FIN205 Topic 4: Accounting and taxation issues

DCF valuations

DCF valuations are based on cash flows after company tax. Hence, CGT will already be incorporated into the cash flows in respect of any forecast CGT events and no specific adjustment is required. A DCF valuation should include any CGT payable on disposal of assets. However, it should not include any CGT on the terminal value, as this is not a disposal but is rather an estimate of the present value at that time of the cash flows from that date forward.

Defined benefit superannuation plan obligations

Disclosures in relation to superannuation fund financing and the under or overfunded status of employer obligations in respect of defined benefit plans are important to the valuer. The existence and quantum of surplus assets or liabilities need to be taken into account in the determination of value. Any indication of significant movement in the value of asset classes, or changes in market interest rates, since the date of the last assessment of surplus assets or liabilities would indicate to the valuer the need to have the extent of the over or under funding re-assessed.

Effect on valuations

Dividend imputation can be incorporated into a valuation by: • adjusting the discount rate — adjusting the cost of equity to reflect increased shareholder returns • adjusting the cash flows by adding the imputation credits back to the after-tax cash-flows. Alternatively, no adjustment may be made at all. It is difficult to assess the full impact on valuations of the introduction of the simplified system in 2002, although it is likely that the value of imputation credits will increase as a consequence of excess imputation credits being refunded to individuals and superannuation funds. This is because the possibility of the value of dividend imputation credits being lost will be eliminated.

Dividend imputation

Dividend imputation was introduced in Australia in 1987 to eliminate double taxation of corporate profits. A simplified system was introduced in 2002. Dividend imputation is the system of granting individual shareholders franking credits on their tax liability in respect of dividends received, to the extent that the dividend-paying company has paid tax on the income from which the dividend is paid. The tax paid by the company effectively represents a prepayment of the personal tax of the shareholder.

Tax consolidation

Under the consolidation regime qualifying groups of entities are treated as single entities for income tax purposes. The head company is responsible for the tax liabilities of the group after consolidation. There are special rules regarding the treatment of losses. If an entity becomes a member of a tax consolidated group, there are certain tests that must be satisfied to determine whether it can transfer any unused carry forward losses into the group. Broadly, these tests are modified versions of the COT and the SBT. If an entity satisfies the modified COT and SBT tests and has transferred losses to the head company that will not automatically entitle the head company to utilise the losses. The head company must satisfy modified versions of the loss recoupment tests before it can use the losses. Any losses that can be transferred are also subject to the following restrictions on their utilisation: • losses that are transferred into the tax consolidated group by subsidiary members can only be utilised after losses that are generated by the consolidated group itself are exhausted • the rate at which transferred losses can be applied by the consolidated group is restricted by the 'available fraction' which seeks to ensure that the head company cannot apply the losses faster than they would have been applied if retained by their originating entity on a stand-alone basis.

1. What matters would a valuation analyst look for when analysing a disclosure note in financial statements on related-party transactions?

1. The importance of the related-party disclosure in the financial statements will depend on the perception of the valuation analyst and the materiality of related party transactions to the overall operations of an entity. Some of the matters which may be considered by the analyst include: • intercompany sales and purchases with related parties — what are the terms of the contracts currently in place? Are the current purchases and sales to related parties at arm's length values, or potentially over or understating the earnings of the company • loans from or to related parties — in most cases, these loans with the related party would be repaid before the sale, but the purchaser should then note the past gearing level of the company at which the historical earnings was achieved • management fees paid to or received from related parties — whether the management fees paid previously to the related parties were on arm's length terms • restrictive covenants with suppliers who are related parties • licences, patents and brand rights owned by the related party — it must be determined whether the patent, license or brand right is being purchased or whether the use of these items is being contracted for. This opens up questions as to the length of the right to use the patents, licenses or brands as the ultimate value of the business will be affected if there is a finite earnings period. A further issue to consider is the actual restrictions on the use of the patent, license or brand rights as a consequence of agreements with an outside party. It is possible for a patent, license or brand right to be non-transferable and hence unable to be purchased.

Deferred tax asset (DTA)

A DTA is an estimated amount of income tax recoverable in the future due to: • deductible temporary differences • the carry forward of unused tax losses or unused tax credits. A deductible temporary difference arises where, in respect of a transaction, the future income tax deduction will be greater than the corresponding expense that will be recognised for accounting purposes (i.e. prepayments and provisions for employee entitlements that have been previously recognised as expenses but are not deductible until paid) or where income has been recognised as assessable for tax but has not yet been recognised for accounting purposes.

Deferred tax liability (DTL)

A DTL must be recognised for the future tax consequences of all taxable temporary differences. A taxable temporary difference occurs where, in respect of a transaction, the future income tax deduction will be lower than the corresponding expense that will be recognised for accounting purposes (e.g. R&D expenses deducted for income tax purposes but have been capitalised in the accounting records) or where income has been recognised for accounting purposes but has not yet been recognised as assessable for tax (e.g. revenue derived from instalment sales contracts).

Disclosure of franking credits

AASB 101: Presentation of Financial Statements requires the disclosure of the amount of franking credits available to the company for the subsequent financial year. Note that these items are not included in the balance sheet. While the franking credits do not represent an asset to the company, they may have value for the shareholder as they may reduce the tax payable by the shareholder on receipt of dividends. Further, the availability of franking credits related to past earnings should be distinguished from those derived from future earnings.

Treatment of related-party transactions

AASB 124 'Related Party Disclosures' provides information about transactions with related parties. There is a wide range of information required to be disclosed in the related-party note and it is important that the valuer considers how related party transactions may affect the valuation. The related-party note highlights potential areas which the valuer can concentrate on and various aspects of the business which may not otherwise have been considered. These areas can be categorised as transactions that may alter the valuer's assessment of: • the level of historical earnings • the level of future earnings • the carrying value of assets or liabilities • the right to the ongoing use of assets. Examples of transactions which could have a material effect on a valuation, especially from the perspective of a prospective acquirer, are discussed below.

Share Based Payments'

AASB 2 'Share Based Payments' requires entities to recognise any equity-based payments as an expense. This includes shares, options, and other equity instruments provided to employees (including directors) as an employee benefit. Share based payments are typically measured at the fair value of goods or services received. For transactions with employees, the entity is required to measure the fair value of the equity instruments granted, because it is typically not possible to estimate reliably the fair value of employee services received. AASB 2 specifies that vesting conditions, other than market conditions, are not taken into account when estimating the fair value of the shares or options granted. As a general principle, the total expense related to equity-settled share-based payments will equal the multiple of the total instruments that vest and the grant-date fair value of those instruments. However, if the equity-settled share-based payment has a market related performance feature, the expense would still be recognised if all other vesting features are met.

