn-out. Recognizing the increased earn-out obligation also results in the recognition of a
remeasurement loss. The remeasurement loss tends to offset some of the improved operating
performance. The converse is also true. Worse than expected operating performance leads to
remeasurement gains that offset poor operating results.5
Measuring the Fair Value of Contingent Consideration
Because the remeasurement of contingent earn-out liabilities from business combinations has
the potential to increase earnings volatility, accurate measurement of the obligation’s fair
value at the acquisition date is important. When approaching the fair value measurement
of contingent consideration, or earn-outs, there are many factors to consider.
A thorough review of the purchase agreement is a good starting point when measuring the fair value of contingent consideration. The agreement will contain the terms of the
earn-out provision, which would include the relevant time frame of the earn-out period, the
applicable performance benchmark or milestone achievement, the amount of the contingent
consideration, as well as other terms. There are an unlimited number of ways an earn-out
provision can be structured because the terms are the result of negotiations between buyer
and seller, each negotiating in their own self-interest. And, there are a number of mechanisms
that can be deployed to refine the terms of the earn-out provision to protect the parties from
future risks.
A clear, unambiguous definition of the earnings metric for the performance benchmark
is in the best interest of both parties. Revenue benchmarks are generally less susceptible to
manipulation than earnings benchmarks. Requiring postclosing audits provides additional
assurance that subsequent performance figures can be trusted, thereby reducing the risk associated with the earn-out and its fair value measurement.6
314
◾ Contingent Consideration
Earn-outs based on milestone achievements are often complex, particularly when the
industry is highly regulated. For instance, the pharmaceutical industry’s milestone achievements may include successful clinical trials, regulatory marketing authorization,
achievement of reimbursement status, and approval for a second use of the product.7
Terms that provide inducement for the acquirer to pursue milestone achievements
and/or terms that penalize the lack of effort may be incorporated into the agreement.
These terms serve to reduce the risk associated with the milestone and with the fair value
measurement of the earn-out.
Earn-out benchmark targets can be structured so that they are cumulative over the
entire earn-out period, or they can be based on monthly, quarterly, or annual targets within
the earn-out period. Partial earn-outs may also be provided for in the agreement, and are a
common feature of milestone-type benchmarks. Another feature, the claw-back provision,
provides for the return of contingent consideration if the target future performance cannot
be sustained.
Floors and caps serve to limit the amount of the earn-out and therefore eliminate some of
the uncertainty surrounding the transaction. A cap protects the buyer’s interest by limiting
the total contingent consideration to be paid, whereas a floor protects the seller by guaranteeing a certain minimum payment. Another contractual protection for the seller’s benefit is an
earn-out escrow provision, which serves to reduce the risk of the buyer’s nonpayment.8
After the terms of the purchase agreement have been thoroughly considered, the timing and risks associated with future benchmark events must be determined. Whether the
benchmark events are related to target operating results or to achieving milestone events,
the process is similar. Historical operating results, industry market data, and discussions with
management are the primary sources of information for the analysis. When the benchmark is
based on operating results, the analyst must also consider whether the valuation should take
place at the consolidated entity level or at a lower operating unit level.
Finally, the analyst must decide on an appropriate valuation method to measure the fair
value of the contingent consideration. Using a probability-weighted expected return method,
an option pricing method, or Monte Carlo simulation are alternative approaches for measuring the fair value of earn-outs.
The Probability-Weighted Expected Return Method9
The first step in the probability-weighted expected return method is to review the purchase
agreement and understand the earn-out provisions. The purpose is to identify the performance benchmark(s), the time frame applicable to the benchmark performance, and the
amount and timing of potential earn-outs.
The second step is to develop a set of potential future outcomes for the underlying
benchmark performance metric. This assessment would be broad, including everything
from macroeconomic and industry factors to specific company, product, and input factors.
When assessing expected operating performance, it may be helpful to decompose expected
performance by product line or location in a bottom-up-type analysis. Another approach is
to use the same reporting structure the company uses for financial statement preparation
or budget analysis. The goal in this step is to develop a set of potential future outcomes
considering the benchmark metric(s) and the applicable time frame.
Accounting for Contingent Consideration
◾
315
Earn-out provisions often have more than one benchmark provision. If so, it is imperative
to understand whether the attainment of one of the benchmarks is independent of the
other, or whether the attainment of one is correlated with the attainment of the other. Joint
probabilities and/or scenario analysis can be used to understand more complex situations
in which benchmarks are correlated with one another. For example, the earn-out provision
for the acquisition of a hamburger chain might have an annual revenue benchmark and a
benchmark based on the number of new stores opened over a specific timeframe. In that case,
the two benchmarks would be positively correlated. Revenues would likely increase as the
acquirer opens new stores.
The third step is to calculate the earn-out amount relating to each of the potential future
outcomes for the underlying benchmark performance(s). And, the fourth step is to assess
the relative risk associated with each potential outcome in order to assign each potential outcome a probability weight. When performing these two steps, it is important to understand
how contractual earn-out terms, such as caps and claw-back provisions, alter the amounts
and risks associated with the earn-outs. The probability weights associated with the potential
outcomes must sum to 100 percent.
The final step in measuring the fair value of contingent consideration is the mathematical
calculation of the expected earn-out. The future value of the earn-out is simply the sum of all
the expected potential outcomes times their related probabilities. The future value of the
earn-out is then discounted to the present fair value of the earn-out using an appropriate
discount rate.
In the following probability-weighted expected return method example, there are two
interdependent benchmarks. The calculation of the earn-out takes into account the joint
probability associated with their attainment.
Assumptions
◾
Acquirer Corporation purchases Target Corporation on January 1, 20X1, for $500
million.
◾
Target Corporation has just introduced a new product line that is expected to generate
significant sales.
◾
If Target achieves a benchmark EBIT of $125 million in 20X1, Acquirer will pay an additional $15 million to the previous owners.
◾
Target also intends to spin off a division in 20X1, and expects to receive $10 million.
◾
If proceeds from the spinoff exceed $15 million, Acquirer will pay an additional $3 million
to the previous owners.
◾
The discount rate is 10 percent.
The fair value of the earn-out provision is $4,432,000, as calculated in Exhibit 12.1.10
Black-Scholes Option Pricing Model
Options are contracts that give the owner the right to buy (or sell) an underlying asset from (to)
the counterparty, at a certain price over a certain period of time. The option grants the owner a
right. The owner can choose to exercise the right or can choose to let the option expire without
exercising it. Options are derivative contracts, meaning their value is dependent on the value
of the underlying asset.
316
◾ Contingent Consideration
EXHIBIT 12.1 Measuring the Fair Value of an Earn-Out Using the Probability-Weighted
Expected Return Method
Spin off
Operating Results
EBIT < $125 million
Joint
Probability
Earnout Probability Weighted
$0
8.75%
$0.000
$15
26.25%
$3.938
$0
47.50%
$0.000
$15
2.50%
$0.375
$3
14.25%
$0.428
$18
0.75%
$0.135
25%
Division is not sold
35%
EBIT > $125 million
75%
EBIT < $125 million
95%
Division is sold for < $15 million
50%
EBIT > $125 million
5%
EBIT < $125 million
95%
Division is sold for > $15 million
15%
EBIT > $125 million
5%
$4.875
Expected
Earnout
$4.432
Present Value
@ 10%
The Black-Scholes option pricing model was developed by Fischer Black and Myron
Scholes in 1973 to calculate the price of an option. It is applicable to European-style options
that can only be exercised on the exercise day, but is commonly used to value American
options that can be exercised any time until they expire. The Black-Scholes model is based
on the assumption that returns on the underlying stock follow a lognormal distribution.
And, the model is able to account for the dividend yield on the underlying stock. The six
basic inputs to the Black-Scholes model are (1) the value of the underlying stock; (2) the
exercise (strike) price; (3) the option term, which is time until expiration; (4) the volatility;
(5) the risk free rate; and (6) the dividend yield. For a publicly traded stock, all of these
inputs are observable. It is important to note that options often have value when they are
out-of-the-money (the exercise price is below the current stock price). Their value is derived
from future potential value, which is recognized in the Black-Scholes model.
Accounting for Contingent Consideration
◾
317
Contingent consideration can be thought of as a real option from the seller’s point of
view. The earn-out provisions of a merger contract give the seller the right to receive additional consideration if certain benchmarks are met. The benchmark provisions are similar to
an exercise price. Therefore, an option pricing model can be used to measure the fair value of
an earn-out.
The following example shows the application of the Black-Scholes option pricing model
to measure the fair value of an earn-out provision.
Assumptions
◾
Acquirer Corporation purchases Target Corporation on January 1, 20X1, for $5 million.
◾
The price is contingent upon Target achieving a benchmark EBIT of $1,125,000 by
December 31, 20X3.
◾
EBIT is currently $1,000,000 per year.
◾
At the end of 20X3, Acquirer will pay additional consideration equal to the excess EBIT
over the benchmark.
◾
The discount rate is 10 percent and the risk-free rate is 3 percent.
◾
Volatility of earnings is 14 percent, based on historic EBIT.
The inputs to the Black-Scholes model for this example are: (1) the current $1 million
level of earnings is the value of the underlying; (2) the benchmark of $1,125,000 serves as
the exercise price; (3) the term is three years; (4) the volatility is 14 percent; (5) the risk-free
rate is 3 percent; and (6) the dividend rate is 0 percent.
The calculations for the Black-Scholes model can be incorporated into an Excel spreadsheet, and the Acquirer Corporation example spreadsheet appears in Exhibit 12.2. The formulas used in the Black-Scholes model spreadsheet are provided in the footnotes to the exhibit.
The call price of $84,413 is the value of the contingent earn-out from the seller’s perspective.
Therefore, it would be an $84,413 earn-out obligation for Acquirer Corporation.
In the example, the contingent earn-out is one dollar for every dollar that EBIT exceeds
the benchmark. This one-to-one payout conforms to the payout pattern of a financial option.
A financial call option is worth one dollar for every dollar that the current price exceeds the
exercise price. However, in the real world, a one-to-one earn-out for contingent consideration
would be unusual.
The Black-Scholes option pricing model can be used to measure the fair value of
earn-outs, even when the earn-out is not one-to-one. However, in order to use the BlackScholes model, a linear relationship must exist between the benchmark and the earn-out. If
the earn-out is based on a percentage of the excess EBIT over the benchmark and a constant
percent is applied to all levels of excess EBIT over the benchmark, then a linear relationship
exists and the Black-Scholes option pricing model can be used with a simple adjustment.
To expand the previous example, assume that Acquirer will pay additional consideration
equal to 30 percent of the excess EBIT over the benchmark. The Black-Scholes model indicated
an $84,413 value for the earn-out, assuming a one-to-one payout. The value of the earn-out
assuming a 30 percent payout of the excess EBIT would be 30 percent of $84,413, or $25,324.
318
◾ Contingent Consideration
EXHIBIT 12.2 Black-Scholes Option Pricing Method
ACQUIRER CORPORATION
VALUATION OF CONTINGENT CONSIDERATION
BLACK-SCHOLES OPTION PRICING METHOD
Assumptions
Expected EBIT
$1,000,000
Threshold EBIT (Exercise Price)
1,125,000
Volatility
14%
Risk-Free Rate
3%
Time to Exercise
3 years
Exercise Price
$1,125,000
Years to Expiration
3
Days to Expiration
1,095
Volatility
14%
Risk-Free Rate, r
3.00%
d1 1
0.0067
N(d1 )
0.5027
N(–d1 ) or [1 – N(d1 )]
0.4973
d2 (1)
−0.2358
N(d2 )
0.4068
N(–d2 ) or [1 – N(d2 )]
0.5932
Dividend Yield
0.00%
Call Option Value2
$84,413
Notes:
1 N(d) = Cumulative density function (area under the normal curve) and d and d is as follows:
1
2
d1 =
ln(Market price/Exercise price) + (r + (Volatility2∕2)) ∗ years to expiration
Volatility ∗ (years to expiration)1∕2
d2 = d1 − ((Volatility) ∗ (years to expiration)1∕2 )
2 Call Price = Market Price ∗ N(d ) – [Exercise Price ∗ e-r(time to expiration) N(d )]
1
2
Measuring the Fair Value of Earn-Outs Using Monte Carlo Simulation
Monte Carlo simulation is a probability-based computer simulation technique that makes use
of repeated trials and random observations from specified inputs to predict future outcomes.
The probability characteristics of the inputs are defined, and can include the type of probability
distribution, the range, the probability, and/or the expected value. The output from a Monte
Carlo Simulation is a frequency distribution based on 100, 1,000, or 10,000 trials, which is
also specified by the user.
Accounting for Contingent Consideration
◾
319
Monte Carlo simulation is best for modeling complex earn-out provisions with multiple
potential outcomes, and/or interdependent outcomes. In practice, it is most often used with
milestone type benchmark achievements such as FDA approvals, patent approvals, or product
launches. Monte Carlo simulation is often used as a supplemental method to corroborate the
results of other models, and it can also be used in conjunction with sensitivity analysis. One
caveat is that the quality of the Monte Carlo simulation is entirely dependent on the quality of
its inputs.
The following example was prepared using Crystal Ball, an Excel-based Monte Carlo simulation program created by Oracle.
Assumptions
◾
Target Corporation has revenues of $100 million in 20X0.
◾
Target Corporation has three projects pending regulatory approval with decisions in
20X1.
◾
Projects A, B, and C have a 30 percent, 40 percent, and 50 percent chance of being
approved, respectively.
◾
If approved, the projects are each expected to generate $10 million in revenue in 20X1.
◾
Acquirer Corporation must pay the previous owners 1 percent of annual revenues for
20X1 to 20X5.
◾
The growth rate for all projects is expected to be similar to historic rates, which were:
00
01
02
03
04
05
06
07
08
09
9%
10%
8%
7%
8%
9%
8%
7%
6%
5%
The first step is to analyze the benchmarks and determine the inputs and probabilities
associated with them. In this example the earn-out is 1 percent of annual revenues for 20X1
to 20X5. Revenues are dependent on the base level of revenues ($100 million in 20X0), the
projected growth rate, and whether projects A, B, and C are approved. The base level of revenue is known, but the growth rate and project approvals are inputs to the model and their
probability characteristics must be analyzed and specified.
An analysis of historic growth indicates the following:
◾
◾
◾
Mean: 7.70 percent
Std Dev: 1.49 percent.
Data Frequency: A 5 percent historic growth rate occurs once, 6 percent occurs once, 7
percent occurs twice, 8 percent occurs three times, 9 percent occurs twice, and 10 percent
occurs once.
Graphing the data frequency permits further analysis. Even though historic data is discrete, the probability distribution for a growth rate would be continuous. The distribution of
historical data in Exhibit 12.3 appears to be similar to a normal distribution based on the shape
of the graph.
The second graph (Exhibit 12.4) is an input screen from Crystal Ball’s Monte Carlo simulation. The expected mean of 7.7 percent and standard deviation of 1.49 percent are specified,
◾ Contingent Consideration
320
4
3
2
1
0
5.00%
6.00%
7.00%
8.00%
9.00%
10.00%
Revenue Growth Rates
EXHIBIT 12.3 Monte Carlo Frequency Distribution of Historic Revenue Growth Rates
Normal Distribution
EXHIBIT 12.4 Monte Carlo Normal Distribution Input Screen
and appear as 8 percent and 1 percent in the probability distribution input screen shown in
the exhibit.
The probability distribution for the three projects is a yes-no distribution in Crystal
Ball. Project A’s 30 percent probability is specified and input into Crystal Ball as shown in
Exhibit 12.5. Note that a yes is denoted as a 1 with a 30 percent probability and a no is
denoted as a 0. The 70 percent probability of a no is automatically calculated by Crystal Ball.
The probability distributions for project B and C are similar.
Once the Monte Carlo Simulation input probability distributions have been specified, an
Excel spreadsheet with links to the probability distributions can be created. The Excel spreadsheet for this example follows. The boxed areas indicate which cells are linked to the Crystal
Ball input probability distributions. The Excel spreadsheet provides the expected value of the
contingent earn-out assuming a 7.7 percent growth rate for all projects and periods, and
Accounting for Contingent Consideration
◾
321
Yes-No Distribution
EXHIBIT 12.5 Monte Carlo Yes-No Distribution
assuming that all three projects are approved. The Excel spreadsheet for this example is presented in Exhibit 12.6.
Running the Monte Carlo Simulation replaces the boxed cells in Exhibit 12.6 with
the specified input probability distributions. The output of a Monte Carlo simulation is
a frequency distribution that shows the probability distribution of the outcomes. In this
example, the Monte Carlo output is a probability distribution based on 1,000 trials, which
appears in Exhibit 12.7. The distribution graph indicates a median of $5,205.16; therefore,
the fair value of the earn-out is $5.2 million.
EXHIBIT 12.6 Excess Spreadsheet
Excel Spreadsheet for Monte Carlo Simulation
Revenues
Growth rate—historic mean,
normal distribution
20X0
20X1
20X2
20X3
20X4
20X5
100,000
107,700 115,993 124,924 134,544 144,903
0.077
Project A Probability
30% Yes-no
1
10,000
10,770
11,599
12,492
13,454
Project B Probability
40% Yes-no
1
10,000
10,770
11,599
12,492
13,454
Project C Probability
50% Yes-no
1
10,000
10,770
11,599
12,492
13,454
Total Projected Revenues
137,700 148,303 159,722 172,021 185,266
Discounted at 10%
600,276
Contingent Earnout @1%
6,003
322
◾ Contingent Consideration
EXHIBIT 12.7 Probability Distribution of Earn-Out
Contingent Consideration from an Asset Perspective
Contingent consideration from an asset perspective refers to two very different situations.
Some earn-outs are actually contingent assets, which may occur if the contract calls for a
refund of a portion of the acquisition price based on future events or conditions. Contingent
consideration from an asset perspective also refers to the situation when an asset valuation
premise is used to measure the fair value of contingent consideration classified as a liability.
The FASB has considered both of these situations through deliberations of the Emerging
Issues Task Force and the Valuation Resource Group, but has reached no authoritative
conclusions.11
We usually think of contingent consideration as the acquirer’s obligation to transfer additional assets or equity interests to the former owner. However, FASB ASC 805 specifically states
that contingent consideration may also give the acquirer the right to the return of previously
transferred consideration if certain conditions are met. ASC 805 also stipulates that contingent consideration recorded as an asset is subject to remeasurement. However, ASC 805 does
not address recognizing a contingent gain arising from the remeasurement of an earn-out
recorded as an asset.
FASB ASC 810, Consolidation, which was issued concurrently with ASC 805, provides for
the seller’s accounting in the deconsolidation of a subsidiary; however, it does not address
earn-outs. Since neither ASC 805 nor ASC 810 addresses earn-outs from the perspective of a
seller, accounting treatment was unclear.
Prior to ASC 810, the seller recognized contingent consideration on a divestiture once
the contingency was resolved, which was consistent with the recognition of other gain
Accounting for Contingent Consideration
◾
323
contingencies. Constituents questioned whether it was appropriate for the seller to recognize
a contingent asset arising from an earn-out. If it is considered appropriate, the next question
was whether the seller’s contingent asset would be subject to remeasurement under ASC
805. The FASB’s Emerging Issues Task Force Issue No. 09-4, Seller Accounting for Contingent
Consideration, attempted to address these questions.
The EITF discussed both the initial measurement and the subsequent remeasurement of
contingent consideration from the seller’s perspective. There were two opposing views, one
favoring and one opposed to the seller’s recognition of a contingent asset for earn-outs. Those
in favor believe that the seller’s accounting treatment should mirror the purchaser’s accounting treatment with respect to contingent consideration, which would include initial recognition at fair value with any subsequent remeasurement reflected in earnings. They also believe
that the seller’s unconditional right to additional consideration should be recognized as an
asset and that any gain or loss on the divestiture should be reflected in the full consideration
to be received.
The opposing view believes that the FASB did not intend the seller to recognize the fair
value of contingent consideration in the gain/loss calculation under ASC 810, and that recognizing contingent gains is a significant departure from existing accounting rules. The opponents also contend that the seller’s accounting for contingent consideration should be similar
to the accounting for receivable financial instruments, which are not remeasured.
Unfortunately, the EITF did not resolve this debate, which is now classified as inactive.
Instead the FASB recommended that additional disclosures should be required in each annual
financial statement until the seller collects or loses the right to the contingent consideration. Disclosures should include the amount recognized, a description of the arrangement
including the range of outcomes and the basis for determining the amount, any change in
the amounts recognized including any differences arising from settlement, any changes
in the range of outcomes, and the reasons for those changes. Immaterial arrangements for
contingent consideration should be disclosed in aggregate when they are material.
Applying an asset valuation premise to the fair value measurement of contingent consideration classified as a liability was discussed by the FASB’s Valuation Resource Group (VRG) at
its November 2010 meeting in connection with VRG Issue No. 2010-05, Fair Value Measurement of Contingent Consideration in a Business Combination. When an asset valuation premise is
used to measure the fair value of contingent consideration under ASC 820, some have questioned whether the asset price must be observable (Level 1 or 2). The VRG considered two
views; those who favor using observable asset prices as inputs and those who favor using any
asset price as inputs (Level 1, 2, or 3) in the measurement of an earn-out liability.
Those who favor the exclusive use of observable inputs from asset markets to measure
the earn-out liability basically believe that an asset approach is an inappropriate way for the
acquirer to measure the contingent earn-out liability. They argue that markets for contingent
assets rarely or never exist. In the absence of such a market, they believe that it is inappropriate
to assume that the acquirer could settle the liability by purchasing a similar asset.
The proponents of using unobservable market prices (Level 3) believe that it is appropriate
to assume an efficient hypothetical market exists where the fair values of an asset and liability
for a contingent earn-out would be equal. The asset and liability would have the same cash
flows and same discount rates; therefore they would be equal.
324
◾ Contingent Consideration
CONCLUSION
Earn-outs are a common feature in business combinations that help the buyer and seller
bridge a price gap during negotiations. Earn-out clauses provide for future adjustments to the
acquisition price based on the target company’s performance or based on the occurrence of
future events. There are an unlimited number of ways an earn-out provision can be structured because the terms are the result of negotiations between buyer and seller; therefore,
a thorough review of the purchase agreement is a good starting point when measuring
the fair value of contingent consideration. The purchase agreement will contain the terms
of the earn-out provision, which would include the relevant time frame of the earn-out
period, the applicable performance benchmark or milestone achievement, the amount of the
contingent consideration, as well as other terms.
