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Disclaimer All information is current as at July 2011 This guide presents the opinions and comments First published August 2011 of the author and not necessarily those of the Published by: Institute of Chartered Accountants in Australia The Institute of Chartered Accountants in Australia (the Institute), PwC or its members. The contents Address: 33 Erskine Street, Sydney NSW 2000 are for general information only. They are not intended as professional advice – for that you PricewaterhouseCoopers should consult a Chartered Accountant or other Address: 201 Sussex Street, Sydney NSW 1171 suitably qualified professional. The Institute and Concise guide to managing business valuation risk PwC expressly disclaim all liability for any loss or ISBN: 978-1-921245-87-9 damage arising from reliance upon any information Copyright © The Institute of Chartered Accountants in Australia contained in this guide. and PricewaterhouseCoopers 2011. All rights reserved.

ABN 50 084 642 571 The Institute of Chartered Accountants in Australia Incorporated in Australia Members’ Liability Limited. 0711-15 ABN 52-780-433-757 PricewaterhouseCoopers Contents

Foreword...... 5

A message from the President ...... 6

Purpose and context ...... 7

Assessing the exposure ...... 9

Evaluating your expertise ...... 16

Exercising appropriate ...... 18

3

Foreword

Over the last five years, there have been many changes to financial reporting standards, tax legislation, mergers and acquisition practice and risk management governance that have increased corporate exposure to valuation risk. The risk is at a level that would have been almost inconceivable only a few years ago, and some might now find the exposure to the risk uncomfortable. This exposure poses new and interesting challenges for the average board member. A well informed director will meet this challenge head on by: >> Mapping out the sources of risk >> Outlining the skills required to defray the and addressing any skill gaps >> Asking key questions around business value, and setting up dedicated controls to deal with this emerging category of risk.

In light of valuation being a fundamental skill risk and a challenging aspect of today’s corporate landscape, the Institute of Chartered Accountants in Australia developed this thought leadership initiative entitled, Concise guide to managing business valuation risk. The guide is primarily for company directors, but may also be helpful for senior officers in their dealings with the board. I trust that you will find this guide useful and practical in managing valuation risks.

Richard Stewart FCA Chairman, Business Valuation Special Interest Group The Institute of Chartered Accountants in Australia

5 A message from the President

Chartered Accountants in both business and practice are acutely aware of the sweeping effect of recent changes in accounting standards and regulation and the effect these have had on their traditional roles. However, many may not have noticed some of the new skills that they will need. Business valuation, a skill previously regarded as peripheral to the core skill-set of many Chartered Accountants, is now front and centre. The Institute of Chartered Accountants in Australia (the Institute) recognises the level of education required to adopt business valuation processes and some of the issues that are outstanding in relation to this practice. Members have access to regular training and development, and a separate community has been established to support this specialised group – the Business Valuation Special Interest Group (BVSIG). To find out more on training and resources available to members or to join our group, I urge you to visit charteredaccountants.com.au/sigs. To support our members, the Institute has developed this thought leadership initiative, Concise guide to managing business valuation risk, the fourth in a series designed to assist directors and senior officers in particular. I trust you will find this guide useful and practical.

Rachel Grimes President The Institute of Chartered Accountants in Australia

Concise guide to managing business valuation risk Purpose and context

The purpose of this guide is to provide information regarding valuation risks that, if not properly mitigated, can harm Australian organisations and their operations around the world. The aim of this guide is to assist directors to: 1. Assess the board’s exposure to valuation risk 2. Evaluate the board’s expertise to deal with valuation issues 3. appropriate due diligence when addressing questions around valuation risk.

Assessing the exposure Directors’ exposure to valuation risk arises from three areas: >> Evolving legislation: over the last five years, new regulation has increased the exposure of directors to valuation risk across tax, accounting, and other areas. In substance, this now means that directors’ risk not only relates to an accurate rendering of the past, but a reasonable estimate of the future. >> Changing corporate balance sheets: Approximately one third of the average corporate balance sheet is now made up of some of the riskiest and hardest to value assets – intangible assets and . >> Increasing volatility of financial markets: In some sectors, asset price volatility has increased almost threefold since 2001. This means that decisions that seem right today may be very wrong when viewed tomorrow.

Evaluating your expertise Valuation risks pervade almost every aspect of corporate thinking, and focus the mind on how each aspect affects the directors’ ultimate responsibility as custodians of shareholder value. This creates reputational risk for directors on top of their statutory due diligence obligations. In dealing with questions of valuation risk, directors need to consider the following key issues: >> What are the skills we need around the board table? >> Which board members will we rely on to have the right expertise to address these issues?