Discontinued operations

AASB 5 'Non-current Assets Held for Sale and Discontinued Operations' requires the entity to provide information regarding both its continuing and discontinued operations. A discontinued operation is a significant component of an entity that has either been sold or is classified as held for sale, where it is highly probable the carrying value is to be recovered principally through a sale transaction rather than through its continued use. The disclosure requirements assist the valuer to appropriately determine the future earnings or cash flow of the continuing business operations and to separately assess the value of the discontinued operations. The main disclosure requirements of AASB 5 of interest to the valuer include: • the separate presentation of the total of the post-tax profit or loss of discontinued operations and the related income tax expense used in determining that amount • the net cash flows attributable to the operating, investing and financing activities of discontinued operations • a description of and the separate presentation of assets classified as held for sale, and of the assets and liabilities in a disposal group classified as held for sale — measured at the lower of its carrying amount and its fair value after deducting costs to sell • the facts and circumstances of the sale, or leading to the expected disposal, and the expected manner and timing of the disposal. AASB 5 ensures the valuer is able to undertake more meaningful going-concern valuations based on profit-generating capacity, as all information regarding discontinuing operations will have been stripped out allowing the continuing operations to be valued using an earnings or discounted cash flow methodology, without the risk that earnings from discontinued operations will be included and inappropriately reflected in valuations. When using an asset-based valuation methodology, assets and liabilities of the discontinued operation will not be included where the discontinued operations have been sold and where there is a pending sale the value of the discontinued operations will have regard for the expected sale price.

Reporting requirements

AASB 8 'Operating Segments' specifies the requirements concerning reporting of segment information in financial statements. Such disclosure is usually made by way of a note to the financial statements and is reconcilable to the income statement and balance sheet. AASB 8 applies only to 'for profit' entities whose debt or equity instruments are being issued or traded in a public market (or that have filed to have such instruments traded). Accordingly, not all Australian entities will be required to present segment information. AASB 8 does not prescribe a mandatory framework for determining reporting segments (such as business or geographical) and requires only one set of segments to be identified. AASB 8 requires operating segments to be identified on the basis of internal reports about components of the entity that are regularly reviewed by the chief operating decision maker in order to allocate resources to the segment and to assess its performance. AASB 8 prescribes minimum quantitative criteria which, if exceeded, require an operating segment to be separately reported, and requires that 75% of an entity's revenue is included in reported segments. AASB 8 requires the measure of profit or loss, assets or liabilities and particular income and expense items to be that used when reporting to the chief operating decision maker with reconciliations of amounts disclosed for reportable segments to corresponding amounts in the entity's financial statements. AASB 8 requires disclosure of information to enable users of financial statements to evaluate the nature and financial effects of the business activities in which it engages and the economic environments in which it operates. To give effect to this, AASB 8 sets out minimum disclosures to be made for each reportable segment — for example, segment profit or loss, total segment assets and total segment liabilities. Rather than disclosing information on a secondary segment, AASB 8 prescribes a minimum level of information to be disclosed if it is not already disclosed in the segment financial information, including information about its products and services, geographical areas and major customers. AASB 8 also requires descriptive information about how operating segments were determined, the products and services provided by the segments, and differences between the measurements used in reporting segment information and those used in the entity's financial statements. AASB 8 allows a component of an entity that sells primarily or exclusively to other operating segments to be included as an operating segment.

Tax-effect accounting

Accounting income, as disclosed in an income statement, is not based on the same concepts as taxable income. Differences arise between accounting and taxable income. For the purpose of financial reporting AASB 112 'Income Taxes' adopts a balance sheet approach to reporting these differences by measuring the difference between the carrying amount of an asset or liability and its tax base (a temporary difference). Temporary differences are categorised as: • deductible temporary differences — temporary differences in respect of future transactions that will result in accounting profit in the future being higher than the corresponding assessable income, for example, the carrying amount of a liability exceeds its tax base • taxable temporary differences — temporary differences in respect of future transactions that will result in assessable income in the future being higher than the corresponding accounting profit, for example, where the carrying amount of an asset exceeds its tax base. In financial statements, the tax effect of deductible temporary differences are recognised as deferred tax assets (DTA) while the tax effect of taxable temporary differences are recognised as deferred tax liabilities (DTL). Temporary differences arising from transactions in the current period are recognised as income or expense in the calculation of after-tax profit for the period other than where the transaction results in a gain or a loss recorded directly in equity or where the transaction is part of a business combination. The underlying principle on which AASB 112 is based is that the tax consequences of transactions that occur during a period should be recognised as an income or expense in the measurement of net profit or loss for the period, so that the income tax expense should be calculated by reference to the accounting profit, rather than the taxable income of the entity. Other than for income or expenses that are not be subject to tax (and never will); the effective tax rate reflected in the measurement of profit will equal the statutory rate. AASB 112 requires a reconciliation between the prima facie tax expense (accounting profit at the prevailing tax rate) and the income tax expense recorded in the income statement, together with a dissection of income tax expense between current and deferred taxes, to be set out in the notes to the financial statements.

Taxation profile

An entity's actual taxation profile will depend on factors such as: • the level of profitability at the EBITDA level — for example, start-up vs mature business • the amount of tax depreciation or capital allowances — for example, service business vs infrastructure asset • gearing — since interest is tax deductible • the corporate structure — for example, companies pay corporate tax and, in Australia, can pay franked dividends; trusts distribute before-tax income, which may include a capital return on a deferred tax basis • any other taxation allowance such as the step up in asset values as a consequence of tax consolidation legislation • exposure to taxes other than corporate income tax that act on profits — for example, coal and iron ore producers are expected to pay additional tax on mining profits under the proposed minerals resource rent tax.

Impact on earnings multiples and discount rates

As stated earlier, differences in international tax rates and tax systems do not significantly affect the methodology in performing valuations. They do, however, often have a significant impact on value as they impact: • the cash attributable to shareholders • the ability of shareholders to have access to this cash. It should also be recognised that differences in tax rates and systems between countries represent only one component in the different multiples and discount rates that may be derived.

Fair value of assets

Assets acquired as part of a business combination are also measured at fair value at the date of the acquisition. Tangible non-current assets are also generally subject to impairment testing under AASB 136 if there is any indication that an asset is impaired. Impairment testing involves assessing the recoverable amount of an asset and ensuring the carrying amount does not exceed the recoverable amount. Recoverable amount is measured as the higher of fair value less costs to sell and value in use. Valuers cannot always rely on the values of assets as stated in the balance sheet as a reliable indicator of their current value. They will need to ensure that the assets reflect their current worth before arriving at a valuation. In addition, the measurement of the fair value of assets in the financial statements may not reflect all factors that may be relevant in determining a market value of the entity and/or may not reflect economic conditions at the date of the valuation or events subsequent to reporting date. For example, during much of 2008 many property trusts traded at prices at a discount to their reported net asset value.

