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With limited exceptions, ASC 805 requires the measurement of assets acquired and liabilities assumed to be recognized at their acquisition-date fair values. ASC 805 incorporates the definition of fair value in ASC 820; therefore, fair value must be measured based on the price that would be received to sell an asset or paid to transfer a liability.
ASC 820 precludes the use of entity-specific assumptions and requires measurement of fair value based on assumptions from the perspective of market participants. Therefore, an acquirer must determine the fair value of assets acquired and liabilities assumed without considering the acquirer’s intended use (if that use is different from that of market participants). As a result, the acquirer may be required to develop hypothetical markets and to consider multiple valuation approaches/techniques. Application of the ASC 820 framework to determine acquisition-date fair values, including the requirement to incorporate a market participant—not entity-specific—perspective, may require a significant amount of time and effort on the part of reporting entities. Furthermore, completion of the purchase accounting process may require additional valuation resources and other specialists in developing appropriate valuation approaches and fair value measurements.

7.3.1 Fair value considerations in business combinations

Understanding the interaction between corporate finance, valuation, and accounting concepts is important when estimating fair value measurements for business combinations. The valuation approaches/techniques in ASC 820 are used individually or in combination to:
  • Perform a business enterprise valuation (BEV) analysis of the acquiree as part of analyzing prospective financial information (PFI), including the measurements of the fair value of certain assets and liabilities for post-acquisition accounting purposes (see FV 7.3.2)
  • Measure the fair value of consideration transferred, including contingent consideration (see BCG 2 and FV 7.3.3.5)
  • Measure the fair value of the identifiable tangible and intangible assets acquired and liabilities assumed in a business combination (see FV 7.3.3)
  • Measure the fair value of any NCI in the acquiree and the acquirer’s previously held equity interest (PHEI) in the acquiree for business combinations achieved in stages (see FV 7.3.5.2 and FV 7.3.5.3)
  • Test goodwill for impairment in each reporting unit (RU) (see FV 7.4 and BCG 9)

7.3.2 Business enterprise valuation

Typically, the initial step in measuring the fair value of assets acquired and liabilities assumed in a business combination is to perform a BEV analysis and related internal rate of return (IRR) analysis using market participant assumptions and the consideration transferred. The BEV analysis is a key valuation tool, which supports many of the valuation assumptions (discount rate, projected cash flows, synergies, etc.) used in measuring the fair value of the identified assets and liabilities of the entity.
The BEV is often referred to as the “market value of invested capital,” “total invested capital,” or “enterprise value,” and represents the fair value of an entity’s interest-bearing debt and shareholders’ equity. The BEV analysis assists in evaluating the PFI, which serves as the basis for the underlying cash flows used to measure the fair value of certain acquired assets. The cash flows used to support the consideration transferred (adjusted as necessary to reflect market participant assumptions) should be reconcilable to the cash flows used to measure the fair value of the assets acquired. When there is no measurable consideration transferred (e.g., when control is gained through contractual rights and not a purchase), the fair value of the entity is still required to be measured based on market participant assumptions.
Generally, the BEV is performed using one or both of the following methods:
  • The income approach (e.g., discounted cash flow method)
  • The guideline public company or the guideline transaction methods of the market approach
Market approach techniques may not require the entity’s projected cash flows as inputs and are generally easier to perform. The market approach may be used as a secondary approach to evaluate and support the conclusions derived using an income approach. Although the market approach techniques are easier to apply, they rely on availability of external data.

7.3.2.1 Income approach in the business enterprise value analysis

The BEV represents the present value of the “free cash flows” available to the entity’s debt and equity holders. The two significant components are free cash flows and the discount rate, both of which need to be reasonable. The source of free cash flows is the PFI.
Evaluating prospective financial information through the business enterprise value and related internal rate of return analyses
Free cash flows of the acquiree is typically measured as:
  • Projected debt-free net income, plus
  • Depreciation and amortization expenses (to the extent they are reflected in the computation of taxable income), adjusted for
  • Changes in debt-free working capital and capital expenditures.

The PFI is a key input in the valuation process and it is important to understand the underlying assumptions. The PFI, adjusted to reflect market participant assumptions, serves as the source for the cash flows used to value the assets acquired and liabilities assumed. The PFI should only include those synergies that would be available to other market participants. That is, the PFI should be adjusted to remove entity-specific synergies.
Conforming the PFI to market participant assumptions usually starts with analyzing the financial model used to price the transaction, and adjusting it to reflect market participant expected cash flows. If the transaction pricing was not based on a cash flow analysis, a similar concept should be applied in preparing the cash flow forecast required to value the acquired assets and liabilities. When differentiating between entity-specific synergies and market participant synergies, entities should consider the following:
  • The acquirer’s rationale for the transaction, particularly as communicated in press releases, board minutes, and investment bankers’ analyses
  • The competitive nature of the bidding process; in a highly competitive bidding environment, an acquirer may pay for entity specific synergies, while if no other bidders are present, an acquirer may not have to pay for the value of all market participant synergies
  • The basis for the projections used to price the transaction, to gain an understanding of the synergies considered in determining the consideration transferred
  • Whether alternative PFI scenarios used to measure the purchase price might be available to assist in assessing the relative risk of the PFI
  • Whether market participants would consider and could achieve similar synergies
  • Whether the highest and best use for the asset(s) may differ between the acquirer’s intended use and use by market participants
  • Whether industry trends (i.e., consolidation, diversification) provide insights into market participant synergies

IRR is the implied rate of return derived from the consideration transferred and the PFI. The calculated IRR should be compared to industry discount rates derived from market data when evaluating and selecting discount rates related to the overall transaction and identifiable tangible and intangible assets.
The appropriate IRR in determining the fair value of the acquiree is the discount rate that equates the market participant PFI to the consideration transferred (assuming the consideration transferred represents fair value and entity-specific synergies were not paid for). Entity-specific synergies, to the extent paid for, will be reflected in goodwill and not reflected in the cash flows used to measure the fair value of specific assets or liabilities. The process of reconciling the PFI to the consideration transferred should also separately consider any nonoperating assets or liabilities (see FV 7.5) that may have been included in the business combination, as such nonoperating assets would not have been included in the PFI.
Conceptually, when the PFI reflects only market participant synergies and the consideration transferred is adjusted for any entity-specific synergies that were paid for, the IRR should be consistent with the industry-weighted average cost of capital (WACC), which is the industry-weighted average rate of return on debt and equity as required by market participants (i.e., investors). Expressed another way, the IRR represents the discount rate implicit in the economics of the business combination, driven by both the PFI and the consideration transferred.
If the IRR differs significantly from the industry WACC, additional analysis may be required to understand the difference. If the implied IRR and WACC differ, it may be an indication that entity-specific synergies are included in the PFI, and therefore should be adjusted accordingly. It may also indicate a bias in the projections. Figure FV 7-1 summarizes the relationship between the IRR, WACC, the existence of synergies, and the basis of the PFI. Both the IRR and the WACC are considered when selecting discount rates used to measure the fair value of tangible and intangible assets.
Figure FV 7-1
Relationship between IRR, WACC, synergies, and consideration transferred
IRR = WACC
Indicates that the PFI may reflect market participant synergies and the consideration transferred equals the fair value of the acquiree.
IRR > WACC
Indicates that the PFI may include entity-specific synergies, the PFI may include an optimistic bias, or the consideration transferred is lower than the fair value of the acquiree (potential bargain purchase).
IRR < WACC
Indicates that the PFI may exclude market participant synergies, the PFI may include a conservative bias, the consideration transferred may be greater than the fair value of the acquiree, or the consideration transferred may include payment for entity specific synergies.
The present value computed varies inversely with the discount rate used to present value the PFI (i.e., a higher discount rate results in lower fair values). Conceptually, when PFI includes optimistic assumptions, such as high revenue growth rates, expanding profit margins (i.e., higher cash flows), or the consideration transferred is lower than the fair value of the acquiree, a higher IRR is required to reconcile the PFI on a present-value basis to the consideration transferred.
Conditional versus expected cash flows
Cash flow models will use either conditional or expected cash flows; and other valuation inputs need to be consistent with the approach chosen. Conditional cash flows are based on a single outcome that is dependent upon the occurrence of specific events. For example, the cash flows may reflect a “most likely” or “promised” cash flow scenario, such as a zero coupon bond that promises to repay a principal amount at the end of a fixed time period. Alternatively, expected cash flows represent a probability-weighted average of all possible outcomes. Since expected cash flows incorporate expectations of all possible outcomes, expected cash flows are not conditional on certain events.
The discount rate applied to measure the present value of the cash flow estimate should be consistent with the nature of the cash flow estimate. In principle, conditional and expected approaches consider many of the same risks but an expected cash flow reflects the risks of achieving the cash flow directly in the cash flow estimates, while a conditional cash flow requires an adjustment to the discount rate to adjust for the conditional nature of the cash flow estimate. Conceptually, both methods should result in consistent valuation conclusions. See FV 7.3.3.3 for an application of this concept to liabilities.
Discount rates
Conceptually, a discount rate represents the expected rate of return (i.e., yield) that an investor would expect from an investment. The magnitude of the discount rate is dependent upon the perceived risk of the investment. Theoretically, investors are compensated, in part, based on the degree of inherent risk and would therefore require additional compensation in the form of a higher rate of return for investments bearing additional risk.
The rate of return on the overall company will often differ from the rate of return on the individual components of the company. For example, the rates of return on an entity’s individual RUs may be higher or lower than the entity’s overall discount rate, depending on the relative risk of the RUs in comparison to the overall company. The discount rate should reflect the WACC of a particular component of the company when measuring the fair value of that business using expected cash flows based on market participant assumptions.
Terminal value
A terminal value should be included at the end of the discrete projection period of a discounted cash flow analysis used in a BEV to reflect the remaining value that the entity is expected to generate beyond the projection period. Business enterprises are generally assumed to have perpetual lives. The most commonly used terminal value technique is the constant growth method (CGM). The terminal value is calculated by dividing annual sustainable cash flow by a capitalization rate (cap rate). The annual sustainable cash flow is often estimated based on the cash flows of the final year of the discrete projection period, adjusted as needed to reflect sustainable margins, working capital needs, and capital expenditures consistent with an assumed constant growth rate. The cap rate is calculated as the discount rate (i.e., WACC or IRR) less the long-term, sustainable growth rate. The cap rate varies inversely to the growth rate and terminal value (i.e., a lower growth rate results in a higher cap rate and a lower terminal value).
The terminal value represents the present value in the last year of the projection period of all subsequent cash flows into perpetuity. A long-term growth rate in excess of a projected inflation rate should be viewed with caution and adequately supported and explained in the valuation analysis.
If the projection period is so short relative to the age of the enterprise that significant growth is projected in the final year, then the CGM should not be applied to that year. Rather, the projection period should be extended until the growth in the final year approaches a sustainable level, or an alternative method should be used.
An alternative to the CGM to calculate the terminal value is the market pricing multiple method (commonly referred to as an exit multiple). Under this method, a current observed pricing multiple of earnings—generally earnings before interest, taxes, depreciation, and amortization (EBITDA) or earnings before interest and taxes (EBIT)—is applied to the entity’s projected earnings for the final year of the projection period. However, this method must be used cautiously to avoid significant misstatement of the fair value resulting from growth rate differences. Inherent in observed, current pricing multiples for entities are implied income growth rates, reflecting the markets’ view of its relatively short-term growth prospects. The implied growth rate inherent in the multiple must be compared to the growth rate reflected in the last year of the projection period. If a pricing multiple observed for an enterprise is applied to the final year of a projection, not only must the implied growth rate in the multiple be consistent with the projected growth, but the implied risk for the enterprise must be consistent with the risk inherent in realizing the projected income.
The terminal value often represents a significant portion of total fair value. Therefore, a relatively small change in the cap rate or market pricing multiple can have a significant impact on the total fair value produced by the BEV analysis. Figure FV 7-2 highlights leading practices in calculating terminal value.
Figure FV 7-2
Leading practices when calculating terminal value
  • Use sustainable cash flows — The terminal value calculated using a DCF approach should be based on a sustainable set of cash flows. If one-time, nonrecurring events (e.g., a one-time large restructuring charge, cash tax impact of net operating loss (NOL) or amortization of intangible assets) distort cash flows in the terminal period, the fair value may be distorted. Adjustments should be made to normalize the terminal year cash flows.
  • Apply sustainable cap rates — For developing companies experiencing rapid cash flow growth over the entire discrete cash flow forecast, the discount rate used to calculate the cap rate should reflect a “normalized” expectation of cash flow. Both the discount rate and growth rate used to calculate the cap rate should reflect a normalized level of cash flows.
  • Projections should reflect a mature business — Terminal values should be calculated at the point when projections reflect the maturity of the business and future significant real growth is not expected (in excess of an inflation rate) in perpetuity. Terminal values that imply significant perpetual growth may overstate fair value. If the terminal year projections do not reflect a mature business, it would be necessary to incorporate the additional growth through a weighted growth or a terminal multiple that reflects companies at the same stage of development.
  • Multiples from current trading data should be adjusted for changes in expected growth — Multiples should reflect the growth and profitability expectations for the business at the end of the explicit projection period. Although multiples may be derived from current market trading data that reflect short-term, high-growth rates, multiples for later periods with lower growth should reflect the growth assumption as of this terminal period (e.g., 10 years out).
  • Select appropriate multiples — The valuation multiple should best reflect how the market assesses the value of a business or an asset. If the company tends to trade on operating metrics, then multiples of earnings, such as total invested capital/sales, total invested capital/EBITDA, or total invested capital/EBIT multiples, may be appropriate multiples to apply. If the company tends to trade as a function of its capital at risk, it may be more appropriate to apply a price/book value multiple.
  • Use an appropriate terminal growth rate assumption — The terminal growth rate should be carefully considered. While an inflationary perpetual growth rate may be appropriate, this is a valuation input that should not be automatically assumed. In some situations, an enterprise will not be able to pass along inflationary price increases due to market and other economic circumstances. If the enterprise’s earnings are not expected to keep pace with inflation, the cap rate or market pricing multiple should reflect a lower than inflationary growth rate. If growth beyond inflation is expected beyond the projection period, a terminal growth rate greater than inflation may be appropriate. In cases such as this, it may be appropriate to consider a market pricing multiple approach rather than the CGM.
  • Consider comparability — Multiples should be derived from companies that exhibit a high degree of comparability to the business enterprise being valued. The implied values should be adjusted based on the differences between the enterprise being valued and the guideline companies.
  • Consider whether a perpetual model is appropriate — Certain businesses may have finite lives; for instance, a power plant can reasonably be expected to have a finite life if no investment was made to sustain its generation capacity. The terminal value may be the liquidation value of the business at the end of its projected life.
  • Consider capital expenditures that are consistent with expected growth — An assumption of sustained growth over a long period (approximating “in perpetuity”) should reflect the necessary capital investment to support the forecasted growth.
  • Test the terminal value — The computed terminal value should be tested against market multiples to evaluate its reasonableness.

