Concise guide to managing business valuation risk€¦ · Concise guide to managing business valuation risk Chartered Accountants in both business and practice are acutely aware of

Concise guide to managing business valuation risk

ABN 50 084 642 571 The Institute of Chartered Accountants in Australia Incorporated in Australia Members’ Liability Limited. 0711-15ABN 52-780-433-757 PricewaterhouseCoopers

DisclaimerThis guide presents the opinions and comments of the author and not necessarily those of the Institute of Chartered Accountants in Australia (the Institute), PwC or its members. The contents are for general information only. They are not intended as professional advice – for that you should consult a Chartered Accountant or other suitably qualified professional. The Institute and PwC expressly disclaim all liability for any loss or damage arising from reliance upon any information contained in this guide.

The Institute of Chartered Accountants in Australia (the Institute) is the professional body representing Chartered Accountants in Australia. Our reach extends to around 70,000 of today’s and tomorrow’s business leaders, representing more than 57,000 Chartered Accountants and 13,000 of Australia’s best accounting graduates currently enrolled in our world-class Chartered Accountants postgraduate program.

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© 2011 PricewaterhouseCoopers Australia. All rights reserved. In this document, ‘PwC’ refers to PricewaterhouseCoopers Australia, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.

All information is current as at July 2011

First published August 2011

Published by: The Institute of Chartered Accountants in Australia Address: 33 Erskine Street, Sydney NSW 2000

PricewaterhouseCoopers Address: 201 Sussex Street, Sydney NSW 1171


ISBN: 978-1-921245-87-9

Copyright © The Institute of Chartered Accountants in Australia and PricewaterhouseCoopers 2011. All rights reserved.

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Foreword . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

A message from the President . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6

Purpose and context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7

Assessing the exposure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9

Evaluating your expertise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Exercising appropriate due diligence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

Contents

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Over the last five years, there have been many changes to financial reporting standards, tax legislation, mergers and acquisition practice and risk management governance that have increased corporate exposure to valuation risk. The risk is at a level that would have been almost inconceivable only a few years ago, and some might now find the exposure to the risk uncomfortable. This exposure poses new and interesting challenges for the average board member. A well informed director will meet this challenge head on by:

> Mapping out the sources of risk

> Outlining the skills required to defray the risks and addressing any skill gaps

> Asking key questions around business value, and setting up dedicated controls to deal with this emerging category of risk.

In light of valuation being a fundamental skill risk and a challenging aspect of today’s corporate landscape, the Institute of Chartered Accountants in Australia developed this thought leadership initiative entitled, Concise guide to managing business valuation risk. The guide is primarily for company directors, but may also be helpful for senior officers in their dealings with the board.

I trust that you will find this guide useful and practical in managing valuation risks.

Richard Stewart FCAChairman, Business Valuation Special Interest Group The Institute of Chartered Accountants in Australia

Foreword


Chartered Accountants in both business and practice are acutely aware of the sweeping effect of recent changes in accounting standards and regulation and the effect these have had on their traditional roles. However, many may not have noticed some of the new skills that they will need. Business valuation, a skill previously regarded as peripheral to the core skill-set of many Chartered Accountants, is now front and centre.

The Institute of Chartered Accountants in Australia (the Institute) recognises the level of education required to adopt business valuation processes and some of the issues that are outstanding in relation to this practice. Members have access to regular training and development, and a separate community has been established to support this specialised group – the Business Valuation Special Interest Group (BVSIG). To find out more on training and resources available to members or to join our group, I urge you to visit charteredaccountants.com.au/sigs.

To support our members, the Institute has developed this thought leadership initiative, Concise guide to managing business valuation risk, the fourth in a series designed to assist directors and senior officers in particular. I trust you will find this guide useful and practical.

Rachel Grimes President The Institute of Chartered Accountants in Australia

A message from the President

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Purpose and context

The purpose of this guide is to provide information regarding valuation risks that, if not properly mitigated, can harm Australian organisations and their operations around the world. The aim of this guide is to assist directors to:

1. Assess the board’s exposure to valuation risk

2. Evaluate the board’s expertise to deal with valuation issues

3. Exercise appropriate due diligence when addressing questions around valuation risk.

Assessing the exposureDirectors’ exposure to valuation risk arises from three areas:

> Evolving legislation: over the last five years, new regulation has increased the exposure of directors to valuation risk across tax, accounting, mergers and acquisitions and other areas. In substance, this now means that directors’ risk not only relates to an accurate rendering of the past, but a reasonable estimate of the future.

> Changing corporate balance sheets: Approximately one third of the average corporate balance sheet is now made up of some of the riskiest and hardest to value assets – intangible assets and goodwill.

