Fair Value Estimates Outside of Financial Instruments

Transcription

1 Fair Value Estimates Outside of Financial Instruments Lau, Kam Yuen Partner, Assurance and Business Advisory Services Lamiya Bhatri Manager, Assurance and Business Advisory Services KPMG in Singapore 9 May 2014

2 Hard facts about fair value estimates 82% of total asset values must be reestimated to derive amounts carried forward 1% fluctuation in the total asset values can result in as much as 38% change in net profit and up to 50% change in comprehensive income Over 70% of all disputes with auditors pertain to estimates Sir David Tweedy 2014 KPMG Services Pte. Ltd. (Registration No: G), a Singapore incorporated company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity.

3 Study findings - total assets by industry 2014 KPMG Services Pte. Ltd. (Registration No: G), a Singapore incorporated company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity.

4 Study findings - total liabilities by sector 2014 KPMG Services Pte. Ltd. (Registration No: G), a Singapore incorporated company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity.

5 Some sources of estimation uncertainty Biological Assets Impairment of Assets Net Realisable Value Share-based Payments Business Combinations Investment Property 2014 KPMG Services Pte. Ltd. (Registration No: G), a Singapore incorporated company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity.

6 Agenda Time 2:00pm 3:30pm 3:30pm - 4:00pm 4:00pm 5:00pm Topic Fair Value Estimates and Accounting Areas FRS 113 Fair Value Measurement Business Valuation Market Study Issues Investment Property Business Combinations BREAK Biological Assets Share-based Payments Net Realisable Value Impairment of Non-financial Assets Key Takeaways from the Session Judgements and Estimates Top 10 Questions on Fair Value and Estimates KPMG s Financial Reporting Assessment Tool (FRAT) Integrated Reporting 2014 KPMG Services Pte. Ltd. (Registration No: G), a Singapore incorporated company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity.

7 Fair value estimates and accounting areas ACCOUNTING STANDARDS Investment Property (FRS 40) Business Combinations (FRS 103) Biological Assets (FRS 41) Revenue (FRS 18) Employee Benefits (FRS 19) Impairment Of Assets (FRS 36) Intangible Assets (FRS 38) Property, Plant & Equipment (FRS 16) RELEVANT ACCOUNTING AREAS Fair Value Model Purchase Price Allocation Valuation of Biological Assets Fair Value of Consideration Transferred Fair Value of Plan Assets Fair-value-less costs to sell and Value-in-use Revaluation model Revaluation model 2014 KPMG Services Pte. Ltd. (Registration No: G), a Singapore incorporated company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity.

8 FRS 113 Fair Value Measurement

9 Scope of FRS 113 Within the scope of FRS 113 Outside the scope of FRS 113 Business combinations (FRS 103) Property, Plant & Equipment (FRS 16) Revenue (FRS 18) Employee benefits (FRS 19) Fair-value-less costs to sell (FRS 36) Intangible Assets (FRS 38) Share-based payments (FRS 102) Leasing (FRS 17) Net realisable value (FRS 2) Value-in-use (FRS 36) Provisioning (FRS 37) Financial Instruments (FRS 39) Investment Property (FRS 40) 9

10 Implications of FRS 113 s FV definition The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm s length transaction. Pre FRS 113 The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. FRS 113 Exit price notion Liabilities: transfer vs settlement Market participant vs entity specific measurement Measurement date 10

11 Where does the transaction take place? Valuation must assume the transaction occurs in a market that it can access which is: Principal market The market with the greatest volume and level of activity for the asset or liability And only in the absence of a principal market: Most advantageous market The market that maximises the amount received after taking into account transaction and transport costs 11

12 Where does the transaction take place? Most advantageous market : Need to determine where an entity will get the highest proceeds considering both of the following Transaction Costs The costs to sell an asset in the principal (or most advantageous) market that are directly attributable to the disposal of the asset and are both: - result directly from and are essential to that transaction - would not have been incurred by the entity had the decision to sell the asset not been made Transport Costs The costs that would be incurred to transport an asset from its current location to its principal (or most advantageous market) 12

13 What should be included in exit price? Transaction costs vs Transport costs Transaction costs Exclude from FV measurement Transport costs Include in the FV measurement of physically settled contracts Transport costs only relevant for physical settled contracts 13

14 Highest and best use of a non-financial asset NEW Do market or other factors suggest that different use by market participant maximises asset s value? No FV is based on asset s current use. Yes Identify other uses that are physically possible, legally permissible AND financially feasible either on: Stand-alone basis; or In combination with other assets or assets and liabilities. Measure FV based on use that maximises the asset s value = highest and best use. 14

