Where Will the SEC Take the IFRS Roadmap?
An AICPA Analysis of Comment Letters on the SEC's Proposal
This is an article by the American Institute of Certified Public Accountants
During the past several years, the move toward a single set of high quality, globally accepted accounting standards has gained momentum. For example, in 2005 the European Union began requiring companies incorporated in its member states whose securities are listed on an EU-regulated stock exchange to prepare their consolidated financial statements in accordance with International Financial Reporting Standards (IFRS). In 2007, the U.S. Securities and Exchange Commission (SEC) agreed to accept from foreign private issuers financial statements prepared in accordance with IFRS without reconciliation to U.S. Generally Accepted Accounting Principles (GAAP). In September 2008, the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) updated and reaffirmed their “Memorandum of Understanding” to converge all major accounting standards (such as revenue recognition and leasing) by 2011 in light of a possible move to IFRS.
Most recently, the SEC released for public comment a proposed roadmap for adoption of IFRS by public companies in the U.S. Comment letters were due April 20, 2009 (extended from February 19, 2009). While many expressed support for the goal of high-quality globally accepted accounting standards, the request for comments produced numerous critics of the SEC's proposed roadmap. Commentators had serious concerns about the cost of adoption, the benefits of adoption compared to convergence, and whether IFRS were in fact as good as or better than U.S. GAAP.
The following analysis of the comment letters the SEC received represents the issues the SEC will grapple with as it considers the proposed roadmap and whether (or how) to transition U.S. public companies to IFRS from U.S. GAAP.
Cost
By far the two most common criticisms of the roadmap were the cost of adoption and the belief that a more measured convergence process was the best option. The current financial crisis was often cited as a deterrent to mandating adoption soon. Several commentators mentioned that in this economy, it is not the time to increase the cost of doing business and a concern that benefits of adoption do not outweigh costs.
Convergence over Adoption
Probably the clearest consensus among those opposed to the roadmap was the belief that continued convergence was a better option than adoption, mostly because fuller convergence between both sets of standards would be less complex and less costly than IFRS adoption. Also, a number of companies agreed that the objectives of the proposed roadmap could be more cost-effectively achieved by continued convergence. If a decision is made in the future ultimately to adopt IFRS, many argue that the transition will be much easier and less costly after allowing more time for convergence.
Even those supportive of adoption urged the SEC to slow down. Under the roadmap calendar-year, large accelerated filers would be required to start filing financial statements using IFRS for the year ended December 31, 2014. Such a timetable would require these companies to start accumulating IFRS data beginning in 2012 because of the need for two years of historical comparative financial statements. The SEC said it would not make a final decision mandating IFRS until 2011. Consequently, the timeline as proposed in the roadmap does not allow sufficient time for conversion.
Consistency Not Guaranteed
Many respondents acknowledged the desirability of eventually establishing a single set of high-quality global accounting standards. However, some question whether IFRS would necessarily allow for easy comparisons of financial statements due to variations of IFRS and the reliance on professional judgment when using the principles-based standards. IFRS proponents cite comparability of financial statements among public companies as one of the chief arguments in favor of adoption.
Other criticisms were concerned that principles-based IFRS would yield a wider variety of results than the more rules-based U.S. GAAP. This diminishes the benefit of comparability. Over time, some believe this situation will force IFRS to become more rules-based.
In addition, while improvement in global comparability will be a benefit to multinational corporations, companies with primarily domestic operations will not recognize the same benefit.
Specific Concerns by Specific Industries
IFRS are less voluminous than U.S. GAAP in part because they contain little industry-specific guidance. Many commentators had certain concerns about how IFRS would impact their particular industry. For example, specific concerns were raised about provisions of IAS 41 - Agriculture, guidance for regulated industries, and the need for completion of the joint IASB/FASB project on accounting for insurance contracts. Companies that use LIFO (last in-first out inventory accounting method) were very concerned about the elimination of LIFO that would be required on a move to IFRS. Acceleration of income taxes would be substantial for many companies on such a move.
IASB Funding
Other critics were concerned about the uncertainty surrounding funding for the IASB. Many believe that the IASB needs to have a more reliable and consistent funding method so it would be impervious to political or corporate pressure. Many said that until these uncertainties are appropriately addressed, a decision to adopt IFRS should be delayed.
What about Private Companies?
Since the SEC regulates only public companies, comments also pointed to concern that the SEC was not recognizing that most companies in the U.S. are not SEC registrants (issuers). Some in the academic community raised the issue of information overload for accounting students. Using IFRS for public companies and U.S. GAAP for private companies means that students will need to learn two different sets of standards.
Importance of SEC Setting a Specific Date
The proposed roadmap states that in 2011 the SEC will consider mandating phased-in adoption starting in 2014 based on the achievement of several milestones, including convergence of accounting standards and accelerated filers' use of IFRS. A number of respondents stressed the importance of the SEC setting a date certain for adoption and definitive deadlines, and sticking to them. Without a stated date for adoption or at least a commitment to adoption, companies do not appear willing to make a significant investment toward conversion.
Support for the Roadmap
There certainly was support in the comment letters for the roadmap, particularly from the largest U.S. accounting firms, foreign-based constituents and some large multinationals.
The American Institute of Certified Public Accountants (AICPA) also expressed its support not only of a single set of comprehensive accounting standards to be used by public companies everywhere in the world, but also its belief that the standards issued by the IASB are best positioned to become those global standards. The AICPA recommended changes to the roadmap, including expansion of the early adoption option to smaller companies, the need for changes in the financial regulatory environment in the U.S., setting a date certain for adoption and improvement in funding mechanisms for the IASB.
While in the minority, some U.S. registrants generally supported the roadmap and mandatory adoption in the near term. These organizations noted the benefits of global comparability, increased transparency, decreased cost of global financial reporting and the belief that converged standards would fall short of the benefits accruing from use of one global set of accounting standards.
Investors
Views from investor groups will be especially important to the SEC in evaluating its roadmap. Responses from investor groups were mixed. Comments ranged from favoring IFRS adoption with investor-friendly milestones to support for a more evolutionary approach of continued convergence to serious concerns that roadmap milestones are inadequate and fail to provide assurance that use of IFRS by U.S. issuers will not reduce the quality of financial reporting. There were relatively few comment letters from investor organizations.