Normalising earnings

Before data presented in the financial statements can be used to prepare a valuation some adjustments will usually need to be made. Capitalisation of earnings valuations are based on future maintainable earnings. Future maintainable earnings are a measure of the underlying earnings of a firm which the firm can be expected to maintain. The accounting earnings figures need to be adjusted having regard for non-recurring and significant or unusual items. DCF valuations are based on forecast cash flows. Forecast cash flows are often derived with reference to the reported earnings figures, especially the EBITDA figure. Likewise, these figures need to be adjusted to reflect underlying earnings that are likely to recur.

Impact on valuations

Capital gains tax does not have a significant impact on valuation methodologies per se. However, in the past it has been a significant issue in corporate restructuring. Its significance in corporate restructuring may decrease as a consequence of the tax consolidations regime, as intra-group transactions are generally ignored. Where a company has had a 50% or more change in majority underlying ownership since 19 September 1985, all assets of the company that were acquired on or before 19 September 1985 are deemed to have been purchased at their market value on the date when the majority change in ownership occurred. Therefore, if a company is valued on the basis of the realisable value of its assets and the 50% change in ownership has occurred, the realisable value of the assets should take into account any CGT liability that may arise on their realisation.

Capital losses

Capital losses can only be offset against capital gains and are not deductible against assessable income of a revenue nature. There are no time limits on capital losses as they may be carried forward indefinitely. The COT and SBT also apply to capital losses, where a company wishes to recoup the losses.

Dividend streaming arrangements

Dividend streaming arrangements involve a company disproportionately directing franked dividends to those shareholders who can benefit most from imputation credits. The underlying principles of the imputation system are that: • tax paid by the company is imputed to shareholders proportionately to their shareholding • the benefits of imputation should be available only to the true economic owners of shares, and only to the extent that those taxpayers are able to use the franking credits themselves. Dividend streaming arrangements undermine these principles by attributing tax paid on behalf of all shareholders to only a proportion of shareholders who can maximise the value of franking credits. The Income Tax Assessment Act contains numerous measures to ensure the integrity of the imputation system, including rules to prevent dividend streaming.

3. Explain what circumstances would warrant an analyst to consider: • a detailed calculation of an entity's tax expense • an approximate tax rate based on historical experience.

Due to the requirements of tax-effect accounting, the income tax expense disclosed in the financial report varies from the prima facia tax on profit before tax and from the actual tax paid. Some valuation methods utilise actual cash flows and accordingly tax paid is more relevant than income tax expense while other methods use earnings multiples that require an assessment of a long term normalised level of tax expense. The starting point for both types of valuation is the use of the statutory rate of tax as an estimate of the long term tax cost. Deviation from this assumption is required where it is likely to cause a material error in the valuation result, including circumstances where: • there are tax losses available for carry forward and deduction against future assessable income • the statutory tax rate is materially different from the effective tax rate and the difference is caused by recurring items such that the statutory tax rate is not representative of the long-term, prospective tax rate of the company • temporary differences and deferred tax balances are material — an approximation of the tax rate through use of the statutory tax rate or the historical effective tax rate will not suffice and a more detailed analysis of the tax calculation is required to determine the effect of the temporary differences on future tax payments. Where there are discontinued operations the analyst should consider the effective tax rate of the continuing operations.

Earnings multiple valuation

Earnings multiple valuations are performed on the assumption that the entity will continue as a going concern. Hence, the disposal of assets is not necessarily relevant and accordingly, CGT is not relevant.

Reliability of asset valuation

Examples of circumstances where accounting standards provide for the fair value measurement of non-current assets include the following. Property plant and equipment (AASB 116) —subsequent to initial recognition at cost, an entity has the option of measuring assets at cost less accumulated depreciation or impairment losses or using a revaluation model. Where a revaluation model is used, revaluations must be made with sufficient regularity to ensure carrying value of assets in each class of asset using the revaluation model does not differ materially from fair value. Non-current assets held for resale (AASB 5) — measurement of assets or disposal groups held for sale is at the lower of its carrying amount and fair value less costs to sell. Immediately before the initial classification of the asset as held for sale, the carrying amounts of the asset is measured in accordance with applicable Australian Accounting Standards, and accordingly may be measured under AASB 116 at either cost or fair value. Biological assets and agricultural produce at the point of harvest (AASB 141) — initial and subsequent measurement of all biological assets is at fair value less expected costs to sell, except where fair value cannot be measured reliably. Cost less accumulated depreciation and impairment losses is used until fair value can be measured reliably. Agricultural produce harvested from an entity's biological assets are also measured at fair value less estimated point-of-sale costs at the point of harvest. Exploration and evaluation assets (AASB 6) — exploration and evaluation assets must be recognised at cost at recognition. After recognition, an entity can apply either the cost model or revaluation model (as per AASB 116 Property, Plant and Equipment or AASB 138) to its exploration and evaluation assets. Investment property (AASB 140) — subsequent to initial recognition at cost, an entity has the option of measuring assets at cost or using a fair value model. The fair value of investment property must reflect the market conditions at reporting date. If an investment property meets the criteria for held-for-sale or is included in a disposal group that is held-for-sale, it shall be measured in accordance with AASB 5 (Non-current Assets Held for Sale and Discontinued Operations).

Financial reporting framework in Australia

Financial reporting involves the preparation of the financial statements as well as the notes (including a summary of significant accounting policies) and other explanatory material. The primary financial statements are the: • statement of financial position (balance sheet) • statement of comprehensive income (income statement) • statement of changes in equity • statement of cash flows. Australian Accounting Standards maintain the reporting entity concept, and together with the exemption for small proprietary companies from having to prepare financial reports in s 292 of the Corporations Act 2001 (Cth), ensures differential reporting requirements for different classifications of entity. Entities that are classified as non-reporting entities may prepare financial reports that comply with the disclosure requirements of a limited number of Australian Accounting Standards. Despite the less onerous disclosure requirements of non-reporting entities, all entities are required to prepare financial statements using the measurement and recognition criteria of Australian Accounting Standards, ensuring the financial reporting framework provides a consistent definition of 'financial position' and 'profit or loss'. The AASB introduced the first stage of a revised differential reporting regime by releasing AASB 1053 'Application of Tiers of Australian Accounting Standards' which provides for financial statements to be prepared under one of 2 tiers. 'Tier 1' — for entities with public accountability and certain other entities — reports would be prepared in accordance with 'full' IFRS in all aspects, whereas 'Tier 2' reports would comply with the recognition and measurement requirements of IFRS but have a lesser disclosure burden. Accordingly the requirement for a consistent definition of 'financial position' and 'profit or loss' will remain under the revised differential reporting framework however fewer entities will be required to apply the full disclosure requirements of IFRS. AASB 1053 applies for reporting periods commencing 1 July 2013 and could have been adopted early, from 1 July 2009.