Example FV 7-5 provides an illustration of the determination of terminal value.
EXAMPLE FV 7-5

Calculating the terminal value
Company A was recently acquired in a business combination for $100,000. Through the BEV and IRR analyses, the acquirer has identified the following market participant PFI for projected years one through five:
Year
Revenues
Net cash flow
Net cash flow growth (%)
Actual year
$95,000
$9,500
Forecast year 1
105,000
10,000
5.3%
Forecast year 2
115,000
11,000
10.0%
Forecast year 3
135,000
12,500
13.6%
Forecast year 4
147,000
13,500
8.0%
Forecast year 5
160,000
14,000
3.7%
View table

The long-term sustainable growth rate is 3%. Based on the consideration transferred and Company A’s cash flows, the IRR was calculated to be 15%, which is consistent with the industry WACC of 15%. In the industry, multiples of annual cash flows range between 7.5 and 10.
What is the terminal value of Company A?
Analysis
In year five, net cash flow growth trended down to 3.7%, which is fairly consistent with the expected long-term growth rate of 3%. The cash flow growth rate in the last year of the PFI should generally be consistent with the long-term sustainable growth rate. For example, it would not be appropriate to assume normalized growth using the Forecast Year 3 net cash flow growth rate of 13.6%. The constant growth model is used to measure the terminal value, as follows:
TV =
CF5(1 + g)
k - g

Where:
TV
=
Terminal value
CF5
=
Year 5 net cash flow
g
=
Long-term sustainable growth rate
k
=
WACC or discount rate

Therefore:
TV =
$14,000 (1 + 0.03)
0.15 – 0.03
TV = $120,167

The computed multiple is 8.6 times prior year’s cash flow ($120,167/$14,000). As this falls within the range of multiples found for companies similar to Company A at the end of the projection period, the terminal value appears reasonable.
Conceptually, the terminal value represents the value of the business at the end of year five and is then discounted to a present value as follows:
PV of TV 1 =
$120,167
(1 + 0.15) 5
PV of TV 1  = $59,744 2
1 The present value = 1/(1+k) ^ t, where k = discount rate and t = number of years.
2 For illustrative simplicity, an end-of-year discounting convention was used.

7.3.2.2 Market approach in the business enterprise value analysis

The market approach is generally used as a secondary approach to measure the fair value of the business enterprise when determining the fair values of the assets acquired and liabilities assumed in a business combination. The market approach is often used to assess the reasonableness of the implied valuation multiples derived from the income approach.
The market approach also may be used when measuring the fair value of an RU as part of the goodwill impairment analysis or when measuring the fair value of an entity as a whole (e.g., for purposes of valuing a noncontrolling interest).
Following are examples of two methods used to apply the market approach in performing a BEV analysis.
Guideline public company method
The most common form of the market approach applicable to a business enterprise is the guideline public company method (also referred to as the public company market multiple method). Publicly traded companies are reviewed to develop a peer group similar to the company being valued, often referred to as “comparable” companies. Market multiples are developed and based on two inputs: (1) quoted trading prices, which represent minority interest shares as exchanges of equity shares in active markets typically involving small (minority interest) blocks; and (2) financial metrics, such as net income, EBITDA, etc. Market multiples are then adjusted, as appropriate, for differences in growth rates, profitability, size, accounting policies, and other relevant factors. The adjusted multiples are then applied to the subject company’s comparable financial metric. This results in the estimated fair value of the entity’s BEV on a minority interest basis, because the pricing multiples were derived from minority interest prices.
If a controlling or majority interest in the subject company is being valued, then a further adjustment, often referred to as a “control premium,” may be necessary. A control premium represents the amount paid by a new controlling shareholder for the benefits resulting from synergies and other potential benefits derived from controlling the enterprise. For example, when measuring the fair value of a publicly traded business, there could be incremental value associated with a controlling interest in the business. As such, a control premium could be added to the company’s market capitalization (using observed market prices) to measure the fair value of a publicly traded company as a whole. A control premium should not be automatically applied without consideration of the relevant factors (e.g., synergies, number of possible market participant acquirers). Reporting entities need to evaluate and assess whether such factors indicate a control premium is justified and, if so, assess the magnitude of the control premium.
Guideline transaction method
The guideline transaction method is another technique within the market approach that is often applied when valuing a controlling or majority ownership interest of a business enterprise. This approach is based upon prices paid in observed market transactions of guideline companies, involving exchanges of entire (or majority interests in) companies, which often include a control premium in the price paid.
Valuation multiples are developed from observed market data for a particular financial metric of the business enterprise, such as earnings or total market capitalization. The valuation multiple is then applied to the financial metric of the subject company to measure the estimated fair value of the business enterprise on a control basis. Generally, the value of control included in the transaction multiple is specific to the buyer and seller involved in the transaction and may not be broadly applicable to the subject company. Therefore, this valuation technique should consider the synergies in the transaction and whether they may be appropriate to the company being valued.
Obtaining and reviewing guideline information
The data used in the techniques within the market approach is typically obtained from several sources, including past transactions that the company has participated in, peer company securities’ filings, periodicals, industry magazines and trade organizations, and M&A databases. The data for a single transaction may be derived from several sources.
The degree of similarity of the observed data to the subject company (industry, transaction date, size, demographics, and other factors) needs to be considered in evaluating the relevance and weight given to the selected financial metric.
The relevance of the market approach in measuring BEV is dependent on the comparability of the companies on which the analysis is based. The higher the degree of correlation between the operations in the peer group and the subject company, the better the analysis. Some of the more significant attributes used to determine comparability are:
  • Type of product produced or service performed
  • Market segment to which the product or service is sold
  • Geographic area of operation
  • Positioning in market
  • Influence of buyers/suppliers
  • Size (e.g., revenue, assets)
  • Growth—historical and projected
  • Profitability
  • Capital intensity (fixed assets and working capital)
  • Leverage
  • Liquidity
  • Diversification
Leading practices when calculating the business enterprise value
Figure FV 7-3 highlights leading practices when calculating the business enterprise value.
Figure FV 7-3
Leading practices when calculating the business enterprise value
Confirm that cash flows provided by management are consistent with the cash flows used to measure the consideration transferred
One of the primary purposes of performing the BEV analysis is to evaluate the cash flows that will be used to measure the fair value of assets acquired and liabilities assumed. The projections should also be checked against market forecasts to check their reasonableness.
Reconcile material differences between the IRR and the WACC
Understanding the difference between these rates provides valuable information about the economics of the transaction and the motivation behind the transaction. It often will help distinguish between market participant and entity-specific synergies and measure the amount of synergies reflected in the consideration transferred and PFI. It will also help in assessing potential bias in the PFI. If the IRR is greater than the WACC, there may be an optimistic bias in the projections. If the IRR is less than the WACC, the projections may be too conservative.
Properly consider cash, debt, nonoperating assets and liabilities, contingent consideration, and the impact of NOL or tax amortization benefits in the PFI and in the consideration transferred when calculating the IRR
Because the IRR equates the PFI with the consideration transferred, it is important to properly reflect all elements of the cash flows and the consideration transferred. Nonoperating assets and liabilities, and financing elements usually do not contribute to the normal operations of the entity. The value of these assets or liabilities should be separately added to or deducted from the value of the business based on cash flows reflected in the PFI in the IRR calculation. If any of these assets or liabilities are part of the consideration transferred (e.g., contingent consideration), then their value should be accounted for in the consideration transferred when calculating the IRR of the transaction.
Develop the WACC by properly identifying and performing a comparable peer company or market participant analysis
The WACC should reflect the industry-weighted average return on debt and equity from a market participant’s perspective. Market participants may include financial investors as well as peer companies.
Use PFI which reflects market participant assumptions instead of entity-specific assumptions
Entities should test whether PFI is representative of market participant assumptions.
Use PFI prepared on a cash basis not an accrual basis
Since the starting point in most valuations is cash flows, the PFI needs to be on a cash basis. If the PFI is on an accrual basis, it must be converted to a cash basis such that the subsequent valuation of assets and liabilities will reflect the accurate timing of cash flows.
Use PFI that includes the appropriate amount of capital expenditures, depreciation, and working capital required to support the forecasted growth
This should be tested both in the projection period and in the terminal year. The level of investment must be consistent with the growth during the projection period and the terminal year investment must provide a normalized level of growth.
Use PFI that includes tax-deductible amortization and/or depreciation expense
PFI should consider tax deductible amortization and depreciation to correctly allow for the computation of after tax cash flows. PFI that incorrectly uses book amortization and depreciation will result in a mismatch between the post-tax amortization and depreciation expense and the pre-tax amount added back to determine free cash flow. (See FV 7.3.2.1 for further information on calculating free cash flows.)
Use multiple valuation approaches when possible
Multiple valuation approaches should be used if sufficient data is available. While an income approach is most frequently used, a market approach using appropriate guideline companies or transactions helps to check the reasonableness of the income approach.

7.3.3 Valuation approach — individual assets and liabilities acquired

Generally, different methods are used to measure the fair value of the majority of assets and liabilities acquired in a business combination, including the components of working capital (e.g., accounts receivable, inventory, and accounts payable) and tangible assets, such as property, plant and equipment. Certain additional considerations are necessary when determining the value of acquired intangible assets.

7.3.3.1 Measuring the fair value of working capital

Working capital is commonly defined as current assets less current liabilities. ASC 805 requires that the components of working capital be recorded at fair value. Valuation considerations for selected components of working capital are as discussed in the following sections.
Inventories
ASC 805 requires that inventory acquired in a business combination be measured at its fair value on the acquisition date in accordance with ASC 820. Fair value is an exit price. That is, it represents the price that would be received by a seller of the inventory in an orderly transaction between market participants.
As described in FV 7.2.5, reporting entities should measure fair value using the valuation approach and technique that is appropriate in the circumstances and for which sufficient data is available.
Inventory acquired in a business combination can be in the form of finished goods, work in process, and/or raw materials.
Finished goods and work-in-process inventory
ASC 820-10-55-21 describes the valuation of finished goods inventory as follows:

ASC 820-10-55-21(f)

Finished goods inventory at a retail outlet. For finished goods inventory that is acquired in a business combination, a Level 2 input would be either a price to customers in a retail market or a price to retailers in a wholesale market, adjusted for differences between the condition and location of the inventory item and the comparable (i.e. similar) inventory items so that the fair value measurement reflects the price that would be received in a transaction to sell the inventory to another retailer that would complete the requisite selling efforts. Conceptually, the fair value measurement will be the same, whether adjustments are made to a retail price (downward) or to a wholesale price (upward). Generally, the price that requires the least amount of subjective adjustments should be used for the fair value measurement.

The fair value of finished goods inventory is generally measured as estimated selling price of the inventory, less the sum of (1) costs of disposal and (2) a reasonable profit allowance for the selling effort. This represents an exit price. Work-in-process inventory is measured similar to finished goods inventory except that, in addition, the estimated selling price is further reduced for the costs to complete the manufacturing process and a reasonable profit allowance for that effort. This is referred to as the top-down method.
Alternatively, reporting entities may start with the book value of the acquired inventory and adjust to add the costs (to the extent not previously capitalized into the book value) and a reasonable profit margin for the procurement/manufacturing process completed as of the acquisition date. This is referred to as the bottom-up method. One approach when using either the top-down or bottom-up method is to assess each expense line item in the PFI to determine if it relates to expenses incurred in the procurement/manufacturing process or is an expense remaining to be incurred to sell the finished goods inventory. Refer to FV 7.3.2 for testing of the PFI. These methods are further discussed in a working draft of inventory valuation guidance issued by the AICPA in November 2018, which will be a chapter in a comprehensive AICPA Business Combinations Accounting and Valuation Guide to be released at a future date (the IVSC expects to release an exposure draft with content similar to the AICPA guide in 2019).
Classifying expenses as procurement/manufacturing or selling requires consideration of the specific attributes of the product. This is especially the case for branded products or products with proprietary technology for which the direct costs of manufacturing are significantly less than the selling price. In this case, an assessment needs to be made as to how much of the additional value contributed by intangible assets is inherent in the inventory versus being utilized during the sales process (e.g., a customer relationship used at the time inventory is sold as part of the selling efforts).
Intangible assets may be internally developed or licensed from third parties. Whether intangible assets are owned or licensed, the impact on the fair value of the inventory should be the same. Analysis is required to determine whether the intangible assets are part of the procurement/manufacturing process and therefore become an attribute of the inventory, or are related to the selling effort. Intangible assets that are used in procurement, the manufacturing process, or that are added to the value of the goods are considered a component of the fair value of the finished goods inventory. When valuing the work-in-process inventory, a similar assessment would be performed to determine at what point during the inventory production cycle the intangible assets contribute value.
Question FV 7-1 discusses intangible asset contributions to inventory valuation.
Question FV 7-1
When considering intangible assets contributions to the inventory valuation, how should a reporting entity evaluate how much of their contribution is added to the inventory during the manufacturing process versus being used in selling the inventory?
PwC response
One key factor a reporting entity should consider is how the inventory would be marketed by a market participant to its customers. There are two concepts, generally referred to as the pull and push models, that may often be used to market inventory to customers. In push marketing, products are promoted by pushing them onto customers (e.g., candy placed at the front counter in a retail store where companies are vying for optimal shelf/location, which requires selling expense). Therefore, in a push marketing model, the intangible assets are sales related and not included in the value of the inventory. In pull marketing, the premise is to pull customers to the products (e.g., a customer goes to a department store to buy luxury brand purses). In this case, although marketing efforts are made to support the brand, no significant retail location or push marketing is required due to the brand recognition inherent in the pull marketing model. Accordingly, in pull marketing, the intangible assets' contribution is included in the value of the inventory.

