Valuations in Financial Valuations in Financial Reporting - - PowerPoint PPT Presentation

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Valuations in Financial Valuations in Financial Reporting Reporting

May 9, 2007 Cheryl Tjon-Hing Valuation Specialist Office of the Chief Accountant

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As a matter of policy, the Securities and As a matter of policy, the Securities and Exchange Commission disclaims Exchange Commission disclaims responsibility for any private publication or responsibility for any private publication or statement of any SEC employee or statement of any SEC employee or

• Commissioner. The comments herein
• Commissioner. The comments herein

express the author's views and does not express the author's views and does not necessarily reflect those of the necessarily reflect those of the Commission, the Commissioners, or other Commission, the Commissioners, or other members of the Staff members of the Staff

Disclaimer Disclaimer

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SEC STAFF AND SEC STAFF AND VALUATIONS VALUATIONS

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The SEC Staff and Valuations: The SEC Staff and Valuations: Division of Corporate Finance Division of Corporate Finance

• Committed to taking valuation issues seriously

Committed to taking valuation issues seriously

• Look for / ask questions to ensure:

Look for / ask questions to ensure:

− − Valuation is in compliance with GAAP

Valuation is in compliance with GAAP

− − Overall fair value conclusions and related key

Overall fair value conclusions and related key assumptions make sense based upon facts and assumptions make sense based upon facts and circumstances circumstances

− − Appropriate valuation methodologies applied

Appropriate valuation methodologies applied

− − There are sufficient disclosures for investors to

There are sufficient disclosures for investors to make their investment decisions make their investment decisions

• May seek advice from OCA as deemed necessary

May seek advice from OCA as deemed necessary

• Common Responses to Valuation Queries

Common Responses to Valuation Queries

− − “

“What my peers are doing What my peers are doing” ”

− − “

“Use of methodology in other filings Use of methodology in other filings” ”

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The SEC Staff and Valuations: The SEC Staff and Valuations: Office of the Chief Accountant Office of the Chief Accountant

Registrant Consultations (Pre Registrant Consultations (Pre-

• filing)

filing)

• Different from the

Different from the “ “comment letter comment letter” ” process process

• Valuation consultation issues may include :

Valuation consultation issues may include :

− − Appropriate methodologies

Appropriate methodologies

− − Valuation factors to consider

Valuation factors to consider

− − Relevant financial reporting guidance to consider

Relevant financial reporting guidance to consider

− − Review overall reasonability of numbers given facts

Review overall reasonability of numbers given facts and circumstances and circumstances

• Do request that issues be discussed and tried

Do request that issues be discussed and tried to be resolved with auditors first before to be resolved with auditors first before seeking consultation with OCA seeking consultation with OCA

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The SEC Staff and Valuations: The SEC Staff and Valuations: Office of the Chief Accountant Office of the Chief Accountant

Registrant Consultations (cont Registrant Consultations (cont’ ’d) d)

Guidance for resolving ‘pre-filing’ questions is

posted on the SEC’s website

www.sec.gov/info/accountants/ocasubguidance.htm

Companies should provide OCA with a written

submission (commonly referred to as a “pre- clearance” submission)

− Auditor participation − Audit committee participation

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SEC STAFF COMMENTS, SEC STAFF COMMENTS, OBSERVATIONS & AREAS of OBSERVATIONS & AREAS of CONCERN CONCERN

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Expertization Expertization Issues Issues

• Written consent of Experts (Rule 436)

Written consent of Experts (Rule 436)

− − Filed as exhibit to 1933 Act filings

Filed as exhibit to 1933 Act filings

− − States that the named expert consents to any

States that the named expert consents to any quotation/summarization of the expert report and/or quotation/summarization of the expert report and/or reference as an expert in the filing reference as an expert in the filing

• Registrant needs to obtain Written Consent:

Registrant needs to obtain Written Consent:

− − Any reference to the use of an expert (e.g.