Capital gains tax

Generally, Australia's capital gains tax (CGT) regime applies to assets acquired (or deemed to be acquired) after 19 September 1985 (post-CGT assets). For assets acquired after 19 September 1985 but before 21 September 1999 which are held for at least 12 months, the cost base of the asset can be indexed to the rate of inflation. Indexation has been frozen at 30 September 1999. Tax on capital gains realised by companies is levied at the prevailing corporate income tax rate. CGT applies to events (e.g. disposals) occurring in relation to a CGT asset. A CGT asset is defined widely to include most properties and rights. Capital gains may be taxed at discounted rates for individuals, trusts, complying superannuation funds, approved deposit funds, pooled superannuation trusts and life insurance companies. Non-residents are currently only subject to tax on gains arising from events in relation to assets which have the necessary connection with Australia, which includes shares or interests in private companies.

Residence status

Generally, withholding tax is levied on dividends paid by resident companies to non-residents at the rate of 30% or if a double tax treaty applies, at the rate of 15%. However, franked dividends are not subject to withholding tax. Fully franked dividends carry a tax credit representing the tax already paid by the company. However, non-residents receiving fully franked dividends cannot take advantage of this credit.

Short and long-term employee benefits

Going-concern valuations, based on profit or cash flow generating capacity should reflect all the costs of employment expected to be incurred. Any unrecorded employee benefits and entitlements, which are not expensed until paid, may have the effect of producing valuations which overvalued the enterprise unless the valuer is able to identify any 'latent' employee obligations. In the context of asset-based valuation methods, the present value of the expected future payments provides the valuer with a comprehensive basis, at least with regard to employee costs, on which to assess the value of net assets on an orderly realisation basis. Liquidation-based valuation measures need to recognise that the immediate payment of employee entitlements may in fact be greater than as disclosed in the financial statements, where a present value of expected future payments yields a lower amount. The valuer in these circumstances is on notice to discover the method adopted in the accounts to reflect the present value of future payments, and compare that to the immediate cost which would be assumed in a liquidation scenario. For example, termination payments payable to employees made redundant may not be recognised on the balance sheet if there is no intention to make them redundant. However, a potential acquirer of the business who intends to make employees redundant would need to factor in these costs. Often employees are entitled to a number of week's salary and wages per year of employment, therefore, the costs of redundancy can be significant.

Current non-residents CGT rules

Government amendments made in the Senate in 2006 ensured that all assets held by foreign residents as at 10 May 2005, and which were subsequently subject to Australian CGT, receive a cost base of market value as at that date. This was a major change for non-residents investing in Australia and allows non-residents to dispose of their Australian assets without the imposition of Australian tax. With effect from 1 April 2004, the Australian CGT rules include a CGT participation exemption where an Australian company disposes of shares in a foreign company. If applicable, the exemption results in a pro-rata reduction in capital gains and losses by reference to the foreign active asset percentage of the foreign company. The CGT legislation provides limited 'rollover relief' (i.e. a deferral of CGT) in some situations (e.g. where an asset is transferred between an Australian company and a foreign resident company within a wholly owned group). Also, gains and losses from some assets are excluded from CGT (e.g. depreciating assets).

Same business test (SBT)

If the required continuity of ownership is not maintained, the company may still be entitled to the deductions if it satisfies a SBT, determined by reference to the business carried on by the company immediately before the change of ownership that caused the continuity of ownership test to be failed. The SBT requires the company to satisfy each of the following items: • same business test — at all times during the year of recoupment, the company carried on the same business that it did immediately prior to the change in ownership that broke the continuity of majority ownership • new business test — at no time during the year of recoupment did the company carry on any business of a kind which it did not carry on as part of its overall business prior to the change in ownership that broke the continuity of majority ownership • new transaction test— at no time during the year of recoupment, did the company derive income from transactions of a kind that it had not entered into in the course of its overall business prior to the change in ownership that broke the continuity of majority ownership.

Orderly realisation of assets valuation

In an orderly realisation of assets valuation, consideration will need to be given to the income tax and CGT consequences of the disposal of certain assets (e.g. investments, property, plant and equipment).

Deviations from the reporting framework

In analysing financial reports, a valuer will need to ascertain whether there have been any deviations from the reporting framework. If so, adjustments may need to be made before performing the valuation. Potential deviations will be highlighted in: • the auditor's opinion — it is important to pay close attention to any qualification by the auditor or non-compliance with any Accounting Standards • the notes to the financial statements — it is important to pay close attention to any changes in the accounting policies adopted over the period being examined, such as a change in the method of depreciation. These may require adjustment by the valuer to ensure comparability of the data.

2. How could an analyst make use of disclosures under segment reporting? 3. Explain

In order to reduce business risk within a company, management may diversify the business operations of a company to include various business activities. Each of these business activities will have had different prospects and history, rates of growth, rates of profitability and degrees of risk. To value each business activity, financial and non-financial information on each activity is required. As the financial statements are not classified into separate statements of financial position and performance for each business activity, analysts must examine other areas to obtain the necessary information. The disclosure requirements of AASB 8 require the inclusion of some of this additional information in the notes to the financial statements. Segment reporting is useful in identifying the various business activities and disclosing basic financial data on these segments. The information provided by segment reporting is reconcilable to the income statement and balance sheet and includes: • segment revenue (internal and external) • segment result • interest revenue and interest expense • depreciation and amortization • interest in profit or loss of associates and joint ventures accounted for by the equity method • material items of revenue and expense • segment assets and liabilities • continuing and discontinued operations • segment capital expenditure • material non-cash expenses • information about products, services and geographical areas. However, it should be acknowledged that although segment reporting does provide some useful and valuable information on the component make-up of the entire entity, it does not provide all the necessary information to determine the value of each business. To complete the valuation for each business activity, further data is usually required.

Foreign currency transactions

In preparing the financial statements of the individual entities, transactions in currencies other than the entity's functional currency are recorded at the rates of exchange prevailing on the dates of the transactions. At each balance sheet date, monetary items denominated in foreign currencies are retranslated at the rates prevailing at the balance sheet date. Non-monetary items carried at fair value that are denominated in foreign currencies are retranslated at the rates prevailing on the date when the fair value was determined. Non-monetary items that are measured in terms of historical cost in a foreign currency are not retranslated. Exchange differences arising on restatement of monetary items at reporting date and settlement date at exchange rates different than when initially recognised are recognised as income or expense in the period of restatement. Exchange differences on revalued non-monetary items are recognised consistent with the revaluation of those items — for example, directly against the revaluation reserve. AASB 139 'Financial Instruments: Recognition and Measurement' requires an entity to account for exchange differences differently from the treatment required under AASB 121, where the transaction was entered into in order to hedge certain foreign currency risks. As of July 2014, entities can also apply AASB 9 concerning such financial instruments transactions.

