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9.7.1 Determining the fair value of a reporting unit

The FASB decided not to prescribe how to determine the fair value of a reporting unit. When attributing assets and liabilities to reporting units, entities can use either an equity premise (i.e., total assets net of all liabilities) or an enterprise premise (i.e., total assets net of only operating liabilities) applied consistently period to period. Assigning all liabilities to the reporting unit under the equity premise may result in a negative carrying value.
As illustrated in Example BCG 9-15, the premise used to attribute assets and liabilities to reporting units can impact the amount of goodwill impairment.
EXAMPLE BCG 9-15
Impact of the valuation premise on goodwill impairment
Reporting Unit A has the following recorded assets and liabilities:
Goodwill
$40
Other assets
$60
Operating liabilities
$(20)
Nonrecourse long-term debt
$(60)
View table
The fair value of Reporting Unit A excluding debt is $50. The fair value of Reporting Unit A including debt would likely be determined based on an option pricing model and thus yield a value greater than zero, but for illustration purposes, is assumed to be zero.
What is the impact of selecting the equity or enterprise premise when determining fair value?
Analysis
The goodwill impairment is different under each of the valuation premises. As shown in the table below, while both the equity premise and the enterprise premise result in an impairment, the amounts differ.
Equity premise
Enterprise premise
Carrying amounts
$20 1
$80 2
Fair value
0
50
Goodwill impairment
$20
$30
View table
1 $40 (goodwill) + $60 (Other assets) – $20 (Operating liabilities) – $60 (Long-term debt)
2 $40 (goodwill) + $60 (Other assets) – $20 (Operating liabilities)

9.7.2 Fair value of reporting units assigned goodwill

The fair value of a reporting unit refers to the price that would be received to sell the reporting unit as a whole in an orderly transaction between market participants at the measurement date. Quoted market prices in active markets are the best evidence of fair value and should be used as the basis for fair value measurement, if available. However, ASC 350-20-35-22 provides guidance that the quoted market prices of an individual security may not be representative of the fair value of the reporting unit as a whole. For example, a control premium (i.e., the premium an acquiring entity is willing to pay for a controlling interest versus the amount an investor would be willing to pay for a noncontrolling interest) may cause the fair value of a reporting unit to exceed its market capitalization. However, an entity should not adjust quoted market prices using broad assumptions. For example, it would not be appropriate to assume that a standard percentage for a control premium should be added to quoted market prices. Instead, a control premium should be based on a detailed analysis and should consider such things as industry and market, economic and other factors that market participants typically consider when determining the fair value of the entity.
Question BCG 9-15
What is a reasonable control premium in determining the fair value of a reporting unit?
PwC response
A control premium can vary considerably depending on the nature of the business, industry and other market conditions. Accordingly, determining a reasonable control premium will be a matter of judgment. In some instances, little or no premium may be appropriate. Generally, when assessing the reasonableness of a control premium, consideration should be given to why an acquirer would pay a premium (e.g., what synergies could market participants achieve if they acquired the reporting unit) and why the current owner is unable to create that value absent a sale. Other consideration should include recent trends in a company’s market capitalization, comparable transactions within a company’s industry, the number of potential acquirers, and the availability of financing. A well-reasoned and documented assessment of the control premium value is necessary; the level of supporting evidence would be expected to increase as the control premium increases from past norms. Further, in a distressed market, consideration should be given as to whether prior market transactions used to evaluate control premiums would be indicative of future transactions. The use of arbitrary percentages or rules of thumb would not be appropriate.
A control premium is justified presumably due to synergies within the business that can be realized upon obtaining control. Therefore, one way to evaluate the reasonableness of a control premium is to perform a bottom up approach by identifying areas in which market participants could extract savings or synergies by obtaining control (e.g., eliminate duplicative costs and product diversification) and quantifying the discounted cash flows expected from the presumed synergies.
The SEC staff has, in some cases, issued comments to companies that assert their current market capitalization does not reflect fair value because of a control premium. Such comments generally request management to provide support for their assertion.
Question BCG 9-16
In distressed markets, is it expected that control premiums will rise?
PwC response
Some have asserted that control premiums should rise when there are broad market price decreases. Their theory is that the underlying fundamentals of a business may remain strong and, therefore, the business maintains its underlying fair value. Similarly, some companies have asserted that they would not be willing to sell at the pricing suggested by the market capitalization, thus suggesting a significant control premium would exist in a fair value transaction. There are several factors that these views may not consider; therefore, a significant increase in control premiums in a time of distressed markets would generally not be expected.
First, in distressed markets, there tends to be a decrease in the number of acquirers willing and able to acquire entities for a variety of reasons, including lack of available capital, increased scrutiny by investors on significant purchases, or a desire to conserve cash. A reduced acquisition demand theoretically leads to a general decline in sales prices. Furthermore, as cash flows and discount rates are revisited in a distressed market, one may find that the fair value of a business has declined. This decrease in fair value would reduce the difference between the fair value of the business and its market capitalization, resulting in a decrease in apparent control premiums.
Accordingly, increased control premiums in a distressed market should be carefully evaluated. A larger control premium must be adequately supported and consider the synergies inherent in a market participant’s perspective of the fair value of a reporting unit. Only in those instances in which a reporting unit could command a higher price in the market can management consider applying a higher control premium. This assessment should be based on all facts and circumstances.
Question BCG 9-17
Can multiple reporting units be combined for purposes of determining fair value?
PwC response
Generally, no. ASC 350-20-35-22 indicates that “the fair value of a reporting unit refers to the price that would be received to sell the unit as a whole in an orderly transaction between market participants at the measurement date.” Measuring the fair value of multiple reporting units together and then attributing the aggregate fair value to the individual reporting units (top-down approach) would generally not be consistent with this guidance. Instead, the fair value of each reporting unit should generally be assessed individually. Any specifically identifiable synergies available to an individual reporting unit by working in combination with other reporting units (e.g., the benefits of lower costs arising from the combined purchasing power of multiple reporting units) may be included in the determination of the reporting unit’s fair value if market participants would be expected to realize such synergies (bottom-up approach).
See FV 7.2 for further information on ASC 820, Fair value measurement, and its impact on determining the fair value of reporting units.

