Impairment Testing Procedures and Pitfalls

Transcription

1 Audio Conference Dial-in Number: ; Access Code: Impairment Testing Procedures and Pitfalls November 3, 2009 Presenters: Cory J. Thompson, CFA, CIRA Ryan A. Gandre, CFA Moderator: Jay B. Wachowicz, CFA Investment Banking Valuation & Financial Opinions Dispute Advisory & Forensic Services

2 Disclaimer This presentation is intended for general information purposes only and is not intended to provide, and should not be used in lieu of, financial, accounting, legal, or other professional advice. Stout Risius Ross, Inc. assumes no liability for the use of the information herein and the audience is encouraged to seek professional assistance with regard to specific matters. The opinions expressed in this webcast are solely those of the presenters and do not necessarily reflect the views of Stout Risius Ross, Inc. 2

3 Agenda When to Test for Impairment Overview of Impairment Testing Procedures Key Issues and Pitfalls in Impairment Testing Questions 3

4 When to Test for Impairment FASB ASC Topic , Goodwill Subsequent Measurement (f/k/a SFAS 142) requires that goodwill is tested for impairment at least annually. Certain triggering events (e.g., a sustained reduction in stock price, significant restructuring activities, or the loss of a material customer) may necessitate an impairment review between annual tests Additional examples are outlined in FASB ASC

5 Overview of Impairment Testing Procedures Goodwill is tested for impairment using a two-phase approach: Step 1: Compare the Fair Value of the reporting unit to its carrying amount, which includes goodwill If Fair Value > carrying amount, then goodwill is not considered to be impaired and Step II is not required If Fair Value < carrying amount, there is an indication that goodwill may be impaired and Step II is required Step 2: The implied Fair Value of goodwill is compared to its carrying amount to determine the impairment charge, if any 5

6 Fair Value and Market Participant Assumptions Price received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date Orderly not a distressed transaction Market participant excludes entity-specific synergies Exit price concept Measurement date contemplate all contemporaneous information 6

7 Step I Testing Procedures Overview Calculate the carrying amount of the subject reporting unit Business Enterprise Value = Total Capital Goodwill Net Working Capital Debt Identified Intangibles Fixed Assets Equity Ensure proper asset allocation if multiple reporting unit entity 7

8 Step I Testing Procedures Calculate Carrying Amount Calculation of Carrying Amount In Thousands of U.S. Dollars Balance Sheet Amount 1 Current Assets $ 245,525 2 Property and Equipment 187,750 3 Other Assets [a] 415,950 4 Total Assets $ 849,225 5 Less: Non-Debt Liabilities (127,775) 6 Carrying Value of Subject Reporting Unit $ 721,450 [a] Includes goodw ill and identified intangible assets. 8

9 Step I Testing Procedures Calculate Carrying Amount Before proceeding with Step I for goodwill, the impairment review of all other definite and indefinite lived tangible and intangible assets should be completed with the carrying amounts adjusted to reflect any impairment Definite-Lived Assets Real and personal property Customer relationships Indefinite-Lived Assets Trade names and trademarks In-process research and development that has not been deemed passed beta 9

10 Step I Testing Procedures Estimate the Fair Value of Subject Reporting Unit Valuation Methodologies Three common valuation approaches pursuant to FASB ASC Topic 820, Fair Value Measurements and Disclosures (f/k/a SFAS 157) Income Approach Discounted Cash Flow Method Market Approach Guideline Public Company Method Merger & Acquisition Method Asset / Cost Approach Adjusted Book Value Method 10

11 Step I Testing Procedures Estimate Fair Value Via the Income Approach In Thousands of U.S. Dollars For the Fiscal Year Ending Year 1 Year 2 Year 3 Year 4 Residual 12/31/ /31/ /31/ /31/ /31/2013 Distributable Cash Flows 1 Debt-Free Net Income $ 83,350 $ 88,440 $ 92,460 $ 96,640 $ 107,250 2 Depreciation and Amortization 72,100 74,270 76,490 78,790 75,880 3 Capital Expenditures (82,400) (84,870) (87,420) (90,040) (95,520) 4 Additional Working Capital (9,500) (9,980) (8,380) (8,710) (7,000) 5 Distributable Cash Flows 63,550 67,860 73,150 76,680 80,610 Present Value of Distributable Cash Flows 6 Weighted Average Cost of Capital 14.0% 14.0% 14.0% 14.0% 7 Discount Period Present Value Factor Present Value of Distributable Cash Flows $ 59,520 $ 55,752 $ 52,717 $ 48,475 Enterprise Value Terminal Value 10 Present Value of Distributable Cash Flows (Through 2012) 216,463 Residual Cash Flow $ 80, Present Value of Residual Cash Flows 463, Enterprise Value 679,728 Weighted Average Cost of Capital 14.0% 12 Less: Residual Growth Rate -3.0% Rounded $ 679,700 Capitalization Rate 11.0% 14 Residual Cash Flow Value 732, Present Value Factor PV of Residual Cash Flows $ 463,

