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Chapter 4: Common areas of application of valuation techniques to non-financial assets when required or permitted by IFRS
Property, plant & equipment including investment properties
An entity applies IFRS 13 to measure the fair value of property plant and equipment:
- when it chooses the revaluation model under IAS 16 (IAS 16 para 31) or the fair value model under IAS 40;
- when it acquires property, plant, and equipment in a business combination; or
- when it elects, on transition to IFRS, to take the fair value as deemed cost exemption in IFRS 1.
The fair value of land and buildings is typically measured using the market approach or the income approach because there is usually available market data for sales and rentals of land and buildings. The principles in each case will be the same: to determine the price that a market participant would pay for the asset.
Fair value will reflect the highest and best use of the asset, which will usually be its existing use, but it might be for some other use. For example, if an entity owns a plot of land in a city center on which it has a warehouse, the site might have the potential for residential development. Its market value could be significantly higher than its value as an industrial site, although the entity would have to incur costs, such as relocation or closure costs, to realize that value.
Guidance on highest and best use of property, plant and equipment
An entity acquires land in a business combination. The land is currently developed for industrial use as a site for a factory. The current use of the land is presumed to be its highest and best use, unless market or other factors suggest a different use. Nearby sites have recently been developed for residential use as sites for high-rise apartment buildings. On the basis of that development and recent zoning and other changes to facilitate that development, the entity determines that the land currently used as a site for a factory could be developed as a site for residential use (that is, for high-rise apartment buildings), because market participants would take into account the potential to develop the site for residential use when pricing the land. The highest and best use of the land would be determined by comparing both of the following:
1. The value of the land as currently developed for industrial use (that is, the land would be used in combination with other assets, such as the factory, or with other assets and liabilities).
2. The value of the land as a vacant site for residential use, taking into account the costs of demolishing the factory and other costs (including the uncertainty about whether the entity would be able to convert the asset to the alternative use) necessary to convert the land to a vacant site (that is, the land is to be used by market participants on a stand-alone basis).
The highest and best use of the land would be determined on the basis of the higher of those values. In situations involving real estate appraisal, the determination of highest and best use might take into account factors relating to the factory operations, including its assets and liabilities.
The depreciated replacement cost approach could be used to measure fair value in the rare instances where an entity is valuing land and buildings or specialized equipment for which there is no market data for sales or rentals.
Application of the replacement cost approach for property, plant and equipment
The fair value of specialised plant and equipment might be measured using the replacement cost method. This represents the highest value that a market participant would pay for an asset with similar utility. The cost approach is based on the principle of substitution. It uses the cost to replace an asset as an indicator of the fair value of that asset. To determine the appropriate substitute asset or asset group as a measure of fair value, the utility of the replacement asset is compared to the utility of the asset being measured. Comparable utility implies similar economic satisfaction, but it does not necessarily require the substitute asset to be an exact duplicate of the asset being measured. The cost of an exact duplicate is referred to as ‘reproduction cost’. The substitute asset is perceived as equivalent if it possesses similar utility to (and, therefore, serves as a measure of fair value of) the asset being valued.
Step 1: Identify the asset’s original cost.
Step 2: Adjust the original cost for changes in price levels between the asset’s original in-service date and the date of the valuation to measure its replacement cost new (RCN). RCN represents the indicated value of current labour and materials necessary to construct or acquire an asset of similar utility to the asset being measured.
Step 3: Adjust RCN to represent any losses in value due to physical deterioration or functional obsolescence of the asset, which results in the value of replacement cost new less depreciation (RCNLD).
Physical deterioration represents the loss in value due to the decreased usefulness of a fixed asset as the asset’s useful life expires. This can be caused by factors such as wear and tear, deterioration, physical stresses and exposure to various elements.
Excessive physical deterioration might result in an inability to meet production standards or in higher product rejections, as the tolerance on manufacturing equipment decreases. In addition, higher than average maintenance expenditure requirements might suggest higher levels of physical deterioration. However, below average maintenance expenditures might also indicate higher levels of physical deterioration, due to inadequate or deferred maintenance.
Functional obsolescence represents the loss in value due to the decreased usefulness of a fixed asset that is inefficient or inadequate, relative to other more efficient or less costly replacement assets provided by new technological developments. Functional obsolescence is observed in several different forms.
If the subject asset has excessive operating costs relative to a new asset, this might indicate a form of functional obsolescence. If, in developing an asset’s RCN, that replacement cost is less than its reproduction cost, this might also be indicative of a form of functional obsolescence. The objective of the measurement is to identify the replacement cost of a modern equivalent asset.
Step 4: Adjustment RCNLD, if necessary, for loss in value due to economic obsolescence, to provide an indication of the fair value of the asset being measured.
Economic obsolescence represents the loss in value due to the decreased usefulness of a fixed asset caused by external factors, independent of the characteristics of the asset or how it is operated. The increased cost of raw materials, labour or utilities that cannot be offset by an increase in price due to competition or limited demand – as well as a change in environmental or other regulations, inflation or high interest rates – might suggest the presence of economic obsolescence. The more specialised the asset, the more it is exposed to economic obsolescence.
IFRS 13 permits the fair value of certain tangible assets to be measured using the replacement cost method. However, there might be instances of industry practice where certain tangible assets are measured using an income or market approach. An example is the measurement of a power plant in the energy sector, which often has few, if any, intangible assets other than the embedded licence, and so the cash flows from the plant reflect only the economic benefits generated by the plant and its embedded licence. Management should have regard to other IFRSs to determine whether the assets measured together need to be accounted for separately. This could result in a fair value measurement above the replacement cost. In this situation, replacement cost represents the highest price that a market participant would be prepared to pay, so reporting entities should consider whether any of the difference is derived from or related to other assets included in the cash flows of the tangible assets, such as customer or contractual assets.
An investment property’s fair value is typically based either on the market approach (reference to sales of comparable properties) or on the income approach (by reference to rentals from the subject property or similar properties). The cost approach is not appropriate for the fair value model under IAS 40. The unit of account is the property plus the current leases. This effectively constrains the use of valuation approaches.
IAS 17 considerations when determining the fair value of leased property under IAS 40
Leased property interest is initially recognised at its fair value or, if lower, at the present value of minimum lease payments. The fair value of the leased property interest, net of all expected lease payments, should be nil, assuming that the lease has been negotiated at market rates. The property interest is recorded at the present value of the minimum lease payments, and so the carrying amount of the property and the lease payments will be the same at inception. Normally, the fair value of the property interest will be equivalent to the minimum lease payments, because these are discounted to present value using the interest rate implicit in the lease.
Pre-paid or accrued operating lease income that has been recorded in the balance sheet is not included in the determination of the fair value of the related investment property. It is already recorded as a separate asset or liability.
Investments in associates, joints, and subsidiaries
Venture capital organizations and similar entities are permitted to choose to measure their investments in associates and joint ventures at fair value, rather than applying equity accounting.
Entities that qualify as investment entities under IFRS 10 measure all investments, including subsidiaries, associates, and joint ventures, at fair value, rather than consolidating or applying equity accounting.
Any investments traded in a listed market can be valued by reference to that market price. Unlisted investments are valued using the market or the income approach. The approach is chosen based on the availability of data to measure fair value. The market approach can be used as the primary approach but is also frequently used as a cross-check on the implied valuation multiple produced by the income approach.
An entity preparing separate financial statements might choose to use fair value to measure all of its investments in associates, joint ventures, and subsidiaries. The policy choice should be applied consistently to each class of investments.
Application of the market approach to valuation of investments in associates, joint ventures and subsidiaries
The market approach can be used as a primary approach to measure the fair value of the investment. It is also often used to assess the reasonableness of the implied valuation multiples derived from the income approach. The two principal methods in applying the market approach are discussed below.
