IMGCAP(1)][IMGCAP(2)]Valuation, by its very nature, is an exercise in judgment.
It is not confined to a rules-based framework of specific prescribed requirements; rather, it is subject to thoughtful application of general principles. As with any judgment-based framework, divergent views on applying the appropriate principle present an ongoing challenge. This diversity may result in investors lacking clarity about valuation estimates and related disclosures, and reduce the credibility of valuation analyses. Several organizations have embarked on efforts to deal with this issue and address the perceived lack of valuation infrastructure, which was identified as a serious concern by the SEC staff as far back as 2005.
While these efforts are well known in the valuation community, entities either preparing their own valuations or being assisted by a valuation specialist should also be familiar with the best practices that are being developed as they will affect valuations for financial reporting and the audit of fair value measurements.
Best Practices
Two organizations have made notable contributions in developing topic-specific best practices. The AICPA and The Appraisal Foundation have founded a number of task forces or working groups with ongoing efforts at various stages of completion. These organizations have established an open due process that includes publishing exposure drafts and soliciting constituent input that is critical in arriving at cogent and broadly accepted guidance.
AICPA's IPR&D Practice Aid
In response to concerns expressed by the SEC in 1998 regarding what appeared to be unreasonable determinations of fair value of acquired assets to be used in R&D activities, the AICPA formed its IPR&D Task Force. The IPR&D Practice Aid resulting from this effort identified best practices related to defining and accounting for, disclosing, valuing, and auditing assets acquired to be used in R&D activities, including specific IPR&D projects. The current version of the IPR&D Practice Aid was released in 2001.
This practice aid has become the framework on which IPR&D valuations are performed and audited. Furthermore, as a testament to the dearth of valuation guidance for financial reporting at the time, the Practice Aid became subject to a variety of off-label uses. For example, the insights related to contributory asset charges and tax amortization benefits are applied in the valuation of a wide array of other assets.
However, FASB’s newly effective fair value and business combination standards dramatically changed the landscape of IPR&D accounting and valuation. In response to these changes, the AICPA reconvened a new task force. An exposure draft of the updated guidance is expected to be published in 2011.
AICPA: Valuation of Privately Held Company Equity Securities Issued as Compensation (“Cheap Stock Practice Aid”)
The AICPA originally formed a task force to study the practice issues in determining the fair value of common stock issued as compensation. The goal of the Cheap Stock Practice Aid was to identify and clarify appropriate approaches and reduce diversity in practice. Various changes in U.S. GAAP, the release of IRC Section 409A, and a lack of clarity on certain topics identified with broad usage have since created a need for an update to this practice aid.
The working draft of the revised practice aid was open for comments through May 31, 2011, and the final document is expected to be released shortly.
AICPA: Testing Goodwill for Impairment Guide
The AICPA Impairment Task Force recently released a working draft of the AICPA Guide, “Testing Goodwill for Impairment.” During the course of its development the Task Force opted to split the guide into two documents. The first will focus on goodwill impairment issues and the other, to be released at a later date, will address intangible assets.
FASB recently issued ASU 2011-08, providing entities with an option to apply a qualitative assessment prior to performing Step 1 of the goodwill impairment test. The guide is not expected to address the option initially but may do so at a later date.
The Appraisal Foundation
The Appraisal Foundation is an independent body, authorized by Congress as the source of appraisal standards and appraiser qualifications, and interested in the advancement of professional valuation.
In late 2006, The Appraisal Foundation established a Task Force on Valuations in Financial Reporting under which several working groups were formed to develop best practices. Topics are selected where there is the greatest diversity in practice.
TAF: The Identification of Contributory Assets and Calculation of Economic Rents
The output of the first working group was published in 2010 and addressed The Identification of Contributory Assets and Calculation of Economic Rents (“CAC Monograph”).
This topic may seem rather obscure to a non-valuation professional, but it represents a critical component of the Multi-Period Excess Earnings Method, a method employed in the valuation of enabling key intangible assets; the manner of its application can have a material impact on the valuation estimate.
TAF: Customer Relationships
The second working group is addressing the valuation of customer relationships, including issues related to selecting the appropriate valuation approach and estimating the remaining useful life of the asset. An exposure draft is expected to be published by the end of this year.
TAF: Control Premiums
The third working group is focused on assessing and measuring control premiums in a financial reporting context. Control premiums, or Market Participant Acquisition Premiums as the working group will refer to them, can have a significant impact on fair value measurements. MPAPs, and their inverse (minority discounts) are a common consideration in the valuation of reporting units, previously held equity interests, non-controlling interests, and common stock issued as compensation, to name a few items. An exposure draft is expected to be published by the end of this year.
The AICPA and TAF are actively developing best practices to support valuations for financial reporting purposes. These efforts mark a transition towards a principles-based professional judgment framework that benefits not only valuation professionals, but preparers and users of financial statements as well.
The development and implementation of best practices will enhance the quality and comparability of fair value estimates, while providing an adequate framework for practitioners to channel their judgment along a narrower path and mitigate diversity in practice.
Gary Roland is a managing director in the Office of Professional Practice at Duff & Phelps. Michael Dolan is a managing director in the Tax Valuation Practice at Duff & Phelps. He is also city leader for the financial advisory and investment banking firm’s New York office.
