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By Stephen Cole and Paula White
NEW GOVERNANCE AND ACCOUNTING RULES PLACE
ATTENTION ON THE FAIR VALUE OF BALANCE SHEET INTANGIBLES
There are new rules that affect governance, accounting auditing and valuation of goodwill and intangibles. Sections 3062 and 1581 of the CICA Handbook have been modified and mirror the new rules introduced in the US (FAS 141 and 142) recently. The thrust of the changes to the Canadian rules is outlined as follows:
• Generally accepted accounting principles no longer require that purchased goodwill be amortized.
• New categories of acquired intangible asset values are to be separately recognized, including contractual and non-contractual customer relations, proprietary but unpatented systems, people subject to employment contracts, and backlog, in addition to the familiar intangible asset categories such as patents, brands and trademarks. Such value will only be recognized separately from goodwill if it arises from a legal right or, if not, it is separable — that is capable of being sold (separability and transferability tests).
• Goodwill value on the balance sheet is to be the excess of intangible value over the aggregate of the identifiable intangible value described above. Hence, goodwill is a residual amount. By default it will include such intangible values as the value of a workforce of "at will" employees, not bound by contract and synergies because they may have no value if separated from the business.
• Goodwill is to be carried on the financial statements, with exceptions, at its fair value. Initial writedown (impairment) of goodwill to fair value will not go through the income statement, nor will it impact earnings per share, provided the adjustment is made in the first fiscal year starting after January 1, 2002. Subsequent writedowns will impact earnings per share directly.
• The fair value of goodwill and useful life of other intangibles need to be assessed yearly pursuant to an annual impairment test (AIT) to ensure value isn't impaired and estimated useful life remains realistic.
• All noncurrent intangible assets other than goodwill will need to be depreciated or amortized over their useful life, unless the asset life is determined to be indefinite.
The valuation of goodwill on the balance sheet for purposes of the AIT is set out above. In essence, it is what is left over after properly valuing everything else.
Paralleling the method of valuing goodwill on the balance sheet sets out the more common valuation techniques that will guide the valuation process. These techniques will undoubtedly become much more sophisticated and refined over the next few years as they receive increasing attention. The most important test of all is the common-sense test, discounted cash flow not-withstanding.
A detailed discounted cash flow model should most frequently be used to determine fair value. Mergers and acquisition and corporate finance "street" knowledge plus traditional business valuation theory will be needed to ensure the valuation balances market realities and the subtleties of the specific business.
Everything else being equal, if there is no amortization of goodwill, expenses will go down and earnings will go up. However, the AIT will impose much stricter responsibility to review all intangible values annually and in times of rapid technological and other changes. The useful life of many intangibles may shorten and the amortization expense will rise. The writedowns as a result of impairment will be part of normal earnings and will not be extraordinary or below the line.
Note that these new rules will harmonize North American earnings calculations and the pooling of interest method for acquisitions is no longer allowed.
Given the new direct focus on value and the breadth of considerations bearing on goodwill, auditors, shareholders, lenders and other stakeholders will rely in part on the published balance sheet values. As a result, there will be a high liability associated with them. The valuations must be in the correct range and must be prepared in accordance with standards.
In most cases, management will undertake the AIT, which will be reviewed by auditors. As auditors cannot prepare valuation opinions for their audit clients, we expect it will be common practice for companies to retain independent valuation specialists to review management's reports and give an independent opinion in the following instances:
• in reviewing, developing or assisting in the development of the procedures and documentation to be maintained by management for the valuation itself and in the questioning/inquiry process to determine if it is necessary to look more carefully;
• where there is, or are reasons to believe there may be, a material impairment;
• where management, auditors, audit committee or boards want a second opinion on a controversial matter or where an error may result in the release of materially misleading financial information;
• where specialized skills or greater appearance of independence is required or simply out of an abundance of caution;
• where there is a likelihood of third-party review or litigation.
It is not likely that underwriters or investment banks will undertake this work due to conflict and the opportunity cost of trading these fees for larger transaction-oriented fees.
Valuation for financial statement purposes and AIT may also constitute a prior valuation requiring disclosure in various securities circumstances, including in the course of going private, fairness opinion and formal valuation related matters.
By their nature, valuations can only provide a reasonable range of accuracy. Absolute precision or preparation of a formal valuation opinion is often not practical. To achieve timely and economical results, because an informal estimate, second opinion or review is much less expensive and less time consuming than a formal opinion, it may be more practical and appropriate.
A formal valuation opinion will therefore be more frequently required when the matter is contentious, when management has not prepared its own substantive analysis or formal opinion or when thorough documentation is critical.
The Canadian Institute of Chartered Business Valuators and its US counterparts prescribe standards and procedures for formal valuation opinions, informal and second opinions and procedural reviews. They reflect generally accepted valuation principles and practices, and address the disclosure and style required in a valuation report, substantive content and methodologies, and scope of work to support opinions and related professional matters.
Undoubtedly, these standards and the related legal precedents will be applied in assessing the valuations, board governance practices and the performance and liability of all the parties involved, including management, boards, independent valuation specialists and auditors.
The independent valuator need not reinvent the wheel. Except as noted earlier, it will be appropriate to work cooperatively, though independently, with management and auditors to ensure timely and economic results. Without losing objectivity, the knowledge base of management and auditors can be highly leveraged by the independent specialist. Generally, valuations will not be built from the ground up but on the preparatory work done by management and, indirectly, auditors.
In reviewing a company's procedures for the AIT, it is critical that consistent valuation principles and templates be applied whenever financial information is released. Proper planning will ensure there are no surprises and the process is efficient and cost effective.
Good processes are integral to discharging the board's role of overseeing, just as are other internal controls. It is essential that management document both the processes and the resulting valuation reports and that the board and the audit committee approve them.
The new accounting rules and the fallout from the US Sarbanes-Oxley Act, Enron and WorldCom debacles are bringing about stricter governance and financial statement reporting responsibilities.
Directors, audit committees, management, securities dealers, investment bankers and, of course, auditors must now focus more carefully on balance sheet goodwill and other intangibles — on their fair value.
A focus on the fair value of goodwill goes to the heart of the value of the enterprise, a broad and vital responsibility. We believe the new rules and focus will lead to more credible financial reporting and to more realistic pricing/valuation practices and protection of shareholder value.
Paula White and Stephen Cole are partners with Toronto-based corporate financial advisers and chartered business valuators Cole & Partners. Stephen Cole is Technical Editor for Business valuation.
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