> Increasing volatility of financial markets: In some sectors, asset price volatility has increased almost threefold since 2001. This means that decisions that seem right today may be very wrong when viewed tomorrow.

Evaluating your expertiseValuation risks pervade almost every aspect of corporate thinking, and focus the mind on how each aspect affects the directors’ ultimate responsibility as custodians of shareholder value. This creates reputational risk for directors on top of their statutory due diligence obligations.

In dealing with questions of valuation risk, directors need to consider the following key issues:

> What are the skills we need around the board table?

> Which board members will we rely on to have the right expertise to address these issues?


> What key points do all board members need to be across?

> How do we manage our due diligence exposure on these?

> When should we call in an expert to help manage the board’s exposure?

Exercise appropriate due diligence Regardless of how well risks are identified and analysed, without adequate and effective due diligence, companies will remain vulnerable to valuation risks. Hence, directors may wish to explore the areas of risk listed below when exercising due diligence.

These include:

> Organisation and governance around valuation questions

> Culture and behaviour in dealing with valuation issues

> Valuation techniques and processes

> Supporting infrastructure requirements for recurring valuation processes.

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Assessing the exposure

Directors have always been rightly perceived as the custodians of shareholder value. In the last five years several dramatic events have occurred in the financial world that have called for directors to become more proficient in issues of valuation. Three areas in which directors’ exposure to valuation risk have arisen are set out below.

Evolving accounting and tax regulationDirectors are required to form an annual view on the financial statements and therefore be cognisant of recent changes to the way mergers and acquisitions are recorded, the increasing use of fair value for financial instruments, ensuring intangibles are not over-valued in the financial statements and the determination of fair values of share-based payments.

A timeline of selected events is shown below:

The introduction of tax consolidation by the Australian Government, which entrenched market valuations at the centre of tax valuation methods, tax loss utilisation, achievement of tax deductions and capital gains tax levies.

The Global Financial Crisis (GFC) saw the failure of a number of notable US investment banks. Many blamed fair value accounting for the lack of confidence in the market. Superannuation funds were hit hard and directors got nervous about the carrying value of recently acquired assets.

Smaller companies became exposed to takeovers, particularly those trading at substantial discounts and with little capital behind them. Some rejected advances, often at a personal cost, and some toughed it out for a better offer. Many however, acquiesced, in order to avoid the risk of a long and protracted fight.

The introduction of international financial reporting standards meant that Directors faced a much more difficult fair value test when forming views on asset carrying values. They were also required to deal with issues regarding financial instruments, which also required fair values.

In 2008, International Accounting Standards Board (IASB) published amendments to IAS 39 Financial Instruments: Recognition and Measurement. The changes to IAS 39 permit reclassification of certain non-derivative financial assets. All reclassifications must be made at the fair value of the financial asset at the date of reclassification. Any previously recognised gains or losses cannot be reversed. The fair value at the date of reclassification becomes the new cost or amortised cost of the financial asset, as applicable.

Banks began to raise capital in record proportions.

2004 2005 2006 2007 20092008 2010


Even as late as this year, proposed Mineral and Petroleum Resources rent taxes will rely on market values for the determination of key tax outcomes.

The increasing exposure in financial statements and tax returns to business valuation judgements changes directors’ responsibilities in a profound manner. These responsibilities essentially have moved from a faithful recording of the past (as has been the case since the time Pacioli first invented modern accounting) to the reasonableness of their estimates (as encompasses in the numerous business valuations required) of the future.

Changing corporate balance sheetsDuring the economic boom of the late 2000’s, a number of transactions were undertaken, often at historically high prices. Consequentially, a large amount of goodwill was recorded on the balance sheet of many acquirers.

For this reason, as well as the increasing focus on non-tangible components of strategic advantage, intangible assets have increasingly made up a significant part of the value of all Australian industry sectors over the last ten years. Chart 1 shows the percentage increase in goodwill and intangible assets from 2001 to 2010 and chart 2 provides a breakdown of the net assets of ASX200 companies as at 31 December 2010.

Chart 1: Percentage increase in goodwill and intangible assets from 2001 to 2010

Consumer discretionary

Consumer staples

Energy

Healthcare

Industrials

Information technology

Materials

Utilities

%1400

1200

1000

800

600

400

200

0

Source: Capital IQ

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On the other hand, there have been a number of distressed acquisitions in the aftermath of the GFC as companies were focusing on maintaining liquidity and managing funding. As a result, many companies recorded a write down of goodwill and assets as market values of companies and assets declined dramatically.

Tangible Assets

2/3

Goodwill1/6

Intangible Assets

1/6

Source: Capital IQ

Chart 2: Breakdown of net assets of ASX 200 companies


Increasing financial market volatilityChart 3 below shows the asset price volatility by ASX 200 industry sector over the last ten years.