Any reference to the use of an expert (e.g. valuation consultant) in 1933 Act filing valuation consultant) in 1933 Act filing

• Any portion of the expert

Any portion of the expert’ ’s report/opinion is s report/opinion is quoted/summarized quoted/summarized

• If it is stated that any information in the filing has

If it is stated that any information in the filing has been reviewed/passed upon by a person whom the been reviewed/passed upon by a person whom the registrant relies upon as an expert registrant relies upon as an expert

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Expertization Expertization Issues Issues

• SEC Executive Compensation Disclosure

SEC Executive Compensation Disclosure

− − Effective for:

Effective for:

• Fiscals ending after 12/15/2006

Fiscals ending after 12/15/2006

• 8Ks filed after 11/07/2006

8Ks filed after 11/07/2006

− − Corporate Governance Disclosure 407 (e)(3):

Corporate Governance Disclosure 407 (e)(3):

“ “the company will be required to describe its processes the company will be required to describe its processes and procedures for the consideration and determination and procedures for the consideration and determination

• f executive and director compensation including:
• f executive and director compensation including:…

…. .any any role of compensation consultants role of compensation consultants in determining or in determining or recommending the amount or form of executive and recommending the amount or form of executive and director compensation, director compensation, identifying such consultants identifying such consultants… …. .

− − 407 Application Q&A

407 Application Q&A – – no consent required no consent required

www.sec.gov/divisions/corpfin/guidance/execcomp407intep.htm www.sec.gov/divisions/corpfin/guidance/execcomp407intep.htm

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Employee Stock Option Valuation Employee Stock Option Valuation Issues Issues

Market Based Option Valuations Market Based Option Valuations

• SEC staff has only commented on the design of

SEC staff has only commented on the design of ESOARS, subject to some adjustments on ESOARS, subject to some adjustments on forfeiture considerations forfeiture considerations

− − No different from the logic behind other option

No different from the logic behind other option pricing models pricing models -

• Law of One Price (

Law of One Price (“ “LOOP LOOP” ”) )

• BSOP

BSOP – – European call value = European call value = value value of a levered

• f a levered

position in the underlying stock position in the underlying stock

• Have

Have not not commented on the following: commented on the following:

− − An appropriate market pricing mechanism;

An appropriate market pricing mechanism;

− − Credible information plan

Credible information plan (see August 31, 2005 letter from OEA to OCA) (see August 31, 2005 letter from OEA to OCA)

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Employee Stock Option Valuation Employee Stock Option Valuation Issues Issues

Analytical Approaches Analytical Approaches -

• Valuation Models

Valuation Models

• Limitations of Black

Limitations of Black Scholes Scholes vs. attributes of target

• vs. attributes of target

award award Expected Term Expected Term -

• Simplified Method

Simplified Method

• At this time, still expected to sunset at December

At this time, still expected to sunset at December 31, 2007 (as stated in SAB 107) 31, 2007 (as stated in SAB 107)

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Employee Stock Option Valuation Employee Stock Option Valuation Issues Issues

Discounts/ Discounts/Premia Premia

• Reference to studies not appropriate as primary

Reference to studies not appropriate as primary support for discounts/premiums applied support for discounts/premiums applied Tax Issues Tax Issues

• Not consider tax implications to employees

Not consider tax implications to employees

− − Value to employee consideration and not to the

Value to employee consideration and not to the issuer of the award issuer of the award

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Equity Value Allocation Issues Equity Value Allocation Issues

• Valuation methodology used must be consistent

Valuation methodology used must be consistent with target share attributes as well as facts and with target share attributes as well as facts and circumstances surrounding the valuation circumstances surrounding the valuation

• Current method issues

Current method issues

− − In the majority of situations, the Staff believes the

In the majority of situations, the Staff believes the use of the current method is likely inappropriate in use of the current method is likely inappropriate in any IPO reporting period any IPO reporting period

− − May be appropriate for:

May be appropriate for:

• Companies where liquidation is imminent

Companies where liquidation is imminent

• Early stage development companies

Early stage development companies

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Valuation Specialists Providing Valuation Specialists Providing Accounting Advice Accounting Advice

• Statement of Auditing Standards 50/97,

Statement of Auditing Standards 50/97, “ “Reports Reports

• n the Application of Accounting Principles
• n the Application of Accounting Principles”

”

− − SAS 50,

SAS 50, para para 5: 5: “ “Reporting Accountants Reporting Accountants” ” should should have adequate technical training and proficiency have adequate technical training and proficiency

• Opinions of Value re: Goodwill

Opinions of Value re: Goodwill

− − Factors to consider may include the following:

Factors to consider may include the following:

• Deferred tax and effective tax rate considerations

Deferred tax and effective tax rate considerations

• Allowance analysis

Allowance analysis

• Tangible asset valuations

Tangible asset valuations

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Other Reporting Issues Other Reporting Issues

• Level of assurance provided by an independent

Level of assurance provided by an independent valuation specialist valuation specialist

− − Calculations/analysis of value considered

Calculations/analysis of value considered inappropriate as primary support inappropriate as primary support

− − Estimates of value

Estimates of value – – varying levels of diligence varying levels of diligence

• Engagement caveats in Valuation Specialist

Engagement caveats in Valuation Specialist reports reports

− − Auditors should understand the implications of any

Auditors should understand the implications of any scope limitations adjust their work accordingly scope limitations adjust their work accordingly

• Only certain assets were considered by the specialist

Only certain assets were considered by the specialist

• Limited access to confidential information

Limited access to confidential information

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Specific SFAS 141/Intangible Asset Specific SFAS 141/Intangible Asset Valuation Issues Valuation Issues

• High levels of goodwill still being observed

High levels of goodwill still being observed

• Customer Relationships

Customer Relationships -

• “

“Primary asset Primary asset” ” considerations considerations

• Tax amortization benefit issues

Tax amortization benefit issues

− − Generally, where asset resides

Generally, where asset resides

− − If not deductible for tax purposes

If not deductible for tax purposes

• Selected valuation methodology applied needs to

Selected valuation methodology applied needs to be consistent be consistent

− − For purchase price allocation and impairment test

For purchase price allocation and impairment test purposes (where asset is tested on a stand purposes (where asset is tested on a stand-

• alone

alone basis) basis)

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SFAS 141/Intangible Asset SFAS 141/Intangible Asset Valuation Issues Valuation Issues

• Grouping of assets into a single model

Grouping of assets into a single model

− − Netting of Individual

Netting of Individual “ “Negative Negative” ”/ Positive Values of / Positive Values of a Class of Assets a Class of Assets

Factors to Consider: Factors to Consider:

• SFAS 141,

SFAS 141, para

• para. A17

. A17

• Complementary assets can be recognized as a

Complementary assets can be recognized as a single asset apart from goodwill if the group of single asset apart from goodwill if the group of assets have similar useful lives assets have similar useful lives

• All or none purchase?

All or none purchase?

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SFAS 141/Intangible Asset SFAS 141/Intangible Asset Valuation Issues Valuation Issues

• Grouping Issues (cont

Grouping Issues (cont’ ’d) d)

− −

Why Why “ “grouping of assets grouping of assets” ” into a single model is relevant: into a single model is relevant:

No such thing as a negative No such thing as a negative valued asset (unless obligation valued asset (unless obligation is a true liability) is a true liability) Tax Amortization Benefit only Tax Amortization Benefit only applied to Assets applied to Assets Example 1: Fair Value Asset A 200 Asset B (100) Grouped Ungrouped Model Models Asset A 200 200 Asset B (100)

• Recorded FV

100 200 Example 2: Contract Asset A Contract Liability B Grouped Model Asset A 200 200 Liability B (100)

• (100)

DCF 100 200 (100) TAB 25 50

• 250

(100) Fair Value 125 150 Ungrouped Models DCF Value 200 (100)

