International Business Valuation Standards

Standards of Value: Theory and Applications, Second Edition By Jay E. Fishman, Shann on P. Pratt, William J. Morrison Copyright 2013 by John Wiley & Sons, Inc. Appendix A International Business Valuation Standards Introduction International business valuation standards are in a stage of evolution. Most efforts to develop international business valuation standards beyond North America are within the context of broader valuation standards, that is, standards that include not only business valuation but also valuation of other types of property, such as real estate and personal property. International Valuation Standards Council By far the oldest and most developed of the international valuation standards movements is the International Valuation Standards Council (IVSC), a nongovernmental organization (NGO) of the United Nations. The IVSC has been in existence since 1981, under the name of The International Assets Valuation Standards Committee (TIAVSC). The Committee changed its name in 1994 to the International Valuation Standards Committee (IVSC). As demand increased for valuation standards in different sectors and markets, it had become clear to the IVSC that its constitution and structure no longer could provide it with the legitimacy or resources required to meet these new challenges. In January 2007, the IVSC published proposals for a radical restructuring to transform the IVSC from a committee of representatives of its member valuation organizations into an independent body. At this time, the organization s name was changed to the International Valuation Standards Council. 347

348 Standards of Value The organization currently has three main bodies: 1. An independent Board of Trustees responsible for the strategic direction and funding of the IVSC and for appointments to the Standards Board and Professional Board 2. A Standards Board with autonomy over its agenda and the creation and revision of valuation standards 3. A Professional Board to promote the development of the profession around the world through producing professional and educational material in support of the standards 1 Valuation Organization Membership traditionally has been available to one national association per country. However, the Appraisal Institute of the United States, the Appraisal Institute of Canada, the Canadian Institute of Chartered Business Valuators, as well as the American Society of Appraisers (ASAs) are full members. 2 At this writing, there are about 72 full organization members. For about five years, the ASA s representative to the IVSC was Vern Blair. Since November 2011, the ASA s representative is Anthony Aaron. The IVSC business valuation standards are closely aligned with the Uniform Standards of Professional Appraisal Practice (USPAP), which are promulgated by the Appraisal Foundation of the United States. In 2011, it issued the ninth edition of International Valuation Standards. The major updates in the latest edition include: 3 1. Created an IVS Framework containing much of the material in IVS 100 103. Because this material was in the nature of a discussion about valuation concepts and principles, it needs to be clearly separated from those standards that provide a clear direction as to what should be done in the course of a valuation assignment. 2. Created a new General Standard dealing with the implementation phase of a valuation assignment. 3. Reorganized the Asset Standards so that the requirements of each standard are more clearly distinguished from the background discussion. 1 International Valuation Standards Council, About the International Valuation Standards Council (IVSC), April 20, 2012 (http://www.ivsc.org/about/index.html). 2 International Valuation Standards Council, Membership, April 20, 2012 (http:// www.ivsc.org/members/index.html). 3 International Valuation Standards Council, The International Valuation Standards (IVS), April 20, 2012 (http://www.ivsc.org/standards/index.html).

International Business Valuation Standards 349 4. Restructured the Financial Reporting Standards. The majority of the text was retained, but clearly presented as guidance on various valuation requirements under International Financial Reporting Standard (IFRS), and will make it clear that IFRS, or such other accounting standard that may be relevant, are the standards that must be followed. 5. Added new Standards for Real Property Interests, Businesses and Business Interests, Valuation of Plant and Equipment and Intangible Assets, Consideration of Hazardous and Toxic Materials, and Valuation of Historic Property. In the ninth edition, the standards are organized as follows: 4 1. IVS Definitions This contains those words or phrases that have a specific meaning in the context of the standards and that appear in more than one standard. Definitions that are used only in a single standard are defined only in that standard. 2. IVS Framework This contains generally accepted valuation concepts and principles upon which the IVS are based and that are to be considered and applied when following the standards. 3. General Standards The three General Standards have general application for all valuation purposes, subject only to variations or additional requirements specified in the Assets Standards or the Valuation Applications. The General Standards are IVS 101, Scope of Work, IVS 102, Implementation, and ICS 103, Reporting. 4. Asset Standards The Asset Standards consist of a standard and commentary. The standard sets our requirements that either modify, or are additional to, those in the General Standards and examples of how the principles in the General Standards are applied to the particular asset class. The commentary provides additional background information that describes the characteristics and methods used for their valuations. The Asset Standards include IVS 200, Businesses and Business Interests, IVS 210, Intangible Assets, IVS 220, Plant and Equipment, IVS 230, Real Property Interests, IVS 233, Investment Property Under Construction, and IVS 250, Financial Instrument. 4 International Valuation Standards Council, Staff Draft Proposed Revised International Valuation Standards, at 3 4, April 27, 2012 (http://www.ivsc.org/ standards/20110214_staff_draft.pdf).