15 Question for you A house is located in the prime location of Atlantis City. All adjacent plots are either occupied by office buildings or have the permission to be used as commercial property. A plot of a similar size to the one the house is currently occupying (with a permission to use as commercial property) has a market value of $6million. What is the fair value of the house? 1. $4 million 2. $6 million 3. $10 million 0% 0% 0%

16 Fair value at initial recognition Transaction is between related parties Transaction is forced Unit of account represented by the transaction is different from unit of account used for measuring fair value The market in which transaction takes place is different from the market in which the entity would sell the asset or transfer the liability May indicate that transaction price and fair value may differ FRS 113 does not prescribe rules for recognition of gains or losses at initial recognition look to FRS that permits/requires the fair value measurement Assumed position is to take to profit or loss unless other FRS says otherwise 16

17 Valuation techniques Market approach Uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities Income approach Converts future amounts (e.g. cash flows or income and expenses) to a single present (discounted) amount Cost approach Reflects the amount that would currently be required to replace the service capacity of an asset (current replacement cost) 17

18 Inputs to valuation techniques Inputs refer broadly to assumptions that market participants would use when pricing the asset or liability, including assumptions about risk Observable - inputs that are developed based on observable market data and reflect market participants assumptions Unobservable - inputs for which market data are not available and which are developed based on the best available information about market participant assumptions Valuation technique should maximise use of relevant observable inputs and minimise use of unobservable inputs 18

19 Fair value hierarchy The fair value hierarchy prioritises the inputs to valuation techniques used to measure fair value into three levels, considering the relative subjectivity of inputs Quoted price for an identical item in an active market? yes Price adjusted? (paragraph 79) no Level 1 no yes Any significant unobservable inputs? no Level 2 yes Level 3 19

20 Fair value hierarchy (cont d) Level 1 Inputs Quoted prices in an active market for identical assets or liabilities provide the best evidence of fair value A market is active if transactions take place with sufficient frequency and volume to provide pricing information on an ongoing basis If there is a Level 1 price, an entity must use that price for the fair value measurement. Exceptions include: entity can use, in certain cases as a practical expedient, an alternative pricing methodology that does not rely exclusively on available quoted prices (e.g. matrix pricing) in some circumstances, quoted price in an active market may not represent fair value at the measurement date (e.g. when significant events take place after the close of the market but before the measurement date) The use of alternative pricing will result in a lower level fair value measurement 20

21 Fair value hierarchy (cont d) Level 2 Inputs Include: quoted prices for similar assets or liabilities in active markets quoted prices for identical or similar assets or liabilities in markets that are not active inputs other than quoted prices that are observable for the asset or liability (e.g. interest rates and yield curves, volatilities, prepayment speeds, loss severities, credit risks and default rates) inputs derived principally from or corroborated by observable market data by correlation or other means An adjustment to a Level 2 input that is not based on observable data and is significant to the entire measurement would result in a Level 3 measurement 21

22 Fair value hierarchy (cont d) Level 3 Inputs The objective of fair value measurement does not change when fair value is measured using unobservable inputs Unobservable inputs should reflect assumptions that market participants would use when pricing the asset or liability, including assumptions about risk An entity should develop the unobservable inputs using the best information available, which may include an entity s own data 22

23 A question for you decrease in volume or level of activity Entity D holds 4% of share capital in Entity F, quoted price on stock exchange is CU 200 at measurement date (Q4-20X2). During Q2-20X2 trading was suspended for 8 weeks and during 20X2 government took several steps to support the market. Due to financial and political instability, the share price and trading activity have declined sharply since Q2-20X2, with historical lows in Q4-20X2. Trading volume at measurement date is proportionate to quarterly trading volume. 23

24 A question for you Is D allowed to use a price, other than the quoted price, to measure the FV of a share in F at the measurement date? 1. Yes 2. No 0% 0%

25 A question for you To measure the FV of CGU X, the following valuation techniques are available to Company Z: a) EBITDA multiple; multiple is based on EBITDA and enterprise value of listed entities that have businesses similar to CGU X. b) Based on the recent sale price for a business similar to CGU X. c) Discounted estimated cash flows for the next five years with a terminal value. 25

26 A question for you Arrange the valuation techniques in the order of appropriateness for FV measurement purposes available to Co. Z to measure the fair value of CGU X. 1. EBIDTA, Recent sale price, Discounted cash flows 2. EBIDTA, Discounted cash flows, Recent sale price 3. Recent sale price, EBIDTA, Discounted cash flows 0% 0% 0%

