For the central bank, there is the uncomfortable position of having made a loss. Being public institutions, central banks are subject to scrutiny from the media and from the government itself.

What are Surplus Assets and Liabilities in business valuation?

What are Surplus Assets and Liabilities in business valuation?

Surplus Assets are represented by any assets that are held by a business that are not core to its underlying operations and do not support the business in any way.
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Tuesday, 4 August 2020
By James Cook

When determining the equity value of a company, a valuer will typically test for the existence of Surplus Assets and Liabilities held by the company.

Surplus Assets are represented by any assets that are held by a business that are not core to its underlying operations and do not support the business in any way. Surplus Assets will typically include:

  • Property (such as the premises) that might be held by the business which would usually be valued separately and added to the enterprise value of the business.
  • Obsolete assets that may have been originally acquired for the business but have since been replaced or have become surplus to the operation of the business.
  • Personal use assets that are not necessary to the running of the business, such as motor vehicles or boats.
  • Surplus working capital such as excess inventory and cash.
  • Loans to directors or other related parties.
  • Investments made by the business that are not core to its underlying operations.

Similarly, when determining the equity value of a company, a valuer will also need to take into account the liabilities of the business. Liabilities that are typically considered and deducted from the enterprise value of the business include:

  • Loans owing to related parties.
  • Provisions for employee entitlements such as long service leave.
  • Any off-balance sheet liabilities such as contingent liabilities that may arise from pending litigation.

Every business that is valued under the capitalisation of future maintainable earnings method should be assessed for surplus assets and liabilities.

The impact of surplus assets and liabilities should be considered at two levels:

Level 1

Where the entity as a whole is being valued, the value of the surplus assets and liabilities should be added/deducted from the capitalisation of future maintainable earnings calculation to determine the entity value.

If the valuation is for the business assets, surplus asset or liability value is only relevant if the assets or liabilities to be included in the class of assets, form part of the valuation.

Level 2

Consideration also needs to be given to whether the surplus assets or liabilities have created holding costs for the business. Where these holding costs are identified, they should be quantified and adjusted out of the calculation of Future Maintainable Earnings.

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Valuation Methodologies: The Capitalisation of Earnings methodology

Valuation Methodologies: The Capitalisation of Earnings methodology

The capitalisation of earnings method is a commonly used valuation methodology that involves determining a future maintainable earnings figure for a business and multiplying that figure by an appropriate capitalisation multiple.
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Tuesday, 4 August 2020
By James Cook

When undertaking a business valuation, valuers are guided by common market practice and the valuation methodologies recommended in the ASIC Regulatory Guide 111.

There are a number of valuation methods which can be used to value a business and some of the more common methods include:

  1. The discounted cash flow method (Income-based Approach)
  2. The capitalisation of future maintainable earnings methods (Income-based Approach)
  3. Asset based methods (Asset-based Approach)
  4. Industry specific rules of thumb (Market-based Approach)

Each of these methods is appropriate in certain circumstances and often, more than one approach is applied at least as a secondary cross-check to a primary method. The choice of methods depends on factors such as the nature of the business being valued, the return on the assets employed in the business, the valuation methodologies usually applied to value such businesses and the availability of the required information.

The selection of an appropriate valuation method to estimate fair market value should be guided by the actual practices adopted by potential acquirers of the business involved.

In the discussion which follows, we outline the Capitalisation of Earnings methodology.

Capitalisation of Earnings methodology: Explained

The capitalisation of earnings method is a commonly used valuation methodology that involves determining a future maintainable earnings figure for a business and multiplying that figure by an appropriate capitalisation multiple. This methodology is generally considered a short form of a discounted cash flow, where a single representative earnings figure is capitalised, rather than a stream of individual cash flows being discounted. The capitalisation of earnings methodology typically involves the determination of:

  1. A level of Future Maintainable Earnings;
  2. An appropriate capitalisation rate or multiple;
  3. Surplus assets and liabilities; and
  4. Net borrowings.

