The IVSC’s newest IVS 230 Inventory Exposure Draft tackles several themes, with particular attention to changes in the top-down method. Most financial analysts would apply the top-down method ‘for the valuation of WIP and finished goods,’ says Mark Zyla in his opening analysis. He notes the need for the Exposure Draft since ‘recent guidance is moving best practices toward a more systematic and detailed approach to allocate the value creation before and after the measurement date.’

Such considerations include:

[A]ccounting for internationally generated IP in the cost structure or apportionment analysis, whether relevant intangible assets are effectively imbedded in the inventory, identification of costs that benefit future periods, the allocation of overhead expenses, etc.

Therefore, the draft sections (60.5 through 60.8 below) that suggest new guidance on how to use the top-down method should be of interest to all business valuers and analysts whose clients carry material inventory.

The Exposure Draft suggests the following steps:

60.5 The key steps in applying the Top-Down Method are to:

(a) Estimate the selling price. The valuer should rely on direct observations of selling prices when the information is available. However, such data is often not available and the selling price is often estimated by applying an appropriate gross profit margin to the net book value of finished goods at the product level or aggregate level. Typically, the projected gross profit margin in the period the inventory will be sold is used.

(b) Estimate the costs to complete (for work-in-process only). Completion costs should include all of the expenditures directly or indirectly remaining to be incurred post-valuation date in bringing the WIP inventory to its finished condition. Costs to complete should be adjusted to remove expenses benefitting future periods.

(c) Subtract the costs of disposal. Costs of disposal represent costs that would be incurred post-valuation date in order to deliver the finished goods to the end customer. Costs of disposal should be adjusted to remove expenses benefitting future periods. Disposal costs generally include selling and marketing expenses while procurement and manufacturing expenses have typically already been incurred for finished goods inventory. In order to properly determine costs of disposal, each expense in the inventory cycle (including indirect overhead) should be categorised as having been incurred and, therefore, contributed to the value of the finished goods inventory or remaining to be incurred during the disposal process.

(d) Subtract the profit allowance on the completion effort (for work-in-process only) and the disposal process. An initial starting point may be to utilise the operating profit of the company. However, this methodology assumes the profit margin would be proportional to the costs incurred. In most circumstances there is rationale to assume profit margins which are not proportional to costs (see Section 90).

(e) Consider any necessary holding costs. Holding costs may need to be estimated in order to account for the opportunity cost associated with the time required to sell the inventory. Additionally, the valuer should consider the risk born during the holding period when determining the required rate of return. Risks may be a function of the length of inventory life cycle and the contractual arrangements with end customers (e.g., manufacturer bears the risk of fluctuation in costs of completion and disposal). Holding costs may be immaterial if the inventory turnover is high and/or the borrowing rate is low.

60.6 When determining the cost to complete, costs of disposal and profit allowance, the valuer should identify and exclude any expenses that are intended to provide future economic benefit and are not necessary to generate the current period revenue. Examples of future-benefit expenses may include research and development (“R&D”) related to new product development; marketing for a new product; recruiting to increase the size of the workforce; expansion into a new territory; depreciation of an R&D facility dedicated to future research; or restructuring costs.

60.7 Internally developed intangible assets should either be modelled as 1) a cost as if they were hypothetically licensed, and therefore included in either the cost of production or disposal, or 2) considered as part of a functional apportionment when determining the appropriate profit allowance.

60.8 When utilising the Top-Down Method, valuers should consider whether sufficient data are available to appropriately apply the key steps. If sufficient data is not available, it may be appropriate to apply other methods or techniques.

The IVSC invites feedback on all matters in this Exposure Draft. Submit comments by 30 April 2020 by emailing comments to comments@ivsc.org.

UK banks have withdrawn mortgage loans, and borrowers are not making payments. Lloyds and others have lowered their loan to value caps, while Nationwide and others have added restrictions to low-deposit borrowers and first-time buyers. Buyers without 25% (or greater) equity are essentially closed out of the market currently.

That’s if you can reach them at all. Vida Homeloans and Together Money have ceased all new mortgage lending. Those still in the business are barely answering the phones since the government said mortgage holders hurt by the coronavirus should be given a three-month respite from paying their mortgages.

Valuations have contributed to the real property stumble: Many analysts in the tangible property world have noted that the banks are liquid. Processing issues aside (call centres are closed and still struggling with work from home), there is also the issue with valuations—particularly as banks are forced to rely solely on inexpensive ‘desktop’ valuations.

Many of the bigger lenders have accepted those for smaller properties with low LTV rates. Others, such as lender more2life, have switched to ‘semi-automated’ valuation so surveyors would not need to visit the homes of potentially vulnerable clients. Legal & General has also stopped physical valuations. They can’t get valuers out for inspections, buyers can’t meet with property agents, and the risk reduction model for the mortgage market has stopped.

These lenders continue to rely on a combination of data from valuer E.surv, information about the borrower’s local area, and opinions from RICS-qualified surveyors.