27 Business valuation market study A market study on business valuations was carried out by the Institute of Valuers and Appraisers of Singapore (IVAS) and the findings were presented at the IVAS Business Valuation Conference This study surveyed various market participants, including people who work in the corporate sector, valuation practitioners, auditors, security analysts, and others. 27

28 Key findings of the study Valuers with less years of experience frequently involved in valuation for financial reporting Different valuation purposes require different standards of values Valuation for intangible assets and biological assets most challenging Valuation is time sensitive Valuation cross-check is important Quality and Independence are top selection criteria for valuers 28

29 Investment property (1/2) Commonly used methods to value Investment Properties The income approach: e.g. The direct income capitalisation method or the discounted cash flow method; The market approach: e.g. The comparable/relative valuation method; and The cost approach: e.g. The replacement cost method The Income Approach This approach relates the value of an asset to the present value of expected future cash flows on that asset. It is therefore necessary to: estimate expected future cash flows on the investment for the life of the asset; and measure the riskiness of the investment and estimate a discount rate based on that riskiness. 29

30 Investment property (2/2) The comparable/relative valuation method This approach estimates the value of a property by comparing it to the prices of similar properties sold in similar locations within a recent period. It provides a mechanism for valuing non-cash flow producing assets. It also takes into account market trends that may not be reflected in cash flows for various reasons, such as leases that have frozen rentals in place while market values have risen, or rent control laws that prevent rents from rising with market values. The cost approach This approach is based on the principal of substitution, which asserts that no prudent buyer or investor will pay more for a property than that amount for which the site could be acquired and for which improvements can be constructed without undue delay. It is a method of appraising property based on depreciated reproduction or replacement cost of improvements, plus market value of the site. 30

31 A question for you What would be the best form of valuation report that you can obtain from your valuer for investment property? 1. Report stating the final valuation amount 2. Report stating that the valuation is for the highest and best use for the property and the assumptions and basis are disclosed 3. Report showing valuation of property in its current use 0% 0% 0%

32 Business combinations (1/3) Under FRS 103 Business Combinations, an acquirer must identify the individual assets and liabilities in the investee, and allocate the purchase price to the assets and liabilities identified. (PPA) Recognition Must meet definition of asset / liability at acquisition date Must be exchanged as part of acquisition Classification and designation Made at acquisition date, irrespective of classification made by acquiree Exception for leases and insurance contracts acquired Measurement Measured at fair value at acquisition date (estimation required e.g. fair value and useful lives of PPE) 32

33 Business combinations (2/3) All identifiable intangible assets recognised separately from goodwill Separable or Arises from contractual or other legal rights Measured at fair value without consideration of intended use FRS 103 also requires intangibles assets such as brand, trademarks, propriety technologies and customer relationships to be identified and recognised at their fair values in the acquirer s books, even though these assets are not reflected as assets in the investee s books. Identification of these assets separately from goodwill is often a challenging task. 33

34 Business combinations (3/3) Step acquisitions 50% Previously owned ownership interest revalued at fair value through profit or loss Reclassify amounts previously in OCI as if NCI had been disposed of through profit or loss In a step acquisition, where the acquirer has a pre-existing stake in the investee, that stake is revalued to fair value at the acquisition date. Any gains or losses arising from revaluing the stake is recognised in profit or loss, even though the shares were never disposed of. Calculating an appropriate and independent fair value for the pre-existing stake is essential. 34

35 Purchase price allocation study 35

36 A question for you Company A has acquired Company Z to form a business combination. As such, there is a need to identify the fair values of all the intangible assets identified separately from goodwill. During this process, Company A identifies customer contracts as an intangible asset separate from goodwill. What approach appears to be most suitable for Company A to value this asset? 1. Cost approach 2. Income approach 3. Market approach 0% 0% 0%

37 Biological assets FRS 41 Agriculture, requires all biological assets, to be accounted for at fair value less costs to sell, with changes in fair value recognised in profit or loss (with limited exceptions.) Under this standard, where there is an active market for particular biological assets, the quoted price in that market is used as the basis to value the assets. This is often the case for consumable biological assets such as poultry. When there is no observable market price, the discounted cash flow method is a technique commonly used to value biological assets. Bearer biological assets such as oil palm and rubber plantations are often valued using this method. The discounted cash flow method thus is highly dependent on a number of key assumptions, such as expected growth rates, expected yields, appropriate discount rates, expected sales prices of harvest, and the expected cost of harvest and maintenance, all of which are extremely judgemental. 37

