Conservatism in valuation for financial reporting – a double-edged sword
Conservatism or prudence is a major building block in financial reporting. Earning and asset value should not be overstated whilst liabilities and expenses should be accounted for in full. This helps guard against potential financial statement manipulation and misrepresentation. Asset valuation, on the other land, is unavoidably judgmental, and conservatism always plays a role. However, the effects of conservatism in valuation are usually multifaceted, and may become unconservative or counter-intuitive, if not self-contradictory. Valuations relating to acquisitions and financial instruments are common areas where conservatism can bring potentially contradictory results.
Purchase price allocation
Upon acquisition, fair values of assets and liabilities, including identifiable intangible assets, are measured and reported in financial statements in accord with HKFRS 3 – Business Combinations. When purchase consideration exceeds the fair values of the assets, the residual amount will become goodwill. This process is known as purchase price allocation (PPA).
According to HKAS 38 – Intangible Assets, goodwill will not be amortised, but subject to impairment testing at least once a year. Fair values of tangible assets and intangible assets with definite lives will be depreciated or amortised according to their remaining economic useful lives.
Income statements in subsequent years will reflect their usage and obsolescence. However, because purchase consideration is usually a fixed amount, and prudence in fair value measurements of assets typically results in values being concluded towards the lower end, future depreciation and amortization expenses are reduced, whilst goodwill carrying amount and associated future impairment risk are increased. In the example below the fair values of identifiable intangible assets (IIA) may range from $300 million to $400 million. By keeping IIA value low, the resulting goodwill amount may increase to $250 million from $150 million. Amortization expense in the coming year may also be booked at $30 million, instead of $40 million, which raises the bottom line from $54 million to $60 million.
Earnout and impairment testing
Earnout is frequently adopted in acquisitions, whereby the selling shareholders provide guarantees on future revenue or profit to the buyers. This helps lower the business risk of the acquirees to the buyers and attract support from the selling shareholders. In case realised profit fall shorts of the guaranteed target, the buyers may claim indemnity from the sellers, or reduce future installments payable of the purchase consideration. An earnout clause will be valued and booked as an indemnification asset or contingent consideration payable at initial recognition and at the end of every financial reporting period, as per HKFRS.
If the target company's earning performance turns bad, the acquirer may claim more indemnity or pay less consideration. Due to its protective nature, valuation of an earnout clause is always inversely related to expected future profit from the acquirees. The lower the expected income, the lower the contingent consideration payable or the higher the indemnification asset value will be.................
Goodwill impairment testing is based on the discounted cash flow (DCF) method, by comparing the recoverable amount (RA) with the carrying amount of the cash generating unit (CGU), or acquiree. When the market environment or business performance of an acquiree turns bad, its earning forecast should be lower than before. Lower RA, if below carrying amount, will result in impairment loss. On the other hand, when business turns adverse and expected earnings drop, the earnout clause would cause a decrease in contingent consideration payable, or an increase in indemnification asset value. Depending on the earnout terms and other factors, impairment loss and fair value change may partly offset each other. But both cannot be conservative at the same time.
A convertible bond (CB) in its simplest form comprises two components, namely host debt and equity conversion. According to HKAS 32 – Financial instruments: Presentation, when a CB is accounted for by the interest amortization method, an effective interest rate will be determined at initial recognition to derive the fair value of the debt component, and the residual amount will be booked as an equity component.
The repayment amount at maturity is a fixed amount as defined in the subscription document. Total interest expense over the life of the CB is equal to redemption amount at maturity less fair value of the debt component at initial recognition, plus any coupon interest payment throughout the period. Hence, the higher the debt amount, the lower the interest expense will become, and vice versa. Under conservatism, should debt or interest expense be under-estimated, if not both?
Borrowing cost is an usual focus in financial analysis. A high enough interest cost is usually assured in measuring the fair value of the debt component in a CB. With a higher interest rate, present value of future debt interest and repayment cashflow and the debt value itself would tend to be lower. Certain types of credit analysis, such as debt/equity ratio, can be affected to the contrary.
In the following example, the credit yield of a CB may be estimated at 5% to 8% per annum, resulting in a debt component value ranging from $169 million to $192 million, with a lower debt component value at the higher discount rate, and vice versa. Using a higher credit yield in CB valuation, results in higher annual interest expense at $13.3 million instead of $9.5 million, and net profit as low as $39 million instead of $42 million as a result. However, analysis of financial leveraging can give a very different picture. By adopting a higher credit yield with a lower debt component value, $169 million in debt and $171 million in total equity are estimated, with a debt/equity ratio of 1.0. But if lower yield and higher debt component values are booked, total debts would reach $192 million and total equity would fall to $148 million, implying a higher 1.3 times debt/equity ratio. By fully providing interest expenses, debt value may be underestimated and equity value may be overstated.
Convertible instruments with private equity as underlying assets
A private unlisted company usually issues different types of equity linked or convertible instruments for their business. Preferred shares (PS) and CB are very common forms of convertible securities. Employee stock option plans (ESOP) are another popular type of incentive scheme for selected staff. Depending on particular terms, both PS and CB may be regarded as compound financial instruments and be booked as financial liabilities accordingly to HKAS 39 – Financial instruments: Recognition and Measurement. ESOP values are accrued as expenses according to vesting period as per HKFRS 2 – Share-based Payment.
The fair values of PS, CB, ESOP, or similar instruments, depend on the values of the underlying assets, that is, the equity values of the issuing companies. When a company is not listed, its value is generally unknown, so a valuation exercise will be needed to determine the value of the underlying equity in order to measure the fair values of the instruments.
When the subject instruments will be booked as liabilities and expenses, how should conservatism by applied to equity valuation? In typical business valuations, the earning forecast, discount rate, etc. are frequently checked to ensure that equity values will not be overstated. However, values of PS, CB and ESOP vary directly with the value of the underlying equity. To ensure that the values of the instruments are fully recognised as expenses or liabilities, the underlying equity values should not be understated, which potentially provides a mechanism for boosting equity value itself. In other words, when the fair value of an equity instrument is measured on the asset side, it should be low enough for to meet conservative expectations. But when the equity value is used for instruments recognized as expenses or liabilities, it should be high enough to meet conservative expectations.
Conservatism is a common concern in accounting and valuation for financial reporting. But, artificially suppressing the values of some assets or instruments may not always produce the most supportable or safest results. Though always depending on judgement, valuation should be based on facts and reasoning, along with the support of objective data. Competent and experienced valuation professionals who understand both financial reporting and valuation aspects know how to keep a balance between the two, to ensure that the valuation result is fair and reasonable, and justifiable, in front of auditors, other professionals, and authorities.
Jack Leung, CFA, FRM