VRC Impairment Webcast 9 28

Lessons Learned:

Impairment Testing in 2010 and Beyond

September 28, 2010

Steve Schuetz, CFA, ASA

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• Mr. Schuetz specializes in the valuation of businesses, assets and liabilities for financial reporting and tax purposes. In particular, hefocuses on the valuation of intellectual property/intangible assets such as trademarks, technology, re-acquired rights, software and customer relationships. He also values business interests for fairness and solvency opinions.

• Mr. Schuetz holds the CFA designation, awarded by the CFA Institute and is an Accredited Senior Appraiser of the American Society of Appraisers (ASA). Mr. Schuetz is a board member of the Tampa Bay Chapter of the Association for Corporate Growth (ACG).

• Mr. Schuetz is a frequent presenter on valuation issues for financial reporting purposes and recently presented at the University of South Florida.

P.J. Patel, CFA

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• Mr. Patel specializes in the valuation of businesses, assets and liabilities for financial reporting purposes. In particular, he focuses on the valuation of intellectual property/intangible assets such as trademarks, technology, software, customer relationships and IPR&D. He also values business interests for tax purposes.

• Mr. Patel is an active member of the AITF and is currently a member of the Appraisal Foundation Working Group preparing a Practice Aid for the valuation of customer relationships. Mr. Patel holds the CFA designation, awarded by the CFA Institute.

• Mr. Patel is a frequent presenter on valuation issues for financial reporting purposes and has recently presented on valuation issues relating to SFAS No. 141/141R, SFAS No. 142/144, SFAS No. 157 and other emerging issues. Mr. Patel recently spoke at the AICPA SEC conference in Washington D.C.

Valuation Research Corporation

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• Formed in 1975, VRC has eight U.S. offices and eight international affiliates.

• VRC provides M & A advisory services, fairness and solvency opinions in support of corporate transactions, and valuations of intellectual property and tangible assets for financial reporting and tax purposes.

• VRC maintains relationships with corporations, lenders, accountants, investment banks, private equity firms, and law firms.

• VRC was instrumental in forming the Appraisal Issues Task Force (AITF), a valuation industry group that meets quarterly to discuss financial reporting related valuation issues.

Agenda – Lessons Learned: Impairment Testing in 2010 and Beyond

• Recurring Issues & Specific Case Studies• Enterprise, total assets or equity valuation• Deferred income tax considerations in applying the goodwill impairment test• Impairment testing under ASC 360 • Discount rates and the selection of multiples• Reconciliation of valuation methodologies• Implied control premiums

• Common Questions in the Audit Review Process• Reporting Unit• Indefinite-lived assets

• Conclusion: Lessons Learned

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Enterprise, Total Assets or Equity Valuation

• ASC 350 states that the first step of the Goodwill Impairment Test is to compare the fair value of a Reporting Unit to its Carrying Value

• EITF 10-A will provide guidance on how the Carrying Amount of a Reporting Unit should be determined when performing Step 1 of the Goodwill Impairment Test• FASB put off the issue for discussion at a future meeting• With no specific guidance, there are different interpretations• Alternatives:

• Enterprise Level• Total Asset Level• Equity Level

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Enterprise, Total Assets or Equity Valuation (cont.)

Goodwill Testing at the Enterprise Level

• Tested by comparing the Carrying Value of the Enterprise with its Fair Value

• Enterprise Value (EV) is commonly defined as:

Debt plus equityor

Total assets less debt-free current liabilities adjusted for deferred taxes

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Advantages and Disadvantages of EV

(+) Generally accepted valuation methodologies and techniques are designed to determine EV

(+) The EV reflects the fair value of debt and equity, thus avoiding the issue of having to estimate the fair value of debt or timing of debt repayment

(+) Many transactions are consummated at the EV level, thereby providing important valuation inputs and market based support for value conclusions

(+) If a Step 2 calculation is required to measure the fair value of goodwill, EV provides a logical starting point

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Goodwill Testing at the Total Asset Level

• Tested by comparing the Carrying Value of Total Assets with its Fair Value

• Total Asset Value is commonly defined as:

EV plus debt-free liabilities adjusted for deferred taxesor

the left side of the balance sheet

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Advantages and Disadvantages of Total Assets

(+) Testing level would appear to be logical since in Step 1, the purpose is to determine if goodwill impairment may exist

(-) The fair value of total assets cannot be directly calculated, as EV must first be calculated and then adjusted for debt-free liabilities and deferred taxes

(-) Transactions are infrequently consummated at this level, thereby making FV and CV estimates less meaningful

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Goodwill Testing at the Equity Level

• Tested by comparing the Carrying Value of the Equity with its Fair Value

• Total Equity Value is commonly defined as:

EV less Debt

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Advantages and Disadvantages of Equity