This response offers two challenges for the profession. First, it reduces the quality of the appraisal. Second, lenders are being more cautious using this approach, adding restrictions around high loan-to-values or where nonstandard building materials are involved.

Some property types are being excluded, and some lending products have been withdrawn.

Business valuers would refer to desktop valuations as ‘calculations,’ and many BVWire—UK readers avoid them, citing IVS standards as applied to BV. Watching professional siblings from RICS or TEGoVA struggle to get their work accepted by banks and lenders is a lesson to us all—this, after all, is professional work product that wouldn’t withstand scrutiny in most business valuation settings.

We get what we pay for, in life and in business valuation. A business valuation prepared according to international standards by leading experts is worth the investment when value is uncertain and times are volatile, as they are now—and all parties must have confidence in the results.

Expert in courts—Strickland challenges business valuers who are adversarial or too keen

Experts who attack other experts, behave discourteously, or slavishly follow the instructions of solicitors will not be treated favourably by the courts because they are deeply dependent on the knowledge that their experts, including business valuation specialists, maintain independence and professionalism.

So said Andrew Strickland, speaking at a free webcast with the ICAEW on 7 April (slides from the webinar available here). He recounted high court and other rulings by judges who were so angered by the failure of their experts, whether medical or financial, that they issued career-ending statements regarding the flaws.

‘For any expert appointed by the court comes power to influence judicial decisions, and with power comes heightened duty to deliver and to communicate fully with those involved in the case,’ Strickland said.

His review of recent UK case law reminds of us to avoid the most common errors in professional judgment experts commit:

• Failing to answer the questions the court asked.

• Not reflecting the need for deep courtesy and consideration, particularly avoiding abrasive conduct, including ‘salty comments’ toward fellow experts in either testimony or written reports. ‘We need to keep any waspish comments in check; they’re likely to rebound against us.’

• Not being aware of relevant facts so that testimony is easily contradicted, particularly when the tone of the presentation is high-handed.

• Putting through changes in draft reports suggested by instructing solicitors, thereby creating the impression of having an opinion that can be bought. The solicitors can erode the independence and integrity of the appraisal process.

• Failing to make assumptions required in the role of experts. We are obliged to make assumptions and answer questions based on hypotheses.

• Failing to follow the instructions of court because the valuer fails to comply with the terms of the determinations. ‘The courts want determinations to work, and are reluctant to overturn them.’ So if an independent joint expert fails to follow the instructions of the determination, the courts will not be pleased.

To help support the inquiries we’ve been receiving from our customers about how to address the coronavirus in the valuations they are working on, BVR has created a new COVID-19 business valuation resource website where we offer links to current news, past articles and webinars, third-party articles, and more to help BVWire—UK readers. As always, you can use the page to reach out to us and let us know how we can help cover the impact on business valuations.

RICS, iiBV, BVR, ICAEW, IVSC, and others have already delivered multiple resources for valuers, and those are included here, or in the new website. One example is last week’s Extreme Uncertainty: How Valuation Experts Should Respond to Today’s Volatility and Risk, which featured Gary Trugman (Trugman Valuation Associates), Harold Martin (Keiter, Stephens, Hurst, Gary & Shreaves PC), Michelle Gallagher (Gallagher & Associates CPAs), and Stacy Preston Collins (Financial Research Associates).

Another great resource is the iiBV’s Impact of COVID19—Global Perspectives, created in collaboration with the International Valuation Standards Council (IVSC), Singapore Accountancy Commission (SAC), Duff & Phelps, and Leadenhall. iiBV’s recorded webinar features: Yann Magnan, IVSC European Board chair, UK; Andre Toh, deputy chair of IVAS—Standards & Technical Committee, Singapore; Carla Nunes, Duff & Phelps, USA; and David Pearson, Leadenhall, Australia.

Among the topics these panels of leading BV professionals covered were:

• What’s known or knowable now? If you have an effective valuation date at 31 December 2019, and your report date is now, many appraisers are adding information about known dates, which are meaningful to the user and should be disclosed, about the coronavirus. Some valuers are including subsequent information in their cover letters rather than in the valuation reports themselves. One example: a family law case dated last November when the business interest was in full swing—but now the business is closed and unlikely to emerge as a going concern after the virus. So, ‘as a matter of equity the challenge is to try to move the valuation date,’ at least in matrimonial situations, said Trugman. Martin commented that, while this might be true in matrimonial cases, in other areas, valuation dates may remain much more fixed. For example, one BVWire—UK reader commented that their firm is doing a 31 December 2019 valuation for a construction firm with a report date of 11 March 2020. Collins said that experts should look to solicitors for instructions on what date to use as values change so rapidly.

A sample timeline from the ASA’s Bob Morrison on COVID, with footnotes, is available to BVWire—UK subscribers at the BVR COVID-19 resource page link above.

• When did COVID become known or knowable? As with many things in BV, the answer is not simple. It could be the first day that the global markets dropped—21 February 2020. ‘But it could be the day that customers were influenced, or the day that the government ordered a business to shut down, or other direct factor on the business,’ said Trugman. ‘You have to talk to the business’—it may not have anything to do with what the FTSE did that day, said Gallagher.