9.7.3 Fair value of reporting units using the income approach

It is often necessary to adjust management’s existing cash flow projections to ensure consistency with the valuation objective of determining the fair value of a reporting unit under ASC 350-20. Following are several considerations provided in the AICPA Goodwill Guide that may result in adjustments to cash flow projections:
  • Planned acquisition activity: Generally cash flow projections used to determine the fair value of a reporting unit should not include prospective cash flows expected from a future acquisition, as market participant cash flows typically would not include assumptions for acquisition activity.
  • Working capital: The DCF method provides an indication of fair value that is consistent with normal levels of working capital. To the extent a reporting unit has an excess or deficit working capital position on the measurement date, that amount should be an adjustment to the fair value of the reporting unit. Cash is generally excluded from working capital in the DCF model. Net working capital is generally calculated on a debt-free basis by excluding the current portion of funded long-term debt because the cash flow model is typically prepared on a debt-free basis. When interest-bearing operating debt is determined to be part of working capital, the interest expense on the interest-bearing operating debt would be treated as part of the cash flows. It is generally appropriate to include deferred revenues as a component of working capital when revenue projections are developed on an accrual basis.
  • Nonoperating assets and liabilities: To the extent nonoperating assets and liabilities are reflected in the carrying amount of a reporting unit, the reporting unit’s fair value should consider these assets and liabilities.
  • Legal form of reporting unit: Reporting units may be held in nontaxable entities such as partnerships or limited liability companies. Generally, it is expected that market participants would be in the legal form of C corporations and thus subject to income taxes. Accordingly, cash flow projections are typically calculated on an after-tax basis to ensure consistency with market participant assumptions.
  • Depreciation and amortization amounts: While depreciation and amortization are not cash flow items, tax depreciation and amortization benefits result in cash tax savings and should be included in the cash flow projections used to determine a reporting unit’s fair value.
  • Share-based compensation: Non-cash expenses associated with share-based compensation should generally be included as a cash outflow when measuring the fair value of a reporting unit to the extent that these expenses are thought to be compensation in lieu of cash.
  • Income tax rate: The appropriate tax rate would generally represent statutory rates adjusted for assumptions that are observable and applicable to market participants.
  • Related party transactions: Intercompany transactions may require adjustment if the terms are not consistent with what market participants would expect to incur or receive.
See FV 7.2.5.1 for further information about determining the fair value of a reporting unit using the income approach.
Question BCG 9-18
If management uses a discounted cash flow approach to value a reporting unit and completes its annual budget process on September 30th, would it be reasonable for the company, which has a calendar year-end, to rely on this budget to complete its fourth quarter goodwill impairment test?
PwC response
Although the September 30th budget may be an appropriate starting point, during volatile economic times, cash flow estimates can change quickly. For impairment testing purposes, the company may need to revise its estimates if market events after September 30th impact the timing or amount of cash flows.