Comparable company market multiple method
Publicly traded companies are reviewed to develop a peer group similar to the company being valued, referred to as ‘comparable’ companies. Market multiples are developed and based on two inputs:
(i) quoted trading prices which represent non-controlling interest shares, because exchanges of equity shares in active markets typically involve small (non-controlling interest) blocks; and
(ii) financial metrics, such as net income, and earnings before interest, taxes, depreciation and amortisation (EBITDA).
Multiples are then applied to the subject company’s comparable financial metric.
Caution is required: if there are too many adjustments required, the selected companies are unlikely to be truly comparable.
This results in the estimated fair value of the entity’s enterprise value (value of equity plus debt) or equity value, depending on which metric is used, on a non-controlling interest basis, because the multiples were derived from noncontrolling interest prices. So, this is suitable for the measurement of investments in associates or joint ventures, both of which are non-controlling interests (that is, there is no control over them under IFRS 10).
Where the valuation derives an enterprise value, the fair value of any debt in the investee must be deducted to arrive at the implied equity value of the investment.
If a controlling or majority interest in a subsidiary is being valued, a further adjustment (‘control premium’) might be necessary. A control premium represents the amount paid by a new controlling shareholder for the synergies and other potential benefits derived from controlling the enterprise. A control premium should not be automatically applied without consideration of the relevant factors (for example, synergies). Companies need to evaluate and assess whether such factors indicate that a control premium is justified and, if so, assess the magnitude of the control premium.
Market transaction multiple method
The market transaction multiple method is a variation of the market approach, and it is often applied when valuing a controlling or majority ownership interest of a business enterprise.
This approach is based on prices paid in observed market transactions of comparable companies, involving exchanges of entire (or majority interests in) companies, which generally include a control premium in the price paid.
Valuation multiples are developed from observed market data for a particular financial metric of the business enterprise, such as earnings or revenue. The valuation multiple is then applied to the financial metric of the subject company to measure the estimated fair value of the business enterprise on a control basis. Generally, the value of control included in the transaction multiple is specific to the buyer and seller involved in the transaction, and might not be broadly applicable to the subject company. Therefore, this valuation technique should consider the synergies in the transaction and whether they are appropriate to the company being valued.
Obtaining and reviewing comparable company information
The data used in either of the market approaches above is typically obtained from several sources, including past transactions in which the company has participated, peer company financial statements, periodicals, industry magazines and trade organisations, and Mergers and Acquisitions’ databases. The data for a single transaction might be derived from several sources.
The degree of similarity of the observed data to the subject company (industry, transaction date, size, demographics, and other factors) needs to be considered in evaluating the relevance and weight given to the selected financial metric.
The relevance of the market approach in measuring fair value is dependent on the comparability of the companies on which the analysis is based. The higher the degree of correlation between the operations in the peer group and the subject company, the better the analysis. Some of the more significant attributes used to determine comparability are:
· Type of product produced or service performed.
· Geographic area of operation.
· Positioning in market.
· Size (for example, revenue, assets).
· Growth (historical and projected).
· Profitability.
· Capital intensity (fixed assets and working capital).
· Leverage.
· Liquidity.
· Diversification.
Some of the attributes above might be adjusted to allow for further comparability between the company being measured and the peer group.
Fair value in business combinations
Fair value measurement is required in several aspects of business combination accounting under IFRS. Fair value is required or permitted for the measurement of:
- consideration including contingent consideration;
- any previously held equity interest;
- any non-controlling interest; and
- most of the identifiable assets acquired and liabilities assumed
Consideration
The consideration transferred is the sum of the acquisition date fair value of the assets transferred, the liabilities incurred by the acquirer to the former owners of the acquiree, and the equity interests issued by the acquirer to the former owners of the acquiree. Examples of consideration transferred include cash, contingent consideration, other assets, a business of the acquirer transferred to the seller, common or preferred equity instruments, options, and warrants. The fair value of consideration, other than cash, must be determined by IFRS 13.
Equity interests issued by the acquirer in a business combination might be either publicly traded or privately held. Where the shares are publicly traded, fair value will be the quoted share price on the acquisition date multiplied by the number of shares issued. The fair value of unlisted shares issued as consideration is measured using valuation techniques – either the market or the income approach.
Recognizing contingent consideration at fair value presents several measurement challenges. Entities will need to consider the key inputs of the arrangement and market participant assumptions when developing the assumptions used to determine the fair value. Key considerations include:
- Estimation of the likelihood and timing of achieving the arrangement’s relevant milestones.
- Exercising judgment when applying a probability assessment for each of the potential outcomes.
- Consideration of the amount to be paid under the arrangement on the acquisition date. This is uncertain and should be carefully considered.
- The fair value of liability-classified contingent consideration will need to be updated each reporting period after the acquisition date.
Changes in fair value measurements should consider the most current probability estimates and assumptions, including changes due to the time value of money
Measuring contingent consideration in a business combination at fair value
Valuation methods for contingent consideration often range from discounted cash flow analyses and binomial models linked to discounted cash flow models, to the more intricate Monte Carlo simulations. The arrangement’s terms, the pay-out structure and the reliability of inputs will influence the type of valuation model used.
Each arrangement has its own specific features requiring different modelling techniques and assumptions. Additionally, for liability-classified contingent consideration, the valuation model will need to be flexible enough to handle changing inputs and assumptions that need to be updated each reporting period. The projected financial information used in valuing the contingent consideration arrangement should be consistent with the projected financial information used in valuing the intangible assets.
Fair value measurement of liability classified, cash-settled contingent consideration (2)
Entity A purchases entity B by issuing 1 million equity shares in entity A to entity B’s shareholders. At the acquisition date, entity A’s share price is C40 per share. Entities A and B agree that, if the shares of entity A are trading below C40 per share one year after the acquisition date, entity A will issue additional shares to entity B’s former shareholders sufficient to protect against price declines below C40 million (that is, the acquisition date fair value of the 1 million shares issued).
The guarantee arrangement creates an obligation that entity A would be required to settle with a variable number of entity A’s equity shares, the amount of which varies inversely to changes in the fair value of entity A’s equity shares. For example, if entity A’s share price decreases from C40 per share to C35 per share one year after the acquisition date, the amount of the obligation would be C5 million. Therefore, the guarantee arrangement would require liability classification on the acquisition date. Changes in the liability will be recognised in entity A’s earnings until the arrangement is settled.
The best estimate or the probability-weighted approach will not be sufficient to value the share-settled arrangement of a public company. In addition to the quantification of projection and credit risks, the modelling of entity A’s share price is required.
The following factors are relevant in performing a valuation for such arrangements for a private company:
· Potential outcomes for entity A’s financial results next year.
· Potential outcomes for entity A’s share price returns over the coming year.
· Correlation of the distributions of the financial results and share price returns.
· Potential outcomes for other market events that could impact the overall stock market.
· Selection of an appropriate discount rate that adequately reflects all of the risks (for example, projection risk, share price return estimation risk, entity A’s credit risk) not reflected in other assumptions of the valuation.
The contingent consideration arrangements illustrated in this example will require a valuation approach incorporating option pricing techniques for a public company.
Fair value measurement of equity-classified contingent consideration
Entity A acquires entity B in a business combination. The consideration transferred is 10 million entity A shares at the acquisition date, and 2 million shares two years after the acquisition date if a performance target is met. The performance target is for entity B’s revenues (as a wholly owned subsidiary of entity A) to be greater than C500 million in the second year after the acquisition. The market price of entity A’s shares is C15 at the acquisition date. Entity A’s management assesses a 25% probability that the performance target will be met. A dividend of C0.25 per share is expected at the end of years 1 and 2, which the seller will not be entitled to receive.
The fair value is estimated at C7,296,786 (see calculation below). The fair value of the contingent consideration at the acquisition date is based on the acquisition date fair value of the shares, and it incorporates the probability that entity B will have revenues in two years greater than C500 million. The value excludes the dividend cash flows in years 1 and 2, and it incorporates the time value of money. The discount rate for the present value of dividends should be the acquirer’s cost of equity, because returns are available to equity holders from capital appreciation and dividends paid. Those earnings are all sourced from net income of the acquirer.