The accounting requirements for the initial recognition of contingent consideration and
the subsequent remeasurement are found in FASB ASC 805. Because the subsequent remeasurement of earn-outs has the potential to impact future earnings, it is important for those
structuring the merger to consider the accounting ramifications during the negotiation phase.
Contingent consideration is recognized as of the acquisition date and is classified either as a
liability or as equity, depending on whether the obligation is certain. If the obligation is certain
(unconditional) at inception, it is classified as a liability. If the obligation is not certain (conditional) at inception, it is classified as equity. Regardless of whether the earn-out provision is
classified as a liability or as equity, contingent consideration is measured at fair value. Contingent consideration classified as a liability is subject to remeasurement at each reporting date
until its ultimate settlement date. However, contingent consideration classified as equity is not
subject to remeasurement. Instead, any gain or loss at settlement is recorded as an adjustment
to equity through other comprehensive income.
The analyst must decide on an appropriate valuation method to measure the fair value
of the contingent consideration. A probability-weighted expected return method, an option
pricing method, and Monte Carlo simulation are alternative approaches for measuring the
fair value of earn-outs.
NOTES
1. Cory J. Thompson and Laura A. Schnorbus, M&A Facilitators: The Value of Earnouts (Chicago,
IL: Stout Risius Ross).
2. Brad Pursel and Todd Patrick, “Valuing Earnouts in Uncertain Times: An Overview of
FAS141R Requirements,” Business Valuation Update 15, no. 11 (November 2009).
3. “Accounting for Contingent Consideration—Don’t Let Earnouts Lead to Earnings Surprises,”
PriceWaterhouseCoopers, Mergers & Acquisitions—A Snapshot, February 2010.
4. Id.
5. Id.
6. Mark J.Gundersen, “Seller, Beware: In an Earnout, the Buyer Has Doubts, the Seller Has
Hopes,” Business Law Today, March/April 2005.
7. Pharma Buy, The Lawyer, October 14, 2010, www.thelawyer.com/pharma-buy/1005787
.article.
Notes
◾
325
8. Jim Afinowich, “Earnouts: Breaking the Impasse in Price Negotiations,” Fox&Fin Financial
Group, February 2008, www.foxfin.com/articles/earnouts.htm.
9. Lynne J. Weberand Rick G. Schwartz, “Valuing Contingent Consideration under SFAS 141R,
Business Combinations: Issues and Implications for CFOs and the Transaction Team,” Business
Valuation Review 28, no. 2 (Summer 2009): 62.
10. Adapted from Weber and Schwartz, 63–64.
11. Tiffany Prudhomme, Adrian Mills, and Greg Forsythe, “Valuation Resources Group Discusses
Four Topics at November 1 Meeting,” Deloitte Heads Up 17, no. 40 (November 8, 2010).
12A
APPENDIX TWELVE A
Measuring the Fair Value of a
Nonfinancial Contingent Liability—
Example of a Loan Guarantee
T
H E FAS B M A S T E R G L O S S A RY defines a contingency as “an existing condition,
situation, or set of circumstances involving uncertainty as to possible gain or loss to
an entity that will ultimately be resolved when one or more future events occurs or
fails to occur.” In a business combination, assets and liabilities arising from contingencies
are recognized as of the acquisition date when the fair value can be determined during the
measurement period. If the acquisition date fair value cannot be determined during the measurement period, the contingent asset or liability would be recognized at the acquisition date
if (1) information is available before the end of the measurement period that indicates an asset
existed or a liability had been incurred, and (2) the amount can be reasonably estimated.1
Examples of nonfinancial contingent liabilities include warranties, environmental liabilities,
litigation matters, and guarantees.
A guarantee is a formal promise to assume responsibility for the debts or obligations
of another person or entity if that person or entity fails to meet the obligation. From the
guarantor’s standpoint, the guarantee is a contingent obligation. FASB ASC 360, Guarantees,
requires that the guarantor recognize a liability for the guarantee in the statement of financial
position at the inception of the guarantee. The accounting for the guarantee depends on the
circumstances. When a guarantee is issued in exchange for cash, the obligation is recorded
at the amount of the consideration received. If the guarantee is issued for the benefit of an
unconsolidated equity investee such as a joint venture, the accounting entry would be to
327
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
328
◾ Measuring the Fair Value of a Nonfinancial Contingent Liability
increase the investment in the joint venture and to recognize the liability. If the guarantee
is issued to an unrelated party without benefit to a related party and if no consideration
is exchanged, then the guarantee is recorded as a liability and the offsetting amount is to
an expense. Therefore, in many situations, the guarantor must determine the appropriate
amount to record the guarantee liability.
According to ASC 360, at inception, the broad objective is for the guarantor to measure
the contingent obligation at fair value. The exception is when the guarantee creates contingent losses that must be recognized under FASB ASC 450, Loss Contingencies, and the amount
of the loss contingency exceeds the fair value of the guarantee. Loss contingencies are recognized when they are probable and when they can be reasonably estimated. Therefore, the
guarantee would be recognized as a loss contingency in situations when it is probable there
will be a payout and when the payout amount is material. In most situations, the guarantee
would be recognized at inception at fair value, which is based on a range of probabilities and
possible amounts.2
The subsequent measurement of a guarantee is generally not at fair value unless the
guarantee is classified as a derivative financial instrument. After the initial recognition of a
guarantee, the guarantor’s release from risk can be recognized at the expiration or settlement
of the guarantee, or through amortization of the obligation. If at any time it becomes apparent
that the guarantee has created a contingent loss that is probable and can be reasonably estimated, then the guarantee would be subsequently adjusted and measured under the guidance
in FASB ASC 450.3
Measuring fair value of the guarantee at inception can be accomplished in a number of
ways, but the Black-Scholes option pricing model is particularly well suited to handle the
contingent nature of a guarantee. The following example illustrates the application of the
Black-Scholes model to the initial measurement of a real estate developer’s loan guarantee.
The example is for illustration purposes only. Facts and circumstances in other situations may
require different assumptions and methods.
THE JORDAN LEE FUND GUARANTEE OF TOWNSEND FARM
DEVELOPMENT, LLC
The Jordan Lee Fund is a private equity firm that owns a 40 percent interest in Townsend
Farm Development, LLC, which was created to purchase and develop an 80-acre farm that
was once owned by the Townsend family. Townsend Farm is a swim/tennis community
of single-family homes located in a high-growth, affluent suburb of Nashville, Tennessee.
Townsend Farm Development, LLC used investor funds to purchase the land and took out
bank loans to finance the development of the subdivision and the construction of the homes.
The proceeds from a development loan were used for the road and utility infrastructure
and to complete the clubhouse, tennis courts, and swimming pool. The development loan
The Jordan Lee Fund Guarantee of Townsend Farm Development, LLC
◾
329
was repaid in March 2008 from profits on home sales through that date. The remaining
financing provided by Tristar Bank and Trust consists of construction loans mortgaged by
specific homes and lots. As the homes are built and sold, the loan principle is not repaid, but,
rather, it is rolled over to finance construction on a new lot. The development achieved initial
success in 2006, 2007, and early 2008, and by September 2008, approximately two-thirds
of the 227 home sites had been built and sold.
In 2008, home sales suddenly slowed as a result of the U.S. financial crisis. In mid-2008,
Tristar Bank and Trust refused to roll over the construction loans to finance construction of
new lots without a guarantee from the Jordan Lee Fund. On September 30, the private equity
fund agreed to guarantee the mortgage loans for 17 homes in various stages of completion at
that date.
The Jordan Lee Fund provides audited U.S. GAAP financial statements to its investors;
therefore, the contingent obligation for the guarantee must be recognized at inception at fair
value. Because the guarantee is similar to a put option from the bank’s perspective, the fund’s
general manager, Wilson Jordan, decided to estimate the guarantee’s fair value using the
Black-Scholes option pricing model. If the value of the homes underlying the mortgage loans
falls below the par value of the mortgage loans, then the borrower is unlikely to be able to
fully repay the mortgage. The bank then has the option to “put” the outstanding loan balance
to the guarantor. The guarantor’s loss would be the difference between the loan amount and
the value of the underlying property.
Wilson Jordan gathered the information for the Black-Scholes model by analyzing the outstanding loans, the homes for sale, and the homes under construction. His analysis of the
subject loans and properties appears in Exhibit 12A.1.
In order to analyze the subject loans and properties, Jordan selected a sample of comparable homes within Townsend Farms. Jordan wanted to use data from previous home sales
to analyze the sales patterns and statistics over the development’s history. He selected every
seventh house, excluding any lots not yet developed or sold, and pulled the information about
the loan, the home, and the sales contract from the company’s files. Jordan also searched
public records for any subsequent transactions for the home. Based on his research, Jordan
determined the average sales price per square foot and the average number of days to sell
the home for each year in the subdivision’s three-year history. Exhibit 12A.2 shows the
comparable sales history from the subdivision.
Based on the data from the three sales transactions to date in 2008, Jordan estimated
that the 17 homes would sell for $147.07 per square foot and that it would take an average
of 286 days to build and sell each home. Since it had already been an average of 120 days
since construction began on the subject homes, he estimated the average remaining time
to sale at 166 days. Three of the subject homes were still under construction; therefore,
Jordan estimated the cost to complete these three homes. He also analyzed Townsend
Farm Development’s selling, general and administrative costs to determine additional costs
the developer would incur to sell the homes. Jordan concluded that the fair value of the
330
EXHIBIT 12A.1
Jordan and Lee, LLC, Townsend Farm Subdivision, Loan Report
Loan Date
Original Loan
Amount
Loan
Balance
at 9/30/2008
Estimated
Cost to
Complete
Main
Square Feet
Loan
per Square
Foot
# Days Loan
Outstanding
# Days
Home on
Market
4314 TFT
3/3/2008
180,000
175,110
—
1866
93.84
211
108
4310 TFT
11/6/2007
180,000
173,920
—
1805
96.35
329
239
19
4302 TFT
9/27/2007
180,000
175,110
—
1926
90.92
369
254
29
4268 TFT
4/11/2008
180,000
166,850
—
1718
97.12
172
62
45
4234 TFT
3/3/2008
180,000
169,150
—
1805
93.71
211
104
Lot #
Address
13
15
75
5382 SP
2/5/2008
180,000
178,690
—
1926
92.78
238
140
78
4149 TFD
5/19/2008
160,000
159,850
—
1784
89.60
134
19
126
5521 MC
5/14/2008
165,000
161,937
—
1355
119.51
139
14
128
5525 MC
1/19/2008
170,000
165,617
—
2458
67.38
255
150
129
5527 MC
1/19/2008
170,000
165,717
—
1941
85.38
255
135
148
5526 MC
6/20/2008
180,000
89,142
85,858
1683
52.97
102
0
157
4404 CC
6/20/2008
180,000
96,315
78,685
1270
75.84
102
0
159
4401 CC
9/27/2007
170,000
165,617
—
1448
114.38
369
249
168
4325 TFT
9/27/2007
175,000
170,298
—
1714
99.36
369
260
184
5432 SW
9/27/2007
170,000
165,617
—
1484
111.60
369
264
228
4343 TFT
5/11/2008
175,000
172,709
—
1388
124.43
142
39
186
5426 SW
6/20/2008
49.0721
102
0
98.13
228
120
180,000
93,924
81,076
1914
2,975,000
2,645,573
245,619
24,317
Average:
912.92
331
EXHIBIT 12A.2
Jordon and Lee, LLC, Townsend Farm Subdivision, Sample of Sales History
Price per
Square Foot
Original
Sale
Date
Original
Sale
Amount
Subsequent
Sale
Date
Subsequent
Sale
Amount
Square
Main
Feet
2006
9/4/2008
220,500
1466
199.84
Days to
Build and Sell
Lot #
Address
Loan
Date
3
4348 TFT
8/15/2006
10/6/2006
292,960
10
4320 TFT
3/1/2007
12/7/2007
256,645
17
4296 TFT
8/15/2006
10/20/2006
286,660
1752
24
4268 TFT
5/1/2007
1/30/2008
239,700
1718
31
4262 TFT
11/1/2006
3/27/2007
262,740
1587
38
4248 TFT
11/30/2005
2/10/2006
278,482
1692
164.59
72
52
4208 TFT
11/30/2005
3/8/2006
261,848
1897
138.03
98
59
4162 TFD
11/1/2006
4/20/2007
296,900
66
5398 SP
4/16/2006
7/20/2006
279,380
73
5386 SP
6/1/2006
9/28/2006
80
4153 TFD
11/1/2006
87
4181 TFD
8/15/2006
1826
296,300
2008
2006
150.41
52
140.55
2007
2008
285
281
163.62
66
139.52
274
165.56
2030
10/3/2007
2007
146
146.26
172.87
170
1714
163.00
95
274,340
1200
228.62
2/27/2007
258,990
1252
11/18/2006
269,532
1230
219.13
95
128
123
119
206.86
118
94
4196 TFD
8/15/2006
12/21/2006
269,474
1230
219.08
101
4182 TFD
8/15/2006
10/31/2006
273,900
1555
176.14
108
4217 TFT
8/18/2006
12/29/2006
263,340
1296
203.19
133
115
4229 TFT
4/16/2006
8/31/2006
272,850
1486
183.61
137
77
(Continued)
332
EXHIBIT 12A.2
(continued)
Original
Sale
Date
Original
Sale
Amount
267,490
Subsequent
Sale
Date
Subsequent
Sale
Amount
Square
Main
Feet
Price per
Square Foot
Days to
Build and Sell
Lot #
Address
Loan
Date
122
5513 MC
11/1/2006
4/30/2007
136
4245 TFT
8/15/2006
11/30/2006
294,731
1714
171.96
107
143
5510 MC
11/30/2005
5/12/2006
278,656
1690
164.89
163
150
4287 TFT
5/1/2007
3/23/2008
257,670
1750
164
4317 TFT
11/1/2006
4/27/2007
284,396
1714
185
5430 SW
5/1/2007
1/15/2008
285,000
1886
227
4337 TFT
8/15/2006
12/28/2006
287,440
1714
Average
Address Key:
TFT—Townsend Farm Trail
SP—Seaton Place
TFD—Townsend Farm Drive
MC—Murry Circle
SW—Seaton Way
2006
1714
2007
2008
2006
156.06
2007
147.24
327
165.93
177
151.11
167.70
183.10
2008
180
259
135
164.87
147.07
106
171
286
◾
The Jordan Lee Fund Guarantee of Townsend Farm Development, LLC
EXHIBIT 12A.3
333
Jordon and Lee, LLC, Townsend Farm Subdivision, Fair Value of Assets
9/30/08
Number of mortgage loans
17
Total square feet
24,317
Estimated selling price per square foot
$
147.07
Estimated sales proceeds
$ 3,576,334
Less cost to complete
(245,619)
Less estimated SG&A Expenses at 14.2% for 166 days (286 – 120)
(230,637)
Estimated Fair Value of Assets
3,100,078
Less: Balance of Loans Outstanding
2,645,573
Excess Fair Value of Assets
$
454,505
homes was $3.1 million on September 30, 2008, and that the developer’s equity position
was worth $454,000 after the loan repayment. Jordan’s calculation of fair value appears
in Exhibit 12A.3.
Finally, Jordan calculated the put value of the guarantee from the bank’s perspective
using the Black-Scholes model. The Black-Scholes input parameters for the Jordan Lee
Fund example are provided as follows with the typical financial option parameters in
parenthesis.
S0 = (Price of the underlying share of stock, today)—The fair value of the homes,
today: $3,100,078.
X = (The strike or exercise price of the option)—The par value of the mortgage loans:
$2,645,573.
R = (The risk-free rate of interest that most closely matches the time horizon)—
Six-month Treasury bills: 1.6 percent.
∑
= (The volatility of the underlying share of stock)—Jordan calculated the standard
deviation based on the quarterly Case-Schiller Index for the Nashville
metropolitan area to serve as an indicator of the volatility of the local housing
market: 38.48 percent.
T = (Time to expiration of the option)—The remaining time left to complete
construction and sell the homes: 166 days.
The Black-Scholes model indicates that the put value of the guarantee is $166,799
from the bank’s perspective. The bank’s put value also serves as an estimate of the fair
value of the guarantor’s obligation. The Black-Scholes option pricing model appears in
Exhibit 12A.4.
◾ Measuring the Fair Value of a Nonfinancial Contingent Liability
334
EXHIBIT 12A.4 Jordon and Lee, LLC, Fair Value of Guarantee, Black-Scholes Option
Pricing Model as of 9/30/08
Current Fair Value of Assets1
$ 3,100,078
Exercise Price (Loan Value)7
$ 2,645,573
Years to Expiration
0.4555
Days to Expiration
166
Valuation Date
9/30/2008
Expiration Date2
39,887
Volatility3
38.48%
Risk-Free Rate4
1.60%
d1 5
0.7684
N(d1 )
0.7789
N(–d1 ) or [1 – N(d1 )]
0.2211
d2 5
0.5087
N(d2 )
0.6945
N(–d2 ) or [1 – N(d2 )]
0.3055
Quarterly Dividend Rate
$
Dividend Yield
—
0.00%
Put Value6
$ 116,799
Notes:
1 Based on estimated fair value of homes in Townsend Farm subdivision as of 9/30/08.
2 Based on average actual time to sell.
3 Based on the standard deviation of the quarterly Case-Schiller index for the Nashville metropolitan area.
4 Based on the six-month Treasuries as of September 30, 2008, U.S. Treasury.
5 N(d) = Cumulative density function (area under the normal curve) and d and d is as follows:
1
2
d1 =
ln(Market price/Exercise price) + (r + (Volatility2 ∕2)) ∗ years to expiration
Volatility ∗ (years to expiration)1∕2
d2 = d1 − ((Volatility) ∗ (years to expiration)1∕2 )
6 Put Price = Exercise Price ∗ [e–r(time to expiration)] ∗ [1 – N(d )] – {Market Price ∗ [1 – N(d )]}.
2
1
7 Based on the loan balances for Townsend Farm subdivision as of 9/30/08.
Notes: Definitions
e = Base of natural logarithms (2.71828).
r = Current interest rate on risk-free investment or risk-free rate.
NOTES
1. FASB ASC 805-20-25-18 to 20.
2. FASB ASC 460-10-30-1 to 3.
3. FASB ASC 460-10-35-2 and 4.
13
C HAPTE R THIR TE E N
Auditing Fair Value Measurement
F
AIR VAL U E MEASU REMENT in financial reporting creates a challenge for auditors.
Measuring fair value requires preparers of financial statements to apply judgment
when selecting appropriate inputs, adjusting those inputs, selecting appropriate
valuation methods, and making assumptions about future periods. Because of the complexity
of fair value measurement, the financial statement preparer may retain an outside valuation
specialist to assist with the measurement. The quality of the fair value measurement depends
on the preparer’s judgment; therefore, auditing fair value measurement also requires
judgment.
The role of the auditor is to obtain sufficient competent audit evidence to provide reasonable assurance that fair value measurement is in conformity with generally accepted accounting principles (GAAP). Auditors in the United States and worldwide face increasing challenges
as fair value measures become more prevalent in financial reporting across the globe. The
International Auditing and Assurance Standards Board (IAASB) describes some of the challenges that auditors face in obtaining sufficient competent audit evidence to opine about the
conformity of fair value measurements to accounting standards. Some of the audit challenges
recognized by the IAASB include:
◾
◾
◾
The measurement objective, as fair value accounting estimates are expressed in terms
of the value of a current transaction or financial statement items based on conditions
prevalent at the measurement date;
The need to incorporate judgments concerning significant assumption that may be made
by others such as valuation specialists engaged by the entity or auditor;
The availability (or lack thereof) of information or evidence and its reliability;
335
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
336
◾
◾
◾
◾ Auditing Fair Value Measurement
The breadth of assets and liabilities to which fair value accounting may be, or is required
to be, applied;
The choice and sophistication of acceptable valuation techniques and models; and
The need for appropriate disclosure in the financial statements about measurement
methods and uncertainty, especially when relevant markets are illiquid.1
At the very least, fair value measurements add an additional layer of complexity to the
presentation of financial statements and the audit of those statements.
In order to fully understand auditing fair value measurement, it will be helpful to understand the governmental and professional organizations that have responsibility for developing auditing standards both in the United States and worldwide. This chapter will begin by
providing a brief overview of the organizations responsible for auditing standards, the legal
and regulatory environment in which they operate, and the auditing standards themselves.
Next, it will introduce auditing standards that specifically apply to fair value measurement,
and it will address which particular standards apply to public, privately held, and international entities. Then, a brief, general overview of the audit process will provide structure for
understanding the audit standards for measuring fair value.
AUDITING STANDARDS
In 2002, Congress passed the Sarbanes-Oxley Act, which created the Public Company
Accounting Oversight Board (PCAOB or the Board), a nonprofit corporation charged with
overseeing the audits of public companies and broker–dealers. Congress delegated oversight
of the PCAOB to the Securities and Exchange Commission (SEC). The PCAOB’s mission is to
protect the interests of investors and the public by promoting the preparation of informative,
accurate, and independent audit reports. The Board seeks to improve audit quality, reduce
the risk of audit failures, and promote public trust in the financial reporting process and
auditing profession.2
Prior to the passage of Sarbanes-Oxley, the auditing profession had been self-regulated.