38 Biological assets sample valuation disclosures * Sourced from Wilmar International Annual Report

39 Biological assets sample valuation disclosures * Sourced from Qian Hu Annual Report

40 Biological assets sample valuation disclosures * Sourced from Qian Hu Annual Report

41 Biological assets Olam case 19 Nov. Muddy Waters (MW), a research firm raises red flags against Olam 21 Nov. Olam files suit against Muddy Waters 26 Nov. MW issues 133pg research report highlighting areas of concern on Olam. (eg. Sustainability of it s business model, noncash accounting gains, confusing accounts, offthe-rail capital expenditure) Olam shares drop significantly Olam has slowly healed from the damage sustained In recent developments, Temasek has offered to buy Olam for S$5.45billion 41

42 What were muddy waters basic accounting concerns? S$million FY2008 FY2009 FY2010 FY2011 FY2012 Total revenue 8,112 8,588 10,455 15,803 17,094 Cost of goods sold (6,519) (6,999) (8,466) (13,127) (13,867) Gross profit 1,593 1,589 1,989 2,677 3,227 Non-cash items: FV gains from biological assets Gains from negative goodwill Total non-cash items: Profit before tax CAPEX ,261 42

43 What were muddy waters basic accounting concerns? 200 Total non-cash items over time S$ million Non-cash items

44 Share based payments Measure employee services indirectly, based on fair value of equity instruments granted Fair value of equity instruments measured at market price for instruments with similar terms and conditions (rare) Measured at grant date If no market exists, fair value is estimated by applying a valuation (e.g. option pricing) model The entity shall estimate the fair value of the shares using valuation techniques. Common valuation methods include Black-Scholes model, Binomial tree model, Trinomial tree model. 44

45 Mini walkthrough on share based payments An entity grants 100 share options to each of its 500 employees. Each grant is conditional upon the employee working in the entity over the next 3 years. The entity estimates the fair value of each share option is $15. On the basis of a weighted average probability, the entity estimates that 20% of employees will leave during the 3 year period and therefore forfeit their rights to the share options. Assuming everything turns out as expected what amounts does the entity recognise during the vesting period, for services received as consideration for the share options? 45

46 Mini walkthrough on share based payments Calculate Closing Balance in Equity Vesting years Total # of employees Employees estimated to leave (20%) No. of employees remaining No of options per employee (100) (100) (100) Fair value at grant date Cumulative vesting fraction 1/3 2/3 3/3 Equity Cl. Bal. 200, , ,000 P or L charge 200, , ,000 46

47 Share based payments These valuation models require inputs which are subject to estimation and assumptions. These inputs can be summarised into contractual, market, and behavioural inputs. Contractual inputs e.g. Strike price, contractual life, vesting period, etc. Market inputs e.g. Stock price, volatility, risk free rate, dividend yield, etc. Behavioural inputs e.g. Exercise multiple, forfeiture rate, etc. Coming up with values for these inputs can prove to be exceedingly difficult especially for private companies whose shares are not publicly traded as well as for newly listed companies which have little historical data to use as a basis for estimation. 47

48 Binomial, trinomial and Black-Scholes models comparison Black-Scholes Model This model assumes that options can be exercised only at the defined exercise date. Bionomial Model This model allows for options which do not have a defined exercise date. The model assumes that the share price either goes up or drops over time. Most commonly used model for valuing Singapore share-based payments Trinomial Model This model extends the Binomial model by incorporating a third possibility, that the share price can stay the same over time. 48

49 A question for you Which of the following is the most subjective input to option pricing models when valuing share based payments? 1. Stock price for a newly listed entity 2. Stock price for an established listed entity 3. Stock price for a private entity 0% 0% 0%

50 A question for you When is the Black-Scholes model most commonly used? 1. For valuing European share options which have a defined exercise date 2. For valuing American share options which do not have a defined exercise date 3. The Black-Scholes Model is always the model used for valuation of share-based payments 0% 0% 0%

51 Inventories LOWER OF COST OR NRV NRV is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. As such, when goods have a short shelf life (e.g. food and drink), have highly volatile prices or are subject to technological obsolescence (e.g. handphones), estimating NRV becomes a critical issue. Unless supported by the actual sale of the goods after the reporting date, estimating the future selling price of the goods on hand and the effect of technological obsolescence on inventories is often highly subjective. 51

52 A question for you Humanoid Co, a company specializing in the production and selling of robots discovers that a batch of industrial robots have a damaged computer chip so that they cannot talk. These robots can only be sold for a lower margin than usual. Should Humanoid Co recognise a write-down of the inventory value to Net realisable value? 1. Yes 2. No 0% 0%