Determining Future Maintainable Earnings:

The Future Maintainable Earnings figure is typically determined by a valuer having regard to historical financial performance and is intended to be earnings which the business can be reasonably expected to achieve.

In determining the appropriate future maintainable earnings figure, a valuer should however consider historical transactions which have involved:

  • Expenses associated with the capital structure and financing costs of the business;
  • Non-arms-length revenue or expenses;
  • Revenue or expenses generated or associated with, redundant assets or assets which are not core to the operations of the business;
  • Owner-related expenses; and
  • Non-recurring, one-off expenses.

Appropriate capitalisation rate or multiple

A multiple can be applied to any of the following measures of earnings:

Revenue – most commonly used for businesses that do not make a positive EBITDA or as a cross-check of a valuation conclusion derived using another method.
EBITDA – most appropriate where depreciation distorts earnings, for example, in a business that has a significant level of depreciating assets but little ongoing capital expenditure requirement.
EBITA – in most costs, EBITA will be more reliable than EBITDA as it takes account of the capital intensity of the business.
EBIT – whilst commonly used in practice, multiples of EBITA can be more reliable as it removes the impact of amortisation which is a non-cash accounting entry that does not reflect a need for future capital investment (unlike depreciation).
NPAT – relevant in valuing businesses where interest is a major part of the overall earnings of the group (e.g. financial services business such as banks).

Multiples of EBITDA, EBITA and EBIT are commonly used to value whole businesses for acquisition purposes where gearing is in the control of the acquirer. In contrast, NPAT (or P/E) multiples are often used for valuing minority interests in a company.

The multiple selected to apply to maintainable earnings reflects expectations about future growth, risk and the time value of money all wrapped up in a single number.

Surplus assets and liabilities

Every business valued under the capitalisation of future maintainable earnings method should be assessed for surplus assets and liabilities. Surplus assets are those assets that are not essential for the operation of the business and will typically include property, non-core investments, excess working capital and loans to private businesses or related parties.

When undertaking this exercise, the impact of surplus assets and liabilities should be considered at two levels:

Level 1
Where the entity as a whole is being valued, the value of the surplus assets and liabilities should be added/deducted from the capitalisation of future maintainable earnings calculation to determine the entity value.

If the valuation is for the business assets, surplus asset or liability value is only relevant if the assets or liabilities to be included in the class of assets, form part of the valuation.

Level 2
Consideration also needs to be given to whether the surplus assets or liabilities have created holding costs for the business. Where these holding costs are identified, they should be quantified and adjusted out of the calculation of Future Maintainable Earnings.

Conclusion: When to use the Capitalisation of Earnings methodology

The capitalisation of earnings method is widely used in practice. It is particularly appropriate for valuing companies with a relatively stable historical earnings pattern which is expected to continue. This method is less appropriate for valuing companies or assets if:

  • There are no suitable listed company transaction benchmarks for comparison;
  • The asset has a limited life (such as a contract, patent, royalty stream);
  • Future earnings or cash flow are expected to be volatile; or
  • There are negative earnings, or the earnings of a business are insufficient to justify a value exceeding the value of the underlying net assets.

For any specific or general business valuation queries, please get in touch with one of our qualified and experienced experts.

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Decoding the Illegal Phoenix: Part 2

Decoding the Illegal Phoenix: Part 2

The Treasury Laws Amendment (Combating Illegal Phoenixing) Bill 2019 seeks to provide a balance between eradicating illegal phoenix activity and providing a framework to facilitate a genuine restructure of a distressed company.
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Monday, 27 July 2020
By Matthew Pease

In the previous article, I outlined the definition of phoenix activity. In this post, I will discuss the four key measures that were part of the Treasury Laws Amendment (Combating Illegal Phoenixing) Bill 2019.

