Valuation challenge: 'Found liable'

THE CONTESTANT:

Susan Saidens

Susan Saidens
Managing director
SMS Valuation & Forensic Services

THIS MONTH’S CHALLENGE: ‘Found liable’

THE CHALLENGE:
ABC Products acquired Tools-for-U in an acquisition. ABC Products is required to measure the fair value of the assets acquired and the liabilities assumed in the acquisition of Tools-for-U for financial reporting purposes. ABC Products has experience with valuing acquired assets and intangible assets, but in the past, fair value measurement of liabilities had been relatively infrequent, if at all.

The liabilities assumed by ABC Products’ acquisition of Tools-for-U have the following characteristics:

• • A non-financial liability consisting of $2.5 million of accounts payable and accrued liabilities.
• • A financial liability consisting of a $7 million BBB-rated 5-yr. fixed-rate debt instrument with an annual 10.0 percent interest coupon, and a restriction preventing the debt instrument from being transferred.

How should these liabilities be valued?

SUSAN SAIDENS’ ANSWER:
The fact situation above has several issues which must be addressed within the context of fair value for financial reporting including, but not limited to:

• • What is the fair value of a non-financial liability?
• • What is the fair value of a financial liability?
• • Does the new framework for fair value measurements apply to liabilities in the same manner as it applies to assets?

Under US GAAP, the fair value of a liability assumed in a business combination under ASC 820 [formerly FAS 157] is based on the price received to transfer the liability to a market participant and is notably not a settlement concept. The transfer price notion of the fair value of a liability remains the same whether the liability is a financial or non-financial liability.

In addition to the transfer price concept, Accounting Standards Update No. 2009-05: Measuring Liabilities at Fair Value, clarified that measuring the fair value of liabilities includes estimating the timing of the payments to be made, considering the current interest rate and market environment of a financial liability (as opposed to when the liability was originally incurred), considering the risk of nonperformance, and, for non-financial liabilities, estimating a profit component that would be required by market participants to service the liability. In a financial liability such as a debt obligation, the profit component is already included in the required interest rate. Further, no adjustment is allowed for any contractual restriction on transferring the liability as the transfer concept of fair value assumes that the liability is transferred to a market participant, continues in existence, and is not settled with the counterparty.

Generally speaking, some fair value framework measurement concepts that are applied in appraising assets, such as “highest and best use” or “valuation premise” may not be applicable to measuring the fair value of a liability. 

The fair value framework would require ABC Products to value their acquired accounts payable and accrued liabilities as follows:

• • Unit of account – The unit of account is the individual accounts payable and accrued liability.
• • Valuation premise – Not applicable.
• • Assess principal market – Accounts payable and accrued liability balances are rarely bought or sold and consequently, there is likely no principal market.
• • Determine most advantageous market   – ABC Products will need to determine market participant assumptions based on a hypothetical potential market using the type of entities interested in short-term liabilities (e.g. an entity willing to service/administer an outstanding balance of accounts payable/accrued liabilities).
• • Valuation technique – Since pricing inputs will be limited at best, ABC Products will probably not apply the market and cost approaches. ABC Products should use a discounted cash flow analysis based on expectations of potential cash outflows associated with transferring the liabilities. Market participants would probably require a fee for administering the payments and they would also include a discount for nonperformance risk based on ABC Products’ own credit standing.
• • Fair value hierarchy – ABC Products is using market participant assumptions in a hypothetical market with no observable inputs. Consequently, this is considered a Level 3 measurement.

As for the assumed debt obligation:

• • Unit of account – The unit of account is the debt instrument.
• • Valuation premise – Not applicable.
• • Assess principal market – There is no identical or similar debt instrument which is traded as asset on an exchange or by a guideline public company. Consequently there is no principal market.
• • Determine most advantageous market – ABC Products will need to determine market participant assumptions based on a hypothetical potential market using the type of entities interested in buying debt instruments.
• • Valuation technique – Since pricing inputs will be limited at best, ABC Products will probably not apply the market and cost approaches. The FASB advocates that ABC Products should use a discounted cash flow analysis based on expectations of the potential cash outflows associated with an entity assuming the debt instrument.    Market participant assumptions would include the same principal of $7 million and term of 5 years. The interest rate may change whether the debt was issued at 10.0 percent when prime was 5.0 percent and how the risk of nonperformance [of the company] from the date of issue is estimated. This change in risk attributes is added to the interest rate. Because this is a financial liability, the interest rate already captures the risk or profit that a market participant would require as compensation for assuming the debt. The FASB also does not allow an adjustment for the existence of any restrictions preventing the debt from being transferred.
• • Fair value hierarchy – ABC Products is using market participant assumptions in a hypothetical market with no observable inputs. Consequently, this is considered a Level 3 measurement.

On a practical level, the fair value of working capital components should not vary significantly from their book value; although the process to illustrate the framework of estimating the fair value still must be prepared and disclosed. The fair value of long-term liabilities will vary from its book value based on current market conditions and interest rates, and the risk of nonperformance from the date of issue of the instrument which includes assessing the company’s own credit risk.