As the coronavirus (COVID-19) pandemic continues to rattle financial markets and the broader global economy, it also has added even greater uncertainty around fair value measurements, a financial reporting requirement that many businesses have long found challenging.
Under both U.S. GAAP and IFRS, accounting standards compel financial statement issuers to measure certain assets or liabilities at fair value. While fundamental valuation approaches – cost, market and income – remain unchanged, it is no longer valid to take a business-as-usual approach to fair value measurements during the current COVID-19 crisis. Indeed, models and inputs that were appropriate for annual financial statements ended December 2019 may be obsolete for interim reporting dates ended during the first quarter of 2020. Instead, management must reassess their models and inputs in order to reliably estimate “the price that would be received to sell an asset or paid to transfer a liability,” particularly as it relates to impairment testing, debt and equity investments, equity-based compensation and derivatives.
Each business is its own unique entity, so the COVID-19 crisis impacts businesses in different ways. Likewise, its impact varies from one industry to the next. Nevertheless, auditors will require robust documentation of qualitative and quantitative considerations of COVID-19 impacts as they relate to both valuation models and inputs, so management should be prepared to provide specifics and supporting information.
The following summarizes fair value measurements as they relate to the cost, income and market approaches.
The cost approach reflects the amount that currently would be required to replace the service capacity of an asset—i.e., current replacement cost. For businesses, this approach measures value by reference to the cost to replace a business’ net assets. In the post-COVID-19 world, cost approaches could become more relevant since depressed market prices and reduced expectations of future cash flow generation might suggest an impairment of intangible assets. This, in turn, could suggest that a business is not worth more than its collection of tangible net assets.
- Historical vs. Replacement Cost: With this approach, cost is a key input. Given changing market conditions, simplifying assumptions for certain assets that book value was indicative of fair value may no longer be valid. Moreover, balance sheet amounts recorded at historical cost may not reflect replacement cost at current pricing.
- Obsolesce: Demand may shift markedly for many businesses. In that case, the question becomes whether there is an underutilization of assets, such as machinery and equipment. It’s also worth asking if this is a function of economic obsolescence that should be factored into management’s model.
- Market Values: Questions arise as to whether market values for assets such as real estate are readily available. And, if underlying models are used to value such assets, do they take into account the current market conditions?
The income approach measures value by converting future amounts (e.g., cash flows or income and expenses) to a present (discounted) amount. Valuation models under this approach compel management to view their models and inputs through a fresh lens. Business leaders who may be accustomed to a business-as-usual approach to forecasts, growth estimates and discount rates must now reassess all material inputs in the broader context of the COVID-19 pandemic.
- Start Simple: Long-term revenue impacts of the crisis can’t accurately be forecasted, so management may find it useful to build upon budgets for the shorter-term with greater visibility. For businesses with revenue streams that are highly seasonal, management may discover that anticipated growth rates initially budgeted for Q3 or Q4 could still be relevant—albeit growing from a lower starting point during the first half of the year.
- More Options: Given all the uncertainty swirling around COVID-19, scenario modeling could be beneficial by enabling management to capture a range of potential outcomes for both top-line forecasts and cost structure. Valuation models used for fair value measurements typically reflect an expected average across potential outcomes. Still, management may be accustomed to analyzing different scenarios for strategic planning. For example, forecasts of a worst or best case predicated on certain variables (e.g., commodity pricing, sales pipeline success rates) could be leveraged and modified to potential outcomes (and likelihood) during the COVID-19 pandemic.
- Cost Structure: Management must evaluate and document cost of sales and operating costs amid current conditions. Some relevant questions in this regard: Are variable and fixed cost of sales appropriately reflecting supply constraints and shortages, not to mention the related impact on pricing? Does the pricing of goods and services purchased reflect this new environment? Does the business incur new costs, such as sanitizing facilities and equipment, masks and protective wear? Are cost-cutting initiatives estimated in the model reflective of one-time costs associated with the savings (e.g., severance)? Does production and throughput reconcile with the new cost structure? And finally, for smaller businesses, how should any funds generated from the Paycheck Protection Program be addressed in the model?
