Fair Value Measurements Amid the COVID-19 Crisis
Business As Usual No Longer Applies
The turmoil that has ripped through the global economy and financial markets further clouds certain financial reporting requirements that were already opaque for management: fair value measurements. Accounting standards under both U.S. GAAP and IFRS require issuers of financial statements to measure certain assets or liabilities at fair value.1 Amid the COVID-19 crisis, a business as usual approach to such measurements will no longer hold. While fundamental valuation approaches – cost, market, and income – remain unchanged, management will need to reassess both the models and inputs they use to reliably estimate “the price that would be received to sell an asset or paid to transfer a liability” as it relates to impairment testing, debt and equity investments, derivatives, and equity-based compensation, among other accounting topics.
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. Facts and circumstances (and the related impact from the crisis) will vary across industries and, in many cases, will be business-specific. Management should be prepared for auditors to require robust documentation of both qualitative and quantitative considerations of the impact of the crisis on both valuation models and inputs.
The cost approach reflects the amount that would be required currently to replace the service capacity of an asset (often referred to as current replacement cost).2 As it relates to a business, the cost approach measures value by reference to the cost to replace a business’ net assets. Cost approaches may gain relevance in the post-COVID-19 environment, as depressed market prices and reduced expectations of future cash flow-generating ability could suggest an impairment of intangible assets, leading to a market participant view that a business is not worth more than its collection of tangible net assets.
- Historical vs. replacement cost – It should be no surprise that cost is a key input management needs to evaluate in terms of developing this approach. 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 – As demand shifts significantly for many businesses, is there an underutilization of certain assets such as machinery and equipment? Is this is a function of economic obsolescence which should be factored into management’s model?
- Market values – Are market values for assets such as real estate readily available? How do the underlying models used to value such assets take into account the current market conditions?
The market approach uses prices and other relevant information generated by market transactions involving identical or comparable (similar) assets, liabilities, or a group of assets and liabilities, such as a business.3 This commonly entails examining transactions in similar equity securities, whether publicly traded or as part of a change-of-control transaction. Fair value measurements in the aftermath of COIVD-19 will require a fresh look at inputs into a market approach.
- Comparables – Market data at the measurement date for a set of comparable publicly traded companies should provide real time evidence of investor sentiment and pricing of similar assets. However, management will need to reaffirm the applicability of comparable companies used for prior measurements. Because the timelines for which different markets were taken off (and will be put back) online by national and local governments across the globe vary, the geographic footprint of a subject business and comparable peers may be more relevant under the current conditions. For example, historically, a peer group of national retailers may have been relied on to value a retailer with a national presence. However, depending on the subject and peer group’s relative market exposure to states with longer stay-at-凯发k8官方旗舰店home orders, the peer group may no longer be applicable.
- Financial inputs – Revenue, earnings, and other financial inputs to a market approach will require careful reconsideration. Historically, management may have provided adequate evidence a business could command a certain trailing multiple of EBITDA in a sale pre-crisis. However, trailing financial metrics may no longer be reliable indicators of the future, and there could be an inconsistency with the historical financials of public companies (calculated on the latest quarterly results) and the current (potentially depressed) market value. At the same time, the availability of forward-looking estimates for public companies may be limited as public companies withdraw or suspend their earnings guidance amid the current conditions.
- Control transactions – For similar reasons noted above, management will need to reassess the applicability of multiples observed from comparable control transactions entered into in the pre-COVID-19 world. There could now be a greater likelihood of distressed sales that could also skew multiples and require careful consideration to determine comparability.
Valuation models under the income approach, which measures value by converting future amounts (for example, cash flows or income and expenses) to a present (discounted) amount, will also require management to take a refreshed look at their models and inputs. Management who may be accustomed to a business as usual approach to forecasts, growth estimates, and discount rates will need to reassess all material inputs in the COVID-19 context.
- Start simple – Since no crystal balls exist to forecast long-term revenue impacts of the crisis, management may find it helpful to build upon budgets for shorter-term with greater visibility. Businesses with revenue streams that are highly seasonal may find that anticipated growth rates initially budgeted for Q3 or Q4 could still be relevant (albeit growing from a lower starting point in the first half of the year).
- More options – Given current uncertainty, scenario modeling may prove helpful and allow management to capture a range of potential outcomes for both top line forecasts and cost structure. Although valuation models used for fair value measurements typically reflect an expected average across potential outcomes, management may be accustomed to analyzing different scenarios for strategic planning. For instance, forecasts of a worst or best case predicated on certain variables – such as commodity pricing or sales pipeline success rates – could be leveraged and modified to potential outcomes (and likelihood) amid the current crisis.
- Cost structure – Management will need to evaluate and document cost of sales and operating costs amid current conditions. Are variable and fixed cost of sales appropriately reflecting any supply constraints and shortages, and the related impact on pricing? Is there validity in the pricing of goods and services purchased? Is the business incurring new costs such as sanitizing facilities and equipment, masks and protective wear, etc.? 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?
- Capital expenditure and working capital – Management who may have benchmarked these uses (or sources) of cash to historical or peer group averages will need to document and model specific plans (or freezes) of cash outlays amid the crisis. Changes to expected working capital levels are likely as the crisis unfolds and impacts all aspects of the cash conversion cycle. Are shipping challenges impacting 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 is often captured in the discount rate used to present value future amounts. This takes the form of industry (beta) and company-specific factors (alpha). We expect overall risk to increase in the near term with the heightened uncertainty caused by the crisis. This may require management’s prior model inputs to deviate from a historical risk levels. However, care must be given to avoid any double counting of business risks that may already be captured in future cash flows or industry risk factors. Moreover, in multiple scenario models, how does relative risk vary across scenarios – or is that taken into account by probability weightings?
- Volatility – An important input into option and other derivative valuation models (e.g., Black-Scholes, Binomial, and Monte Carlo simulations), management’s volatility assumptions in current conditions will need to consider the extent to which the extreme recent volatility would be taken into account in the expected volatility market participants would consider.
ConclusionPre-COVID-19, relatively stable economic conditions and financial markets may have permitted a more passive approach to periodic fair value measurements. With the disruption caused by the coronavirus crisis, managers will need reassess these models and inputs and provide auditors with more robust documentation as to how business expectations are expected to change as a new normal unfolds.
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1. As defined in ASC 820 and IFRS 13.
2. ASC 820-10-55-3D and IFRS 13.B8.