(+) The Carrying Value can be taken directly from the Reporting Unit’s balance sheet

(+) If the Reporting Unit is a public company with a single Reporting Unit, a simple comparison of market capitalization with the Carrying Value of equity can provide an initial Step 1 indication

(-) Valuing the equity requires accounting for the debt of the Reporting Unit. Significant diversity exists regarding whether debt should reflect fair value, book value, or the current obligation. The method of incorporating debt may lead to different Step 1 conclusions (i.e., the choice may not be consistent with how investors value equity)

(-) In situations where the Reporting Unit has negative equity, the Step 1 conclusion would result in no impairment, since the fair value of the equity cannot be below zero. This conclusion is not intuitive and can differ from the conclusion at the total asset or EV level

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Goodwill Testing - Equity vs EV Level – Case Study

Equity Level versus Enterprise Value level

• Public company that operates in the steel fabrication industry• Substantial goodwill as a result of a large acquisition• Operating results depressed as a result of the downturn in the economy• Stock price depressed as of the valuation date• Negative book value of equity• Due to long life on PP&E, long lived assets pass the ASC 360 recoverability

test: No impairment of long lived assets• Based on an Equity level test, implication was that there was no impairment• This specific Big 4 auditor typically requires testing at the Equity level, but

asked for an EV level test in this case• EV level test indicated impairment at Step 1, and a Step 2 analysis was

performed as a result• Result was a significant goodwill write-off

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Deferred Income Tax Considerations (EITF 02-13)

• How should an entity account for differences between the book and tax bases of assets and liabilities (i.e., deferred tax balances) in determining:

a) A Reporting Unit’s fair value?b) A Reporting Unit’s carrying amount? andc) The implied fair value of goodwill?

• The Emerging Issues Task Force (EITF) reached consensus on the following issues.

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Deferred Income Tax Considerations (cont.)

Issue 1: Assumption regarding whether an assumed sale would betaxable or nontaxable

• Matter of judgment evaluated in a case-by-case basis, and should consider:• Whether the assumption is consistent with those that marketplace participants

would incorporate into their estimates of fair value,• The feasibility of the assumed structure, and• Whether the assumed structure results in the highest economic value to the

seller for the reporting unit, including consideration of related tax implications.

• In determining the feasibility of a nontaxable transaction, an entity should consider:

• Whether the reporting unit could be sold in a nontaxable transaction, and• Whether there are any income tax laws and regulations or other corporate

governance requirements that could limit an entity’s ability to treat a sale of the unit as a nontaxable transaction.

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Issue 2: Should Deferred Income Taxes be included in the carrying amount of a Reporting Unit for purposes of Step 1 of the ASC 350 (SFAS 142) goodwill impairment test?

• Deferred income taxes should be included in the carrying value of a Reporting Unit, regardless of whether the fair value of the Reporting Unit will be determined assuming it would be bought or sold in a taxable or nontaxable transaction

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Issue 3: For purposes of determining the implied fair value of a Reporting Unit’s goodwill in Step 2 of ASC 350 (SFAS 142), what income tax basis an entity should use for a Reporting Unit ‘s assets and liabilities in order to measure deferred tax assets and liabilities (i.e., existing or new).

• Use the income tax basis of a Reporting Unit’s assets and liabilities implicit in the tax structure assumed in the estimation of fair value of the Reporting Unit in Step 1

• In performing Step 2 of the goodwill impairment test, the implied fair value of a Reporting Unit’s goodwill is determined in the same manner that the amount of goodwill recognized in a business combination was estimated and accounted for in accordance with ASC 805 (SFAS 141/141r).

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Deferred Income Tax Case Study

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• Private company (the “Company” or “Reporting Unit”) that operates in the computer software industry

• Reporting Unit fails Step 1 of the goodwill impairment test; Step 2 must be performed• In Step 1 of the ASC 350 impairment test, the company concludes that’s it would recognize

the highest economic value from the Reporting Unit by selling it in a nontaxable transaction; as a result of this assumption the analysis in Step 2 would be as follows:

• Fair Value of Reporting Unit $ 12,409• Less Fair Value of net tangible &

identifiable intangible assets (5,472)Less deferred tax assets (or Plus deferred tax liabilities)**($3,082 – $4,198 = ($1,116) x 40% = ($446)) 446

• Implied Fair Value of Goodwill 6,491

• Carrying Value of the Goodwill 10,500• Indicated Impairment $ 4,009

• **$3,802 = Fair Value of Net Assets; $4,498 = Tax Basis of Net Assets; 40% = Tax Rate• Deferred tax accounts on the books at the time of valuation may differ from the theoretical

deferred tax accounts which result from the impairment testing (as shown above).

Deferred Income Tax Case Study (cont.)