The American Institute of Certified Public Accountants (AICPA) required its members to
comply with auditing standards promulgated by the Auditing Standards Board (ASB), the
AICPA’s senior technical committee over audit and attestation standards. The AICPA’s ASB
issues Statements on Auditing Standards (SASs) with chronological numbers, and each one
addresses a specific topic. The SASs are collected and codified in the AICPA Clarified Statements
on Auditing Standards, which provides all currently effective auditing standards and interpretations of those standards, arranged by subjects designated by “AU-C” section numbers.3
The AICPA’s recently completed clarity project was designed to make auditing standards
easier to understand and apply by clearly stating the auditor’s objectives and responsibilities with respect to generally accepted auditing standards (GAAS). Clarified standards have
also been converged with International Standards on Auditing (ISAs) issued by the International Auditing and Assurance Board (IAASB). The purpose of the clarified standards was
not to create any additional audit requirements; however, the AICPA acknowledges that some
adjustments to practice may be required.4
Auditing Standards
◾
337
GAAS were originally issued in SAS No. 1, and appear in their current form in AU-C
Section 200. These original 10 auditing standards cover general standards, standards of fieldwork, and reporting standards, and they require member compliance and the application of
professional judgment. However, the term GAAS is also commonly applied to the entire body
of AICPA auditing standards. Currently, the AICPA auditing standards apply to nonpublic
companies only.
Among the PCAOB’s first actions was to adopt the AICPA standards as Interim Auditing
Standards in April 2003. Preexisting standards from the AICPA continue to be one source of
authoritative auditing standards to the extent they have not been superseded or amended.
When the PCAOB first adopted the standards, it continued to use the topical organization and
AU reference numbers. The Board also began to issue new auditing standards under a sequential AS numbering system, which is the second source of authoritative standards for public
companies. Therefore, PCAOB auditing standards came from two original sources and were
organized in two separate numbering systems.
In 2015, in order to improve the usability of auditing standards, the Board reorganized
auditing standards under a topical structure. At the same time, the Board rescinded several
interim auditing standards including AU 150, Generally Accepted Auditing Standards. The new
structure has five main sections with the following structure:
1. General Auditing Standards
◾
1000, General Principles and Responsibilities
◾
1200, General Activities
◾
1300, Auditor Communications
2. Audit Procedures
◾
2100, Audit Planning and Risk Assessment
◾
2200, Auditing Internal Control over Financial Reporting
◾
2300, Audit Procedures in Response to Risk—Nature, Timing and Extent
◾
2400, Audit Procedures for Specific Aspects of the Audit
◾
2500, Audit Procedures for Certain Accounts or Disclosures
◾
2600, Special Topics
◾
2700, Auditor’s Responsibility Regarding Supplemental Information
◾
2800, Concluding Audit Procedures
◾
2900, Post-Audit Matters
3. Auditor Reporting
◾
3100, Reporting on Audits of Financial Statements
◾
3300, Other Reporting Topics
4. Matters Relating to Filings Under Federal Securities Laws
5. Other Matters Associated with Audits 5
The reorganization project also encompassed amendments to certain interim auditing
standards that the Board believed were no longer necessary and related updates and references to certain terms and phrases. Among the interim standards rescinded were AU 150,
Generally Accepted Auditing Standards, and AU 201, Nature of the General Standards. Accordingly,
all references to GAAS were also removed.6
338
◾ Auditing Fair Value Measurement
The PCAOB’s Strategic Plan for 2010 to 2014 addressed international convergence of
auditing standards broadly by outlining its intentions to “participate in international efforts
to improve auditor oversight and auditing practices worldwide” by attending “international
meetings of audit regulators” and by monitoring “the work of other standards-setters.”7
At the time, observers believed that convergence of international auditing standards was
likely. However, the path that the Board has taken was not to pursue conversion, but to foster
cross-border cooperation to strengthen audit quality globally.
The PCAOB entered its first cooperative agreement with the Professional Oversight Board
of the United Kingdom in January 2011. The purpose was “to facilitate cooperation in the
oversight of auditors and public accounting firms that practice in the two regulators’ respective jurisdiction.” The agreement allows the PCAOB to conduct inspections of U.K. public
accounting firms that audit or play a substantial role in the audits of U.S. issuers and vice
versa.8 Since then, the PCAOB has entered into similar arrangements with approximately
20 other countries primarily in Europe and Asia.9
In connection with its efforts to foster international cooperation among audit regulators, the PCAOB annually hosts the International Institute on Audit Regulation. The topics
for the 10th annual meeting held in December 2016 included cybersecurity and emerging
audit technology.10 The Board also created the International Forum of Independent of Independent Audit Regulators (IFIAR) in 2006 to enable independent audit regulators to share
knowledge and experience related to inspections of audit firms. Members include 50 independent audit regulators from around the world and observers from organizations such as the
Basel Committee on Banking Supervision, the European Commission, and the World Bank.
In connection with its international outreach, the Board is an observer to a number of other
international organizations, including the International Auditing and Assurance Standards
Board (IAASB).11
Founded in 1978, the IAASB is an organization that is committed to serving the public
interest by independently setting high-quality standards for auditing, quality control, review,
and other assurance-related services. The IAASB facilitates and promotes convergence of
international and national standards with the goal of enhancing the quality and uniformity
of practice throughout the world. Participating national auditing standards setters from
around the world include those from the United States, the United Kingdom, Canada, China,
Japan, The Netherlands, France, Germany, Hong Kong, India, New Zealand, South Africa,
the Nordic Federation, Australia, and Brazil. Although the organization’s International
Standards on Auditing (ISAs) are not authoritative, individual countries’ national standards
setters often adopt them without modification or with minor modifications.12
THE AUDIT PROCESS
The SEC defines an audit as an examination of an issuer’s financial statements by an independent public accounting firm in accordance with the rules of the SEC or PCAOB for purposes
of expressing an opinion on such statements. An issuer is any public company required to file
reports with the SEC or that has filed a registration statement for a public offering of securities. The audit report is a document prepared following an audit in which a public accounting
The Audit Process
◾
339
firm either sets forth an opinion about the issuer’s financial statement or asserts that no such
opinion can be expressed.13
The SEC’s definition of an audit excludes any reference to GAAS as the AICPA auditing
standards have been superseded by SEC and PCAOB rules for public issuers. For audits of
private companies, GAAS still apply.
The American Accounting Association, whose members consist of accountants in
academia, defines auditing as “a systematic process of objectively obtaining and evaluating
evidence regarding assertions about economic actions and events to ascertain the degree of
correspondence between those assertions and established criteria and communicating the
results to interested users.”14,15 Montgomery’s Auditing suggests further breaking down this
definition into five parts:
1. Assertions about economic actions and events
2. Degree of correspondence between assertions and established criteria
3. Objectively obtaining and evaluating evidence
4. Systematic process
5. Communicating the results to interested users16
A graphical representation of the audit process is presented in Exhibit 13.1.
Assertions about
Economic Actions
and Events
Degree of
Correspondence
between Assertions
and Established
Criteria
Objectively Obtaining
and Evaluating
Evidence
Systematic Process
Communicating the
Results to Interested
Users
EXHIBIT 13.1 The Audit Process
340
◾ Auditing Fair Value Measurement
Assertions about Economic Events and Conditions
Evaluating management’s assertions about the fair value of assets and liabilities included in
the entity’s financial statement or financial statement disclosures is an integral part of the
annual audit. For example, management may include the fair value of technology acquired
in a business combination on the company’s balance sheet at $10 million as of December 31,
201X. Since acquired assets and liabilities are measured at fair value under FASB ASC 805,
Business Combinations, applying the valuation methods prescribed in FASB ASC 820, Fair Value
Measurement to the measurement of technology will require management to make assumptions about economic events and conditions, and the likelihood of those events and conditions
occurring in the future. These assumptions must be quantified so that they can be audited.
Quantification is typically achieved by selecting a valuation model from one of the three broad
categories of valuation approaches: the cost approach, the market approach, or the income
approach. Or, the fair value measurement can be quantified by selecting a combination of
valuation models using various valuation approaches. Therefore, in order to evaluate management’s assertions about the fair value of a particular asset or liability, the auditor must
first determine whether the general approach and specific valuation model are appropriate
for the fair value measurement. Then, the auditor must determine whether the assumptions
underlying the fair value measurement are reasonable.
Degree of Correspondence between Assertions
and Established Criteria
The primary objective of an audit is to provide an opinion about management’s assertions
that economic events and conditions are represented fairly in the financial statements. When
auditing financial statements, GAAP is the established accounting standard against which
these economic events and conditions are measured for conformity. GAAP requires that
certain financial statement assets, liabilities, and equity instruments be measured or disclosed
at fair value. GAAP also specifies methods for measuring fair value and the attributes of
appropriate inputs to those methods.
Objectively Obtaining and Evaluating Evidence
The objective in auditing fair value measurements is to obtain and evaluate evidence that
will support the auditor’s opinion that management’s fair value measurement conforms to
GAAP. The work of an outside valuation specialist retained by management to assist with
the fair value measurement can serve as audit evidence. Although management maintains
responsibility for the fair value measurement’s presentation in the financial statements, the
valuation specialist’s work product may be used as audit evidence in the audit of the fair
value measurement.
Going back to the example of the technology acquired in a business combination, assume
management retains a valuation specialist to assist with the fair value measurement of the
technology as of the acquisition date. The valuation specialist can use one or more of the
three standard valuation approaches (cost, market, or income) to estimate the fair value of
the acquired technology. The valuation specialist will issue a report describing the methods
The Audit Process
◾
341
and assumptions used to estimate the fair value of the technology and provide supporting
schedules showing calculation of the $10 million value. The valuation specialist’s report
will provide audit evidence to support management’s assertion that the fair value of the
technology is $10 million on the date of the business combination.
Systematic Process
The term systematic process conveys the point that there is a process to auditing fair value
measurements. Consequently, planning the audit is a vital part of the audit process. A carefully
EXHIBIT 13.2 Report of Independent Registered Public Accounting Firm
Board of Directors and Shareowners
The Coca-Cola Company
We have audited the accompanying consolidated balance sheets of The Coca-Cola Company
and subsidiaries as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, shareowners’ equity, and cash flows for each of
the three years in the period ended December 31, 2016. These financial statements are the
responsibility of the Company’s management. Our responsibility is to express an opinion on
these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes assessing
the accounting principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our audits provide
a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material
respects, the consolidated financial position of The Coca-Cola Company and subsidiaries at
December 31, 2016 and 2015, and the consolidated results of their operations and their
cash flows for each of the three years in the period ended December 31, 2016, in conformity
with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), The Coca-Cola Company and subsidiaries’ internal control
over financial reporting as of December 31, 2016, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations
of the Treadway Commission (2013 Framework) and our report dated February 24, 2017
expressed an unqualified opinion thereon.
Ernst & Young LLP
Atlanta, Georgia
February 24, 201718
342
◾ Auditing Fair Value Measurement
conceived audit strategy must provide a plan to test the reasonableness of management’s
assumptions incorporated into the fair value measurement. This aspect of auditing fair value
measurements requires auditing judgment. Montgomery’s Auditing describes the phrase
systematic process as one that uses at least in part the scientific method. Although the term
scientific method probably conveys a much more rigid approach to obtaining a conclusion
than is possible or warranted in most audits, it does provide the notion that an audit is a structured process.17 In our business combination example, the planning process would include
considering the addition of a valuation specialist to the audit team when auditing the fair
value of the developed technology. The audit team’s valuation specialist would systematically
analyze the work of management’s outside valuation specialist as documented and supported
in the outside specialists’ valuation report. He would also evaluate the reasonableness and
reliability of the conclusion that the fair value of the acquired technology is $10 million.
Communicating the Results to Interested Users
The purpose of an audit is to provide users of financial statements assurance that those
financial statements meet the requirements of GAAP. Management asserts that a company’s
financial statements are prepared in accordance with GAAP. The auditor’s report provides
conclusions about whether management’s assertions are accurate and whether the financial statements do indeed conform to GAAP. If they do not conform to GAAP, the report
provides the reasons. Therefore, the audit report provides a level of comfort to the users of
the financial statements. Expanding on the previous example, the $10 million fair value
of acquired technology is but one component of the company’s entire financial position.
Though not specifically stated, the auditor’s report provides assurance that the fair value
measurement conforms to FASB ASC 820, Fair Value Measurement, and to FASB ASC 805,
Business Combinations, among other accounting standards.
Exhibit 13.2 is an example of an auditor’s report.
EVOLUTION OF AUDIT STANDARDS FOR FAIR VALUE
MEASUREMENTS AND DISCLOSURES
Prior to the issuance of AU 328, Auditing Fair Value Measurements and Disclosures, auditors
referred to AU 342, Auditing Accounting Estimates (SAS No. 57), for guidance when auditing
estimates that support a fair value measurement. AU 342 defined accounting estimates as “an
approximation of a financial statement element, item, or account.”19
When market prices are not available, management estimates fair value by using
valuation techniques, which require inputs based on assumptions that market participants
would make when estimating the price of a similar asset or liability. The Auditing Standards
Board (ASB) believed that incorporating assumptions that a market participant would
use introduced complexity and that auditors needed additional guidance when auditing
management’s fair value measurement beyond the guidance provided in AU 342 for auditing
estimates. The ASB provided this additional guidance through AU 328, Auditing Fair Value
Measurements and Disclosures, originally issued as SAS No. 101.
Evolution of Audit Standards for Fair Value Measurements and Disclosures
◾
343
Auditing Fair Value Measurements and Disclosures was the first auditing standard that
specifically addressed fair value measurement and was originally effective for audits of
financial statements beginning after June 15, 2003. At the time of its issuance, fair value
measurement was required for debt and equity instruments classified as “trading securities”
or as “available for sale” in accordance with SFAS 115, Accounting for Certain Investments in
Debt and Equity Securities. SFAS 119 and SFAS 133, issued in 1994 and 2000, respectively,
expanded the application of fair value measurement to disclosures and accounting for derivatives. Therefore, when AU 328, Auditing Fair Value Measurements and Disclosures, was issued,
fair value measurement was primarily applicable to financial assets and liabilities. AU 328,
Auditing Fair Value Measurements and Disclosures, was among the preexisting standards
adopted by the PCAOB in April 2003.
The need for management to use judgment in financial reporting is a trend that is
likely to continue. One reason relates to the convergence of U.S. GAAP with international
accounting standards, which have a greater number of accounting standards that require
fair value measurements and disclosures. Standards permitting fair value measurements
such as The Fair Value Option (FASB ASC 825-10-25) have increased the number of assets and
liabilities measured at fair value on a recurring basis in financial reporting. The application
of fair value measurement to certain financial statements is also becoming more complex.
For instance, applying fair value measurement concepts to FASB ASC 815, Derivatives and
Hedging, certainly requires a higher level of management expertise and judgment than in
the past. The potentially significant and material impact of these fair value measurements
to the financial statements as a whole creates a need for auditing guidance that is specific to
such measurements.
The Board issues Staff Audit Practice Alerts to provide guidance to auditors. Although
Staff Audit Practice Alerts are not PCAOB rules, they are a resource to help auditors apply
PCAOB standards and laws in certain circumstances. Four Staff Audit Practice Alerts address
auditing fair value measurement and were issued to clarify and strengthen audit guidance
during the financial crisis. They are Alert No. 2: Matters Related to Auditing Fair Value
Measurements of Financial Instruments and the Use of Specialists, issued in 2007, Alert No. 3:
Audit Considerations in the Current Economic Environment, issued in 2008, Alert No. 4: Auditor
Considerations Regarding Fair Value Measurements, Disclosures and Other-Than-Temporary
Impairments, issued in 2009, and Alert No. 9: Assessing and Responding to Risk in the Current
Economic Environment in 2011. Staff Audit Practice Alert Nos. 2 and 9 provided broad
guidance about auditing fair value measurements.
One section of Staff Audit Practice Alert No. 2 relating to the hierarchy of inputs to a
fair value measurement continues to be relevant. The guidance in Staff Audit Practice Alert
No. 9 was provided during the economic crisis. Even though the guidance was provided in the
midst of the financial crisis, most of the concepts continue to be relevant. They are particularly
applicable to the audits of companies experiencing financial distress. Both of these Alerts are
presented in later sections.
Auditing fair value measurements and disclosures will be discussed in this chapter from
the perspective of a U.S. public company; therefore, the PCAOB guidance will be the primary
source of guidance. However, the guidance is also generally applicable to private companies
344
◾ Auditing Fair Value Measurement
and international companies located in countries that have adopted International Standards
for Auditing.
As mentioned previously, in 2015, the Board reorganized auditing standards and related
amendments into a topic structure with an integrated numbering system. The structure
includes several topics that are relevant to fair value measurements, such as:
◾
◾
◾
◾
1210, Using the Work of a Specialist
2501, Auditing Accounting Estimates
2502, Auditing Fair Value Measurements and Disclosures
2503, Auditing Derivative Instruments, Hedging Activities and Investments in Securities
In June 2017, the PCAOB issued two proposed amendments to existing auditing
standards, Release No. 2017-002, Auditing Accounting Estimates, Including Fair Value Measurements, and Release No. 2017-003, Auditor’s Use of the Work of Specialists. The Board asked
to receive comments from the public by August 30, 2017.
Release No. 2017-002, Auditing Accounting Estimates, Including Fair Value Measurements,
replaces AS 2501, Auditing Accounting Estimates, and supersedes AS 2502, Auditing Fair Value
Measurements and Disclosures, and AS 2503, Auditing Derivative Instruments, Hedging Activities
and Investments in Securities. In its summary of the proposal in Release No. 2017-002, the
Board says that the single standard will strengthen and enhance audit requirements by
setting forth a uniform, risk-based approach. Release No. 2017-003, Auditor’s Use of the
Work of Specialists, is designed to increase audit attention when a specialist is used and to
align the requirements with risk assessment standards. These proposals are discussed in
more detail in the following sections, as they are likely to become authoritative guidance for
public companies.
AUDITING STANDARD 2501, AUDITING ACCOUNTING ESTIMATES,
INCLUDING FAIR VALUE MEASUREMENTS
The PCAOB released a proposal for a new auditing standard in June 2017 that applies
to auditing accounting estimates, which includes fair value measurements. The Board
acknowledges that accounting estimates are an essential element of financial statements,
that they are pervasive, and that they often substantially affect the financial statements.
Valuations of financial assets and nonfinancial assets such as intangible assets recognized in
business combinations incorporate estimates in the fair value measurement. Other common
examples of valuations for financial reporting that require estimates include impairments
of long-lived assets, allowance for credit losses, contingent liabilities, and revenues from
customer contracts. The nature of accounting estimates, which are based on subjective
assumptions and measurement uncertainty, makes them susceptible to management bias.20
Auditing Standard 2501, Auditing Accounting Estimates, Including Fair Value Measurements
(AS 2501 Auditing Estimates & FVM), is designed to replace former standards on auditing
accounting estimates, auditing fair value measurements, and auditing investments with
a single standard. The Board cited three main reasons to improve auditing standards for
Auditing Accounting Estimates, Including Fair Value Measurements
◾
345
estimates including FVM. The first is to address a susceptibility inherent in estimates and
fair value measurements to management bias. The new standard provides guidance for
risk assessment and the application of professional skepticism in response to potential
for management bias. The second reason for the proposed standard is to provide a more
uniform, risk-based approach to auditing estimates with the aim of improving the audit
practices associated with the risks of material misstatement due to error or fraud. The
third reason is to improve requirements for using third-party pricing sources in fair value
measurements.21
Former auditing requirements in 2501, Auditing Accounting Estimates, and 2502, Auditing
Fair Value Measurements and Disclosures, both permit the application of one or more of the
following approaches in a substantive test of an accounting estimates.
◾
◾
◾
Testing management’s process by evaluating significant assumptions for reasonableness
and by testing the completeness, accuracy, relevance, and consistency of data used
Developing an independent estimate
Reviewing subsequent events or transactions that occur prior to the issuance of the audit
report to provide evidence of the estimate’s reasonableness
However, the Board considered the level of requirements within each of the existing standards to be inconsistent.22
The Board also cited numerous deficiencies relating to estimates and fair value measurements that continue to be identified in PCAOB inspections. Deficiencies include failures to
sufficiently test data used by issuers to develop accounting estimates, failures to evaluate the
reasonableness of significant management assumptions, failures to understand information
provided by third-party pricing service, and failures to understand the process for determining fair value measurements of brokers and dealers of investment securities.23 The prevalence
of fair value measurement audit deficiencies is evident in an annual survey of audit deficiencies
that is presented in Appendix C of this chapter.
The remainder of this section covers some of the more salient features of AS 2501,
Auditing Estimates & FMV, as well as the PCAOB’s rationale for proposed modifications. The
Board adopted the new standard on December 20, 2018, subject to SEC approval. The new
standard takes effect for audits of financial statements for fiscal years ending on or after
December 12, 2020.24
Objective
The auditor’s objective is to obtain sufficient evidence to determine whether accounting estimates are reasonable in the circumstances, have been accounted for and disclosed in conformity with the applicable financial reporting framework, and are free from bias that results
in material misstatement.25 In its discussion of proposed rules, the Board indicates that the
goal is to have auditors devote more attention to addressing potential management bias in
accounting estimates.26 The Board discusses the causes and sources of management bias and
the reasons for auditor bias at length. Principle agency theory describes the economic relationship between investors and managers, which is exacerbated by information asymmetry
346
◾ Auditing Fair Value Measurement
and may lead to moral hazard issues that influence management to make more favorable
accounting estimates. Other biases such as management optimism and overconfidence may
affect management estimates.
The relationship between the auditor who is an agent of investors and management may
also suffer from misaligned incentives. The auditor may not sufficiently challenge management’s estimates or underlying assumptions in order to preserve an amicable client relationship. This has the potential to affect auditor judgment and may introduce auditor biases such
as anchoring bias, confirmation bias, and familiarity bias. These cognitive biases may threaten
the auditor’s application of professional skepticism and may prevent the auditor from focusing
on potential management biases.27
Identifying and Assessing Risks of Material Misstatement
The focus of this requirement is on developing a process to identify accounting estimates in
financial statement accounts and disclosures, to understand management’s process for developing estimates, and to identify and to assess the risk of material misstatement related to the
estimates. The auditor must therefore be able to determine which accounts and disclosures
are subject to estimation risk and to understand the different risks associated with each significant estimate.28 In order to do so, the auditor should consider the following risk factors in
accounting estimates:
◾
◾
◾
◾
◾
The degree of uncertainty associated with the future outcome or event underlying the
significant assumptions
The complexity of the process for developing the accounting estimate
The number and complexity of significant assumptions included in the estimate
The degree of subjectivity associated with significant assumptions
When forecasts are incorporated into the estimate, the length of the forecast period and
the degree of uncertainty regarding forecast trends29
Assessing the risk of material misstatement also applies to financial instruments.
