A Sample of SEC Comments on Fair Value Measurements for Financial Reporting By Lindsey Lee, CPA/ABV, ASA, CFA and Shishir R. Khetan, CFAIntroduction As part of the financial reporting process for public companies, the Securities and ExchangeCommission (SEC) may review an issuers submitted filing. Although the SEC does not review everyfiling, it is required under Sarbanes-Oxley to review the filings of every public company at least onceevery three years. In the event the SEC staff identifies instances where it believes a company canenhance its disclosure or improve its compliance with the applicable disclosure requirements, the SECstaff will issue a comment letter. The SEC staff "views [this] comment process as a dialogue with acompany about its disclosures." Although each comment letter is specific to the issuer and the underlying facts and circumstancesof the topic discussed, comment letters do provide valuable insight into issues the SEC staff hasconsistently identified and addressed. The following highlights certain valuation related topics that haveappeared in recent SEC comment letters and includes examples of comments from the SEC staff.Purchase Price Allocations In several instances, the SEC staff has focused on acquisitions where an issuer has allocated little,if any, of the purchase price to intangible assets other than goodwill. The SEC staff may comment whenan issuers disclosure or press release indicates an intangible asset was acquired but no portion of thepurchase price was allocated to the intangible asset. The following are examples of comments from theSEC on these topics: • "It remains unclear why no customer-related intangible assets were recorded for any of the acquisitions. Based on your disclosure on page F-24 it appears that the economics of the transactions are based on established current per patient valuations for dialysis centers. " • "[Y]ou allocated only a relatively small portion of the purchase price to specifically identifiable intangible assets consisting of customer contracts, with the remaining portion of the excess purchase price allocated to goodwill. … If any other identifiable intangibles were determined to have little or no value, please explain in detail your basis for this conclusion.”
• "Please tell us why you and [your] valuation specialist made a preliminary estimate that there was no fair value to … customer lists and why no value was ascribed to customer relationships. Given that [the Targets] business is highly depended on customer loyalty and repeat business, and that approximately 80% of [its] transactions are related to repeat customers, we are unsure why no value was ascribed to customer-related intangible assets."Goodwill Impairment Testing The SEC staff has commented frequently on issuers testing for goodwill impairment. The staffmay comment when an issuer has one or more indicators of goodwill impairment, such as decliningrevenues and market capitalization less than the issuers book value, yet has not recorded an impairment.The following are examples of recent comments from the SEC staff. • "Please … [explain] how you determined that no portion of your goodwill is impaired in light of the significance and duration of the disparity between your equity book value and market capitalization." • "[Y]ou explained your position that no goodwill impairment indicators were present at June 30, 2009 which would cause an interim test of goodwill impairment. This conclusion was based on your forecast for profitability and improving business conditions. However, it appears that such improvements have not transpired, as your net sales and operating results in each quarter of 2009 showed significant declines from the comparable prior year quarters. Please tell us how your projected future cash flows at June 30, 2009 compared to actual results. " • "Please tell us how you determined a decline in forecasted revenue for fiscal year 2010 was not a triggering event to test goodwill for impairment." • "Please advise us in detail regarding your basis for assuming a robust recovery in 2010 given the negative performance of your stock and your cautionary 2009 fourth quarter earnings release." • "(The) decline in your market capitalization may be indicative of an impairment of your recorded investment in its intangible assets and goodwill. Given the significant disparity between your current market capitalization and your book value, please explain the facts and
circumstances which management believes are responsible for the significant disparity between your market capitalization and the book values for your equity."Fair Value of Issuers Equity Securities Claiming the market price of its common stock is not indicative of its fair value, some issuerswith publicly traded shares have relied on various valuation methods for their common stock instead. Ininstances, such claims have yielded comments from the SEC staff, including the following: • “[I]t is the SEC Staff and FASB Staff’s views that a quoted market price in an active market for an identical asset is most representative of fair value and thus is required to be used, generally without adjustment, in fair value measurements. Furthermore, transactions in inactive markets, although likely not determinative, should be considered in management’s estimate of fair value if those transactions are orderly. Accordingly, please tell us in detail why you do not consider recent prices from actual sales of your common stock to be relevant observable inputs." • "We note that the independent valuation performed as of March 31, 2009 appears to use only one valuation method for determining the fair value of your common stock. Please tell us what consideration was given to using multiple valuation techniques to compute a range of fair value estimates in determining the point within that range that is most representative of fair value. Considering the use of a single valuation approach generally does not enable you to highlight weaknesses in approaches and/or assumptions and inconsistencies in logic, please tell us how you corroborated the fair value of your common stock determined by the independent valuation.” • “We note that you determine the fair value of your company using a market approach based on multiples of projected EBITDA. … Please reconcile the fair value of equity used in the impairment test with the actual market capitalization for a reasonable range leading up to February 28, 2009. … If the reconciling differences between the market capitalization and fair value of equity may be attributed to marketability discounts or control premiums, please quantify such differences and provide us with objective support for the amount of each difference.”
Embedded Derivatives An embedded derivative refers to one or more terms within a contract that affect some or all ofthe issuers cash flows in a manner similar to a derivative. Accounting Standards Codification (ASC 815)sets out the criteria to determine whether an embedded derivative within a contract should be bifurcatedand reported at fair value. Determining whether a term is an embedded derivative is complex andrequires detailed analysis under both ASC 815-15 and ASC 815-40. Examples of terms within preferredstock and debt that the SEC has requested an issuer to determine whether such item is an embeddedderivative include: • conversion features, • anti-dilution provisions, • prepayment options, and • mandatory and contingent redemption options. The following are examples of comments by the SEC staff on embedded derivatives: • "Please be aware that we do not believe the use of the Black-Scholes-Merton option pricing model is appropriate to value compound embedded derivatives or conversion options that are accounted for as derivatives. … If the company does not have the necessary valuation expertise internally to properly value these complex derivatives, the company may need to consult with an outside valuation firm.” • “Please explain to us in more detail, including all assumptions, how you arrived at the fair value of the bundled embedded derivative instrument which includes the conversion feature and prepayment penalty, as it appears from this disclosure that you valued these two derivatives separately using two different methods. Please note that we believe that these two features should be measured at fair value in a single valuation model and should not be the sum of the separate fair values of each embedded derivative.”
Conclusion Valuation for financial reporting can be daunting and often requires high levels of experience andexpertise. The SEC staff has encouraged issuers to consider retaining the services of a valuationspecialist if the issuer does not have the expertise to measure the fair value of intangible assets andcomplex financial instruments. HFBE has significant experience measuring for financial reportingpurposes the fair value of intangible assets and complex financial instruments, and performing purchaseprice allocations and impairment testing of goodwill and other intangible assets.Lindsey Lee, CPA/ABV, ASA, CFA is a Vice President and Shishir R. Khetan, CFA is a ManagingDirector with HFBE Inc.