Example FV 7-6 illustrates how intangible assets contribute to the fair value of inventory.
EXAMPLE FV 7-6
Evaluating how intangible assets contribute to the fair value of inventory
Company XYZ acquires Company ABC in a business combination. Company ABC manufactures clothing in the United States and produces shirts under a highly recognized brand name.
Should Company XYZ ascribe the value contributed by the intangible assets (brand name) to shirts in finished goods inventory as part of its acquisition accounting?
Analysis
Yes. The fair value of a premium brand shirt is greater than the fair value of a mass-market branded shirt due not only to the higher cost of fabric and the incremental cost of attaching a logo, but also due to the power of the brand to pull the product through the distribution channel. On the other hand, intangible assets expected to be utilized as part of the selling process would be considered selling related and therefore excluded from the fair value of the finished goods inventory.

Raw materials inventory
Raw materials inventory is recorded at fair value and is generally measured based on the price that would be received by a seller of the inventory in an orderly transaction between market participants (i.e., current replacement cost).
Example FV 7-7 illustrates measurement of raw materials purchased in a business combination.
EXAMPLE FV 7-7
Measuring the fair value of raw materials inventory
Company A acquires Company B in a business combination. On the acquisition date, Company B has lumber raw materials (that are used in the production process) that were initially purchased (historical cost) at $390 per 1,000 board feet. The current fair value is $410 per 1,000 board feet.
At what value should Company A record the lumber raw materials inventory as part of its acquisition accounting?
Analysis
The fair value of the lumber raw materials inventory is based on the price that a market participant would receive to sell the lumber in its principal (or most advantageous) market. Therefore, Company A should recognize the acquired lumber raw materials inventory at $410 per 1,000 board feet at the acquisition date.

7.3.3.2 Fair value of property, plant and equipment

The fair value of certain tangible assets (e.g., buildings, machinery, and equipment) is typically established using the market approach because there is usually available market data for sales and rentals of buildings, machinery, and equipment. The income approach is typically used to value assets that generate a discrete income stream (e.g., a power plant), or that act in concert with other tangible assets (e.g., a network of wireless towers). In the rare instances in which a reporting entity is valuing buildings, machinery, or equipment for which there is no market or cash flow data, the depreciated replacement cost approach may be appropriate to measure fair value.
The fair value of other tangible assets, such as unique properties or plant and equipment, is often measured using the replacement cost or the cost approach. This represents the highest value that a market participant would pay for an asset with similar utility. The cost approach is based on the principle of substitution. It uses the cost to replace an asset as an indicator of the fair value of that asset. Comparable utility implies similar economic satisfaction, but does not necessarily require that the substitute asset be an exact duplicate of the asset being measured. The cost of an exact duplicate is referred to as reproduction cost. The substitute asset is perceived as equivalent if it possesses similar utility and, therefore, may serve as a measure of fair value of the asset being valued.
Typically, the first step in the cost approach is to identify the asset’s original cost. The next step is to adjust the original cost for changes in price levels between the asset’s original in-service date and the date of the valuation to obtain its “replacement cost new.” Replacement cost new represents the indicated value of current labor and materials necessary to construct or acquire an asset of similar utility to the asset being measured.
Next, adjustments are made to replacement cost new to reflect any losses in value due to physical deterioration or functional obsolescence of the asset, which results in “replacement cost new, less depreciation.” Physical deterioration represents the loss in value due to the decreased usefulness of a fixed asset as the asset’s useful life expires. This can be caused by factors such as wear and tear, deterioration, physical stresses, and exposure to various elements.
Excessive physical deterioration may result in an inability to meet production standards or in higher product rejections as the tolerance on manufacturing equipment decreases. Higher than average maintenance expenditure requirements may also suggest higher levels of physical deterioration. However, below average maintenance expenditures may also indicate higher levels of physical deterioration due to inadequate or deferred maintenance. Functional obsolescence represents the loss in value due to the decreased usefulness of a fixed asset that is inefficient or inadequate relative to other more efficient or less costly replacement assets resulting from technological developments. Functional obsolescence is observed in several different forms. If the subject asset has higher operating costs relative to a new asset, this may indicate a form of functional obsolescence. If in developing an asset’s replacement cost new, that replacement cost is less than its reproduction cost, this may also be indicative of a form of functional obsolescence. It is important to consider functional obsolescence as the objective of the fair value measurement is to identify the replacement cost of a modern equivalent asset.
Physical and functional obsolescence are direct attributes of the asset being valued. However, to provide an indication of the fair value of the asset being measured, further adjustment may be necessary to “replacement cost new less depreciation” for any loss in value due to economic obsolescence. Economic obsolescence represents the loss in value due to the decreased usefulness of a fixed asset caused by external factors, independent from the characteristics of the asset or how it is operated. Increased cost of raw materials, labor, or utilities that cannot be offset by an increase in price due to competition or limited demand, as well as a change in environmental or other regulations, inflation, or high interest rates, may suggest economic obsolescence.
Certain tangible assets are measured using an income or market approach. An example is the measurement of a power plant in the energy sector, which often has few, if any, intangible assets other than the embedded license. The cash flows from the plant reflect only the economic benefits generated by the plant and its embedded license. Management should consider other US GAAP to determine whether the assets measured together need to be accounted for separately. This approach could result in a fair value measurement above the replacement cost. In this situation, management should consider whether any of the difference relates to other assets included in the cash flows, such as customer or contractual assets that could be separately recognized.
Other considerations
Other issues with respect to the valuation of inventory include estimating holding (opportunity) costs and obsolescence.
Holding costs may need to be estimated to account for the opportunity cost associated with the time required for a market participant to sell the inventory. In other words, this represents the foregone return on investment during the time it takes to sell the inventory. When considering whether holding costs should be included (i.e., added) in the inventory valuation, it is important to ensure that holding costs are not already included in the other assumptions, such as the profit assumptions being applied.
When determining the fair value of inventory, the impact of obsolescence should also be considered. The acquiree often has recorded a valuation reserve to reflect aging, obsolescence, and/or seasonality in its inventory carrying value. When adjusting the acquiree's carrying value of inventory to fair value, consideration is needed as to whether obsolescence has already been factored into the inventory or if any reduction to the carrying value of the inventory is needed to record it at fair value. When a valuation reserve has previously been recorded, an understanding of which inventory (i.e., all or a portion) the valuation reserve relates to is important in assessing whether the inventory is reflected at fair value.

7.3.3.3 General principles for measuring fair value of liabilities

ASC 820 provides high-level guidance and a framework for measuring the fair value of nonfinancial liabilities, but do not provide practical valuation guidance. ASC 820-10-35-16 defines a liability based on a transfer concept, which assumes that the liability is transferred to a market participant, and therefore, continues in existence and is not settled with the counterparty. The following discussion focuses on potential issues that may emerge in measuring fair value of nonfinancial liabilities.
A liability is not necessarily a negative asset
A liability is not considered merely a “negative asset” when measuring fair value. Some concepts applied in valuing assets, such as “highest and best use” or “valuation premise,” may not have a readily apparent parallel in measuring the fair value of a liability. In measuring liabilities at fair value, the reporting entity must assume that the liability is transferred to a credit equivalent entity and that it continues after the transfer (i.e., it is not settled). As such, it follows that the hypothetical transaction used for valuation is based on a transfer to a credit equivalent entity that is in need of funding and willing to take on the terms of the obligation. If there is an observable market for the transfer of a liability, it must be used to determine the fair value. It is only in the absence of an observable market that ASC 820 requires preparers to consider the value of the corresponding asset held by a market participant.
The concern with reliance on the value from the perspective of the asset holder is that assets and liabilities typically transact in different markets and therefore may have different values. For example, the holder of an automobile warranty asset (the right to have an automobile repaired) likely views the warranty asset in a much different way than the automaker, who has a pool of warranty liabilities. The holders of the asset and liability do not transact in the same market and would be unlikely to value the asset and liability in the same way. The valuation of liabilities is an evolving area.
For additional information on valuing nonfinancial liabilities, refer to IVS 220, Nonfinancial liabilities. The General IVSC standards apply to valuations of nonfinancial liabilities and valuations with a nonfinancial liability component. IVS 220 contains additional requirements that apply to valuations of nonfinancial liabilities.
Not all liabilities are the same
Some accounting standards differentiate an obligation to deliver cash (i.e., a financial liability) from an obligation to deliver goods and services (i.e., a nonfinancial liability). Financial liabilities are typically interest bearing and nonfinancial liabilities typically are not. An entity’s financial liabilities often are referred to as debt and its nonfinancial liabilities are referred to as operating or performance obligations. Unlike debt, which requires only a cash transfer for settlement, satisfying a performance obligation may require the use of other operating assets.
Different liabilities can have fundamentally different characteristics. For example, debt or a performance obligation may mature simply by the passage of time (i.e., noncontingent) or may depend on other events (i.e., contingent) resulting in performance and other related risks.
A performance obligation may be contractual or noncontractual, which affects the risk that the obligation will be satisfied. These differences affect the variability and magnitude of risks and uncertainties that can influence the settlement or satisfaction of the obligation and its fair value. Therefore, it is important to consider these differences when measuring the fair value of performance obligations. This is particularly critical when considering future cash flow estimates and applicable discount rates when using the income method to measure fair value.
Not all cash flows and rates of return are the same
Projected future cash flows can be “conditional” (sometimes referred to as “promised” or “traditional”) or “expected” (see FV 7.3.2.1). While these principles apply in using future cash flow estimates to measure the fair value of assets and liabilities, they are more widely used in the context of measuring assets. They are discussed below in the context of liabilities. A conditional cash flow estimate reflects a specific (single) condition, such as the “most likely,” “maximum,” or “promised” amount or set of conditions. For example, for a zero coupon bond in which a debtor promises to repay $500 at the end of a five-year period, the $500 is referred to as the contractual amount and the condition is that the debtor does not default.
In contrast, an “expected” amount represents a statistical aggregation of the possible outcomes reflecting the relative probability or likelihood of each outcome. In the following $500 zero coupon bond example, there are three possible outcomes, representing different expectations of cash flow amounts.
Cash flow payment
Probability
Weighted payment
Outcome 1
$500
85%
$425
Outcome 2
250
10%
25
Outcome 3
0
5%
0
___________
Expected cash flow
$450
For simplicity of presentation, the effect of income taxes is not considered.
In this example, the conditional, or contractual, amount (i.e., $500) differs from the expected amount (i.e., $450). This difference is important because the discount rate used to measure the present value of the cash flows should be selected based on the nature of the cash flows being discounted. That is, the discount rate selected should adjust for only those risks not already incorporated into the cash flows. For example, conditional cash flows should be discounted using a rate inclusive of risk, while expected cash flows should only be discounted for those risks not already incorporated in the cash flows. For this reason, when measuring the present value of expected cash flows, the discount rate will be lower than the rate utilized for measuring conditional cash flows. The fair value calculation using both conditional and expected cash flow approaches should give a similar result.
As the level of uncertainty about expected future cash flows increases, the fair value of assets will decrease and the fair value of liabilities will increase. This is because market participants may expect an increase in compensation in exchange for accepting a higher level of uncertainty. Typically, the risk component of a liability will be calculated separate from the discount rate, whereas for assets, the uncertainty may be considered in the selection of the discount rate or separately.
Consideration of taxes
Market participants will generally consider the potential effects of income taxes when determining the fair value of a liability; however, those considerations are different than those for an asset. Taxes represent a reduction of the cash flows available to the owner of the asset. A liability is a probable future sacrifice of assets by the reporting entity to a third party. The payment of a liability may result in a tax deduction for the reporting entity. However, the tax consequences do not change the amount owed by the reporting entity to the third party. Taxes are generally not deducted from the amount owed to the third party.
Comparable debt securities that have observable prices and yields are a common starting point when estimating a discount rate to use to fair value a liability using the income approach. Different instruments may have different tax attributes. To be considered similar, the tax attributes should be similar. For example, the interest payments on a debt instrument may be taxable, but the principal payments may be nontaxable. Accordingly, the market interest rate selected that will be used to derive a discount rate should be consistent with the characteristics of the subject liability.

