Valuation Issues in Financial Reporting: FAS 141&142 and Beyond!
by Mark L. Zyla, CPA/ABV, CFA, ASA
In today’s environment, financial statements are receiving unprecedented scrutiny from outside parties, namely from both investors and the Securities and Exchange Commission. Correspondingly, auditing firms are heavily scrutinizing the work of outside experts such as valuation analysts whose work impact financial reporting. Valuation experts working on engagements related to financial reporting such as SFAS 141, Business Combinations SFAS 142, Goodwill and Other Intangible Assets, not only have to understand the technical aspects of valuation, but also have to understand the valuation issues from the perspective of an auditor. A valuation analyst, working on engagements for the purpose of financial reporting requires special knowledge that goes beyond just their valuation expertise in order to satisfy the company’s auditors and potentially the SEC.
The changes in the scrutiny of financial statements directly affects everyone involved in the process – company’s management, their auditing firm and the valuation analyst. Working on valuation engagements that impact financial statements requires the valuation analyst not only understand the responsibilities of each of the three parties, but also to understand the unique conceptual challenges of working on these types of engagements. Previously the heaviest scrutiny a valuation analyst and their work product received on performing valuations for financial reporting purposes was based on the analyst’s qualifications and experience. While these are still obviously important, the scrutiny is now focused more fully on the reasonableness of assumptions behind the valuation. As such, the change in focus to the assumptions that underlie the valuation creates a greater need of coordination between auditors, valuation analysts and management.
Management is ultimately responsible for the presentation of the financial statements. Often management will retain a valuation expert to assist them with estimating the fair values of assets, particularly in estimating the intangible assets acquired in a business combination or to assist management in estimating the fair values of reporting units to test for the potential impairment of goodwill. As such, management’s responsibility extends to retaining a qualified valuation specialist. A qualified valuation specialist is one who not only has the appropriate valuation expertise, but also has the requisite experience with working on valuations for financial reporting.
Since management is ultimately responsible for the presentation of the financial statements, it is also responsible for identifying the acquired intangible assets that should be allocated as part of an acquisition. Additionally management has the responsibility for supplying the appropriate documentation of the supporting assumptions behind the valuation. Sometimes this is challenging because many companies accounting systems are not set up to capture some of the specific data that may be needed for the valuation.
The auditing firm uses the work of the valuation specialist as part of their requirement to obtain sufficient competent audit evidence to provide reasonable assurance that the stated fair values conform to Generally Accepted Accounting Principles or “GAAP”. As such, the auditor may test the assumptions of the valuation models. The auditor may not only scrutinize the valuation report, but may ask to look the supporting documents in the valuation specialist’s workpapers. Often the auditor may employ their own valuation specialist to either review the report of the specialist or even go to the extent of having a “shadow” valuation prepared in order to compare the results of the “shadow” valuation to the expert retained by management.
Consequently all of these changes affect the valuation analyst and their work product. The valuation analyst has a higher level of expectations about their work product particularly from the standpoint of information that is utilized and testing of the assumptions in the valuation analysis. The valuation analyst should have detailed documentation in their workpapers about the assumptions used to support their valuation methods. Additionally the valuation analyst should have supporting information in their files of how they tested management’s assumptions. The valuation analyst also has to be aware of concepts in the valuation for financial reporting that may be somewhat unique for this purpose.
It is incumbent upon the auditor to test management’s assumptions that provide the basis for the analysis to estimate the fair value of assets for financial reporting purposes. The valuation analyst should be aware of this and test management’s assumptions as well. One of the ways to test management’s assumptions is to review contemporaneous documents that provide additional information that can collaborate or contradict management’s expectations. Examples of the types of information that should be reviewed to corroborate management’s assumptions include:
- Offering memoranda
- Due diligence reports
- Board of Director materials prepared to support the acquisition
- Research reports of analysts
- Technology development plans
- Product plans and budgets
- Website content and press releases
Fortunately there is some information that is now available to help both valuation analysts and auditors sort out the complexities in estimating fair value for financial reporting purposes. The AICPA has recently issued tools kits for both auditors and valuation analysts to help with the unique requirements of measuring fair value for financial reporting purposes.1
These changes increase the complexity of estimating fair value for financial reporting. There are several concepts that are unique to performing a valuation for financial reporting that a valuation analyst should understand that have implications on the engagement. These concepts are:
- The standard of value of fair value
- The concept of “Market Participants”
- Synergy in an allocation of purchase price
- Observable market prices are the preferred approach
- Working with the client’s auditing firm
The first concept in auditing fair value measurements that a valuation analysis should understand is the appropriate standard of value. The standard of value in financial reporting is one of fair value. Fair value is defined as “the amount at which the asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale”.2 The Fair value standard of value is the important to understand because the standard of value controls the appropriateness of assumptions and methodologies in estimating value. Fair value in financial reporting is often confused with other more established standards of value. Fair value is not investment value which is the value to a particular buyer. Fair value is not fair market value which describes a hypothetical buyer and seller which is the standard of value for tax reporting requirements. Fair value defined by accounting literature is also obviously not the fair value standard common to many disputes. While the concept of the fair value standard is still evolving in authoritative accounting literature, several characteristics have been established.