12 Step I Testing Procedures Estimate Fair Value Via the Market Approach In Thousands of U.S. Dollars Range of Indicated Multiples Selected Subject Reporting Indicated Measure of Performance Minimum Median Maximum Multiples Unit Results Enterprise Value 1 EV / LTM EBITDA 4.2x 5.0x 7.3x 4.5x $ 168,700 $ 759,200 2 EV / 2009 EBITDA 3.8x 4.8x 6.8x 4.0x 175, ,800 3 EV / 2010 EBITDA 3.5x 4.4x 6.5x 3.5x 183, ,000 4 Concluded Enterprise Value $ 701,300 12

13 Step I Testing Procedures Reconciliation of Fair Value and Indication of Impairment Reconciliation and Indication of Impairment In Thousands of U.S. Dollars Fair Value Discounted Cash Flow Method $ 679,700 Guideline Public Company Method 701,300 Indicated Enterprise Value $ 690,500 Add: Cash and Cash Equivalents 5,650 Add: Nonoperating Assets 1,500 Total Adjustments to Enterprise Value 7,150 Indicated Adjusted Enterprise Value $ 697,650 Carrying Value of Subject Reporting Unit $ 721,450 Indication of Impairment Impaired 13

14 Step II Testing Procedures Overview Compares Fair Value of goodwill with the carrying amount of goodwill Implied Fair Value of goodwill is determined in the same manner as in a business combination (residual approach) Assign the Fair Value of the reporting unit (determined in Step I) to all of its assets and liabilities including any unrecognized intangibles as if the reporting unit had been acquired in a business combination 14

15 Step II Testing Procedures Key Considerations Measure all assets and liabilities at Fair Value to derive implied Fair Value of goodwill Real and personal property Inventory Deferred revenue Favorable / unfavorable leasehold interests Identifiable intangibles (including unrecognized intangibles) Contingent consideration liabilities Impairment loss = amount by which the Fair Value of goodwill < the carrying amount Don t forget to re-compute deferred taxes upon a Step II goodwill impairment to calculate the final goodwill write-off 15

16 Key Issues and Pitfalls in Impairment Testing Market Participant Assumptions Supportability of growth rates, capital expenditures, and margins Not necessarily representative of what you think you can do with the business, but rather what another market participant would achieve. Is the most likely market participant a financial or strategic buyer? Coordination of financial forecasts between international operations, accounting, and Board expectations 16

17 Key Issues and Pitfalls in Impairment Testing Multiple Reporting Units What is a reporting unit? Support and documentation of corporate overhead & asset / liability allocation to multiple reporting units Fair Value inter-company pricing Reconciliation of the sum of all reporting units to public market capitalization with support for material difference 17

18 Key Issues and Pitfalls in Impairment Testing Reconciliation to Public Market Capitalization May need to value reporting units that do not maintain goodwill for reconciliation purposes Use of Fair Value versus book/par value for interestbearing debt If debt includes change-in-control provision that requires accelerated payment, par value may be more appropriate If the debt could be repurchased at Fair Value prior to hypothetical acquisition of the controlling interest OR if the debt could be transferred in a control transaction, Fair Value may be more appropriate This should also be a consideration in deriving multiples via the Guideline Public Company Method 18

19 Key Issues and Pitfalls in Impairment Testing Reconciliation to Public Market Capitalization Reasons for differences in calculated Fair Value vs. market capitalization Control Premium Ability of a controlling shareholder to benefit from synergies and other intangible benefits that arise from control Liquidity Factors Non-public Information Available at the measurement date but not yet disclosed or reflected in the market until after the measurement date 19

20 Key Issues and Pitfalls in Impairment Testing Control Premium Two applications of a control premium or discount Market capitalization reconciliation Apply the control premium to the share trading price Adjusting DCF or pricing multiple approach (e.g., GPCM or M&A method) Apply the control premium or discount to the value resulting from the valuation approach 20

21 Key Issues and Pitfalls in Impairment Testing Control Premium Levels of Value Traditional View Expanded View Control Premium Control Value Marketable Minority Minority Interest Discount Marketability Discount Nonmarketable Minority Strategic Control Premium Strategic Control Value Financial Control Value Financial Control Premium Marketable Minority Marketability Discount Minority Interest Discount Nonmarketable Minority Public Equivalent Value Fin. Control and Mkt. Minority may Converge 21

22 Key Issues and Pitfalls in Impairment Testing Control Premium The value of a control premium is not in control itself, but rather in the buyer s unique ability to generate higher cash flows Financial Control Benefits Change Suboptimal Management Day-to-Day Control Acquire or liquidate assets Optimal capital structure Management compensation Unequal Treatment Economic benefits Timing of distributions Limited access to information Strategic Control Benefits Reduction in Competition Revenue / Profit Supercharge Cost Savings / Economies of Scale 22

23 Key Issues and Pitfalls in Impairment Testing Control Premium Market Cap. Reconciliation 23 Why is this reasonable? What benefits will the control buyer realize?