7.3.3.4 Fair value of nonfinancial liabilities

The business combinations standard requires most nonfinancial liabilities assumed (for example, provisions) to be measured at fair value, except as limited by ASC 805-10-15-4. ASC 820-10-35-18 requires the entity’s credit risk to be included in determining the fair value of a nonfinancial liability.
Some common nonfinancial liabilities assumed in a business combination include contingent liabilities and warranties.
Example FV 7-8 provides an overview of the application of a basic discounted cash flow technique to measure a warranty liability.
EXAMPLE FV 7-8

Measuring the fair value of a warranty liability
Company A is acquired in a business combination. Company A is a manufacturer of computers and related products and provides a three-year limited warranty to its customers related to the performance of its products. Expenses related to expected warranty claims are accrued based on the detailed analyses of past claims history for different products. Company A’s experience indicates that warranty claims increase each year of a contract based on the age of the computer components.
One of Company A’s product lines (Line 1) has significant new components for which there is little historical claims data as well as other components for which historical claims data is available.
Given the availability of historical claims data, the acquirer believes that the expected cash flow technique will provide a reasonable measure of the fair value of the warranty obligation.
Using the information provided, what is the fair value of the warranty obligation based on the probability adjusted expected cash flows?
Analysis
To develop the probabilities needed to estimate expected cash flows, the acquirer evaluates Company A’s historical warranty claims. This includes evaluating how the performance of the new components used in Line 1 compares to the performance trends of the other components for which historical claims data is available. The acquirer develops expected cash flows and a probability assessment for each of the various outcomes. The cash flows are based on different assumptions about the amount of expected service cost plus parts and labor related to a repair or replacement. The acquirer estimates the following outcomes for Line 1, each of which is expected to be payable over the three-year warranty period.
The expected cash flows of the warranty claims are as follows:
Product Line 1
Probability
Year 1
Year 2
Year 3
Outcome 1
50%
3,000
6,000
12,000
Outcome 2
30%
8,000
14,000
20,000
Outcome 3
20%
12,000
20,000
30,000
View table
In calculating the fair value of the warranty obligation, the acquirer needs to estimate the level of profit a market participant would require to perform under the warranty obligations. The acquirer considers the margins for public companies engaged in the warranty fulfilment business as well as its own experience in arriving at a pre-tax profit margin equal to 5% of revenue.1
The acquirer also needs to select a discount rate to apply to the probability-weighted expected warranty claims for each year and discount them to calculate a present value. Because the expected claim amounts reflect the probability weighted average of the possible outcomes identified, the expected cash flows do not depend on the occurrence of a specific event. In this case, the acquirer determined that the discount rate is 7%.3 The table below reflects the expected cash flows developed in the previous table with the value of each outcome adjusted for the acquirer’s estimate of the probability of occurrence.
Product Line 1
Year 1
Year 2
Year 3
Outcome 1
1,500
3,000
6,000
Outcome 2
2,400
4,200
6,000
Outcome 3
2,400
__________
4,000
__________
6,000
__________
Probability weighted
6,300
11,200
18,000
Pre-tax profit (5%)1
315
__________
560
__________
900
__________
Warranty claim amount
6,615
11,760
18,900
Discount period2
0.5
1.5
2.5
Discount rate3
7%
7%
7%
Present value factor4
0.9667
0.9035
0.8444
Present value of warranty claims5
6,395
10,625
15,959
Estimated fair value6(rounded)
33,000
View table
1 The expected payment should include a profit element required by market participants, which is consistent with the fair value transfer concept for liabilities. The profit element included here represents an assumed profit for this example.
2 A mid-year discounting convention was used based on the assumption that warranty claims occur evenly throughout the year.
3 In practice, determining the discount rate can be a challenging process requiring a significant amount of judgment. The discount rate should reflect a risk premium that market participants would consider when determining the fair value of a contingent liability. For performance obligations (e.g., warranties) determination of discount rates may be more challenging than for financial liabilities, as data to assess the nonperformance risk component is not as readily obtainable as it may be for financial liabilities.
4 Calculated as 1/(1+k)^t, where k = discount rate and t = discount period.
5 Calculated as the warranty claim amount multiplied by the present value factor.
6 Calculated as the sum of the present value of warranty claims for years 1 through 3.

7.3.3.5 Fair value of financial liabilities

With limited exceptions, ASC 805 requires the measurement of liabilities assumed to be at their acquisition-date fair values. ASC 805 incorporates the definition of fair value in ASC 820; therefore, fair value must be measured based on the price that would be paid to transfer a liability.
Refer to FV 6 for further details on the fair value measurement of financial liabilities.
Contingent assets and liabilities
The valuation of contingent assets and liabilities is an area for which there is limited practical experience and guidance. ASC 805-20-25-19 through ASC 805-20-25-20B clarifies the initial recognition, subsequent measurement, and related disclosures arising from contingencies in a business combination. Under ASC 805, assets acquired and liabilities assumed in a business combination that arise from contingencies are required to be recognized at fair value at the acquisition date if fair value can be determined during the measurement period. If the acquisition date fair value of such assets acquired or liabilities assumed cannot be determined during the measurement period, the asset or liability should generally be recognized in accordance with ASC 450, Contingencies. See BCG 2 for more information.
A technique consistent with the income approach will most likely be used to estimate the fair value if fair value is determinable. A straightforward discounted cash flow technique may be sufficient in some circumstances, while in other circumstances more sophisticated valuation techniques and models such as real options, option pricing, Probability Weighted Expected Return Method sometimes called PWERM, or Monte Carlo simulation may be warranted.
Contingent consideration
Contingent consideration is generally classified either as a liability or as equity at the time of the acquisition. For details on the determination of the classification of contingent consideration, refer to BCG 2. Measuring the fair value of contingent consideration presents a number of valuation challenges. Generally, there are two methodologies used in practice to value contingent consideration. The first is a scenario-based technique and the second is an option pricing technique. The scenario-based technique involves developing discrete scenario-specific cash flow estimates or potential outcomes in circumstances when the trigger for payment is event driven. These amounts are then probability weighted and discounted using an appropriate discount rate. For example, a contingent payment that is triggered by a drug achieving an R&D milestone is often valued using a scenario-based method. The option pricing technique, which is more fully described in the Appraisal Foundation paper Valuation Advisory #4: Valuation of Contingent Consideration, is similar in concept, but uses an option-pricing framework for valuing contingent consideration. This eliminates the need to determine the appropriate discount rate and replaces scenarios with a volatility assumption. Option pricing techniques rely on estimates of volatility and a milestone-specific risk, referred to as Market Price of Risk. The option pricing technique is most appropriate in situations when the payment trigger is in some way correlated to the market (for example, if payment is a function of exceeding an EBITDA target for a consumer products company). The scenario method applies in situation when the trigger is not correlated (for example, if payment is tied to a decision by a court).
As is the case for all models, entities will need to consider the key inputs of the arrangement and market participant assumptions when developing the fair value of the arrangement. This will include the need to estimate the likelihood and timing of achieving the relevant milestones of the arrangement. Entities will also need to exercise judgment when applying a probability assessment for each of the potential outcomes. In the case of the option pricing method, the volatility assumption is key. In some cases, the volatility will not be objectively determinable (e.g., a revenue-based trigger for a company that has few or no reasonable comparative companies). In such cases, market participants may consider various techniques to estimate fair value based on the best available information.
The fair value of liability-classified contingent consideration will need to be updated each reporting period after the acquisition date. Changes in fair value measurements should consider the most current estimates and assumptions, including changes due to the time value of money.
Example FV 7-9 provides an overview of the application of a basic technique to measure contingent consideration.
EXAMPLE FV 7-9

Measuring the fair value of cash settled contingent consideration — liability classified
Company A purchases Company B for $400. Company A and Company B agree that if revenues of Company B exceed $2500 in the year following the acquisition date, Company A will pay $50 to the former shareholders of Company B. Company B is a biotech with one unique oncology product. Company A should classify the arrangement as a liability because it requires Company A to pay cash.
How could the fair value of the liability be calculated based on the arrangement between Company A and Company B?
Analysis
Company A would most likely consider a scenario-based discounted cash flow methodology to measure the fair value of the arrangement. A key determination for this approach is selecting a discount rate that best represents the risks inherent in the arrangement. In reality, there is more than one source of risk involved. For example, both projection risk (the risk of achieving the projected revenue level) and credit risk (the risk that the entity may not have the financial ability to make the arrangement payment) need to be considered.
Each of these risks may be quantifiable in isolation. When the two risks exist in tandem, consideration should be given to factors such as the potential correlation between the two risks and the relative impact of each risk upon the realization of the arrangement.
One alternative approach to determine the fair value of the cash settled contingent consideration would be to develop a set of discrete potential outcomes for future revenues. Some outcomes would show revenue levels above the $2500 performance target and some would be below. Outcomes showing revenues above the $2500 threshold would result in a payout. For those below the threshold, there would be no payout.
Each discrete payout outcome would then be assigned a probability and the probability-weighted average payout discounted based on market participant assumptions. For example, using the following assumed alternative outcomes and related probability, the fair value of the arrangement would be calculated as follows.
Outcome
Revenue level
Payout
Probability
Probability-weighted payout
1
$2000
$0
10%
$0
2
2250
0
15
0
3
2500
0
15
0
4
2750
50
40
20
5
3000
50
20
10
Total:
100%
$30
Discount rate 1
20%
Fair value:
$25
View table
1 A discount rate of 20% is used for illustrative purposes.

Example FV 7-10 provides an overview of the measurement of liability-classified share-settled contingent consideration.
EXAMPLE FV 7-10

Measuring the fair value of share settled contingent consideration — liability classified
Company A purchases Company B by issuing 1 million common shares of Company A stock to Company B’s shareholders. At the acquisition date, Company A’s share price is $40 per share. Company A and Company B agree that if the common shares of Company A are trading below $40 per share one year after the acquisition date, Company A will issue additional common shares to Company B’s former shareholders sufficient to mitigate price declines below $40 million (i.e., the acquisition date fair value of the 1 million common shares issued).
The guarantee arrangement creates an obligation that Company A would be required to settle with a variable number of Company A’s equity shares, the amount of which varies inversely to changes in the fair value of Company A’s equity shares. For example, if Company A’s share price decreases from $40 per share to $35 per share one year after the acquisition date, the amount of the obligation would be $5 million. Therefore, the guarantee arrangement would require liability classification on the acquisition date. Further, changes in the liability will be recognized in Company A’s earnings until the arrangement is settled.
How could the fair value of the contingent consideration arrangement be calculated based on the arrangement between Company A and Company B?
Analysis
The contingent consideration arrangements would likely be valued using an option pricing technique that estimates the value of a put option. In this example, Company A is guaranteeing its share price, effectively giving a put option on the transferred shares. Assuming a 2% risk-free rate, no dividends, 55% volatility, a one-year put option with a stock price of $40 million, a strike price of $40 million, and time to expiration of one year, the put value is $8.2 million.
The best estimate or the probability-weighted approach will likely not be sufficient to value the share-settled arrangement. In addition to the quantification of projection and credit risks, the modeling of Company A’s share price is required. The following factors, which are relevant in performing a valuation for such arrangements, are what make it unlikely that the probability-weighted approach would be appropriate:
  • Potential outcomes for Company A’s financial results next year
  • Potential outcomes for Company A’s share price over the coming year 
  • Correlation of the potential financial results with share prices
  • Potential outcomes for other market events that could impact the overall stock market
  • Selection of an appropriate discount rate that adequately reflects all of the risks not reflected in other assumptions (e.g., projection risk, share price return estimation risk, Company A’s credit risk)

Example FV 7-11 provides an overview of the measurement of equity-classified share-settled contingent consideration.
EXAMPLE FV 7-11

Measuring the fair value of share-settled contingent consideration — equity classified
Company A acquires Company B in a business combination. The consideration includes 10 million Company A shares transferred at the acquisition date and 2 million shares to be issued 2 years after the acquisition date, if a performance target is met. The performance target is met if Company B’s revenues (as a wholly owned subsidiary of Company A) exceed $500 million in the second year after the acquisition. The market price of Company A’s stock is $15/share at the acquisition date. Company A management assesses a 25% probability that the performance target will be met. A dividend of $0.25 per share is expected at the end of years 1 and 2. The seller will not be entitled to receive a dividend on the contingent shares.
Because Company A has already received Company B’s business upon transfer of the 10 million Company A shares, the agreement for Company A to contingently deliver another 2 million shares to the former owners of Company B is a prepaid contingent forward contract.
How could the fair value of the equity classified prepaid contingent forward contract be valued based on the arrangement between Company A and Company B?
Analysis
There may be several acceptable methods for determining the fair value of the forward contract. One that is commonly used is a model based on discounted expected payment. In this case, the fair value of the contingent consideration at the acquisition date would be based on the acquisition-date fair value of the shares and incorporate the probability of Company B achieving the targeted revenues. The fair value would exclude the dividend cash flows in years 1 and 2, as the market price is inclusive of the right to receive dividends to which the seller is not entitled and would incorporate the time value of money.
The discount rate for the present value of dividends should be the acquirer’s cost of equity 1 because returns are available to equity holders from capital appreciation and dividends paid. Those earnings are all sourced from net income of the acquirer.
Based on the facts above and an assumed 15% cost of equity, the fair value would be calculated as follows.
A
B
C
Revenue forecast ($ millions)
Probability
Payment in shares
Probability weighted number of shares
350
30%
0
450
45%
0
>500
25%
2,000,000
500,000
Probability-weighted shares
500,000
Share price1
$15/share
Probability weighted value
$7,500,000
Dividend year 1 (500,000 shares x $0.25/share)
$125,000
Dividend year 2 (500,000 shares x $0.25/share)
$125,000
Present value of dividend cash flow (assuming 15% discount rate)2
$203,214
Present value of contingent consideration (7,500,000 – 203,214)
$7,296,786
1 In most cases, there will be a correlation between the revenues of Company B and the share price of Company A. This requires a more complex analysis in which the movement of Company A’s share price fluctuates with Company B’s revenues. A simplifying assumption has been made in this example that Company B’s revenues and Company A’s share price are not correlated.
2 The required rate of return on dividends would likely be less than the cost of equity in many cases. For simplicity, the example used the same discount rate.

