Daszkal Bolton Habif Arogeti & Wynne Armanino McKennamedia.straffordpub.com/products/review-of-fair... · 5/16/2012 · – Statement of Accounting Standards (SAS) ... Deferred income

Presenting a live 110‐minute teleconference with interactive Q&A

Review of Fair Value Calculations During Financial Statement AuditsDuring Financial Statement AuditsNavigating SAS 57, SAS 73, SAS 101 and Other Standards in Testing Measurements and Disclosures

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, MAY 16, 2012

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

Arlene Ravalo-Jao, Senior Manager, Business Valuation, Daszkal Bolton, Sunrise, Fla., g , , , ,

Michael Blake, Director of Valuation Services, Habif Arogeti & Wynne, Atlanta

Dirk Van Dyke, Managing Director, Valuation Services Practice, Armanino McKenna, San Jose, Calif.

For this program, attendees must listen to the audio over the telephone.

Please refer to the instructions emailed to the registrant for the dial-in information.Attendees can still view the presentation slides online. If you have any questions, pleasecontact Customer Service at1-800-926-7926 ext. 10.

Conference Materials

If you have not printed the conference materials for this program, please complete the following steps:

• Click on the + sign next to “Conference Materials” in the middle of the left-hand column on your screen hand column on your screen.

• Click on the tab labeled “Handouts” that appears, and there you will see a PDF of the slides for today's program.

• Double click on the PDF and a separate page will open. Double click on the PDF and a separate page will open.

• Print the slides by clicking on the printer icon.

Continuing Education Credits FOR LIVE EVENT ONLY

Attendees must listen to the audio over the telephone. Attendees can still view the presentation slides online but there is no online audio for this program.

Attendees must stay on the line for at least 100 minutes in order to qualify for a full 2 credits of CPE. Attendance is monitored as required by NASBA.

Please refer to the instructions emailed to the registrant for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.at 1 800 926 7926 ext. 10.

Tips for Optimal Quality

S d Q litSound Quality

For this program, you must listen via the telephone by dialing 1-866-873-1442and entering your PIN when prompted. There will be no sound over the web connection.co ect o .

If you dialed in and have any difficulties during the call, press *0 for assistance. You may also send us a chat or e-mail [email protected] immediately so we can address the problem.

Viewing QualityTo maximize your screen, press the F11 key on your keyboard. To exit full screen, press the F11 key againpress the F11 key again.

Review of Fair Value Calculations D i Fi i l St t t A dit During Financial Statement Audits Seminar

May 16, 2012

Dirk Van Dyke, Armanino [email protected]

Arlene Ravalo-Jao, Daszkal [email protected]

Michael Blake, Habif Arogeti & Wynne [email protected]

Today’s Program

A li bl A ti g St d d Slid 7 Slid 27Applicable Accounting Standards[Arlene Ravalo-Jao]

A Wh A i Oft F ll Sh t

Slide 7 – Slide 27

Slid 28 Slid 42Areas Where Appraisers Often Fall Short[Dirk Van Dyke, Arlene Ravalo-Jao]

Testing Measurements And Disclosures


Slide 43 Slide 53Testing Measurements And Disclosures[Michael Blake]

Impact Of Valuations Of Common Stock Under Sect 409A


Slide 54 Slide 59Impact Of Valuations Of Common Stock, Under Sect. 409A[Dirk Van Dyke]

Impact Of PCAOB Reviews


Slide 60 – Slide 69Impact Of PCAOB Reviews[Michael Blake]

Slide 60 Slide 69

APPLICABLE ACCOUNTING Arlene Ravalo‐Jao, Daszkal Bolton

APPLICABLE ACCOUNTING STANDARDS

Agenda For This Sectiong

• Accounting Standards Overview – Statement of Accounting Standards (SAS) – FASB Accounting Standards Codifications (ASC)

• Transactions involving fair value measurements– Business combinations

i f i i– Testing for impairment– Equity compensation/consideration paid

8

Statements On Auditing Standards (SAS)Statements On Auditing Standards (SAS)

