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Business Valuators Get Help from the Accountants in Valuing Private Company Debt Obligations

The Hancock Firm regularly values debt issued by privately-held companies and other commitments or contingencies involving the private company. When the subject company has financial statements that have been reported upon by independent accountants or auditors, substantive insights into the obligations or alleged obligations may be ascertained. For example, take the following edited excerpt from a  report issued by The Hancock Firm.

In a writing dated August 31, 2008, XYZ, Inc. granted to EFG, Inc. the right to contingent financial awards. The right is non-interest bearing. The term of the writing appears to be perpetual (at least until the payment of the obligation). XYZ, Inc. granted EFG, Inc. the right to a certain fixed amount ($2,500,000) if and when certain XYZ, Inc. business lines were sold to ABC, Inc. in the approximate amount of $41 million.

XYZ management expressed its unequivocal opinion that the sale was not reasonably certain and, in fact, the prospect for realization was “fairly dim” (according to Mr. Smith, XYZ, Inc. President). XYZ does not carry any quantified liability to EFG, Inc. on its books or financial statements (audited by MNOP, Inc.).

The accounting treatment of the August 31, 2008 writing by XYZ, Inc. is telling. The FASB, in its original Statement #5 regarding accounting for loss contingencies (and later in its exposure draft on same in 2008), stated in part:

“For the purpose of this Statement, a contingency is defined as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (hereinafter a “gain contingency”) or loss (hereinafter a “loss contingency”) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. Resolution of the uncertainty may confirm the acquisition of an asset or the reduction of a liability or the loss or impairment of an asset or the incurrence of a liability.” Furthermore, the Statement reads:

“Not all uncertainties inherent in the accounting process give rise to contingencies as that term is used in this Statement. Estimates are required in financial statements for many on-going and recurring activities of an enterprise. The mere fact that an estimate is involved does not of itself constitute the type of uncertainty referred to in the definition in (the) paragraph (above). For example, the fact that estimates are used to allocate the known cost of a depreciable asset over the period of use by an enterprise does not make depreciation a contingency; the eventual expiration of the utility of the asset is not uncertain. Thus, depreciation of assets is not a contingency as defined in (the) paragraph (above), nor are such matters as recurring repairs, maintenance, and overhauls, which interrelate with depreciation. Also, amounts owed for services received, such as advertising and utilities, are not contingencies even though the accrued amounts may have been estimated; there is nothing uncertain about the fact that those obligations have been incurred.” Statement #5 goes on to state:

“When a loss contingency exists, the likelihood that the future event or events will confirm the loss or impairment of an asset or the incurrence of a liability can range from probable to remote. This Statement uses the terms probable, reasonably possible, and remote to identify three areas within that range, as follows:

  1. Probable. The future event or events are likely to occur.
  2. Reasonably possible. The chance of the future event or events occurring is more than remote but less than likely.
  3. Remote. The chance of the future event or events occurring is slight.”

The three above characterizations are important in the attempt to quantify a contingency. Examples of loss contingencies include:

  1. Collectability of receivables.
  2. Obligations related to product warranties and product defects.
  3. Risk of loss or damage of enterprise property by fire, explosion, or other hazards.
  4. Threat of expropriation of assets.
  5. Pending or threatened litigation.
  6. Actual or possible claims and assessments.

FASB Statement #5 mandates that an estimated loss from a loss contingency “shall be accrued by a charge to income if both of the following conditions are met:

  1. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability has been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.
  2. The amount of loss can be reasonably estimated.”

Thus, Statement #5 helps serve to support that XYZ, Inc.’s accounting treatment of the August 31, 2008 writing is appropriate and consistent with the alleged facts and Mr. Smith’s statement that the prospects for realization of the sale are “fairly dim”. Mr. Smith’s statement is analogous to stating that the prospects are “remote” and certainly, at best, “reasonably possible, i.e. having the chance of the future event or events occurring is more than remote but less than likely. In either case, the contingency stated in the August 31, 2008 letter did not meet the auditor’s test for quantification under generally accepted accounting principles.

It is obvious from the accounting treatment that the contingent obligation in the August 31, 2008 writing carries no value under generally accepted accounting principles. From a valuation perspective, indications of value are not readily apparent because:

  1. No ready market exists for such contingency
  2. No comparable transactions are published and available

No financial forecast or projection based on plausible future outcomes is available or can be compiled from the available facts and circumstances

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