Each arrangement should be evaluated based on its own specific features, which may require different modeling techniques and assumptions. Additionally, the valuation model used for liability-classified contingent consideration would need to be flexible enough to accommodate inputs and assumptions that need to be updated each reporting period. The PFI used in valuing contingent consideration should be consistent with the PFI used in other aspects of an acquisition, such as valuing intangible assets. The valuation model used to value the contingent consideration needs to capture the optionality in a contingent consideration arrangement and may therefore be complex.
Debt
When an entity with listed debt is acquired, market evidence shows that the listed price of the debt changes to reflect the credit enhancement to be provided by the acquirer (i.e., it reflects the market’s perception of the value of the liability if it is expected to become a liability of the new group). If the acquirer does not legally add any credit enhancement to the debt or in some other way guarantee the debt, the fair value of the debt may not change.
The fair value of debt is required to be determined as of the acquisition date. If the acquiree has public debt, the quoted price should be used. If the acquiree has both public and nonpublic debt, the price of the public debt should be considered as one of the inputs in valuing the nonpublic debt.
Question FV 7-2 illustrates how a company should measure the fair value of debt assumed in a business combination.
Question FV 7-2
How should a company measure the fair value of debt assumed in a business combination?
PwC response
The credit standing of the combined entity in a business combination will often be used when determining the fair value of the acquired debt. For example, if acquired debt is credit-enhanced because the debt holders become general creditors of the combined entity, the value of the acquired debt should follow the characteristics of the acquirer’s post combination credit rating. However, if the credit characteristics of the debt acquired remain unchanged after the acquisition because, for example, the debt remains secured by only the net assets of the acquired entity, the value of the acquired debt should reflect the characteristics of the acquiree’s pre-combination credit rating.

7.3.3.6 Deferred revenue (subsequent to the adoption of ASU 2021-08)

Deferred revenue represents an obligation to provide products or services to a customer when payment has been made in advance and delivery or performance has not yet occurred. Examples of deferred revenue obligations that may be recognized in a business combination include upfront subscriptions collected for magazines or upfront payment for post-contract customer support for licensed software.
In October 2021, the FASB issued ASU 2021-08, Business Combinations (Topic 805): Accounting for Contract Assets and Contract Liabilities from Contracts with Customers, which requires contract assets and contract liabilities (i.e., deferred revenue) acquired in a business combination to be recognized and measured by the acquirer on the acquisition date in accordance with ASC 606, Revenue from Contracts with Customers. The new guidance is an exception to the fair value model in business combination accounting and only applies to acquired contract assets and contract liabilities.
The new guidance is effective for public business entities for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. For all other entities, the new guidance is effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years.
Refer to BCG 2.5.16 for more information.
Under current US GAAP, contract assets and contract liabilities acquired in a business combination are recorded by the acquirer at fair value. Refer to FV 7.3.3.6A.

7.3.3.6A Deferred revenue (prior to the adoption of 2021-08)

This section discusses the guidance in ASC 805 prior to the adoption of ASU 2021-08, Business Combinations (Topic 805): Accounting for Contract Assets and Contract Liabilities from Contracts with Customers. FV 7.3.3.6 discusses the guidance in ASC 805 subsequent to the adoption of ASU 2021-08.
Deferred revenue represents an obligation to provide products or services to a customer when payment has been made in advance and delivery or performance has not yet occurred. Examples of deferred revenue obligations that may be recognized in a business combination include upfront subscriptions collected for magazines or upfront payment for post-contract customer support for licensed software.
The fair value of a deferred revenue liability typically reflects how much an acquirer has to pay a third party to assume the liability. The deferred revenue amount recorded on the acquiree’s balance sheet generally represents the cash received in advance, less the amount amortized for services performed to date. Accordingly, the acquiree’s recognized deferred revenue liability at the acquisition date is rarely the fair value amount that would be required to transfer the underlying contractual obligation.
Fair value considerations when deferred revenue exists
Generally, there are two methods of measuring the fair value of a deferred revenue liability. The first method, commonly referred to as a bottom-up approach, measures the liability as the direct, incremental costs to fulfill the legal performance obligation, plus a reasonable profit margin if associated with goods or services being provided, and a premium for risks associated with price variability. Direct and incremental costs may or may not include certain overhead items, but should include costs incurred by market participants to service the remaining performance obligation related to the deferred revenue obligation. These costs do not include elements of service or costs incurred or completed prior to the consummation of the business combination, such as upfront selling and marketing costs, training costs, and recruiting costs.
The reasonable profit margin should be based on the nature of the remaining activities and reflect a market participant’s profit. If the profit margin on the specific component of deferred revenue is known, it should be used if it is representative of a market participant’s normal profit margin on the specific obligation. If the current market rate is higher than the market rate that existed at the time the original transactions took place, the higher current rate should be used. The measurement of the fair value of a deferred revenue liability is generally performed on a pre-tax basis and, therefore, the normal profit margin should be on a pre-tax basis.
An alternative method of measuring the fair value of a deferred revenue liability (commonly referred to as a top-down approach) relies on market indicators of expected revenue for any obligation yet to be delivered with appropriate adjustments. This approach starts with the amount that an entity would receive in a transaction, less the cost of the selling effort (which has already been performed) including a profit margin on that selling effort. This method is used less frequently, but is commonly used for measuring the fair value of remaining post-contract customer support for licensed software.
When valuing intangible assets using the income approach (e.g., Relief-from-royalty method or multi-period excess earnings method) in instances where deferred revenues exist at the time of the business combination, adjustments may be required to the PFI to eliminate any revenues reflected in those projections that have already been received by the acquiree (because the cash collected by the acquiree includes the deferred revenue amount). If the excess earnings method is used, the expenses and required profit on the expenses that are captured in valuing the deferred revenue should also be eliminated from the PFI. However, if cash based PFI is used in the valuation, and therefore acquired deferred revenues are not reflected in the PFI, then no adjustment is required in the valuation of intangible assets using the income approach.

7.3.4 Fair value of intangible assets

ASC 805 requires entities to recognize separately from goodwill the identifiable intangible assets acquired in a business combination at their acquisition-date fair values. Few intangible assets are traded in an active market. When they are, fair value can be measured by reference to the quoted price of an identical asset and can be a Level 1 measurement. When they are not traded, the reporting entity will need to use one or more valuation approaches/techniques. Figure FV 7-8, which follows the description of the approaches, summarizes some key considerations for measuring the fair value of intangible assets.

7.3.4.1 Income approach for intangible assets

The income approach is a valuation approach used to convert future cash flows to a single discounted present value amount. It is discussed in FV 4.4.3.
The most common techniques within the income approach, along with the types of intangible assets they are typically used to measure, are included in Figure FV 7-4.
Figure FV 7-4
Intangible asset income approach techniques
Multi-period excess earnings method including the distributor method
Customer relationships and enabling technology
Relief-from-royalty method
Trade names, brands, and technology assets
Greenfield method
Broadcast, gaming and other long-lived government-issued licenses
With and without method
Non-compete agreements, customer relationships
View table

The cost savings and premium profit methods are other ways to value intangible assets but are used less frequently.
Multi-period excess earnings method
The multi-period excess earnings method (MEEM) is a valuation technique commonly used for measuring the fair value of intangible assets. The fundamental principle underlying the MEEM is isolating the net earnings attributable to the asset being measured. Cash flows are generally used as a basis for applying this method. Specifically, an intangible asset’s fair value is equal to the present value of the incremental after-tax cash flows (excess earnings) attributable solely to the intangible asset over its remaining economic life.
Intangible assets are generally used in combination with other tangible and intangible assets to generate income. The other assets in the group are often referred to as “contributory assets,” as they contribute to the realization of the intangible asset’s value. To measure the fair value of an intangible asset, its projected cash flows are isolated from the projected cash flows of the combined asset group over the intangible asset’s remaining economic life. Both the amount and the duration of the cash flows are considered from a market participant’s perspective.
The fair value measurement of an intangible asset starts with an estimate of the expected net income of a particular asset group. “Contributory asset charges” or “economic rents” are then deducted from the total net after-tax cash flows projected for the combined group to obtain the residual or “excess earnings” attributable to the intangible asset. The contributory asset charges represent the charges for the use of an asset or group of assets (e.g., working capital, fixed assets, other tangible assets) and should be calculated considering all assets, excluding goodwill, that contribute to the realization of cash flows for a particular intangible asset. Goodwill is excluded as it is generally not viewed as an asset that can be reliably measured. (See further discussion of contributory asset charges within this section.) The excess cash flows are then discounted to a net present value. The net present value of any tax benefits associated with amortizing the intangible asset for tax purposes (where relevant) is added to arrive at the intangible asset’s fair value.
The contributory asset charges are calculated using the assets’ respective fair values and are conceptually based upon an “earnings hierarchy” or prioritization of total earnings ascribed to the assets in the group. The earnings hierarchy is the foundation of the MEEM in which earnings are first attributed to a fair return on contributory assets, such as investments in working capital, and property, plant, and equipment. These are considered a prerequisite to developing the ability to deliver goods and services to customers, and thus their values are not included as part of the intangible assets’ value.
The return or charge for each asset should be based upon comparable or hypothetical market rates, which reflect the amount market participants would charge for the use of the asset (i.e., a “market-derived rent”). In addition, contributory assets may benefit a number of intangible and other assets. The total return or charge earned by a particular asset should be distributed among the assets that benefit from its use. Therefore, in determining the fair value of intangible assets, a capital-intensive manufacturing business should have a higher contributory asset charge from fixed assets (in absolute terms) than that of a service business.
Terminal values are not appropriate in the valuation of a finite-lived intangible asset under the income approach. However, it is appropriate to add a terminal value to a discrete projection period for indefinite-lived intangible assets, such as some trade names.
The key assumptions of the MEEM, in addition to the projected cash flows over the asset’s remaining useful life, include consideration of the following, each of which is discussed in the subsequent sections:
  • Discount rate, including reconciliation of the rate of return
  • Contributory asset charges
  • Tax amortization benefits

MEEM — discount rates for intangible assets
Using the appropriate discount rate is an important factor in a multi-period excess earnings analysis, whether using expected (i.e., probability adjusted) or conditional (i.e., management’s best estimate) cash flows. The determination of the appropriate discount rate to be used to estimate an intangible asset’s fair value requires additional consideration as compared to those used when selecting a discount rate to estimate the business enterprise valuation (BEV). Refer to FV 7.3.2 for further details on the BEV.
The discount rate should reflect the risks commensurate with the intangible asset’s individual cash flow assumptions. Some intangible assets, such as order or production backlog, may be assigned a lower discount rate relative to other intangible assets, because the cash flows are more certain. Other intangible assets, such as technology-related and customer relationship intangible assets are generally assigned higher discount rates, because the projected level of future earnings is deemed to have greater risk and variability. While discount rates for intangible assets could be higher or lower than the entity’s weighted average cost of capital (WACC), they are typically higher than discount rates on tangible assets.
Figure FV 7-5 depicts the continuum of risks that are typically associated with intangible assets, although specific facts and circumstances should be considered.
Figure FV 7-5
Spectrum of risk for intangible assets
Figure FV 7-45 Spectrum of risk for intangible assets View image
The WACC represents the average expected return from the business (i.e., all the assets and liabilities used collectively in generating the cash flows of the entire business) for a market participant investor, and includes an element to compensate for the average risk associated with potential realization of these cash flows. The internal rate of return (IRR) in a business combination represents the implied return from the transaction that may include acquirer-specific elements.
Conceptually, the WACC applicable for the acquiree should be the starting point for developing the appropriate discount rate for an intangible asset. The WACC and the IRR should be equal when the projected financial information (PFI) is market participant expected cash flows and the consideration transferred equals the fair value of the acquiree. However, circumstances arise in practice when the WACC and the IRR are not equal, creating the need for further analysis to determine the appropriate starting point for an intangible asset discount rate. See FV 7.3.2.1.
If a difference exists between the IRR and the WACC and it is driven by the PFI (i.e., optimistic or conservative bias rather than expected cash flows, while the consideration transferred is the fair value of the acquiree), leading practice would be to revise the PFI to better represent expected cash flows and recalculate the IRR. If the PFI is not adjusted, it may be necessary to only consider the IRR as a starting point for determining the discount rates for intangible assets.
If the IRR is higher than the WACC because the overall PFI includes optimistic assumptions about revenue growth from selling products to future customers, it may be necessary to make adjustments to the discount rate used to value the intangibles in the products that would be sold to both existing and future customers as existing customer cash flow rates are lower. If the revenue growth rate for the existing customer relationships does not reflect a similar level of growth or risk than future customers, then the discount rate for existing customer relationships should generally be based on the WACC without such adjustments.
If the difference between the IRR and the WACC is driven by the consideration transferred (i.e., the transaction is a bargain purchase or the buyer has paid for entity-specific synergies), then the WACC may be more appropriate to use as the basis of the intangible assets’ discount rate. The relationship between the WACC and the IRR in certain circumstances impacts the selection of discount rates for intangible assets.
The WACC is generally the starting point for determining the discount rate applicable to an individual intangible asset. However, as discussed above, in certain circumstances the WACC may need to be adjusted if the cash flows do not represent market participant assumptions, for example, because the information needed to adjust the cash flows is not available.
Figure FV 7-6 illustrates how the relationship between the WACC and the IRR impacts the selection of discount rates for intangible assets in certain circumstances.
Figure FV 7-6
The relationship between the WACC and the IRR and the selection of discount rates for intangible assets
The projected financial information (PFI) represents market participant cash flows and consideration represents fair value
WACC = IRR
Alternatively:
The PFI are optimistic or pessimistic, therefore, WACC ≠ IRR
Adjust cash flows so WACC and IRR are the same
Consideration is a bargain purchase
Use WACC
PFI includes company specific synergies not paid for
Adjust PFI to reflect market participant synergies and use WACC
Consideration is not fair value, because it includes company-specific synergies not reflected in PFI
Use WACC
View table
Premiums and discounts are applied to the entity’s WACC or IRR to reflect the relative risk associated with the particular tangible and intangible asset categories that comprise the group of assets expected to generate the projected cash flows. Once the appropriate WACC has been identified, the rate is disaggregated to determine the discount rate applicable to the individual assets. This process is typically referred to as “rate stratification.” The range of discount rates assigned to the various tangible and intangible assets should reconcile, on a fair-value weighted basis, to the entity’s overall WACC. For example, working capital and fixed assets are generally assigned a lower required discount rate relative to a company’s overall discount rate, whereas intangible assets and goodwill are assigned a higher discount rate. This is because achieving the cash flows necessary to provide a “fair” return on tangible assets is more certain than achieving the cash flows necessary to provide a fair return on intangible assets. Application of the concept is subjective and requires significant judgment.
MEEM — reconciliation of rates of return
The stratification of the discount rate to the various classes of assets is a challenging process, because there are few, if any, observable active markets for intangible assets. Nonetheless, reporting entities should assess the overall reasonableness of the discount rate assigned to each asset by reconciling the discount rates assigned to the individual assets, on a fair-value-weighted basis, to the WACC of the acquiree (or the IRR of the transaction if the PFI does not represent market participant assumptions). This reconciliation is often referred to as a “weighted average return analysis” (WARA). The WARA is a tool used to assess the reasonableness of the selected discount rates.
The rate of return assigned to each asset should be consistent with the type of cash flows associated with the underlying asset; that is, the expected cash flows or conditional cash flows, as the rate of return may be different for each. Assets valued using expected cash flows would have a lower required rate of return than the same assets valued using conditional cash flows because the latter cash flows do not include all of the possible downside scenarios. The discount rates used in the WARA should be appropriate for expected cash flows. Using discount rates appropriate to conditional cash flows will distort the WARA analysis as the discount rate for the overall company will generally be on an expected cash flows basis. The value of the assets used in the WARA should be adjusted to the extent the assets’ value is not amortizable for tax purposes. Some transactions (for example, share acquisitions in some jurisdictions) do not result in a change in the tax basis of acquired assets or liabilities assumed.
Determining the implied rate of return on goodwill, is necessary to assess the reasonableness of the selected rates of return on the individual assets acquired, and is the reconciling rate between the WACC and total of individual asset rates in the WARA. Although goodwill is not explicitly valued by discounting residual cash flows, its implied discount rate should be reasonable, considering the facts and circumstances surrounding the transaction and the risks normally associated with realizing earnings high enough to justify investment in goodwill.
Example FV 7-12 shows a WARA reconciliation used to test the reasonableness of the discount rates applied to the individual assets.
EXAMPLE FV 7-12