7 >> What key points do all board members need to be across? >> How do we manage our due diligence exposure on these? >> When should we call in an expert to help manage the board’s exposure?

Exercise appropriate due diligence Regardless of how well risks are identified and analysed, without adequate and effective due diligence, companies will remain vulnerable to valuation risks. Hence, directors may wish to explore the areas of risk listed below when exercising due diligence. These include: >> Organisation and governance around valuation questions >> Culture and behaviour in dealing with valuation issues >> Valuation techniques and processes >> Supporting infrastructure requirements for recurring valuation processes.

Concise guide to managing business valuation risk Assessing the exposure

Directors have always been rightly perceived as the custodians of shareholder value. In the last five years several dramatic events have occurred in the financial world that have called for directors to become more proficient in issues of valuation. Three areas in which directors’ exposure to valuation risk have arisen are set out below.

Evolving accounting and tax regulation Directors are required to form an annual view on the financial statements and therefore be cognisant of recent changes to the way mergers and acquisitions are recorded, the increasing use of for financial instruments, ensuring intangibles are not over-valued in the financial statements and the determination of fair values of share-based payments. A timeline of selected events is shown below:

The Global Financial Crisis Smaller companies became (GFC) saw the failure of exposed to , The introduction of tax a number of notable US particularly those trading at consolidation by the investment . Many substantial discounts and Australian Government, blamed fair value accounting with little capital behind them. which entrenched market for the lack of confidence in Some rejected advances, often valuations at the centre of the market. Superannuation at a personal cost, and some tax valuation methods, tax funds were hit hard and toughed it out for a better offer. loss utilisation, achievement directors got nervous about Many however, acquiesced, in of tax deductions and capital the carrying value of recently order to avoid the risk of a long gains tax levies. acquired assets. and protracted fight.

2004 2005 2006 2007 2008 2009 2010

The introduction of In 2008, International Accounting Banks began to international financial Standards Board (IASB) published raise capital in reporting standards meant amendments to IAS 39 Financial record proportions. that Directors faced a much Instruments: Recognition and Measurement. more difficult fair value test The changes to IAS 39 permit when forming views on asset reclassification of certain non-derivative carrying values. They were financial assets. All reclassifications must also required to deal with be made at the fair value of the financial issues regarding financial asset at the date of reclassification. Any instruments, which also previously recognised gains or losses required fair values. cannot be reversed. The fair value at the date of reclassification becomes the new cost or amortised cost of the financial asset, as applicable.

9 Even as late as this year, proposed Mineral and Petroleum Resources rent taxes will rely on market values for the determination of key tax outcomes. The increasing exposure in financial statements and tax returns to business valuation judgements changes directors’ responsibilities in a profound manner. These responsibilities essentially have moved from a faithful recording of the past (as has been the case since the time Pacioli first invented modern accounting) to the reasonableness of their estimates (as encompasses in the numerous business valuations required) of the future.

Changing corporate balance sheets During the economic boom of the late 2000’s, a number of transactions were undertaken, often at historically high prices. Consequentially, a large amount of goodwill was recorded on the balance sheet of many acquirers. For this reason, as well as the increasing focus on non-tangible components of strategic advantage, intangible assets have increasingly made up a significant part of the value of all Australian industry sectors over the last ten years. Chart 1 shows the percentage increase in goodwill and intangible assets from 2001 to 2010 and chart 2 provides a breakdown of the net assets of ASX200 companies as at 31 December 2010.

Chart 1: Percentage increase in goodwill and intangible assets from 2001 to 2010 % 1400

1200 Consumer discretionary 1000 Consumer staples

800 Energy

600 Healthcare Industrials 400 Information technology 200 Materials

0 Utilities

Source: Capital IQ

Concise guide to managing business valuation risk Chart 2: Breakdown of net assets of ASX 200 companies

Goodwill 1/6

Intangible Tangible Assets Assets 1/6 2/3

Source: Capital IQ

On the other hand, there have been a number of distressed acquisitions in the aftermath of the GFC as companies were focusing on maintaining liquidity and managing funding. As a result, many companies recorded a write down of goodwill and assets as market values of companies and assets declined dramatically.

11 Increasing financial market volatility Chart 3 below shows the asset price volatility by ASX 200 industry sector over the last ten years.