Impact on orderly realisation of assets valuation

In the event of a valuation being performed on the basis of an orderly realisation of assets, it is unlikely that a value would be attributed to franking credits. This is because valuations of this nature are generally performed when the business is to cease operations, or the future maintainable earnings are uncertain. Hence, the ability of the business to generate profits and consequently their ability to pay dividends is uncertain. Therefore, the value of any franking credits is lost, as they could not be utilised.

Franking credits - Tax losses

In the past, the existence of tax losses in a group company often prevented the repatriation of franked or unfranked dividends to the ultimate holding company of a group. This was because such dividends were required to be included in assessable income and, in the case of dividends received by a company with current or prior year losses, would absorb those losses. Such dividends would ordinarily be effectively tax-free because of the dividend rebate. The end result was that tax losses were absorbed by what should have been tax-free income. As previously noted, as part of the tax reform measures, the dividend rebate for franked dividends was removed from 30 June 2002 in conjunction with the introduction of the new imputation rules. The dividend rebate for unfranked dividends was removed from 30 June 2003 for unfranked dividends received from resident companies. Instead, companies are now required to include both unfranked and the grossed up amount of franked dividends in assessable income and claim a credit or tax offset for the amount of the franking credit. In effect, fully franked dividends are effectively tax-free as a consequence of the franking rebate. As a related measure, companies are allowed to choose the amount of prior year losses they wish to use and in this way prevent effectively tax-free franked dividends absorbing prior year losses. The legislation also prevents current year losses absorbing franked dividends. These measures ensure that where a group company in a non-consolidated group has tax losses, it will be able to receive franked dividends from lower tier subsidiaries for on-payment to the ultimate holding company without sacrificing its tax losses. While these measures will not impact consolidated groups as group company dividends are ignored for tax purposes, they are relevant for consolidated groups that receive dividends from non-wholly owned companies — that is, companies which are not members of the consolidated group.

Withholding taxes Interest

Interest paid by an Australian resident to a non-resident is normally subject to a final withholding tax of 10%on the gross interest payment. While Australia's double tax agreements (DTAs) do not generally reduce the rate of interest withholding tax below 10%, a protocol to the DTA with the US and more recently, the DTA with the UK provide for a withholding tax exemption on interest paid to government bodies and financial institutions. Generally, Australia has no taxing rights in respect of interest arising in Australia and derived by the US or UK resident that is a financial institution, provided certain conditions are satisfied. Where an amount is indemnified against the withholding tax, the indemnification payment is not subject to interest withholding tax. Interest paid by an Australian resident on debt securities (such as debentures) that are offered to the public is exempt from withholding tax, irrespective of whether a tax treaty is in place.

Key issues in valuation

It provides a foundation for discussion of key issues relating to financial reports in the valuation process, such as: • the need to normalise earnings represented in the financial reports — to take account of non-recurring and unusual items • segment reporting issues — taking account of the composite nature of many companies • valuation issues related to goodwill and other intangible assets (discussed in Topic 7) • valuation of assets generally • liability for employee benefits • treatment of related-party transactions in the financial reports • provisions, contingent liabilities and contingent assets • inclusion of information related to discontinued operations • valuing foreign currency translations.

Disclosure requirements

Key disclosure requirements of AASB 121 that may assist the valuer include: • the amount of exchange differences recognised in profit or loss • the net amount of exchange differences recognised directly in equity, rather than in the profit and loss • when the presentation currency is different to the functional currency, the reasons for this and disclosure of what the functional currency is. The valuer can use this information: • to help determine risk associated with the economic environment to which foreign operations are exposed • in forecasting earnings and the extent revenues or earnings are denominated in various currencies • in forming a view on the likely impact of changes in exchange rates. It is extremely difficult to predict exchange rate fluctuations used to calculate the values of monetary transactions and to calculate changes in the value of an entity's monetary assets and liabilities. The valuer needs to take into consideration the dates at which the various translations took place because if exchange rates fluctuate considerably, the presented accounts may not present a realistic base for determining likely future outcomes.

Licences, patents and brand rights owned by related parties

Licences, patents and brand related rights such as trademarks are commonly held in a separate company from which the trading business operates. A royalty or licence fee for use of these assets may be paid by the trading company to a related party. It must be determined whether the patent, licence or brand rights are being purchased, or whether licensing arrangements will continue, and on what terms. The length of the right to use these assets, the territory in which they can be used, and the amount of the royalty or licence fee payable will affect the expected tenure and amount of future earnings as well as the right to compete in different geographical markets, and consequently will affect the value of the business. There may be restrictions on the patent, licence or brand rights as a consequence of agreements with an outside party. It is possible for a patent, licence or brand right to be non-transferable and hence unable to be purchased.

Management fees paid to or received from related parties

Management fees with related parties would usually be terminated on the sale of the company. Their effect on the historical and future performance of the company should be clarified by considering whether the management fees paid previously to the related parties was on arm's length terms.

Withholding taxes - dividends

Non-residents are subject to withholding tax on the unfranked portion of dividends received from an Australian resident. The dividend withholding tax rate is 30%, subject to Australia's DTAs which is generally reduced to 15%. There are a small number of treaties which have different withholding tax rates including: • the Australia-USA DTA (effective from 1 July 2003) reduces the withholding tax rate to nil where an US corporate investor holds at least 80% of the voting power of an Australian company, if it satisfies certain public listing requirements. A 5% rate applies where the US corporate investor holds direct voting interests of at least 10% in an Australian company • the Australia-UK DTA (effective from 1 July 2004) provides for the same rates as the US protocol within the context of a UK corporate shareholder • the Australia-Russia DTA (effective from 1 July 2004) reduces the withholding tax rate to 5% if certain conditions are met • the Australia-Mexico DTA reduces the withholding tax rate to nil for dividends paid or credited on or after 1 January 2004 if the shareholder holds at least 10% of the voting power in the company. Certain partly or fully unfranked dividends that are paid to non-residents may be exempt from dividend withholding tax under the foreign dividend account rules. Generally, these dividends are sourced from exempt foreign dividends received by an Australian company. However, rules were recently proposed to provide relief for foreign shareholders in relation to certain foreign-sourced income earned through an Australian corporate entity, known as the conduit foreign income (CFI) regime. Broadly, the regime seeks to allow CFI earned by an Australian company to be repatriated to its foreign shareholders exempt from Australian dividend withholding tax.

Topic learning outcomes

On completing this topic, students should be able to: • apply components of the financial report of a company in the context of a valuation • explain the adjustments that need to be made in order to normalise earnings for the purpose of conducting a valuation • explain the main taxation concerns dealt with in the valuation process and their possible effect on future earnings • explain the potential value of tax losses • apply the different methodologies for incorporating tax losses into a valuation of a business or issued capital.

