How to Address Fair Value Issues with an Auditor During an Acquisition
After your company makes, or is in the process of making an acquisition, it is important to understand the purchase accounting. You know about fair value, and you have studied ASC 805 – Business Combinations in detail, but what’s next? Let us help answer a few questions to help save you time and cost.
After your company makes or is in the process of making an acquisition, it is important to understand the purchase accounting. You know about fair value, and you have studied ASC 805 – Business Combinations in detail, but what’s next? Let us help answer a few questions to help save you time and cost.
Q: What is the typical process?
A: You will need to have a conversation with your auditors assessing:
- The necessity for pushdown accounting and distinguishing between equity and cost method investments.
- Identifying which intangible assets were acquired that need to be recorded at fair value.
- Specifics of the transaction including any debt that was acquired, non-controlling interests, equity roll-forwards, and contingent considerations. This is a good opportunity to get a sense as to how much scrutiny the audit team will put on your valuation.
Q: Can we perform the valuation of intangible assets ourselves?
A: This depends on the auditor’s comfort level with the person doing the valuation. According to GAAP, the individual performing the valuation must have credentials that are deemed adequate for this type of work. As discussed in our article titled, “Purchase Price Allocations: Can We Do This In-house?,” often times auditors will reject management’s internally-prepared valuation work and request that a third-party gets involved. We find that it is better to get a third-party involved early in the process to avoid extra struggles and potential time crunches.
Q: What happens after I decide to hire a third party to do the valuation?
A: You will likely get a list of preferred vendors from the audit team. We recommend you use someone from that list even if you have worked with another firm before. Speaking from experience, the process can go a lot smoother with certain valuation professionals than others, even if they have worked with you in the past and are familiar with your company. Valuation professionals that have already been vetted could save significant time on the review side.
Once you contact a valuation professional, they will most likely request to have an initial discussion with you and the auditors. Be suspicious if this process is overlooked. After this initial discussion, you will then reiterate to the auditors the specifics of the transaction and what needs to be valued. You may also discuss specific methods and anticipated approaches. The goal is to avoid surprises down the road.
After the valuation professional has an idea of the scope of the valuation, they will send a document request list highlighting the necessary information needed to perform the valuation. Do not take this list lightly as it often contains items that the auditors will also request during their review. If something gets overlooked, it could slow down the process and potentially cause shifts in the values of the intangible assets down the road.
Throughout the process, the valuation professional will keep you abreast on their status and will likely have a few follow-up questions.
Q: Does the valuation work get reviewed by the auditors?
A: This depends on the materiality of the transaction and sophistication of the auditors. Typically, once you submit your valuation work, the auditors will begin reviewing the underlying projected financial information. The auditor must find the assumptions reasonable and the valuation methods appropriate and properly applied.
Q: If the valuation work is reviewed, what are the auditors looking for?
A: The following is a list of the most important things that the audit team is concerned with:
- Projected revenue growth with consideration given to variances from period to period
- Projected margins with consideration given to variances from period to period
- Projected balance sheet items vs. historical levels (specifically working capital requirements and capital expenditures)
- Reasonable useful lives applied to intangible assets
Q: What are some common or potential “red flags?”
A: The audit team’s valuation members may discuss these areas in particular with you:
- Business Enterprise Value (BEV) is within a reasonable range of the purchase consideration.
- IRR, WACC, and WARA (weight average return on assets) are within a reasonable range.
- There is not too much goodwill or negative goodwill present.
- Market participant assumptions/projections are applied and supported with all sources documented.
- Proper use of taxable (asset deal) or nontaxable (stock deal) projections.
- Equity consideration issued as part of the transaction was properly valued.
- Support of discounts for minority interests.
- Proper methods and reasonable assumptions applied in the valuation of the contingent consideration.
- If working capital excludes cash then it should be included in the DCF.
- Intangible returns should not be higher than the cost of equity or lower than WACC (excl. IPR&D, deferred revenue, contractual assets).
- Consideration of multiple reporting units.
- Use of at least one Multi-Period Excess Earning Model (MPEEM).
- Bifurcated cash flows if using two MPEEMs.
- Tangible assets and debt should be recorded at fair value.
In summary, you can do the valuation yourself, but you must be careful to understand the fair value guidance that exists and to use supportable and documented assumptions in the valuation. Proper care should be taken when determining market participant assumptions, as they can significantly alter the fair value conclusions. If a third party valuation specialist is used, make sure you have proactive conversations connecting them to the auditors and their review team.
For More Information
Contact Andy Clausen with your specific questions or to begin a conversation about the right level of compliance, communication and efficiency needed to achieve your valuation goals.