Article:

Valuation issues in your financial statements

27 June 2017

Yatra Forudi, Associate Director, Corporate Finance |

As the 2017 financial year draws to a close, it is timely to consider some of the key valuation related requirements in your financial statements. Our latest update covers the valuation issues to consider when completing your purchase price allocation (PPA), impairment testing or employee share valuations. Consideration of these matters will assist you to understand these issues and to address the questions your statutory auditor may ask in relation to valuations inherent in your financial statements.  

While the overarching valuation premise across each of those topics is generally that of fair value, the relevant accounting standards contain more specific valuation requirements.

Purchase Price Allocations

Where a transaction is identified as a business combination for AASB 3 purposes, the acquiring entity is required to measure certain identifiable assets acquired and the liabilities assumed at their fair values on the acquisition date, with a few exceptions.  This includes intangible assets which meet the recognition criteria set out in AASB 3. This process of identifying and measuring the acquired assets and liabilities is referred to as purchase price allocation or PPA.

Some of the valuation issues relevant to PPAs include:

Valuation Issue

Comment

Acquisition date The valuation is required to be completed on the acquisition date (the date on which the acquirer obtains control of the acquiree) as outlined in AASB 3 paras 8-9.The correct determination of the acquisition date can be a complex issue in certain circumstances and may require an analysis of the activities, approvals and processes to ensure the acquisition date is being correctly determined in accordance with the requirements of AASB 3.
Measurement period AASB 3 allows a measurement period for the finalisation of calculations related to business combinations. If insufficient information is available to value each asset / liability with reasonable certainty, a provisional calculation can be completed in the reporting period immediately following the business combination. The valuation must be finalised and included in the AASB 3 disclosures in the financial statements within the measurement period as set out in AASB 3 paras 45-50.
Fair value of purchase consideration The purchase consideration for the acquisition must be measured at fair value at the acquisition date, including any consideration provided in the form of:
  • Cash
  • Scrip
  • Deferred consideration (present value)
  • Contingent consideration (probability weighted present value)
Determining the fair value of the purchase consideration may create certain valuation issues of its own.
Separable and identifiable Certain assets and liabilities acquired must be separately measured at their fair value on acquisition date. Intangible assets are identifiable if they are either separable (i.e. capable of being separated from the entity and sold/transferred) or they arise from contractual/legal rights, regardless of whether those rights are separable from the entity.
Contributory assets The methodology for the valuation of certain identifiable intangible assets must consider the interaction between those assets and the value of any ‘contributory assets’ (e.g. working capital, shared service staff) which supports the revenue generating capacity of separately identified assets.
Specialised assets It is important to obtain separate valuations of specialised assets (e.g. specialised machinery, industrial property) by appropriately qualified valuers.
Determine costs of acquisition and account for in P&L The costs of acquisition including professional fees are required to be accounted for separately in the P&L and are not included in the value of the assets and liabilities acquired.
Certain assets and liabilities are measured under the relevant accounting standard Certain assets and liability balances such as deferred income tax and employee provisions are required to be measured in accordance with the relevant accounting standards.

Key PPA valuation issues of interest to your statutory auditors are likely to include:

  • The way in which the identification of assets / liabilities has been undertaken
  • The appropriateness of the valuation method utilised for each identifiable asset / liability
  • The forecast period over which the cash flows relating to the identifiable assets are calculated
  • The reasonableness of the apportionment of value to each identifiable asset, liability and the residual value.

Impairment Testing

Impairment testing is the process of reviewing the carrying values of certain assets shown in the company’s balance sheet to determine whether those values continue to be supportable or should be written down (or ‘impaired’) in accordance with AASB 136. AASB 136 typically applies to property plant and equipment and intangible assets. (Impairment testing of financial assets is covered in AASB 139 and is not dealt with separately in this article).

Under AASB 136, the impairment test is completed by comparing the carrying values of the relevant assets with their recoverable amounts. The recoverable amount is the higher of the asset’s value in use (‘VIU’) or fair value less cost of disposal (‘FVLCD’).

Some valuation issues relevant for impairment testing include:

Valuation Issue

Comment

Establish Cash Generating Units (‘CGUs’)

The company’s CGUs must be established to determine the separate units for valuation. For AASB 136 purposes, CGUs are the smallest identifiable group of assets that generate cash inflows that are largely independent of the cash inflows from other assets or groups of assets. For example, this may represent an entity’s operating segments, product lines, distribution channels, etc.
Recoverable amounts of assets must be calculated for individual assets, where possible or for the CGUs to which the asset belongs.

Allocation of goodwill to CGUs

Goodwill acquired in a business combination is required to be allocated from the acquisition date to the cash generating units which are expected to benefit from the synergies of the combination under AASB 136 para 80.

When is impairment testing required?

An entity is required to assess at the end of each reporting period whether there is any indication that an asset may be impaired.
Regardless of whether there is an indicator of impairment, the entity is also required to:

  • test an intangible asset with an indefinite useful life or an intangible asset not yet available for use for impairment annually by comparing its carrying amount with its recoverable amount.
  • test goodwill acquired in a business combination for impairment annually.