350 Standards of Value 5. Valuation Applications Valuation Applications are produced for two of the most common purposes for which valuations are required: financial reporting and secured lending. Each application contains a standard and guidance. Broad Definitions The IVSC standards define value broadly in this way: Value is not a fact, but an opinion, of either: a) the most probable price to be paid for an asset in an exchange or, b) the economic benefits of owning an asset. A value in exchange is a hypothetical price and the hypothesis on which the value is estimated is determined by the purpose of the valuation. A value to the owner is an estimate of the benefits that would accrue to a particular party from ownership. The word valuation can be used to refer to the estimated value (the valuation conclusion) or to refer to the preparation of the estimated value (the act of valuing). In these standards, it should generally be clear from the context which meaning is intended. Where there is potential for confusion, or a need to make a clear distinction between the alternative meanings, additional words are used. 5 The IVSC standards define market value as: The estimated amount for which an asset should exchange on the valuation date between a willing buyer and a willing seller in an arm s length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently, and without compulsion. 6 The standards define investment value, or worth, as: The value of an asset to the owner or prospective owner for individual investment or operational objectives. This is an entity-specific basis of value. Although the value of an asset to the owner may be the same as the amount that could be realized from its sales to another party, the basis of value reflects the benefits received by an entity from holding the assets and, therefore, does not necessarily 5 International Valuation Standards Council, IVS Framework, April 27, 2012 (http:// www.ivsc.org/standards/reg_framework.html). 6 Id., at 8.

International Business Valuation Standards 351 involve a hypothetical exchange. Investment value reflects the circumstances and financial objectives of the entity for which the valuation is being produced. It is often used for measuring investment performance. 7 Approaches to Valuation According to the IVSC standards, the three approaches described and defined in the Framework are the main approaches used in valuation. They all are based on the economic principles of price equilibrium, anticipation of benefits, or substitution: Market Approach. This comparative approach provides an indication of value by comparing the subject assets with identical or similar assets for which the price information is available. In general, a property being valued (a subject property) is compared with sales of similar properties that have been transacted in the open market. Listings and offerings may also be considered. Income Approach. This comparative approach provides an indication of value by converting future cash flows to a single current capital value. The Income Approach considers the income that an asset will generate over its useful life and indicates value through a capitalization process. Capitalization involves the conversion of income into a capital sum through the application of an appropriate discount rate. The income stream may be derived under a contract or contracts, or be non-contractual, e.g. the anticipated profit generated from either the use of or holding of the assets. Methods that fall under the Income Approach include: 1) Income Capitalization Method, 2) Discount Cash Flow Method, 3) various Option Pricing Models. In general, the principle of substitution holds that the income stream which produces the highest return commensurate with a given level of risk leads to the most probable value figure. Cost Approach. This approach provides an indication of value using the economic principle that a buyer will pay no more for an asset than the cost to obtain an asset of equal utility, whether by purchase or by construction. 8 In a real estate context, one would normally not be justified in paying more for a given property than the cost of acquiring equivalent land and constructing an alternative 7 Id., at 10 11. 8 Id., at 13 14.

352 Standards of Value structure, unless undue time, inconvenience, and risk are involved. In practice, the approach also involves an estimate of depreciation for older and/or less functional properties where an estimate of cost new unreasonably exceeds the likely price that would be paid for the appraised property. 9 In the latest version of International Valuation Standard, the discussion on non-market-based valuations was deleted. Types of Property The IVSC recognizes the customary division of property into six discrete categories: 10 1. Businesses and Business Interests 2. Intangible Assets 3. Plant and Equipment 4. Real Property Interests 5. Investment Property Under Construction 6. Financial Instruments IVS defines a business as any commercial, industrial, service, or investment activity. The IVSC standards analyze three approaches to business valuations: 1. The market and income approaches described in the IVS Framework can be applied to the valuation of a business or business interest. The cost approach cannot normally be applied except in the case of early stage or startup businesses where profits and/or cash flow cannot be reliably determined and adequate market information is available on the entity s assets. 2. The value of certain types of businesses (e.g., an investment or holding business) can be derived from a summation of the assets and liabilities. This is sometimes called the net asset approach or asset approach. This is not a valuation approach in its own right as the values of the individual assets and liabilities are derived using one or more of the principal 9 Id., at 33 34. at 26. 10 International Valuation Standards Council, Staff Draft: Proposed Revised International Valuation Standards, April 2012, at 79 (www.ivsc.org/standards/20110214_ staff_draft.pdf).