Generally, Level 1 fair value inputs based on trades of identical financial instruments in
active markets have lower risk of material misstatement than Level 2 fair value inputs based
on observable transactions for similar assets or Level 3 unobservable fair value inputs. The
FASB Master Glossary defines observable inputs as “inputs that are developed using market
data, such as publicly available information about actual events or transactions that reflect
the assumptions that market participants would use when pricing the asset or liability.”
Unobservable inputs are defined as “inputs for which market data are not available and that
are developed using the best information available about the assumptions that market
participants would use when pricing the asset or liability.”
The auditor must understand the nature of the financial instrument, including its terms
and characteristics. The auditor must also assess the level and quality of inputs to the fair
value measurement. In addition, there may be other factors that affect the risk of material
misstatement for the fair value measurement of a financial instrument such as credit risk,
counterparty risk, market risk, and liquidity risk.30
Auditing Accounting Estimates, Including Fair Value Measurements
◾
347
Responding to the Risks of Material Misstatement
The auditor is required to design and implement appropriate responses to address the risk of
material misstatement including substantive procedures. As the risk of material misstatement
increases, the required level of evidence from substantive procedures should also increase.
When fraud risk is identified, the auditor must apply heightened professional skepticism in
gathering and evaluating audit evidence. The substantive approaches to test a fair value
measurement estimate remain unchanged from previous accounting standards, but the
proposed standard extends these requirements to all estimates. Substantive approaches
include testing the company’s process for developing the estimate, developing an independent
expectation, and evaluating evidence from subsequent transactions occurring after the
measurement date.31
In the Board’s discussion of the proposed rules, it elaborates on the auditor’s requirements
for testing the company’s process for developing the estimate by saying that the testing applies
to the assumptions, the data, and the methods. Evaluation of the method should include an
assessment of whether it conforms to the requirements of the applicable financial reporting
framework (i.e., U.S. GAAP or IFRS) and whether it is appropriate for the nature of the related
account, the business, the industry, and the entity operating environment.32
Testing Data Used
Testing data used generally falls under AS 1105, Audit Evidence; however, proposed 2017-002,
Auditing Estimates & FMV, includes amendments to it. The requirements under AS 1105
relating to the evaluation of audit evidence produced by the company remain unchanged.
The proposal introduces additional requirements that apply to accounting estimates.
The auditor must evaluate whether the data is relevant to the measurement objective for
the estimate, whether the data is internally consistent with its use by the company in other
estimates tested, whether the source of data has changed from year to year, and whether any
change in the source of data is appropriate.33
Identifying and Evaluating the Reasonableness
of Significant Assumptions
A significant assumption is one that is important to the recognition or measurement of
an accounting estimate in the financial statements. When identifying which assumptions
are significant, the auditor should consider certain risk factors such as the sensitivity of
the estimate to a minor change in the assumption. Assumptions that are susceptible to
manipulation or bias or are related to a risk of material misstatement would generally be
considered significant. Assumptions that involve unobservable data or company adjustments
to observable data are factors that should be assessed when determining whether the
assumption is significant. Another type of assumption that may be considered significant is
one that is dependent on the company’s intent and ability to carry out a specific course of
action. Either the company or the auditor can identify significant assumptions; however, any
assumption identified by the company as significant should also be classified by the auditor
as significant.34
348
◾ Auditing Fair Value Measurement
In its discussion of PCAOB enforcement actions, the Board listed the failure to perform
procedures to determine the reasonableness of significant assumptions first among the top
four causes of violations.35 The PCAOB’s discussion also indicates that the proposed standards
emphasize a requirement for the auditor to evaluate whether the company has a reasonable
basis for the significant assumption or for the selection of the assumption from a range of
potential assumptions.36 Significant assumptions should be evaluated for consistency with
the following data:
◾
◾
◾
◾
◾
The industry, economic, and regulatory environment
The company’s objectives, strategies, and risks
Existing market information
Historical or recent experience and any changes in conditions
Other significant assumptions used by the company in other estimates
Auditors may also test a significant assumption by developing an independent expectation for that assumption; however, the auditor must have a reasonable basis to support the
independent expectation.37
The PCAOB strengthened the requirements for evaluating the reasonableness of significant assumptions based on management’s intentions by requiring the auditor to assess
whether the company’s ability to carry out a particular course of action is reasonable. In its
proposed standard, the Board included several specific factors to consider when assessing the
company’s ability to carry out a particular course of action, including the following:
◾
◾
◾
◾
The company’s past history of carrying out its intentions
Written plans or relevant documentation such as budgets or minutes
The company’s stated reasons for choosing a particular course of action
The company’s ability to carry out a particular course of action including considering its
financial resources, any legal, regulatory, or contractual restrictions, and whether any
required third-party actions are likely38
Using Pricing Information from Third Parties
When auditing financial instruments, an auditor may use pricing information from third
parties to test pricing data used by management or to develop an independent estimate of
price. Third-party pricing information generally comes from two sources: pricing services
and broker/dealers. Regardless of the source, the goal is for the auditor to obtain sufficient
audit evidence to respond to the risk of material misstatement. The auditor must also assess
the reliability and relevance of pricing data acquired from either source.
When the auditor uses a pricing service to provide audit evidence, the nature and source
of the pricing data and the circumstances in which it was obtained affect its reliability.
In assessing its reliability, the auditor should consider the experience and expertise of the
pricing service in valuing financial instruments similar to the subject financial instrument,
whether the methodology used by the pricing service for estimating fair value is consistent
with the requirements of the applicable framework such as U.S. GAAP, and whether the
Auditing Standards for Auditor’s Use of the Work of Specialists
◾
349
pricing service has a relationship with the client that would enable the client to influence
the price provided.
The relevance of the audit evidence from the pricing service depends on factors that are
similar to levels within the fair value hierarchy. Quoted prices in active markets for identical securities have the highest level of relevance. Fair values based on transactions of similar financial instruments are generally less relevant; therefore, further consideration of the
method used to identify similar instruments and the factors used to determine comparability is warranted. The auditor should also perform additional audit procedures to evaluate the
process used by the pricing service. When there have been no recent transactions for an identical or similar security or when the price is determined using a quote from a broker/dealer,
relevance should be assessed by developing an understanding of how the fair value was developed, including whether inputs represent assumptions that a market participant would use
to price the security. Then the auditor should perform additional audit procedures to evaluate the appropriateness of the valuation method and the reasonableness of observable and
unobservable inputs.
There are circumstances in which an auditor relies on multiple pricing services to support
a price. When multiple pricing services are used, less information is needed about the methods
and inputs used by the pricing services if the following conditions are met.
◾
◾
◾
◾
There are recent trades of identical or similar financial instruments.
The financial instrument is routinely priced by several pricing services.
Prices obtained from multiple pricing services are consistent.
Pricing information is generally based on observable inputs.
When the preceding conditions are not met, the auditor must perform additional procedures including assessing the appropriateness of the valuation method and the reasonableness
of observable procedures.
Pricing evidence may also be provided by a broker/dealer of securities. As a general rule,
quotes are more relevant and reliable when they are timely, binding quotes without restrictions, limitations, or disclaimers from unaffiliated market makers for that security. Therefore,
the auditor should evaluate several factors to determine whether evidence provided by a broker/dealer is relevant and reliable. The broker/dealer should be independent of the client so
that the client has no influence over the amount of the quote. The broker/dealer should also
be a market maker for the particular security for which fair value is being estimated. And the
quote should reflect market conditions as of the financial statement date. A quote that is binding on the broker/dealer without any restrictions or limitations is also considered to be more
reliable and relevant.39
AUDITING STANDARDS FOR AUDITOR’S USE OF THE WORK
OF SPECIALISTS
The PCAOB defines a specialist as a person or firm possessing special skill or knowledge in a
particular field other than accounting or auditing. Companies often use specialists to develop
accounting estimates for financial statement purposes. Actuaries, appraisers, valuation
350
◾ Auditing Fair Value Measurement
specialists, environmental engineers, petroleum engineers, and legal specialists are examples
of professionals who may be engaged to evaluate significant account and disclosures in
financial reporting.40 The work of specialists is often used in valuations of assets acquired
and liabilities assumed in business combinations, goodwill impairments, insurance reserves,
intangible assets, pension and post-retirement obligations, asset impairments, stock options,
and financial instruments.41 Specialists include (1) those who are hired by a company,
(2) those who work directly for a company, (3) those who are hired by auditing firms,
and (4) those who are employed directly by the firm. Currently, the applicable accounting
standard depends on the role of the specialist. AS 1201, Supervision of the Audit Engagement
(AS 1201), applies to the first three types of specialists and AS 1210, Using the Work of a
Specialist (AS 1210), applies to the fourth category of specialist.42
The PCAOB issued Release No. 2017-003 to propose amendments to AS 1201, to replace
AS 1210, and to make additional changes to AS 1105, Audit Evidence. Release No. 2017-003
was issued concurrently with 2017-002, Auditing Estimates & FVM, because the Board recognized the increasing complexity of business transactions and an increasing prevalence of
accounting estimates in fair value measurement for financial reporting. The Board noted that
the work of specialists is often used to develop audit estimates including fair value measurement. Through the amendments, the Board hopes to provide enhanced investor protection by
strengthening requirements for evaluating the work of company employed or engaged specialists and by requiring a risk-based supervisory approach to auditor’s specialists.43 The PCAOB
issued the amendments as PCAOB Release 2018-06, Amendments to Auditing Standards for the
Auditor’s Use of the Work of a Specialist, on December 20, 2018.
As background to the amendments, the Board noted that it had observed substantial
diversity in practice with respect to using the work of specialists. PCAOB inspections continue to identify deficiencies related to the auditor’s use of specialists’ work particularly with
respect to failures to evaluate the assumptions used by company specialists in fair value measurements and failures to consider contradictory evidence or issues raised by an auditor’s
specialist.44 The Board also noted two trends that have emerged as a result of inspections. The
first is that larger accounting firms appear to have acted with respect to deficiencies related
to the auditor’s use of a specialist. Deficiencies related to auditor hired or employed specialists
have declined. However, deficiencies related to auditing the work of the company’s specialists
continue to be observed.45
The Board also cited SEC enforcement actions related to the use of specialists. Those cases
primarily relate to auditing the work of company specialists and include failing to perform
audit procedures to address the risk of material misstatements, failing to evaluate the professional qualifications of the specialist, failing to understand the methods and assumptions used
by the specialist, failures to evaluate the relationship between the specialist and the company,
and failures to apply additional audit procedures to address material differences between the
specialist’s findings and the financial statement assertion.46
The amendments in Release 2017-003 are designed to strengthen the requirements for
evaluating the work of a company’s specialist by setting forth a uniform, risk-based approach.
This would include additional requirements for testing and evaluation data used by the
specialist and requiring the auditor to evaluate significant assumptions used by the specialist.
For auditor employed and engaged specialists, the focus would be to apply a risk-based
Auditing Standards for Auditor’s Use of the Work of Specialists
◾
351
supervisory approach that considers the significance of the specialists’ work to the auditor’s
conclusions about the financial statement assertion, the risk of material misstatement, and
the knowledge and skill of the specialist.47
The proposals include the addition of a new appendix to AS 1105, Audit Evidence, that
includes additional requirements when using the work of a company’s specialist as audit
evidence. Another new appendix to AS 1201, Supervision of the Audit Engagement, provides
additional requirements for supervising auditor-employed specialists. Finally, a new AS 1210
replaces the standards for using the work of an auditor-engaged specialist.48
Appendix B to AS 1105, Using the Work of a Company’s Specialist
as Audit Evidence49
Appendix B extends AS 1105’s requirement for understanding the company’s financial
reporting information system so that auditors must also understand the work and report
of the company’s specialist and the company’s procedures and controls related to the specialist’s work. Therefore, the auditor must understand the nature and purpose of the specialists’
work and the company’s process for selecting and using the work of the specialist. The auditor
must also understand the source of data used by the specialist and whether the company has
provided the data or whether it comes from external sources.
The auditor must also assess the knowledge, skill, and ability of the company’s specialist;
however, the level of the assessment depends on the significance of the specialist’s work to the
auditor’s conclusion about the financial statement assertion and the risk of material misstatement. As these risks increase, the level of required evidence about the specialist’s knowledge
skill and ability increases. Evidence includes professional certifications, licenses, professional
certifications, relevant experience, and the reputation and standing of the specialist. The auditor is also required to assess the specialist’s relationship to the company and whether there is
potential for the company to influence the specialist’s conclusions.
The level of required audit testing of the specialist’s work also depends on the auditor’s
assessment of certain risks and conditions. Conditions that indicate a higher level of required
audit testing are when the specialist’s work is significant to the auditor’s conclusion, when
there is a higher risk of material misstatement, and when the company has the ability to influence the specialist’s judgments and conclusions. Less testing is required when the auditor
concludes that the specialist has a high level of knowledge, skill, and ability. As part of the
planning process, the auditor must consider whether an auditor’s specialist is needed to test
and evaluate the company’s specialist.
The auditor must evaluate the methods and significant assumptions used by the specialist, as well as the relevance and reliability of the specialist’s work in relationship to the
financial statement assertion. The auditor must also test the data used by the specialist.
Company-produced data should be evaluated for accuracy and completeness. Data obtained
by the specialist from external sources should be tested for relevance and reliability. The
auditor should also evaluate whether the specialist uses the data appropriately. If the specialist
helps the company develop an estimate, the auditor must comply with the requirements of AS
2501, Auditing Accounting Estimates, Including Fair Value Measurements.
352
◾ Auditing Fair Value Measurement
The preceding paragraph discusses the requirements of the auditor as they relate to details
of the specialist’s analysis. The auditor is also required to consider the specialist’s work from
an overall perspective to determine whether it supports or contradicts the conclusion about
the financial statement assertion. In order to assess the relevance and reliability of the specialist’s work as it relates to the specialist’s conclusion, the auditor should consider the results
of the audit work relating to the data methods and significant assumptions used by the specialist; the nature of restrictions, disclaimers, or limitations in the specialist’s report; and the
consistency of the specialists work with other audit evidence and the auditor’s understanding
of the company and its operating environment. If the specialist’s findings contradict the financial statement assertion or if the specialist’s work does not provide sufficient evidence to support the financial statement assertion, then the auditor should perform additional audit work.
Appendix C to AS 1201, Supervision of the Work of an
Auditor-Employed Specialist50
Appendix C, which is a proposed addition to AS1201, Supervision of the Audit Engagement,
applies to the supervision of auditor-employed specialists who obtain or evaluate audit evidence for a financial statement assertion. The level of supervision required depends on the
significance of the specialist’s work to the auditor’s conclusion about the financial statement
assertion; the risk of material misstatement; and the knowledge, skill, and ability of the specialist. Existing standards relating to assigning personnel based on their skill and ability and those
relating to independence and ethics also apply to the auditor-employed specialist.
The engagement partner and/or other members of the engagement team are responsible
for supervising the specialist. The supervisor and specialist should come to an understanding
and document the specialist’s responsibilities, the objectives of the work to be performed,
and the nature and approach to be used. In addition, the degree of responsibility that
the specialist has for the following matters should be clearly communicated and documented:
◾
◾
◾
◾
◾
◾
◾
Testing data provided by the company
Evaluating the relevance and reliability of data from external sources
Evaluating methods used by the company or the company’s specialist
Using the specialist’s own methods
Evaluating significant assumptions used by the company
Development of the specialist’s own assumptions
Whether the specialist is responsible for producing a report that describes the work
performed, the results, and the specialist’s findings or conclusions
The engagement partner and/or supervisor also has the responsibility to inform the specialist about matters that could influence his work. Matters that might influence the specialist’s work include general information about the company, the operating environment,
the company’s processes for developing accounting estimates, whether the company used a
specialist to develop the estimate, the requirements of the accounting framework as it relates
to the estimate, and possible accounting and auditing issues. The engagement partner and/or
supervisor must also encourage the specialist to apply professional skepticism.
Auditing Standards for Auditor’s Use of the Work of Specialists
◾
353
The engagement partner and/or supervisor must also see that the specialist’s work is coordinated with the rest of the engagement team to be sure that there is a proper level of evaluation of evidence to support the financial statement assertion. This includes considering other
applicable auditing standards when the specialist tests the company’s process for developing
an estimate, when the specialist develops an independent expectation for an estimate, or when
the specialist evaluates the work of a company specialist.
The engagement partner and/or supervisor is responsible for reviewing the report or
related documentation of the auditor-employed specialist to ensure that it provides sufficient
appropriate evidence. They should specifically address whether the specialist’s work meets
their understanding about the responsibilities of the specialist and about the work to be
performed. They must also address whether the specialist’s conclusions are consistent
with the work the specialist has done, with other evidence obtained by the auditor, and with
the auditor’s understanding of the company and its operating environment. If the specialist’s
conclusion contradicts the financial statement assertion or if the conclusion does not provide
a sufficient level of appropriate evidence, the partner and/or supervisor should perform additional procedures or ask the specialist to perform additional activities. Additional procedures
may be required if the specialist’s work was not performed in accordance with the auditor’s
instructions, if the report contains restrictions or limitations, or if the methods used by the
specialist are inappropriate.
AS 1210, Using the Work of an Auditor-Engaged Specialist51
The previous auditing standard AS 1210, Using the Work of a Specialist, has been amended so
that the proposed new standard applies only to situations in which the auditor uses the work
of an auditor-engaged specialist. The objective of the standard is to determine whether
the work of the auditor-engaged specialist is suitable to support the auditor’s assertion about
the financial statement assertion.
Many of the requirements in this standard are parallel to those for using the work of a
company’s specialist in Appendix B to AS 1105 and Appendix C to AS 1201 discussed earlier. The requirements to assess the knowledge and skill of the specialist are the same as those
in Appendix B, and the results will determine the level of review and evaluation required
for the specialist’s work. The engagement partner and/or supervisor must also assess whether
the specialist and the entity that employs the specialist have a relationship to the company that
might cause a lack of objectivity due to a conflict of interest.
The requirements to supervise and coordinate the work of the auditor-engaged specialist
are the same as those for an auditor-employed specialist in Appendix C. The requirements
for evaluating and reviewing the work of the auditor-engaged specialist are also the same
as those in Appendix C; however, the level of review required depends on the significance of the
specialist’s work to the conclusion about the financial statement assertion; the risk of material misstatement; and the knowledge, skill, and ability of the specialist. Finally, the requirements for evaluating the specialist’s conclusion and deciding whether additional procedures
are required are the same as those in Appendix C.
354
◾ Auditing Fair Value Measurement
PROPOSED INTERNATIONAL STANDARD ON QUALITY
MANAGEMENT 1
The International Auditing and Assurance Standards Board (IAASB), which provides international auditing standards, recently issued an Exposure Draft ISQM1, Quality Management for
Firms that Perform Audits or Review of Financial Statements, or Other Assurance or Related Services
Engagements, which proposes to increase the level of quality control internally of international
audit firms through a proposed system of quality management. The proposed system would
have eight components:
1. Governance and leadership
2. Risk assessment process
3. Ethical requirements
4. Acceptance and continuation of client relationships
5. Engagement performance
6. Resources
7. Information and communication
8. Monitoring and remediation process52
Adoption by the International Accounting Firms will lead to an enhanced system of internal controls related to audit engagements. As such, it is likely that the audits of fair value
measurements with the use of outside valuation specialists and resulting judgment will have
an even greater level of audit focus.
PRACTICAL GUIDANCE FOR AUDITORS
Management is responsible for the accounting estimates incorporated in financial statements,
including fair value measurements. In order to present the fair value measurement fairly,
management should establish an accounting and financial reporting process for determining
when fair value measurements and disclosures are required, for selecting appropriate methods for measuring fair value from the three basic approaches to valuation, for identifying and
adequately supporting any significant assumptions used in the fair value measurement, for
preparing the valuation internally or with assistance from an outside valuation specialist, and
finally, for ensuring that the presentation and disclosure of fair value measurements are in
accordance with the appropriate financial reporting framework.53
Auditing a fair value measurement can be complex and some fair value measurements
are much more complicated than others. The level of complexity is due to the nature of the
item being measured at fair value and the degree of sophistication of the valuation method
itself. For example, when performing goodwill impairment testing under FASB ASC 350,
Intangibles—Goodwill and Other, the fair value of the reporting unit’s equity may be estimated
by management using valuation methods such as the discounted cash flow method or the
guideline public company method. Auditing complex fair value measurements such as the
Practical Guidance for Auditors
◾
355
fair value of a reporting unit in an impairment test is an example of greater uncertainty
regarding the reliability of the measurement process being likely to result in a risk of material
misstatement. Appendixes 13A and B contain a collection of questions frequently asked by
auditors in connection with business combination and goodwill impairment engagements.
The questions are grouped according to valuation approach and include questions relating
to specific types of intangible assets.
PCAOB Staff Audit Practice Alert No. 2, Matters Related to Auditing
Fair Value Measurements of Financial Instruments and the Use
of Specialists
The PCAOB issued Staff Audit Practice Alert No. 2, Matters Related to Auditing Fair Value Measurements of Financial Instruments and the Use of Specialists, in 2007. The PCAOB said the purpose of this alert was to remind auditors of publicly traded companies about their responsibility
for auditing fair value measurements of financial instruments. There are specific factors that
are likely to increase audit risk related to the fair value of financial instruments. One particularly relevant factor is an unstable or volatile economic environment. The PCAOB specifically
asks the auditor to focus on certain areas in the implementations of FASB ASC 820, Fair Value
Measurement. Staff Audit Practice Alert No. 2 has four sections:
1. Auditing fair value measurements
2. Classification within the fair value hierarchy
3. Using the work of valuation specialists
4. Use of a pricing service
Three of these four sections will be replaced by PCAOB proposals in AS 2501 and Release
2017-003, which are discussed in later sections. The guidance relating to the classification
within the fair value hierarchy continues to be relevant.
Classification within the Fair Value Hierarchy under FASB ASC 820, Fair Value
Measurements and Disclosures
FASB ASC 820, Fair Value Measurement provides a three-level fair value hierarchy. The purpose of the hierarchy is to provide financial statement users information about the relative
reliability of the inputs in a fair value measurement. A particular fair value measurement is
classified within the hierarchy based on the lowest level input that is significant to the fair
value measurement in its entirety.