24 24 Key Issues and Pitfalls in Impairment Testing Control Premium No bright line rules or safe harbors Rules of thumb are not adequate Measures the extent to which market participants would pay to gain control over the equity Typically not an Enterprise Value premium since control premium studies calculate the premium on an equity basis Applicability is specific to each entity / reporting unit Inappropriate to blindly apply aggregate premium from Mergerstat studies at minimum, need to investigate recent premiums in the subject company s industry. Opportunities for financial control benefits may be limited for industry leaders. This limits the applicable control premium.

25 25 Key Issues and Pitfalls in Impairment Testing Substantiation of Discount Rate Selection Cost of Debt Capital structure should reflect market participant levels Public comparables actual debt leverage may not be attainable in this market (use longer term results) NOLs can result in a lower applicable tax rate when computing the after-tax cost of debt Required Return on Equity Betas appropriate comparables and levering / relevering Lower Treasury yields + static equity risk premium = lower return on equity But, increased systematic risk in the current market environment Additional Market Risk Premium Accounts for low risk-free rate and increased systematic risk

26 Key Issues and Pitfalls in Impairment Testing Substantiation of Discount Rate Selection Additional Market Risk Premium 10-year BBB spread to U.S. Treasury = 1.91% (median) 12/31/2008 = 5.55% (3.64% higher) 9/30/2009 = 2.70% (0.79% higher) Interest Rate Spread Analysis 20-Year U.S. Treasury vs. BBB Composite Yield 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% Spread % 0.0% U.S. Treasury BBB Composite Spread Med. Spread Source: Bloomberg L.P.

27 27 Key Issues and Pitfalls in Impairment Testing Deferred Income Tax Considerations FASB ASC & (f/k/a EITF 02-13) When measuring a reporting unit s Fair Value, must determine if it would be sold in an asset (taxable) or stock (nontaxable) transaction. In general, must consider: Consistency with market participant assumptions Feasibility of the assumed structure Whether the assumed structure results in the highest economic value to the seller, including consideration of related tax implications When considering feasibility of nontaxable transaction, must consider: Whether the reporting unit could be sold in a stock transaction Whether there are any income tax laws or other corporate governance requirements that could limit the ability to sell the unit in a stock deal

28 Key Issues and Pitfalls in Impairment Testing Deferred Income Tax Considerations Attribute Tax Basis of Assets Asset (Taxable) Transaction Step-up basis (lower future taxes for buyer) Stock (Nontaxable) Transaction Carryover basis (higher future taxes for buyer) [a] NOLs and Tax Credits Not transferrable Transferrable (subject to IRC Sec. 382 limitations) Critical Contracts (Leases, Debts, etc.) Require consent for transfer May require consent for transfer if CIC provisions Corporate Liabilities Excluded from transaction Remains with corporation Structure Preference Buyer Seller 28 [a] A step-up in basis can also be achieved through a 338(h)(10) election

29 Key Issues and Pitfalls in Impairment Testing Deferred Income Tax Considerations If both a taxable and nontaxable sale are feasible, FASB ASC through explains how to measure which transaction structure results in the greatest economic value to the seller Deferred income taxes must be included in the carrying value of a reporting unit, regardless of whether the Fair Value is determined assuming an asset (taxable) vs. stock (nontaxable sale) 29

30 30 Key Issues and Pitfalls in Impairment Testing Recent PCAOB Notes October 14-15, 2009 Meeting on Auditing Fair Value Measurements and Using the Work of a Specialist It is a fundamental requirement that the auditor obtain sufficient competent audit evidence to provide reasonable assurance that Fair Value measurements and disclosures are in conformity with the applicable accounting principles. Auditors need to exercise sufficient professional skepticism when performing audit procedures and evaluating Fair Value measurements and other accounting estimates. The need for professionals with specialized skills or knowledge has increased in response to the challenges of auditing certain Fair Value measurements. Discussion question: Should there be a requirement for the auditor to presume that a Fair Value measurement with a high degree of measurement uncertainty is a fraud risk?

31 SEC Commentary Recent Comment Letter Topics New areas of focus noted in comment letters from the SEC regarding future disclosures: A qualitative and quantitative discussion of material assumptions. Sensitivity analyses of material assumptions based upon reasonably likely changes. How the assumptions and methodologies used for valuing goodwill have changed over time. A qualitative and quantitative discussion of any reporting units that are at risk for impairment. Quantitative information regarding any significant known trends. Any material and useful information that you gather and analyze regarding the risks of recoverability of your assets. 31

32 32 Questions

33 Overview of SRR Jay B. Wachowicz, CFA Cory J. Thompson, CFA, CIRA Ryan A. Gandre, CFA