Where to Go from Here
Release of the proposed roadmap in November 2008 was followed by expressions of concern about IFRS adoption from SEC Chairwoman Mary Schapiro in her confirmation hearings in January 2009. Many are wondering about the future of IFRS in the United States. The Commission will review the comment letters from the various stakeholders and plan a course of action. Most would probably agree that future direction from the Commission is eagerly awaited.
Tuesday, May 26, 2009
Monday, May 25, 2009
Valuations for Financial Reporting in Today's Market
Great article on valuation in financial reporting in the Journal of Accountancy--reproduced below.
The current economic environment has presented unprecedented circumstances for members of the business valuation profession. Those who perform valuations for financial reporting are grappling with issues surrounding impairment, market capitalization versus fair value determinations, reasonable rates of return, and active versus distressed and inactive markets, to name a few.
The JofA hosted a virtual round-table discussion with valuation professionals from the financial reporting sector to gauge how they are handling such issues in today’s climate and what their outlook is for the near future.
THE PANELISTS
Dave Dufendach, CPA/ABV, ASA, is a partner in Grant Thornton’s Seattle valuation practice. His primary focus is fair value for financial reporting: performing reviews for audit purposes in addition to valuations for nonaudit clients.
Walter McNairy, CPA, is a Raleigh, N.C.-based member in charge of Dixon Hughes PLLC’s public company practice.
Mike Morhaus, CPA/ABV/CFF, CVA, ASA, is a senior manager in the Forensic and Valuation Services department of Anders Minkler & Diehl in St. Louis. He specializes in the valuation of closely held business and other financial assets and has testified in the courts of Missouri and Illinois on a variety of business valuation and forensic accounting issues.
Bernard Pump, CPA/ABV/CFF, is a partner in Deloitte’s Chicago location, specializing full time in the valuation of closely held businesses.
Carolyn Worth, CPA/ABV, is a partner with KPMG LLP in the San Francisco office. She has been doing valuations for about 30 years, dealing mostly with public companies and fair value accounting.
Kevin R. Yeanoplos, CPA/ABV/CFF, ASA, is the director of valuation services for Brueggeman and Johnson Yeanoplos PC of Tucson, Ariz. He is currently a commissioner on the AICPA’s National Accreditation Commission and the immediate past chair of the ABV Credential Committee.
JofA: Have you ever faced a similar environment, and if so, what kind of lessons did you learn from it?
Carolyn Worth: A lot of economists are making comparisons to the Japanese banking crisis of 1990. I see similarities with a lack of understanding by the investor on the risks that the banks were taking in a very difficult credit environment. Now a lot of companies are relying more heavily on the income approach and ignoring the market approach, because they’re seeing dislocation between the two methodologies. If you ignore the market approach, then you’re ignoring other investors’ understanding of what they think the future economic benefits of the cash flow will be from these companies. The best thing to do is try to reconcile the two.
Bernard Pump: There’s an interesting parallel to the tech boom when we couldn’t explain the market pricing of companies. Through valuation techniques, you couldn’t get as high as the market with some of these tech stocks. The situation is similar today where in many industries, especially financial services, you can’t force the valuations low enough to replicate the market pricing of some of these companies.
Dave Dufendach: Another difference between that environment and today is we didn’t have FAS 157 (FASB Statement no. 157, Fair Value Measurements) back then with its laser-focus on market observations, so that adds a new element to the current situation.
Pump: It’s a wonderful thing that we have companies embracing income approaches under the FASB guidance because you can see the potential for that downward spiral if you are relying exclusively on the market approaches. Many of my clients are private-equity firms that have always used a market multiple in pricing their securities under FAS 157. Now they’re looking to the income approach, and I find it somewhat amusing that they’ve fully embraced the income approach as opposed to the market approach.
COMPARABILITY CHALLENGES
When pricing multiples drop significantly, challenges arise on how to perform services in light of not having a normal, usual market to turn to for comparability. The market is valuing companies at an all-time low, resulting in market approach valuations that are lower than the income approach valuations. The market approach uses pricing multiples of similar public companies as a benchmark to value the subject company, while the income approach tends to rely on a discounted cash flow methodology. Generally, when the market is “properly” priced, these two methods should result in a similar estimate of value for the subject company, assuming all factors are held equal.
However, in today’s environment, valuation analysts are seeing a wide spread between these two estimates of value that cannot be easily reconciled. As one panelist suggests, the intrinsic value of the subject company is greater than the indication under the market value, causing problems for the valuation analyst, particularly with respect to impairment testing under FASB Statement no. 142, Goodwill and Other Intangible Assets, since intrinsic value is not fair value.
JofA: Are you able to reconcile values or is it impossible to get back to reconciliation between the market method and an income approach?
Pump: We’re performing FAS 142 impairment tests. The SEC requests that you reconcile the market capitalization of the company to the summed-up value of the business reporting units, the business as a whole. The difference between those is called an implied control premium with the market value usually being a little bit less than the overall value through the other methods. And that number’s been in the range of 10% to 20% historically. Right now it’s not uncommon to see 100% implied control premium (acquisition premium). It’s a real challenge, because even after you’ve drilled down on the projections and put as much risk premium as you can into the discount rate, you can’t get very close to the publicly traded stock price.
Walter McNairy: When our clients are ready to write down goodwill impairment, they want to write it down to their market cap versus some interim valuation between market cap and book value. Getting clients to realize that they may have impairment and that the market cap is significantly less than book value has been a difficult task.
Pump: I’ve got clients that are trading below their liquidation value, yet some of them are currently profitable. So it’s a challenge to understand how the market is pricing some of these businesses.
Kevin Yeanoplos: It becomes even more problematic when you’re trying to reconcile the values with a privately held company, because there tends to be more disjointedness between the market approach and the private companies. Every one of these issues that we’ve discussed for public companies becomes even more problematic with the private ones.