International Business Valuation Standards 353 valuation approaches described in the IVS Framework before being aggregated. 11 3. IVS defines a financial instrument as a contract that creates rights or obligations between specified parties to receive or pay cash or other financial consideration, or an equity instrument. The contract may require the receipt or payment to be made on or before a specific date or be triggered by a specified event. An equity instrument is any contract that creates a residual interest in the assets of an entity after deducting all of its liabilities. There are special attentions when applying the standard of Financial Instruments: Many types of instruments, particularly those that are traded on exchanges, are routinely valued using computer-based automated valuation models. These models are often linked to proprietary trading platforms. It is beyond the scope of IVS to examine such models in detail. It is important when using a particular valuation method or model to ensure that it is calibrated with observable market information on a regular basis. This ensures that the model reflects current market conditions and identifies any potential deficiencies. As market conditions change, it might become necessary either to change the model(s) used or to make additional adjustments to the valuations. 12 Toronto Valuation Accord The Toronto Valuation Accord (TVA) was born in late 2003 to attempt to bring convergence between the superpowers of accounting policy the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) with respect to valuation for financial reporting. 13 Signers of the TVA were: American Society of Appraisers Appraisal Institute 11 International Valuation Standards Council, International Valuation Standards 2011, April 27, 2012 (www.ivsc.org/standards/reg_200.html). 12 Id. 13 The authors are grateful to Lee Hackett, FASA, executive vice president of American Appraisal Associates, Inc. and one of the Appraisal Foundations representatives to the Toronto Valuation Accord, for his input to this section.

354 Standards of Value Appraisal Institute of Canada Royal Institution of Chartered Surveyors United States Royal Institution of Chartered Surveyors Canada Centre for Advanced Property Economics The Appraisal Foundation 14 The activities and concerns of the TVA should be of interest, particularly to those involved in providing services that assist financial reporting requirements. Mission and Objectives The TVA states its mission and objectives in this way: The issue of valuation for financial reporting (VFR) poses a key emerging topic for the valuation profession. Recent events in the accounting profession and in the business world have brought issues of professional independence, measurement of asset value and transparency of reporting to the forefront. Accounting standards in the United States and Canada are expected to converge to a common global standard with the international accounting community, of which a component will be methodology for the reporting of assets. Under the Basel capital accords, the banking industry must account for assets and liabilities on a market basis, which has implications for the valuation profession. Accordingly, it is important that each organization representing the valuation profession in the United States and Canada, including real property, personal property and business appraisal, participate in a coordinated fashion to ensure a unified response on behalf of valuers and valuation standards. Participation in the Toronto Valuation Accord of October 2003 was a first step in this endeavor. The following is proposed as a plan for continued progress by the organizations and the profession: 1. We recognize that the recent movement of international standards toward convergence and harmonization, and the related emphasis on market (fair) value, increases the responsibilities of valuers in Canada, the United States, and worldwide to participate in the 14 International Valuation Standards Council, Toronto Valuation Accord, April 20, 2012 (www.ivsc.org/news/nr/2003/1022nr-toronto.pdf).

International Business Valuation Standards 355 establishment of reporting standards for the benefit of the users of financial reports and the public at large; 2. We agree to work together to develop policies and establish a plan to position the valuation profession as represented by their members, as the professionals of choice in the provision of valuation for financial reporting purposes and related services; 3. We encourage each organization to establish a plan for how that organization will inform and educate its members on valuation for financial reporting issues and will identify a principal contact in each organization who will coordinate with the other organizations to exchange information regarding those issues and the organization s plan. 15 Definitions The IASB states current value as being fair value, which the IASB defines as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm s length transaction. The IASB sets forth these three criteria for fair value measurement: 1. Quoted market prices in an active market 2. Recent transactions for similar assets 3. Other valuation techniques FASB defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (e.g., other than in a forced, or liquidation, sale). It further states that valuation techniques used to estimate fair value shall emphasize market inputs, including those derived from active markets, regardless of which approach (market, income, cost) is used. While there is unanimous concurrence on the use of current value financial reporting, within the TVA there is ongoing discussion as to the premise underlying fair value. Some members think that fair value should be abolished and current value should be defined as market value; further, they believe that market value should be premised on in-exchange, reflecting highest and best use. Other members think that fair value as set forth by the accounting superpowers is an acceptable basis (as it has been for years under Accounting Procedures Board 16/17 and currently under FASB 141) and should be based on market value concepts. Market value concepts, as defined and used within TVA, mean that the premise for market value could 15 Toronto Valuation Accord Mission Statement 2003.

