fair value (2)

Valuation Failures

In the latest BVWire newsletter, there’s something of a bombshell (if you’re into this kind of thing):

Fair value is on hold at the FASB, observes Adam Smith (FASB), due to concerns over the BV profession. Up to now, the FASB has been a proponent of fair value in financial statements. This trend will not continue, according to Smith, because of the fragmented nature of the profession and lack of a unified set of standards. Why should the FASB spend all this time on fair value if investors have no faith in the numbers?

No faith in the numbers? That’s pretty strong language given that valuations are used all the time in business for accounting, purchase price allocation, tax and fund raising purposes.

Could it be that bad? Here’s a story I heard just last week at the IP Finance conference last week in NY. One of the panelists told the story about a portfolio of patents that his company needed to value for transfer pricing purposes. Because they were held in different countries around the world, the company decided to get two different valuations of the portfolio. One valuation came in at $100 million. The other came in at $266 million. One of the biggest differences in the two analyses was the discount rate used to calculate the net present value of the cash flows--which means that the two valuators saw very different levels of risk and opportunity in the portfolio. There appears to be qualitative analysis in the process but it’s not necessarily repeatable and verifiable.

Why is this happening? I think it’s part of the intangibles story. The shift away from a tangible, industrial economy to an intangible, knowledge economy is changing how value is created. Lots of people talk about the fact that intangibles have come to dominate corporate valuation (20% of corporate value is in tangible net worth, the remaining 80% is intangible). But there’s a lot less talk about what those intangibles are and how they should be analyzed. This leaves any financial analysis of a company open to a lot of subjectivity and variation. (By the way, the valuation community is not unique in this. Everyone is facing the challenge that the numbers don’t add up the way they used to)
What’s the answer? The first thing is to admit there’s a problem with the system. If valuations can have such a broad swing, then there’s work to do. Second, is to talk about how knowledge intangibles should be measured. How can the assumptions be handled in a more consistent way?

The answer isn’t just in the numbers. It’s hard to evaluate knowledge using dollars or quantitative indicators. What we really need is more disciplined qualitative analysis.

At Smarter-Companies we’re focusing on qualitative analysis based on stakeholder feedback. Our assumption is that those who are in the best position to judge the strength and sustainability of knowledge intangibles (like process, data, competencies, networks) are the stakeholders of the organization. They know better than anyone (including a valuator) if and how well the intangibles support the company’s value creation process.
Is there a way to incorporate stakeholder feedback in the valuation process? Yes. And I’m betting it will happen sooner than you think.

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The Problem with Accounting

10468394077?profile=originalThere is a clear and succinct post at WSJ I recommend called Shift to Valuations, Estimates Challenges Auditors  that talks about the challenges auditors face in their evaluation of corporate financial statements. Emily Chanson summarizes a speech by Jay Hanson of the Public Company Accounting Oversight Board (PCAOB):

estimates and measurements are one of the most frequently identified trouble spots by the U.S. auditor watchdog, as managers and accountants have to spend more time focusing on the fair value of financial instruments, goodwill impairments and intangible assets in the new economy.

I had this same discussion a number of times over the years with my father. He was a CPA and CIA (Certified Internal Auditor, a little more settled than the espionage types). In the first half of his career he was an auditor at Exxon then was an independent auditor with his own practice and ultimately served one term as the State Auditor of New Mexico. He’s gone now but he and I used to have long conversations about changing financial standards and the challenges that intangibles create for accountants.

You see, accounting has the unenviable challenge of applying a tool set designed for the tangible economy to the rapidly-changing and radically-different intangible economy. These standards favor tangible assets and generally recognize spending on intangible assets as operating expenses. This approach has failed to measure or capture the enormous value in the knowledge, ideas and connections that companies have been able to build using information technology and the internet over the last 30 years. These intangible knowledge and collaboration assets are the key drivers of revenues and profits in almost every company today. But since they exist outside the balance sheet, the tangible net worth of the average public company in the U.S. is equal to just 20% of its total corporate value. The rest is., well, intangible and generally not well-understood.

The accounting profession is trying to adapt to this changing world by focusing more intensely on fair value rather than historic costs. But the truth is that accounting (as it is conceived today) will never be able to fully account for many of the intangibles in a business. Many intangibles like people, relationships and culture are not owned assets that can be isolated and quantified on a balance sheet. But they are critical to the competitive (and collaborative) advantage of every company.

This is why we are advocating the promulgation of ICounting. It is a separate skill set that is complementary to Accounting. It is less worried about resources that are owned and controlled and more about resources that are available and connected to an enterprise. Accounting uses financial transactions as a way of measuring financial health and success of an organization. ICounting uses value transactions (the exchange of knowledge, trust and solutions) as a way to understand the health and success f an organization. Each has its place.

Mr. Hanson explains that the PCAOB finds that

auditors fail to check the reasonableness of management assumptions, don’t weigh valuation risk properly, and don’t appropriately consider positive and contradictory evidence in evaluating estimates

How to check "reasonableness and risk," how to "evaluate estimates" in today’s business without understanding the intangibles? Even the Accountants will have to learn ICounting.

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