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Contributory Asset Charge (CAC) Contributory Asset Charge (CAC) Issues Issues

MuIti MuIti-

• period Excess Earnings Method (MEEM) on

period Excess Earnings Method (MEEM) on MEEM MEEM CACs CACs -

• caution:

caution:

• “

“Royalty stream Royalty stream” ” generated is often excluded from generated is often excluded from the valuation of the charging asset the valuation of the charging asset

− − Similar concepts as:

Similar concepts as:

• Migration technique in IPR&D Practice Aid

Migration technique in IPR&D Practice Aid

• Relief from royalty method

Relief from royalty method

• If using an ROA or Gross Lease Method, as asset

If using an ROA or Gross Lease Method, as asset lives increase, most likely will result in lives increase, most likely will result in unreasonable results or insolvable models for both unreasonable results or insolvable models for both assets assets

− − Eg

• Eg. Business Entity with only 2 assets and asset 2

. Business Entity with only 2 assets and asset 2 contributes to asset 1 contributes to asset 1

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Contributory Asset Charges (CAC) Contributory Asset Charges (CAC) Issues Issues

Return on Assets Method

(Assume only CAC is the one noted below and taxes are NIL)

Year Year Year Year Year Year Residual Entity Business Plan 1 2 3 4 5 6 Years Revenue 4,000 4,200 4,400 4,600 4,800 5,000 Net Operating Cash Flow 1,500 1,600 1,700 1,800 1,900 2,000 33,333 Enterprise Value 26,317 Asset 1 Cash Flow before CAC 1,000 1,000 1,000 1,000 1,000 1,000 10,000 CAC - Asset 2 (1,789) (1,908) (2,027) (2,147) (2,266) (2,385) (39,751) Cash flow to be discounted (789) (908) (1,027) (1,147) (1,266) (1,385) (29,751) Discount Rate 10% 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645 0.5645 (717) (750) (772) (783) (786) (782) (16,793) Fair Value (21,384) Asset 2 Cash Flow before CAC charge 500 600 700 800 900 1,000 23,333 CAC Income 1,789 1,908 2,027 2,147 2,266 2,385 39,751 Cash flow to be discounted 2,289 2,508 2,727 2,947 3,166 3,385 63,084 Discount Rate 10% 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645 0.5645 2,081 2,073 2,049 2,013 1,966 1,911 35,609 Fair Value

B

47,701 1,500 Business Plan Annual CAC

B x 10%

4,770.07 CAC as a % of Revenue 119.3%

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Contributory Asset Charges (CAC) Contributory Asset Charges (CAC) Issues Issues

Cash flow projections often need to be adjusted Cash flow projections often need to be adjusted for for “ “return of return of” ” portion of CAC but are not portion of CAC but are not

• When comparable royalty rates not available, 2

When comparable royalty rates not available, 2 main methods to determine CAC: main methods to determine CAC:

Return on Asset Method Return on Asset Method Return on and Return of the asset are calculated separately Gross Lease Method Gross Lease Method Return on and Return of the asset are calculated together

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Contributory Asset Charges (CAC) Contributory Asset Charges (CAC) Issues Issues

Return on Asset Method Return on Asset Method

Charge of the asset is reflected by depreciation and amortization Charge on the asset is reflected by Return on Assets

Gross Lease Method Gross Lease Method

Lease charge reflects both a return on and

• f charge of the asset

Return on charge for wasting assets may need to be factored into the projections Return on charge for wasting charge needs to be backed

• ut of the projections

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Contributory Asset Charges (CAC) Contributory Asset Charges (CAC) Issues Issues

Other Other

• Royalty/Licensing rates and

Royalty/Licensing rates and CACs CACs

• Capital intensive industries/large

Capital intensive industries/large capex capex projected projected

• CAC cause value result to be negative

CAC cause value result to be negative

• Reported asset number selected from a valuation

Reported asset number selected from a valuation range range

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Conclusion

Questions and Answers

? ? ?