53 Impairment of non-financial assets (1/3) Individual asset whenever possible Otherwise by cashgenerating unit As per FRS 36 Impairment of Assets, an asset is impaired when its carrying amount exceeds its recoverable amount. The recoverable amount of an asset or cash-generating unit (CGU) is the higher of it s value-in-use and it s fair value less cost to sell. Often the most judgemental areas in impairment assessment is the grouping of individual assets into CGUs, being the smallest groups of assets that are capable of generating independent cash inflows. Establishing CGUs wrongly can end up grouping of a profit generating CGU with a loss making one, and hence masking the impairment. 53

54 Impairment of non-financial assets (2/3) - Value in use Reasonable and supportable assumptions specific to CGU Management s best estimate Ignore financing cash flows From continuing use of asset Value-in-use is generally the future discounted cash flows that the asset or the CGU is expected to generate over its remaining useful life. In performing value-in-use calculations, assumptions are made about expected future cash flows, the cash flow forecast period and the expected future growth rates, along with the appropriate discount rate, all of which are based on the successful implementation of the company s business plans. In economic downturn, reliable estimates are difficult to achieve. 54

55 Impairment of Non-financial assets (3/3) - Fair value less cost to sell An exit price measured based on assumptions used by market participants Assumes transaction takes place in entity s principal (or most advantageous) market Less costs of disposal (excluding costs that are already liabilities) Measured using: Market approach Income approach Cost approach 55

56 A question for you The provision of FRS 113, Fair Value Measurement, apply to which of the following? 1. Value-in-use 2. Fair value less cost-to-sell 0% 0%

57 A question for you Lila-Timber sells wood chips to Lila-Cosmetics for L$ 50 per kilo. Lila-Cosmetics uses the wood chips in its cosmetics Lila- Timber L$50 Lila- Cosmetics Lila-Timber could sell the wood chips on the open market for L$ 70 per kilo L$70 Lila-Timber and Lila-Cosmetics are separate CGUs for the purpose of the Lila-Tech consolidated financial statements Open market What kilo price should be used in calculating the value-inuse of Lila-Timber? 1. $50 2. $70 0% 0%

58 Key takeaways from the session Significant judgement Involved Valuation may be complex Appropriate valuers must be engaged Communication with shareholders and other stakeholders essential Different accounting framework across standards for establishing values FRS 113 defines fair value but not for everything 58

59 Judgements and estimates List of Areas Current versus non current classifications Gross versus net presentation Valuation fair value hierarchy level 3 Deferred tax Provisions Goodwill Impairment of assets (PPE, intangibles, etc) Where there is an accounting policy choice (e.g. PPE: revaluation model or cost model) 2014 KPMG Services Pte. Ltd. (Registration No: G), a Singapore incorporated company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. 59

60 Top 10 questions on fair values and estimates More than 80 percent of the total assets on a typical balance sheet require some form of human judgement 1 Are the use of fair values and accounting estimates extensive in your financial statements? 2 Are they aligned with your objective and the economic environment? 3 Do we have adequate controls over the fair valuation and estimation process? 4 Has management/audit sufficiently reviewed your fair values and estimates? 5 Are comfortable with the models, inputs and assumptions? 6 Have you considered alternative results? 7 With the recent and upcoming changes in accounting have you assessed potential impact? 8 What risks do you face and how sensitive are you to them? 9 Are your systems supporting the complexities of fair valuation and estimation process? 10 Are your people up-to-date with rapid changes in requirements? 2014 KPMG Services Pte. Ltd. (Registration No: G), a Singapore incorporated company and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. 60

61 KPMG s financial reporting assessment tool (FRAT) KPMG s Financial Reporting Assessment Toolkit (FRAT) provides a holistic scorecard for an objective and in-depth assessment of your company s fair value and estimation process. The scorecard encompasses six aspects: Performance and Reliance Governance and Compliance Fair Valuation and Estimation Methodology Systems and Processes People Business Impact This scorecard offers a useful and critical examination of the robustness and quality of the financial reporting process in generating the fair values and estimates included in financial statements 61

62 KPMG s financial reporting assessment tool (FRAT) KPMG s Financial Reporting Assessment Toolkit (FRAT) 62

63 Integrated reporting Integrated Reporting Could the Olam issue be avoided? Communication of accounting/value relevance is crucial Explaining how long term value has been developed and protected Investors are the focus of an integrated report The purpose of an integrated report is to explain value creation in the short, medium and long term to investors Telling the business s story IR is built around seven components of content: Linking the components Focusing on key drivers of business value 63

64 Questions?

65 Thank you Lau, Kam Yuen Partner, Assurance and Business Advisory Services Lamiya Bhatri Manager, Assurance and Business Advisory Services KPMG in Singapore 9 May 2014