SAS 57 SAS 73 SAS 101 Auditing fair Auditing accounting

estimates

• Obtaining and l ff

Using the work of a specialist

• Using the specialist’s k d d

gvalue measurements

and disclosures

• Addresses audit d levaluating sufficient

appropriate audit evidence to support significant accounting ti t (AU S t

work as audit evidence in performing substantive tests to evaluate material fi i l t t t

considerations relating to the measurement and disclosure of financial statement

t t destimates (AU Sect. 342)

financial statement assertions (AU Sect. 336)

components presented or disclosed at fair value (AU Sect. 328)

Available at: http://www.aicpa.org/research/standards/auditattest/pages/sas.aspx

9

Companyp y

FAIR VALUE

Audit

VALUE

ValuationAudit Team

Valuation Specialist

10

Company Management’s RoleCompany Management s Role

• Management is responsible for establishing an accounting and financial reporting process for determining fair value measurement.

• Discuss with auditors the involvement of a valuation specialistp

11

Audit Team RoleAudit Team Role

• The auditor should obtain sufficient appropriate audit evidence to provide reasonable assurance that fair value measurements and disclosures are in conformity with GAAP.

– Source: SAS 101

12

Valuation SpecialistValuation Specialist

• Assist the audit team in evaluating the FV measurements estimated by:– Management, if expertise available in‐house– Another valuation specialistp

OR

• Retained by management to estimate the FV measurement (for non‐audit clients due to independence)

13

General Framework:FASB Accounting Standards Codification

(ASC)( )

Deal closes The year after… Did not go well …

Purchase Price

Allocation

Testing for Impairment

Impairment LossesAllocation p

ASC 805B i bi i

ASC 350: Intangibles – goodwill and otherl d iBusiness combinations ASC 360: Property, plant and equipment

ASC 820Fair value measurementsFair value measurements

14

Fair Value Definition – ASC 820Fair Value Definition ASC 820

• Standard of Value ‐ Fair value under GAAP

– “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 y yparticipants at the measurement date.” (ASC 820, fair value measurements and disclosures)

15

“Acquisition Method” (Purchase Price q (Allocation) – ASC 805

Recognition of “new” assets and measurement update to fair value

AssetsCurrent assets (cash, A/R)Inventory

LiabilitiesCurrent liabilitiesBonds payableInventory

Property, plant and equipmentIntangible assets (“contractual” or

“separable” criteria)

Bonds payableNotes payableCapital leases

Customer relationshipsTrade name and trademarksPatents

Equity • May involve valuation specialist,

especially if consideration was in Non‐compete agreements

Goodwill

p yequity of privately held company

Determination of useful life of intangible assets

16

Acquisition Of DisneyAcquisition: Dec. 31, 2009 ($ in millions)

Cash and cash equivalents $105q

Accounts receivable and other assets 137

Film costs 304

Intangible assets (character IP: 40-year life) 2,870

Goodwill 2,269

Total assets acquired 5,685

Accounts payable and other liabilities (320)

Deferred income taxes (1,033)

Non-controlling interests (90)

Net assets $ 4,242

Valuation Of Intangible AssetsValuation Of Intangible Assets

Income •Multi‐period excess earnings method • Customer relationships

Income Approach

• Relief from royalty method Market • TrademarksApproach

• Replacement cost• Software used in operations

Cost Approachpp

18

Order Of Impairment TestingOrder Of Impairment TestingOrder Of Impairment

Test When To Test ASC

FASB ASC

TestingFinite‐lived, intangible

Undiscountedcash flows vs.

If impairment isindicated

360

and tangible assets

carryingamount

Indefinite‐lived,intangible assets

Fair value vs.carryingamount

Annually and ifindicated

350

Goodwill Step “Zero,”Step One,

Annually and ifindicated

350

Step Two

19

Finite‐Lived Intangible Assets(Long‐lived assets subject to amortization)(Long lived assets subject to amortization)

• Impairment testing is required if there are adverse factors or events. Some examples:– Loss of a significant customer acquired in

a business combination – Closing a manufacturing plant facility, and

no alternative location or use for the machinery and equipment

20

Goodwill And Other Intangible Assets

• Annual testing, or more frequently if there are adverse factors (ASC 350)

• Impairment testing is done at the reporting unit level.