There are no re-measurements of the fair value in subsequent periods.
A B C Revenue forecast (C’m) Probability (%) Payment in shares Probability -weighted number of shares 350 30 0 450 45 0 550 20 2,000,000 400,000 650 5 2,000,000 100,000 Total 500,000
C Probability-weighted shares [C = sum of (A × B)] 500,000 D Share price [given] 15 E Probability-weighted value [E = C × D] 7,500,000 F Acquirer’s cost of equity [given] 15% G1 Dividend year 1 [G1 = 0.25 × C] 125,000 G2 Dividend year 2 [G2 = 0.25 × C] 125,000 H Present value of dividend cash flow [H = G / (1+F) + G / (1+F)^2] 203,214 I Present value of contingent consideration [I = E – H] 7,296,786
Previously held equity interests
The fair value of the previously held equity interest in a publicly traded entity should be based on the observable quoted market price. The previously held equity interest in an entity that is not publicly traded will need to be measured using valuation techniques – either the market or the income approach. One approach, frequently used in practice, is to derive the value of the unlisted previously held equity interest from the per-share value of the consideration transferred to obtain control. Application of the market or income approach for a less-than-controlling interest is similar for both a previously held equity interest and a non-controlling interest.
Non-controlling interests
An entity might choose the proportionate share method or the fair value method to value the non-controlling interest (NCI). If fair value measurement is chosen, the measurement approach will depend on whether the NCI remains publicly traded or not. The fair value for an NCI that remains publicly traded after acquisition should be determined using the NCI’s quoted market price. A method of estimating the fair value of an unlisted NCI, often seen in practice, is to gross up the fair value of the controlling interest to a 100% interest including a control premium, where appropriate. This method reflects the goodwill for the acquiree as a whole, in both the controlling interest and the NCI. Use of both the market and income approaches should be considered because they might provide further support for the fair value of the NCI.
When measuring the fair value of an unlisted NCI, entities need to consider the extent to which the NCI is expected to benefit from the synergies of the business combination. The price paid to obtain control typically includes a premium reflecting the synergies that the acquirer expects to achieve. If the NCI will also benefit from those synergies, the fair value measurement will include that premium. But, if the acquirer intends the synergies to be realized in another part of its group, in which the NCI has no participation, the fair value of the NCI shares will not include the value of the synergies.
Measuring the fair value of a less than controlling interest: market approach
Entities might need to consider using the market approach to value an NCI that is not publicly traded and for which the controlling interest value is not an appropriate basis for estimating fair value. The first step in applying this method is to identify publicly traded companies that are comparable to the acquiree. Pricing multiples of revenue or earnings are calculated from the guideline companies; these are analysed, adjusted, and applied to the revenue and earnings of the acquiree. Applying the pricing multiples to the acquiree’s earnings results in the fair value of the acquiree on an aggregate basis. This is then adjusted to reflect the pro rata NCI ownership interest and control premium, if required, for any synergies from the acquisition that would be realised by the NCI. Similarly, the pricing multiples could be applied directly to the pro rata portion of the acquiree’s earnings to estimate the fair value of the NCI. The purchase price of the transaction should be used as a benchmark.
Measuring the fair value of a less than controlling interest: income approach
The income approach could be used to measure the NCI’s fair value, using a discounted cash flow analysis to measure the value of the acquired entity’s whole business. The analysis performed as part of assigning the fair value to the assets acquired and liabilities assumed might serve as the basis for the fair value of the acquiree as a whole. Understanding whether a control premium exists, and whether the NCI shareholders benefit from the synergies from the acquisition, is critical in measuring the NCI’s fair value.
If it is determined that a control premium exists and the premium would not extend to the NCI, there are two methods widely used to remove the control premium from the fair value of the business enterprise:
· Method 1: calculate the pro rata NCI interest to the value of the business enterprise and apply a minority interest discount.
· Method 2: adjust the projections used for the value of the business enterprise analysis, to remove the economic benefits of control embedded in the projections.
Fair value measurement of an unlisted less than controlling interest
Entity A acquires 350 shares, or 70%, of entity B, which is privately held, for C2,100 or C6 per share. There are 500 shares outstanding. The outstanding 30% interest in entity B represents the NCI that is required to be measured at fair value by entity A. At the acquisition date, entity B’s most recent annual net income was C200. Entity A used the public entity market multiple method to measure the fair value of the NCI. Entity A identified three publicly traded companies comparable to entity B, which were trading at an average price-to earnings multiple of 15. Based on differences in growth, profitability, liquidity and product differences, entity A adjusted the observed price-to-earnings ratio to 13, for the purposes of valuing entity B.
To measure the fair value of the NCI in entity B, entity A could initially apply the price-to-earnings multiple in the aggregate as follows:
Entity B net income C200 Price-to-earnings multiple 13 Fair value of entity B C2,600 Entity B NCI interest 30% Fair value of entity B NCI C780 Entities must assess whether the consideration transferred for the 70% interest includes a control premium paid by the acquirer and whether that control premium would extend to the NCI when determining its fair value. In this example, the fair value of entity B (using the market approach) is C2,600, which represents a minority interest value, because the price-to-earnings multiple was derived from per-share prices (that is, excludes control). If it had been appropriate to include the control premium in the fair value estimate, grossing up the 70% interest yields a fair value for the acquiree as a whole of C3,000 (C2,100/0.70), compared to the C2,600 derived above, and a value for the NCI of C900.
Intangible assets
An entity applies IFRS 13 to measure the fair value of intangible assets where:
- it applies the revaluation model under IAS 38 [IAS 38 para 75]; or
- it acquires intangible assets in a business combination
Few intangible assets are traded in an active market. Where they are, fair value will be measured by reference to the quoted price of an identical asset and will be a Level 1 measurement.
Entities are required by IFRS 3 to recognize the identifiable intangible assets acquired in a business combination at their acquisition date fair values. The income approach is most commonly used to value acquired intangible assets, because of their unique nature. The valuation inputs used in the income approach should be developed based on market participant assumptions. The most common variations of the income approach are:
- multi-period excess earnings method (MEEM);
- relief from royalty (RFR);
- greenfield method, and
- ‘with and without’ method.
The cost savings and premium profit approach are also used, but less frequently
Applying the multi-period excess earnings method (MEEM)
The fundamental principle underlying the MEEM is to isolate the net earnings attributable to the asset being measured. Cash flows are used as a basis for applying this method. An intangible asset’s fair value is equal to the present value of the incremental after-tax cash flows (excess earnings) attributable solely to the intangible asset over its remaining useful life.
Intangible assets are generally used, in combination with other tangible and intangible assets, to generate income. The other assets in the group are often referred to as ‘contributory assets’, because they contribute to the realisation of the intangible asset’s value.
To measure the fair value of an intangible asset, its projected cash flows are isolated from the projected cash flows of the combined asset group over the intangible asset’s remaining economic life. Both the amount and the duration of the cash flows are considered from a market participant’s perspective. To apply the MEEM, the following steps need to be performed:
1. The expected net income of a particular asset group should be estimated.
2. ‘Contributory asset charges’ or ‘economic rents’ are deducted from the total net after-tax cash flows projected for the combined group, to obtain the residual or ‘excess earnings’ attributable to the intangible asset. The contributory asset charges represent the charges for the use of an asset or group of assets (for example, working capital, fixed assets, trade names), and they should be applied for all assets, excluding goodwill, that contribute to the realisation of cash flows for a particular intangible asset.
3. The excess cash flows are discounted to a net present value.
4. The net present value of any tax benefits associated with amortising the intangible asset for tax purposes (where relevant) is added, to arrive at the intangible asset’s fair value.
The contributory asset charges are calculated using the assets’ respective fair values, and they are based on an ‘earnings hierarchy’ or prioritisation of total earnings ascribed to the assets in the group. The earnings hierarchy is the foundation of the MEEM, in which earnings are first attributed to a fair return on contributory assets (such as investment in working capital) and property, plant and equipment. These are considered a prerequisite to developing the ability to deliver goods and services to customers, and thus their values are not included as part of the intangible asset’s value.