Chart 3: Asset price volatility

AUD 20,000

15,000

10,000

5,000

0 4/01 9/01 2/02 7/02 12/02 5/03 10/03 4/04 8/04 1/05 6/05 11/05 4/06 9/06 2/07 7/07 12/07 5/08 10/08 3/09 8/09 1/10 6/10 11/10

Energy Materials Financials Industrials Consumer discretionary Telecommunication services Consumer staples Information technology Utilities Healthcare

Source: Capital IQ

As can be clearly seen, asset price volatility in some sectors has increased almost threefold since 2001. This means that viewing value as a stable and relatively unchanging number over time, has now become a dangerously outdated assumptions. This increases directors’ exposure to hindsight observations in respect of their business valuation judgements.

Concise guide to managing business valuation risk Where are questions of value an issue? In our view, value pervades all aspects of an organisation. Hence, it is critical for directors to be able to fully analyse and communicate the value implications of major decisions. To illustrate this pervasiveness, we have highlighted some of the questions that arise for directors that rely on an understanding of valuation principles:

Area Question

Value and >> Can we link strategic decisions and options to value strategy (shareholder return) outcomes and ongoing performance benchmarking? >> Do we understand the value impacts of growth options? >> Have we leveraged our intellectual property and brand?

Value and risk >> Do we understand the relationship between value and risk? >> Do we have the capability to model cash flow and ?

Capital allocation >> What is appropriate for our company? decisions >> What hurdle rate do we apply for our investments? >> How do we manage our portfolio across activities?

Mergers and >> How do we negotiate a correct price for mergers and acquisition acquisition? decisions >> How do we evaluate potential transactions?

Capital investment >> What valuation techniques should we adopt for investment analysis evaluation? >> Do we have the capability to assess potential new projects and analyse of underperforming assets?

Value reporting >> How do investors value our company? >> What relevant information can we provide to the investors to assist them in their decision-making?

Continued overleaf >

13 Area Question

Taxation >> How much of our tax bill depends on valuation judgments? >> How do we manage the stamp duty exposure of our company? >> How do we manage the capital gains tax exposure of our company? >> Have we optimised tax consolidation decisions through valuations?

Financial >> How much do our financial statements depend on business reporting valuation judgments? >> Do we understand the implications of fair values (mark to market accounting)? >> Do we understand the accounting implications of allocating purchase price over assets and asset impairment testing, including carrying value of intangible assets and goodwill? >> Do we know the disclosures (e.g. valuation policies) required for financial reporting purposes?

Legal disputes >> Do we have the capability to value the impact of disputes with key stakeholders, such as suppliers, customers or shareholders?

Contractual >> How do we assess major contractual arrangements which obligations are based on value sharing principles?

Remuneration >> How do we value existing plans? of key executives >> Have we ensured the effectiveness of the plans to align and directors management and employee interests? >> What valuation techniques do we adopt to measure remuneration?

Regulatory >> How do we assess pricing and return on capital? regimes >> How should we value capital employed?

Concise guide to managing business valuation risk Minimum standards of care Clearly the pervasiveness of valuation issues creates a reputational risk for directors. However, on top of this, there are some legislative risks also. According to the Corporations Act 2001, directors and other officers must demonstrate minimum standards of care and diligence as described in Section 180 of the Act, as follows:

Section 180 Care and diligence – civil obligation only Care and diligence – directors and other officers (1) A director or other officer of a corporation must exercise their powers and discharge their duties with the degree of care and diligence that a reasonable person would exercise if they: (a) were a director or officer of a corporation in the corporation’s circumstances; and (b) occupied the office held by, and had the same responsibilities within the corporation as, the director or officer

Meeting the minimum standards of care requires that directors: >> Be familiar with fundamental operations of the business >> Keep informed about the company’s activities >> Monitor the company’s affairs >> Maintain familiarity with the financial status of the company by appropriate means such as active review of company’s financial statements and board papers and to make further enquiries into matters revealed by those documents >> Be reasonably informed of the company’s financial capacity and understanding of key financial information and be able to apply it to the management’s decision making >> Seek qualified experts, if necessary; although directors need to exercise discretion and judgment when relying on such expert’s advice.