As can be clearly seen, asset price volatility in some sectors has increased almost threefold since 2001. This means that viewing value as a stable and relatively unchanging number over time, has now become a dangerously outdated assumptions.

This increases directors’ exposure to hindsight observations in respect of their business valuation judgements.

AUD

20,000

15,000

10,000

5,000

0

Source: Capital IQ

Materials

Industrials

Telecommunication services

Information technology

Healthcare

Energy

Financials

Consumer discretionary

Consumer staples

Utilities

4/01 9/01 2/02 7/02 12/02 5/03 10/03 4/04 8/04 1/05 6/05 11/05 4/06 9/06 2/07 7/07 12/07 5/08 10/08 3/09 8/09 1/10 6/10 11/10

Chart 3: Asset price volatility

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Where are questions of value an issue?In our view, value pervades all aspects of an organisation. Hence, it is critical for directors to be able to fully analyse and communicate the value implications of major decisions. To illustrate this pervasiveness, we have highlighted some of the questions that arise for directors that rely on an understanding of valuation principles:

Area Question

Value and strategy

> Can we link strategic decisions and options to value (shareholder return) outcomes and ongoing performance benchmarking?

> Do we understand the value impacts of growth options? > Have we leveraged our intellectual property and brand?

Value and risk > Do we understand the relationship between value and risk? > Do we have the capability to model cash flow and value at risk?

Capital allocation decisions

> What capital structure is appropriate for our company? > What hurdle rate do we apply for our investments? > How do we manage our portfolio across activities?

Mergers and acquisition decisions

> How do we negotiate a correct price for mergers and acquisition?

> How do we evaluate potential transactions?

Capital investment analysis

> What valuation techniques should we adopt for investment evaluation?

> Do we have the capability to assess potential new projects and analyse divestment of underperforming assets?

Value reporting > How do investors value our company? > What relevant information can we provide to the investors to assist them in their decision-making?

Continued overleaf >


Area Question

Taxation > How much of our tax bill depends on valuation judgments? > How do we manage the stamp duty exposure of our company?

> How do we manage the capital gains tax exposure of our company?

> Have we optimised tax consolidation decisions through valuations?

Financial reporting

> How much do our financial statements depend on business valuation judgments?

> Do we understand the implications of financial instrument fair values (mark to market accounting)?

> Do we understand the accounting implications of allocating purchase price over assets and asset impairment testing, including carrying value of intangible assets and goodwill?

> Do we know the disclosures (e.g. valuation policies) required for financial reporting purposes?

Legal disputes > Do we have the capability to value the impact of disputes with key stakeholders, such as suppliers, customers or shareholders?

Contractual obligations

> How do we assess major contractual arrangements which are based on value sharing principles?

Remuneration of key executives and directors

> How do we value existing option plans? > Have we ensured the effectiveness of the plans to align management and employee interests?

> What valuation techniques do we adopt to measure remuneration?

Regulatory regimes

> How do we assess pricing and return on capital? > How should we value capital employed?

Minimum standards of careClearly the pervasiveness of valuation issues creates a reputational risk for directors. However, on top of this, there are some legislative risks also.

According to the Corporations Act 2001, directors and other officers must demonstrate minimum standards of care and diligence as described in Section 180 of the Act, as follows:

Section 180 Care and diligence – civil obligation onlyCare and diligence – directors and other officers(1) A director or other officer of a corporation must exercise their powers and discharge

their duties with the degree of care and diligence that a reasonable person would exercise if they:(a) were a director or officer of a corporation in the corporation’s circumstances; and(b) occupied the office held by, and had the same responsibilities within

the corporation as, the director or officer

Meeting the minimum standards of care requires that directors:

> Be familiar with fundamental operations of the business

> Keep informed about the company’s activities

> Monitor the company’s affairs

> Maintain familiarity with the financial status of the company by appropriate means such as active review of company’s financial statements and board papers and to make further enquiries into matters revealed by those documents

> Be reasonably informed of the company’s financial capacity and understanding of key financial information and be able to apply it to the management’s decision making

> Seek qualified experts, if necessary; although directors need to exercise discretion and judgment when relying on such expert’s advice.

In addition to Section 180 of the Act, directors also have an obligation to sign off on accounts and obligations under Section 344.

These minimum standards of care require the director or officer to demonstrate an active review and understanding of the key financial matters. If the director or officer violates his/her fiduciary duties, he/she may be subject to penalties.

As is well known on other issues, if directors take a systematic, informed, commonsense approach to their decision making and do not take on tasks or roles beyond their abilities, they will be on the right track to avoid costs and liabilities.

In respect of valuation issues, just how is that accomplished?