The return or charge for each asset should be based on comparable market rates, which reflect the amount that market participants would charge for use of the asset (that is, a ‘market-derived rent’). In addition, contributory assets might benefit a number of intangible and other assets. The total return or charge earned by a particular asset should be distributed over the assets that benefit from its use. For example, in determining the fair value of intangible assets, a capital-intensive manufacturing business should have a higher contributory asset charge from fixed assets than that of a service business.
Terminal values are not appropriate in the valuation of a finite-lived intangible asset under the income approach. However, it is appropriate to add a terminal value to a discrete projection period for indefinite-lived intangible assets, such as some trade names.
The key assumptions of the MEEM, in addition to the projected cash flows over the asset’s remaining useful life, are as follows:
· Discount rates, including reconciling rates of return.
· Application of contributory asset charges.
· Tax amortisation benefit.
· Attrition and obsolescence.
Discount rates for intangible assets
An appropriate discount rate is an important factor in any income model used to value intangible assets, whether using expected (that is, probability-adjusted) or conditional (that is, management’s best estimate) cash flows. It is generally recognised by valuation practitioners that the total cash flows attributable to a group of assets can be disaggregated according to the varying levels of risk associated with the cash flows generated by the asset groups.
The discount rate should reflect the risks commensurate with the intangible asset’s individual cash flow assumptions. Some intangible assets, such as order or production backlog, might be assigned a lower discount rate relative to other intangible assets, because the cash flows are more certain.
Other intangible assets, such as technology-related and customer relationship intangible assets, are generally assigned higher discount rates, because the projected level of future earnings is deemed to have greater risk and variability. Whilst discount rates for intangible assets could be higher or lower than the entity’s weighted average cost of capital (‘WACC’), they are typically higher than discount rates on tangible assets. The spectrum of risk is shown in the following diagram:
The WACC represents the average expected return on the capital invested in a business for a market participant investor. The internal rate of return (IRR) represents the implied return from the transaction, and this might include acquirer-specific elements.
The WACC applicable for the acquiree should be the starting point for developing the appropriate discount rate for an intangible asset. The WACC and the IRR should be equal when the projected financial information (PFI) is market participant expected cash flows and the consideration transferred equals the fair value of the acquiree. However, there might be cases where the WACC and the IRR are not equal, creating the need for further analysis to determine the appropriate starting point for an intangible asset discount rate.
If a difference exists between the IRR and the WACC, and it is driven by the cash flows (that is, optimistic or conservative bias rather than expected cash flows, while the consideration transferred is the fair value of the acquiree), best practice would be to use expected cash flows. If this is not possible, it might be necessary to consider the IRR as a starting point when considering adjustments to discount rates for intangible assets. However, in this situation it is important to assess whether the cash flows allocated to the individual intangible assets have been adjusted to eliminate the optimistic or conservative bias reflected in the overall business cash flows.
For example, if the IRR in a technology acquisition is higher than the WACC, because the business cash flows include optimistic assumptions about revenue growth from selling products to future customers, adjustments must be made to the discount rate used to value the technology in the products that would be sold to both existing and future customers. However, if the revenue growth rate for the existing customer relationships does not reflect a similar level of growth or risk, the discount rate for existing customer relationships should generally be based on the WACC, without such adjustments.
If the difference between the IRR and the WACC is driven by the consideration transferred (that is, the transaction is a bargain purchase or includes entity-specific synergies), the WACC might be more applicable to use as the basis of the intangible assets’ required returns. The relationship between the WACC and the IRR in certain circumstances impacts the selection of discount rates.
Reconciliation of rates of return
The assignment of stratified rates to the various classes of asset is a challenging process, because there are few (if any) observable active markets for intangible assets. Companies should assess the overall reasonableness of the discount rate assigned to each asset by reconciling the discount rates assigned to the individual assets, on a fair value weighted basis, to the WACC of the acquiree (or the IRR of the transaction, if the cash flows do not represent market participant assumptions). This reconciliation is often referred to as a ‘weighted average return analysis’ (WARA). The WARA is a tool to assess the reasonableness of the selected discount rates.
Although goodwill is not explicitly valued by discounting residual cash flows, its implied discount rate should be reasonable, considering the facts and circumstances surrounding the transaction and the risks normally associated with realising earnings high enough to justify investment in goodwill. Determining the implied rate of return on goodwill is necessary, to assess the reasonableness of the selected rates of return on the individual assets acquired.
The rate of return should be consistent with the type of cash flows associated with the underlying asset (that is, expected or conditional cash flows), because the rate of return might be different. Assets valued using expected cash flows would have a lower required rate of return than the same assets valued using conditional cash flows, because the latter cash flows include additional uncertainty.
Contributory asset charges
Cash flows associated with measuring the fair value of an intangible asset should be reduced or adjusted by contributory asset charges. The practice of taking contributory asset charges on assets such as net working capital, fixed assets and other identifiable intangible assets is widely accepted among valuation practitioners.
Which assets to include?
There are varying views related to which assets should be used to calculate the contributory asset charges. Some valuation practitioners have argued that goodwill in its entirety should be included as a contributory asset, presumably representing going concern value, institutional know-how, repeat patronage, and reputation of a business. A majority of valuation practitioners and accountants have rejected this view, because goodwill is generally not viewed as an asset that can be reliably measured. However, assembled workforce, as an element of goodwill, might be identifiable and reasonably measured, even though it does not meet the accounting criteria for separate recognition. As a result, an assembled workforce is typically considered a contributory asset, even though it is not recognised separately from goodwill. It is rare to see a valuation of an intangible asset that includes a contributory asset charge for a portion of goodwill, with the exception of an assembled workforce. Improperly including a contributory asset charge will tend to understate the intangible asset’s fair value and overstate goodwill.
Should both return ‘on’ and ‘of’ investment be included?
The analysis should include both returns ‘on’ and ‘of’ the contributory asset. However, it should be noted that, sometimes, the ‘of’ component is already reflected in the asset’s cash flow forecast.
For self-constructed assets, such as customer lists, the cost to replace them (that is, the return of value) is typically included in normal operating costs and, therefore, is already factored into the projected financial information (PFI) as part of the operating cost structure. Because this component of return is already deducted from the entity’s revenues, the returns charged for these assets would include only the required return on the investment component. The return of component encompasses the cost to replace an asset, which differs from the return on component, which represents the expected return from an alternate investment with similar risk (that is, opportunity cost of funds). Where returns of the asset are not included in the operating cost structure, a return on and a return of value would both be charged.
For example, where a royalty rate is used as a technology contributory asset charge, the assumption is that the entity licenses its existing and future technology, instead of developing it in-house. If the cash flows were developed on the assumption that future technology will be developed inhouse, the royalty rate would reflect cash expenditures for research and development. In this case, the cash flows used to value the individual intangible asset (for example, customer relationships) should be adjusted by eliminating the cash spent on research and development for future technology. This is because the royalty is the cost for licensing completed technology (whether current or future) from a third party. As a result, inclusion of cash spent on research and development in the cash flows results in double counting, because there is no need to develop a technology in-house where it is assumed that it will be licensed from a third party.
Tax amortisation benefit
Many business combinations result in the acquiring entity carrying over the acquiree’s tax basis. As a result, the amounts recorded for financial reporting purposes will most likely differ from the amounts recorded for tax purposes. A deferred tax asset or deferred tax liability should generally be recognised for the effects of such differences. Although no ‘step up’ of the intangible asset’s tax basis actually occurs, the estimation of fair value should still reflect hypothetical potential tax benefits as if it did. (For instance, in business combination accounting, the unit of account is the individual asset, and not the business. In most jurisdictions, the acquirer of a single asset acquires the tax basis in the amount of the price paid. The tax amortisation benefit (‘TAB’) seeks to capture the value of this hypothetical benefit.)