In an article entitled SFAS 157 Fair Value Measurements: Implementation Challenges for the
Alternative Investment Industry, author Chris Mears says,
Unfortunately, the term “significant” is not defined by the standard. In assessing the
significance of a market input, the fund should consider the sensitivity of the fair
value to changes in the input used. Assessing the significance of an input will require
judgment considering factors specific to the financial instrument being valued.
The tone from the top should be one of conservatism in assigning level designations
to securities with unobservable inputs.54
356
◾ Auditing Fair Value Measurement
The article goes on to provide clarifying examples for designating appropriate fair value
levels for disclosure. In one example, Level 2 is assigned to a total return swap in which the
underlying notational position is an actively traded (Level 1) security. The rationale is that the
unit of measure is the total return swap, not the underlying stock.
Another example shows how options could be classified as Level 1, 2, or 3 in the fair
value hierarchy. Options traded on an exchange in an active market would be classified as
Level 1. Those traded on an exchange, but not in an active market, would be Level 2. Options
valued using widely accepted models with observable inputs would also be considered Level 2.
Finally, options priced using models with unobservable inputs and significant adjustments and
judgments would be assigned to Level 3.55
The PCAOB Alert notes that because the risk of material misstatement is higher using
lower levels of inputs, there are different disclosures associated with each of the three levels of
the fair value hierarchy. The auditor should consider whether management has misclassified
the level of measurement within the fair value hierarchy.
PCAOB STAFF AUDIT PRACTICE ALERT NO. 9, ASSESSING
AND RESPONDING TO RISK IN THE CURRENT ECONOMIC
ENVIRONMENT
The PCAOP issued Staff Audit Practice Alert No. 9 on December 6, 2011, just in time for the
annual audit season. The Alert acknowledged that the economic recovery had been slower
than anticipated, that global uncertainty had contributed to economic volatility, and that
economic conditions affect companies’ operations and financial reporting. The PCAOB issued
Alert No. 9 to update guidance contained in Alert No. 3, Audit Considerations in the Current
Economic Environment. Alert No. 9 was designed to help auditors identify economic conditions that might affect the risk of material misstatement and it highlights certain risk assessment requirements and audit responses in audit standards. The Alert is organized into four
main sections:
1. Considering the impact of economic conditions on the audit
2. Auditing fair value measurements and estimates
3. The auditor’s consideration of a company’s ability to continue as a going concern
4. Auditing financial statement disclosures
In the first section, the PCAOB says that current economic conditions may require an
auditor to reassess the planned audit strategy, materiality levels, risk assessments, and the
planned audit response. A year-end reassessment may be warranted when planning and risk
assessments are done early in the year, or when audit testing is performed at an interim date.
The second section provides general guidance when auditing fair value measurements
in challenging economic conditions. When auditing fair value measurements and estimates,
the auditor must consider whether estimates are determined in conformity with the financial reporting framework, whether they are reasonable, and that they do not result in a bias
that materially misstates the financial statements. Based on an assessment of risk, the auditor
Assessing and Responding to Risk in the Current Economic Environment
◾
357
must consider whether audit evidence supports significant assumptions. Auditors should be
particularly alert to situations in which:
◾
◾
◾
◾
Estimates based on past experience do not reflect current market conditions or expected
future conditions.
Reductions in forecasted economic growth or low interest rates affect important
assumption underlying estimates, such as the assumptions underlying an impairment
analysis.
Uncertainty about the value of collateral, counterparty risk, sovereign default risk, or currency volatility affects the assumptions underlying the value of financial instruments.
An active market does not exist for certain financial instruments and assumptions are
integral to complex valuation methods.
The PCAOB goes on to say that auditors must weigh audit evidence that supports and
contradicts management’s assertions about fair values and estimates, and that auditors must
be aware of the potential for management bias. If the auditor identifies a bias, it may affect the
conclusion about the operating effectiveness of controls and the conclusion about the existence of a material misstatement in the financial statements.
The fair value measurement and estimates section of the Alert also specifically addresses
audit considerations when reviewing and testing a company’s process for conducting a
qualitative goodwill impairment test under ASU 2011-08, Testing Goodwill for Impairment.
The auditor should:
◾
◾
◾
◾
Identify the sources of data and the factors that the company used when forming assumptions, and consider whether they are relevant, reliable, and sufficient.
Consider whether there are additional key factors or alternative assumptions.
Evaluate whether assumptions are consistent with each other, the supporting data, historical data, and industry data.
Consider whether changes in the business or industry may cause other factors to become
significant.
The third section of the Alert addresses the auditor’s responsibility for determining
whether the company has the ability to continue as a going concern. The PCAOB specifically
says that the auditor should consider the adequacy of management’s plans for dealing with
adverse conditions and consider the adequacy of support for such plans. In addition, the
auditor must consider the need for full disclosure about the company’s ability to continue as
a going concern. Disclosures should address the events and conditions that initially caused
doubt about the company’s ability to continue as a going concern, and mitigating factors
that alleviate the doubt, including management’s plans.
In the final section of the Alert, the PCAOB emphasizes that economic conditions may
increase the risk of omitted, incomplete, or inadequate financial statement disclosures. The
auditor’s risk assessment should address the susceptibility of material misstatement due to
error or fraud, recognizing that fraud might be perpetrated or concealed through incomplete
358
◾ Auditing Fair Value Measurement
or inaccurate disclosures. The auditor must also assess internal controls over disclosures, particularly qualitative, complex disclosures that require judgment to prepare. The Alert suggests that additional audit supervision may be necessary when auditing complex, qualitative
disclosures, and that audit evidence might come from sources outside the company.
AICPA NONAUTHORITATIVE GUIDANCE
The AICPA’s Forensic and Valuation Service Center provides specific subject level guidance
about best practices relating to valuation services through its Practice Aids. A task force
formed for each topic area worked with AICPA staff to develop guidance that was approved
by the Financial Reporting Executive Committee of the AICPA. Three of the Practice Aids
relate to the application of fair value measurements to specific areas for financial reporting
purposes. The fair value measurement Practice Aids include:
◾
◾
◾
◾
◾
Assets Acquired to Be Used in Research and Development Activities. Although the title suggests a limited scope, this publication, commonly known as the In-Practice Research and
Development (IPR&D) Practice Aid, is often applied to other types of intangible assets
acquired in business combinations. The Practice Aid was first issued by the AICPA in 2001
and the updated version reflects guidance from ASC 820, Fair Value Measurement, on the
measurement of intangible assets.
Valuation of Privately-Held-Company Equity Securities Issued as Compensation. The guidance applies a fair value–based measurement principal from ASC 820 to privately held
equity securities for reporting purposes under ASC 718, Compensation, Stock Compensation. The guide’s focus is not on estimating the fair value of the entity as a whole. Instead,
the focus is on the fair value of the individual common shares or other equity securities
issued by the privately held company.
Testing Goodwill for Impairment. The AICPA practice aid provides guidance for the application of ASC 820’s fair value measurement framework and valuation techniques to goodwill impairment testing. The practice aid clarifies such topics as allocating assets and
liabilities to reporting units, allocating goodwill to reporting units, and measuring the
fair value of a reporting unit. It also provides examples and discussion of the approaches
and techniques most often used in practice for measuring the fair value of reporting units.
Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and
Other Investment Companies. The AICPA released an Exposure Draft prepared by the PE/VC
Task Force, “to provide guidance to investment companies and their advisers regarding
the valuation of certain aspects of the accounting related to their investments in both
equity and debt instruments of privately-held enterprises and certain enterprises with
traded instruments.”56
Business Combinations. The AICPA expects to release an Exposure Draft of an Accounting
and Valuation Guide on Business Combinations during 2020.
Although these practice aids provide nonauthoritative guidance to financial statement
preparers and auditors about specific fair value measurement issues, they are considered to
be best practice guidance for the measurement of fair value by the AICPA.
Conclusion
◾
359
THE APPRAISAL FOUNDATION
The Appraisal Foundation, authorized by the U.S. Congress, is a nonprofit educational organization dedicated to the advancement of the valuation profession. Founded in 1987, the
organization was formed as a direct result of the government’s intervention into the savings
and loan crisis of the mid-1980s. Its purpose is to provide a source of appraisal standards and
qualifications. The foundation is not an individual member organization but rather one that
is composed of other organizations.57
In addition to its other services, the foundation sponsors and facilitates Business
Valuation Working Groups, which are charged with developing best practices for specific
valuation issues in financial reporting. There are several completed and in-progress Appraisal
Foundation projects that contribute to best practices in valuation.
◾
◾
◾
◾
Best Practices for Valuations in Financial Reporting: Intangible Asset Working Group—
Contributory Assets and its companion publication Identification of Contributory Assets
and Calculation of Economic Rents: Toolkit were the first monographs issued for financial
reporting. They address best practices for using the multiperiod excess earnings method
(MPEEM), including the identification of contributory assets, the use of “dual” charges,
the calculation of rates of return on intangible assets, and the reconciliation of the
weighted average required rate of return on assets acquired in a business combination
to the weighted average cost of capital. The toolkit provides complete examples for
practitioners who wish to apply MPEEM best practices in their fair value measurement of
intangible assets.58
Appraisal Practices Board VFR Valuation Advisory 2: The Valuation of Customer-Related
Assets, issued in June 2016, provides best practice guidance related to the valuation of
customer-related assets for valuation purposes. The fair value of customer-related assets
is measured and reported in connection with business combinations, asset acquisitions,
goodwill impairment testing, long-lived asset impairment testing, and reorganizations.
VFR Work Group 3’s project Control Premiums for Financial Reporting has issued a
revised exposure draft in September 2015 entitled The Measurement and Application of
Market Participant Acquisition Premiums. Best practice guidance for control premiums
from the Appraisal Foundation is covered in Chapter 5, “Impairment,” under the
section “Quantitative Impairment Test and Measurement of an Impairment Loss” in the
subsection “Control Premium.”
VFR Work Group 4’s project Valuing Contingent Consideration was issued its first exposure
draft in February 2017. Although this guidance is preliminary, it is nonetheless considered to be best practices and was covered in Chapter 12, “Contingent Consideration.”
CONCLUSION
Since fair value measurements often include unobservable inputs that are based on management assumptions, auditing the fair value measurements is complex and requires heightened
judgment. When market prices are unavailable, a client-engaged valuation specialist, whose
360
◾ Auditing Fair Value Measurement
work can be used as audit evidence, often estimates the fair value measurement. However,
when a valuation specialist performs the measurement, management is ultimately responsible
for the fair value measurement reported in the financial statements. When the company’s outside auditors use the work of the company’s valuation specialist as audit evidence, they must
also apply professional judgment to ascertain whether the specialist’s methods, assumptions,
data, and conclusion support a fair value measurement in conformity with the appropriate
financial reporting framework. The auditor may also use a valuation specialist who is an
employee of the auditing firm or one who is engaged by the audit firm. In either case, the
auditor supervises the specialist’s work.
Fair value measurements create an interesting new dynamic between the management
of the company who prepares the financial statement, the company’s independent auditor
who audits the financial statements for conformity to the financial statement framework, and
an outside valuation specialist engaged by management to develop fair value measurements
included in the financial statements. One key to success is effective and early communication among management, the outside valuation specialist, and the company’s independent
auditing firm about the assumptions and methods used in determining fair value.
AS 2501, Auditing Estimates, Including Fair Value Measurements, provides the latest guidance specific to auditors when auditing fair value measurements. Although the amendments
are not final until SEC approval, the PCAOB’s objectives to create more uniformity among
requirements for auditing estimates and fair value measurements will likely carry through to
the final standard. Among the requirements are that the auditor must (1) evaluate significant
assumptions used by the specialist, (2) consider whether the valuation model is appropriate,
and (3) test the underlying data used in the analysis. The PCAOB has also emphasized the need
for professional skepticism when auditing complex estimates and fair value measurements.
NOTES
1. “Challenges in Auditing Fair Value Accounting Estimates in the Current Market Environment,” International Auditing and Assurance Standards Board, October 2008.
2. http://pcaobus.org/about/history/pages/default.aspx, accessed July 31, 2017.
3. www.aicpa.org/research/standards/AuditAttest/pages/clarifiedSAS.aspx, accessed August
7, 2017.
4. Id.
5. PCAOB Release No. 2015-002, Reorganization of PCAOB Auditing Standards and Related Amendments to PCAOB, March 31, 2015, 2–4 and Appendix 1.
6. Id., 7–8.
7. PCAOB Strategic Plan 2010-2014, November 23, 2010, 26, http://pcaobus.org.
8. “PCAOB Enters into Cooperative Agreement with United Kingdom Audit Regulator,” press
release, http://pcaobus.org/NewsRelease/Pages/01102011_UK.aspx.
9. https://pcaobus.org/International/Pages/RegulatoryCooperation.aspx, accessed August 8,
2017.
10. http://pcaob.org/News/Releases/Pages/10th-Annual-International-Institute-12-5-16
.aspx.
11. http://pcaobus.org/international/pages/IFIAR-other-international-organizations.aspx,
accessed August 8, 2017.
Notes
◾
361
12. http://www.iaasb.org/about-iaasb/national-auditing-standards-setters , accessed August 8,
2017.
13. PCAOB Rulemaking: SEC Release No. 34-47990; File No. PCAOB-2003-03, June 5, 2003,
www.sec.gov/rules/pcaob/34-47990.htm, accessed August 9, 2017.
14. http://aaahq.org, accessed August 9, 2017.
15. The American Accounting Association, “The Report of the Committee on Basic Auditing
Concepts,” Accounting Review 47.
16. Vincent M. O’Reilly, et al., Montgomery’s Auditing, 12th ed. (New York: John Wiley & Sons,
1998 and 2001, Supplement), 1.2–1.6.
17. Id., 1.5.
18. The Coca-Cola Company Form 10-K, December 31, 2016, Standard & Poor’s Capital IQ.
19. AU 342, Auditing Accounting Estimates, section 342.01, http://pcaobus.ogr, accessed August
29, 2011.
20. PCAOB Release No. 2017-002, “Proposed Accounting Standard: Auditing Accounting
Estimates, Including Fair Value Measurements,” June 1, 2017, 4–5.
21. Id., 14–15.
22. Id., 9–10.
23. Id., 2.
24. Ken Tysiac, “PCAOB Strengthens Rules for Auditing Estimates, Supervising Specialists,” Journal of Accountancy, December 20, 2018, www.journalofaccountancy.com/news/2018/dec/
pcaob-estimates-standard-201820339.html.
25. Id., Appendix 1—Proposed Auditing Standard, A1-1.
26. Id., 16.
27. Id., 2 –33.
28. Id., Appendix 1, A1-1 to A1-2.
29. Id., Appendix 2, 16–17.
30. Id., Appendix 1, 14.
31. Id., Appendix 1, 2–3.
32. Id., 18.
33. Id., Appendix 1, A1-5 to A1-6.
34. Id., Appendix 1, A1-6.
35. Id., 13.
36. Id., 17.
37. Id., Appendix 1, A1-7.
38. Id., Appendix 1, A1-8.
39. Id., Appendix 1, 14–18.
40. PCAOB Release No. 2017-003, Proposed Amendments to Accounting Standards for Auditor’s Use
of the Work of Specialists, June 1, 2017, 1.
41. Id., 10.
42. Id., 7.
43. Id., 1.
44. Id., 2.
45. Id., 14.
46. Id., 15.
47. Id., 19.
48. Id., 21.
49. Id., Appendix 1, A1-10 to A1-13.
362
◾ Auditing Fair Value Measurement
50. Id., A1-17 to A1-20.
51. Id., A1-20 to A1-24.
52. “Proposed International Standards on Quality Management 1,” IAASB, www.iaasb.com,
accessed May 15, 2019.
53. Auditing Fair Value Measurements and Disclosures: A Toolkit for Auditors, AICPA, paragraph 7,
www.aicpa.org.
54. Chris Mears, “SFAS 157 Fair Value Measurements: Implementation Challenges for the Alternative Investment Industry,” September 2008, www.rko.com/pdfilb/SFAS_157_Fair_Value
.pdf, p. 3.
55. Id., 26.
56. Working Draft of the AICPA Accounting and Valuation Guide’s Valuation of Portfolio Company
Investments of Venture Capital and Private Equity Funds and Other Investment Companies, AICPA,
May 15, 2018, 9.
57. About the Appraisal Foundation/Mission & History, http://netforum.avectra.com, accessed
September 2, 2011.
58. “Best Practices for Valuations in Financial Reporting: Intangible Asset Working Group—
Contributory Assets, and Identification of Contributory Assets and Calculation of Economic
Rents: Toolkit,” Financial Reporting, http://netforum.avectra.com, accessed September 2,
2011.
13A
APPENDIX THIRTEEN A
Auditing Fair Value Measurement in a
Business Combination
AUDITOR QUESTIONS
This appendix includes a collection of questions auditors frequently ask after their review
of the analysis supporting a business combination. The questions are grouped by valuation
approach and other general questions.
GENERAL
1. How is the industry defined and what is the relevant SIC/NAICS Code? Were other
industries were considered?
2. Is the company/industry young or mature? In what life cycle stage is the company/industry?
3. Is the company cyclical in nature? How does the current economic outlook impact the
company’s operating outlook?
4. Are any nonoperating or nonrecurring items included in the company’s historic financial statements? Are there any discontinued operations?
5. What type of transaction structure did you assume in your analysis and how did you
arrive at that assumption? Is the assumption of a stock transaction or asset purchase
consistent with the client’s projected financial information?
6. Were there any assets considered but not ultimately valued? If so, provide the rationale
for not ascribing value to these assets. Were any assets acquired that management does
not intend to use? If so, were any of these assets deemed to be defensive assets?
363
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
364
◾ Auditing Fair Value Measurement in a Business Combination
7. Explain how you have determined that fixed assets’ book value reflects fair market value.
8. Are third-party appraisals available for material fixed assets? If so, has the required
return or pricing multiple been considered?
9. Has the capacity of fixed assets been considered as it relates to the current levels of
production? Has excess capacity been identified? Are there indications of economic
obsolescence?
10. Is the Company’s interest-bearing debt recorded at fair value? How does the company interest rate on its debt compare to rates that market participants would be
charged?
11. Provide support for the economic useful lives used in the valuations of the intangible
assets.
12. What is the basis for the premium for the estimated return of the intangible assets?
13. Provide support for the fair value of the contingency considerations in the transaction.
14. Has the fair value of deferred taxes been provided by management and is it calculated
correctly?
15. Were there any NOLs as of the valuation date that could be utilized by the acquirer? If so,
discuss considerations given to the NOLs.
16. Discuss whether the after-tax rate of return for the debt-free working capital is
appropriate.
17. Has an enterprise-level tax shield been calculated and is it consistent with the assumed
transaction structure? Is the discount rate consistent with the discount rate from
the DCF?
18. Does the IRR reconcile to the weighted average return on assets (WARA)?
INCOME APPROACH
1. Describe how the projections were prepared and how they relate to the market participants’ projections, including who prepared the projections (i.e., acquirer or the target
entity).
2. Comment on whether the projections used in the analysis include any synergies and the
specific nature of any synergies that were included.
3. Discuss how you gained comfort with the projections provided by management.
4. Are projections consistent with historic performance, previous forecasts, and industry
forecasts?
5. Are revenue growth rates consistent with prior projected growth rates and recent operating performance? Are projected operating margins consistent with prior projected
margins and recent operating performance?
6. Discuss why you chose to use the H-model to calculate the terminal value.
7. Describe the rationale for the selected growth rates in the H-model.
8. Discuss what factors are driving revenue growth rates.
9. Is the long-term growth rate consistent with market participant assumptions and
industry forecasts?
10. Is the long-term growth rate consistent with prior years?
Income Approach
◾
365
11. What have the historical working capital levels (as a percentage of sales) been for
the company? Do cash flow projections include sufficient working capital to support
growth?
12. Explain how the reduction in working capital is achieved by the company, given their
business model, historic working capital levels, and customer base.
13. Discuss how the debt-free working capital factor was selected based on the provided
range.
14. Explain why the industry data is more reflective of the company’s working capital needs
than the actual level.
15. Provide details regarding the change in working capital calculation in year 1.
16. Are capital expenditures in the terminal period consistent with the level of capital
expenditures in the discrete forecast period? Are there sufficient capital expenditures to
support growth?
17. Are capital expenditures in the terminal period consistent with the level of depreciation
expense in the terminal period? If capital expenditures in the terminal period are above
a normalized level, has the tax benefit of the depreciation overhang been calculated and
included in the present value of the asset?
18. Confirm whether the terminal year growth rate was based on a normalized basis.
19. Explain how you derived the present value of the tax amortization for the BEV valuation.
20. Explain how deferred revenue and deferred compensation were considered in the BEV
valuation.
21. Does the relationship between the purchase price and the DCF value make sense? What
are the reconciling items between the purchase price and DCF?
22. Is the discount rate for the terminal period the same as the discount rate for the last
discrete period in the projected cash flows?
23. Does the company have excess cash and has it been included in the DCF value?
24. Has an appropriate market participant tax rate been assumed that takes into consideration federal and state taxes? Is the tax rate used consistently throughout the analysis of
the business combinations?
WACC
1. Explain why the WACC deviates from the IRR. Is that an indication that the WACC does
not reflect all the riskiness of the business?
2. Have the risk free rate, the equity risk premium, the industry risk premium, and the size
premium been adequately considered and supported?
3. How do the capital structures of the selected comparable companies differ from that of
the subject company and the estimated optimal structure? Provide any other support
for the capital structure.
4. Provide the comparable guideline companies that you selected to arrive at the beta and
capital structure used in the WACC calculation.
5. Provide the support calculation for how you determined the beta. Is the industry for the
selected beta closely comparable to the subject company, or should other industry betas
be considered?
366
◾ Auditing Fair Value Measurement in a Business Combination
6. Does the relevered beta reflect market participant assumptions about the optimal capital structure? Is the assumption about the optimal capital structure consistent with the
capital structure in the WACC?
7. Provide support for the selected cost of debt. Is it reflective of current borrowing rates for
market participants?
