The Asset-Based Valuation Approach

Asset Accumulation Method

This discussion is the third part of a series. Previous discussions introduced the theoretical concepts and the practical applications of the asset-based business valuation approach. This discussion describes one common Asset-based Approach valuation method: the asset accumulation (AA) method.

[su_pullquote align=”right”]Resources:

Intangible Asset Valuation and Fair Value Accounting

Business Valuation Accelerator Clinic 2: Asset Approach

What You Can’t See Has Value—The Valuation of Intangible Assets

Business Valuation Certification and Training Center

Advanced Valuation: Applications and Models Workshop

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Introduction

This discussion is the third part of a series.  Previous discussions introduced the theoretical concepts and the practical applications of the asset-based business valuation approach.  This discussion describes one common Asset-based Approach valuation method—the Asset Accumulation (AA) Method.

Application of the AA Method

The AA Method is well suited for valuations performed for transaction, taxation, and controversy purposes.  All business valuation approaches and methods can indicate the defined value of the business entity.  The AA Method helps to explain that indicated value by specifically identifying the value impact of each category of the company assets and liabilities.  This informational content of the AA Method is particularly useful when the analysis is used to identify:

1. which asset categories are contributing how much value to the total company value;
2. which asset accounts serve as the collateral for each secured creditor;
3. which asset accounts are available to serve as collateral for future secured financing;
4. which asset accounts are available to be sold off from the company core operations;
5. which asset accounts are available to enter either a lease or a license transaction;
6. what would be the asset revaluation-related income tax consequences of alternative transaction structures for the sale of the subject company;
7. what the opening balance sheet would look like to the acquirer after the sale of the company—or what a fresh-start accounting opening balance sheet would look like after a company’s reorganization;
8. what the value of the company would be under various premise of value scenarios, such as a going-concern valuation versus an orderly liquidation valuation;
9. what are the values of the individual asset categories contributed by individual investors in the formation of a joint venture or LLP or LLC; and
10. what was the amount of damages suffered by the individual asset categories of an entity that experienced a tort, a breach of contract, or some other damages event?

Asset Accumulation Method Procedures

The AA Method may be the most difficult business valuation method to perform.  However, the AA Method may be the easiest business valuation method to understand.

The first AA Method procedure is the identification of all the company asset and liability categories.  Typically, this procedure starts with the financial accounting balance sheet.

Some analysts prefer to start this procedure with an audited balance sheet.  This preference is not a requirement to perform the AA Method.  All the asset and liability accounts are subject to revaluation to the valuation assignment standard of value.  Therefore, it is not particularly important if the analyst starts with an audited, reviewed, compiled, or internally prepared balance sheet.  It is not particularly important whether the balance sheet is prepared in compliance with U.S.  GAAP or international GAAP.  Again, the reported asset and liability accounts are going to be restated to the intended standard of value.

It is helpful to start with a balance sheet prepared as close as possible to the valuation date.  However, this is a convenience and not a requirement.  Sometimes, the analyst does not have a balance sheet available at the beginning of the analysis.  In that case, the analyst has to start with a blank page and independently identify all of the asset categories and liability categories associated with the company.

In this procedure, the analyst identifies all the company’s assets.  This process includes all of the assets that are already recorded on the balance sheet.  And, this process includes all of the assets that are owned and operated by the company—but are not recorded on the balance sheet.  Most internally created intangible assets will not be recorded on the balance sheet.  The analyst will have to identify and capitalize (which simply means record) these off-balance sheet intangible assets on the revalued balance sheet.

The analyst identifies all the company liabilities.  This process includes all the liabilities that are already recorded on the balance sheet.  And, this process includes all the liabilities that are either (1) not typically recorded on a balance sheet or (2) created as part of the hypothetical sale transaction.  For example, contingent liabilities are not typically recorded on a balance sheet but would be considered in an AA Method analysis.  Income taxes related to the hypothetical asset sale and expenses related to the hypothetical sale transaction are examples of liabilities that would be created in the valuation process.

The second AA Method procedure is to value all the identified asset and liability accounts.  The analyst restates all the recorded asset and liability accounts to the assignment standard of value.  The analyst records all the previously unrecorded assets and liabilities at the assignment standard of value.

The analyst considers all generally accepted property valuation approaches in this procedure, including consideration of all Cost Approach, Market Approach, and Income Approach methods.  The analyst ensures that the individual asset and liability accounts are restated to the same standard of value—and the same premise of value—as was intended for the business valuation assignment.