Fair Value is:
- Generally established on an asset by asset and a situation by situation basis
- Normally a control value
- Individual assets do not include buyer’s synergies. Synergies are included as part of goodwill
- May include tax amortization benefits
- Net of “cost to sell”
- Only considers “market participants” in the assumptions
A second concept that a valuation analyst should understand is that under the standard of fair value for financial reporting, the FASB emphasizes that the assumptions utilized in the valuation should include one of “market participants”. The concept of market participants is still evolving, however in general, the market participants concept requires the valuation analyst to utilize assumptions in the valuation in that encompasses all potential buyers who:
- Actively manage businesses
- May or may not be engaged in negotiations with seller
- Excludes buyers without current operating and market data available such as financial buyers or passive investors3
The market participant concept is important for the valuation analyst to understand because the assumptions used by the valuation specialist in their approaches to estimating value, particularly in projected financial information, should only include those that a “market participant” could realize.
A third concept that the valuation analyst should also understand is how synergies in an acquisition are allocated to a purchase price. Fair value as defined in the accounting literature only incorporates assumptions that would affect market participants. Synergy by definition includes benefits by a specific buyer not market participants. In estimating fair value of specific assets for financial reporting purposes, a valuation analyst should not include any strategic or synergistic benefits in the assumptions used in the valuation analysis. Fair value should only include assumptions that incorporate benefits that market participants would enjoy. Any value from strategic or synergistic benefits should be included as part of goodwill. So for example, if the valuation analyst uses a discounted cash flow analysis to estimate the fair value of an acquired intangible asset, the elements of the discounted cash flow analysis (the cash flows, discount rate, etc.) should only reflect what market participants would enjoy.4 Many if not most business combinations are priced based upon some perceived level of synergy. In estimating, fair value of individual assets for a purchase price allocation, any value related to synergies is allocated to goodwill.
Using the Three Approaches to Value to Estimate Fair Value 5
Valuation analysts are familiar with the concept of the three approaches to value which of course, are the cost, the market and the income approaches. Most valuation analysts would agree that these three approaches in theory, should all point to similar indications of fair value. However often in reality, only one or two approaches may be appropriate given the type of intangible asset or business interest. As an example the valuation of certain intangible assets may lend themselves to be valued more by a cost or income approach since there is usually not an established market for certain intangible assets.
In spite of the theory that all approaches should provide a similar indication of value, the FASB has expressed a preference for the use of observable market prices under the market approach as a primary indication of fair value wherever there is sufficient available information.6 Consequently, the valuation specialist should focus on the market approach as a primary method where appropriate, supported by the cost and income approaches. In any event, the valuation specialist should use assumptions in their analysis that reflect overall market participants in each of the methods under the three approaches of estimating fair value. However, in estimating fair value for financial reporting, the market approach is first among equals.
Working with the Client’s Auditing Firm
The changes brought by these new statements have affected the relationships between company’s management, the company’s auditors and outside valuation analysts. Previously auditors relied on the work product of the valuation specialist based upon the specialist’s qualifications and experience. While these are obviously still important, auditors and thus the valuation analyst currently are held to a higher standard to test the reasonableness of management’s assumptions behind the valuation. One such test is to perform sensitivity analysis on management’s assumptions that underlie the valuation. The auditor will likely ask the valuation analysts to perform a sensitivity analysis to test the value drivers in the analysis so the valuation analysts should prepare for this during the course of their analysis. Additionally, auditors will need to fully comprehend the methods and assumptions used by the valuation analyst and cannot just rely upon the specialist’s conclusions. Additionally, both the valuation analyst and the auditor should understand the valuation concepts that are unique to valuations for financial reporting.
Auditing fair value measurements requires a new level or cooperation between auditors, management and valuation specialists. Although the valuation specialist is retained by management, the auditor often will often need to be provided with comfort with the selection of the valuation analyst before the engagement commences. The auditor should carefully review the analyst’s resume and statement of qualifications. The valuation analyst should have experience not just with valuation issues in general, but have specific experience with valuations related to financial reporting. The auditor should make sure the valuation specialist fully understands the concept of fair value under GAAP and has experience with these types of engagements. The valuation specialist makes the auditor comfortable about the methods and assumptions during the course of the engagement rather than at the end of it. One way to accomplish this is to meet with the client and their auditor at the beginning of the engagements and have them agree to the valuation methodologies and certain assumptions prior to starting the engagement.
The latest pronouncements from the FASB relating to the financial statement presentation of business combinations and the accounting treatment of goodwill requires an valuation analyst to have an specific level of understanding of estimating fair value. The complexities involved in estimating fair value often require management of an acquiring company to retain the services of an outside valuation specialist. The work of the outside specialist is often used to audit evidence as to the fair value of the acquired assets. As such, the valuation analyst must understand several basic valuation concepts related to measuring fair value. These concepts involve several issues. One issue is understanding the standards of fair value and how that impacts the methods and assumptions underlying the valuation. A second is knowing how the concept of market participants impacts assumptions and how synergy in a transaction is allocated. A third is understanding the importance of the market approach in relation to the three basic approaches to value and a fourth is knowing how to work closely with the client’s auditing firm. Understanding these concepts will help a valuation analyst prepare appropriately their analysis for financial reporting purposes.
2Statement of Financial Accounting Standards No. 141, Appendix F, Page 123.
3AICPA Practice Aid, “Assets Acquired in a Business to be used in Research and Development Activities: A Focus on Software, Electronic Devises, and Pharmaceutical Industries”, Page 4.
4IBID, page 8
5See Appendix I: Valuation Approaches to Estimating Fair Value; Auditing Fair Value Measurements and Disclosures, pg 28, www.aicpa.org
6Auditing Fair Value Measurements and Disclosures, Page 28.
Mark L. Zyla, CPA/ABV, CFA, ASA is a valuation analyst in Atlanta, Georgia. He is co-author of Valuation for Financial Reporting: Intangible Assets, Goodwill and Impairment Analysis, SFAS 141 and 142; John Wiley & Sons; 2002. He can be reached at firstname.lastname@example.org or (404) 898-1137.