‘You can only manage what you can measure.’
Since the adoption of International Financial Reporting Standards (IFRS), the underlying principles of financial reporting have been moving towards the concept of fair value from historical cost. Advocates believe fair value based reporting can provide more relevant, useful, and comparable information on the value of a company and its assets and liabilities. Critics counter that earnings and other financial metrics are too vulnerable to short term changes in market expectation and sentiment, which have an impact on fair value. Regardless whether you agree or disagree with the fair value concept, the best approach is to be proactive when dealing with it, so that there are no surprises. Instead of passively waiting for, and being adversely affected by valuation results, it is wise to plan and prepare in advance. In what follows we will examine several critical areas of valuation for financial reporting that should be considered.
Financial instruments and embedded derivatives
The valuation of financial instrument is one of the most complicated areas for financial reporting. Whenever you invest in or issue new securities, fair value measurement is required. Whilst transaction prices may be adopted as fair value at initial recognition, mark-to-model valuation will be needed for financial year-end reporting. The change in fair value of financial instruments, especially derivatives, is a frequent eye-catching item that impacts the income statement. When long-term debts are involved, effective interest rate also affects net profit over the tenure.
For most financial assets and liabilities, including embedded derivatives (except items being measured at amortized cost) year-end fair value measurement is required. Values are derived using sophisticated spreadsheet models with inputs drawn primarily from market data. The resulting values go into the balance sheet and the corresponding movement in value goes through to the income statement. This may catch you by surprise and is unfortunately out of your control. Depending on terms and conditions in the financial instrument contract, you may liquidate the asset, repay the debt, or negotiate for a revision of terms, but room for improvement is limited once a deal is made.
To be forewarned regarding any potential earnings shock on the re-valuation of a financial instrument, you should consider pre-transaction fair value management. This typically involves the following steps before fixing the contract:
- Review initial draft of the transaction terms and conditions to identify fair value measurement requirements;
- Pro forma valuation based on latest practicable date or expected market data and initial transaction terms (base scenario analysis);
- Sensitivity analysis of valuation and earnings impact with different market parameters and transaction terms; and
- Decision: go or not – revise or negotiate further the transaction terms when appropriate, or consider hedging or other remedies, then step 1 again.
Step 1: Transaction terms review
Financial instrument valuations usually impact income statements in two ways, namely (1) amortized effective interest; and (2) change in fair value through the Profit & Loss Account (P&L) or Other Comprehensive Income (OCI).The effective interest method is usually used to value fixed income securities, invested or issued loans, and debts receivables or payables. Other instruments, including embedded derivatives of fixed income securities, are accounted for through change in fair value through P&L or OCI. International Accounting Standard (IAS) 39 also specifies an exception for unlisted equity investment, which can be booked at cost, subject to impairment test. However, this clause has been removed in IFRS 9.
For debt securities, early redemption clauses are the most common form of embedded derivatives which require year-end valuation. Early redemption is the discrete right of the issuer or investor and gives the party a right to call or put back the security to the other side. Identification of the equity component in a convertible bond requires that a fixed amount of principal be converted into a fixed number of shares. Non-fulfilment of this fixed-to-fixed condition would turn the equity conversion feature of a convertible bond from an equity component to a derivative liability component, which may impact the P&L each year.
Transaction analysis should not be conducted on a piecemeal basis, but should rather be viewed from a broader transaction perspective. For example, to finance the acquisition of a company you might issue convertible bonds to the selling shareholders. This not only involves a bond valuation, but also affects the purchase consideration, goodwill calculation, and will need future impairment testing.
Step 2: Pro forma valuation and earning impact analysis (base scenario analysis)
Based on draft transaction terms and latest market data, a pro forma valuation model can be developed. The model should assume that the deal is made at the latest practicable date or that relevant market parameters will be at similar levels when the deal is made. If effective interest applies, an interest amortization table can also be developed to calculate the upcoming interest expense.
Step 3: Sensitivity analysis
By altering certain clauses of the proposed transaction and market inputs, valuations and effective interest rates under different scenarios can be derived. For instruments which require year-end measurement, another set of input assumptions can be used to measure potential fair value changes. If there is any particular expectation of key variables like share price and interest rate, their valuation and earning impact may also be incorporated as base or alternate scenarios.