Dufendach: With a private company that has multiple reporting units, you don’t have that market cap sitting out there to observe and reconcile to. We often see in place of that an overall value for 123(R) purposes (FASB Statement no. 123(R), Share-Based Payment). We try to diligently ensure that what we’re looking at for impairment is appropriately reconciled with whatever other indications of value might be out there for the overall company.
JofA: Are there any other common problems that you are seeing in valuations for financial reporting purposes?
Yeanoplos: One of the key issues that we are all facing is valuing a company, as of a particular date. Let’s say it was Sept. 30, 2008, a date on which there were significant market issues. Do we address it in terms of liquidity or of risks associated with a future economic benefit?
Dufendach: Related to that is the question of whether or not a triggering event has occurred. Is a drop in the market, whether you’re public or private, sufficient to require an impairment test other than the scheduled date?
The guidance in FAS 142 doesn’t talk about value of reporting units in terms of temporary or other than temporary, leaving it to professional judgment. The seven explicit items in 142 that indicate there might be a triggering event are not all-inclusive, and we have to consider whether a big drop in the market (below carrying value) may fall under the guidance of suggesting an impairment test needs to be performed.
JofA: Do you look at the last year, or do you look at the last 10 years? What kind of experience are you having with that?
Mike Morhaus: Along the lines of the smaller companies, we’re going back more than the traditional three to five years. For some of the construction companies we’re going back 10 years so we can get a better handle on the business cycles to answer the question: Is this low we’re in right now typical for the company? Typically, the DCFs and the single-period models are based on a five-year history, and that’s not sufficient for us anymore.
Worth: One analysis that we’ve added to our review of the financials is to look at actual vs. forecast for the last year, for the last quarters. We’re testing the reliability of management’s historical forecasting capabilities (their ability to forecast in prior periods).
Dufendach: There’s always been a focus on “vetting the forecast,” getting comfortable with the key assumptions, but it’s become even more important. When evaluating an income approach based on a five-year forecast, we are putting a renewed focus on the key assumptions that are embedded in that.
Worth: A lot of valuation professionals are dissatisfied with the equity risk premium, the historical equity risk premium. For the first time I’m seeing a lot of specific company risk adjustments in the weighted average cost of capital (WACC) and the discount rates to try to accommodate the recognition that sees the debt markets are more active, they’re showing more confidence in what the risk is. We are taking the active debt markets as a better indicator of what’s going on in overall risk than some other historical data that we have.
Dufendach: It’s very difficult to know how much we can rely on historical information in this environment. All the key assumptions need to be carefully reviewed.
Pump: Over the past few years, valuation professionals have made a lot of adjustments to the equity risk premium because volatility was very low for a number of years. There were a lot of explanations why equity risk premiums were as high as they were and speculation they need to be adjusted downward. I think that whole philosophy will be re-evaluated under the current market circumstances.
People like Aswath Damodaran, professor of finance at New York University, are talking about looking at forward-estimated equity risk premiums, as opposed to long-term historicals. And the equity risk premiums may fluctuate over time, depending on the markets. For lack of a better road map, many appraisers are putting an adjustment to the equity risk premium in as a specific company risk premium, because there’s no better way to do it right now.
JofA: Some have alleged that the implementation of fair value accounting is the reason for the financial decline. Do you agree or disagree?
Yeanoplos: Fair value may have simply uncovered conditions that already existed. Confusion still exists as to what fair value is or isn’t and understanding the implementation. The confusion is creating some of the market unrest, but I am still uncomfortable saying that fair value caused this. I believe that it’s necessary and is moving us in the right direction.
Pump: Not wanting to recognize the values that might be on the balance sheet—real values— is problematic. The markets tend to focus on short-term results, and to some extent these results may exacerbate the problem in a short-term manner, but I think the market sees past these noncash adjustments.
Worth: A lot of companies are fighting the fair value adjustments because of the violation of debt covenants. It may be that the debt covenant shouldn’t have been tied to the fair value of the assets, but rather, the realization of the assets.
Dufendach: I think that mark-to-market and FAS 157 has been very good in terms of transparency and getting more information to investors. Some of the criticisms of it may come not from the standard itself, but from some of the early applications of it, where perhaps distressed values were observed and taken for fair value and caused some write-downs that might not have been required under a better interpretation of FAS 157. I believe both the FASB and the SEC have made moves to try to clarify those issues.
JofA: The fallout of the economic crisis has had significant impact in many valuation areas other than just determining fair value for financial reporting. Differing levels of value and different standards of value (definitions of value) are involved in valuations prepared for other purposes. For example, estate and gift valuations focus on “fair market value” rather than “fair value.” Given the severe stress and chaos in the financial markets because of illiquidity, excessive leverage and financial mismanagement, how responsive will government agencies such as the IRS be to large valuation discounts assumed in estate valuations, real estate valuations and business valuations?
Pump: In the short run the SEC may be more flexible regarding discounts, simply as a matter of necessity, especially concerning public companies. In the long run I expect that the IRS and the SEC are going to return to the trend that we’ve seen for the past few years, which is requiring more support for the discounts. The SEC has encouraged us to use put option valuations as measures for lack of marketability, and the IRS has pushed for more detailed support for discounts for lack of marketability and control. I don’t see that going away, other than maybe on a temporary basis. On a temporary basis, I don’t think the IRS is going to back down on their discounts.
Yeanoplos: The one thing that’s important to remember with the IRS valuations is that there is definitely a requirement to look at factors that exist as of a particular date.
JofA: If you were talking with a director of a company, would you give them any suggestions on additional due diligence that they should be doing at this point in terms of valuations for financial reporting?
Worth: I wouldn’t hire the company that’s getting a commission on the transactions to do the fairness opinion. There’s an inherent conflict in there. If the SEC wanted to do anything, they should make sure it’s an independent party that provides advice to the board of directors. I believe the advisers should be equally independent of the company or the outcome of the transaction in order to provide unbiased advice.
Yeanoplos: I think that the board of directors should understand the technical aspects of fair value reporting much better, because whether they fully understand fair value or not, they definitely understand that it does have a significant impact on the value of the company. That’s one piece of advice I’d give the directors. If they don’t know it backwards and forwards now, they definitely should.