• A reporting unit (RU) is an operating segment• A reporting unit (RU) is an operating segment.– A component of the enterprise whose operating results are regularly

reviewed by company’s main decision‐makerhi h di fi i l i f i i il bl– For which discrete financial information is available

Note: ASC 360 establishes the impairment testing of long-lived assets (including finite-lived intangible assets). 21

Goodwill And Other Intangible Assets (Cont.)

• Goodwill impairment– Fair value (FV) of reporting unit

Looks like we overpaid for ( ) p g

is less than its carrying amount.o e pa d othat deal …


Goodwill Impairment Loss DisclosureGoodwill Impairment Loss Disclosure

• During fiscal 2009, the company recorded non‐cash impairment charges of $279 million.– 142 million for FCC radio licenses, and$65 million for investment in UTV– $65 million for investment in UTV

• The FCC radio license impairment charges reflected overall market declines in certain radio markets in which we operate. These impairment charges were estimated using a discounted cash flow model.Example from SEC 10‐K filing, Disney, 10/1/2011p f f g y

23

What was the dollar amount of goodwill impairment forof goodwill impairment for U.S. companies in 2010?

a. $6 billion$b. $30 billion

c. $54 billiond. $188 billion

24

Dollar Amount Of Goodwill Impairment ForpU.S. Companies In 2010 (Billions)

Largest 2010goodwillgoodwill

impairment:Bank of America

$ b ll$12.4 billion

Choice a Choice bChoice dChoice c

25

Source: 2011 Goodwill Impairment Study, by the Financial Executives Research Foundation and Duff & Phelps

Goodwill And Other Intangible AssetsStep Zero (ASU• Qualitative assessment – more likely than not th i i i t? Ifthere is impairment?

Step One• Is FV of RU less than carrying amount of RU

If Yes

• Is FV of RU less than carrying amount of RU, including goodwill?

Step Two

If Yes

• Is “implied value” of goodwill less than the carrying amount of goodwill? If

Yes

Record goodwill impairment loss


Stock Compensation (ASC 718)Stock Compensation (ASC 718)

• Applies to share‐based payment transactions– Entity acquires goods or services by issuing equity instruments or by

incurring liabilities that are settled on the price of the entity’s shares or other equity instruments of the entity.

• Stock options or other share‐based compensation• Payment for services

– Fair value in accordance to ASC 718 and ASC 505‐50 (non‐employees)Fair value in accordance to ASC 718 and ASC 505 50 (non employees)

27

Di k V D k A i M K

AREAS WHERE APPRAISERS

Dirk Van Dyke, Armanino McKennaArlene Ravalo‐Jao, Daszkal Bolton

AREAS WHERE APPRAISERS OFTEN FALL SHORT

Supporting The Reporting Unit ValuationSupporting The Reporting Unit Valuation

• Income approach– Management forecast

• Comparison of growth rates, profit margin and other assumptions with industry or historical vs. prior forecasts

– Discount rateDiscount rate• Reconciliation with internal rate of return, based on purchase price

• Capital asset pricing method: Beta estimate• Build‐up method: Company‐specific risk adjustment

• Market approach– Selection of guideline public companies: Debate on applicability of

control premiumcontrol premium– Transactions in company’s stock/offers– Comparable transactions method

29

Entity Value And Internal Rate Of Return

30Source: Example from the Appraisal Foundation, “The Identification of Contributory Assets and Calculation of Economic Rents Toolkit – Exhibit B‐5,” http://www.appraisalfoundation.org/

Reliable Management ForecastsReliable Management Forecasts

Management forecasts are coming under greater scrutiny.

Unreliable forecasts may include any of the following:o Consistently different‐than‐past resultso Consistently different than past results o Not prepared in the normal course of businesso Produce a DCF value inconsistent with values under alternative

approachesapproacheso Not consistent with analyst expectations for comparable public

company F il i l d i hi di io Failure to include assumptions, or hinges on extraordinary assumptions

© AMLLP 2012 ‐ All Rights Reserved 31© AMLLP 2012 ‐ All Rights Reserved 31

Reliable Management Forecasts (Cont.)Reliable Management Forecasts (Cont.)