Other issues

Other issues that may indicate a need to adjust the earnings figures include: • changes in tax rates and the tax status of the business • recoupment of tax losses and the effective tax rate • changes in accounting policies — for example, changes to depreciation rates or amortisation • the financial effect of the adoption of new accounting standards or amendments to the measurement or recognition requirements of existing accounting standards • the existence of operating and finance leases (for the lessee) • impairment of goodwill or other tangible or intangible assets • foreign exchange gains or losses • income or expenses relating to surplus assets • related-party transactions • adjustments to the level of provisions • recent significant capital expenditure • recent acquisitions and related transaction costs — note that transaction costs are expensed for reporting periods beginning on or after 1 July 2009. In addition, disclosure of judgments made in applying accounting policies and that have a significant effect on amounts recognised must be disclosed.

Dealing with tax in valuations -Capitalisation of earnings approach

Pre-tax multiples As the measure of earnings used in this methodology is before taxation and value derived represents the enterprise value (or value of the assets held by an entity), no adjustments are necessary to the earnings multiple or in the determination of maintainable EBIT/EBITDA. However, to determine the value of the interests of equity holders, certain tax adjustments may be required to arrive at the value of issued capital. These include: • addition of the value of any tax losses (methods for valuing tax losses are set out below) • deduction of any provision for income tax. It can be argued that the provision for income tax should not be deducted as it may be considered a trade creditor and therefore represent working capital. However, where an income tax provision is due to an unusual or one-off event the additional component of the provision should be deducted. Post-tax multiple (PE) As the measure of earnings used in this methodology is after taxation and is used to measure the value of equity directly, it is important to consider the effective tax rate to be applied in the determination of maintainable earnings. This tax rate should be representative of the long-term, prospective effective tax rate of the company, regardless of historical tax rates or particular, non-maintainable tax concessions.

Intercompany sales and purchases with related parties

Purchases and sales of inventory between related parties need to be reviewed to ascertain the basis on which inventories have been valued. The valuer needs to consider the effect of these transactions on historical and prospective financial results. Issues to consider include: • are there any contracts in place which bind the purchaser into continuing a relationship with a related party as a customer or supplier • are the current purchases and sales to related parties on arm's length terms, and do they have the potential for over or understating the historical earnings of the company • is the company reliant on transactions with related parties to generate revenue and what is the likelihood of a change in the nature or volume of business • will changes in any arrangements have a material effect on the after-tax profit of the entity being valued?

Ability to pay franked dividends

Section 254T of the Corporations Act 2001 provides that dividends may only be paid out of profits of a company. In this respect, it is important to note that the Corporations Act is referring to the profits of the company itself and not to the consolidated financial result of the group of which it is a member. In addition, in order to pay franked dividends, a company which is not a member of a consolidated group, or the head company of a consolidated group, must have a credit balance in its franking account. For companies which are not members of a consolidated group, franking credits arise from, among other things: • the payment of company tax • the receipt of franked dividends. Transactions giving rise to franking debits include: • the receipt of a refund of company tax • the payment of a franked dividend. In the case of a tax consolidated group, the head company maintains a single franking account for the group as a whole. While a subsidiary is a member of a consolidated group, any franking credits or debits that would have arisen in its franking account if it were not a member of the group are attributed to the franking account of the head entity. Accordingly, subsidiary members of a consolidated group cannot frank dividends paid to its parent. Moreover, such dividends are ignored for tax purposes as the group is taxed as a single entity and inter-company transactions disregarded.

Withholding tax - royalty

Tax is chargeable on all amounts received 'as or by way of royalty' in Australia. The term 'royalty' is broadly defined and can extend to rental payments for the use of certain equipment. The withholding tax rate on royalties paid or credited to non-residents is generally 30% and is a final tax. Where the recipient is a resident of a country with which Australia has concluded a DTA, the withholding tax rate is generally reduced to 10% of the gross royalties, unless the royalties are effectively connected with a branch in Australia or the treaty specifically provides for a lower rate, for example: • the treaties Australia has with the US and UK provides for a general 5% withholding tax rate • the Australia-Mexico DTA provides a cap of 10% on the withholding tax rate for royalties paid or credited on or after 1 January 2004 • where a royalty amount is indemnified against the withholding tax, the indemnification payment is also subject to royalty withholding tax (unlike interest).

Taxation in DCF approach

Taxation issues to consider when performing a DCF valuation include the following: • where the cash flows are before interest and taxation, adjustments to enterprise value may be required to determine the value of issued capital, similar to that set out under the pre-tax multiple valuation described above • where the cash flows are after taxation, it is important to reflect the actual rate of cash tax payment and the period in which payment occurs: - the notional tax rate applied against profit before tax may not give the cash tax payable (i.e. adjustments may be necessary to reflect differences between accounting profit and assessable income) - although tax may become payable in one year, the actual payment of tax may occur in a following period • where cash flows are before interest but after taxation, valuers should ensure that the tax paid does not include any taxation shield provided by interest payments (to the extent interest provides a tax shield it is typically reflected in the discount rate under a DCF approach). The importance of this factor will depend on how the cash flows and taxation amounts are calculated or sourced. For example, if operating cash flows are taken from the statement of cash flows, they are likely to include the tax effect of interest payments and may need to be adjusted.

Stapled securities

The 'stapling' of securities is a relatively recent phenomenon. Stapling of two securities means that securities in different entities cannot be traded separately. The types of securities that can be stapled to each other include shares in a company, units in a unit trust and certain debt instruments. In the case of units in a unit trust being stapled to shares in a company, stapling is usually effected by appropriate provisions in both the company's constitution and the trust deed. Generally, listed stapled securities trade as one security and the Australian Securities Exchange quotes one price for the stapled security. Examples include GPT, Stockland, Map, Multiplex and Australand. The effect of stapled securities is that the trust component distributes profit with a different tax profile to that of the company. In the case of the trust, this can be tax-free. This can make the valuation of such securities more complex. The purpose, however, is to bring forward the timing of various benefits to shareholders and accordingly increasing the value of the investment. In Australia, most examples of stapled securities involve listed companies and listed trusts where units in a unit trust are stapled to shares in a company. As the market generally determines the value of the security based on its cash yield, the theory is that distributions via the unit trust in this situation will attract a better trading price than (say) via the company, irrespective of whether the company pays a franked or unfranked dividend. Accordingly, stapled securities have been seen as a means of increasing investor yield and share prices. Moreover, as trusts generally must distribute all income in order not to pay tax, the company whose shares are stapled to units in the unit trust has served to also provide a means of profit retention to fund future investment.

Tax losses in a capitalisation of earnings valuation

The appropriate method of incorporating tax losses into an earnings multiple valuation is to capitalise earnings on an after-tax basis (assuming a full tax charge is incurred) and then to add back the present value of the tax saving resulting from the carried forward tax losses over the period in which they are expected to be absorbed. This effectively treats tax losses as a surplus asset.