Schedule 1
This measure introduced new phoenix offences to prohibit the creditor-defeating dispositions of company assets prior to a liquidation. This can include property sold for less than market value, at a time when the company was insolvent or became insolvent as a result of the transaction or even if the transaction results in the company entering administration within twelve months (no insolvency required). The measure allows liquidators and ASIC to recover such property. It is also designed to penalise those who engage in or facilitate any such disposition including company directors or even pre-appointment advisors through the introduction of new civil and criminal liability provisions.

Schedule 2
This measure ensures that directors are held accountable for misconduct which includes backdating resignations as office holders or ceasing to act as director when this will leave a company with no directors. Commencing on 18 February 2021, a director’s resignation will take effect on the desired date as long as the form is lodged with ASIC within 28 days of that date. Otherwise, the date will be the day the form is lodged. ASIC or a court may agree to backdate a resignation, however an application will need to be made within 56 days of the resignation date and if sufficient evidence can be provided to confirm the resignation actually occurred on the earlier date.

Schedule 3
This measure has enabled changes to the taxation system and the Director Penalty Notice (DPN) regime. Of note is that a DPN can now include outstanding Goods and Services Tax, Wine Equalisation Tax and Luxury Car Tax. Only debts incurred from 1 April 2020 can be included. Directors should be made aware of the differences between a lockdown and non-lockdown DPN. For further information on this, please refer to the ATO website or give our office a call for additional guidance.

Schedule 4
This measure simply enables the ATO to retain any taxation refunds where a taxpayer has failed to lodge a return or provided information to the ATO as required. This will ensure that a taxpayer has satisfied their obligations and paid any outstanding statutory debts prior to being entitled to that refund. This measure commenced on 1 April 2020 and applies to refunds payable after that date.

These changes attempt to find that balance between eradicating illegal phoenix activity but allowing a genuine restructure of a distressed company. There is still some way to go on this matter with the exploration of director identification numbers and calls to adopt some form of the UK method in pre pack administrations. These changes will have an impact on directors and company advisors who will need to be aware of their continued obligations when dealing with company assets prior to an insolvency appointment.

They will need to comply with these obligations or face the potential for harsh civil and criminal penalties. With the right advice, a genuine restructure is possible and one that will not fall foul of an investigating liquidator and the new powers under this Bill.

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Directors’ duties under the temporary COVID-19 measures

Directors’ duties under the temporary COVID-19 measures

Temporary relief from personal liability for insolvent trading will apply with respect to debts incurred in the ordinary course of the company’s business.
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Monday, 20 July 2020
By James Cook

An Overview of Directors’ Duties

Directors and officers of companies are subject to a number of statutory and general law obligations, including:

  • Care and diligence: to exercise their powers and discharge their duties with due care, skill and diligence;
  • Good faith and proper purpose: to act in good faith in the best interests of the company, and for a proper purpose;
  • Not to misuse information or position: not to improperly use or profit from their position or information obtained as a director to gain an advantage for themselves or someone else, or to cause detriment to the Company;
  • Avoiding conflicts of interest or duty: to avoid conflicts between the Director’s personal interests and the company’s interests, and between the Director’s duties to the Company and the Director’s duties to anyone else;
  • Financial information: to take reasonable steps to ensure that a company complies with its obligations in the Corporations Act 2001 (Cth) (“the Corporations Act”) related to the keeping of financial records and financial reporting); and
  • Insolvent trading: to ensure that a company does not trade whilst insolvent or where they suspect it might be insolvent.

Temporary safe harbour from insolvent trading

In an effort to create a safety net to lessen the threat of actions that could unnecessarily push companies into insolvency and force the winding up of otherwise profitable businesses, the Australian Government introduced the Coronavirus Economic Response Package Omnibus Act 2020 (“the CERPO Act”) which is designed to provide directors of corporations with temporary easing of insolvent trading laws.

In line with the CERPO Act, section 588GAAA has now been introduced into the Corporations Act and provides directors with a new safe harbour defence to rely on for the incurring of debts whilst trading insolvent.