Reliable revenue projections demonstrate the following:o Revenue growth rates consistent with history

• Applicable to more mature companieso New revenues streams accurately timedo New revenues streams accurately timed

• New product developmento Changes to revenue supported by other information

l i• Early stage companies


Reliable Management Forecasts (Cont.)Reliable Management Forecasts (Cont.)

Considerations for projected expenseso Forecasts based on normalized operations

• By the “out years” of forecasto Well‐defined fixed vs variable costso Well defined fixed vs. variable costs

• Supportable economies of scaleo Consistent variables with history

O lid if• Or, valid reason if not


Company Discount RateCompany Discount Rate

Mature companieso Weighted average cost of capital

• Cost of equity: Capital asset pricing model Start‐up companiesStart up companies

o Weighted average cost of capitalo Start‐up companies

C f di• VC rate of return studies• Six studies


Discount Rate By Stage Of Start‐UpDiscount Rate By Stage Of Start Up

Start‐up: Pre‐prototype of producto 50% to 100%+

Pre‐commercialization of producto 40‐70%o 40 70%

Starting to commercializeo 40‐60%

i Shi i d Expansion: Shipping producto 30‐50%

Mezzanine: Profitable o 25‐40%


Supporting Valuation Ofl i hiCustomer Relationships

• Revenue and attrition rate– Historical experience vs. prospective experience– Term of cash flows: Contract term, renewal expectation – Estimated useful lifeEstimated useful life

• Gross margin and profitabilityO i i d / l bl– Operating expenses: Fixed costs/scalable costs

– Marketing costs: Exclude business development

• Contributory charges

• Discount rateDiscount rate

36

Customer Relationship Example: Income Approach (Multi‐Period Excess Earnings Method)

37Source: Example from the Appraisal Foundation, “The Identification of Contributory Assets and Calculation of Economic Rents Toolkit – Exhibit B‐12,” http://www.appraisalfoundation.org/

Supporting Valuation Of TrademarksSupporting Valuation Of Trademarks

• Selection of royalty rate– Comparability of market transactions and subject intangible– Relative strength and recognition in market and industry

• Revenue– Revenues benefitting from trademark – segregate by product line, if

necessarynecessary

• Discount rate

38

Trademark Valuation Example: Market Approach (Relief From Royalty Method)(Relief From Royalty Method)

Source: Example from the Appraisal Foundation, “The Identification of Contributory Assets and Calculation of Economic Rents Toolkit – Exhibit B‐10,” http://www.appraisalfoundation.org/

39

Weighted Average Return On Assets (WARA)

Source: Example from the Appraisal Foundation, “The Identification of Contributory Assets and Calculation of Economic Rents Toolkit – Exhibit B‐18,” http://www.appraisalfoundation.org/

40

Resources AvailableResources Available

• Appraisal Foundation – Appraisal Issues Taskforce– Best Practices for Valuations in Financial Reporting: Intangible Asset

Working Group ‐ Contributory Assets– Identification of Contributory Assets and Calculation of Economic y

Rents: Toolkit– Evaluating Assessment and Measurement of Control Premiums in

Valuations for Financial Reportingp g

41

Resources Available (Cont.)Resources Available (Cont.)

• AICPA– IPR&D practice aid: Assets Acquired in a Business Combination to Be

Used in Research and Development Activities– Practice aid: Valuation of Privately‐Held‐Company Equity Securities y p y q y

Issued as Compensation (cheap stock practice aid) – Exposure draft: Impairment practice aid (issued 11/2011)

42

TESTING MEASUREMENTS Michael Blake, Habif Arogeti & Wynne

AND DISCLOSURES

Goals Of TestingGoals Of Testing

• “Take my word for it” is not auditing – it’s Enron.

• Reconcile differing professional approaches to valuation

• Ensure understanding of the fair value analysis and conclusion

bli h bl f i• Establish reasonableness of assumptions

• NOT to force an appraiser into the auditor’s pet template

44

References For TestingReferences For Testing

• SAS 73 – Using the Work of a Specialist• SAS 57 – Auditing Accounting Estimates• SAS 101‐ Auditing Fair Value Measurements and Disclosures

• None provides specific testing procedures.• Testing procedures vary widely firm to firm.