Step 4: Decision – go or not
Based on the above analysis, the potential earnings impact of a proposed transaction can be estimated. Management can then decide whether these results are acceptable or whether further modification of the transaction is required. Other hedging activities may also be considered. Depending on the complexity and materiality of the proposed transaction, more comprehensive analyses such as what-if analysis of earning impact target, probability estimation, risk measurement, and stress testing may also be performed. If substantial revision is required, then another round of analysis from step 1 above will be helpful.
Fair value management analysis involves in-depth understanding of the proposed transaction and relevant clauses, solid knowledge of financial reporting requirements, as well as hands on financial modeling and valuation experience. If your in-house finance team allocates plenty of time and manpower, then conducting the exercise in-house can be a good option. However, in lieu of tight resources and limited modeling expertise, third party professionals not only help you save time and effort, but provide an additional assurance against unnecessary earnings shocks. When a deal is made, the instrument will be valued as required and affect your earnings. Be prepared early to protect your own financial report.
Your assets and liabilities on the balance sheet will be booked and measured at financial year end. Have a comprehensive pro forma valuation model ready before year-end which can simply be updated at year-end. This helps saves time and expense when you are at your busiest point.
“Price is what you pay, value is what you get,” Warren Buffet said. When you pay for an asset, and it declines in value, then you make a loss. This is the basic idea of impairment testing. In a typical goodwill impairment test, if the Value-In-Use (VIU) or recoverable amount of a cash generating unit (CGU) is not as high as the carrying amount, goodwill is impaired and a charge to the income statement results. In particular, IAS-36 specifies that the valuation has to be conducted from a market player's perspective. That means, in theory, how much your asset or your subsidiary company is worth depends on how much a hypothetical “market player” thinks it is worth, not what you think.
A VIU valuation is a Discounted Cash Flow (“DCF”) based valuation. Earnings and cash flow forecasts are always key inputs, but how should such parameters be considered in terms of reasonableness? Are the forecasts realistic and achievable?
Financial forecasts are usually prepared from top line to bottom line, from earning to cash flow. A common starting point is revenue. How much you make and sell decides how much you earn. To project your top line, your historical sales performance is a key reference. Your business’ historical revenue growth and your listed peers’ expected growth by securities analysts are often cited. Project pipelines and outstanding orders are also referenced.
After revenue has been projected, costs and expenses follow. Material and other costs of revenue, expense budget, any cost saving planning should also be considered. In practice, profit is often projected directly based on historical or comparables’ profit margin, and adjusted for other factors. Capex and fixed asset schedules, historical and comparables working capital period ratios are adopted to create a cash flow forecast.
When a valuation model is submitted to the auditor a Q&A session - often tedious - follows. Among various questions, it is a common practice to compare the previous year’s forecast against actual performance and to compare this year’s forecast against last year’s forecasted and actual performance. In this discussion valuers with experience and understanding of your business will know how to justify the valuation model used and arrive at a fair value that every party considers acceptable and reasonable. This will save a lot of your valuable time and effort.
Make sure you are equipped with enough information for valuing your assets and liabilities, and someone who can utilize this information for your reporting and management planning purposes. A good valuer can help you manage your information to foresee the value on your balance sheet and justify this against inquiries from auditors, authorities and other parties – even before a deal is made. Experienced professionals can spot salient features in your upcoming transaction and their likely impacts on your P&L account. Valuation is more than calculation and report writing, it is also understanding and ability to justify. A well executed valuation project ensures that the number arrived at can stand firm against questions and critics. This helps you to foresee how your upcoming transaction might affect your earnings, and saves your time and effort, at your busiest time preparing your annual result.
Don’t go astray
Opinion shopping might be considered by some – but it is never recommended. Opinion shopping means searching for and hiring third party practitioners, such as valuers and auditors, who are willing to arrive at or accept your desired result with minimal, if any, inquiry into reasonableness or feasibility. Apart from ethical concerns, the consequence can be serious.
Remember the now infamous auditor for Madoff? Valuation practice is relatively speaking much smaller than auditing and accounting practice. The reputations of some valuers are an open secret among practitioners and their work is often subject to severe suspicion and questioning by auditors as well as authorities and exchanges. Beyond the reputation issue, subsequent questions, clearing, and amendments work can be more troublesome than usual and put any planned timeframe under stress. In some instances, the whole valuation is rejected and must be re-done by another valuer, wasting both time and money. If a valuation is undertaken for transaction reference purposes, the whole project may even be delayed or suspended for failure to justify the valuation to authorities. So it is crucial to ensure not only that valuation is done, but done properly.