8. Describe the basis for the company-specific risk premium. Have all risks been appropriately considered? Is the company-specific risk consistent with previous years?
9. Is the discount rate consistent with the cash flows? When cash flows to equity are being
discounted, is the discount rate the cost of equity? When debt free cash flows are being
discounted, is the discount rate the WACC?
10. Is the WACC consistent with prior-year WACC calculations?
Customer Relationship
1. Are there specific customers that the company is dependent on? How does the sales history to these particular customers compare to the overall customer base?
2. Are customers stratified in homogeneous groups?
3. Why was the remaining useful life chosen?
4. Confirm that the percent of revenue used is a reasonable proxy for the amount of sales
and marketing expenses that would be required to attract new customers.
5. We noticed that the projected depreciation expenses used in the customer relationship
valuation are the same as those for the overall company. Confirm that there will be no
depreciation expenses incurred for generating revenue associated with new customers.
6. Provide support for the decay factor / attrition rate regarding how it was determined and
how it compares to historical levels.
Noncompetition Agreement
1. Provide support for the assumptions for the revenue lost to competition and the probability of success absent the noncompetition agreement.
2. Discuss whether the depreciation and capital expenditures should be estimated based on
revenue projections assuming there was no noncompetition agreement in place.
3. Explain why you did not consider a return of component in the noncompetition agreement
valuation.
COST APPROACH
Technology
1. Provide a brief description of the technology including the competitive advantage it provides and explain the rationale for selecting the cost approach as the most appropriate
method to value the technology.
2. How was the obsolescence estimated for the technology?
3. Discuss in more detail the profitability factor utilized in the technology fair value.
Market Approach—General
◾
367
4. Discuss whether the inputs for calculating the costs to re-create/replace the technology
are pretax or after-tax and explain the rationale.
5. Does the useful life make sense given its commercial use and the competitive climate in
the industry?
6. Has obsolescence been appropriately considered? Are functional or technological obsolescence present in the asset? Has economic obsolescence from factors external to the
company occurred?
7. How does the cost to reproduce the technology compare to the cost to replace it?
Workforce
1. Provide the supporting calculation of the total inefficiency training costs associated with
the workforce.
2. Discuss whether it is appropriate to consider the ramp-up effect for the employees to
achieve full productivity.
MARKET APPROACH—GENERAL
Trade Name/Trademarks
1. What is the original royalty source data for the trade name?
2. Provide the market data, as well as an explanation of your considerations to arrive at the
royalty rate.
3. Confirm that 100 percent of the company’s revenues are associated with the valued
trademarks. Are there specific identifiable revenue streams associated with particular
trademarks?
4. Discuss whether there will be any trademark value remaining (e.g., defensive value) after
the company discontinues the use of the trademarks.
5. Please confirm the company does not intend to use the acquired trademark after X years.
Licenses—Relief from Royalty Method
1. Why is the royalty rate appropriate, given that, in a recent similar transaction, a lower
royalty rate was used?
2. What are the unique features of the company’s hypothetical license? How is it similar to
the comparable licenses selected for use in the relief from royalty method?
3. How do the length of the license, the renewal terms, termination provisions, geographic
area, technical support, and the market presence of comparable licenses compare to the
subject company’s hypothetical license?
13B
APPENDIX THIRTEEN B
Auditing Fair Value Measurement in a
Goodwill Impairment Test
T
HIS APPENDIX INCLU DE S examples of issues auditors may consider in the audit of
the analysis of fair value measurements in a Step 1 impairment test. The questions are
grouped by general questions and valuation approaches.
GENERAL
1. How is the industry defined and what is the relevant SIC/NAICS Code? Were other industries considered?
2. Is the entity/industry young or mature? In what life cycle stage is the entity/industry?
3. Is the entity cyclical in nature? How does the current economic outlook impact the
entity’s operating outlook?
4. Are any nonoperating or nonrecurring items included in the entity’s historic financial
statements? Are there any discontinued operations?
5. Are third-party appraisals available for material fixed assets? If so, has the required
return or pricing multiple been considered?
6. Has the capacity of fixed assets been considered as it relates to the current levels of production? Has excess capacity been identified? Does excess capacity indicate economic
obsolescence?
7. Are there other indications of economic obsolescence?
8. Has an enterprise-level tax shield been calculated?
369
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
370
◾ Auditing Fair Value Measurement in a Goodwill Impairment Test
9. How is the reporting unit defined? Does the entity have a single reporting unit, or
multiple reporting units?
10. At what level is goodwill being tested? Is it recorded at the parent or acquired
subsidiary level?
11. Do the projected cash flows used in the impairment analysis match the reporting unit
being tested for impairment?
12. Does the carrying value of the reporting unit being tested agree to the balance sheet?
INCOME APPROACH
1. How were the projections prepared and how do they relate to the market participants’
projections? Who prepared the projections (i.e., acquirer or the target entity)?
2. Discuss the process used to gain comfort with the projections provided by management.
3. Are projections consistent with historic performance, previous forecasts, and industry
forecasts?
4. Discuss what factors are driving revenue growth rates. Are revenue growth rates
consistent with prior projected growth rates and recent operating performance?
5. Are projected operating margins consistent with prior projected margins and recent
operating performance?
6. Is the long-term growth rate consistent with market participant assumptions and industry forecasts? Is the long-term growth rate consistent with prior years?
7. Is the long-term growth rate in the terminal period consistent with long-term economic
growth and industry expectations? What factors were considered when selecting the
terminal year growth rate?
8. Is the discount rate for the terminal period the same as the discount rate for the last
discrete period in the projected cash flows?
9. How was the terminal (perpetual) value determined? Were other models considered?
10. If the H-model is selected to calculate the terminal value, describe the rationale for the
selected growth rates in the H-model. What economic and industry factors were considered in determining the extraordinary growth rate and the length of the transition
period to stable growth?
11. What have the historical working capital levels (as a percentage of sales) been for
the entity? Do cash flow projections include sufficient working capital to support
growth?
12. Explain how changes in working capital levels are achieved by the entity, given its
business model, historic working capital levels, and customer base.
13. Discuss how the debt-free working capital level as a percentage of revenues was selected
based on the range indicated by the industry. Explain whether the industry data
or whether the entity’s actual working capital level is more reflective of the entity’s
working capital needs.
14. Are capital expenditures in the terminal period consistent with the level of capital
expenditures in the discrete forecast period? Are there sufficient capital expenditures to
support growth?
WACC
◾
371
15. Are capital expenditures in the terminal period consistent with the level of depreciation
expense in the terminal period? If capital expenditures in the terminal period are above
a normalized level, has the tax benefit of the depreciation overhang been calculated and
included in the present value of the asset?
16. If the entity acquired intangible assets in a transaction structured as an asset purchase,
is the present value of the tax amortization benefit for intangible assets included in the
business enterprise value?
17. Does the entity have deferred revenue or deferred compensation? If so, have they been
appropriately considered in the business enterprise value?
18. Does the entity have excess cash and has it been included in the DCF value?
19. Has an appropriate market participant tax rate been assumed that takes into consideration federal and state taxes? Is the tax rate used consistently throughout the analysis of
the business combinations?
20. Have the partial year and midyear conventions been appropriately applied to the cash
flows?
WACC
1. Does the WACC appropriately reflect all the risks of the business?
2. Have the risk free rate, the equity risk premium, the industry risk premium, and the size
premium been adequately considered and supported?
3. If the entity has international operations, was a foreign operations risk premium considered?
4. How do the capital structures of the selected comparable companies differ from that of
the subject entity, and the estimated optimal structure? Provide support for the selected
capital structure.
5. Which comparable guideline companies were considered to arrive at the beta and capital
structure selected for the WACC calculation? Are comparable guideline companies used
consistent with prior years?
6. Is the industry for the selected beta closely comparable to the subject entity, or were other
industry and guideline company betas considered?
7. Does the relevered beta reflect market participant assumptions about the optimal capital structure? Is the assumption about the optimal capital structure consistent with the
capital structure in the WACC?
8. How was the selected cost of debt determined? Is it reflective of current borrowing rates
for market participants?
9. What is the basis for the entity specific risk premium? Have all risks been appropriately
considered? Is the entity-specific risk consistent with previous years?
10. Is the discount rate consistent with the cash flow projections? When cash flows to equity
are being discounted, is the discount rate the cost of equity? When debt free cash flows
are being discounted, is the discount rate the WACC?
11. Is the discount rate consistent with the level of risk in the cash flow projections?
12. Is the WACC consistent with prior year WACC calculations?
372
◾ Auditing Fair Value Measurement in a Goodwill Impairment Test
THE MARKET APPROACH
Guideline Public Company Method
1. Were guideline public companies identified through discussions with management? Were
other guideline public companies considered and/or included in the analysis? If so, what
was the source?
2. Are guideline public companies consistent with the prior years’ analysis?
3. Were stock prices as of the valuation date?
4. How were the subject entity and the guideline companies analyzed for similarity? Are
operating ratios similar?
5. Were any adjustments made to the subject entity or guideline companies? If so, discuss
how they improved comparability.
6. Discuss how valuation multiples were selected, including the weighting of the various
indications of value.
7. Does the Market Value of Invested Capital (MVIC) for guideline companies exclude cash?
8. Is the MVIC indicated by the guideline public company method assumed to be a controlling or noncontrolling value? Was a control premium considered?
9. When analyzing the comparable companies’ MVIC, was the calculation made based on a
fully diluted basis?
Guideline Transaction Method
1. What were the selection criteria for the guideline transactions?
2. Was sufficient information available to determine whether the companies in the guideline
transactions were comparable to the subject entity? What were the points of comparison?
3. Discuss how valuation multiples were selected, including the weighting of various
indications of value.
14
C HAPTE R F O U R TE E N
Fair Value Measurement Case Study1
LEARNING OBJECTIVES
Dynamic Analytic Systems, Inc. is a fictitious company. The narrative and exhibits in this
case study illustrate concepts from the Financial Accounting Standards Board’s (FASB)
Accounting Standards Codification 820, Fair Value Measurement (ASC 820), FASB ASC
805, Business Combinations (ASC 805), and FASB ASC 350, Intangibles—Goodwill and Other
(ASC 350). The case study is intended to provide an integrated illustration of a business
combination valuation engagement using the acquisition method and subsequent impairment analysis to illustrate points and provide examples. The case study is not intended to be
used for any other purpose. Although the case has been prepared using commonly accepted
valuation techniques, there is variation among practitioners within the profession. Others
may choose alternative valuation methods and assumptions instead of the ones presented in
the case study.
The case study has questions and exhibits intermingled throughout the fact pattern, so
that readers can test their understanding of the concepts presented throughout the text. Suggested answers can be found in Appendix 14A, which follows this chapter.
After reading this material, readers should be able to apply the concepts presented
in ASC 820, Fair Value Measurement; ASC 805, Business Combinations; and ASC 350,
Intangibles—Goodwill and Other. The case study will help readers understand how a valuation
professional applies valuation techniques to estimate fair value, how to use the acquisition
method of accounting, how to test for impairments of goodwill and other intangible assets,
and how to calculate any impairment charge.
373
Fair Value Measurement: Practical Guidance and Implementation, Third Edition.
Mark L. Zyla.
© 2020 John Wiley & Sons, Inc. Published 2020 by John Wiley & Sons, Inc.
374
◾ Fair Value Measurement Case Study
The case study incorporates applicable highlights from the Mandatory Performance
Framework for the Certified in Entity and Intangible Valuations Credential and the Application of
the Mandatory Performance Framework2 (Mandatory Performance Framework), which are
designed for use by all valuation professionals who provide valuation services for financial
reporting purposes. These key concepts are designated by a MPF → or an AMPF → and
include a section citation in the case study solutions in Appendix 14A.
BUSINESS BACKGROUND AND FACTS—DYNAMIC ANALYTIC
SYSTEMS, INC.
Dynamic Analytic Systems, Inc. (DAS) is a cloud-based data storage and analytics software
company. Its cloud infrastructure provides scalable, secure data storage and processing
services. DAS also offers analytics capabilities through its partnership with a third-party
analytics application firm. Second generation upgrades to the cloud infrastructure have just
been completed that provide an expanded menu of options to DAS’s customers. The platform
upgrades will also provide the base for DAS’s own analytics application product development.
Recently DAS decided to shift the company’s strategic focus toward a software-as-a-service
(Saas) cloud-based business model focused on data analytics. Accordingly, management
has decided to sunset its current flagship product after five years and to convert existing
customers to its Saas model. In the mean time, DAS plans to continue marketing third-party
analytics applications to existing market segments. The analytics apps software produced by
outside vendors currently accounts for 15 percent of DAS’s sales. DAS plans to introduce its
own analytics product, Dynalytics in January 20X3.
DAS’s versatile cloud infrastructure attracted the attention of Daniel Novaro, CEO of
AltoStratus Cloud Solutions, Inc.’s (AltoStratus), which resulted in AltoStratus acquiring DAS
on December 31, 20X1. AltoStratus agreed to pay $30.0 million in cash and 42,000 shares
of AltoStratus stock at closing. AltoStratus is publicly traded on the NASDAQ exchange. The
closing price was $45.00 per share on December 31, 20X1.
In addition to the cash and stock consideration, AltoStratus will assume a $5.0 million
note payable to one of DAS’s creditors. The note is due December 31, 20X4, and has a
6 percent annual interest rate, which Mobil Systems considers to be equal to the market
interest rate for similar financing.
AltoStratus will also pay additional consideration to DAS’s founder Thomas Parker
based on the dollar amount of DAS’s EBITDA for 20X2. If EBITDA exceeds 110 percent
of historic 20X1 EBITDA of $7.5 million, Parker will receive 50 percent of every dollar
over the $8.25 million target. The payout is capped at $10 million EBITDA. If EBITDA fall
below the target level, Parker will receive nothing. The additional consideration provides an
incentive for Parker to serve as a consultant and maintain relationships with key customers
over an extended transition period. Because the amount ultimately paid to the former
Business Background and Facts—Dynamic Analytic Systems, Inc.
◾
375
owner depends on future events, the earn-out is contingent consideration. Parker also
signed an employment agreement with AltoStratus containing a noncompetition clause.
AltoStratus incurred $750,000 in legal fees and other due diligence costs associated with the
acquisition of DAS.
1. You have been engaged by AltoStratus Technology Inc. to perform a fair value
measurement of identified intangible assets as of the acquisition date. Discuss the
acquisition method. What are the steps in the acquisition method? What is the
measurement date of the business combination? What would cause the measurement
date to differ from the acquisition closing date?
Fair Value of Consideration Transferred
Under FASB ASC 805, Business Combinations, the consideration transferred is the aggregate
acquisition date fair values of the assets transferred by the acquirer, liabilities incurred by the
acquirer to former owners, and equity interests issued by the acquirer. It includes cash, other
assets, a business or subsidiary of the acquirer, contingent consideration, common or preferred equity, options, warrants and member interests of mutual entities (ASC 805-30-30-7).
The starting point when valuing intangible assets using the acquisition method is determining
the fair value of the consideration transferred.
2. Calculate the fair value of the consideration transferred. What is an alternative to
calculating the fair value of the consideration transferred under the acquisition
method? What is the valuation professional’s responsibility with respect to the initial
transaction?
3. How is the contingent consideration treated under ASC 805?
4. What is the payoff structure for the Dynamic Analytic Systems earnout and what does its
graph look like? What is the best method to value this type of payoff structure? What
are the inputs to the valuation calculation? What is the value of the contingent
consideration? (See Exhibits A14.1–A14.3, contained in the Case Study Solution for the
valuation of contingent consideration.)
Exhibit 14.1 shows the calculation of the fair value of the consideration transferred.
376
◾ Fair Value Measurement Case Study
EXHIBIT 14.1 Dynamic Analytic Systems, Inc.: Fair Value of Consideration Transferred as of
December 31, 20X1
Cash
Equity Consideration—Mobile Systems1
Contingent Consideration—Thompson2
Note Payable3
$30,000,000
1,890,000
238,150
5,000,000
Transaction Costs4
Fair Value of Acquisition Price
—
$37,128,150
Notes:
1 42,000 shares at closing price on 12/31/X1 of $45.00/share.
2 The fair value of expected contingent consideration is recognized at acquisition date, as part of the
purchase price per FASB ASC 805.
3 The note payable excludes accrued interest.
4 Transaction costs are excluded from the fair value of consideration under ASC 805.
5 Transaction costs are excluded from fair value of the acquisition price because deal-related costs are
expensed under ASC 805.
Business Combination Engagement—Information Request
5. What information will you typically need to gather in order to perform an intangible
asset valuation under the acquisition method? How does a valuation professional
obtain the requisite information?
Exhibit 14.2 contains prospective financial information (PFI) and common-size calculations that show each line item as a percentage of total sales.
6. When using management’s prospective financial information (PFI) as a basis for fair
value measurement under income approaches, does a valuation professional need
to analyze management forecasts? Under what circumstances would it be appropriate
to make adjustments to management projections? What other responsibilities does
the valuation professional have with respect to management’s PFI?
Business Enterprise Value
Exhibit 14.3 shows DAS’s business enterprise value (BEV). Because the business combination
is a stock acquisition, the discounted cash flows exclude any tax amortization benefit from
goodwill and intangible assets. If the case study business combination were an asset acquisition instead, it may be appropriate to include the impact on cash flows for future tax deductions
relating to the amortization of goodwill and intangible assets.
377
EXHIBIT 14.2 Dynamic Analytic Systems, Inc.: Projected Income Statements and Common-Size Income Statements as of
December 31, 20X1
For Year Ending December 31,
20X2
Dynamic Cloud Data Platform
20X3
20X4
$35,680,000
20X5
75%
$33,087,000
20X6
$35,993,000
85%
$37,792,000
85%
65%
$32,375,000
60%
6,352,000
15%
6,669,000
15%
4,757,000
10%
5,090,000
10%
5,396,000
10%
—
0%
—
0%
7,136,000
15%
12,726,000
25%
16,188,000
30%
Analytic Apps:
Third-Party Apps
Dynalytics App
Discounts
(20,800)
0%
(27,300)
0%
(29,200)
0%
(31,300)
0%
(33,200)
0%
Total Sales
42,324,200
100%
44,433,700
100%
47,543,800
100%
50,871,700
100%
53,925,800
100%
Growth
4%
5%
7%
7%
6%
Cost of Sales
25,390,625
60%
27,993,875
63%
29,953,625
63%
32,049,875
63%
33,972,250
63%
Gross Profit
16,933,575
40%
16,439,825
37%
17,590,175
37%
18,821,825
37%
19,953,550
37%
SG&A Expenses
8,335,825
20%
7,826,325
18%
8,374,675
18%
8,960,575
18%
9,500,800
18%
EBITDA
8,597,750
20%
8,613,500
19%
9,215,500
19%
9,861,250
19%
10,452,750
19%
Depreciation
EBIT
539,500
1%
576,875
1%
617,500
1%
661,375
1%
700,375
1%
8,058,250
19%
8,036,625
18%
$8,598,000
18%
$9,199,875
18%
9,752,375
18%
378
EXHIBIT 14.3 Dynamic Analytic Systems, Inc.: Discounted Cash Flow Analysis of the Company’s Business Enterprise Value
20X2
Sales
Growth
20X3
20X4
20X5
Terminal
Value
20X6
$42,324,200 100.0% $44,433,700 100.0% $47,543,800 100.0% $50,871,700 100.0% $53,925,800 100.0% $55,544,000 100.0%
4.2%
5.0%
7.0%
7.0%
6.0%
3.0%
Cost of Sales
25,390,625
60.0%
27,993,875
63.0%
29,953,625
63.0%
32,049,875
63.0%
33,972,250
63.0%
34,991,686
63.0%
Gross Profit
16,933,575
40.0%
16,439,825
37.0%
17,590,175
37.0%
18,821,825
37.0%
19,953,550
37.0%
20,552,314
37.0%
SG&A Expenses
8,335,825
19.7%
7,826,325
17.6%
8,374,675
17.6%
8,960,575
17.6%
9,500,800
17.6%
9,785,899
17.6%
EBITDA
8,597,750
20.3%
8,613,500
19.4%
9,215,500
19.4%
9,861,250
19.4%
10,452,750
19.4%
10,766,415
19.4%
617,500
1.3%
661,375
1.3%
743,151
EBIT
8,058,250
19.0%
8,036,625
18.1%
9,199,875
18.1%
9,752,375
18.1%
10,023,264
18.0%
Less: Taxes
Less: Depreciation
(2,095,145)
539,500
−5.0%
1.3%
(2,089,523)
576,875
−4.7%
1.3%
(2,235,480)
−4.7%
(2,391,968)
−4.7%
1.3%
(2,535,618)
700,375
−4.7%
(2,606,049)
−4.7%
1.3%
Debt-Free Net Income
5,963,105
14.1%
5,947,103
13.4%
6,362,520
13.4%
6,807,908
13.4%
7,216,758
13.4%
7,417,216
13.4%
Plus: Depreciation
539,500
1.3%
576,875
1.3%
617,500
1.3%
661,375
1.3%
700,375
1.3%
743,151
1.3%
Less: Capital Expenditures
(539,891)
−1.3%
(566,800)
−1.3%
(617,500)
−1.3%
(672,100)
−1.3%
(721,500)
−1.3%
(743,151)
−1.3%
Less: Incremental Working Capital
(275,872)
−0.7%
(337,520)
−0.8%
(497,616)
−1.0%
(532,464)
−1.0%
(488,656)
−0.9%
(258,912)
−0.5%
Cash Flows to Invested Capital
5,686,842
13.4%
5,619,658
12.6%
5,864,904
12.3%
6,264,719
12.3%
6,706,977
12.4%
7,158,304
12.9%
Terminal Value
Partial Period
42,107,668
1.00
1.00
1.00
1.00
1.00
1.00
Period
0.50
1.50
2.50
3.50
4.50
4.50
Present Value Factor
0.913
0.761
0.634
0.528
0.440
0.440
5,191,353
4,275,018
3,717,986
3,309,537
2,952,645
18,537,262
Present Value Cash Flows to
Invested Capital
379
Sum of PV of CF
19,446,539
Assumptions
PV of Terminal Value
18,537,262
Discount Rate1
20.0%
Internal Rate of Return2
20.7%
Tax Rate3
26.0%
Debt-Free Working Capital Excess
Preliminary Value
Enterprise Value, Rounded
491,274
38,475,074
$38,475,000
Long-Term Growth Rate4
3.0%
Debt-Free Working Capital %5
16.0%
Notes:
1 Weighted average cost of capital per Exhibit 14.3.
2 Implied rate which reconciles the future expected cash flows to the fair value of the acquisition price.
3 Estimated corporate tax rate.
4 Based on Management’s projections, the growth prospects of the industry and the overall economy.
5 Per Exhibit 14.17
Year
Partial Period
Period
PV Factor
Year
Partial Period
Period
PV Factor
Year
Partial Period
Period
PV Factor
Sum of PV Factors 20X1 to 20Y6
20X2
1.00
0.50
0.913
20X6
1
5.50
0.367
20Y1
1
10.50
0.147
5.19
20X3
1.00
1.50
0.761
20X7
1
6.50
0.306
20Y2
1
11.50
0.123
20X4
1.00
2.50
0.634
20X8
1
7.50
0.255
20Y3
1
12.50
0.102
20X5
1.00
3.50
0.528
20X9
1
8.50
0.212
20Y4
1
13.50
0.085
20X6
1.00
4.50
0.440
20Y0
1
9.50
0.177
20Y5
1
14.50
0.071
20Y6
—
14.50
0.071
380
◾ Fair Value Measurement Case Study
7. What does business enterprise value mean, and why is it calculated? What are the
common methods to calculate the BEV? How does the market participant assumption
influence the BEV? Why would a valuation professional calculate the BEV under the
acquisition method?
