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Feature

PJ Patel
Senior Vice President
Valuation Research Corp.

Let’s Talk Fair Value … and Management’s Value Creation

SFAS 157 – how boards use fair value reporting rules to assess the executive team’s performance.

By PJ Patel

The FASB’s recent issuance of the Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements, has faced significant scrutiny.

The rule has come to the forefront as many companies face write-downs in the process of assessing the fair value of assets on their balance sheet. Many companies are grumbling about these write-downs in light of current economic conditions.

SFAS 157 defines fair value, establishes a framework for measuring fair value in Generally Accepted Accounting Principles (GAAP), and expands disclosures about fair value measurements. It is often used in conjunction with SFAS Nos. 142 and 144 to assess the impairment of assets.

Despite recent complaints about Statement 157, boards of directors may find that the information resulting from these assessments (SFAS No. 157 together with SFAS Nos. 142 and 144) can provide a useful benchmark in evaluating the contribution of an acquisition and, ultimately, the performance of management.

Those Fabled Synergies
As you would expect, when doing an acquisition most management teams are optimistic about the synergies and growth opportunities a potential acquisition may represent. Post-transaction, boards have the ability to review whether management’s promises ever came to fruition. One approach is for boards to consider the results of the company’s annual fair value measurements for impairment testing purposes.

The first step immediately post-transaction is for the acquiring company to allocate the purchase price for financial reporting purposes. The purchase price allocation gives an immediate picture of how the company/market participants assess the value of the assets of the acquired company.

Thereafter, on an annual or more frequent basis, the company tests the acquired assets for impairment. That’s when you get to see whether the deal was accretive or dilutive and whether the deal went as management promised or planned. One year after an acquisition, the company’s balance sheet approximately estimates the carrying value at the time of acquisition (since there has only been one year of depreciation/amortization). However, the fair value of the company may have changed significantly.

Asking ‘What Has Changed?’
Say your company pays $100 million to acquire a company. One year later, if the acquired company is valued at $110 million, and therefore shows no impairment, this would likely mean the acquisition was worthwhile either through realization of synergies or other benefits.

However, if the acquired company is now valued at $90 million, the board needs to ask what has changed. Perhaps you aren’t getting the synergies you expected, or multiples in the industry have declined, or the outlook for the business is now a lot lower than was originally planned.

Keep in mind that the economic downturn has had a deep effect on the value of some assets, as revenue, margins, and multiples for many companies are lower today than they were a year ago. You may find that the deterioration in the value of assets may not reflect on the success or lack of success of an acquisition but rather reflects a challenging economy.

Meaningful Information
The board can use the fair value measurements to assess the performance of management. If the acquisition is performing well, why? Is it accretive to earnings? Are there other similar acquisitions that may provide similar benefits? If it isn’t doing well, was management too optimistic about the promised synergies? Were the growth estimates too aggressive? Were the margin expansion opportunities overstated?

Answers to these questions can provide meaningful information to boards.

PJ Patel is senior vice president of Valuation Research Corp. He specializes in business valuations as well as valuations of intangible assets, including in-process R & D, software, trademarks, patents, and copyrights. He has completed major engagements in such industries as life sciences, consumer brands, and software.

Prior to joining Valuation Research, Mr. Patel held the position of director, financial consulting, with Marshall & Stevens Inc. In this capacity, he valued public and private companies for financing purposes, tax and financial reporting, sales-leasebacks, litigation support, bankruptcy, and fairness and solvency opinions.

He holds the designations of chartered financial analyst (CFA) and accredited senior appraiser (ASA). He can be contacted at ppatel@valuationresearch.com.