This article originally appeared in the September 2009 Private Equity Manager Monthly, a monthly printer-friendly publication delivered to subscribers to Private Equity Manager.
ACE, a middle-market private equity group, is preparing a fair value analysis for their independent auditors related to their recent acquisition of Sky, Inc., a $100 million distribution company. In addition to measuring the acquired identifiable intangible assets, ACE also needs to establish the fair value of the acquired tangible assets.
Accounts receivable is the only tangible asset that ACE acquired from Sky. How should ACE measure the fair value of the accounts receivable acquired at the date of acquisition?
SUSAN SAIDENS’ ANSWER:
The fact situation above raises several important concepts within the context of FASB Statement of Financial Accounting Standards No. 157: Fair Value [“SFAS 157”] which replaces the guidance in the old FASB Statement of Financial Accounting Standards No. 141 about fair value measurements. Under the new SFAS 157 fair value framework, ACE must determine answers for the following questions for the acquired accounts receivable:
• What is the unit of account for the asset or asset group?
• What is the principal or most advantageous market?
• Who are the market participants?
• What is the highest and best use? Is that use in-use or in-exchange?
• What are the assumptions of those market participants [who often may be hypothetical market participants]
• Identifying whether the inputs to value the assets are observable or non-observable and where the inputs fall under the SFAS 157 hierarchy of Level 1 [quoted prices for identical assets], Level 2 [quoted prices or other inputs for similar assets], or Level 3 [other valuation techniques].
What ACE should NOT do:
ACE wants to record the net realisable value [i.e., gross amount of accounts receivables less an amount for uncollectible accounts receivable] at the acquisition date. However, the new definition of fair value requires assuming an exit price value for the accounts receivable which may be something other than net realisable value.
Under SFAS 157, ACE is prohibited from carrying forward Sky’s allowance for uncollectible accounts receivable because accounts receivable must now be recorded at acquisition-date fair value reflecting both current interest rates as well as credit quality.
One solution for ACE:
At a minimum, ACE must identify the exit market and the potential hypothetical buyer [the market participant] for the acquired accounts receivable. One such market participant might be a factor.
A factor buys receivables at a discount because they assume the risk of collection. Consequently, Ace needs to assess a discount on the accounts receivable balance for the uncertainty of collection from the factor’s perspective.
ACE might assess this discount based upon the age of the receivable, the company that owes each receivable, as well as the fact that some receivables may not be factorable.
By thinking though this type of analysis, ACE has identified the framework of SFAS 157 fair value that is necessary to begin valuing the acquired accounts receivables for his auditors.
• ACE identified the unit of account for the acquired accounts receivable [e.g., individual balances/the amount each company owes].
• ACE identified the highest and best use of this asset [e.g., in-exchange].
• ACE identified the principal or most advantageous market [e.g., an Open Market which is accessible to investors or consumers].
• ACE identified the market participants [e.g., factoring companies].
• ACE identified the hierarchy level for disclosure purposes as a Level 2 asset [e.g., similar factoring
prices in the market place].
(This article originally appeared in the September PDF issue of Private Equity Manager Monthly).