9.7.4 Fair value of reporting units using the market approach

When valuing a reporting unit using the market approach, stock trading prices or transaction prices generated by market transactions involving businesses comparable to the reporting unit are used. Two commonly used valuation techniques for measuring the fair value of a reporting unit are the guideline public company method and the guideline transaction method. The guideline public company method identifies the stock prices of public companies that are comparable to the reporting unit being tested. Performance metrics, such as price-to-revenues or price-to-EBITDA, are calculated for the comparable public companies and applied to the subject reporting unit’s applicable performance metrics to estimate the reporting unit’s fair value. The guideline transaction method identifies recent merger and acquisition transaction data for acquisitions of target companies that are similar to the subject reporting unit. Metrics such as multiples of the selling price to revenue, EBITDA or earnings measures are calculated for the guideline transactions and applied to the subject reporting unit’s applicable revenue or earnings metric to estimate the reporting unit’s fair value.
Under both the guideline public company method and the guideline transaction method, it is necessary to consider what makes a company “comparable” to the subject reporting unit from a valuation standpoint. While not an all-inclusive list, the AICPA Goodwill Guide lists operational characteristics that may be considered, such as whether the comparable company and the reporting unit (1) are in the same industry or sector, (2) are in similar lines of business, (3) have similar geographic reach (for example, domestic versus international versus multinational), (4) have similar customers and distribution channels, (5) have contractual or noncontractual sales, (6) have similar seasonality trends, (7) have similar business life cycles (e.g., short cycle characterized by ever-changing technology versus long cycle driven by changes in commodity pricing), (8) are in similar stage of business life cycle (e.g., start up, high growth, mature), or (9) have similar operating constraints (e.g., reliance or dependence on key customers or government regulations).
The AICPA Goodwill Guide also lists financial characteristics that may be considered, such as whether the comparable company and the subject reporting unit (1) are of similar size (e.g., revenues, assets, or market capitalization, if the company is public), (2) have similar profitability (e.g., EBITDA, operating margin, contribution margin), (3) have similar anticipated future growth in revenues and profits, (4) have a similar asset-base (e.g., manufacturing versus service business), or (5) have a similar pattern of owning versus leasing real properties, machinery, and equipment (e.g., an entity that owns its manufacturing operations versus one that leases the building and machinery used for its operations).
Under both the guideline public company method and the guideline transaction method, it is often necessary to adjust observed market multiples or transactions to make the comparable company data more consistent with the subject reporting unit. If guideline companies or transactions exhibit certain differences from the subject reporting unit but are otherwise deemed to be comparable to the reporting unit, the multiples or transactions associated with these companies should be adjusted to account for these differences. Such adjustments may relate to factors including profitability, anticipated growth, size, working capital, nonrecurring or nonoperating income or expenses, or differences in accounting policies. Once multiples or transactions have been adjusted, outliers that are not considered to be sufficiently comparable to the reporting unit should be eliminated from the data set. Generally, multiples that are in a narrow range are better indications of value than a data set with multiples that exhibit wide dispersion.
While the considerations applicable to the guideline public company method and guideline transaction method are similar, some additional considerations in applying the guideline transaction method include:
  • Availability of data: Sufficient data about a specific transaction may not be available to determine whether the transaction provides a basis for measuring the reporting unit’s fair value. For example, if information supporting the financial characteristics or the tax structure of the transaction is not available, it may be difficult to establish that the transaction would be comparable to a transaction in which the reporting unit is sold.
  • Relevant time period: It is not appropriate to use guideline transactions that took place during periods in which economic conditions were not comparable to conditions at the goodwill impairment test date. Generally, the older the transaction, the less relevant the information.
When applying the market approach, it is important to determine whether the resulting enterprise value would be considered a controlling or noncontrolling interest. The guideline public company method has historically been regarded as indicating the enterprise or equity value on a noncontrolling basis. Because the subject reporting unit is valued on a controlling interest basis in step one of the goodwill impairment test, in some cases, it may be appropriate to apply a control premium to convert the reporting unit value determined using the guideline public company method to a controlling interest basis.
The guideline transaction method is typically regarded as indicating the enterprise or equity value on a controlling interest basis. Therefore, a premium for control would generally not be applied to the reporting unit value determined using the guideline transaction method.
Question BCG 9-19
May management rely exclusively on comparable company pricing multiples when determining the fair value of a reporting unit?
PwC response
A common pitfall is the use of a market multiple of a public company that is not comparable to the reporting unit being tested. For example, a reporting unit may not be comparable to a public company that includes multiple reporting units. In these cases, relying solely on market comparables would not be appropriate, and in determining fair value, management may need to place more reliance on another method, such as a discounted cash flow analysis.