Dufendach: Awareness of how any transaction will be viewed from a FAS 142 perspective is important to the extent that a big premium is being paid in an acquisition. For example, will that be supportable six, nine, 12 months later, when all the assumptions have to switch over to a market participant standard and a real look at risk premiums and other factors going on in the market? I think that boards of directors would certainly be well-advised to keep in mind how this is going to look from a FAS 142 perspective.
JofA: Is there anything that you want JofA readers, specifically CPAs who are outside of the BV arena, to understand about valuations and the current climate?
Dufendach: The proper focus of valuation is and always should be the long term. We’re all facing the difficulties of assessing what the length of the recession is going to be and the impact it’s going to have on companies’ values. The market is signaling something to us: that the world has gotten much riskier.
Also see sidebars:
Concerns From an Auditor's Standpoint, by Walter McNairy
FASB Updates Fair Value Guidance
Web-exclusive content:
Additional Comments From the Virtual Round Table
Virtual Valuation Round Table: Definitions
Editor's note: The JofA would like to thank Gary Trugman, CPA/ABV, MCBA, ASA, MVS, and Robin Taylor, CPA/ABV, CFE, CVA, CBA, for their contributions to this article. Trugman, president of Trugman Valuation Associates Inc., serves on the AICPA’s ABV Examination Committee, is chairman of the Ethics Committee of the Institute of Business Appraisers Inc., and is an editorial adviser to the JofA. Taylor is a member of Dixon Hughes PLLC in Birmingham, Ala., and is chairman of the AICPA’s Business Valuation Committee.
The current economic environment has presented unprecedented circumstances for members of the business valuation profession. Those who perform valuations for financial reporting are grappling with issues surrounding impairment, market capitalization versus fair value determinations, reasonable rates of return, and active versus distressed and inactive markets, to name a few.
The JofA hosted a virtual round-table discussion with valuation professionals from the financial reporting sector to gauge how they are handling such issues in today’s climate and what their outlook is for the near future.
THE PANELISTS
Dave Dufendach, CPA/ABV, ASA, is a partner in Grant Thornton’s Seattle valuation practice. His primary focus is fair value for financial reporting: performing reviews for audit purposes in addition to valuations for nonaudit clients.
Walter McNairy, CPA, is a Raleigh, N.C.-based member in charge of Dixon Hughes PLLC’s public company practice.
Mike Morhaus, CPA/ABV/CFF, CVA, ASA, is a senior manager in the Forensic and Valuation Services department of Anders Minkler & Diehl in St. Louis. He specializes in the valuation of closely held business and other financial assets and has testified in the courts of Missouri and Illinois on a variety of business valuation and forensic accounting issues.
Bernard Pump, CPA/ABV/CFF, is a partner in Deloitte’s Chicago location, specializing full time in the valuation of closely held businesses.
Carolyn Worth, CPA/ABV, is a partner with KPMG LLP in the San Francisco office. She has been doing valuations for about 30 years, dealing mostly with public companies and fair value accounting.
Kevin R. Yeanoplos, CPA/ABV/CFF, ASA, is the director of valuation services for Brueggeman and Johnson Yeanoplos PC of Tucson, Ariz. He is currently a commissioner on the AICPA’s National Accreditation Commission and the immediate past chair of the ABV Credential Committee.
JofA: Have you ever faced a similar environment, and if so, what kind of lessons did you learn from it?
Carolyn Worth: A lot of economists are making comparisons to the Japanese banking crisis of 1990. I see similarities with a lack of understanding by the investor on the risks that the banks were taking in a very difficult credit environment. Now a lot of companies are relying more heavily on the income approach and ignoring the market approach, because they’re seeing dislocation between the two methodologies. If you ignore the market approach, then you’re ignoring other investors’ understanding of what they think the future economic benefits of the cash flow will be from these companies. The best thing to do is try to reconcile the two.
Bernard Pump: There’s an interesting parallel to the tech boom when we couldn’t explain the market pricing of companies. Through valuation techniques, you couldn’t get as high as the market with some of these tech stocks. The situation is similar today where in many industries, especially financial services, you can’t force the valuations low enough to replicate the market pricing of some of these companies.
Dave Dufendach: Another difference between that environment and today is we didn’t have FAS 157 (FASB Statement no. 157, Fair Value Measurements) back then with its laser-focus on market observations, so that adds a new element to the current situation.
Pump: It’s a wonderful thing that we have companies embracing income approaches under the FASB guidance because you can see the potential for that downward spiral if you are relying exclusively on the market approaches. Many of my clients are private-equity firms that have always used a market multiple in pricing their securities under FAS 157. Now they’re looking to the income approach, and I find it somewhat amusing that they’ve fully embraced the income approach as opposed to the market approach.
COMPARABILITY CHALLENGES
When pricing multiples drop significantly, challenges arise on how to perform services in light of not having a normal, usual market to turn to for comparability. The market is valuing companies at an all-time low, resulting in market approach valuations that are lower than the income approach valuations. The market approach uses pricing multiples of similar public companies as a benchmark to value the subject company, while the income approach tends to rely on a discounted cash flow methodology. Generally, when the market is “properly” priced, these two methods should result in a similar estimate of value for the subject company, assuming all factors are held equal.
However, in today’s environment, valuation analysts are seeing a wide spread between these two estimates of value that cannot be easily reconciled. As one panelist suggests, the intrinsic value of the subject company is greater than the indication under the market value, causing problems for the valuation analyst, particularly with respect to impairment testing under FASB Statement no. 142, Goodwill and Other Intangible Assets, since intrinsic value is not fair value.
JofA: Are you able to reconcile values or is it impossible to get back to reconciliation between the market method and an income approach?
Pump: We’re performing FAS 142 impairment tests. The SEC requests that you reconcile the market capitalization of the company to the summed-up value of the business reporting units, the business as a whole. The difference between those is called an implied control premium with the market value usually being a little bit less than the overall value through the other methods. And that number’s been in the range of 10% to 20% historically. Right now it’s not uncommon to see 100% implied control premium (acquisition premium). It’s a real challenge, because even after you’ve drilled down on the projections and put as much risk premium as you can into the discount rate, you can’t get very close to the publicly traded stock price.