45

Dividing And AuditingDividing And Auditing

Auditor’s Test Valuation Support TestsAuditor s Test• Projections• Probabilities and

Valuation Support Tests• Availability of data• Acceptability of techniques

contingencies• Integrity of customer

relationships

applied• Reasonableness of

assumptionsp• Physical presence of

tangible assets• Viability of intangible assets

p• Accuracy and consistency of

data• Competence and• Viability of intangible assets

• Overall outlook of the company

• Competence and independence of valuation producer

46

Common Areas Of Testing In Fair ValueCommon Areas Of Testing In Fair Value

• Discount rates• Growth rates• Probabilities (where weighting is used)• Market comparables and multiplesMarket comparables and multiples• Volatilities• Royalty rates

i i f l li• Remaining useful lives

47

Agreeing To DisagreeAgreeing To Disagree

• Appraisers approach the valuation analysis differently.

• Important to understand the difference between disagreement and definitively wrongy g

• Reasonableness is much more credible with support.

• Sometimes, it won’t work out, and a new appraisal will have to be obtained.

48

Probability TestingProbability Testing

• Probabilities can be used to drive many valuations.– Sensitivity analysis– Equity value allocation– Considering multiple techniquesConsidering multiple techniques– Considering multiple data sources– Contingent assets, liabilities, consideration

• “Story” is sufficient today but won’t be for long.

• Appraisers and auditors will need to become comfortable with real options theory, simulation techniques and data mining.

49

Remaining Useful LifeRemaining Useful Life

• Many intangible assets have defined useful lives.

• Fair value RuL is not unique to the acquirer.

• Disclosures of similar RuLs by companies in industry

C id i f l l li i i• Consideration of legal limitations

• Based on historical attrition/depletion

• Mathematical models, such as Iowa curves

50

Fair Value Of LeasesFair Value Of Leases

• Benchmark against market cap rates

• Observe market leasing rates for similar properties in similar areas

• Engage a real estate specialist

51

Required ReturnRequired Return

• Often rely on imputed IRR in transaction, which is dicey (only considers one market participant)

• Test using build‐up methods, CAPMg p ,

• Test using empirical studies such as Pepperdine Private Cost of Capital

• Provide support for company specific risk in cost of equity build‐up

52

Growth RatesGrowth Rates

• Test growth rates vs. industry forecasts

• Test vs. public competitors and analyst estimates

• Test vs. implied growth rates in public company valuations (Ibbotson Cost of Capital Yearbooks are a great shortcut)great shortcut)

• Test growth rate vs. indices such as Inc. 5000

• Challenge core assumptions

53

IMPACT OF VALUATIONS OF Dirk Van Dyke, Armanino McKenna

COMMON STOCK, UNDER SECT 409ASECT. 409A

Stock Valuation Guidance – AICPA Practice AidStock Valuation Guidance AICPA Practice Aid

AICPA Practice Aid on Valuation of Privately‐Held Company Equity Securities Issued as Compensation (ASC 718)o First issued in 2004

• FAS 123r and 157, and IRC Sect. 409A were not in place., po On March 28, 2011, AICPA released an exposure draft practice aid. o Final version ‐ After 2012 busy season (hopefully)

Company gets valuation of common stock firsto Company gets valuation of common stock first.• Then, issues stock options at value of common stock


409A/ASC 718 Valuations409A/ASC 718 Valuations

Need to be compliant with AICPA practice aido Allocation of value of 100% equity interest to different classes of stock

• Probability weighted expected return method (PWERM)• Option pricing method (OPM)Option pricing method (OPM)• Current value method

o Not allowed unless impending sale/IPO of companyb id h d ( i f h b )• Hybrid methods (mix of the above)


409A/ASC 718 Valuations (Cont.)409A/ASC 718 Valuations (Cont.)

Consistency is important.o Are the projections the same as those provided to investors?o Repeat valuations

• Were the same comps used in prior valuation?Were the same comps used in prior valuation? o If not, explain why

• Explain changes in discount rateh i di bl ?o Are the assumptions auditable?