The effect of income taxes should be considered where an intangible asset’s fair value is estimated as part of a business combination. The tax amortisation benefit (‘TAB’) is applied when using the income approach, but it is not applied to the market approach. Market-based data used in the market approach is assumed to include the potential tax benefits resulting from obtaining a new tax basis (that is, it is reflected in the price of the asset).
The tax benefits should reflect the tax legislation in the domicile where the asset is situated. However, if there are no tax benefits possible (that is, the tax legislation in the subject jurisdiction does not permit market participants to recognise a new tax basis under any circumstance), the fair value of the assets should not include any tax benefits.
Relief from royalty method
The relief from royalty (RFR) method of the income approach is relatively specialised, for use in measuring the fair value of those intangible assets that are often the subject of licensing (such as trade names, patents and proprietary technologies).
The fundamental concept underlying this method is that, in lieu of ownership, the acquirer can obtain comparable rights to use the subject asset via a licence from a hypothetical third-party owner. The asset’s fair value is the present value of licence fees avoided by owning it (that is, the royalty savings). To appropriately apply this method, it is critical to develop a hypothetical royalty rate that reflects comparable comprehensive rights of use for comparable intangible assets. The use of observed market data (such as observed royalty rates in actual arm’s length negotiated licences) is preferable to more subjective unobservable inputs.
Royalty rate selection requires judgement, because most brands, trade names, trademarks and intellectual property have unique characteristics. The underlying technology or brand might have been licensed or sub-licensed to third parties. The actual royalty rate charged by the entity for the use of the technology or brand to other parties is generally the best starting point for an estimate of the appropriate royalty rate. However, in the absence of actual royalty rate transactions, market-based royalty rates for similar products, brands, trade names or technologies are used. Market rates are adjusted so that they are comparable to the subject asset being measured, and to reflect the fact that market royalty rates typically reflect rights that are more limited than those of full ownership. Market royalty rates can be obtained from various third-party data vendors and publications.
Greenfield method
The subject intangible asset is valued under the greenfield method using a hypothetical cash flow scenario of developing an operating business from an entity that, at inception, only holds the subject intangible asset. Consequently, this valuation method is most relevant for assets that are considered to be scarce or fundamental for the business, even if they do not necessarily drive the excess returns that might be generated by the overall business. For example, the greenfield method is frequently used to value broadcasting licences. These assets are fundamental for a broadcasting business, but they do not necessarily generate excess returns for the business. Excess returns might be driven by the broadcast content or technology.
This method considers the fact that the value of a business can be divided into three value categories: the ‘going concern value’; the value of the subject intangible asset; and the value of the excess returns driven by other assets. The going concern value is the value of having all necessary assets and liabilities assembled, such that normal business operations can be performed. Under the greenfield method, the investments required to recreate the going concern value of the business (both capital investments and operating losses) are deducted from the overall business cash flows. This results in the going concern value being deducted from the overall business value. Similarly, the value of the excess returns, driven by intangible assets other than the subject intangible asset, is also excluded from the overall business cash flows, by using cash flows providing only market participant or normalised levels of return. The result of deducting the investment needed to recreate the going concern value and excluding the excess returns driven by other intangible assets from the overall business cash flows is to provide a value of the subject intangible asset (that is, the third element of the overall business).
The greenfield method requires an understanding of how much time and investment it would take to grow the business, considering the current market conditions. The expenses and capital expenditures required to recreate the business would be higher than the recurring expense and capital expenditure level of an established business. In addition, the time to recreate (or the ‘ramp-up’ period) also determines the required level of investments (for example, to shorten the ramp-up period, more investment would be required).
In summary, the key inputs of this method are the time and required expenses of the ramp-up period, the market participant or normalised level of operation of the business at the end of the ramp-up period, and the market participant required rate of return for investing in such a business (discount rate). The tax amortisation benefit of the intangible asset should also be included in determining the value of the subject intangible asset.
‘With and without’ method
The value of the subject intangible asset under the ‘with and without’ method is calculated by taking the difference between the business value estimated under two sets of cash flow projections: The value of the business with all assets in place at the valuation date. The value of the business with all assets in place, except the subject intangible asset, at the valuation date.
The fundamental concept underlying this method is that the value of the subject intangible asset is the difference between an established, ongoing business and one where the subject intangible asset does not exist. If the subject intangible asset can be rebuilt or replaced in a certain period of time, the period of lost profit is limited to the time to rebuild. However, the incremental expenses required to rebuild the subject intangible asset also increase the difference between the scenarios and, therefore, the value of the subject intangible asset.
This valuation method is most applicable for assets that provide incremental benefits, either through higher revenues or lower cost margins, but where there are other assets that drive revenue generation. This method is sometimes used to value customer-related intangible assets where the MEEM is used to value the primary asset (for example, technology). Key inputs of this method are the assumptions of how much time and additional expenses are required to recreate the subject intangible asset, and the level of lost cash flows that should be assumed during this period. The expenses required to recreate the subject intangible asset should generally be higher than the expenses required to maintain its existing service potential. In addition, to shorten the time to recreate it would generally require a higher level of investment.
The tax amortisation benefit of the intangible asset should also be included in determining the value of the subject intangible asset.
Weighted average return analysis
Entity A acquires entity B in a business combination for C400 million. Reconciling entity B’s cash flows to the consideration transferred of C400 million results in an internal rate of return (IRR) of 12%. Assume a 40% tax rate.
The weighted average cost of capital (WACC) for comparable companies is 11.5%.
Assets Fair value % of total After-tax discount rate Weighted d average discount rates C’m % % % Working capital 30 7.5 4 0.3 Fixed assets 60 15 8 1.2 Patent 50 12.5 12 1.5 Customer relationships 50 12.5 13 1.6 Developed technology 80 20 13 2.6 Residual goodwill 130 32.5 15 4.9 Total 400 100 12.1
The discount rates selected for intangible assets (in conjunction with the rates selected for other assets, including goodwill) results in a weighted average return analysis (WARA) of 12.1%, which approximates to the comparable entity WACC and IRR of 11.5% and 12%, respectively. Therefore, the selected discount rates assigned to the assets acquired appear reasonable.
The rates used for contributory assets, which are working capital (4%) and fixed assets (8%), are generally consistent with after-tax observed market rates. Discount rates on working capital and fixed assets are derived assuming a combination of equity and debt financing. The cost of debt on working capital could be based on the company’s short-term borrowing cost. The fixed asset discount rate could assume a greater portion of equity in its financing compared to working capital. The entity’s overall borrowing cost for the debt component of the fixed asset discount rate would be used, rather than a short-term borrowing cost (as used for working capital).
The rates used to derive the fair value of the patent, customer relationships and developed technology (of 12%, 13% and 13%, respectively) each represent a premium to the WACC (11.5%). The premium should be based on judgement and consistent with market participant assumptions. Certain intangible assets (such as backlog contracts) are perceived to be less risky than other intangible assets (such as customer relationships, developed technology and goodwill). Discount rates on lower-risk intangible assets might be consistent with the entity’s WACC, whereas higher-risk intangible assets might reflect the entity’s cost of equity capital.
The implied discount rate for goodwill (15%) should, in most cases, be higher than the rates assigned to any other asset. Goodwill has the most risk of all of the assets on the balance sheet; however, the implied rate of return should typically not be significantly higher than the rate of return on most other intangible assets. If the implied rate of return on goodwill is significantly different from the rates of return on the identifiable assets, the selected rates of return on the identifiable assets should be reconsidered.
Significant professional judgement is required to determine the discount rates that should be applied in performing WARA reconciliation. In this example, a selected rate of return on intangible assets greater than 14% would result in a lower fair value of the intangible assets and a higher implied fair value of goodwill (implying a lower rate of return on goodwill compared to other assets). This might suggest that the selected return on intangible assets is too high, because goodwill should conceptually have a higher rate of return than intangible assets.
Relevant tax regime when determining the tax amortisation benefit
Question:
A US entity acquires a UK-based entity with a trademark that brands sales of a product made in France. Is the relevant tax legislation that of the UK (where the asset is currently domiciled), France (where the asset ultimately generates cash flows) or another country (for example, the US)?
