The Impact of Market Participant Assumptions on Goodwill Impairment Testing and the Valuation of Intangible Assets for Purchase Price Allocations
At a recent Nashville Chapter of Financial Executives International meeting, the topics included the complexity involved with measuring fair value under two of the Financial Accounting Standards Boards most recent pronouncements in this area - SFAS No. 141R Business Combinations and SFAS No. 157 Fair Value Measurements. Within the January/February 2007 edition of Financial Executive, there is a table entitled - FEI CEOs Top 10 Financial Reporting Challenges. Three of the ten financial reporting challenges listed in that table were as follows:
Fair Value – SFAS
While SFAS No. 157 coherently explains and defines FASB's use of fair value in the financial literature, it does not ease the burden of financial executives to implement the standards. For example, a great deal of conversation persists regarding market participants, principal markets, most advantageous markets, etc. These concepts are perhaps a little easier to apply when considering financial assets; however, they are more difficult to implement with intangible assets. Further, there are other issues to consider when applying the standards to intangible assets such as the treatment of expected synergies and whether or not to include some or all of those synergies in the valuation of various assets.
Pronouncement
Effective Date
SFAS No. 157 – Fair Value Measurements
Currently effective for financial assets and financial liabilities
Effective for non-financial assets and non-financial liabilities for fiscal years beginning after November 15, 20081
SFAS No. 141(R) – Business Combinations
Fiscal years beginning on or after December 15, 2008
Market Participants
There are many considerations that must be addressed when applying SFAS No. 141, SFAS No. 142 (dealing with goodwill and annual impairment testing), and SFAS No. 141(R) under the fair value standard defined by SFAS No. 157. SFAS No. 157 defines fair value as an exit price – or how much value could be obtained upon sale of the asset immediately after acquisition by the reporting entity. A key component in measuring the exit price under fair value is the market participant assumption. Market participants are buyers and sellers in the principal (or most advantageous) market for the asset or liability. Market participants generally are:
While a true marketplace generally does not exist for many of the individual intangible assets that are included in business combinations and sales, the "fair value of the asset or liability shall be determined based on the assumptions that market participants would use in pricing the asset or liability. In developing those assumptions, the reporting entity need not identify specific market participants. Rather, the reporting entity should identify characteristics that distinguish market participants generally…"3
Impact of Market Participant Assumption on Goodwill Impairment Testing
One situation in which market participant assumptions frequently impact financial reporting involves goodwill impairment testing. Assume that a group of investors buys a company using the following market participant assumptions identified through a review of public company information:
Further, assume that most companies in the industry are leveraged with interest-bearing debt ranging from 25% to 35% of total invested capital, however, also assume that the investor group funds the transaction with 70% debt rather than the range indicated by market participants. Not increasing the required rate of return to account for this higher leverage and related risk to common equity might cause the buyer to face an impairment of the asset soon after acquisition. This is due to the fact that, under SFAS No. 142 and SFAS No. 157, market participants would be expected to value the asset using a lower debt structure which, all else being equal, will lead to a higher weighted average cost of capital and a lower fair value.
Conclusion
Many auditors already expect management to apply many of the concepts set forth in SFAS No. 157 when valuing intangible assets although that pronouncement is not actually effective for a few more months as it applies to non-financial assets and non-financial liabilities. Clearly, market participant assumptions need to be identified and supported when assigning valuations to intangible assets when acquiring or merging with another company.
The market participant assumptions must be continually evaluated and supported when testing those assets for impairment in subsequent years. While relevant data can be obtained from many sources, it is our experience that auditors prefer support from a sample of public companies. This, of course, can be a time-consuming effort for many financial executives who will look at these issues once a year.
New Guidance On Determination of the Useful Life of Intangible Assets
On April 25, 2008, the FASB issued Staff Position on Statement No. 142 (FSP FAS 142-3) which provides additional guidance on the determination of useful lives for intangible assets that are accounted for pursuant to SFAS No. 142. With this announcement, the FASB is attempting to improve the consistency between the useful life of a recognized intangible asset and the period of expected cash flows used to measure the fair value of that intangible asset under SFAS No. 141. Further, the FASB addresses whether or not a difference between the (1) useful life of an intangible asset and (2) the period of expected cash flows used to measure the fair value of the asset might be justified.
It is interesting to note that FSP FAS 142-3 places primary importance on the reporting entity's historical experience regarding useful lives and secondary reliance upon market participant assumptions in the absence of historical experience. This contrasts with the fair value measurement's primary focus on market participant assumptions rather than the reporting entity's own assumptions.
The FSP provides an example in which market participants would assume that an acquired technology license would contribute to cash flows for three years and the acquiring company should determine the fair value of the acquired asset on that basis. However, the acquiring entity expects to complete next-generation technology within two years that will make the acquired technology license obsolete. While the fair value should be estimated assuming cash flows for three years because market participants would not know about the next generation technology, the useful life of the acquired technology license is only two years.
From this example, it is clear that the FASB anticipates that there will be circumstances in which the time over which market participants forecast an intangible asset to generate cash flows will differ from the actual useful life of that asset in the hands of a particular buyer. While this situation may be uncomfortable to many financial executives, the market participant assumptions will create scenarios such as this leading to a higher value under fair value that leads to unforeseen higher amortization expense in the short term.
1Staff Position on Statement No. 157 (FSP FAS 157-2), Financial Accounting Standards Board.
2Statement of Financial Accounting Standards No. 157, Fair Value Measurements, Financial Accounting Standards Board, para. 10.