Walter McNairy: When our clients are ready to write down goodwill impairment, they want to write it down to their market cap versus some interim valuation between market cap and book value. Getting clients to realize that they may have impairment and that the market cap is significantly less than book value has been a difficult task.
Pump: I’ve got clients that are trading below their liquidation value, yet some of them are currently profitable. So it’s a challenge to understand how the market is pricing some of these businesses.
Kevin Yeanoplos: It becomes even more problematic when you’re trying to reconcile the values with a privately held company, because there tends to be more disjointedness between the market approach and the private companies. Every one of these issues that we’ve discussed for public companies becomes even more problematic with the private ones.
Dufendach: With a private company that has multiple reporting units, you don’t have that market cap sitting out there to observe and reconcile to. We often see in place of that an overall value for 123(R) purposes (FASB Statement no. 123(R), Share-Based Payment). We try to diligently ensure that what we’re looking at for impairment is appropriately reconciled with whatever other indications of value might be out there for the overall company.
JofA: Are there any other common problems that you are seeing in valuations for financial reporting purposes?
Yeanoplos: One of the key issues that we are all facing is valuing a company, as of a particular date. Let’s say it was Sept. 30, 2008, a date on which there were significant market issues. Do we address it in terms of liquidity or of risks associated with a future economic benefit?
Dufendach: Related to that is the question of whether or not a triggering event has occurred. Is a drop in the market, whether you’re public or private, sufficient to require an impairment test other than the scheduled date?
The guidance in FAS 142 doesn’t talk about value of reporting units in terms of temporary or other than temporary, leaving it to professional judgment. The seven explicit items in 142 that indicate there might be a triggering event are not all-inclusive, and we have to consider whether a big drop in the market (below carrying value) may fall under the guidance of suggesting an impairment test needs to be performed.
JofA: Do you look at the last year, or do you look at the last 10 years? What kind of experience are you having with that?
Mike Morhaus: Along the lines of the smaller companies, we’re going back more than the traditional three to five years. For some of the construction companies we’re going back 10 years so we can get a better handle on the business cycles to answer the question: Is this low we’re in right now typical for the company? Typically, the DCFs and the single-period models are based on a five-year history, and that’s not sufficient for us anymore.
Worth: One analysis that we’ve added to our review of the financials is to look at actual vs. forecast for the last year, for the last quarters. We’re testing the reliability of management’s historical forecasting capabilities (their ability to forecast in prior periods).
Dufendach: There’s always been a focus on “vetting the forecast,” getting comfortable with the key assumptions, but it’s become even more important. When evaluating an income approach based on a five-year forecast, we are putting a renewed focus on the key assumptions that are embedded in that.
Worth: A lot of valuation professionals are dissatisfied with the equity risk premium, the historical equity risk premium. For the first time I’m seeing a lot of specific company risk adjustments in the weighted average cost of capital (WACC) and the discount rates to try to accommodate the recognition that sees the debt markets are more active, they’re showing more confidence in what the risk is. We are taking the active debt markets as a better indicator of what’s going on in overall risk than some other historical data that we have.
Dufendach: It’s very difficult to know how much we can rely on historical information in this environment. All the key assumptions need to be carefully reviewed.
Pump: Over the past few years, valuation professionals have made a lot of adjustments to the equity risk premium because volatility was very low for a number of years. There were a lot of explanations why equity risk premiums were as high as they were and speculation they need to be adjusted downward. I think that whole philosophy will be re-evaluated under the current market circumstances.
People like Aswath Damodaran, professor of finance at New York University, are talking about looking at forward-estimated equity risk premiums, as opposed to long-term historicals. And the equity risk premiums may fluctuate over time, depending on the markets. For lack of a better road map, many appraisers are putting an adjustment to the equity risk premium in as a specific company risk premium, because there’s no better way to do it right now.
JofA: Some have alleged that the implementation of fair value accounting is the reason for the financial decline. Do you agree or disagree?
Yeanoplos: Fair value may have simply uncovered conditions that already existed. Confusion still exists as to what fair value is or isn’t and understanding the implementation. The confusion is creating some of the market unrest, but I am still uncomfortable saying that fair value caused this. I believe that it’s necessary and is moving us in the right direction.
Pump: Not wanting to recognize the values that might be on the balance sheet—real values— is problematic. The markets tend to focus on short-term results, and to some extent these results may exacerbate the problem in a short-term manner, but I think the market sees past these noncash adjustments.
Worth: A lot of companies are fighting the fair value adjustments because of the violation of debt covenants. It may be that the debt covenant shouldn’t have been tied to the fair value of the assets, but rather, the realization of the assets.
Dufendach: I think that mark-to-market and FAS 157 has been very good in terms of transparency and getting more information to investors. Some of the criticisms of it may come not from the standard itself, but from some of the early applications of it, where perhaps distressed values were observed and taken for fair value and caused some write-downs that might not have been required under a better interpretation of FAS 157. I believe both the FASB and the SEC have made moves to try to clarify those issues.
JofA: The fallout of the economic crisis has had significant impact in many valuation areas other than just determining fair value for financial reporting. Differing levels of value and different standards of value (definitions of value) are involved in valuations prepared for other purposes. For example, estate and gift valuations focus on “fair market value” rather than “fair value.” Given the severe stress and chaos in the financial markets because of illiquidity, excessive leverage and financial mismanagement, how responsive will government agencies such as the IRS be to large valuation discounts assumed in estate valuations, real estate valuations and business valuations?
Pump: In the short run the SEC may be more flexible regarding discounts, simply as a matter of necessity, especially concerning public companies. In the long run I expect that the IRS and the SEC are going to return to the trend that we’ve seen for the past few years, which is requiring more support for the discounts. The SEC has encouraged us to use put option valuations as measures for lack of marketability, and the IRS has pushed for more detailed support for discounts for lack of marketability and control. I don’t see that going away, other than maybe on a temporary basis. On a temporary basis, I don’t think the IRS is going to back down on their discounts.
Yeanoplos: The one thing that’s important to remember with the IRS valuations is that there is definitely a requirement to look at factors that exist as of a particular date.