• Auditors are trained to examine history.• Not comfortable with forward‐looking valuations

o Lack of marketability discount• Different method(s) used


409A/ASC 718 Valuations (Cont.)409A/ASC 718 Valuations (Cont.)

Timing and reliability of 409A valuation Ideal situation

o Contemporaneous valuation o Done by independent firmo Done by independent firm

• IRS applies most scrutiny to internal valuation.• Especially spreadsheet‐only calculations

S i f ll l io IRS regs require full valuation report.


Market Approach: BacksolveMarket Approach: Backsolve

Recent transaction in the company’s own securitieso Usually preferred stock

With unrelated investors or among unrelated investors themselves Use the option pricing method to value common stockUse the option pricing method to value common stock

o OPM allocates value of company to all equity holders.o Future‐looking method

l i hi h l f h if ld d• Results in higher value of common than if company sold today Things to consider

o Differences in rights and preferenceso Timing of financing vs. valuation date


IMPACT OF PCAOB REVIEWSMichael Blake, Habif Arogeti & Wynne

Areas Of FocusAreas Of Focus

• Goodwill impairment• Long‐lived asset impairment• Inventory valuation• Debt valuationDebt valuation• Hard‐to‐value/price securities

61

Common CriticismsCommon Criticisms

• Failure to sufficiently evaluate assumptions used in projections• Failure to sufficiently evaluate company specific risk premium• Failure to understand methods and data sources utilized by pricing sources• Failure to reconcile divergent results from utilizing different valuationFailure to reconcile divergent results from utilizing different valuation

methods• Over‐reliance on management• Projections differ sharply from past performance• Projections differ sharply from past performance• Test reasonableness of remaining useful life

62

More Common CriticismsMore Common Criticisms

• Failure to obtain understanding of methods and assumptions associated with valuation of hard‐to‐value assets

• Failure to test valuation of deferred costs

• Failure to identify level of value within hierarchy under ASC 820 (whether inputs were observable)inputs were observable)

• Failure to support allowances for loan losses

63

What Are “Hard‐to‐Valuei i l ”?Financial Instruments”?

• No observable market– Insurance policies– Private debt– Auction rate securitiesAuction rate securities– Collateralized mortgage obligations– Mortgage‐backed securities

S– Swaps

64

Big 4 No.1 (2010)Big 4 No.1 (2010)

• 16/26 criticisms related to fair value disclosures

• Most common deficiency was in goodwill impairment testing and the model assumptions.p

• Next was hard‐to‐value investments

• Establishing observability/non‐observability of inputs

65

Big 4 No. 2 (2010)Big 4 No. 2 (2010)


• Mostly related to hard‐to‐value assets

• Failure to understand data and methodologies used by pricing services

ffi i /d fi i li f l• Insufficient/deficient sampling of large asset groups

• Failure to reconcile values produced by independent testing and the values recorded by the client

66

Big 4 No. 3 (2010)Big 4 No. 3 (2010)


• Failed to obtain sufficient evidence of understanding of valuation models

• Failed to reconcile prices obtained from third parties with client’s price

il d l i d• Failure to test model input data

• Failure to test observability of inputs

• Failure to recognize risks associated with valuation models

67

Big 4 No. 4 (2010)Big 4 No. 4 (2010)

• 10/28 of criticisms related to fair value• Insufficient support of models for goodwill impairment testing

(mostly projections)• Failure to test data provided to external specialist for purchase price• Failure to test data provided to external specialist for purchase price

allocation• Failure to establish expertise of analyst• Failure to understand valuation models used by pricing services• Failure to distinguish observable from unobservable inputs

68

Summary Of CommentsSummary Of Comments

• 37/89 criticisms were related to fair value, or 42%

• Hard‐to‐value securities seemed to generate the most frequent criticism.

• Failure to challenge/support projections figured prominently.

O li hi d i• Over‐reliance on third parties

• Too much “black box”

69

Documents

Daszkal Bolton Habif Arogeti & Wynne Armanino McKennamedia.straffordpub.com/products/review-of-fair... · 5/16/2012 · – Statement of Accounting Standards (SAS) ... Deferred income