3Ibid., para. 11
At a recent Nashville Chapter of Financial Executives International meeting, the topics included the complexity involved with measuring fair value under two of the Financial Accounting Standards Boards most recent pronouncements in this area - SFAS No. 141R Business Combinations and SFAS No. 157 Fair Value Measurements. Within the January/February 2007 edition of Financial Executive, there is a table entitled - FEI CEOs Top 10 Financial Reporting Challenges. Three of the ten financial reporting challenges listed in that table were as follows:
- fair value measurements
- complexity in financial reporting and
- business combinations
Fair Value – SFAS
While SFAS No. 157 coherently explains and defines FASB's use of fair value in the financial literature, it does not ease the burden of financial executives to implement the standards. For example, a great deal of conversation persists regarding market participants, principal markets, most advantageous markets, etc. These concepts are perhaps a little easier to apply when considering financial assets; however, they are more difficult to implement with intangible assets. Further, there are other issues to consider when applying the standards to intangible assets such as the treatment of expected synergies and whether or not to include some or all of those synergies in the valuation of various assets.
Pronouncement
Effective Date
SFAS No. 157 – Fair Value Measurements
Currently effective for financial assets and financial liabilities
Effective for non-financial assets and non-financial liabilities for fiscal years beginning after November 15, 20081
SFAS No. 141(R) – Business Combinations
Fiscal years beginning on or after December 15, 2008
Market Participants
There are many considerations that must be addressed when applying SFAS No. 141, SFAS No. 142 (dealing with goodwill and annual impairment testing), and SFAS No. 141(R) under the fair value standard defined by SFAS No. 157. SFAS No. 157 defines fair value as an exit price – or how much value could be obtained upon sale of the asset immediately after acquisition by the reporting entity. A key component in measuring the exit price under fair value is the market participant assumption. Market participants are buyers and sellers in the principal (or most advantageous) market for the asset or liability. Market participants generally are:
- Independent of the reporting unit;
- Knowledgeable about the asset or liability, the transaction and information that is usual and customary;
- Able to transact for the asset or liability; and
- Willing to transact for the asset or liability.2
While a true marketplace generally does not exist for many of the individual intangible assets that are included in business combinations and sales, the "fair value of the asset or liability shall be determined based on the assumptions that market participants would use in pricing the asset or liability. In developing those assumptions, the reporting entity need not identify specific market participants. Rather, the reporting entity should identify characteristics that distinguish market participants generally…"3
Impact of Market Participant Assumption on Goodwill Impairment Testing
One situation in which market participant assumptions frequently impact financial reporting involves goodwill impairment testing. Assume that a group of investors buys a company using the following market participant assumptions identified through a review of public company information:
- Projected sales growth;
- Projected operating profit margin;
- Rate of return for common equity; and
- Interest rates.
Further, assume that most companies in the industry are leveraged with interest-bearing debt ranging from 25% to 35% of total invested capital, however, also assume that the investor group funds the transaction with 70% debt rather than the range indicated by market participants. Not increasing the required rate of return to account for this higher leverage and related risk to common equity might cause the buyer to face an impairment of the asset soon after acquisition. This is due to the fact that, under SFAS No. 142 and SFAS No. 157, market participants would be expected to value the asset using a lower debt structure which, all else being equal, will lead to a higher weighted average cost of capital and a lower fair value.
Conclusion
Many auditors already expect management to apply many of the concepts set forth in SFAS No. 157 when valuing intangible assets although that pronouncement is not actually effective for a few more months as it applies to non-financial assets and non-financial liabilities. Clearly, market participant assumptions need to be identified and supported when assigning valuations to intangible assets when acquiring or merging with another company.
The market participant assumptions must be continually evaluated and supported when testing those assets for impairment in subsequent years. While relevant data can be obtained from many sources, it is our experience that auditors prefer support from a sample of public companies. This, of course, can be a time-consuming effort for many financial executives who will look at these issues once a year.
New Guidance On Determination of the Useful Life of Intangible Assets
On April 25, 2008, the FASB issued Staff Position on Statement No. 142 (FSP FAS 142-3) which provides additional guidance on the determination of useful lives for intangible assets that are accounted for pursuant to SFAS No. 142. With this announcement, the FASB is attempting to improve the consistency between the useful life of a recognized intangible asset and the period of expected cash flows used to measure the fair value of that intangible asset under SFAS No. 141. Further, the FASB addresses whether or not a difference between the (1) useful life of an intangible asset and (2) the period of expected cash flows used to measure the fair value of the asset might be justified.
It is interesting to note that FSP FAS 142-3 places primary importance on the reporting entity's historical experience regarding useful lives and secondary reliance upon market participant assumptions in the absence of historical experience. This contrasts with the fair value measurement's primary focus on market participant assumptions rather than the reporting entity's own assumptions.
The FSP provides an example in which market participants would assume that an acquired technology license would contribute to cash flows for three years and the acquiring company should determine the fair value of the acquired asset on that basis. However, the acquiring entity expects to complete next-generation technology within two years that will make the acquired technology license obsolete. While the fair value should be estimated assuming cash flows for three years because market participants would not know about the next generation technology, the useful life of the acquired technology license is only two years.
From this example, it is clear that the FASB anticipates that there will be circumstances in which the time over which market participants forecast an intangible asset to generate cash flows will differ from the actual useful life of that asset in the hands of a particular buyer. While this situation may be uncomfortable to many financial executives, the market participant assumptions will create scenarios such as this leading to a higher value under fair value that leads to unforeseen higher amortization expense in the short term.
1Staff Position on Statement No. 157 (FSP FAS 157-2), Financial Accounting Standards Board.
2Statement of Financial Accounting Standards No. 157, Fair Value Measurements, Financial Accounting Standards Board, para. 10.
3Ibid., para. 11
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