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• Applying a taxable transaction assumption with the same Company the analysis would be as follows :

• Fair Value of Reporting Unit $ 12,409• Less Fair Value of net tangible &

identifiable intangible assets (5,472)Less deferred tax assets (or Plus deferred tax liabilities)**($3,082 – $3,082 = 0 x 40% = 0) 0

• Implied Fair Value of Goodwill 6,937

• Carrying Value of the Goodwill 10,500• Indicated Impairment $ 3,563

• **$3,802 = Fair Value of Net Assets; $3,802= Tax Basis of Net Assets; 40% = Tax Rate

• As Fair Value = tax basis in a taxable no deferred tax liability or asset exists.

Impairment Testing Under ASC 360 (SFAS 144)

An impairment loss shall be recognized if the Carrying Amount of along-lived asset (Asset Group) is not recoverable and exceeds itsfair value

• An Asset Group is the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities (paragraph 360-10-35-23).

• The carrying amount of a long lived asset (Asset Group) is not recoverable if it exceeds the sum of the undiscounted, pretax cash flows expected to result from the use and eventual disposal of the asset (Asset Group).

• Life is based on the remaining useful life of the primary asset.

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Impairment Testing Under ASC 360 (SFAS 144) (cont.)

3 Steps ASC 360• Step 1: Undiscounted Cash Flow Recoverability Test

• If Impairment is indicated (carrying amounts exceed the sum of undiscounted cash flows) proceed to Step 2

• Step 2: Determination of Impairment Loss • Fair Value of long-lived asset (asset group) less the carrying value of the

asset (aggregate carrying value of the asset group)• Step 3: Allocation of the Impairment Loss

• Pro-rata allocation of impairment loss starting from the greatest to least proportional asset

• Fair values of the individual long-lived assets being tested are applied as a floor value

• Pro-rata allocation amounts that exceed impairment allowed per the floor value carry forward to be allocated on a pro-rata basis to the remaining long-lived assets

• Possible that not all impairment is allocated to the long-lived assets based on fair value floor

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Impairment Testing Under ASC 360 - Case Study

Impairment Testing of Long-lived Assets

• Private company that operates in the for-profit education industry• Substantial goodwill as a result of acquisition by a PEG• Operating results depressed as a result of the downturn in the

economy• Asset Group is the Reporting Unit• Primary Asset is Building• Long-lived assets were PP&E and customer relationships• Impairment indicated on pretax, pre-discounted cash flow basis• Step 2 - Calculation determined impairment of $4 mil.• Step 3 - Impairment limited to $50k (customer value) as the fair

value of the PP&E exceeded book value• Excess impairment goes to goodwill

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Discount Rate

Key consideration is “market participant” versus subject entity

WACC components:

• Capital Structure assumption• Key driver of discount rate• Subject company structure or market participant structure?

• Assumed Cost of Debt• After tax

• Cost of Equity• Risk-free rate• Beta• Equity risk premium• Size premium

• Subject company size vs market participant size, or somewhere in-between?

• Additional company-specific risk premium

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Reconciliation of Valuation Methodologies

Preferred valuation methodology is development of a value estimate using multiple valuation approaches.

• Appropriate approach(s) dictated by underlying fundamentals of the subject company and availability of relevant market data.

• Approach(s) employed, underlying assumptions, and independent market support under greater scrutiny in audit review.

• Valuation methodologies are the Cost Approach, the Market Approach, and the Income Approach.

• Support for valuation approach weightings in conclusions

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Reconciliation of Valuation Methodologies (cont.)

Cost Approach

• Used generally in start-ups, situations involving businesses with going concern questions, or holding companies

• Cost approach represents a “sum of the parts” valuation

• Fair value underlying assets (including intangible assets) and liabilities

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Market Approach

Guideline Company Market Approach

• Are there a sufficient number of comparable companies from which meaningful conclusions may be drawn?

• Do the multiples derived from the publicly traded comparables require adjustments to reflect differences between them and the subject?

• Do the publicly traded comparables experience sufficient liquidity (average daily trading volume) from which meaningful conclusions may be drawn?

• Does current market volatility (specific comparable company volatility) impact selection of appropriate multiples?

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Market Approach (cont.)

Transactions Multiples Market Approach• Are there a sufficient number of comparable transactions from which

meaningful conclusions may be drawn?• Are they recent, reflecting current capital markets?

• Do the multiples derived from the transactions require adjustments to reflect differences between them and the subject?

• Is there sufficient information from which synergies/restructuring costs can be quantified and transactions drivers can be identified?