VIU

VIU is the present value of the expected future cash flows of the asset or CGU.
It requires the application of consistent cash flows and discount rates (i.e. pre-tax cash flows discounted at pre-tax discount rates, nominal cash flows at nominal discount rates, etc) and the use of supportable assumptions in calculating forecasts.
Forecast cash flows must exclude any estimated future cash inflows or outflows expected to arise from future restructurings or from improving or enhancing the asset’s performance.
Projections based on budgets/forecasts are required to cover a maximum period of five years, unless a longer period can be justified.

FVLCD

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. To measure FVLCD, the costs of disposal (e.g. legal costs, stamp duty, removal costs) are deducted from fair value.

Sensitivity analysis

If a reasonably possible change in a key assumption used to calculate the recoverable amount would cause the CGU’s carrying amount to exceed its recoverable amount, the company must present sensitivity analysis results relating to that assumption.
This information is to assist the readers to understand the impact of a specific movement in key variables (e.g. discount rate, price per unit of sales) on the calculated recoverable amount.

Cross-check

It is good practice to cross-check the recoverable amount calculations with the relevant market metric. For example: implied multiples from the recoverable amount calculations relative to comparable asset/entity values.  

Key valuation issues of interest to your auditors in relation to impairment testing are likely to include:

  • Have the CGUs been established at the appropriate granular level?
  • How supportable are the assumptions adopted in the forecast cash flow analysis?
  • How has the discount rate used in the impairment testing been established and is it reasonable?
  • Has the impairment (if applicable) been allocated to the correct assets / CGU?
  • Does the recoverable amount determined by the company cross-check with relevant market value measures?

Employee Share Schemes

Employee share schemes (‘ESS’) cover arrangements for the compensation of employees with reference to equity instruments in the company. AASB 2 sets out the requirements for the valuation of ESS and other equity based compensation arrangements for financial reporting purposes.
Some valuation issues relevant for an ESS include:

Valuation Issue

Comment

Grant date

The initial valuation must be completed at grant date. Assessment of the grant date is critical and is sometimes contentious.  Grant date is defined in Appendix A of AASB 2, and is the date when the company and the employee have a shared understanding of the terms and conditions of the share-based payment arrangement.

Cash settled or equity settled

If the ESS instrument is cash-settled, its value is recalculated each reporting period until it is settled.
If the ESS instrument is equity-settled, its value is calculated only once at grant date.

Treatment of vesting conditions

Market conditions (which relate to the market price of the company’s shares including, for example, share price growth, total shareholder returns, etc) are required to be considered in the calculation of the value per equity instrument.
Non-market conditions (which relate to the company’s operational / financial performance including, for example, earnings per share, sales revenue, EBITDA growth, service conditions, etc) are required to be considered in calculating the number of instruments that are likely to vest – and not in calculating the value per equity instrument.
Additionally, performance conditions - market or non-market - require a service condition to be part of the arrangement to be accounted for. A service condition is akin to a non-market condition and refers to the requirement of continuous employment of an employee from the grant until the vesting of an ESS instrument.

Non-vesting conditions

The company is required to take into account all non-vesting conditions when estimating the fair value of the equity instruments granted.
A non-vesting condition is a condition other than one which determines whether the company receives the services which entitle the employee to a share-based payment (e.g. regular contributions to an ESS plan by an employee).

Option Methodology/Model

Simple ESS instruments with only non-market conditions can be valued using the Black-Scholes or Binomial Pricing model.
ESS instruments which contain market conditions are generally valued using Monte Carlo simulations to determine the probability of the instrument vesting (i.e. the likelihood that the market condition will be met).

Valuation inputs

Generally, the valuation inputs relating to a share option valuation include grant date, expiry date, share price at grant date, the exercise price, volatility, dividend yield and risk-free rate.

Key valuation issues of interest to your auditors in relation to an ESS are likely to include:

  • The way in which volatility has been determined, including references to historical volatility. 
  • Selection of the valuation method, having regards to terms of the instrument being valued.
  • The date of the valuation relative to the grant date.
  • The market conditions considered in valuing the instrument and the non-market conditions considered when determining the number of instruments to vest.
  • Have conditions of the arrangement been appropriately classified in accordance with the requirements of AASB 2?

This update highlights a range of important valuation issues to consider when preparing your financial reports. BDO’s Financing Reporting & Accounting and Corporate Finance teams are experienced in statutory financial reporting and valuations, and can assist in making your compliance processes easier and more efficient. If you have any questions or would like more information, please contact your BDO adviser.

Note: This is not a comprehensive overview. Make sure you consult your BDO adviser for more information or to seek assistance in preparing your financial statements.

Contributors to this article: Yatra Forudi, Scott Birkett, Clark Jarrold, Steven Sorbello, Mark Whittaker.