THE THOUGHT PROCESS

An Occasional Newsletter
Published by Value Concepts LLC
Wyndmoor, PA April 2003

WHAT IS FAIR VALUE?

In this newsletter, we will examine the concept of “fair value,” primarily in relation to the valuation of intangible assets in an allocation of purchase price, following an acquisition.

The term fair value first received wide exposure in the financial community (in an asset valuation context) as a result of FASB 141, Business Combinations, released June 30, 2001. FASB 141 and its companion statement, FASB 142, Goodwill and Other Intangible Assets, left many in the corporate world scratching their heads hard over the interpretation and implementation of fair value.

The most useful and concise definition is found in the AICPA Practice Aid, Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus on Software, Electronic Devices, and Pharmaceutical Industries (published in late 2001). Although this document explicitly disavows any authoritative status or official FASB approval, it has rapidly become the de facto interpretive standard for issues relating to the valuation of intangible assets for financial reporting purposes.

The following summary definition appears on page 8 of the Practice Aid:

The fair value of an acquired asset, including an intangible asset, for financial reporting purposes, is the amount at which that asset would be bought or sold on a piecemeal basis in a current transaction between the seller and a hypothetical marketplace buyer (that is, a marketplace participant) in other than a forced or liquidation sale.

This definition is best understood as the blueprint of a new conceptual structure, affecting or interacting with a range of issues including compliance, valuation methodology, disclosure, and corporate governance. As a consequence, it is not particularly useful to compare fair value to fair market value, investment value, or other common valuation terms.

In what follows, we will try to make clear the key elements of this truly new terminology.

Market Participants: Includes all potential buyers who would take an active role in managing an acquired company, but does not include financial buyers. It does not matter whether the potential buyers are engaged in discussions with the seller of the business. The term market participant includes competitors in the same line of business as the seller, not the buyer, if the lines of business are different.

In addition, assumptions employed in the development of Prospective Financial
Information (PFI), for valuation purposes, must be those of the market participants thus defined. The idea of “industry assumptions” comes to mind.

Piecemeal: The fair value of an acquired intangible asset would be based on an asset-by-asset analysis, and would be the hypothetical market price for that asset as if that asset were traded on an established market. (Admittedly, intangibles rarely are traded on an established market). The fair value of the asset should be based on the best information available in the circumstances. It should consider prices for similar assets and the results of employing valuation methods to the extent possible in the circumstances. The value of individual assets would not include synergies or benefits attributable to their interactions with other assets.

Synergy: Fair value does not include strategic or synergistic value that results from assumptions or expectations that are specific to a particular buyer and seller. Fair value reflects and incorporates (in the actual calculations of value) assumptions and expectations of market participants. If the buyer pays the seller any significant consideration for strategic or synergistic benefits in excess of those expected by market participants, these excess (or “entity-specific”) benefits are to be removed from the value of assets acquired and placed in goodwill. The term hypothetical (one might almost say “typical”) buyer is used in the definition to emphasize that we are not to be concerned with a specific buyer.

Amortization: The fair value of an intangible asset includes the present value of the tax amortization benefits. There is a special formula that the valuation specialist must use to compute this part of the total value of the asset.

Motivation: The definition of fair value excludes consideration of forced or liquidation sale. In other words, it assumes the absence of “negative” compulsion.

Comments and Conclusion

Although the AICPA Practice Aid has become the Bible in this context, it is well to remember that it was published in 2001. That was before the Sarbanes-Oxley law mandated (July 1, 2002) that the accounting firm which audits a company’s financials must not be the same firm that performs valuations for that company. The degree of integration among the auditors and the valuation specialists assumed in the Practice Aid is very extensive. Without question, the new landscape presented by FASB 141-142 necessitates a significant degree of interaction and cooperation among management, accountants, and valuation specialists. However, careful observance of the Auditor Independence clause of the law must also be factored into any implementation plan.

Assets to be used in research and development activities are among the most difficult to value of any assets. The Practice Aid is ambitious and thorough in its discussion of how to treat these assets in a fair value context. However, the valuation of many intangible assets is considerably more straightforward. The procedures appropriate to R & D assets are not necessarily the most useful for such other assets.

The most important thing to remember about the fair value terminology is that it is NEW. The full implications of the term are still being explored, and there is significant discussion and difference of opinion regarding its meaning in specific situations. The areas of concept and application touched by the term “fair value” are quite large. We expect the operational meaning of the term to undergo significant evolution and development over the next several years.

Value Concepts has been an independent appraisal firm since 1996. To learn more about us, visit our web site at www.valueconcepts.net .

If you do not wish to receive future newsletters. click here and type "unsubscribe" in the subject line.