Valuation Insights, First Quarter 2012

In this edition of Valuation Insights, we discuss the SEC’s increased focus on management’s use of pricing services to estimate the fair value of assets.

Increased Scrutiny on the Use of Pricing Services

The U.S. Securities and Exchange Commission’s (SEC) emphasis that companies are responsible for estimating the fair value of assets, including when pricing services are used, has recently become a hot topic. Companies often don’t know the inputs, models and judgements used, which is even more concerning in volatile markets and during the valuation of asset-backed securities and thinly-trailed bonds.

Management should be prepared for increased scrutiny on fair value estimates obtained from pricing services and should be able to disclose calculation practices and the nature of inputs through due diligence and constant monitoring. Internal control processes can be aided by Duff & Phelps' valuation expert services. Furthermore, Duff & Phelps' Alternative Asset Advisory team can provide an independent assessment of the reasonableness of the estimate of value and can inspect valuation procedures.

AICPA Draft Guides on IPR&D and Goodwill Impairment

The AICPA’s Financial Reporting Executive Committee has issued two working drafts for public comment, the AICPA Accounting and Valuation Guide Assets Acquired to Be Used in Research and Development Activities (“IPR&D Guide”) and AICPA Accounting and Valuation Guide Testing Goodwill for Impairment (“GWI Guide”).

The IPR&D Guide serves as the replacement for the current practice aid and offers guidance on new accounting and valuation issues, including defensive IPR&D assets, implications of the FASB ASC 820 fair value framework, IPR&D in an asset acquisition and more.

The GWI Guide addresses goodwill impairment testing, including practice issues related to the first steps of the impairment test and examines measuring the fair value of a reporting unit in accordance with the guidance in ASC 820.

Observations on European Size Premium and Calculating Cost of Capital in the Current Environment

On October 21, Duff & Phelps held a conference entitled “How to Price the Risk of Equity: Global Evidence from New Markets”. The conference primarily examined equity risk premium (“ERP”), but also highlighted recent evidence of a size premium effect in Europe and included discussions on risk free rates and whether normalization of rates may become necessary during certain periods.

The ERP is essential when estimating the cost of capital and is a crucial ingredient in business valuations, project evaluations and overall pricing of risk. Estimating the ERP can be a crucial decision when developing a discount rate, as it can have a large impact on the concluded discount rate.