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Financial Accounting and the Myth of Corporate Longevity

Published on April 11, 2011 in the New York Law Journal


The Financial Accounting Standards Board (FASB) continues to issue pronouncements that are intended to improve investors’ and lenders’ ability to value equity and debt securities. Numerous statements, revisions and interpretations have defined and implemented that element of Generally Accepted Accounting Principles (GAAP) known as the Fair Value standard.


Amid the fray of deliberation over what methods companies should use to develop hypothetical models that estimate how much the value of their assets might have changed since the last financial statement, proactive investors and lenders should recognize that current financial accounting methods are in effect an attempt to merge an apparition of the past with management’s vision of a possible future. Although the accounting methods prescribed by the FASB produce precise estimates made as of a single date in the past, there is significant evidence that the relevance and accuracy of these methods as representations of realizable values in the future is suspect.  Large accounting errors can arise from a misinformed attempt to comply with the FASB’s fair value pronouncements by synthesizing hypothetical market values based on assumptions of market conditions that simply do not exist.

The assumption that a company’s cash flow will continue in perpetuity is one example of a faulty premise that is pervasive throughout the valuation industry, and with the introduction of the fair value standard the error has propagated throughout the accounting industry as well. The error typically materializes in a discounted cash flow (DCF) analysis in the form of an estimate of firm value at the end of the final year of a discrete cash flow projection, referred to as the terminal year.

The terminal year value is usually based on an assumption that the final year cash flows will increase the following year by an estimated annual growth rate, and then continue to grow at a constant rate in perpetuity. It is these two assumptions that clear the way for small estimation errors in the cost of capital and long term growth rate to produce a large error in the valuation conclusion.  This is because the terminal year value is typically calculated by capitalizing the terminal year cash flow using a cap rate that reflects the estimated future cost of capital minus the estimated future long term growth rate.

While the terminal year value is very sensitive to the growth rate and cost of capital estimates, any error is dampened somewhat by the present value factor used to convert the future terminal year value to a present value. This is the common retort to criticism that the DCF method is prone to overstating value.   The criticism is often valid however, as small decreases in the cost of capital estimate and small increases in the long term growth rate estimate can combine to yield exponentially large increases in the discounted terminal year value that comprises 50 to 90 percent of the indicated enterprise value.   The size of any error in the enterprise value conclusion depends on how different the cost of capital, growth rate, and firm life expectancy estimates are from reality.  Small variations in all three assumptions can combine to yield valuation conclusions that differ by more than 200 percent.

Economic factors suggesting that an infinite life assumption is inappropriate for operating companies include the uncertain cost and availability of expansion and replacement capital, more efficient technologies controlled by new market entrants, and the finite remaining useful lives of the companies’ underlying assets. Interestingly, in the hundreds of purchase price allocations and asset impairment tests my firm has performed or reviewed, almost all of the subject companies’ income-generating assets were valued under the premise of a finite remaining useful life.

In accordance with GAAP, the difference between the total fair value of the identifiable underlying assets and the estimated fair value of the enterprise as a whole is reported as an asset on the company’s balance sheet entitled ‘Goodwill’. The Goodwill account is thus never valued directly, but is calculated as a residual amount assumed to represent a collection of assets that are unidentifiable and therefore impossible to value.  In the case of a goodwill impairment test, if it can be shown that a premise of perpetual firm life is incorrect, and enterprise value determined under that premise is therefore likely to be overstated, then the unexplainable difference between the fair value of a firm (determined under a perpetual life assumption) and the lower value of its assets (determined under a shorter, finite life assumption) is nothing more than an irreconcilable error. This is also true in the case of accounting for the value of assets acquired in an acquisition, and under current fair value accounting rules, it is the appraised Fair Value of the acquired firm that must be allocated to the firm’s identifiable assets, not the actual purchase price.

Instead of calling the residual an error, the FASB has pronounced that the unexplainable difference will be labeled ‘Goodwill’ and reported as an asset on the acquiring company’s balance sheet. This is a major weakness of the FASB’s prescribed method for accounting for acquisitions, as well as those pronounced by the IASB, AICPA, PCAOB and the SEC. In recognition of this, the Valuation Resource Group (VRG), consisting of observers from all five regulatory bodies and representatives of the valuation and accounting industry, continue to meet on a regular basis in an attempt to agree upon how companies should consistently test the validity of reported goodwill values.  After nine meetings of the VRG since 2007, this issue is one of many that remain unresolved.  The reason for this is that they have not addressed the origin of the goodwill account: errors in estimates of the future cost of capital, growth rate, and most of all, company life expectancy.

In my firm’s research to support numerous purchase price allocations and intangible asset impairment tests, we have uncovered convincing empirical evidence that the expected remaining life of the majority of existing companies is less than 10 years.   Since there are numerous factors that affect the survival rate of firms, including their industry, size, and age, a company does not  face the same risk of death each year, because the hazards will change over time with the company’s circumstances.  We have found that generally the probability of failure declines as a function of size and age, but this phenomenon is often due in part to specific underlying conditions that manifest themselves as a survival bias that which can skew the probability distribution and understates the failure rate of large and old firms.

The Small Business Administration publishes data accumulated by the U.S. Census Bureau and Internal Revenue Service showing the number of firm births and deaths each year since 1989 (see www.sba.gov/advocacy/849/12162). In 2006 there were 6.02 million firms in the U.S. that had employees. Within a year, 592,410, or 9.84% of those firms had gone out of business.  Over the period 1990 to 2007, an average of about 10% of the firms that were operating at the start of each year had ceased operations the following year.  A 90% annual survival rate implies that only 35% of the original sample of firms will survive after 10 years.

In comparison, Dr. Kelly Cassidy’s 2007 survey of 122 different breeds of dogs indicated that more than 50% of breeds have an average longevity of over 10 years. Perhaps it is therefore reasonable to expect that your dog will outlive most of the companies in existence today.

Various academic studies confirm our findings. A 1991 study conducted by Indiana University distinguished professor David Audretsch revealed that 35.4% of 11,514 small businesses in 14 industry sectors survived the ten year period from 1976 to 1986.  The Thomas Register of American Manufacturers published data on 3,431 firms entering and exiting 33 product markets between 1906 and 1991, which was determined by multiple academic studies to indicate that the average period of survival for those companies was about 7 years.  In a 1989 study of the opening and closing of 350,000 U.S. manufacturing plants from 1963-1982, Penn State University professors Timothy Dunne, Mark Roberts and Larry Samuelson found that after 10 years only 26% of the plants were still operating, and less than 20% survived after 15 years. The survival rate of the manufacturing firms that owned the manufacturing plans was surmised to be slightly higher, because many of them operated multiple plants, of which some survived.

Since the premise of perpetual life and constant earnings growth for the large majority of companies is controverted by the empirical evidence, the accuracy of any valuation conclusion based on that premise is naturally suspect. The above data is convincing evidence that valuation and investment advisors should include a detailed analysis of the probable remaining life of the firm in their valuation analyses, and quantify the effect in their conclusion of value.  Omission of such an analysis from valuations for financial reporting or investment marketing purposes may soon be construed as negligence if the Fair Value standard is modified to reflect the economic facts.

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