The third AA Method procedure is the mathematical subtraction of the total liabilities value from the total asset value.  This subtraction indicates the value of the total equity.  This value indication can be adjusted to conclude the value of the invested capital (i.e., long-term debt plus total equity) or to conclude the value of one class of equity (e.g., voting common stock).

The AA Method value conclusion is typically stated as a marketable, controlling ownership interest level of value.  To the extent that another level of value is appropriate for the valuation assignment (e.g., a nonmarketable, noncontrolling level of value), the analyst may consider appropriate valuation adjustments.

The remainder of this discussion focuses on the identification and valuation of individual asset and liability accounts.

Current Asset Accounts

Current asset accounts typically include cash, marketable securities, prepaid expenses, accounts receivable, materials and supplies, and inventory.  The analyst performs whatever due diligence procedures that may be necessary to confirm the existence of these current asset accounts.  The analyst restates the asset account balances to a current value as of the valuation date.

For most current asset accounts, the account value does not change materially under alternative standards of value.  For many valuations, the analyst often applies a simplifying assumption: that the recorded current asset account balance is representative of the intended standard of value account balance.

If there are material amounts of accounts receivable or inventory balances, then the analyst may revalue these accounts.  When valuing the accounts receivable balance, the analyst may create a contra-asset account (like a reserve for uncollectible accounts) to conclude the current value of this asset.  In quantifying this reserve (or reduction) account, the analyst considers the age of the subject receivables and the collectability of the subject receivables.  The analyst may restate the historical cost of the entity’s inventory account to a current value.  The current inventory value is often reflected by a replacement cost estimation or a FIFO inventory accounting convention for the subject asset.  In addition to estimating the replacement cost for the inventory, the analyst may consider appropriate contra-asset valuation reserves for inventory shrinkage or inventory obsolescence.

Tangible Real and Personal Property

This category of assets includes two principal subcategories: (1) real estate and (2) tangible personal property.  Real estate typically includes land, land improvements, buildings, and building improvements.  Tangible personal property (TPP) includes productive machinery and equipment, tools and dies, computer and office equipment, furniture and fixtures, and vehicles and transportation equipment.

Depending on the age of these assets, there may be a material difference between the historical cost basis asset balances recorded on the balance sheet and the asset current values.  Depending on the experience and expertise of the analyst, the analyst may (1) perform the asset revaluation or (2) rely on property appraisals performed by third-party specialists.

The value of land and land improvements is often based on the Market Approach and the sales comparison method.  The value of the buildings and building improvements is often based on the Cost Approach and the replacement cost new less depreciation (RCNLD) method.  Buildings and building improvements may also be valued by reference to the Market Approach if sales of sufficiently comparable properties are available.  The use of the Cost Approach is somewhat more common when applying the AA Method—particularly if the value in continued use premise of value is appropriate.

The value of the machinery, equipment, and other TPP is typically based on the Cost Approach and the RCNLD method.  The analyst may test the replacement cost new (RCN) indications by analyzing recent purchases of sufficiently comparable new equipment items.  It is unlikely that the analyst will be able to identify sales of sufficiently comparable portfolios of operating assets.  For this reason, the Market Approach is not often used to value TPP in the AA Method analysis.  It is also uncommon for the analyst to be able to associate a specific income stream with the TPP.  For that reason, the Income Approach is not often used on the AA Method to value TPP.

Most of the owned real estate and TPP will be recorded on the balance sheet.  The analysis of this asset category is primarily a valuation analysis instead of an identification analysis.  The analyst may investigate whether the entity operates leased TPP in addition to owned TPP.  Such leases may be treated as operating leases under current GAAP.  For AA Method valuation purposes, the analyst may consider capitalizing the value of the leased equipment.

Throughout the valuation of this asset category, the analyst is mindful to apply a consistent standard of value and a consistent premise of value.  The asset valuation standard of value and premise of value should be consistent with the standard and premise that is appropriate for the valuation assignment.

Intangible Real and Personal Property

The intangible real property (IRP) category includes the following types of assets:

1. Real property leases
2. Easements and rights of way
3. Air rights, water rights, surface use rights
4. Mineral, mining, and extraction rights
5. Building permits and development licenses

Each of these groups of IRP can be valued by using various Cost Approach, Market Approach, or Income Approach property valuation methods.