In addition to Section 180 of the Act, directors also have an obligation to sign off on accounts and obligations under Section 344. These minimum standards of care require the director or officer to demonstrate an active review and understanding of the key financial matters. If the director or officer violates his/her fiduciary duties, he/she may be subject to penalties. As is well known on other issues, if directors take a systematic, informed, commonsense approach to their decision making and do not take on tasks or roles beyond their abilities, they will be on the right track to avoid costs and liabilities. In respect of valuation issues, just how is that accomplished? Evaluating your expertise

A complex interrelated set of financial skills and business acumen is involved in business valuation, including: >> Financial forecasting >> Accounting and >> Benchmarking and industry analysis >> Capital markets understanding >> Capital structure assessment >> Strategic understanding >> Financial mathematics including quantitative and derivative pricing >> Legal concepts of value. >> Monte Carlo simulation analysis.

The list presents a fairly broad set of skills. Evaluating your level of expertise can be achieved by asking the following questions. >> Do we know how to value a business or interest for each stated purpose? There are differences in the basis and levels of value, as well as there being a variety of prescribed techniques and methodologies, all of which depend on the purpose to which the valuation is put. Understanding these differences is crucial to aligning directors’ judgements with the correct framework.

>> Do we know what the appropriate valuation methodologies are for the assets we hold? The three main methodologies are cost, income and market. They are united by the economic law of one price, which states, ‘In an efficient market, all identical goods must have only one price’. It is vital to be expert across all methodologies as there is often a need to cross check the principal method with at least one alternative.

Concise guide to managing business valuation risk >> Do we know the difference between economic value and accounting value? Oscar Wilde once wrote, ‘a cynic knows the price of everything and the value of nothing’. No director can afford to be a cynic, as their views on fundamental value impact their ability to make the right long term decisions for shareholders. However, in many cases, accounting values focus heavily on definitions of value that are almost akin to current price as opposed to fundamental or long term value. Understanding and managing this potential dichotomy tests many professional valuers, and no doubt casual observers of business valuation. >> Do we know the basis (e.g. value, deprival value, fair market value, fair value, and value in use) and levels of value (e.g. controlling interest vs. minority value) and the impact of each? Divergent bases of value are almost incomparable, and can lead to difficulties particularly if applied in a regulatory or dispute scenario. In addition, differences across the levels of value can be material, so it is of major importance to check the appropriate valuation level. >> Do we have a robust internal view of value as opposed to just relying on our share price as the fundamental benchmark? Without a robust internal view, the company is a hostage to the vagaries of the market or other external views. However, internal views need to test for realism if they do differ from those of the market.

Given the increasing exposure of boards to the outcomes of business valuation, it would be prudent to look around the board table and evaluate where the experience to answer these questions lies. In addition, directors often set the ‘tone from the top’ in relation to the perceived importance of issues within an organisation. As such, it is important for directors to understand the level of expertise inherent within the organisation in dealing with issues of value and create a culture which is accepting of the relative importance of the issues. In many cases, it may be worthwhile for directors to consult with qualified experts especially when faced with difficult business valuation issues. If so, assessing the expert’s independence and expertise may be relevant.

17 Exercising appropriate due diligence

To address the legal and reputation risks around business valuation, directors must continually review the thinking around valuation risks by asking questions, such as: >> Have we reconciled views on value taken in transactions, financial reporting and tax scenarios and can we defend divergent views if they exist? >> Have we sense checked this internal view with external benchmarks and potential transaction scenarios? >> How have we mapped out the key uncertainties around value and understood both normal variation and potential ‘tail risk’ or unexpected events? >> Have we applied the same rigour around valuation risk to our acquisition targets? >> Where are financial statements crucially dependent on opinions of value? >> What is the basis of these opinions? >> Where do major tax outcomes depend on valuations?

On top of asking, and evaluating the response to, these questions, directors need to consider the risk and control environment around business valuation. A possible framework which directors’ can use to evaluate this risk and control environment is as follows:

Concise guide to managing business valuation risk Areas Evaluation criteria

Organisation and >> What decision making forum explicitly considers governance valuation risk? >> Who is responsible for the valuation process? >> Who reviews the valuations? >> Is the person conducting the valuation work sufficiently objective and free from bias?

Culture >> What sort of behaviours do we wish to encourage around valuations? – Rigorous or ‘quick and dirty’? – Optimistic or pessimistic? – Self serving or realistic?

Process and >> How do your valuation processes compare with your technique competitors? >> How do you use reliable data in your valuations? >> How do you integrate external providers into your valuation? >> How do you cross check your outcomes to minimise the risk of valuation error? >> How do you consider the risk of changes in value, and the consequential impact of those changes e.g. solvency, covenant breaches? >> How do valuation issues get escalated?

Infrastructure >> What is the suite of tools that the organisation uses to establish values? >> What standards should be employed? >> How should you engage with external advisors?

19 Contact details

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