8. When is it appropriate to include tax benefits in the calculation of BEV?
9. How does the implied internal rate of return (IRR) compare to the discount rate? How
does the inclusion of the tax benefits impact the IRR?
10. Discuss the following elements of the BEV in Exhibit 14.3:
◾
Calculation of the terminal value
◾
What are the alternatives for calculating the terminal value?
◾
How is debt treated, and what are the alternatives to this treatment?
Weighted Average Cost of Capital (WACC)
The business enterprise value is calculated using a discount rate of 17 percent. Exhibit 14.4
shows the calculation of the 17 percent weighted average cost of capital (WACC) and is based
on prevailing market rates on December 31, 20X1. The notes contained on the exhibit provide
additional source information.
11. When using a weighted average cost of capital, how are the relative weights of debt
and equity typically determined? What are the alternative methods for calculating the
cost of equity? Under the Mandatory Performance Framework, what responsibility
does the valuation professional have with respect to the discount rate?
Identifying and Valuing Intangible Assets
12. Why is it necessary for the valuation professional to analyze the company’s preliminary
acquisition balance sheet? What are the implications for fair value measurement if
the balance sheet is misstated?
13. Why is the highest and best use assumption important in the fair value measurement
of intangible assets?
14. How is the assumption about the taxable status of the business combination a highest
and best use assumption?
15. How should the target company’s deferred revenue be treated when applying
the acquisition method?
Business Background and Facts—Dynamic Analytic Systems, Inc.
◾
381
16. How does a valuation professional typically identify an acquired company’s intangible
assets? Who is responsible for identifying the intangible assets? What are the likely
acquired intangible assets in this case study?
17. What are the criteria for recognizing intangible assets under ASC 805? How does this
differ for privately held companies that elect the Private Company Council alternative
for recognition of intangible assets under ASU 2014-18?
18. What are the three broad approaches to valuing intangible assets and specific
methods within those approaches that you would use to value DAS’s intangible
assets? What are the advantages and disadvantages of each of the approaches? What
should the valuation professional consider when determining an appropriate valuation
method?
Although many of the costs associated with the cloud data storage platform and development of the Dynalytics application were expensed as incurred, DAS has kept meticulous
records from the inception of these projects. The records include the number of hours to create these software projects by employee and the hourly salaries for each employee involved
in the projects. Management estimates that benefits and overhead cost an additional 33 percent and 15 percent, respectively. For software projects, management believes the opportunity
cost is equal to the company’s weighted average cost of capital of 20 percent, and expects
to make an 18 percent profit.
19. The cloud data storage platform is DAS’s most important asset, and it was the reason
that AltoStratus acquired DAS. What additional consideration does this situation
warrant? What alternate approaches can be used to value the cloud platform? What
should the valuation professional consider when selecting an appropriate valuation
method?
The Cost Approach
20. When performing a valuation using the cost approach, which costs would you likely
consider?
382
EXHIBIT 14.4 Dynamic Analytic Systems, Inc.: Weighted Average Cost of Capital (WACC) as of December 31, 20X1
Cost of Equity:
After Tax Cost of Debt: kd = Kb(1 – t)
Build-up Method: Ke = Rf + RPm + RPs + RPu
Risk-Free Rate (Rf)
2.70%1
Borrowing Rate (Kb)
6.00%6
Market Premium (RPm)
6.90%2
Tax Rate (t)
26.00%7
Size Premium (RPs)
5.60%3
kd =
4.44%
6.00%4
Company-Specific Risk Premium (RPu)
ke =
21.20%
Capital Asset Pricing Model: Ke = Rf + 𝛃(RPm) + RPs + RPu
Weighted-Average Cost of Capital (WACC)
Risk-Free Rate (Rf)
2.70%1
Cost
Weighted
Cost
Market Premium B(RPm), where B = 1.215
8.38%5
Equity
Capital
Structure (8)
90.00%
22.00%
19.80%
Small Company Market Premium (RPs)
5.60%3
Debt
10.00%
4.44%
0.44%
Company-Specific Risk Premium (RPu)
6.00%4
ke =
22.68%
WACC =
20.24%
average ke =
22.00%
Rounded =
20.00%
Notes:
1 20-Year Treasury Bond as of June 30, 20X1; Federal Reserve Statistical Release.
2 Duff & Phelps 20XI Valuation Handbook: Guide to Cost of Capital. Many valuation specialists add an industry adjustment factor. However, the adjustment is
controversial and there is wide diversity in practice.
3 Duff & Phelps 2016 Valuation Handbook: Guide to Cost of Capital (Long-Term Returns in Excess of CAPM Estimations for the 10th Decile Portfolio of the
NYSE/AMEX/NASDAQ).
4 Company-specific risk implied from the reconciliation of management’s PFI and purchase price.
5 Based on the leverage adjusted beta for the guideline public company and relevered for the Company’s capital structure and estimated corporate tax rate.
6 LIBOR plus 5% (proxy for marginal borrowing rate.)
7 Estimated corporate tax rate.
8 Based on median level of capital structure for the guideline public companies. S&P Capital IQ.
◾
Business Background and Facts—Dynamic Analytic Systems, Inc.
383
EXHIBIT 14.5 Dynamic Analytic Systems, Inc.: Valuation of The Cloud Data Storage
Platform as of December 31, 20X1
Productivity
Estimated
Hours to
Recreate
Lines of
Code
Lines
per Hour
Module A
65,250
2
Module B
107,500
3
35,833
Module C
97,500
3
32,500
8,500
4
Module D
32,625
2,125
278,750
103,083
Fully Loaded, Hourly Rate1
106.76
Reproduction Cost
11,004,718
Less: Obsolescence based on remaining useful life
25%
(2,751,179)
Replacement Cost
8,253,538
Fair Value of Graphic Design Software, Rounded
$8,254,000
Note:
1 The fully loaded, hourly rate includes:
Blended hourly salary
Benefits
Overhead
Opportunity Cost of Development
Entrepreneurial Profit
33%
15%
20%
18%
$56.26
18.57
8.25
11.25
12.42
= (56.26 / (1 − 18%) * 18%)
$106.76
Exhibit 14.5 shows a calculation of the cloud data storage platform’s reproduction cost
and replacement cost, and Exhibit 14.6 shows a calculation of the Dynalytics development
project’s replacement cost.
21. What is the difference between reproduction cost and replacement cost?
Obsolescence is deducted from the reproduction cost to arrive at the replacement
cost. What types of obsolescence would the valuation professional consider?
22. Why would an opportunity cost of development and entrepreneurial profit be
included as part of the costs?
384
◾ Fair Value Measurement Case Study
EXHIBIT 14.6 Dynamic Analytic Systems, Inc.: Valuation of In-Process Development of the
Dynalytics Application as of December 31, 20X1
Cost of In-Process R&D1
$1,114,200
Opportunity Cost2
20%
Entrepreneur’s Profit2,3
18%
222,840
246,020
Total Replacement Cost
1,583,060
Fair Value In-Process R&D, Rounded
$1,583,000
Notes:
1 Information provided by management.
2 Assumes a one year period applies to the opportunity costs to develop.
3 Calculated as (Cost/(1 – Margin) * Margin) and assumes a one-year period applies to entrepreneurial
profit.
23. The fair value measurement of DAS’s cloud data storage platform and in-process
development includes opportunity costs and entrepreneur’s profit (footnote 1
in Exhibit 14.5). What are common proxies used to estimate these costs? How is
entrepreneur’s profit calculated?
24. Why is there a time frame included in the calculation of opportunity costs
and entrepreneur’s profit in Exhibit 14.6?
25. What are the alternatives to using the replacement cost method to estimate the fair
value of customer relationships?
DAS has 44 dedicated employees, including 20 highly qualified application designers
and programmers. Several of the application designers and programmers are considered
to be indispensable, because they are the creative force behind the company’s product development. In addition to payroll information, DAS files contain information on direct hiring
and training costs. DAS also estimates inefficiency costs for new employees based on effectiveness percentages ranging from 70 percent to 90 percent and on a three- to six-month period
required to achieve full productivity.
Exhibit 14.7 shows the valuation of DAS’s assembled workforce.
26. Is assembled workforce an identifiable intangible asset under the acquisition method?
Why would the fair value of an assembled workforce be determined under
the acquisition method? Why are opportunity costs and entrepreneur’s profit
excluded? Can other methods be used to value the assembled workforce?
385
EXHIBIT 14.7 Dynamic Analytic Systems, Inc.: Valuation of Assembled Workforce as of December 31, 20X1
Average
Annual Salary1
Fringe
Benefits1
Average Annual
Salary with
Benefits
Total Hiring
Cost per
Employee2
Number of
Employees as of
Valuation Date1
Total Hiring
Cost
Executive
184,560
60,905
245,464
49,093
4
196,372
Sales
144,936
47,829
192,764
38,553
7
269,870
Apps Designers
106,893
35,275
142,167
28,433
12
341,201
Administrative
37,307
12,311
49,619
9,924
6
59,543
Programmers
75,309
24,852
100,161
20,032
8
160,258
Warehouse
42,368
13,982
56,350
11,270
Employee
Classification
7
78,890
44
1,106,133
Average Salary
with Benefits
Percent
Effective1
Number of
Months Until Full
Productivity1
Inefficiency
Training Costs
Direct
Training
Costs3
Total Training
Costs per
Employee
Number of
Employees as of
Valuation Date1
Executive
245,464
90%
6.0
12,273
5,884
18,157
4
72,628
Sales
192,764
90%
3.0
4,819
2,761
7,580
7
53,062
Apps Designers
142,167
90%
3.0
3,554
2,016
5,570
12
66,846
Administrative
49,619
90%
3.0
1,240
1,845
3,085
6
18,511
Programmers
100,161
80%
3.0
5,008
2,145
7,153
8
57,224
Warehouse
56,350
70%
3.0
4,226
1,005
5,231
7
36,618
44
304,889
Employee
Classification
Notes:
1 Information provided by Management.
2 Estimated to be 20% of average annual salary and benefits, based on discussions with management.
3 Estimated by Human Resources based on recent costs for classes and materials.
Total Training
Cost
Subtotal
1,411,022
Rounded to
1,411,000
386
◾ Fair Value Measurement Case Study
The Market Approach—Relief from Royalty
Prospects for future sales are enhanced by DAS’s widespread name recognition within the
industry. When its cloud-based software was introduced to the market eight years ago, the
marketing director created a sensation at the industry’s largest trade show. That introduction
was followed up by an award-winning, targeted advertising campaign. As a result, DAS’s marketing research indicates that many industry participants recognize the DAS name and logo,
and associate it with cloud storage and data management software.
Royalty rates for licenses within the data storage industry are presented in Exhibit 14.8,
and DAS’s trade name is valued using the relief from royalty method, as shown in Exhibit 14.9.
27. The fair value of the trade name is determined using a royalty savings rate of 2 percent
based on comparable industry rates. What factors should the valuation professional
consider when selecting an appropriate industry royalty rate? What are some of the
challenges in applying the relief from royalty method?
28. Is the relief from royalty method a market or an income valuation approach? What
assumptions are incorporated into this valuation? When assessing the royalty rates
from third party license agreements, what should the valuation professional consider?
Should the profit split rule-of-thumb method be used?
The Income Approach
The noncompete employment agreement signed by Thomas Parker provides value to the company by protecting future revenues from competition. The agreement is for a four-year period.
Based on his close personal relationship with several key customers who are experiencing
rapid sales growth, AltoStratus estimates that direct competition by Thomas Parker would
cause a 20 percent loss in revenue. The probability that Thomas Parker would compete is considered to be relatively high because he has the means and ability to do so and he has numerous
contacts in the industry. Therefore, AltoStratus assessed the probability of competition as 50
percent.
The noncompetition agreement is valued using a with/without method under the income
approach in Exhibit 14.10.
29. Are there alternative methods that can be used to measure the fair value of a
noncompetition agreement? What assumptions form the basis for this valuation?
As a result of its sophisticated marketing efforts, DAS has attracted wide recognition and
a broad customer base for its cloud data storage services. Due to high customer satisfaction
ratings, customer relationships tend to last for several years. Existing customers provide a
captive market for cross selling the company’s analytics software applications.
387
EXHIBIT 14.8 Dynamic Analytic Systems, Inc.: Data Storage Industry as of December 31, 20X1
Royalty
Licensor
Licensee
Undisclosed
Alphatec, Inc.
Date
May - Y9
Terms
International
Low
High
2.5%
3.2%
Telecomp Inc.
Century Software, Corp.
Jan- Y9
Nonexclusive
1.0%
1.5%
QuickComm, Inc
Dynatech Cloud Solutions
Dec - X8
Exclusive
2.0%
2.5%
Cloudesk, Corp.
LPM Digital Storage, Inc.
Feb - X8
NA
1.5%
2.0%
Interactive Software, Inc.
Data Tech, Corp.
Jan - X8
Nonexclusive
0.0%
1.0%
American Software Enterprises, Ltd
Sigma CloudSource, Inc.
Nov - X7
Exclusive
2.3%
2.7%
BlackBox Data Solutions
Global Tech, Corp.
Jun - X7
NA
1.0%
1.0%
Mar - X6
International, sole and exclusive
2.7%
3.0%
Alphatech Technologies, Inc.
High
2.7%
3.2%
3rd Q
2.4%
2.8%
Mean
1.6%
2.1%
Median
1.8%
2.3%
1st Q
1.0%
1.4%
Low
0.0%
1.0%
Mode
1.0%
1.0%
Selected Royalty Rate:
2.0%
Source: The royalty rates in this exhibit are typically available from Royalty Source, www.royaltysource.com. However, the companies and the royalty rates
presented in this exhibit are not real.
388
EXHIBIT 14.9 Dynamic Analytic Systems, Inc.: Valuation of Trade Name as of December 31, 20X1
20X2
Revenue
Growth
20X3
20X4
20X5
20X6
20Y2
$42,324,200 100% $44,433,700 100% $47,543,800 100% $50,871,700 100% $53,925,800 100%
4%
5%
(247,228) −1%
(264,533) −1%
(280,414) −1%
(334,828) −1%
After-Tax Royalty Savings
626,398
657,619
703,648
752,901
798,102
952,972
1.00
2%
1,017,434
1%
1.00
1.00
2%
1%
1,078,516
3%
(231,055) −1%
1%
950,876
6%
(220,086) −1%
1%
2%
7%
846,484
Less: Taxes
1.00
888,674
7%
Pretax Royalty Savings
Partial Period
2%
$64,390,000 100%
1.00
2%
1%
1,287,800
1.00
Period
0.50
1.50
2.50
3.50
4.50
10.50
Present Value Factor
0.894
0.716
0.572
0.458
0.366
0.096
560,268
470,554
402,792
344,789
292,390
91,522
PV of After-Tax Royalty Savings
Sum of PV of Savings
Amortization Benefit Multiplier
Preliminary Value
Concluded Value, Rounded
3,011,221
Assumptions
1.09
Discount Rate
3,293,076
$3,293,000
25.0%
Long-Term Growth Rate
3.0%
Tax Rate
26.0%
Royalty Rate
Remaining Useful Life
2.0%
10 years
2%
1%
389
EXHIBIT 14.10 Dynamic Analytic Systems, Inc.: Analysis of Noncompetition Agreement as of December 31, 20X1
20X2
Revenue
Growth
20X3
$42,324,200
4.2%
Revenue Lost to Competition
8,464,840
× Probability of Competition
50%
20X4
$44,433,700
5.0%
20.0%
8,886,740
20X5
$47,543,800
$50,871,700
7.0%
20.0%
50%
9,508,760
7.0%
20.0%
50%
10,174,340
20.0%
50%
Adjusted Revenue
$38,091,780
100.0%
$39,990,330
100.0%
$42,789,420
100.0%
$45,784,530
100.0%
Cost of Sales
22,851,563
60.0%
25,194,488
63.0%
26,958,263
63.0%
28,844,888
63.0%
Gross Profit
15,240,218
40.0%
14,795,843
37.0%
15,831,158
37.0%
16,939,643
37.0%
SG&A Expenses
7,502,243
19.7%
7,043,693
17.6%
7,537,208
17.6%
8,064,518
17.6%
EBITDA
7,737,975
20.3%
7,752,150
19.4%
8,293,950
19.4%
8,875,125
19.4%
Depreciation
485,550
1.3%
519,188
1.3%
555,750
1.3%
595,238
1.3%
EBIT
7,252,425
19.0%
7,232,963
18.1%
7,738,200
18.1%
8,279,888
18.1%
Less: Taxes
(1,885,631)
−5.0%
(1,880,570)
−4.7%
(2,011,932)
−4.7%
(2,152,771)
−4.7%
Debt-Free Net Income
5,366,795
14.1%
5,352,392
13.4%
5,726,268
13.4%
6,127,117
13.4%
Plus: Depreciation
485,550
1.3%
519,188
1.3%
555,750
1.3%
595,238
1.3%
Less: Capital Expenditures
(485,902)
−1.3%
(510,120)
−1.3%
(555,750)
−1.3%
(604,890)
−1.3%
−0.8%
(303,768)
−0.8%
(447,854)
−1.1%
(479,218)
−1.1%
Less: Incremental Working Capital
(306,524)
Debt-Free Cash Flows—With
Competition
5,059,918
5,057,692
5,278,414
5,638,247
Debt-Free Cash Flows—Without
Competition
5,686,842
5,619,658
5,864,904
6,264,719
(Continued)
390
EXHIBIT 14.10
(continued)
20X2
Cash Flows Attributable to Noncompete
Agreement
20X3
20X4
20X5
626,924
561,966
Partial Period
1.00
1.00
1.00
1.00
Period
0.50
1.50
2.50
3.50
Present Value Factor
586,490
626,472
0.898
0.724
0.584
0.471
Present Value of Cash Flows to Invested Capital
562,994
406,984
342,536
295,070
Preliminary Value of Noncompete Agreement
1,607,585
Assumptions
Amortization Benefit Multiplier
Concluded Value of Noncompetition
Agreement, Rounded
1.10
$1,764,000
Discount Rate
24.0%
Tax Rate
26.0%
Long-Term Growth Rate
3.0%
Term of Benefit from
Noncompete Agreement
4 years
Assu
Business Background and Facts—Dynamic Analytic Systems, Inc.
◾
391
Exhibit 14.11 shows the valuation of customer relationships under the distributor
method.
30. When is the distributor method most appropriately used? What must be considered in
applying the distributor method? What are market participant assumptions and inputs
are used in the distributor method?
Six months before selling DAS to AltoStratus, Thomas Parker registered a copyright to
protect some of the upgrades and features contained in the second generation version of DAS’s
cloud data management and storage platform. In addition, the company had recently beefed
up its sales force by hiring three seasoned salespeople and a new vice president of sales. AltoStratus’s CEO Daniel Novaro reviewed DAS’s sales projections as part of the acquisition due
diligence process and was favorably impressed.
DAS’s cloud data storage platform is valued using the multiperiod excess earnings method
in Exhibit 14.12.
31. The required rate of return on contributory assets is deducted from the cash flows of
the company to arrive at excess earnings. What are contributory assets? Discuss how
to estimate the required return on each of the contributory assets. What are typical
contributory tangible assets, what are the relevant market participant assumptions
and documentation requirements? For intangible contributory assets, what
documentation is required?
32. What is an appropriate discount rate to use for the cash flows attributable to the cloud
data storage platform? How does this rate compare to the company’s weighted
average cost of capital?
33. How would your analysis of the cloud data storage platform using the multiperiod
excess earnings method differ if the purpose of the valuation were to assist
management in maximizing the benefit from the acquired cloud data storage
platform? Would projections include synergies with AltoStratus? Would the discount
rate differ?
In-process development of the Dynalytics analytics product is also valued using the multiperiod excess earnings method in Exhibit 14.13.
34. How is it possible to use the excess earnings method to estimate the value of two
different assets?