Discount rate considerations

The capital asset pricing model (CAPM) provides a cost of equity calculation that is independent of any specific income tax considerations. Note that the cost of equity (Ke) derived from CAPM is an after-tax measure, applicable to cash flows calculated after corporate tax. The WACC specifically incorporates the tax benefits of debt funding in its formula, thereby assuming that interest is fully deductible (referred to as an interest tax shield). It is therefore important to reflect the long‑term effective tax rate of the company in a WACC calculation.

Franked dividends - Accounting losses

The corporate structure of a group may inhibit individual companies in the group from fully utilising their available franking credits for the benefit of the ultimate shareholders of the group. For example, assume that a profit-making subsidiary in a non-consolidated group pays a franked dividend to its parent which is loss-making in an accounting sense. The parent company may or may not be the ultimate holding company of the group. The receipt of the franked dividend by the parent company generates a franking credit. However, as the parent company receiving the dividend has a loss for accounting purposes (e.g. due to the amortisation of goodwill or similar items), it will not be able to pay a dividend out to its ultimate shareholders or to another group company interposed between it and the ultimate holding company. Therefore, franking credits will be trapped in the parent company. This problem may still arise in a tax consolidated group. As indicated above, all franking credits attributable to the group reside with the head company (including franking credits transferred to the head company on the formation of the consolidated group). However, dividends may have to be paid up from downstream subsidiaries to give the head company sufficient accounting profits to fund the payment of a franked dividend to its shareholders. If a subsidiary member has accounting losses, this may prevent accounting profits from subsidiaries further downstream from being repatriated to the head company.

Cost of employee benefits

The cost of employment of an entity's workforce is often a major factor in the cost structure of an organisation. The objective of Australian Accounting Standard AASB 119 'Employee Benefits' is to recognise the cost of employment for all employee benefits (other than those to which AASB 2 'Share Based Payments' applies) in the profit and loss where a service has been provided by an employee. An employer must recognise a liability where the employee has provided a service and the employer has a future obligation to provide the corresponding employee benefit. These benefits include: • short-term employee benefits such as wages and annual leave, paid sick leave and bonuses paid within 12 months, as well as non-monetary benefits such as the provision of a motor vehicle • post-employment benefits such as pensions • other long-term employee benefits such as long service leave • termination benefits such as redundancy pay. Benefits which fall due for payment within 12 months of the employee providing the service (short-term benefits) are measured on an undiscounted basis. Post-employment benefits provided in the form of defined benefit plans are recognised in the balance sheet at an amount equal to the present value of the defined benefit obligation — that is, the present value of expected future payments required to settle the obligation resulting from employee service in the current and prior periods — as adjusted for unrecognised actuarial gains and losses and unrecognised past service cost, and reduced by the fair value of plan assets at the balance sheet date. Calculating the present value of defined benefit obligation involves making a number of actuarial assumptions including, for example, employee retention rates, discount rates, future salary levels and the expected rate of return on plan assets. Consequently the amount of any asset or liability reflects a 'going' concern assumption and may change as economic conditions change. Other long-term benefits are also measured in present value terms and recorded as liabilities on the balance sheet.

Equity-based remuneration schemes

The disclosures in relation to equity-based remuneration schemes have important implications for valuers concerned with the valuation of equity. The dilution effect of employee entitlements to equity needs to be recognised when estimating the value of shares and parcels of shares. The rights and obligations of employees involved in employee share plans need to be carefully considered when estimating the value of shares, particularly the value of classes of shares.

Tax loss carry forward tests

The entitlement of companies to deductions in respect of prior year losses is restricted. The objective of the restrictions is to maintain the principle that those who obtain the benefit of the loss deductions should be the same as the persons who owned and controlled the company during the year in which the losses were incurred. Tax losses are permitted to be carried forward and deducted against assessable income if one of the following tests is satisfied: • the 'continuity of ownership' test (s 165-12 of the Income Tax Assessment Act 1997 (Cth) (ITAA 97)) • the 'same business' test (s 165-13 and 165-210 of ITAA 97).

Continuity of ownership test (COT)

The general principle that applies to the carry forward of prior year deductions for both revenue and capital losses is that a company is not entitled to a deduction for a prior year tax loss if there is a failure to maintain continuity of majority beneficial ownership throughout the entirety of the period commencing with the loss year through to and including the income year in which the deduction for the losses is claimed. The COT requires that more than 50% of the shares in the company continue to be beneficially owned by the same persons from the start of the loss year to the end of the income year (beneficial ownership must confer the right to continuity of voting power, dividend rights and capital distributions). In addition, under the 'same share' test, a person's share in the company is only counted for the COT if the person holds exactly the same shares throughout the relevant period.

Taxation assumptions

The taxation assumptions adopted in a valuation depend on the level of the valuation (e.g. valuing the business or the shares) and the purpose of the valuation. If the valuation is for accounting or tax purposes then no change of control would be assumed. Reasons for conducting a valuation for accounting or tax purposes include: • to comply with AASB 3 'Business Combinations' • for tax consolidation in accordance with the Australian Taxation Office's Market valuation guidelines. Note: Tax consolidation is beyond the scope of this subject but is included here simply to give an idea of the relevant application. If the valuation is for takeover purposes, the bidder would need to closely examine their ability to utilise any carry forward tax losses. A valuation for the purpose of assessing the equity value in shares would base the taxation assumptions on the business continuing its current operations.

Goods and services tax

The goods and services tax (GST) was introduced on 1 July 2000 and is a broad-based indirect tax on private consumption in Australia. The GST replaced the wholesale sales tax and was originally intended to replace a number of state indirect taxes. The GST taxes consumption of goods and services in Australia, including imports. Exports are GST-free. GST is a tax on a supply or importation of goods and services, except to the extent that the supply or importation is input taxed or GST-free. A good or service can attract GST each time it is supplied or imported along the commercial chain to its final consumption in Australia. The significant feature of GST is that it is generally creditable along the commercial chain and therefore should not create a cost, other than cash flow. The exception is those entities that make input taxed supplies; generally they cannot reclaim the GST on expenses which relate to those supplies and therefore the GST is a cost. From a valuation perspective, the impact of GST is already incorporated into the results of the entity. As such, no further adjustments are required.

Loans from or to related parties

The purchaser should be aware of the terms and conditions of related party loans including the repayment terms of any loans and the applicable interest rate. In most cases, loans with a related party would be repaid before a sale, but a purchaser should be aware of the past gearing level of the company at which the historical earnings was achieved.

Companies paying higher franked dividends are valued more

The research performed by McKinsey & Company (1994) indicates that franking credits can represent a large proportion of the company's market capitalisation. The research notes that for the top 100 Australian companies in total, the value of franking credits at 70% of face value is $2.1 billion per annum — equivalent to $21 billion of capitalised value. Given the above, the effect of dividend imputation on earnings-based valuations is to increase the multiple for companies paying franked dividends. Stated another way, companies with similar earnings and risk profiles, but with different available franking credits, will be valued differently by the market with a higher value being attributable to those companies that have greater franking capacity. In May 1999, both NAB and Westpac announced that future dividends would not be fully franked, as opposed to past dividends. The immediate effect was a decrease in their share price. Both NAB and Westpac now pay fully franked dividends.