Weighted average return analysis
Company A acquires Company B in a business combination for $400 million. Reconciling Company B’s PFI to the consideration transferred of $400 million results in an internal rate of return of 12%. Assume a 40% tax rate. The WACC for comparable companies is 11.5%.
($ in millions)
Assets
Fair value
Percent of total
(a)
After-tax discount rate
(b)
Weighted average discount rates
(a) x (b)
Working capital
$30
7.5%
4.0%
0.3%
Fixed assets
60
15.0
8.0
1.2
Patent
50
12.5
12.0
1.5
Customer relationships
50
12.5
13.0
1.6
Developed technology
80
20.0
13.0
2.6
Goodwill
130
32.5
15.0
4.9
Total
$400
100.0%
12.1%
View table

The rates used for contributory assets, which are working capital (4%) and fixed assets (8%), are assumed to be consistent with after-tax observed market rates. In general, discount rates on working capital and fixed assets are derived assuming a combination of equity and debt financing. The cost of debt on working capital could be based on the company’s short-term borrowing cost. The fixed asset discount rate typically assumes a greater portion of equity in its financing compared to working capital. The entity’s overall borrowing cost for the debt component of the fixed asset discount rate would be used rather than a short-term borrowing cost as used for working capital.
Do each of the respective discount rates included in the WARA performed by Company A appear reasonable?
Analysis

The discount rates selected for intangible assets in conjunction with the rates selected for other assets, including goodwill, results in a WARA of 12.1%, which approximates the comparable entity WACC and IRR of 11.5% and 12%, respectively. Therefore, the selected discount rates assigned to the assets acquired appear reasonable.
The rates used to derive the fair value of the patent, customer relationships, and developed technology of 12%, 13%, and 13%, respectively, each represent a premium to the WACC (11.5%). The premium should be based on judgment and consistent with market participant assumptions. Certain intangible assets, such as patents, are perceived to be less risky than other intangible assets, such as customer relationships and developed technology. Discount rates on lower-risk intangible assets may be consistent with the entity’s WACC, whereas higher risk intangible assets may reflect the entity’s cost of equity.
The implied discount rate for goodwill (15% in this example) should, in most cases, be higher than the rates assigned to any other asset, but not significantly higher than the rate of return on higher risk intangible assets. Generally, goodwill has the most risk of all of the assets on the balance sheet. If the implied rate of return on goodwill is significantly different from the rates of return on the identifiable assets, the selected rates of return on the identifiable assets should be reconsidered.
Significant professional judgment is required to determine the stratified discount rates that should be applied in performing a WARA reconciliation. A higher selected rate of return on intangible assets would result in a lower fair value of the intangible assets and a higher implied fair value of goodwill (implying a lower rate of return on goodwill compared to other assets). This may suggest that the selected return on intangible assets is too high, because goodwill should conceptually have a higher rate of return than intangible assets.

Leading practices in determining contributory asset charges
Cash flows associated with measuring the fair value of an intangible asset using the MEEM should be reduced or adjusted by contributory asset charges. The practice of taking contributory asset charges on assets, such as net working capital, fixed assets, and other identifiable intangible assets, is widely accepted among valuation practitioners. However, there are varying views related to which assets should be used to calculate the contributory asset charges. Some valuation practitioners have argued that certain elements of goodwill or goodwill in its entirety should be included as a contributory asset, presumably representing going concern value, institutional know-how, repeat patronage, and reputation of a business. A majority of valuation practitioners and accountants have rejected this view because goodwill is generally not viewed as an asset that can be reliably measured.
However, assembled workforce, as an element of goodwill, may be identifiable and reasonably measured, even though it does not meet the accounting criteria for separate recognition. As a result, an assembled workforce is typically considered a contributory asset, even though it is not recognized separately from goodwill according to ASC 805-20-55-6. It is rare to see a valuation of an intangible asset that includes a contributory asset charge for a portion of goodwill, with the exception of an assembled workforce. Improperly including a contributory asset charge will tend to understate the fair value of the intangible asset and overstate goodwill. This is an evolving area; valuation practitioners are debating which other elements of goodwill might be treated in the same way as an assembled workforce and if such elements can be reasonably measured.
Another common practice issue in determining contributory asset charges is the inclusion of both returns “on” and “of” the contributory asset when the “of” component is already reflected in the asset’s cash flow forecast. The “return of” component encompasses the cost to replace an asset, which differs from the “return on” component, which represents the expected return from an alternate investment with similar risk (i.e., opportunity cost of funds). For self-constructed assets, such as customer lists, the cost to replace them (i.e., the return of value) is typically included in normal operating costs and, therefore, is already factored into the PFI as part of the operating cost structure. Because this component of return is already deducted from the entity’s revenues, the returns charged for these assets would include only the required return on the investment (i.e., the profit element on those assets has not been considered) and not the return of the investment in those assets.
The applied contributory asset charge may include both a “return on” and a “return of” component in certain circumstances taking into consideration the factors discussed in the prior paragraph. This may require an adjustment to the PFI used to value a particular intangible asset. For example, when a royalty rate is used as a technology contributory asset charge, the assumption is that the entity licenses its existing and future technology instead of developing it in-house. If the PFI was developed on the assumption that future technology will be developed in-house, it would reflect cash expenditures for research and development. In this case, the PFI used to value the individual intangible asset (e.g., customer relationships) should be adjusted by eliminating the cash spent on research and development for future technology. This is because the royalty is the cost for licensing completed technology (whether current or future) from a third party. As a result, inclusion of cash spent on research and development in the PFI results in double counting as there is no need to develop a technology in-house when it is assumed to be licensed from a third party.
MEEM — tax amortization benefits
The effect of income taxes should be considered when an intangible asset’s fair value is estimated as part of a business combination, an asset acquisition, or an impairment analysis. The fair values of the acquired assets and liabilities assumed for financial reporting purposes and tax purposes are generally the same in a taxable business combination (see further discussion in TX 10). Accordingly, the present value of the intangible asset’s projected cash flows should reflect the tax benefit that may result from amortizing the new tax basis in the intangible asset. Generally, the tax amortization benefit is applied when using the income approach and is not applied when using the market approach. Market-based data used in the market approach is assumed to include the potential tax benefits resulting from obtaining a new tax basis.
Some business combinations result in the acquiring entity carrying over the acquiree’s tax basis. As a result, the amounts recorded for financial reporting purposes will most likely differ from the amounts recorded for tax purposes. A deferred tax asset or deferred tax liability should generally be recognized for the effects of such differences. Although no “step up” of the intangible asset’s tax basis actually occurs, the estimation of fair value should still reflect hypothetical potential tax benefits as if it did. ASC 820 requires each asset to be measured at fair value as if hypothetically acquired separately, in which case the tax benefit would be realized. US GAAP requires that the tax amortization benefit be factored into an asset’s fair value, regardless of the tax attributes of the transaction (e.g., taxable or nontaxable). The tax benefits should reflect the tax legislation in the domicile where the asset is situated. However, if there are no tax benefits possible (i.e., the tax legislation in the subject jurisdiction does not permit market participants to recognize a new tax basis under any circumstance), then the fair value of the assets should not include any tax benefits.
Distributor method
The distributor method is another valuation technique consistent with the income approach. It is a variation of the MEEM used to value customer relationship intangible assets when they are not a primary value driver of an acquired business. The distributor method may be an appropriate valuation model for valuing customer relationships when the nature of the relationship between the company and its customers, and the value added by the activities the company provides for its customers, are similar to the relationship and activities found between a distributor and its customers. For example, valuing the customer relationship asset using the distributor method may be appropriate when the company sells a commodity-like product and customer purchasing decisions are driven largely by price. The distributor method would likely be an inappropriate method in cases where the company provides significant value added products or services that may be highly specialized and difficult for customers to switch vendors.
The fundamental concept underlying the distributor method is that an earnings approach can be performed similar to how one might value a distribution company. Profit margins are estimated consistent with those earned by distributors for their distribution effort, and contributory asset charges are taken on assets typically used by distributors in their business (e.g., use of warehouse facilities, working capital, etc.). This is contrasted with the traditional MEEM approach that considers the overall cash flows of a product or business (that will frequently earn higher margins) and have more contributory assets (e.g., use of intellectual property, trade names, etc.). Discount rates used to value the customer relationship when using the distributor method should reflect the risks of a distribution business.
Although considered a MEEM method, the distributor method can be seen as being similar to a relief-from-royalty method in that both methods attempt to isolate the cash flows related to a specific function of a business. One advantage of using the distributor method is that the customer relationship asset can be valued using a defined subset of cash flows of the total business. As a result, the remaining cash flows of the business can be used in a separate MEEM for the primary value driving asset, such as intellectual property or other assets, without the need for contributory assets charges that result in double counting or omitting cash flows from the valuation of those assets.
Potential concerns with the use of the distributor method include the following:
  • The relationship between a reporting entity and its customers is often greater than that found between a distributor and its customers. As a result, the use of the distributor method may understate the value of the customer relationship asset.
  • Finding appropriate comparable distributor inputs (profit margins and contributory asset returns) consistent with the industry of the entity being analyzed may be difficult for several reasons including:
    • Distributors are not found in all industries
    • Distributors are often small companies and may not have the economies of scale of a larger company
    • Disaggregating the functions of a business in order to estimate distributor inputs may be viewed as arbitrary
  • The distributor method should not be used to value a primary asset as it likely does not capture all of the cash flows that the business derives from the asset. The primary asset of a business should be valued using the cash flows of the business of which it is the primary asset. It is unlikely that cash flows of a proxy would be a better indication of the value of a primary asset.
Relief-from-royalty method
Relief-from-royalty (RFR) is a commonly-used method for measuring the fair value of intangible assets that are often the subject of licensing, such as trade names, patents, and proprietary technologies. The fundamental concept underlying this method is that in lieu of ownership, the acquirer can obtain comparable rights to use the subject asset via a license from a hypothetical third-party owner. The asset’s fair value is the present value of license fees avoided by owning it (i.e., the royalty savings). To appropriately apply this method, it is critical to develop a hypothetical royalty rate that reflects comparable comprehensive rights of use for comparable intangible assets. The use of observed market data, such as observed royalty rates in actual arm’s length negotiated licenses, is preferable to more subjective unobservable inputs.
Royalty rate selection requires judgment because most brands, trade names, trademarks, and intellectual property have unique characteristics. If available, the actual royalty rate charged by the entity for the use of the technology or brand is generally the best starting point for an estimate of the appropriate royalty rate. The use of observed market data, such as observed royalty rates in actual arm’s length negotiated licenses for similar products, brands, trade names, or technologies, may also be used to estimate royalty rates. Market rates are adjusted so that they are comparable to the subject asset being measured, and to reflect the fact that market royalty rates typically reflect rights that are more limited than those of full ownership. Market royalty rates can be obtained from various third-party data vendors and publications.
In the absence of market-derived rates, other methods have been developed to estimate royalty rates. These include the profit split method (in which the profits of the business are allocated to the various business functions), the return on assets method (in which returns on other assets are subtracted from the profits of the business), and the comparable profits method (in which the profitability measures of entities or business units that carry out activities similar to that provided by the intangible asset are considered).
Example FV 7-13 provides an overview of the relief-from-royalty method.
EXAMPLE FV 7-13

The relief-from-royalty method
Company A acquires technology from Company B in a business combination. Prior to the business combination, Company X was licensing the technology from Company B for a royalty of 5% of sales. The technology acquired from Company B is expected to generate cash flows for the next five years. Company A has determined the relief-from-royalty method is appropriate to measure the fair value of the acquired technology.
The following is a summary of the assumptions used in the relief-from-royalty method:
Projected revenue represents the expected cash flows from the technology.
The royalty rate of 5% was based on the rate paid by Company X before the business combination, and is assumed to represent a market participant royalty rate. Actual royalty rates charged by the acquiree (Company B) should be corroborated by other market evidence where available to verify this assumption.
Based on an assessment of the relative risk of the cash flows and the overall entity’s cost of capital, management has determined a 15% discount rate to be reasonable.
Based on the discount rate, tax rate, and a statutory 15-year tax life, the tax benefit is assumed to be calculated as 18.5% of the royalty savings.
What is the fair value of the technology utilizing the relief-from-royalty method?
Analysis
The fair value of the technology would be calculated as follows.