JofA: If you were talking with a director of a company, would you give them any suggestions on additional due diligence that they should be doing at this point in terms of valuations for financial reporting?
Worth: I wouldn’t hire the company that’s getting a commission on the transactions to do the fairness opinion. There’s an inherent conflict in there. If the SEC wanted to do anything, they should make sure it’s an independent party that provides advice to the board of directors. I believe the advisers should be equally independent of the company or the outcome of the transaction in order to provide unbiased advice.
Yeanoplos: I think that the board of directors should understand the technical aspects of fair value reporting much better, because whether they fully understand fair value or not, they definitely understand that it does have a significant impact on the value of the company. That’s one piece of advice I’d give the directors. If they don’t know it backwards and forwards now, they definitely should.
Dufendach: Awareness of how any transaction will be viewed from a FAS 142 perspective is important to the extent that a big premium is being paid in an acquisition. For example, will that be supportable six, nine, 12 months later, when all the assumptions have to switch over to a market participant standard and a real look at risk premiums and other factors going on in the market? I think that boards of directors would certainly be well-advised to keep in mind how this is going to look from a FAS 142 perspective.
JofA: Is there anything that you want JofA readers, specifically CPAs who are outside of the BV arena, to understand about valuations and the current climate?
Dufendach: The proper focus of valuation is and always should be the long term. We’re all facing the difficulties of assessing what the length of the recession is going to be and the impact it’s going to have on companies’ values. The market is signaling something to us: that the world has gotten much riskier.
Also see sidebars:
Concerns From an Auditor's Standpoint, by Walter McNairy
FASB Updates Fair Value Guidance
Web-exclusive content:
Additional Comments From the Virtual Round Table
Virtual Valuation Round Table: Definitions
Editor's note: The JofA would like to thank Gary Trugman, CPA/ABV, MCBA, ASA, MVS, and Robin Taylor, CPA/ABV, CFE, CVA, CBA, for their contributions to this article. Trugman, president of Trugman Valuation Associates Inc., serves on the AICPA’s ABV Examination Committee, is chairman of the Ethics Committee of the Institute of Business Appraisers Inc., and is an editorial adviser to the JofA. Taylor is a member of Dixon Hughes PLLC in Birmingham, Ala., and is chairman of the AICPA’s Business Valuation Committee.
Monday, May 11, 2009
XBRL Readiness Lags Behind
According to a survey of 500 public companies that the SEC requires to begin filing their financials in XBRL format in June, 340 companies, about 70% have made the conversion. The survey was done by the nonprofit standards group XBRL US.
Advocates of XBRL say that the requirements will result in more accessible SEC reports that are easier to analyze, with enhanced capability to quickly compare companies’ results. Companies will use XML data tags (“taxonomies”) to file their financial information on EDGAR. Companies currently file their financial reports in text or HTML.
XBRL will be phased in over two years, with companies having more than $5 billion in shares held by the public required to file using XBRL starting with their June 2009 quarterly reports. A further 1,800 other large filers will be required to file in XBRL in June 2010, and all other publicly traded companies and foreign private issuers will be required to comply starting in June 2011.
XBRL US released its 2009 US GAAP Taxonomy for XBRL in April this year.
Advocates of XBRL say that the requirements will result in more accessible SEC reports that are easier to analyze, with enhanced capability to quickly compare companies’ results. Companies will use XML data tags (“taxonomies”) to file their financial information on EDGAR. Companies currently file their financial reports in text or HTML.
XBRL will be phased in over two years, with companies having more than $5 billion in shares held by the public required to file using XBRL starting with their June 2009 quarterly reports. A further 1,800 other large filers will be required to file in XBRL in June 2010, and all other publicly traded companies and foreign private issuers will be required to comply starting in June 2011.
XBRL US released its 2009 US GAAP Taxonomy for XBRL in April this year.
Friday, May 8, 2009
Public Companies Oppose IFRS Roadmap
Below is from a blog at the Controllers’ Leadership Council by Joey Borson
The comment period for the SEC’s proposed IFRS roadmap closed two weeks ago, and Controllers’ Leadership Roundtable analysis shows respondents remain divided on whether IFRS should be adopted in the United States. 44% of comment writers broadly support the Roadmap’s view of IFRS conversion while 38% support convergence between IFRS and US GAAP without formal adoption of IFRS; 18% did not clearly express an opinion on whether IFRS should be adopted in the United States.
Roadmap opinion cleaves along predictable lines. Companies currently applying multiple accounting standards internationally tend to support IFRS, while those only on US GAAP see no real benefit to the transition. As a result, large, global companies generally support IFRS conversion, while smaller, domestically focused companies oppose IFRS adoption in favor of a more gradual convergence between IFRS and US GAAP.
The average revenue of companies that generally support IFRS adoption via the Roadmap is $52.52 billion. The average revenue of companies supporting convergence without IFRS adoption is $18.13 billion.
Overall, more public companies opposed the Roadmap than supported it, 57% to 43%.
The industries most supportive of the Roadmap were: health care companies (67%); energy companies (60%); information technology (56%); and financial companies (56%).
The industries least supportive of the Roadmap were: utilities (none); consumer discretionary companies (17%); consumer staples companies (25%); telecommunication companies (33%) and industrial companies (38%).
Accounting firms and professional organizations (e.g. accounting associations) supported the Roadmap (89% and 86% respectively) while trade groups were less enthusiastic with only 40% supporting.
Proposed Roadmap Changes:
Even those who generally support the Roadmap are critical of some of its provisions.
Set an IFRS ‘Date Certain’: The current Roadmap does not provide a clear IFRS adoption date. Instead, it sets a series of milestones, and commits the SEC to make a final adoption decision sometime in 2011. This is too late for companies who plan to adopt in 2014, as the lead-time for a responsible IFRS adoption requires at least three to four years of planning, and companies are unwilling to spend significant resources on preparation without a firm SEC commitment to IFRS. 56% of all respondents (including those who did not support the Roadmap) called for the SEC to set a clear ‘date certain’ for IFRS adoption in the US.
Reduce Comparative GAAP Requirements: The Roadmap requires US companies to provide three years of comparative US GAAP numbers before switching exclusively to IFRS. This is several years longer than required by European and Canadian companies, and will create significant technology costs. Instead, 32% of respondents call on the SEC to reduce this requirement to only one or two years.