Solution:
The rebuttable presumption is that the relevant tax legislation is that where the asset is domiciled (the UK, in this example). This is because the market participant would be expected to receive tax deductions where the asset is domiciled for tax purposes.
This presumption could be rebutted if there is a clear expectation that potential acquirers of the asset, at the acquisition date, would be likely to price the asset with regard to the asset’s tax treatment in other tax jurisdictions to which the asset might reasonably be transferred. It would also be necessary to confirm that there are no legal or tax impediments on such an assumed future transfer.
Application of the relief from royalty method
Entity A acquires technology from entity B in a business combination. Prior to the business combination, entity X was licensing the technology from entity B in three countries, for a royalty of 5% of sales. The technology acquired from entity B is expected to generate cash flows for the next five years.
Entity A has determined that the relief from royalty method is appropriate to measure the fair value of the acquired technology. The following is a summary of the assumptions used in the relief from royalty method:
· Revenue: Represents the projected revenue expected from the technology over the period of expected cash flows, which is estimated to be five years.
· Royalty rate: The royalty rate of 5% was based on the rate paid by entity X before the business combination and, based on analysis performance by entity A, it is assumed to represent a market participant royalty rate. Actual royalty rates charged by the acquiree (that is, entity B) should be corroborated by other market evidence, where available.
· Discount rate: Based on an assessment of the relative risk of the cash flows and the overall entity’s cost of capital, 15% is considered reasonable.
· Tax amortisation benefits: Represents the present value of tax benefits generated from amortising the intangible asset. Based on the discount rate, tax rate and a statutory 15-year tax life, the tax benefit was calculated to be 18.5% of the sum of present values.
Year 1 Year 2 Year 3 Year 4 Year 5 Revenue C10,000 C8,500 C6,500 C3,250 C1,000 Royalty rate 5% 5% 5% 5% 5% Royalty savings 500 425 325 163 50 Income tax rate 40% 40% 40% 40% 40% Less: Income tax expense (200) (170) (130) (65) (20) After-tax royalty savings C300 C255 C195 C98 C30 Discount period1 0.5 1.5 2.5 3.5 4.5 Discount rate 15% 15% 15% 15% 15% Present value factor2 0.9325 0.8109 0.7051 0.6131 0.5332 Present value of royalty savings3 C280 C207 C137 C60 C16 Sum of present values C700 Tax amortisation benefit4 129 Fair value C829 1 Represents a mid-period discounting convention, because cash flows are recognised throughout the year.
2 Calculated as 1 / (1 + k) ^t, where k = discount rate and t = discount period.
3 Calculated as the after-tax royalty savings multiplied by the present value factor.
4 The tax amortisation benefit was calculated to be 18.5% of the sum of the present value of cash flows.
IAS 17 expenditures that a market participant would include in a cash flow model or projected financial information
Entity S runs a number of casinos. It operates its head office function from two separate buildings, different in size, and in different locations as a result of historical acquisitions. The cost of exiting the second smaller building is not considered to be significant.
Entity S applies IAS 17 to its leases and accounts for both building leases as operating leases.
The annual goodwill impairment test is based on a fair value less costs to sell basis, using a discounted cash flow model.
The lease costs of the second premises should not be included in the cash flows. Operating a head office from two offices is considered unusual. A buyer of the business would be likely to cancel the second lease, especially where the benefit outweighs the cost of exiting. Restructuring activities that are expected to enhance the value of a business are taken into account when determining fair value less costs to sell.
Non-financial liabilities
Non-financial liabilities are generally accounted for under IAS 37. IAS 37 does not require or permit fair value measurement. Non-financial liabilities are measured at fair value under IFRS 13 only when they are assumed in a business combination. Example 11 of the Illustrative Examples accompanying IFRS 13 provides further guidance and considerations on fair valuing at decommissioning liability acquired in a business combination.
Non-financial liabilities are usually operating or performance obligations. Satisfying a performance obligation might require the use of operating assets or the entity’s employees. A performance obligation might mature simply by the passage of time (non-contingent), or it might depend on other events (contingent) to confirm the amount or existence of the obligation. The performance obligation might be contractual or non-contractual. This could well affect the risk that the obligation will be satisfied, and thus its fair value.
Non-financial liabilities are generally valued using an income or a cost approach because there is no active market for them. Similar principles apply to using a cash flow model (income approach) to measure liabilities at fair value as when using the method to value assets. However, when measuring the fair value of a liability, the valuation needs to consider the risk that the cash outflows will be greater than expected, and this increased risk increases the fair value of the liability.
Measurement of deferred revenue at fair value
Deferred revenue, in the context of a business combination, represents an obligation to provide products or services to a customer where payment has been made in advance, and delivery or performance has not yet occurred. Deferred revenue is a liability and represents a performance obligation. The deferred revenue amount recorded on the acquiree’s balance sheet generally represents the cash received in advance, less the amount amortised for services performed to date, rather than a fair value amount.
The fair value of a deferred revenue liability typically reflects how much an acquirer has to pay a third party to assume the liability (that is, a transfer of the liability). Thus, the acquiree’s recognised deferred revenue liability at the acquisition date is rarely the fair value amount that would be required to transfer the underlying contractual obligation.
Generally, there are two methods of measuring the fair value of a deferred revenue liability. The first method (commonly referred to as a ‘bottom-up’ approach) measures the liability as the direct, incremental costs to fulfil the legal performance obligation, plus a reasonable profit margin associated with goods or services being provided, and a premium for risks associated with variability of these costs. Direct and incremental costs might or might not include certain overhead items, but should include only costs incurred by market participants to service the remaining performance obligation related to the deferred revenue obligation. These costs do not include elements of service, or costs incurred or completed prior to the completion of the business combination, such as up-front selling and marketing costs, training costs and recruiting costs.
The reasonable profit margin should be based on the nature of the remaining activities, and it should reflect a market participant’s profit. If the profit margin on the specific component of deferred revenue is known, it should be used if it is representative of a market participant’s normal profit margin on the specific obligation. If the current market rate is higher than the market rate that existed at the time when the original transactions took place, the higher current rate should be used. The measurement of the fair value of a deferred revenue liability is generally performed on a pre-tax basis and, therefore, the normal profit margin should be on a pre-tax basis.
An alternative method of measuring the fair value of a deferred revenue liability (commonly referred to as a ‘top-down’ approach) relies on market indicators of expected revenue for any obligation yet to be delivered. This approach starts with the amount that an entity would receive in a transaction, less the cost of the selling effort (which has already been performed) including a profit margin on that selling effort. This method is used less frequently, but it is commonly used for measuring the fair value of remaining post-contract customer support for licensed software.
If deferred revenues exist at the time of the business combination, the interaction with other acquired assets and liabilities should be considered when determining fair value. Such assets and liabilities, which could impact on measuring deferred revenue at fair value, are:
· intangible assets;
· inventory; and
· working capital.
Measurement of contingent liabilities
An acquirer should recognise, at fair value on the acquisition date, those contingent liabilities assumed that are reliably measurable present obligations. IAS 37 defines contingent liabilities as either present or possible obligations. Present obligations that are contingent liabilities are legal or constructive obligations that result from a past event, but are not recognised, because either an outflow of resources is not probable, or the amount cannot be measured with sufficient reliability. Possible obligations are obligations that arise from past events whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within an entity’s control.
Some variation of the income approach will most likely be used to estimate the fair value, if fair value is determinable. A straightforward discounted cash flow technique might be sufficient in some circumstances; in other circumstances, more sophisticated valuation techniques and models (for example, real options, option pricing, or Monte Carlo simulation) might be warranted.
Measurement of a warranty obligation in a business combination
Entity A is acquired in a business combination. Entity A is a manufacturer of computers and related products, and it provides a three-year limited warranty to its customers related to the performance of its products. Expenses related to expected warranty claims are accrued based on the detailed analyses of past claims history for different products. Entity A’s experience indicates that warranty claims increase each year of a contract, based on the age of the computer components.