Year 1
Year 2
Year 3
Year 4
Year 5
Revenue
$10,000
$8,500
$6,500
$3,250
$1,000
Royalty rate
5.0%
5.0%
5.0%
5.0%
5.0%
Royalty savings
500
425
325
163
50
Income tax rate
40%
40%
40%
40%
40%
Less: Income tax expense
(200)
(170)
(130)
(65)
(20)
After-tax royalty savings
$300
$255
$195
$98
$30
Discount period 1
0.5
1.5
2.5
3.5
4.5
Discount rate
15%
15%
15%
15%
15%
Present value factor 2
0.9325
0.8109
0.7051
0.6131
0.5332
Present value of royalty savings 3
$280
$207
$137
$60
$16
Sum of present values
$700
Tax amortization benefit 4
129
Fair value
$829
1 Represents a mid-period discounting convention, because cash flows are recognized throughout the year.
2 Calculated as 1/(1+k)^t, where k = discount rate and t = discount period.
3 Calculated as the after-tax royalty savings multiplied by the present value factor.
4 Calculated as 18.5% of the sum of present values.

Greenfield method
The Greenfield method values an intangible asset using a hypothetical cash flow scenario of developing an operating business from an entity that at inception only holds the intangible asset. Consequently, this valuation technique is most relevant for assets that are considered to be scarce or fundamental to the business, even if they do not necessarily drive the excess returns that may be generated by the overall business. For example, the Greenfield method is frequently used to value broadcasting licenses. These assets are fundamental to a broadcasting business but do not necessarily generate excess returns for the business. Excess returns may be driven by the broadcasted content or technology.
This technique considers the fact that the value of a business can be divided into three categories: (1) the “going concern value,” (2) the value of the subject intangible asset, and (3) the value of the excess returns driven by other assets. The going concern value is the value of having all necessary assets and liabilities assembled such that normal business operations can be performed. Under the Greenfield method, the investments required to recreate the going concern value of the business (both capital investments and operating losses) are deducted from the overall business cash flows. This results in the going concern value being deducted from the overall business value. Similarly, the value of the excess returns driven by intangible assets other than the subject intangible asset is also excluded from the overall business cash flows by using cash flows providing only market participant or normalized levels of returns. The result of deducting the investment needed to recreate the going concern value and excluding the excess returns driven by other intangible assets from the overall business cash flows provides a value of the subject intangible asset, the third element of the overall business.
The Greenfield method requires an understanding of how much time and investment it would take to grow the business considering the current market conditions. The expenses and capital expenditures required to recreate the business would be higher than the expense and capital expenditure level of an established business. In addition, the time to recreate or the ramp-up period also determines the required level of investments (i.e., to shorten the ramp-up period more investment would be required). In summary, the key inputs of this method are the time and required expenses of the ramp-up period, the market participant or normalized level of operation of the business at the end of the ramp-up period, and the market participant required rate of return for investing in such a business (discount rate).
The tax amortization benefit of the intangible asset should also be included in determining the value of the subject intangible asset.
With and without method
The value of an intangible asset under the with and without method is calculated as the difference between the business value estimated under the following two sets of cash flow projections as of the valuation date:
  • The value of the business with all assets in place
  • The value of the business with all assets in place except the intangible asset
The fundamental concept underlying this method is that the value of the intangible asset is the difference between an established, ongoing business and one where the intangible asset does not exist. If the intangible asset can be rebuilt or replaced in a certain period of time, then the period of lost profit, which would be considered in valuing the intangible asset, is limited to the time to rebuild. However, the incremental expenses required to rebuild the intangible asset also increase the difference between the scenarios and, therefore, the value of the intangible asset.
This valuation method is most applicable for assets that provide incremental benefits, either through higher revenues or lower cost margins, but where there are other assets that drive revenue generation. This method is sometimes used to value customer-related intangible assets when the MEEM is used to value another asset. Key inputs of this method are the assumptions of how much time and additional expense are required to recreate the intangible asset and the amount of lost cash flows that should be assumed during this period. The expenses required to recreate the intangible asset should generally be higher than the expenses required to maintain its existing service potential. The estimate should also consider that shortening the time to recreate it would generally require a higher level of investment.
The tax amortization benefit of the intangible asset should also be included in determining the value of the intangible asset.

7.3.4.2 Market approach for intangible assets

The market approach, discussed in FV 4.4.1, may be applied to measure the fair value of an intangible asset that is, or can be, traded, and for which market data is reasonably available. Intangible assets tend to be unique and typically do not trade in active markets. For those transactions that do occur, there tends to be insufficient information available. However, there are some types of intangible assets that may trade as separate portfolios (such as brands, cable television, or wireless telephone service subscriptions), as well as some licenses to which this approach may apply.
When applying the market approach to intangible assets, relevance and weight should be given to financial and key nonfinancial performance indicators (see FV 7.3.2.2 for further details). As a practical matter, information about key nonfinancial performance indicators (e.g., value per bed for hospitals, value per advisor for an advisory business, value per subscriber for a telecommunications company) may be more relevant and available than pure financial metrics. When used, these performance metrics should be reviewed carefully. For example, a cell phone subscription in an area with low monthly usage would not be of equivalent value to a subscription in an area with a high monthly usage.
Another factor to consider when valuing assets is that price and value are often affected by the motivations of the buyer and seller. For example, the selling price of an asset that is sold in liquidation is not a useful indication of fair value.
The market approach typically does not require an adjustment for incremental tax benefits from a “stepped-up” or new tax basis. The market-based data from which the asset’s value is derived is assumed to implicitly include the potential tax benefits resulting from obtaining a new tax basis. An adjustment may be required, however, if the tax rules in the domicile where comparable transactions occurred are different from the tax rules where the subject asset is domiciled.

7.3.4.3 Cost approach for intangible assets

The cost approach discussed in FV 4.4.2, while more commonly used to value machinery and equipment, can be an effective means of estimating the fair value of certain intangible assets that are readily replicated or replaced, such as routine software and assembled workforce. However, it is seldom appropriate to use a cost approach for an intangible asset that is one of the primary assets of the business.
The cost approach, applied to intangible assets, may fail to capture the economic benefits expected from future cash flows. For example, the costs required to replace a customer relationship intangible asset will generally be less than the future value generated from those customer relationships. This is because the cost approach may fail to capture all of the necessary costs to rebuild that customer relationship to the mature level/stage that exists as of the valuation date, as such costs are difficult to distinguish from the costs of developing the business.
A market participant may pay a premium for the benefit of having the intangible asset available at the valuation date, rather than waiting until the asset is obtained or created. If the premium would be significant, then an “opportunity cost” should be considered when using the cost approach to estimate the fair value of the intangible asset. That opportunity cost represents the foregone cash flows during the period it takes to obtain or create the asset, as compared to the cash flows that would be earned if the intangible asset was on hand today. Some factors to consider when determining if opportunity cost should be applied include the following:
  • Difficulty of obtaining or creating the asset
  • Period of time required to obtain or create the asset
  • Scarcity of the asset
  • Relative importance of the asset to the business operations

If the additional opportunity cost included in the cost approach is based on the total enterprise cash flows, then the calculation would be similar to the approach in the with and without method. However, intangible assets valued using the cost approach are typically more independent from other assets and liabilities of the business than intangible assets valued using the with and without method. Further analysis is required to determine whether the opportunity cost can be estimated by alternative approaches, like renting a substitute asset for the period required to create the subject intangible asset.
Estimating the opportunity cost can be difficult and requires judgment. Also, it may not be appropriate to include the total lost profit of a business in the value of one intangible asset if there are other intangible assets generating excess returns for the business.
The cost approach typically requires no adjustment for incremental tax benefits from a “stepped-up” or new tax basis. The market-based data from which the asset’s value is derived under the cost approach is assumed to implicitly include the potential tax benefits resulting from obtaining a new tax basis. Under the cost approach the assumed replacement cost is not tax-effected while the opportunity cost is calculated on a post-tax basis.

7.3.4.4 Assets not used in their highest and best use

The business combination guidance clarifies that assets that an acquirer does not intend to use or intends to use in a way other than their highest and best use must still be recorded at fair value based on market participant assumptions. In general, assets that are not intended to be used by the acquirer include overlapping assets (e.g., systems, facilities) that the acquirer already owns, thus they do not view such assets as having value. Figure FV 7-7 shows the relationship between the relative values at initial recognition of assets the acquirer does not intend to actively use.
Figure FV 7-7
Considerations for assets the acquirer does not intend to actively use
Categories
Observations
  • Acquirer entity will not actively use the asset, but a market participant would (e.g., brands, licenses)
  • Typically of greater value relative to other defensive assets
  • Common example: Industry leader acquires significant competitor and does not use target brand
  • Acquirer entity will not actively use the asset, nor would another market participant in the same industry (e.g., process technology, know-how)
  • Typically smaller value relative to other assets not intended to be used
  • Common example: Manufacturing process technology or know-how that is generally common and relatively unvaried within the industry, but still withheld from the market to prevent new entrants into the market

Defensive intangible assets
Defensive intangible assets are a subset of assets not intended to be used and represent intangible assets that an acquirer does not intend to actively use, but intends to prevent others from using. Defensive intangible assets may include assets that the acquirer will never actively use, as well as assets that will be actively used by the acquirer only during a transition period. In either case, the acquirer will lock up the defensive intangible assets to prevent others from obtaining access to them for a period longer than the period of active use. Examples of typical defensive intangible assets include brand names and trademarks. However, not all assets that are not intended to be used are defensive intangible assets. If an asset is not being used and market participants would not use the asset, it would not necessarily be considered a defensive intangible asset. For example, the billing software acquired by the strategic buyer in Example FV 7-4 is not considered a defensive asset even if it is not intended to be used beyond the transition period. For further details on the recognition of defensive assets, refer to BCG 4.
A business may acquire in-process research and development (IPR&D) that it does not intend to actively use. However, if a market participant would use it, the IPR&D must be measured at fair value. For further discussion of IPR&D not intended to be used by the acquirer refer to BCG 4.
A reporting entity’s determination of how a market participant would use an asset will have a direct impact on the initial value ascribed to each defensive asset. Therefore, identifying market participants, developing market participant assumptions, and determining the appropriate valuation basis are critical components in developing the initial fair value measurement for defensive assets. Additional considerations would include the following:
  • Unit of account — All defensive assets should be recognized and valued separately. They should not be combined with other assets even if the purpose of acquiring the defensive asset is to enhance the value of those other assets. By locking up a trade name, for example, and preventing others from using it, the acquirer’s own trade name may be enhanced. The enhancement in value is measured as a separate unit of account rather than as additional value to the acquirer’s pre-existing trade name, even if assumptions about the enhanced value of the existing asset are the basis for valuation of the defensive asset.
  • Defining market participants — Market participants for a given defensive asset may be different from those for the transaction as a whole.
  • Valuation techniques and approaches — Common valuation techniques will likely still apply for defensive assets (e.g., relief-from-royalty, with-and-without), taking into account the cash flows reflecting market participant assumptions. However, while the valuation techniques may be consistent with other intangible assets, the need to use market participant assumptions and hypothetical cash flow forecasts will require more effort. For example, determining the hypothetical cash flows that a market participant would generate if it were to use the defensive asset in the marketplace will require a significant amount of judgment. Accordingly, assumptions may need to be refined to appropriately capture the value associated with locking up the acquired asset. Such assumptions may consider enhancements to other complementary assets, such as an existing brand, increased projected profit margins from reduced competition, or avoidance of margin erosion from a competitor using the brand that the entity has locked up. If no market participants in the industry would actively use the asset, it may also be appropriate to estimate the direct and indirect benefits associated with the defensive use of the asset although the value is likely to be low.
Regardless of the methodology used in valuing the defensive asset, it is important not to include value in a defensive asset that is already included in the value of another asset.
Example FV 7-14 provides an example of a defensive asset.
EXAMPLE FV 7-14

Defensive asset
Company A (a large beverage company) acquires Company B (a smaller beverage company) in a business combination. Company A acquired Company B in order to gain distribution systems in an area that Company A had an inefficient distribution system. While Company A does not plan on using Company B’s trademark, other market participants would continue to use Company B’s trademark.
Is Company B’s trademark a defensive asset?
Analysis
Although Company A has determined that it will not use Company B’s trademark, other market participants would use Company B’s trademark. As a result, the trademark is a defensive asset and should be valued using market participant assumptions.