Broaden Early Adoption Criteria: Currently, only very large companies in a limited subset of industries would be permitted to early-adopt IFRS. Other companies would like the opportunity to early-adopt, especially those who have foreign parents or significant overseas operations already using IFRS. 27% of respondents call on the SEC to expand early adoption eligibility.
In addition, 10% of respondents asked the SEC to place a moratorium on future accounting changes for a year or two before IFRS adoption. This would prevent companies from navigating changes to US GAAP while attempting to adopt IFRS. 10% of respondents also called for the SEC to increase safe harbor provisions for forward looking information in financial statements, thus limiting company’s legal liabilities when reporting future managerial assumptions.
IFRS Concerns: There are a series of frequent complaints about transitioning to IFRS:
Cost Concerns: By all accounts, transitioning to IFRS is costly. Roundtable research indicates that it will be at least as expensive as Sarbanes-Oxley implementation, and other companies fear it may be far more. 39% of respondents are concerned about the high costs of implementation, especially in the economic environment, with most fearing that the potential benefits will not equal the almost certain costs.
Specific IFRS Standards: 38% of respondents dislike existing IFRS standards. They either fear the consequences of existing standards (IFRS does not allow LIFO inventory accounting, which will cause the tax bills of many companies to increase) or because specific topics that are relevant to them are not well developed in IFRS (included Rate Regulated accounting, government contracting, and investment and insurance accounting).
Principles Based Accounting: IFRS is more ‘principles-based’ than US GAAP, with less detailed guidance and specific rules. This concerns 34% of respondents, who fear that it will lead to IFRS being applied differently by different companies, thus hindering financial statement comparability.
Other concerns include the current IASB governance structure (33%); the capability of other regulatory authorities (including the IRS, SEC, and state agencies) to deal with IFRS (19%); training issues (15%); and a view that IFRS was not necessary in the US (8%).
This survey includes 146 comment letters published on the SEC’s website. Only respondents speaking in an official capacity were included.
The comment period for the SEC’s proposed IFRS roadmap closed two weeks ago, and Controllers’ Leadership Roundtable analysis shows respondents remain divided on whether IFRS should be adopted in the United States. 44% of comment writers broadly support the Roadmap’s view of IFRS conversion while 38% support convergence between IFRS and US GAAP without formal adoption of IFRS; 18% did not clearly express an opinion on whether IFRS should be adopted in the United States.
Roadmap opinion cleaves along predictable lines. Companies currently applying multiple accounting standards internationally tend to support IFRS, while those only on US GAAP see no real benefit to the transition. As a result, large, global companies generally support IFRS conversion, while smaller, domestically focused companies oppose IFRS adoption in favor of a more gradual convergence between IFRS and US GAAP.
The average revenue of companies that generally support IFRS adoption via the Roadmap is $52.52 billion. The average revenue of companies supporting convergence without IFRS adoption is $18.13 billion.
Overall, more public companies opposed the Roadmap than supported it, 57% to 43%.
The industries most supportive of the Roadmap were: health care companies (67%); energy companies (60%); information technology (56%); and financial companies (56%).
The industries least supportive of the Roadmap were: utilities (none); consumer discretionary companies (17%); consumer staples companies (25%); telecommunication companies (33%) and industrial companies (38%).
Accounting firms and professional organizations (e.g. accounting associations) supported the Roadmap (89% and 86% respectively) while trade groups were less enthusiastic with only 40% supporting.
Proposed Roadmap Changes:
Even those who generally support the Roadmap are critical of some of its provisions.
Set an IFRS ‘Date Certain’: The current Roadmap does not provide a clear IFRS adoption date. Instead, it sets a series of milestones, and commits the SEC to make a final adoption decision sometime in 2011. This is too late for companies who plan to adopt in 2014, as the lead-time for a responsible IFRS adoption requires at least three to four years of planning, and companies are unwilling to spend significant resources on preparation without a firm SEC commitment to IFRS. 56% of all respondents (including those who did not support the Roadmap) called for the SEC to set a clear ‘date certain’ for IFRS adoption in the US.
Reduce Comparative GAAP Requirements: The Roadmap requires US companies to provide three years of comparative US GAAP numbers before switching exclusively to IFRS. This is several years longer than required by European and Canadian companies, and will create significant technology costs. Instead, 32% of respondents call on the SEC to reduce this requirement to only one or two years.
Broaden Early Adoption Criteria: Currently, only very large companies in a limited subset of industries would be permitted to early-adopt IFRS. Other companies would like the opportunity to early-adopt, especially those who have foreign parents or significant overseas operations already using IFRS. 27% of respondents call on the SEC to expand early adoption eligibility.
In addition, 10% of respondents asked the SEC to place a moratorium on future accounting changes for a year or two before IFRS adoption. This would prevent companies from navigating changes to US GAAP while attempting to adopt IFRS. 10% of respondents also called for the SEC to increase safe harbor provisions for forward looking information in financial statements, thus limiting company’s legal liabilities when reporting future managerial assumptions.
IFRS Concerns: There are a series of frequent complaints about transitioning to IFRS:
Cost Concerns: By all accounts, transitioning to IFRS is costly. Roundtable research indicates that it will be at least as expensive as Sarbanes-Oxley implementation, and other companies fear it may be far more. 39% of respondents are concerned about the high costs of implementation, especially in the economic environment, with most fearing that the potential benefits will not equal the almost certain costs.
Specific IFRS Standards: 38% of respondents dislike existing IFRS standards. They either fear the consequences of existing standards (IFRS does not allow LIFO inventory accounting, which will cause the tax bills of many companies to increase) or because specific topics that are relevant to them are not well developed in IFRS (included Rate Regulated accounting, government contracting, and investment and insurance accounting).
Principles Based Accounting: IFRS is more ‘principles-based’ than US GAAP, with less detailed guidance and specific rules. This concerns 34% of respondents, who fear that it will lead to IFRS being applied differently by different companies, thus hindering financial statement comparability.