• What is the composition of the buyers?• Differences in operational approaches (strategic versus financial)• Differences in capital structure (strategic versus financial)

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Income Approach (Discounted Cash Flow – “DCF”)

Key elements: • Underlying cash flow projections -

• Historical budgets/forecasts versus actual• Budget process (e.g., formal, bottom-up approach; one-year

budget versus multi-year forecast)• Historical volatility of revenue and cash flow

• Weighted Average Cost of Capital• Long-term growth rate assumption • Terminal value calculation• Tax impacts layered into DCF or accounted for separately

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Reconciliation of Valuation Methodologies – Case Study

Application of Cost, Market & Income Approaches

• Private company that operates in the publishing industry• Started valuing the business in June 2007, twice per year• Valuation in June 2007 employed a market approach (guideline companies

and transactions) and a DCF analysis• 50% weighting on market approaches, 50% weighting on DCF

• Valuation in December 2007 employed a market approach (guideline companies and transactions) and a DCF analysis

• 50% weighting on market approaches, 50% weighting on DCF• Value declined 40% based on deteriorating operating results and market

multiples• Valuation in December 2008, and thereafter, employed a cost approach

• Value declined 25% based on deteriorating operating results and market multiples

• Management no longer able to provide forecasts with a reasonable level of confidence

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Implied Control Premiums

Fair Value Relative to Market Value

• Consideration when testing publicly traded companies• Mergerstat data shows range from 0% to 100%• Industry averages/means typically range from 0% to 35%

• Is a value conclusion that implies a control premium reasonable?• Does an implied control premium explain completely a fair value

higher than the market capitalization?• Did the valuation methodologies employed consider a control

premium?

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Control Premiums

• What is a Control Premium?

• What is an Acquisition Premium?

• Current Views

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Implied Control Premiums – Case Study

Implied Control Premium• Public company that operates in the transportation industry• Market price of stock on the testing date: approx. $2.40 per share• Fair Value conclusion of stock value on testing date: approx. $5/per

share• Implied Control Premium: approx. 107%• During audit review, explained:

• Only some of premium related to benefits resulting from control• Some of premium related to negative overreaction to industry• Market had not priced-in benefits of fuel surcharge• Market had not priced-in benefits of acquisition synergies• We had numerous analysts’ reports setting $6+ target prices for the stock• Shortly after the sign-off by the auditors, stock price increased to more

than $5 per share

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Recent Audit Review Questions

Audit Review Questions

Relating to the valuation of a Reporting Unit:• Discuss and support the reconciliation of valuation methodologies• Support the conclusion of the Discount Rate/WACC used in the

Income Approach (WACC) • How did the valuation specialist get comfortable with

management’s projections?• What is the fair value of the subject reporting unit’s debt and how

might the WACC analysis change if the fair value of the subject’s debt was used in the analysis?

• How is corporate debt allocated to separate reporting units?• How is corporate overhead allocated to reporting units?• For public companies, detail market capitalization reconciliation

(allocation to the individual reporting units)

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Recent Audit Review Questions

Audit Review Questions (cont.)

• Relating to the valuation of Indefinite-lived Intangible Assets• Provide a comparison of discount rates and royalty rates applied

from one year to the next and discuss why the rates changed/stayed the same

• Relating to the impairment testing of long-lived assets• What is the appropriate level of aggregation for the asset group?• What is the primary asset?• What is the remaining useful life?

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Contact Information

PJ [email protected]

Steve [email protected]

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U.S. Office Locations

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Boston101 Federal StreetBoston, MA 02110617.342.7366

Chicago200 W. Madison Street Chicago, IL 60606312.957.7500

Cincinnati105 East Fourth Street Cincinnati, OH 45202513.579.9100

Milwaukee330 East Kilbourn Avenue Milwaukee, WI 53202414.271.8662

New York500 Fifth Avenue New York, NY 10110212.983.3370

Princeton200 Princeton Corporate CenterEwing, NJ 08628609.452.0900

San Francisco50 California Street , Suite 3050San Francisco, CA 94111415.277.1800

Tampa777 S. Harbour Island Blvd.Suite 980Tampa, FL 33602813.463.8511

International Affiliate Office Locations

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Buenos Aires Franklin D. Roosevelt 2445Piso 10Buenos Aires C1428 BOKArgentina

Caracas Oficina 1-3, Torre Charan,Avenida Los MangosLas Delicias, Caracas 1050 Venezuela

Hong Kong22nd Floor, Siu On Centre188 Lockhart RoadWanchai, Hong Kong

LondonCloister HouseRiversideNew Bailey StreetManchester, M3 5AG

MadridAlcalá, 265, Edificio 228027 Madrid Spain

MelbourneLevel 10, 470 Collins St.Melbourne, Victoria 3000Australia

MonterreyAntonio Gaona No. 2000-401Col. FloridaMonterrey, N.L.C.P. 64810Mexico

São PauloRua Paes Leme, 524 - 12 Andar - PinheirosCEP 05424-904 São Paulo SP Brazil

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VRC Impairment Webcast 9 28