The intangible personal property (IPP) category includes the following types of assets:

1. Customer-related intangible assets (e.g., customer contracts, customer relationships)
2. Contract-related intangible assets (e.g., licenses and permits, supplier contracts)
3. Employee-related intangible assets (e.g., employment agreements, assembled workforce)
4. Data-processing-related intangible assets (e.g., computer software, automated databases)
5. Engineering-related intangible assets (e.g., engineering drawings, product formulations)
6. Intellectual property intangible assets (e.g., patents, copyrights, trademarks)

Each of these examples of IPP can be valued by using various Cost Approach, Market Approach, or Income Approach property valuation methods.

In this part of the analysis, the effort is as much about asset identification as it is about asset valuation.  Most IRP and IPP categories are not reported on the balance sheet.  Typically, internally created intangible assets are not recorded on a balance sheet.

The analyst must first identify all the intangible assets that are owned by the company.  Then, the analyst must value each of the identified categories of IRP and IPP.  The analyst considers that the right to use an intangible asset is itself an intangible asset.  For example, if a corporate subsidiary has the right to use the parent company’s trademark or computer software or patents, then that subsidiary owns an intangible asset (i.e., the right to use the parent’s intangible asset).

It is common to apply different valuation methods to value different categories of intangible assets.  Computer software, engineering drawings, and the assembled workforce are often valued using the Cost Approach and the RCNLD method.  Trademarks, patents, and copyrights are often valued using the Market Approach and the relief from royalty (RFR) method.  And, customer relationships, proprietary product formula, and licenses and permits are often valued using the Income Approach and the multiperiod excess earnings method (MEEM).

Because it is common to use multiple valuation methods, the analyst is careful not to overvalue the intangible assets.  The analyst is careful not to assign the same value increment to more than one intangible asset category.  Likewise, the analyst is careful to value all the intangible asset categories—and not let any value increment “fall through the crack.”

In the typical AA Method analysis, the analyst uses one or more Income Approach methods to value some of the intangible assets.  Most Income Approach methods include some type of contributory asset charge procedure.  That procedure helps to avoid double-counting intangible asset values.  Similarly, most Income Approach methods include some type of residual earnings or excess earnings calculation procedure.  That procedure helps to avoid the undercounting of intangible asset values.

Intangible Value in the Nature of Goodwill

This category of assets includes the company’s goodwill and going-concern value.  It is relatively easy to identify the existence of goodwill.  If the company is a going-concern business, it probably owns goodwill.  Both the existence of historical financial statements and of financial projections and forecasts are indicia of goodwill.  The existence of goodwill does not indicate the value of goodwill.  Just because a company owns goodwill, that does not mean that the goodwill has a positive value.  Goodwill can have a positive value, a zero value, or a negative value.

Analysts often apply the capitalized excess earnings method (CEEM) to estimate the value of goodwill in the AA Method.  The CEEM is particularly applicable since it relies on the values already assigned to the current assets, real estate and TPP, and IRP and IPP.  In the CEEM, the analyst assigns a fair rate of return (usually based on the company’s cost of capital) to all of the company’s identifiable assets.  This calculation indicates the required earnings.  The analyst compares the actual earnings (usually measured at the earnings before interest and taxes level) to the required earnings.

If the actual earnings exceed the required earnings, then the difference (the excess earnings amount) is capitalized as an annuity in perpetuity.  This positive annuity value is called goodwill.  If the actual earnings are less than the required earnings, then the difference (the income shortfall) is capitalized as an annuity in perpetuity.  This negative annuity value is called economic obsolescence.  This economic obsolescence (or negative goodwill value) is used to reduce the values of the other identified assets.

Using this CEEM application, the analyst can use the goodwill value (positive or negative) to avoid overcounting or undercounting asset values in the AA Method.

Other Assets

The other assets category is principally composed of two groups of assets:

1. Noncurrent financial assets and
2. Excess or nonoperating assets

The noncurrent financial assets include such assets as deferred federal income tax (DFIT) and investments in unconsolidated subsidiaries.  The value of the DFIT account may change based on the revaluation of depreciable tangible assets or amortizable intangible assets.  The DFIT account value may also change based on the assumed sale transaction structure.

The value of investments in subsidiaries (or in long-term notes receivable or similar investments) will change if the analyst revalues the underlying subsidiary entity.  The analyst may or may not revalue these noncurrent financial assets depending on their materiality.