Key considerations
Figure FV 7-8 summarizes some key considerations in measuring the fair value of intangible assets.
Figure FV 7-8
Leading practices in measuring the fair value of intangible assets
Use an appropriate valuation methodology for the primary intangible assets
The income approach is most commonly used to measure the fair value of primary intangible assets. The market approach is not typically used due to the lack of comparable transactions. The cost approach is generally not appropriate for intangible assets that are deemed to be primarily cash-generating assets, such as technology or customer relationships. As discussed in FV 7.3.4.3, the cost approach is sometimes used to measure the fair value of certain software assets used for internal purposes, an assembled workforce, or assets that are readily replicated or replaced.
Value intangible assets separately
In most cases, intangible assets should be valued on a stand-alone basis (e.g., trademark, customer relationships, technology). In some instances, the economic life, profitability, and financial risks will be the same for several intangible assets such that they can be combined. See BCG 4.2.2 for further information on the separability criterion.
Consider and assess the economic life of an asset
For example, the remaining economic life of patented technology should not be based solely on the remaining legal life of the patent because the patented technology may have a much shorter economic life than the legal life of the patent. The life of customer relationships should be determined by reviewing expected customer turnover.
Use PFI that reflects market participant assumptions
PFI should be representative of market participant assumptions, rather than entity-specific assumptions.
Use PFI prepared on a cash basis not an accrual basis
Since the starting point in most valuations is cash flows, the PFI needs to be on a cash basis. If the PFI is on an accrual basis, it must be converted to a cash basis such that the subsequent valuation of assets and liabilities will reflect the accurate timing of cash flows.
Use PFI that includes the appropriate amount of capital expenditures, depreciation, and working capital required to support the forecasted growth
The level of investment in the projection period and in the terminal year should be consistent with the growth during those periods. The terminal period must provide a normalized level of growth.
Use PFI that includes tax-deductible amortization and/or depreciation expense
PFI should consider tax deductible amortization and depreciation to correctly allow for the computation of after-tax cash flows. PFI that incorrectly uses book amortization and depreciation will result in a mismatch between the post-tax amortization and depreciation expense and the pre-tax amount added back to determine free cash flow. (See FV 7.3.2.1 for further information on calculating free cash flows.)
Select discount rates that are within a reasonable range of the WACC and/or IRR
In general, low-risk assets should be assigned a lower discount rate than high-risk assets. The required return on goodwill should be highest in comparison to the other assets acquired.
Use the MEEM only for the primary intangible asset
The MEEM, which is an income approach, is generally used only to measure the fair value of the primary intangible asset. Secondary or less-significant intangible assets are generally measured using an alternate valuation technique (e.g., relief-from royalty, greenfield, or cost approach). The MEEM should not be used to measure the fair value of two intangible assets using a common revenue stream and contributory asset charges because it results in double counting or omitting cash flows from the valuations of the assets.
Include the tax amortization benefit when using an income approach
As discussed in FV 7.3.4.1, the tax benefits associated with amortizing intangible assets should generally be applied regardless of the tax attributes of the transaction. The tax jurisdiction of the country the asset is domiciled in should drive the tax benefit calculation.
Foreign currency cash flows
When a discounted cash flow analysis is done in a currency that differs from the currency used in the cash flow projections, the cash flows should be translated using one of the following two methods:
  • Discount the cash flows in the reporting currency using a discount rate appropriate for that currency. Convert the present value of the cash flows at the spot rate on the measurement date.
  • Use a currency exchange forward curve, if available, to translate the reporting currency projections and discount them using a discount rate appropriate for the foreign currency.
Reacquired rights
An acquirer may reacquire a right that it had previously granted to the acquiree to use one or more of the acquirer’s recognized or unrecognized assets. Examples of such rights include a right to use the acquirer’s trade name under a franchise agreement or a right to use the acquirer’s technology under a technology licensing agreement. Such reacquired rights generally are identifiable intangible assets that are separately recognized apart from goodwill in accordance with ASC 805-20-25-14. The reacquisition should be evaluated separately to determine if a gain or loss on the settlement should be recognized. For further details on the recognition of reacquired rights see BCG 2.
Reacquired rights are identified as an exception to the fair value measurement principle, because the value recognized for reacquired rights is not based on market participant assumptions for the life of the reacquired right. The value of a reacquired right is determined based on the estimated cash flows over the remaining contractual life, even if market participants would reflect expected renewals in their measurement of that right according to ASC 805-20-30-20, as discussed in more detail in BCG 2.
The value of a reacquired right should generally be measured using a valuation technique consistent with an income approach. That technique would consider the acquiree’s cash flows after payment of the royalty rate to the acquirer for the right that is being reacquired.
The market and the cost approaches are rarely used to value reacquired rights. The usefulness of these approaches is diminished by the requirement to limit the term of the reacquired right to the remaining contractual term. For example, a market approach could not be readily applied to a reacquired right as a market price for a comparable intangible asset would likely include expectations about contract renewals; however, these expectations are excluded from the measurement of a reacquired right.

7.3.5 Fair value of NCI and previously held equity interests

Any noncontrolling interest (NCI) in the acquiree must be measured at its acquisition-date fair value under US GAAP.
A business combination in which an acquirer holds a noncontrolling equity investment in the acquiree immediately before obtaining control of that acquiree is referred to as a business combination achieved in stages, or a step acquisition. In accordance with ASC 805-10-25-10, the acquirer should remeasure its previously held equity interest (PHEI) in the acquiree at its acquisition-date fair value in a step acquisition and recognize the resulting gain or loss in earnings (profit or loss).
The fair value of the controlling ownership interest acquired may generally be valued based on the consideration transferred. However, the determination of the fair value of the NCI in transactions when less than all the outstanding ownership interests are acquired, and the fair value of the PHEI when control is obtained may present certain challenges. The consideration transferred for the controlling interest on a per-share basis may be an indication of the fair value of the NCI and PHEI on a per-share basis in some, but not all circumstances. In certain circumstances, an acquirer will be able to measure the acquisition-date fair value of the NCI and PHEI based on active market prices for the remaining equity shares not held by the acquirer, which are publicly traded. However, in other situations, an active market for the equity shares will not be available. According to ASC 805-20-30-7, in those circumstances, the fair value of the NCI and PHEI will likely need to be established through other valuation approaches and methods.

7.3.5.1 Determining the impact of control on the NCI

The existence of control premiums or minority interest discounts should be considered when measuring the fair value of the NCI. The acquirer may have paid a control premium on a per-share basis or conversely there may be a discount for lack of control in the per-share fair value of the NCI as noted in ASC 805-20-30-8.
A control premium generally represents the amount paid by a new controlling shareholder for the benefit of controlling the acquiree’s assets and cash flows. The elements of control derived by an acquirer can be categorized as (1) benefits derived from potential synergies that result from combining the acquirer’s assets with the acquiree’s assets and (2) the acquirer’s ability to influence the acquiree’s operating, financial, or corporate governance characteristics (e.g., improve operating efficiency, appoint board members, declare dividends, and compel the sale of the company).
Synergies will often benefit the acquiree as a whole, including the NCI. Entities should understand whether, and to what extent, the NCI will benefit from those synergies. Consideration of a noncontrolling (minority interest) discount may be necessary to account for synergies that would not transfer to the NCI. Companies should not mechanically apply a noncontrolling discount to a controlling interest without considering whether the facts and circumstances related to the transaction indicate a difference exists between the controlling and noncontrolling values. It is helpful to understand how the negotiations between the acquiree and acquirer evolved when assessing the existence of a control premium. For example, if multiple bidders were involved in the negotiations, it is important to understand what factors were included in determining the amount of consideration transferred and what synergies were expected to be realized. Additionally, understanding the significant issues that were subject to the negotiations and how they were eventually resolved may provide valuable insight into determining the existence of a control premium.

7.3.5.2 Measuring the fair value of the NCI

Generally, the fair value of the NCI will be determined using the market and income approaches, as discussed in FV 7.2.5.2 and FV 7.2.5.1, respectively. However, the determination of fair value for the NCI that remains publicly traded post acquisition should be made using the NCI’s quoted market price if an active market price for the shares not held by the acquirer is available. This is consistent with ASC 820-10-35-41, which states that price quotations at the acquisition date in an active market provide the most reliable and best evidence of fair value, and should be used when they exist.
A reasonable method of estimating the fair value of the NCI, in the absence of quoted prices, may be to gross up the fair value of the controlling interest to a 100% value to determine a per-share price to be applied to the NCI shares (see Example FV 7-13). This method reflects the goodwill for the acquiree as a whole, in both the controlling interest and the NCI, which may be more reflective of the economics of the transaction. This method assumes that the NCI shareholder will participate equally with the controlling shareholder in the economic benefits of the post-combination entity which may not always be appropriate. However, although there is no control inherent in the NCI, in some circumstances the NCI may receive a portion of the overall benefits from the synergies that are inherent in the control premium. Therefore, when discussing NCI in this section, we refer to the synergistic benefit as a “control premium” even though control clearly does not reside with the NCI. Use of both the market and income approaches should also be considered, as they may provide further support for the fair value of the NCI.
NCI – market approach
Entities may need to consider using the market approach, specifically, the guideline public company method, to value an NCI that is not publicly traded and for which the controlling interest value is not an appropriate basis for estimating fair value. See further information at FV 7.3.2.2.
The first step in applying this method is to identify publicly-traded companies that are comparable to the acquiree. Pricing multiples of revenue or earnings are calculated from the guideline companies; these are analyzed, adjusted, and applied to the revenue and earnings of the acquiree. Applying the pricing multiples to the acquiree’s earnings produces the fair value of the acquiree on an aggregate basis. This is then adjusted to reflect the pro rata NCI and control premium, if required, for any synergies from the acquisition that would be realized by the NCI. Similarly, the pricing multiples could be applied directly to the pro rata portion of the acquiree’s earnings to estimate the fair value of the NCI.
Example FV 7-15 provides an example of measuring the fair value of the NCI using the guideline public company method. It also presents issues that may arise when this approach is used.
EXAMPLE FV 7-15

Measuring the fair value of the NCI using the guideline public company method
Company A acquires 350 shares, or 70%, of Company B, which is privately held and meets the definition of a business, for $2,100 ($6.00 per share). There are 500 shares outstanding. The outstanding 30% interest in Company B represents the NCI. At the acquisition date, Company B’s most recent annual net income was $200. Company A used the guideline public company method to measure the fair value of the NCI. Company A identified three publicly traded companies comparable to Company B, which were trading at an average price-to-earnings multiple of 15. Based on differences in growth, profitability, and product differences, Company A adjusted the observed price-to-earnings ratio to 13 for the purpose of valuing Company B.
How would Company A initially apply the price to earnings multiple in measuring the fair value of the NCI in Company B?
Analysis
To measure the fair value of the NCI in Company B, Company A may initially apply the price-to-earnings multiple in the aggregate as follows:
Company B net income
$200
Price-to-earnings multiple
x13
Fair value of Company B
2,600
Company B NCI interest
30%
Fair value of Company B NCI
$780
View table
Entities will have to understand whether the consideration transferred for the 70% interest includes a control premium paid by the acquirer and whether that control premium would extend to the NCI when determining its fair value. In this example, the fair value of Company B using the market approach is $2,600, which represents a minority interest value because the price-to-earnings multiple was derived from per-share prices (i.e., excludes control). If it had been determined to be appropriate to include the control premium in the fair value estimate, grossing up the 70% interest yields a fair value for the acquiree as a whole of $3,000 ($2,100/0.70), compared to the $2,600 derived above, resulting in a value for the NCI of $900 ($3,000 × .30).
NCI – income approach
The income approach may be used to measure the NCI’s fair value using a discounted cash flow method to measure the value of the acquired entity. The BEV and IRR analysis performed as part of assigning the fair value to the assets acquired and liabilities assumed may serve as the basis for the fair value of the acquiree as a whole. Again, understanding whether a control premium exists and whether the NCI shareholders benefit from the synergies from the acquisition is critical in measuring the fair value of the NCI. This can be achieved by understanding the motivation behind the business combination (e.g., expectations to improve operations or influence corporate governance activities) and whether the expected synergies would result in direct and indirect cash flow benefits to the NCI shareholders.
If it is determined that a control premium exists and the premium would not extend to the NCI, there are two methods widely used to remove the control premium from the fair value of the business enterprise.
  • Calculate the NCI’s proportionate share of the BEV and apply a minority interest discount.
  • Adjust the PFI used for the BEV analysis to remove the economic benefits of control embedded in the PFI.

7.3.5.3 Measuring the fair value of previously held equity interest

The acquirer should remeasure any PHEI in the acquiree and recognize the resulting gain or loss in earnings in accordance with ASC 805-10-25-10. The fair value of any PHEI should be determined consistent with paragraph B387 of FAS 141(R). A PHEI that has been measured at fair value as of each reporting date prior to the acquisition should be measured similarly as of the acquisition date. The resulting gain or loss should be recognized in the income statement and may include previously unrecognized gains or losses deferred in equity.
The fair value of the PHEI in a company that remains publicly traded should generally be based on the observable quoted market price without adjustment. If there are multiple classes of stock and the PHEI is not the same class of share as the shares on the active market, it may be appropriate to use another valuation method. A PHEI of a company that is not publicly traded should be measured using the market or income approaches or the fair value derived from the consideration transferred.
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