Non-recurring and significant or unusual items

The starting point in reviewing financial statements is to identify items that Accounting Standards require to be disclosed separately. AASB 101 provides for, as a minimum, separate disclosure of a number of items in the income statement that may be of interest in determining a normalised income figure, including: • finance costs • the share of profit or loss of associates and joint ventures • post tax profit or loss and gain or loss on measurement of assets or liabilities to fair value of discontinued operations • expenses categorised by nature or function. In addition to those disclosures explained above, additional line items, headings and subtotals shall be presented on the face of the income statement when such presentation is relevant to an understanding of the entity's financial performance. The valuer should also consider the requirement for the nature and amount of income and expense items that are material to be disclosed separately, either on the face of the income statement or in the notes. Circumstances that would give rise to the separate disclosure of items of income and expense may include: • write-downs of inventories to net realisable value or of property, plant and equipment to recoverable amount, as well as reversals of such write-downs • restructuring of the activities of an entity and reversals of any provisions for the costs of restructuring • disposals of items of property, plant and equipment • disposals of investments • discontinued operations • litigation settlements • other reversals of provisions.

Segment reporting

The tendency for business enterprises to diversify their operations (geographically, by product or operation) complicates the valuation process. These different business activities do not necessarily fall into discrete subsidiary or divisional boxes but may be spread across divisions, groups of divisions, subsidiaries and geographic locations. The internal legal structure of business enterprises often has little direct correlation to the operations conducted. To complicate matters further, the business enterprise may hold varying interests in these entities or groups of entities. Different business operations have different prospects and histories, different rates of profitability and growth, and exposure to differing degrees of risk. Where an entity undertakes more than one operation, the financial statements of single entities and groups of entities do not provide sufficient information to adequately identify the differing aspects of multiple activities. Segment reporting seeks to redress, to some extent, the composite nature of entity‑based financial reporting by providing details, albeit in summary, of the break‑up of the combined financial picture into the component parts of its multiple business activities and economic environments in which they operate. The suitability and application of different valuation methods to the different business segments are subject to the valuer's ability to identify and quantify the business undertakings of an organisation. The segment disclosures in financial reports are therefore of great benefit in assessing these fundamental valuation questions. It is also important for the valuer to note the interdependence, if any, of business segments in a particular entity. The reported performance of the segments in the entity's financial report may not be the same if the segment is examined on a notional stand-alone basis. The impact of economies of scale, business synergies, transfer pricing policies and stand-alone costs will affect the valuer's assessment of the stand-alone value of the segment.

Tax losses carried forward

The valuation placed on carry forward tax losses can substantially influence the ultimate valuation of the equity of an entity. Tax losses are attached to a legal entity such as a company, rather than a business. The valuation of tax losses is only relevant where a transaction involves the purchase of issued capital as opposed to the purchase of the assets of a business. Irrespective of whether tax losses are disclosed as a DTA or not, the actual valuation of tax losses may be material to the overall valuation. The separate value placed on the tax losses will either be required to adjust the value of the DTA to the current market value, or to be added to the net assets of the company where it was previously not booked. The valuation of tax losses will depend on the availability of the losses and the ability of the company or potential purchasers to generate taxable income against which to utilise those losses.

Tax losses in a DCF valuation

There are two methods of incorporating tax losses into a DCF analysis: • incorporating the realisation of tax losses into the cash flows. The cumulative tax losses can be calculated and carried forward to be offset against future taxable income until they are fully utilised • calculating the present value of the tax losses separately from the cash flows from operations and adding the present value of the tax losses to the present value of the cash flows. Consideration needs to be given to the amount, timing and likelihood of utilisation of the tax losses.

Foreign currency translation

Valuing entities which operate across different countries and use different currencies can be quite difficult. It is important to understand the domicile in which an entity or its subsidiaries generate earnings and the extent to which an entity or group is exposed to foreign currency transactions. AASB 121 'The Effects of Changes in Foreign Exchange Rates' prescribes the methodology for the translation of transactions and balances denominated in a foreign currency. All amounts reported in financial statements must be in a presentation currency. The presentation currency may be any currency and may be different from the functional currency, which is the currency of the primary economic environment in which an entity operates. Note: The presentation currency is the currency which is used to present the accounts in the annual report. For example, BHP Billiton presents its accounts in USD due to the global nature of its operations. AASB 121 contains requirements for the individual entities making up a group to prepare their financial statements in their functional currency. When preparing consolidated financial statements the results and financial position of each entity are expressed in a common presentation currency.

Foreign operations

When translating results of a foreign operation from a foreign currency (its functional currency) into the presentation currency, the following procedure should be used: • translate monetary assets and liabilities at the closing exchange rate • translate non-monetary assets and liabilities carried at historical cost using the transaction date exchange rate • translate non-monetary assets and liabilities carried at fair value using the valuation date exchange rate • translate income and expenses at exchange rates at the dates of the transactions or an appropriate average rate • recognise all resulting exchange differences as a separate component of equity.

Provisions, contingent liabilities and contingent assets

When undertaking a valuation, the valuer needs to take into consideration any contingent assets or contingent liabilities which, by definition, are not recognised in an entity's financial statements. Contingent assets and contingent liabilities are possible assets and possible liabilities that do not meet the criteria for recognition in financial statements. The disclosure requirements of AASB 137 'Provisions, Contingent Liabilities and Contingent Assets' provide the valuer with useful information in relation to provisions and contingencies. An entity must disclose the nature and a description of contingent liabilities and contingent assets and where practical, an estimate of their financial effect. Where practical, an entity must also disclose an indication of the uncertainty relating to the amount and timing of any outflows relating to contingent liabilities. Contingent liabilities are disclosed unless the possibility of an outflow is remote while contingent assets are disclosed where it is probable there will be an inflow. AASB 137 also requires the recognition of the present obligation under an onerous contract as a provision. An onerous contract is defined as one in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. The valuer should be aware of any provisions for onerous contracts and ensure they are properly reflected in the valuation, either in determining the level of maintainable earnings or in assessing the level of future cash flows in a discounted cash flow analysis. Onerous contract provisions may mean the historical financial statements do not reflect a normal level of earnings or working capital balances.

Acquired subsidiaries

Where a subsidiary has been acquired, the accumulated profits of the subsidiary are not available to the parent company. While the subsidiary is able to declare a dividend out of pre-acquisition profits in favour of its parent company, that dividend is not a profit which the parent company may distribute to its own shareholders. The payment of the dividend by the subsidiary out of pre-acquisition profits reduces the value of its own shares, as the dividend must be applied by the parent company in writing down the value of its investment in the subsidiary in its own accounts.