Entity A has three distinct computer products. One of its product lines (line 1) has significant new components for which there is little historical claims data, as well as other components for which historical claims data is available. Taking into account the liability’s short-term nature and the expected cash flows over the warranty period, the acquirer determines that a 7% discount rate is applicable.
In applying the acquisition method, the acquirer should calculate a fair value estimate for warranty claims related to lines 2 and 3 and to line 1.
Determine the model
Cash flow models can be based on expected cash flows or conditional cash flows. Given the availability of historical claims data, the acquirer believes that the expected cash flow technique will provide a better measure of the warranty obligation.
Develop the probabilities
To develop the probabilities needed to estimate expected cash flows, the acquirer evaluates entity A’s historical warranty claims. This includes evaluating how the performance of the new components used in line 1 compares to the performance trends of the other components for which historical claims data is available.
The acquirer develops expected cash flows and a probability assessment for each of the various outcomes, as shown below. The cash flows are based on different assumptions about the amount of expected service cost, plus parts and labour, related to a repair or replacement. The acquirer estimates the following outcomes for line 1, each of which is expected to be payable over the three-year warranty period:
Warranty claims – expected cash flows
Product line 1 Probability Year 1 Year 2 Year 3 C C C Outcome 1 50% 3,000 6,000 12,000 Outcome 2 30% 8,000 14,000 20,000 Estimate potential outcomes
In calculating the amount of the warranty obligation, the acquirer needs to estimate the level of profit that a market participant would require to perform under the warranty obligations. The acquirer considers the margins for public companies engaged in the warranty fulfilment business, as well as its own experience, in arriving at a pre-tax profit margin equal to 5% of revenue.
Discount, as appropriate
The acquirer also needs to select a discount rate to apply to the probability weighted expected warranty claims for each year and discount them to calculate a present value. The expected claim amounts reflect the probability weighted average of the possible outcomes identified. In this case, the acquirer determined that the discount rate is 7%. Calculate the fair value The table below reflects the expected cash flows developed from the data in the previous table, with the value of each outcome adjusted for the acquirer’s estimate of the probability of occurrence:
Warranty claims – expected cash flows – probability adjusted
Product line 1 Year 1 Year 2 Year 3 C C C Outcome 1 1,500 3,000 6,000 Outcome 2 2,400 4,200 6,000 Outcome 3 2,400 4,000 6,000 Probability weighted 6,300 11,200 18,000 Pre-tax profit (5%) 1 315 560 900 Warranty claim amount 6,615 11,760 18,900 Discount period 2 0.5 1.5 2.5 Discount rate 3 7% 7% 7% Present value factor 4 0.9667 0.9035 0.8444 Present value of warranty claims 5 6,395 10,625 15,959 Estimated fair value 6 (rounded) 33,000 1 The expected payment should include a profit element required by market participants, which is consistent with the fair value transfer concept for liabilities. The profit element included here represents an assumed profit for this example, and it should only be viewed from the perspective of how to apply the profit element.
2 A mid-year discounting convention was used, based on the assumption that warranty claims occur evenly throughout the year.
3 In practice, determining the discount rate can be a challenging process requiring a significant amount of judgement. The discount rate should consider a risk premium that market participants would consider when determining the fair value of a contingent liability. The determination of discount rates for performance obligations (such as warranties and deferred revenues) might be more challenging than for financial liabilities, because assessment of the non-performance risk component is not so readily obtainable as it might be for financial liabilities.
4 Calculated as 1 / (1 + k) ^t, where k = discount rate and t = discount period.
5 Calculated as the warranty claim amount multiplied by the present value factor.
6 Calculated as the sum of the present value of warranty claims for years 1 to 3.
Inventory acquired in a business combination
IFRS 3 requires inventory acquired in a business combination to be measured at fair value. The fair value of finished goods inventory is measured by determining net realisable value (that is, estimated selling prices of the inventory, less the sum of
(i) costs of disposal and
(ii) a reasonable profit allowance for the selling effort),because this represents an exit price.
Work in progress inventory is measured in a similar way to finished goods inventory except that, in addition, the estimated selling price is adjusted for the costs to complete the manufacturing, and a reasonable profit allowance for the remaining manufacturing effort.
Raw material inventories are recorded at fair value, and they are generally measured based on the price that a market participant would currently pay for the inventory. This often approximates to cost.
Inventory
Inventories are measured at fair value in two situations:
- when acquired in a business combination under IFRS 3; and
- when held by commodity broker traders.
Broker traders are those who trade in commodities on their behalf or behalf of others. Their inventories are normally traded in an active market and are purchased with a view to resale shortly, generating a profit from fluctuations in price or margins. An entity that is a broker trader could adopt a policy to measure inventories at fair value less costs of disposal. Measurement of these two types of inventory is within the scope of IFRS 13.
Biological assets
Biological assets are required by IAS 41 to be measured at fair value less costs to sell, at both initial recognition and at each subsequent reporting date. They fall within the scope of IFRS 13 for both measurement and disclosure.
Many biological assets have relevant market-determined prices or values available because varieties of agricultural produce are often basic commodities that are traded actively. For example, there is usually an active market with quoted prices for calves and piglets. The quoted price in that market is an appropriate basis for determining the fair value of the asset.
Some bearer biological assets, such as breeding animals that produce multiple offspring, might seldom be sold. Other techniques for measuring fair value might be necessary. Fair value is estimated based on relevant transaction prices for the same asset or similar assets, with adjustments for differences or using sector benchmarks.
Market-based valuation techniques for biological assets
Fair value could be based on recent market transaction prices, but IAS 41 states that prices set in a forward sales contract are not necessarily relevant in determining fair value. Fair value should reflect current market conditions in which a willing buyer and seller would enter into a transaction, and it should not reflect expectations of future market conditions. At the date when the contract is signed between willing parties, the contract price would be the best estimate of the future market price, and so it would be a relevant price to use in a cash flow model. At a later date, historical contract prices might bear no relation to the current fair value of the biological asset itself. As a result, the fair value of a biological asset or agricultural produce is not adjusted because of the existence of a contract, unless the contract price represents the current market price. When valuing a crop that is still growing, however, the forward price for the harvest time can be used to measure fair value, subject to the considerations above.
Biological assets are often physically attached to land (for example, trees and vines). There might be no separate market for biological assets that are attached to the land, but an active market might exist for the combined assets (that is, for the biological assets, raw land and land improvements) as a package. An entity might use information regarding the combined assets to determine fair value for the biological assets. For example, the fair value of raw land and land improvements might be deducted from the fair value of the combined assets to arrive at the biological assets’ fair value.
Fair value in the absence of market-based prices or values
Where market-based prices or values are not available for a biological asset in its present location and condition, fair value should be measured on the basis of a valuation technique which is appropriate in the circumstances and for which sufficient data is available to measure fair value. The use of relevant observable inputs should be maximised, whilst minimising the use of unobservable inputs. An example of an appropriate valuation technique would be the use of a present value technique, where the present value of expected net cash flows from the asset is discounted at a current market-based rate.
The fair value of biological assets is generally determined through the use of a discounted cash flow method as a valuation technique, because market-determined prices or values are not available. The fair value of these assets is derived from the expected cash flows of the agricultural produce.
The cash flow model should include all directly attributable cash inflows and outflows, and only those cash flows. The inflows will be the price in the market of the harvested crop, for each crop, over the asset’s life. The outflows will be those incurred in raising or growing the asset and getting it to market (for example, direct labour, feed, fertiliser and transport to market). The ‘market’ is where the asset will be sold. For some assets, this will be an actual market; for others, it might be the ‘factory gate’.
Consistent with the objective of estimating fair value, the cash flows should be based, as far as possible, on market data. For example, while there is a market for fully grown salmon, there is no market for partly grown salmon. The fair value of a partly grown salmon is measured by projecting the cash flows from the sale of the salmon fully grown, less the cash outflows needed to grow the salmon to its marketable weight and discounting them to a present-day value.