24 February is the week the markets really started to crash, so a lot happened very quickly between 20 February and 15 March. Within that period, most businesses were affected within a very short window, said Collins.

Martin says they’re ‘trying to separate knowledge of the health crisis vs. the point when the economic impacts began to be felt.’ Collins described a client with a distribution chain in China who knew in mid-January that their business was feeling the pain. ‘It’s a business-by-business and industry-by-industry situation’ when values changed dramatically, she concluded.

• How about forecasting the timing and magnitude of any recovery? Trugman asked whether, in certain industries, there will ever be recovery. ‘We see a lot of small businesses that will never reopen, so we can’t even speculate on the possibility of recovery. If a business is closed now, would anyone ever buy them? Can someone reasonably conclude that business has any fair market value,’ Trugman asked.

‘In this concept we can look back to the economic damage of the last quarter of 2008,’ says Martin. ‘Like then, we need to look at each company within an industry to do alternative cashflow projections and then conduct a weighted scenario analysis to reach a conclusion of value. We look to management to provide assumptions. They are the most knowledgeable about the sector, though we provide our professional judgment to critique the reasonableness of their projections.’

Keep in mind that various parts of the world are not forecasting the peak of the pandemic until midsummer or even beyond, several of the panelists warned. ‘The mere fact that we have an extended period of time of exposure to volatility is different than 2008-9. No one knows if we’re looking at months or years. We have to do stress tests on businesses,’ said Gallagher.

‘You’re going to have to assume different periods of recovery and different post-depression growth rates,’ Martin agreed.

‘This is a good time to revisit the implied ERP rather than the historical ERP,’ advises Dr. Michael A. Crain (Florida Atlantic University). ‘The implied ERP reacts to changes in the risk-free rate but the long-term historical average ERP changes very little.’ As in the UK, risk-free rates are now in uncharted territory as the entire yield curve for U.S. bonds fell below 1% for the first time in history.

Ron Seigneur (Seigneur Gustafson LLP) offers this word of caution: ‘Much like the manufactured rate drop during the great recession to help the economy, using a build-up model with these low “risk-free” rates, keeping all else equal, creates an illusion of value that does not exist.’ He says, ‘Overall market risk is increasing in most sectors, as is volatility risk, so the analyst needs to make up the delta elsewhere.’

Crain and Seigneur are product leaders on BVR’s Cost of Capital Professional.

Those looking for global premia can turn to the just-released survey of the market risk premium (MRP) and risk-free rate (RF) used in 81 countries from Pablo Fernandez, professor of finance, IESE Business School. ‘Many respondents use a RF higher than the yield of the 10-year Government bonds for European countries,’ comments Fernandez this year.

The updated results also link to Fernandez’s previous annual surveys, from 2008 to 2019.

Solicitors and their clients use Who’s Who Legal (WWL) to research case law and find experts. They have just released their latest analysis of the leading forensic accountants in the UK. According to WWL, these practitioners ‘are distinguished for their market-leading work on accounting irregularities and regulatory compliance amongst other topics.’

WWL's Global Elite Thought Leaders are nominated via a survey of ‘peers, corporate counsel and other market sources’ so business valuers who wish to be considered should reach out to their client lists for support. The 2020 winners, which hardly comprise a complete list of the best forensic experts in the UK, include:

EMEA

• Will Davies—Grant Thornton, London;

• Toby Duthie—Forensic Risk Alliance, London;

• Richard Indge—EY, London; and

• David Jimenez-Ayala—Duff & Phelps, Madrid.

Other leading professionals in England:

• Ben Johnson of Berkeley Research Group;

• Andrew Durant of FTI Consulting; and

• Alex Plavsic of KPMG.

Leading firms:

• Grant Thornton; and

• EY.

D&P has increased its recommended U.S. equity risk premium (ERP) from 5.0% to 6.0% for use as of 25 March 2020. This new rate, used in conjunction with a normalised risk-free rate of 3.0% (reaffirmed), implies a ‘base’ U.S. cost of equity capital estimate of 9.0% (6.0% + 3.0%), according to Duff & Phelps’ client alert.

‘To be clear, this means that for critical quarter-end valuations dated 31 March 2020, the recommended ERP is 6.0%,’ the firm says. ‘However, several economic and financial risk factors that we evaluate were already present during the week of 9 March 2020.’

The increased ERP attempts to match market conditions in the US but should be an indicator in Britain where the FTSE’s risk has increased and prices have dropped, revenues have decreased or disappeared, and billions of pounds of value have been erased, as reported in BVWire.

ASA-Europe Business Valuation Conference, 24 September, Prague (details available soon)

IVSC Annual General Meeting, 14-16 October, Chicago

EACVA 14th Annual Business Valuation Conference, 29-30 October, Munich

Our thanks to Marianne Tissier, Andrew Strickland, and Nick Talbot for their valuable contributions to BVWire—UK.

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David Foster at ukeditor@bvresources.com or +011-917-741-3853.