Directors and their advisors however, should bear in mind that this relief will only apply to debts incurred in the ordinary course of the company’s business and during the period 25 March 2020 to 24 September 2020 and importantly, this does not relieve directors’ of the balance of their fiduciary duties under the Corporations Act.

Where directors seek to rely on section 588GAAA as a defence to trading a company whilst insolvent, they will need to be able to point to a continuing viable business that is supported by appropriate forecasts and/or advice from appropriately qualified professionals.

Continuing to trade an unviable business without a proper plan or strategy exposes directors to personal liability under the relevant statutory provisions of the Corporations Act so it is critical that directors make themselves aware of these provisions and actively manage the company’s financial position on a regular basis.

The safe harbour provisions in section 588GA will remain an important consideration, mirroring, if possible, this new and temporary safe harbour. Accordingly, if the business is insolvent, or likely to become insolvent at any point of time, directors should still ensure they satisfy or explain why they are not able to satisfy the preconditions to safe harbour protections, including to record the strategy in a written plan.

25 September 2020 and beyond

Whilst the Treasury Amendment Bill does contemplate further possible extensions to this timeframe, directors and their advisors should be proactively monitoring the company’s financial position and seek advice from appropriately qualified professionals if the company’s outlook changes.

Early intervention is the key to maximising value for stakeholders and giving the business its best chance of survival.

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Decoding the Illegal Phoenix: Part 1

Decoding the Illegal Phoenix: Part 1

According to a 2018 report prepared by PwC, the direct costs to the Australian economy resulting from illegal phoenix activities are estimated to be between $2.85bn - $5.13bn per year
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Friday, 17 July 2020
By Matthew Pease

What is the definition of phoenix activity?

Unfortunately, there is no one agreed upon definition of phoenix activity.

  • The ATO defines it as when a new company is created to continue the business of the old company that has been deliberately liquidated to avoid paying its debts.
  • ASIC defines it as when company directors transfer the assets of the old company to a new company without paying market value and leaving the debts with the old company which is then placed into liquidation. When a liquidator is then appointed, there are no assets remaining to recover and creditors cannot be paid. 

Illegal phoenix activity has far reaching economic impact to business in unpaid trade creditors, to employees for unpaid entitlements and to government in unpaid taxes.

A 2018 report prepared by PwC for the Phoenix Taskforce estimated the direct costs to the Australian economy resulting from illegal phoenix activities to be between $2.85 – $5.13 billion per year.

Not all phoenix activity is illegal according to the Phoenix Research Team who have categorised phoenix activity into five categories:

  1. Legal phoenix: also known as ‘business rescue’, where directors have no intention to defraud creditors, and saving the business (but not the company) is the best course of action for all stakeholders.
  2. Problematic phoenix: technically legal, where there is no evidence of directors intending to defraud creditors, but the net effect of the phoenixing is not beneficial to creditors. This may involve an ill equipped director who has had past business failures.
  3. Illegal type 1: where an improper intention to transfer assets and defraud creditors is formed at or immediately before the time of business failure.
  4. Illegal type 2: phoenix as a business model, where the company is set up to deliberately engage in personally profitable phoenix activity (i.e. the business was never operated so as to succeed).
  5. Complex illegal: in addition to illegal type 2, this model also coincides with more serious crimes such as creating false invoices (e.g. GST fraud), false identities, fictitious transactions, money laundering, visa breaches, and misusing migrant labour.

With these different categories, the question then becomes which phoenix activity is illegal and what is being done to combat this practice?

The Government is attempting to eradicate phoenix activity and the Treasury Laws Amendment (Combating Illegal Phoenixing) Bill 2019 was passed by both houses of Parliament on 5 February 2020. This Bill implements four key measures to combat illegal phoenix activity:

  1. introducing new phoenix offences;
  2. ensuring that directors are held accountable for misconduct
  3. introducing changes to the Director Penalty Notice regime; and
  4. authorising the ATO to retain tax refunds where a taxpayer has failed to lodge a return.

These measures will be discussed in further detail in a later post.

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