9.7.5 Use of quoted market price of reporting unit on single date

ASC 820 requires an entity to begin its analysis in determining the fair value of a reporting unit with the quoted market price, if one is available, as of the measurement date (i.e., as of a single date). However, when using quoted market prices to estimate the fair value of a reporting unit, an entity should consider all available evidence. Accordingly, a single day’s quoted market price may not necessarily reflect a reporting unit’s fair value. That might be the case if, for example, significant events occur which impact share price near the time goodwill is being tested for impairment. Determining whether to consider quoted market prices on more than a single date will depend on the facts and circumstances of each situation.
In a distressed market, it may be appropriate to consider recent trends in a company’s trading price instead of just a single day’s trading price in evaluating fair value. Frequently, averages over relatively short periods are used to determine representative market values. In some cases, prices may have moved dramatically over a short period of time or there may be a specific event that may have impacted market prices. Therefore, all relevant facts and circumstances must be evaluated. For example, an average may not be appropriate if a company’s share price had a continued downward decline. On the other hand, an average may be a reasonable proxy for fair value when share prices experience significant volatility. However, stock prices after the impairment test date should not be considered unless those prices reflect the affirmation of events that existed as of the test date.
If a reporting unit’s market capitalization falls below its carrying amount, it may not be appropriate for an entity to assert that the reporting unit’s market capitalization is not representative of its fair value. Examples of evidence to support a fair value greater than market capitalization may be (1) an analysis that indicates that a control premium should be added to the reporting unit’s market capitalization; or (2) as a result of an unusual event or circumstance, a temporary decline in quoted market prices occurs that indicates that the reporting unit’s market capitalization during that brief time would not represent the reporting unit’s fair value.

9.7.6 Multiple techniques to estimate reporting unit fair value

In instances where a quoted market price in an active market is not available or the current market price is believed to not be representative of fair value, the methodology used to determine fair value may be a single valuation technique or multiple valuation techniques (e.g., a present value technique and a market pricing multiple). If multiple valuation techniques are used, the entity should evaluate and weigh the results considering the reasonableness of the range indicated in determining the fair value. The results may indicate that a single point within the range or a weighting of values within the range is the most representative of fair value in the circumstances. The methodology (including the use of more than one valuation technique) that an entity uses to determine the fair value of a reporting unit should be applied consistently.
If a weighted approach with multiple valuation techniques is used to determine the fair value of reporting units, it is not necessary to use the same weighting for all reporting units. Each reporting unit should be valued individually using an approach that results in the best estimate of fair value of the reporting unit in the given circumstances—different approaches or weightings may be appropriate for determining the fair values of different reporting units.
Question BCG 9-20 considers the accounting treatment of a change in valuation technique from a market approach to an income approach.
Question BCG 9-20
If a company has historically utilized a market multiple approach in determining the fair value of its reporting units, can it use a discounted cash flow analysis in the current year?
PwC response
Yes. In accordance with ASC 820-10-35-25, a change in a valuation technique is appropriate if the change is an equal or better representation of fair value. A change in a valuation technique is considered a change in accounting estimate. See FV 4.4.4 for additional information.

