Fair Value for Impairment Testing

Standard of Value

Every valuation assignment begins with a determination of the appropriate definition, or standard, of value. The standard of value provides guidance about how value is determined and from what perspective. The appropriate standard of value for most financial reporting valuation assignments, including impairment testing, is fair value, as defined in ASC 820.

Note that fair value is different than other standards of value such as fair market value or the legally-defined statutory fair value.

Fair value is defined in the glossary of ASC 820 as “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.” Fair value assumes a hypothetical transaction for the subject asset or liability at the measurement date. ASC 820 provides additional clarification related to the nature of this hypothetical transaction, which we summarize below.

Market Exposure

ASC 820 explicitly states that fair value assumes exposure to the relevant market for a sufficient period of time for normal marketing activities. The hypothetical transaction is not a forced liquidation or distressed sale. However, it does reflect prevailing market conditions.

Exit Price

Fair value is measured from the perspective of the owner of the asset. In other words, it is measured as the price that would be received to sell an asset (exit price) rather than the price that would be paid to acquire an asset (entry price). In the context of measuring the fair value of a reporting unit, exit and entry prices are often indistinguishable.

Relevant Market

According to ASC 820, the hypothetical transaction occurs in the “principal market” for the asset, or if there is no principal market for the asset, the hypothetical transaction occurs in the “most advantageous market” for the asset. The principal market is defined as “the market in which the reporting entity would sell the asset… with the greatest volume and level of activity….” In the context of ASC 350, there is generally no principal market for reporting units (or intangible assets); unlike securities, reporting units are not homogenous assets with active markets. So what is the most advantageous market?

The most advantageous market is defined as “the market in which the reporting entity would sell the asset… with the price that maximizes the amount that would be received for the asset… considering transaction costs in the respective markets.” Depending on the circumstances surrounding a particular situation, the most advantageous market for a reporting unit could be the market made up of strategic buyers or the market made up of financial buyers. In any case, the most advantageous market is ultimately defined by the relevant market participants, as we will discuss later.

While transaction costs should be included in the consideration of the most advantageous market for the given asset, these costs must be excluded from the fair value measurement itself. Transactions are an attribute of a market rather than the subject asset itself, and as such, they are not a component of the “price that would be received”.

Market Participants

Fair value is defined from the perspective of market participants rather than a specific party, such as the reporting entity. A market participant is defined as 1) an unrelated party, 2) knowledgeable of the subject asset, 3) able to transact, and 4) motivated but not compelled to transact. In the context of the most advantageous market, potential market participants could be existing industry players, companies looking to enter the industry, private equity investors, or other parties.

ASC 820 clarifies that it is not necessary to identify specific market participants, but rather the characteristics that distinguish market participants in the given situation should be identified. For example, private equity investors generally rely on different funding sources than large operating companies; this is a distinguishing characteristic that would be relevant in the context of fair value.

Fair value is determined with reference to the assumptions market participants would use in valuing the subject asset or liability; assumptions used by the reporting entity may not be consistent with those made by market participants.

Highest & Best Use

Fair value also assumes that an asset will be employed in its highest and best use by market participants. Highest and best use is defined in ASC 820 as the use that would maximize the value of the asset or group of assets within which the subject asset would be used. Fair value should be determined based on the hypothetical transaction price assuming the asset would be used within the “highest and best use” asset group, and that the other assets in that group would be available to market participants. If an asset is most valuable outside the context of any other assets, the fair value should be measured based on a hypothetical transaction of the asset on a stand-alone basis.

For reporting units, the use of an “in-use” or “in-exchange” valuation premise is not often controversial. The delineation of the likely market participants is often more significant in determining the degree to which synergies with potentially complementary businesses ought to be reflected in the fair value measurement.

Valuation Techniques & Inputs

Having discussed the definition of value pertinent to goodwill impairment testing, we will introduce some foundational valuation concepts in the following sections.

Approaches to Value

Generally accepted valuation theory (as well as ASC 820) recognizes three general approaches to valuation. , Within each approach, a variety of valuation methods (or techniques) can be applied to fair value measurement in a given situation. ASC 820 states that valuation techniques consistent with these approaches should be used to measure fair value.

• The income approach converts a stream of expected future economic benefits into a single present value. Valuation methods under the income approach generally include variations of two techniques: single-period capitalization and discounted cash flow analysis. Option pricing models can also be used under the income approach in certain situations.
• The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities (including a business) to determine value. Market methods compare the subject with transactions involving similar investments, including publicly traded guideline companies and sales involving controlling interests in public or private guideline companies. Consideration of prior transactions in interests of a valuation subject is also a method under the market approach.
• In the context of business valuation, the cost approach is often described as an asset-based approach under which value is measured with reference to the values of the individual assets and liabilities of the reporting unit.

In the context of measuring the fair value of a reporting unit for purposes of the Step 1 goodwill impairment test, valuation techniques under the market and income approaches are generally most appropriate. Business valuation techniques under the cost approach frequently do not capture the value of goodwill and certain other intangible assets; in such cases, the resulting valuation indications would not be consistent with the objective of measuring fair value.

Fair Value Hierarchy

Inputs to the various valuation techniques may be either observable or unobservable. ASC 820 contains a hierarchy which prioritizes inputs into three broad levels:

• Level 1 inputs are observable quoted prices in active markets for identical assets;
• Level 2 inputs generally include observable quoted prices for similar assets in active markets or quoted prices for identical assets in markets that are not active; and,
• Level 3 inputs are unobservable inputs that are developed based upon the best information available under the circumstances, which might include the reporting entity’s own data.

Fair value measurements should rely on the highest level inputs available. ASC 820 notes that the availability of inputs can impact the selection of valuation techniques, but clarifies that the hierarchy prioritizes valuation inputs, not techniques.

Fair value measurements for impairment testing tend to rely heavily on Level 3 inputs, but can also include Level 2 inputs. Common inputs include:

• Projected financial performance for a reporting unit (Level 3) ;
• Market pricing information for publicly traded guideline companies (Level 2);
• Pricing information for recent control transactions in similar businesses (Level 3);
• Cost of capital estimates (Level 2 or Level 3);
• Other inputs

By their nature, unobservable inputs cannot be derived from external market information. Accordingly, unobservable inputs should reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability.

Reprinted from Mercer Capital’s Value Added (TM), Vol. 22, No. 1, May 2010