Evaluating your expertise

A complex interrelated set of financial skills and business acumen is involved in business valuation, including:

> Financial forecasting

> Accounting and financial analysis

> Benchmarking and industry analysis

> Capital markets understanding

> Capital structure assessment

> Strategic understanding

> Financial mathematics including quantitative financial economics and derivative pricing

> Legal concepts of value.

> Monte Carlo simulation analysis.

The list presents a fairly broad set of skills. Evaluating your level of expertise can be achieved by asking the following questions.

> Do we know how to value a business or security interest for each stated purpose? There are differences in the basis and levels of value, as well as there being a variety of prescribed techniques and methodologies, all of which depend on the purpose to which the valuation is put. Understanding these differences is crucial to aligning directors’ judgements with the correct framework.

> Do we know what the appropriate valuation methodologies are for the assets we hold?

The three main methodologies are cost, income and market. They are united by the economic law of one price, which states, ‘In an efficient market, all identical goods must have only one price’.

It is vital to be expert across all methodologies as there is often a need to cross check the principal method with at least one alternative.

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> Do we know the difference between economic value and accounting value?Oscar Wilde once wrote, ‘a cynic knows the price of everything and the value of nothing’.

No director can afford to be a cynic, as their views on fundamental value impact their ability to make the right long term decisions for shareholders. However, in many cases, accounting values focus heavily on definitions of value that are almost akin to current price as opposed to fundamental or long term value. Understanding and managing this potential dichotomy tests many professional valuers, and no doubt casual observers of business valuation.

> Do we know the basis (e.g. insurance value, deprival value, fair market value, fair value, and value in use) and levels of value (e.g. controlling interest vs. minority value) and the impact of each? Divergent bases of value are almost incomparable, and can lead to difficulties particularly if applied in a regulatory or dispute scenario.

In addition, differences across the levels of value can be material, so it is of major importance to check the appropriate valuation level.

> Do we have a robust internal view of value as opposed to just relying on our share price as the fundamental benchmark? Without a robust internal view, the company is a hostage to the vagaries of the market or other external views. However, internal views need to test for realism if they do differ from those of the market.

Given the increasing exposure of boards to the outcomes of business valuation, it would be prudent to look around the board table and evaluate where the experience to answer these questions lies.

In addition, directors often set the ‘tone from the top’ in relation to the perceived importance of issues within an organisation. As such, it is important for directors to understand the level of expertise inherent within the organisation in dealing with issues of value and create a culture which is accepting of the relative importance of the issues.

In many cases, it may be worthwhile for directors to consult with qualified experts especially when faced with difficult business valuation issues. If so, assessing the expert’s independence and expertise may be relevant.


Exercising appropriate due diligence

To address the legal and reputation risks around business valuation, directors must continually review the thinking around valuation risks by asking questions, such as:

> Have we reconciled views on value taken in transactions, financial reporting and tax scenarios and can we defend divergent views if they exist?

> Have we sense checked this internal view with external benchmarks and potential transaction scenarios?

> How have we mapped out the key uncertainties around value and understood both normal variation and potential ‘tail risk’ or unexpected events?

> Have we applied the same rigour around valuation risk to our acquisition targets?

> Where are financial statements crucially dependent on opinions of value?

> What is the basis of these opinions?

> Where do major tax outcomes depend on valuations?

On top of asking, and evaluating the response to, these questions, directors need to consider the risk and control environment around business valuation. A possible framework which directors’ can use to evaluate this risk and control environment is as follows:

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Areas Evaluation criteria

Organisation and governance

> What decision making forum explicitly considers valuation risk?

> Who is responsible for the valuation process? > Who reviews the valuations? > Is the person conducting the valuation work sufficiently objective and free from bias?

Culture > What sort of behaviours do we wish to encourage around valuations?– Rigorous or ‘quick and dirty’?– Optimistic or pessimistic?– Self serving or realistic?

Process and technique

> How do your valuation processes compare with your competitors?

> How do you use reliable data in your valuations? > How do you integrate external providers into your valuation?

> How do you cross check your outcomes to minimise the risk of valuation error?

> How do you consider the risk of changes in value, and the consequential impact of those changes e.g. solvency, covenant breaches?

> How do valuation issues get escalated?

Infrastructure > What is the suite of tools that the organisation uses to establish values?

> What standards should be employed? > How should you engage with external advisors?

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GPO Box 2650, DX 77 Sydney NSW 1171

Phone +61 (2) 8266 0000 Fax +61 (2) 8266 9999

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The Institute of Chartered Accountants in Australia

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Concise guide to managing business valuation risk€¦ · Concise guide to managing business valuation risk Chartered Accountants in both business and practice are acutely aware of

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