356 Standards of Value be expressed as in-exchange, in-use, or liquidation, depending on the facts and circumstances and the owner s or market participants intent. Fair Value Measurement Regardless of whether current value accounting is adopted, measurement of fair value of acquired assets is under scrutiny by the IASB and FASB. IASB criteria were listed in the previous section. FASB issued an Exposure Draft on fair value measurements on June 23, 2004. Subsequently, there have been comment period reports and two public hearings to discuss the proposals, which have led to a June 2006 postballot daft on fair value measurements. FASB favors a hierarchal approach to estimating fair value, which it refers to as levels : Level 1. Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 2. Quoted prices for similar assets or liabilities in active markets or quoted prices for identical or similar assets or liabilities in markets that are not active. Level 3. Unobservable inputs for an asset or liability, that is, inputs that reflect the reporting entities own assumptions about the assumptions that market participants would use in pricing the asset or liability. Obviously, there is a priority for market inputs if available and reliable and comparable; but there is nothing to preclude valuers from their prior practice of using valuation techniques appropriate to the economic availability of data. FASB identifies two premises of value that could be utilized in estimating fair value: in-use and in-exchange. Value-in-use is based on an installed machine that will be used in income-producing activities of an entity. Valuein-exchange is contrasted as an installed machine that will be sold to another entity. There is an implication that the intent of the buyer will drive the premise of value. However, to do so, it would be necessary to show that any likely buyer would be expected to behave in a similar manner. FASB goes further and identifies other premises that might be employed. Orderly liquidation could prevail if there was a requirement to dispose of any assets because of regulatory decrees, for example. Abandonment basis could also be appropriate if products are to be rebranded or trademarks discontinued. FASB presented two alternative approaches regarding using

International Business Valuation Standards 357 present value of future cash flows in accounting measurements. Called the traditional approach, it is acceptable to utilize a single, best estimate of future cash flows and discount same to present value at a discount rate that reflects the risk involved. Another approach, called the expected cash flow approach, utilizes multiple projections of possible outcomes that can be assigned probabilities and then discounted to present value. Discount rate treatment utilizing an expected cash flow approach may require reflection of market-based risk premiums in one of two ways. The expected cash flow can be reduced for risk and then discounted at a risk-free rate. Alternatively, the expected cash flows are discounted at a risk-adjusted discount rate. The recent decisions of FASB and the direction FASB is promoting on the enumerated emerging issues provide us with a clear signal: FASB has recognized that worldwide financial markets are demanding a unified set of financial reporting standards. No longer will a company have to follow U.S. generally accepting accounting principles (GAAP) to list shares in New York and list the same shares in London based on U.K. GAAP or international GAAP. Another signal of convergence is the change in treatment of in-process research and development; it is no longer allowed to be written off, but must be amortized as required under International Accounting Standards (IAS) 36 and 38. Business combination rules under IAS and FASB are likely to become identical with regard to identification of intangibles separable from goodwill. More signs of convergence abound as IASB has adopted FASB s definition of a business combination: a transaction or other event in which an acquirer obtains control of one or more businesses. Both groups also have converged on the definition of goodwill: Goodwill is future economic benefits arising from assets that are not individually identified and separately recognized. 16 Conclusion The North American professional valuation groups are coming together to promote the ability of professional valuers to meet the valuation needs of the new global financial reporting standards. The accounting and regulatory community and valuers themselves must become aware of the changes to come and must study these changes in order to continue and grow in a professional valuation career. 16 Lee P. Hackett, Executive Vice President of American Appraisal Associates, Inc., Valuation for Financial Reporting, unpublished paper, Milwaukee, WI (2005).

358 Standards of Value Royal Institute of Chartered Surveyors The Royal Institute of Chartered Surveyors (RICS), based in the United Kingdom, is comprised primarily of real estate appraisers. RICS published its first set of valuation standards in 1974. The purpose of the RICS standards is to provide users of valuation services with confidence that a valuation provided by an RICS-qualified valuer has been undertaken in compliance with the highest professional standards. The standards have evolved to the RICS Appraisal and Valuation Standards, last revised in March 2012. 17 RICS defines market value as: The estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm s-length transaction after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion. 18 It is the stated goal of RICS to narrow as much as possible the differences between the RICS standard and the International Valuation Standards. International Financial Reporting Standards The International Financial Reporting Standards were previously known as International Accounting Standards (IAS) and are set by the International Accounting Standards Board (IASB). This board works closely with the Financial Accounting Standards Board in the United States. To draw a parallel, the IASB is to the FASB as the International Valuation Standards Committee is to USPAP. 17 RICS Appraisal and Valuation Standards, revised (RICS Business Services Limited, a wholly owned subsidiary of the Royal Institute of Chartered Surveyors, Coventry, UK, January 2005). Isurv, VS 3.2 Market Value, July 25, 2012 (www.isurv.com/site/scripts/documents_ info.aspx?categoryid=1158&documentid=4764&pagenumber). 18 Id., at glossary at 2.