New accounting rules related to fair value in 2008 were blamed for everything from the
credit freeze to the stock market collapse to Tom Brady’s knee injury. The second phase
of these rules, effective in 2009, affects how companies account for items such as
mergers and acquisitions, goodwill, and impaired real estate.
The first phase of the rules, effective in 2008, related to financial assets and liabilities –
stocks and bonds, derivatives such as interest rate swaps, and the like. These rules
required that such items, which are typically reported in the financial statements at their
fair value, be valued based on what market participants would value them at. It was no
longer acceptable for a company to use its own internal model to value an item, without
considering what data might be available in the marketplace regarding the value others
might place on it.
This year, the rules apply to nonfinancial assets and liabilities. These are typically items
that are only reported at fair value in certain circumstances. For example
- In a merger or acquisition, the assets and liabilities of the acquired company –
financial and nonfinancial – are initially measured at their fair value.
-If a current or prior merger involved the recognition of goodwill, management is
required to assess the goodwill each year to determine if it is impaired, and thus
must be written down. This impairment analysis is done by comparing the fair
value of the company (or of the portion of the company to which the goodwill
relates) to its book value.
-If a company has reason to believe its real estate or other long-lived assets may be
impaired (for example, because they have become damaged, or because they are
used to make products that are no longer generating positive cash flow for the
company), management is again required to perform a an analysis to determine if
it is actually impaired, and thus must be written down. If certain conditions are
met, this analysis also involves the determination of the fair value of the asset in
comparison to its book value.
It has been common practice in the past to employ internal models to perform the fair
value analyses required in these situations. However, the new rules, contained in the
Financial Accounting Standards Board’s Accounting Standards Codification (see separate
article), Topic 820, require that you consider how other potential buyers and sellers of
these types of assets would value them.
One significant element contained in Topic 820 is the change in focus from entry price to
exit price. Think of entry price as the price paid by you to purchase an asset. Exit price is
how much you could recoup by re-selling the same asset in the principal (or most
advantageous) market. Since most nonfinancial assets and liabilities do not have an active
market or exchange to determine value, different approaches are utilized to provide an
estimate of the value. These approaches are the cost approach, the market approach, and
the income approach.
The asset (or cost) approach estimates value by evaluating what it would cost to recreate
the assembly of assets for the company. In practice, this approach is most relevant for
holding companies. For operating companies, it is difficult to estimate the intangible
value (workforce in place, branding, etc.) without applying one or more of the following
approaches.
The market approach looks to transactions of shares in public companies that are similar
to the subject company. Multiples are derived from the public companies and compared
to the subject company to provide an estimate of value. The market approach also can
involve evaluating sales of private companies in the same or similar industry and
comparing those ratios and metrics to the subject company. This approach is analogous to
determining the sales price of a house by using comparable sales. As with pricing a
house, there is as much art as science involved in selecting the appropriate comparable
to be used in the analysis.
The income approach measures the future benefits of the assets to the owner. A benefit
stream, usually some form of cash flow, is determined and then discounted back to a
present value. This approach takes into consideration the time value of money, a dollar
today is more valuable than a dollar tomorrow, and the potential to earn a return on an
investment, which is the common motivation for owning a business. The estimate of
value is a function of the future benefits divided by the risk inherent in achieving that
level of performance.
In today’s economy, we have seen many companies estimating that future cash flow will
be reduced. The cost of borrowing money has also increased. These two factors have a
compound effect on the value of companies, causing rapid declines in value. This drop in
value may lead to a determination that goodwill has been impaired, requiring the
intangible value of the company to be written down.
If your company is in this situation, this may be an ideal time to address estate planning.
Since the lifetime gifting exclusions are based on dollars, a greater portion of the overall
value may be able to be transferred.
Have questions? Please contact Tracy Harding (tharding@bdmp.com) for more
information.