For the purposes of estimating fair value of biological assets, financing cash flows are ignored. Any cash flows to be incurred in re-establishing biological assets after harvest are also excluded from the valuation (for example, the cost of re-planting a crop). A provision for re-planting might be required by IAS 37, once the biological asset is harvested, but it is not part of the asset’s fair value, because it is not a characteristic of the asset.
An imputed contributory asset charge should be included where there are no cash flows associated with the use of assets essential to the agricultural activity; otherwise, the fair value will be overstated. The most common example of where this is necessary is where the land on which the biological asset is growing is owned by the entity. The cash flows should include a notional cash outflow for ‘rent’ of the land, to be comparable with the asset of an entity that rents its land from a third party. The fair value of a biological asset is independent of the land on which it grows or lives. This approach is relevant in relation to long-term biological assets (such as timber plantation forests), but it is also appropriate for some short-term assets.
Sometimes, it is appropriate to adopt different valuation methods for different groups of assets. IAS 41 acknowledges that this could be helpful, and it gives the examples of assets grouped by age and quality.
The purpose of a net present value calculation is to determine an estimate of the fair value of a biological asset in its present location and condition. An entity must, therefore, consider the present location and condition of the asset when determining an appropriate discount rate to be used and in estimating expected net cash flows. In determining the present value of expected net cash flows, an entity includes the net cash flows that market participants would use when pricing the asset in its principal or most advantageous market.
Occasionally, cost will approximate to fair value, particularly where:
· little biological transformation has taken place since the costs were originally incurred (for example, tree seedlings planted immediately prior to a balance sheet date or newly acquired livestock); or
· the impact of biological transformation on price is not expected to be material (for example, in respect of the initial growth in a 30-year pine plantation cycle).
Estimating fair value of short-lived biological assets in the absence of market-based prices or values
A quarterly reporting company, with a December year end, incurs costs of C900 in respect of sowing a wheat field for the quarter to June 20X8. Management expects to harvest the wheat at the end of November 20X8. The field is owned by the reporting entity and has an original cost of C2,000.
Due to the lack of an active market for part-grown wheat and very few sales of part-grown fields, there is no market-based fair value available. Consequently, for the purposes of preparing the financial statements, the wheat’s fair value (excluding the land) should be based on the present value of the expected net cash flows. The relevant discount rate is 11%.
Management’s projections, as at 30 June 20X8, of future cash flows are as follows:
3 months to Sept 20X8 3 months to Dec 20X8 Total Period C C C Cash inflows – 4,000 4,000 Cash outflows 1 (450) (1,000) (1,450) Net cash flows (450) 3,000 2,550 Discounted at 11% (438) 2,847 2,409 1 Included in the cash outflows is a contributory asset charge, related to land and other assets, recognised separately. This is not a ‘true’ cash flow in this case, because there is no rental payable in this scenario. However, the charge is included in the valuation to ensure a consistent value with a situation where, for example, the land is rented.
Hence, the wheat field should be recognised at 30 June 20X8 at C4,409 (being C2,000 in respect of land and C2,409 in respect of part-grown wheat). A fair value gain of C2,409 and the operating costs incurred during the quarter should be recognised in the quarterly income statement.
In the three months ended 30 September 20X8, actual cash outflows amounted to C550, so this amount should be recognised as an operating expense. At 30 September 20X8, management’s revised projections (based on the then current trends for wheat prices for delivery in November 20X8) were as follows:
3 months to Dec 20X8 Period C Cash inflows 3,800 Cash outflows 1 (1,000) Net cash flows 2,800 Discounted at 11% 2,728 1 Included in the cash outflows is a contributory asset charge related to land and other assets recognised separately.
Hence, the wheat should be measured at a fair value of C2,728. A fair value gain of C319 and the operating costs of C550 should be recognised in the quarterly income statement. The accounting treatment of the increase in fair value since the planting date is described in chapter 33 para 21.
At the point of harvest, the wheat is worth C4,700. The biological asset immediately before harvest should be measured at that amount, with a fair value gain of C1,972 recognised in the income statement. At the date of harvest, the wheat’s fair value is de-recognised as a biological asset and recognised as inventory, at C4,700 as its deemed cost. One method of presentation, when the wheat is sold, is for the entity to report revenue of C4,700 and a cost of sales (the deemed cost of inventory) of C4,700. Therefore, no gross profit is recognised if the harvested produce is immediately sold after harvest, without adding value to the inventory by further processing.
In practice, alternative presentation methods could exist for different industries.
Fair value in impairment testing of non-financial assets
Few assets or businesses will be traded in an active market, and thus be a Level 1 measurement. The assets within IAS 36’s scope that are most likely to meet the Level 1 criteria are investments in associates or subsidiaries listed on an active market. The fair value of these assets will be measured by reference to the quoted price and the number of shares held. For most other assets (or businesses), a valuation technique will be used to measure fair value.
There are several valuation methodologies that are used to assess the value of a business or an asset. More than one methodology is normally used, to ensure that the valuations are cross-checked and considered in light of all appropriate market evidence. The replacement cost method is not appropriate for impairment testing, because it does not measure the economic benefits recoverable from use or disposal. For some assets, particularly land and buildings, fair value might be measured by using the market approach, because there is usually market data on sales or rentals. For most assets and businesses, however, an income approach will be appropriate.
Measuring fair value less costs of disposal for impairment testing: income approach
A first assessment of the valuation is performed using cash flows prepared by management. There must be market evidence to support the key assumptions underpinning the cash flow analysis; for example, growth rates might be considered by benchmarking to industry/analyst reports.
If certain of the assumptions used are not those that a market participant would use, those cash flows must be adjusted to take into account the assumptions that are supported by market evidence.
The cash flows to be used in a discounted cash flow, prepared to determine fair value less costs of disposal, are likely to be different from those in a value in use calculation.
Any differences in the assumptions in the cash flows used for the fair value less costs of disposal, compared to the cash flow forecasts used in the value in use analysis, need to be considered for reasonableness.
The assumptions could include re-structuring, re-organisations or future investments (that would be excluded from a value in use calculation) if all rational market participants would be expected to undertake these expenditures and re-organisations in order to extract the best value from the purchase. In addition, because fair value less costs of disposal (FVLCD) is a post-tax measure, tax cash flows (whilst excluded from a value in use calculation) are included in the FVLCD calculation.
The discount rate applied to the market participant cash flows should reflect a market participant’s required return on the investment. This might be the reporting entity’s cost of capital. The discount rate should reflect the return required on the asset or business being tested for impairment in isolation. A group’s cost of capital is the weighted average of the risks of the group and not necessarily the risk of the asset or business being tested for impairment.
If comparable transactions in similar assets or businesses are available, they should be used as market evidence. Consideration should be given to the comparability of the acquired asset/business to the asset/CGU being tested (for example, in terms of factors such as size, growth expectations, profitability and risk). This evidence might arise in the implied multiple of earnings before interest, taxes, depreciation and amortisation (EBITDA), or revenue that was paid in a comparable transaction, which, when applied to the current model (and adjusted for points of difference), provides support for the valuation.
For example, if there are a number of recent transactions in comparable entities where the price paid is six times EBITDA, and management has produced a valuation that is ten times EBITDA, the external data would appear not to support the assumptions made in the valuation. Care is needed in selecting comparable entities; risk profile and size might well be more important than geography. Care is also needed to avoid selection bias: if one transaction in ten provides some support for the EBITDA multiple, but the same transaction is regarded in the financial press as an over-payment and an isolated example, it might be an outlier and should be given little weight.
As a cross-check, it is useful to benchmark the fair value less costs of disposal of a CGU to multiples implied by quoted comparable companies, although consideration will need to be given to comparability in terms of size, growth expectations, profitability, risk etc. In the unlikely event that a benchmark or comparable transactions do not exist, any possible external evidence (such as growth rates or industry trends) is used to support the cash flow projections.