9.7.7 Reconciling total fair value of reporting units to market cap

Frequently, public companies have more than one reporting unit and, therefore, do not use the quoted market price of their stock to directly determine the fair value of reporting units. However, there is an expectation that the aggregation of reporting unit fair values can be reconciled to the company’s market capitalization. While not a requirement of ASC 350-20, the company’s overall market capitalization should reconcile, within a reasonable range, to the sum of the fair values of the individual reporting units.
Such reconciliation often includes both qualitative and quantitative assessments. As is the case in many areas requiring judgment, contemporaneous documentation of the assumptions and their applicability to the specific facts and circumstances is important.
When an entity performs a qualitative assessment for some reporting units but proceeds to step one for others, reconciling the overall market capitalization to the aggregate fair value of reporting units can be challenging. There is no requirement to determine the fair value of reporting units that do not have goodwill or for which only a qualitative impairment test is performed. It may not be cost effective for some entities to determine the fair value of a reporting unit not subject to a step one test solely to allow for a reconciliation to the company’s overall market capitalization. However, a comparison of the aggregate fair values of reporting units for which a step one test is performed to the entity’s market capitalization still may be useful in order to establish that the aggregate fair value is not unreasonable relative to overall market capitalization. For example, if an entity has five significant reporting units and performs step one for three of the five reporting units, the fair value determined for those three reporting units should not exceed the overall market capitalization for the entity and in most cases should be less than the overall market capitalization since the other two reporting units would be presumed to have value. In addition, the AICPA Goodwill Guide indicates that when performing an overall comparison to market capitalization, entities could include the current year fair values for reporting units for which quantitative measurements were performed and estimate the fair value for the reporting units for which qualitative assessments were performed using a reasonable methodology.
Even though a reconciliation to market capitalization may not be required, the underlying factors surrounding a decline in market capitalization and whether those factors affect the fair value of the reporting unit being tested should be considered. SEC staff comments have historically focused on significant market declines and on the reconciliation of reporting unit fair values to a company’s overall market capitalization. In these comments, the SEC staff frequently asks how companies took into consideration the fact that their market capitalization was below their book value when determining that goodwill had not been impaired.
Question BCG 9-21
If management believes that the current trading price of its stock is not representative of fair value, can it assert that the market data is not relevant when determining the fair value of a reporting unit?
PwC response
A company’s market capitalization and other market data cannot be ignored when assessing the fair value of a company’s reporting units. In a depressed economy, declines in market capitalization could represent factors that should be considered in determining fair value, such as an overall re-pricing of the risk associated with the company. However, in inactive markets, market capitalization may not be representative of fair value, and other valuation methods may be required to measure the fair value of an entity comprised of a single reporting unit. Determining the factors affecting market capitalization and their impact on fair value requires the application of judgment.
Question BCG 9-22
Is it acceptable if there is a significant difference between the aggregate fair values of a company’s reporting units (derived using a cash flow analysis) and overall market capitalization?
PwC response
When a significant difference exists between a company’s market capitalization and the aggregate fair values of a company’s reporting units, the reasons for the difference should be understood. A company’s cash flow models may not fully consider the risk associated with achieving those cash flows. Cash flow assumptions should be revisited and potential changes in the amount, timing, and risks associated with those cash flows should be evaluated given the market environment. Cash flow analyses based on probability-weighted scenarios should likely include a wide range of potential outcomes.
Question BCG 9-23
What are common reconciling items between the aggregate fair values of a company’s reporting units and its market capitalization?
PwC response
A common reason for a difference between the aggregate fair values of the reporting units and the company’s overall market capitalization is that control premiums associated with a reporting unit are not reflected in the quoted market price of a single share of stock.
Other differences may be linked to external events or conditions, such as broad market reaction to circumstances associated with one or a few reporting companies. For example, the deteriorating financial condition of one company in a particular market sector could cause temporary market declines for other companies in the same sector. Unusual market activity, such as a spike in short selling activity, may also have a temporary impact on a company’s market capitalization but not reflect its underlying fair value. Short-term fluctuations in volatile markets may not necessarily reflect underlying fair values. It is therefore important to be able to explain the market fluctuations as part of the reconciliation of market capitalization to the estimated fair values of reporting units. The AICPA Goodwill Guide indicates it is a best practice to identify and document the reasons for differences between the aggregate fair value of reporting units and the observable market capitalization. Factors identified include control synergies, data that may not be available to a market participant, tax consequences, entity-specific versus market participant capital structures, excessive short positions against the stock, and controlling or large block interests.
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