- Capital Expenditure and Working Capital: If management benchmarked such uses or sources of cash to historical or peer group averages, they must now document and model specific plans or freezes of cash outlays during the COVID-19 crisis. It’s likely that changes to expected working capital levels will arise as this crisis continues to unfold and impact every facet of the cash conversion cycle. To that end, management should ask themselves: Do shipping challenges impact inventory and time of delivery? Is the current collectability of receivables and revised payment terms appropriately modeled in the near term?
- Discount Rate: Business risk often is captured in the discount rate used to present value future amounts. This takes the form of industry (beta) and company-specific factors (alpha). It is expected that overall risk will increase in the near term due to heightened uncertainty surrounding COVID-19. Consequently, management’s prior model inputs may need to deviate from historical risk levels. That said, it’s critical to avoid any double counting of business risks that may already be captured in future cash flows or industry risk factors. Additionally, in multiple scenario models, how does relative risk vary across scenarios? Is it taken into account by probability weightings?
- Volatility: This is an important input into option and other derivative valuation models (e.g., Black- Scholes, Binomial and Monte Carlo simulations). To that end, management’s volatility assumptions in current conditions must evaluate the extent to which extreme recent volatility amid COVID-19 would be taken into account in the expected volatility market participants would consider.
This approach utilizes prices and other relevant information driven by market transactions involving identical or similar assets, liabilities or a group of assets and liabilities, such as a business. Oftentimes, this entails studying transactions in similar equity securities, whether publicly traded or as part of a change-of-control transaction. As the COVID-19 crisis begins to subside, fair value measurements likely will require a fresh look at inputs into a market approach.
- Financial Inputs: Financial inputs to a market approach, such as revenue and earnings, will require careful reconsideration. Historically, management may have provided sufficient evidence that a business could command a certain trailing multiple of EBITDA in a sale pre-crisis. However, in the post-COVID-19 world, trailing financial metrics may no longer be reliable indicators of the future. Moreover, an inconsistency could exist with the historical financials of public companies (calculated on the latest quarterly results) and the current (i.e., potentially depressed) market value. Concurrently, the availability of forward-looking estimates for public companies could be limited as public companies withdraw or suspend their earnings guidance amid current pandemic conditions.
- Comparables: For a set of comparable publicly traded companies, market data at the measurement date should provide real-time evidence of investor sentiment and pricing of similar assets. That said, management must reaffirm the applicability of comparable companies used for prior measurements. Because timelines for which different markets were taken off (and will be put back) online by national and local governments vary, the geographic footprint of a subject business and comparable peers may be more relevant under the current conditions. For example, a peer group of national retailers may historically have been relied on to value a retailer with a national presence. Yet, depending on the subject and peer group’s relative market exposure to states with longer stay-at-home orders, said peer group may no longer be applicable.
- Discounts and/or Premiums: Often times, certain discounts and/or premiums (e.g. discounts for lack of marketability, control premiums, etc.) need to be considered in estimating fair value. Given the impact COVID-19 has had on financial markets recently, some of the more traditional quantitative sources used to estimate these discounts/premiums (many of which rely on dated information) may need to be reassessed. That said, given the relatively limited amount of historical information that exists with respect to the impact COVID-19 might have on these measures, management may need to consider more qualitative adjustments to these traditional discount/premium estimates. Some of the questions that management may want to ask themselves in estimating the magnitude of these qualitative adjustments include: Is the market for my business/asset now less liquid? Would a buyer be willing to pay more or less for a controlling stake in my business given the way I have managed around the crisis?
- Control Transactions: For similar reasons noted above, management must reassess the applicability of multiples observed from comparable control transactions entered into in the pre- COVID-19 world. As a result, there now could be a greater likelihood of distressed sales that could also skew multiples and require careful consideration to determine comparability.
COVID-19 has affected financial markets and the economy, creating greater uncertainty around fair value analyses. As a result, management must reassess their valuation models and assumptions in order to reliably estimate fair value. While every business and industry is unique, with COVID-19 impacting each in different ways, auditors will still require documentation of these assumptions, as well as other considerations around COVID-19 impacts as they relate to fair value measurements.