The excess or nonoperating assets are usually tangible assets that are not being used by the subject company.  Examples of this asset category include land held for investment purposes, assets of discontinued operations, or assets held for sale.  Regardless of the standard of value and premise of value used in the subject entity analysis, this asset category is typically valued based on a net realizable value.  That value represents the expected selling price of the asset less the expected costs of disposal.

Current Liability Accounts

The current liabilities often include accounts and notes payable, accrued expenses, and income taxes payable.  Customer deposits are also recorded as current liabilities if they are expected to be earned during the next year.  This account category also includes the current portion of the long-term debt.

Since these liability accounts are all due in less than one year, there is usually little revaluation involved with the current liability accounts.  It is common to include the current portion of noncurrent liabilities with the long-term debt accounts—and then revalue the entire long-term liabilities balance.

Long-Term Liability Accounts

Long-term liabilities typically include bonds, notes, mortgages, and debentures payable.  In the AA Method analysis, the long-term liability accounts are easy to identify.  This is because these liabilities are recorded on the balance sheet.

Depending on the applicable standard of value in the assignment, these

liabilities are often restated to the amount at which the liability could be extinguished as of the valuation date.  The analyst may consider various factors in the current value analysis of these long-term liabilities, such as: embedded interest rate versus current market interest rate, term to maturity, payment history, prepayment penalties, conversion features, and whether the instrument is callable.

If the current value amounts are materially different from the recorded balances, the analyst substitutes the current values of the long-term liability accounts on the balance sheet.

Contingent Liabilities

Unlike long-term liabilities, contingent liabilities are not recorded on the balance sheet.  The existence of contingent liabilities may be disclosed in the footnotes to audited financial statements.  These disclosures may tell the analyst where to look.  However, they do not tell the analyst the value of the contingent liabilities.  And, the valuation date may not be the same as the audited financial statement date.

The analyst may have to perform due diligence to identify the existence of contingent liabilities.  The analyst may interview operations and financial management (and general counsel), if such executives are made available as part of the valuation process.  While there are many types of contingent liabilities, the analyst may enquire about: employee disputes, litigation claims, contract disputes, taxation audits and other issues, and regulatory agency reviews.

The first step related to contingent liabilities is to identify the liability.  The second step is to estimate a value for the liability.  The analyst can use many different methods to conclude a fair value for these contingencies, including scenario analysis, decision tree analysis, and others.  Ultimately, these analyses involve estimating (1) an amount of the liability payment, (2) the timing of the liability payment, and (3) the probability of the liability payment.  The present value of the various alternative payout events is an indication of the contingent liability value.

Net Asset Value Conclusion

The net asset value conclusion represents the purely mathematical procedure in the AA Method analysis.  The analyst has used judgment and applied valuation approaches and methods to estimate the value of all the asset accounts.  The analyst has used judgment and applied valuation approaches and methods to estimate the value of all the liability accounts.  At this point in the analysis, the analyst subtracts the total liability value from the total asset value to conclude the net asset value.

The net asset value is also called the total equity value.  It is the total of all the company’s equity accounts.  So, this total would include both common stock and preferred stock.  And, this total would include both voting stock and nonvoting stock.

This total equity indication is typically concluded on a marketable, controlling ownership interest level of value.  If the valuation subject is some ownership interest other than 100 percent of the entity equity, then the analyst may have to identify and apply appropriate valuation adjustments.  Such valuation adjustments may include the following:

1. Discount for lack of control and
2. Discount for lack of marketability

Presumably, other entity-level valuation adjustments were already considered in the asset-category valuation analyses.  Such entity-level valuation adjustments could include key person dependence, key customer dependence, key supplier dependence, and so forth.

Summary

This discussion presented a description of the AA Method to value a going-concern operating business.  The next discussion in this series presents an illustration of the AA Method to value a hypothetical business enterprise.

Robert Reilly, CPA, ASA, ABV, CVA, CFF, CMA, CBA, is a managing director of Willamette Management Associates based in Chicago. His practice includes business valuation, forensic analysis, and financial opinion services. Throughout his notable career, Mr. Reilly has performed a diverse assortment of valuation and economic analyses for an array of varying purposes.
Mr. Reilly is a prolific writer and thought leader who can be reached at (773) 399-4318, or by e-mail to rfreilly@willamette.com.