Other concerns include the current IASB governance structure (33%); the capability of other regulatory authorities (including the IRS, SEC, and state agencies) to deal with IFRS (19%); training issues (15%); and a view that IFRS was not necessary in the US (8%).
This survey includes 146 comment letters published on the SEC’s website. Only respondents speaking in an official capacity were included.
Check out the amazing Controllers' Leadership Roundtable .
Thursday, May 7, 2009
Holes in Krispy Kreme's Accounting
n March 4 this year, the SEC settled administrative charges against Krispy Kreme Doughnuts, Inc. the U.S. doughnut retailer. During 2003 and 2004, the SEC claimed that Krispy Kreme improperly accounted for its executive bonus plan in order to report earnings at, or one cent above, its earnings guidance. Krispy Kreme, without admitting or denying the SEC’s charges, agreed to cease-and-desist from future violations of provisions of the federal securities laws.
Bonuses were contingent upon Krispy Kreme meeting or exceeding goals for return on assets and a percentage increase in EPS.
The SEC stated that Krispy Kreme operated its bonus plan “as a de facto reserve accounting mechanism.” Rather than accruing bonuses during the year based on projected annual EPS, the SEC alleged that Krispy Kreme accrued bonus amounts equivalent to any profits over one cent above its EPS guidance in weak quarters, and in weak quarters, reversed previous accruals to meets its quarterly EPS guidance plus one cent, and accordingly trigger bonuses.
The SEC settled actions with four former Krispy Kreme executives, including the former Chairman, President and CEO, COO, CFO, and Senior Vice President of Finance. Without admitting or denying the SEC’s charges, their individual settlements included disgorgement of bonuses and fines suspensions from SEC practice.
Bonuses were contingent upon Krispy Kreme meeting or exceeding goals for return on assets and a percentage increase in EPS.
The SEC stated that Krispy Kreme operated its bonus plan “as a de facto reserve accounting mechanism.” Rather than accruing bonuses during the year based on projected annual EPS, the SEC alleged that Krispy Kreme accrued bonus amounts equivalent to any profits over one cent above its EPS guidance in weak quarters, and in weak quarters, reversed previous accruals to meets its quarterly EPS guidance plus one cent, and accordingly trigger bonuses.
The SEC settled actions with four former Krispy Kreme executives, including the former Chairman, President and CEO, COO, CFO, and Senior Vice President of Finance. Without admitting or denying the SEC’s charges, their individual settlements included disgorgement of bonuses and fines suspensions from SEC practice.
IFRS Hot Topics
I subscribe to an email news service called IFRS Report, from the AICPA. A few stories I'm following there:
Herz: Full convergence shouldn't delay U.S. adoption of IFRS
Financial Accounting Standards Board Chairman Robert Herz said on April 30 that a lack of complete convergence should not stop the U.S. from adopting international accounting standards in the next three to five years. "Most people seem to be arguing [for] continued convergence until the two sets of standards get identical. I think trying to get every [nook] and cranny, particularly all the nooks and crannies of U.S. GAAP, could take quite a long period of time," Herz said. Reuters
Off-balance-sheet items next task for standards setters
Now that the controversy surrounding fair-value accounting rules is fading, accounting's standards-setting bodies are getting ready to deal with off-balance-sheet issues and loan-loss provisions, says James Kroeker, the Securities and Exchange Commission's acting chief accountant. When the International Accounting Standards Board and the Financial Accounting Standards Board release their new guidance on these issues in June, they will bring about major changes in financial reporting, he said. CFO.com , Bloomberg
IASB insider opposes hastily changing accounting rules
Tom Jones of the International Accounting Standards Board says making quick changes to fair-value accounting rules will not fool investors. "You can't expect to have an independent standard setter that you expect to jump every time someone has a good idea, to cook the books to make things easier," said Jones, a board member of the IASB. "To try to blame accounting is the old story, it's blaming the thermometer for the high fever. Accounting just tells you what it's about. If politics drives accounting standards, investors won't have a clue what real life is about." Reuters
IASB official calls idea behind easing of fair-value rules "crazy"Tom Jones, vice chairman of the International Accounting Standards Board, said the decision to loosen fair-value accounting rules hurts global investors and makes corporate reporting less credible. Jones' criticism follows a move by the Financial Accounting Standards Board to issue additional guidance that provides more flexibility in determining fair market value. Financial Post (Canada)
You can subscribe to the report here.
Herz: Full convergence shouldn't delay U.S. adoption of IFRS
Financial Accounting Standards Board Chairman Robert Herz said on April 30 that a lack of complete convergence should not stop the U.S. from adopting international accounting standards in the next three to five years. "Most people seem to be arguing [for] continued convergence until the two sets of standards get identical. I think trying to get every [nook] and cranny, particularly all the nooks and crannies of U.S. GAAP, could take quite a long period of time," Herz said. Reuters
Off-balance-sheet items next task for standards setters
Now that the controversy surrounding fair-value accounting rules is fading, accounting's standards-setting bodies are getting ready to deal with off-balance-sheet issues and loan-loss provisions, says James Kroeker, the Securities and Exchange Commission's acting chief accountant. When the International Accounting Standards Board and the Financial Accounting Standards Board release their new guidance on these issues in June, they will bring about major changes in financial reporting, he said. CFO.com , Bloomberg
IASB insider opposes hastily changing accounting rules
Tom Jones of the International Accounting Standards Board says making quick changes to fair-value accounting rules will not fool investors. "You can't expect to have an independent standard setter that you expect to jump every time someone has a good idea, to cook the books to make things easier," said Jones, a board member of the IASB. "To try to blame accounting is the old story, it's blaming the thermometer for the high fever. Accounting just tells you what it's about. If politics drives accounting standards, investors won't have a clue what real life is about." Reuters
IASB official calls idea behind easing of fair-value rules "crazy"Tom Jones, vice chairman of the International Accounting Standards Board, said the decision to loosen fair-value accounting rules hurts global investors and makes corporate reporting less credible. Jones' criticism follows a move by the Financial Accounting Standards Board to issue additional guidance that provides more flexibility in determining fair market value. Financial Post (Canada)
You can subscribe to the report here.
Subscribe to:
Posts (Atom)