392
EXHIBIT 14.11
Dynamic Analytic Systems, Inc.: Valuation of Customer Relationships as of December 31, 20X1
20X2
Projected Revenues
Decay Factor
20X3
20X4
20X5
20X6
20X7
20X8
20X9
42,324,200 44,433,700 47,543,800 50,871,700 53,925,800 55,543,600 57,209,900 58,926,200
0.22
0.16
0.11
0.08
Remaining Revenues
35,826,662 26,950,401 20,662,450 15,841,611 12,032,472
8,880,297
6,553,900
4,836,957
EBITDA
2,507,866
1,886,528
1,446,372
1,108,913
842,273
621,621
458,773
338,587
7.0%
7.0%
7.0%
7.0%
7.0%
7.0%
7.0%
7.0%
Less: Taxes
(652,045)
(490,497)
(376,057)
(288,317)
(218,991)
(161,621)
(119,281)
(88,033)
Debt-Free Net Income before Contributory Charge
1,855,821
1,396,031
1,070,315
820,595
623,282
459,999
339,492
250,554
Less: Contributory Asset Charge
(644,880)
(485,107)
(371,924)
(285,149)
(216,585)
(159,845)
(117,970)
(87,065)
Contributory Asset Charge as a Percentage of Revenue
1.8%
1.8%
1.8%
1.8%
1.8%
1.8%
1.8%
1.8%
Debt-Free Cash Flow to Dynamic Cloud Data Platform
1,210,941
910,924
698,391
535,446
406,698
300,154
221,522
163,489
Partial Period
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
Period
0.50
1.50
2.50
3.50
4.50
5.50
6.50
7.50
EBITDA Margin
Present Value Factor
0.85
0.61
0.43
0.31
0.891
0.707
0.561
0.445
0.353
0.281
0.223
0.177
Present Value of Debt-Free Cash Flows
1,078,792
644,060
391,897
238,462
143,749
84,199
49,318
28,887
Sum of PV of DFCF
2,659,364
Amortization Benefit Multiplier
Preliminary Value
Concluded Value Mobile Applications Technology
1.09
2,898,856
$2,899,000
Assumptions
Discount Rate
26.0%
Tax Rate
26.0%
Customer Decay Factor
3 years
393
EXHIBIT 14.12 Dynamic Analytic Systems, Inc.: Valuation of DAS’s Cloud Data Storage Platform as of December 31, 20X1
Projected Dynamic Cloud Data Platform Revenue
Mobile Application %
EBITDA
20X2
20X3
20X4
20X5
20X6
35,993,000
37,792,000
35,680,000
33,087,000
32,375,000
85%
85%
75%
65%
60%
7,311,628
7,326,002
6,915,918
6,413,766
6,275,434
EBITDA Margin
20.3%
19.4%
19.4%
19.4%
19.4%
Less: Depreciation
(458,797)
(490,647)
(463,413)
(430,159)
(420,479)
EBIT
6,852,831
6,835,355
6,452,506
5,983,607
5,854,955
719,860
755,840
713,600
661,740
647,500
Adjusted EBIT
6,132,971
6,079,515
5,738,906
5,321,867
5,207,455
Less: Charge for Use of Tradename
Less: Taxes
(1,594,572)
(1,580,674)
(1,492,115)
(1,383,685)
(1,353,938)
Debt-Free Net Income before Contributory Charge
4,538,399
4,498,841
4,246,790
3,938,182
3,853,517
Less: Contributory Asset Charge
(1,634,710)
(1,647,295)
(1,470,080)
(1,289,750)
(949,942)
Contributory Asset Charge as a Percentage of Revenue
4.5%
4.4%
4.1%
3.9%
2.9%
Debt-Free Cash Flow to Dynamic Cloud Data Platform
2,903,688
2,851,547
2,776,710
2,648,432
2,903,575
Partial Period
1.00
1.00
1.00
1.00
1.00
Period
0.50
1.50
2.50
3.50
4.50
Present Value Factor
0.902
0.733
0.596
0.485
0.394
Present Value of Debt-Free Cash Flows
2,618,167
2,090,368
1,654,885
1,283,278
1,143,826
Sum of PV of DFCF
8,790,525
Amortization Benefit Multiplier
Preliminary Value
Concluded Value Mobile Applications Technology
1.10
Assumptions
9,683,274
Discount Rate
23.0%
Tax Rate
26.0%
Remaining Useful Life
5 years
$9,683,000
394
EXHIBIT 14.13
Dynamic Analytic Systems, Inc.: Valuation of In-Process Development of Dynalytics as of December 31, 20X1
Projected Revenue from IPR&D
20X2
20X3
$0
$0
Growth
EBITDA
EBITDA Margin
Less: Depreciation
20X4
20X5
20X6
20X7
20X8
$7,136,000
$12,726,000
$16,188,000
$16,673,640
$17,173,849
NA
NA
78.3%
3.0%
3.0%
3.0%
—
—
1,383,184
2,466,878
3,137,814
3,231,948
3,328,907
20.3%
19.4%
19.4%
19.4%
19.4%
19.4%
19.4%
—
—
(92,683)
(165,449)
(210,246)
(297,260)
(306,178)
3,022,729
EBIT
—
—
1,290,501
2,301,429
2,927,568
2,934,688
Less: Charge for Use of Tradename
—
—
142,720
254,520
323,760
333,473
343,477
Adjusted EBIT
—
—
1,147,781
2,046,909
2,603,808
2,601,215
2,679,252
(298,423)
(532,196)
(676,990)
(676,316)
(696,605)
Debt-Free Net Income before Contributory Charge
—
—
849,358
1,514,713
1,926,818
1,924,899
1,982,646
Less: Contributory Asset Charge
Less: Taxes
—
—
(294,016)
(496,067)
(474,986)
(478,433)
(492,786)
Contributory Asset Charge as a Percentage of Revenue
4.5%
4.4%
4.1%
3.9%
2.9%
2.9%
2.9%
Debt-Free Cash Flow to Mobile Applications Technology
—
—
555,342
1,018,646
1,451,832
1,446,466
1,489,860
Partial Period
1.00
1.00
1.00
1.00
1.00
1.00
1.00
Period
0.50
1.50
2.50
3.50
4.50
5.50
6.50
Present Value Factor
0.887
0.699
0.550
0.433
0.341
0.269
0.211
—
—
305,528
441,276
495,222
388,497
315,080
Present Value of Debt-Free Cash Flows
Sum of PV of DFCF
Amortization Benefit Multiplier
Preliminary Value
Concluded Value Mobile Applications Technology
—
—
1,945,603
1.09
Assumptions
2,114,408
Discount Rate
27.0%
Tax Rate
26.0%
Remaining Useful Life
7 years
$2,114,000
Business Background and Facts—Dynamic Analytic Systems, Inc.
◾
395
DAS has decided to use the distributor method under the income approach to estimate the
fair value of customer relationships. How are the inputs to this method different than those
used in the MPEEM?
Exhibit 14.14 shows the calculation of the required return on contributory assets for
valuing DAS’s cloud data storage platform and in-process development.
35. What is the difference between return of capital and return on capital as shown in the
calculation of required return on contributory assets?
36. Contributory charges under the multiperiod excess earnings method are one of the
more controversial topics in valuation. What are some of the issues? How do you
handle negative working capital as a contributory charge? Do you take a charge on
goodwill, or not? How do you handle contributory charges on noncompete
agreements when there is a mismatch between the contractual protection and the
life of the expected benefit?
The valuation of DAS’s cloud data storage platform using the cost approach indicates a
fair value of $8,254,000 and the valuation using the multiperiod excess earnings method
indicates an $9,683,000 fair value.
37. When the values calculated under the two valuation methods are significantly
different, what would you consider in determining the appropriate measure of fair
value? What guidance does ASC 820, Fair Value Measurements, provide when more
than one valuation technique is appropriate? What responsibility does the valuation
professional have with respect to reconciling the value from multiple approaches?
38. Which of the intangible assets in this case study is subject to amortization? How do
you estimate a remaining useful life?
Goodwill
39. How is the fair value of goodwill measured?
40. Once all the opening balance sheet adjustments are recorded, including those
to intangible assets and goodwill, how is the total purchase price reflected
on AltoStratus’s books, on DAS’s books, and on the consolidated company’s books.
396
EXHIBIT 14.14
Dynamic Analytic Systems, Inc.: Required Return on Contributory Assets as of December 31, 20X1
20X2
Total Revenue
20X3
20X4
20X5
20X6
20X7
$ 42,324,200 $ 44,433,700 $ 47,543,800 $ 50,871,700 $ 53,925,800 $ 55,544,000
Growth
4.2%
5.0%
7.0%
7.0%
6.0%
3.0%
Multiplied by: DFWC %
16.0%
16.0%
16.0%
16.0%
16.0%
16.0%
6,771,872
7,109,392
7,607,008
8,139,472
8,628,128
8,887,040
300,671
315,657
337,751
361,393
383,089
394,585
539,891
566,800
617,500
672,100
721,500
743,151
Required Debt-Free Working Capital
Required Working Capital Return
4.4%
(1)
Capital Expenditures (2)
Less: Depreciation
Net Fixed Assets Balance
Required Return on Capital Investment
4.4%
Noncompetition Agreement Beginning Value
$ 1,764,000
Noncompetition Agreement Required Return
24.0%
Assembled Workforce Beginning Value
ASWF Required Return
576,875
617,500
661,375
700,375
743,151
2,373,849
2,373,849
2,384,574
2,405,699
2,405,699
(1)
105,846
105,399
105,399
105,875
106,813
106,813
(1)
423,360
423,360
423,360
423,360
—
—
(1)
338,640
338,640
338,640
338,640
338,640
338,640
(1)
753,740
753,740
753,740
753,740
753,740
753,740
$ 1,411,000
24.0%
Customer Relationships Beginning Value
$ 2,899,000
Customer Relationships Required Return
26.0%
Required Return on Contributory
Assets (as a % of Revenue)
539,500
2,383,924
$ 2,383,533
4.5%
Assusssss
4.4%
Assusssss
4.1%
Assusssss
3.9%
Assusssss
2.9%
Assusssss
2.9%
Assusssss
Business Background and Facts—Dynamic Analytic Systems, Inc.
◾
397
EXHIBIT 14.15 Dynamic Analytic Systems, Inc.: Acquisition Summary as of December 31,
20X1
Dollar Amount
Cash
Equity Consideration
Contingent Consideration
Note Payable
$30,000,000
1,890,000
238,150
5,000,000
Acquisition Costs
–
$37,128,150
Concluded Value Estimate
Tangible Assets
Working Capital, net
$7,031,030
Fixed Assets
2,383,533
Intangible Assets
Dynamic Cloud Data Platform Technology
9,683,000
Tradename
3,293,000
Customer Relationships
2,899,000
Noncompetition Agreement
1,764,000
In-process Development
2,114,000
Assembled Workforce
1,411,000
Goodwill
Total Assets Acquired
6,549,587
$37,128,150
Exhibit 14.15 shows the final summary of intangible assets and goodwill under the acquisition method.
Reconciling the Required Rate of Return to the Weighted Average
Cost of Capital
When valuing intangible assets under the acquisition method, an important final step is to
calculate the Weighted Average Return on Assets (WARA) indicated by the respective asset’s
fair values and required returns. The WARA should be similar to the company’s weighted
average cost of capital (WACC). Exhibit 14.16 shows a calculation of the Weighted Average
Return on Assets for the acquired assets. Exhibit 14.17 provides the supporting calculation of
debt free working capital.
398
◾ Fair Value Measurement Case Study
EXHIBIT 14.16 Dynamic Analytic Systems, Inc.: Comparison of Weighted Average Return
on Assets to WACC as of December 31, 20X1
Assets Acquired:
At
12/31/20X1
Required Debt-Free Working Capital
$
Estimated
Required
Return
Estimated
Required Return
($000s)
6,539,756
4.44%
Fixed Assets
2,383,533
4.44%
$
290,365
105,829
Dynamic Cloud Data Platform Technology
9,683,000
23.00%
2,227,090
Noncompete Agreement
1,764,000
24.00%
423,360
Assembled Workforce
1,411,000
24.00%
338,640
Tradename
3,293,000
25.00%
823,250
Customer Relationships
2,899,000
26.00%
753,740
In-Process Development
2,114,000
27.00%
570,780
Goodwill
6,549,587
30.00%
1,964,876
36,636,876
Plus: Excess DFWC
Fair Value of Consideration
$7,497,930
491,274
$ 37,128,150
Weighted Average Return on Assets
20.2%
WACC
20.0%
Difference
0.2%
Internal Rate of Return:
20.7%
Notes:
1 The estimated required returns consider the relative risk of the individual intangible assets.
2 The allocation excluding a tax amortization benefit in the value of intangible assets does not vary
significantly from the allocation above.
41. What is the weighted average return on assets (WARA) for the business combination?
Why would one calculate the (WARA) for the business combination? What is the
starting point for the calculation? What is the difference between the WARA and the
WACC? What is the purpose of reconciling the WARA for acquired assets to the
company’s WACC? What is the difference between the WARA and the Internal Rate of
Return (IRR) shown in Exhibit 14.3?
42. How do you determine the risk premium over the weighted average cost of capital for
each of the intangible assets and for goodwill?
Bargain Purchase
Now, suppose that all facts in the case study are the same except that cash consideration
is $15.5 million instead of $30.0 million. AltoStratus makes a bargain purchase when it
acquires DAS. The gain from the bargain purchase is $6,539,413. The summary of the
acquisition method assuming the bargain purchase is shown in Exhibit 14.18.
Business Background and Facts—Dynamic Analytic Systems, Inc.
◾
399
EXHIBIT 14.17 Dynamic Analytic Systems, Inc.: Debt-Free Working Capital Requirement
Industry Debt-Free Working Capital Requirements1
NAICS Code
541512
541511
Computer
Custom Computer
System Design
Programming
As a Percentage of Total Assets
Current Assets
69.1%
72.1%
Less: Current Liabilities
51.1%
48.7%
Working Capital
18.0%
23.4%
Working Capital
18.0%
23.4%
Plus: Notes Payable—Short-term
10.9%
9.9%
Plus: Current Mat.—L.T.D.
2.9%
1.9%
Debt-Free Working Capital (DFWC)
31.8%
35.2%
Debt-Free Working Capital
31.8%
35.2%
Times: Total Assets—$000
$ 13,292,327
$ 20,321,797
Debt-Free Working Capital—$000
$
4,226,960
$
7,153,273
Debt-Free Working Capital—$000
$
4,226,960
$
7,153,273
Divided by: Total Sales—$000
$ 25,110,934
$ 46,502,956
16.8%
15.4%
DFWC as a Percentage of Sales
Median Industry DFWC Requirements5
16.00%
Trailing 12 Months’ Revenue—December, 31 20X12
40,600,000
Required DFWC3
6,539,756
Actual DFWC4
7,031,030
DFWC Excess (Deficit)
$491,274
Notes:
1 Risk Management Association’s 20X0-20X1 Annual Statement Studies.
2 Per Dynamic Analytic’s historic financial statements through December 31, 20X1.
3 Dynamic Analytic’s trailing 12 months Revenue, 20X1 multiplied by industry level DFWC requirement.
4 Per preliminary balance sheet.
5 Management believes a normal level of working capital is approximately 16%.
43. How is a bargain purchase treated under ASC 305, Business Combinations? Why is the
assembled workforce not recognized?
Subsequent Testing for Impairment
Under the original case study facts (cash consideration is $30.0 million) assume that a year
has passed and that DAS experienced a downturn in 20X2. The rollout of DAS’s Dynalytics
400
◾ Fair Value Measurement Case Study
EXHIBIT 14.18 Dynamic Analytic Systems, Inc.: Acquisition Summary—Bargain Purchase
as of December 31, 20X1
Dollar Amount
Cash
Equity Consideration
Contingent Consideration
Note Payable
Acquisition Costs
$15,500,000
1,890,000
238,150
5,000,000
–
$22,628,150
Concluded Value Estimate
Tangible Assets
Working Capital, net
$7,031,030
Fixed Assets
2,383,533
Intangible Assets
Mobile Application Technology
9,683,000
Tradename
3,293,000
Customer Relationships
2,899,000
Noncompetition Agreement
1,764,000
Concluded Value In-process Research and
Development
2,114,000
Assembled Workforce
Gain from Bargain Purchase
Total Assets Acquired
–
(6,539,413)
$22,628,150
product has not achieved expected results. The product received less than favorable user
reviews in trade publications. Several reviewers noted that a competitor has a vastly superior
product. Sales declined slightly in the first quarter 20X2 and continued to decline at an
accelerating pace through the end of the year. DAS has also experienced an exodus of
experienced design personnel due to poor morale and a culture clash with AltoStratus. DAS’s
marketing director recently announced her imminent departure, which was viewed by senior
management as a serious blow to the company’s prospects for future sales.
The value of AltoStratus’s DAS reporting unit has dropped significantly. Management’s
latest estimate of business enterprise value based on discounted cash flows is $24.5 million,
which represents a decline in value of approximately 37 percent. AltoStratus’s stock price has
also declined, losing almost 25 percent in one year. It is currently trading at $33.75, down
from the $45.00 price per share on the day it acquired DAS (Exhibit 14.19). The decline
in AltoStratus’s stock price is attributable to DAS’s poor performance. AltoStratus’s other
operations and overall market conditions are unchanged from a year ago.
401
EXHIBIT 14.19 Dynamic Analytic Systems, Inc.: Discounted Cash Flow Analysis—DAS Reporting Unit, as of December 31, 20X2
20X3
Sales
20X4
20X5
20X6
Terminal
Value
20X7
$ 32,094,000
100.0%
$34,995,000
100.0%
$37,380,000
100.0%
$39,051,000
100.0%
$40,234,000
100.0%
$41,039,000
Cost of Sales
19,997,179
62.3%
22,046,889
63.0%
23,549,345
63.0%
24,602,336
63.0%
25,347,336
63.0%
25,854,484
Gross Profit
12,096,821
37.7%
12,948,111
37.0%
13,830,655
37.0%
14,448,664
37.0%
14,886,664
37.0%
15,184,516
37.0%
SG&A Expenses
6,428,723
20.0%
6,895,323
19.7%
7,203,643
19.3%
7,472,005
19.1%
7,701,911
19.1%
7,856,011
19.1%
EBITDA
5,668,098
17.7%
6,052,787
17.3%
6,627,012
17.7%
6,976,659
17.9%
7,184,753
17.9%
7,328,505
17.9%
661,375
2.1%
721,154
2.1%
770,298
2.1%
804,742
2.1%
829,110
2.1%
845,699
2.1%
EBIT
5,006,723
15.6%
5,331,634
15.2%
5,856,713
15.7%
6,171,917
15.8%
6,355,643
15.8%
6,482,807
15.8%
Less: Taxes
(1,301,748)
−4.1%
(1,386,225)
−4.0%
(1,522,745)
−4.1%
(1,604,698)
−4.1%
(1,652,467)
−4.1%
(1,685,530)
−4.1%
Debt-Free Net Income
3,704,975
11.5%
3,945,409
11.3%
4,333,968
11.6%
4,567,218
11.7%
4,703,176
11.7%
4,797,277
11.7%
Plus: Depreciation
661,375
2.1%
721,154
2.1%
770,298
2.1%
804,742
2.1%
829,110
2.1%
845,699
2.1%
Growth
Less: Depreciation
9.0%
6.8%
4.5%
3.0%
100.0%
2.0%
63.0%
Less: Capital Expenditures
(404,820)
−1.3%
(456,030)
−1.3%
(503,720)
−1.3%
(666,974)
−1.7%
(652,099)
−1.6%
(845,699)
−1.6%
Less: Incremental Working Capital
(513,504)
−1.6%
(464,160)
−1.3%
(381,600)
−1.0%
(267,360)
−0.7%
(189,280)
−0.5%
(128,800)
−0.3%
Cash Flows to Invested Capital
3,448,026
10.7%
3,746,373
10.7%
4,218,946
11.3%
4,437,627
11.4%
4,690,907
11.7%
Terminal Value
4,668,477
11.4%
25,935,983
(Continued)
402
EXHIBIT 14.19
(continued)
20X3
Period
Present Value Factor
0.50
20X4
1.50
20X5
20X6
2.50
20X7
3.50
4.50
Terminal
Value
4.50
0.913
0.761
0.634
0.528
0.440
0.440
Present Value of Cash Flows to Invested
Capital
3,147,603
2,849,962
2,674,551
2,344,317
2,065,101
11,417,923
Sum of PV of CF
13,081,534
PV of Terminal Value
11,417,923
Discount Rate1
20.0%
Preliminary Value
24,499,457
Tax Rate2
26.0%
Enterprise Value, Rounded
$24,499,000
Assumptions
Long-Term Growth Rate3
2.0%
Debt-Free Working Capital %4
16.0%
Notes:
1 Weighted Average Cost of Capital per Exhibit 13.4.
2 Estimated corporate tax rate.
3 Based on Management’s projections, the growth prospects of the industry and the overall economy.
4 Per Exhibit 13.17.
Business Background and Facts—Dynamic Analytic Systems, Inc.
◾
403
Suspecting that a write down of the Dynalytics asset group may be necessary and
that goodwill may be impaired, Daniel Novaro, AltoStratus’s CEO, consulted a valuation
professional to discuss the qualitative impairment test under ASC 350.
44. What are the qualitative events and circumstances that would be used to assess
goodwill for impairment under ASC 350, Intangibles—Goodwill and Other? How are
the factors applied in the qualitative test? If the qualitative test indicates impairment,
what is required? What other option does the Company have?
After considering a qualitative impairment test, which would require substantial
auditable documentation, Daniel Novaro decides that a quantitative impairment test for
the DAS reporting unit would be more expedient. Therefore, Novaro decides to forego the
qualitative test and perform step one of the goodwill impairment test. In addition he decides
to test the Dynalytics asset group under ASC 360 in conjunction with the impairment test of
the reporting unit. He asks the valuation professional to perform the impairment tests.
The valuation professional analyzes management’s latest estimate of DAS’s business
enterprise value and concludes that the assumptions are reasonable and that it is properly
calculated. However, he wants to use a market-based approach to confirm the reporting unit’s
value. After thoroughly researching the industry, he finds five companies that are roughly
comparable in terms of size, market share, and financial characteristics.
Information on the comparable companies, including their price to earnings ratios (P/E)
is presented in Exhibit 14.20.
45. Based on the selected P/E ratio of 7.0 and projected 20X3 earnings of $3.248 Million
(Debt Free Cash Flow to Invested Capital of $3.448 million less $200,000 interest), what
is the implied value of DAS? How does the implied value compare to the $24.5 million
value calculated using the discounted cash flows? What would be some possible
reasons for the differences? How can the two values be reconciled?
46. In the quantitative goodwill impairment test, which two values are compared to
determine whether a reporting unit is impaired? What is the difference between
the impairment test based on invested capital and the test based on total ass