The Financial Accounting Standard Board’s Accounting Standards Codification Topic 820, Fair Value Measurement, (ASC 820) provides a framework for measuring or estimating the fair value of certain assets and liabilities. It provides a hierarchy with three levels that are differentiated by the inputs used to derive estimates. Level 1 valuations are based on quoted prices in active markets for identical assets or liabilities. Level 2 valuations are based on directly or indirectly observable market data for similar or comparable assets or liabilities. Orderly transactions between market participants may not be observable at the valuation date; therefore, Level 3 valuations are based on management’s judgments and assumptions about unobservable inputs. While standard setters and most users believe an appropriately developed Level 3 valuation provides valuable information and is better than the alternative (e.g., possibly irrelevant historical value), some critics of Level 3 valuations refer to such valuations as being marked to “make believe.”1 There are a number of valuation models that are commonly used for Level 3 measurement: stock option pricing models (e.g., the Black Scholes model), discounted cash flows method, discounted dividend method, and others. Even though some inputs into these models could qualify for Level 1 or Level 2 treatment, the overall model and the related asset or liability being estimated would be considered a Level 3 model/valuation if any of the significant inputs are unobservable because the level of the asset or liability is determined based on the lowest level input. In the next section you will find a dialogue between an audit manager and an audit senior discussing the fair value method and assumptions used by audit client Morris Mining Corporation to form a fair value estimate. Morris Mining, Corp., with a fiscal year-end of December 31, owns and operates mining facilities in the U.S. and Canada and distributes various extracted ores and minerals to customers throughout the world. In January 2019, Morris Mining acquired another mining company called King Co. The acquisition is expected to be synergistic, as the location and nature of King’s operations fit well with Morris Mining’s long- term strategy. The combined firm controls greater market share in key ores and minerals and some redundant overhead costs can be streamlined to improve overall profitability. According to valuation analyses conducted by Morris Mining and its advisors in preparation of the acquisition, the purchase price will exceed the value of identifiable net assets. As a result Morris Mining will record goodwill and the identifiable assets and liabilities of King Co. will be recorded on the books of Morris Mining at fair value. One of the assets that will require fair value measurement is a patent that King Co. was granted two years ago. King Co. engineers developed and patented the design for a new mining machine that significantly improves mining efficiency.The patent obtained by King Co. gives the company the right to exclude others from commercial exploitation of the invention for a period of 20 years. King Co. developed some prototypes of the new mining machine, the “Extract-o-Matic 1000,” and then entered into an agreement with a manufacturing firm called Build-IT, Inc.The agreement gives Build-IT the exclusive rights to manufacture and sell the Extract- o-Matic 1000 machines for a period of 12 years. In exchange, King Co. receives a yearly royalty payment in the amount of 10 percent of the revenue from sales of the Extract-o-Matic 1000. After acquiring King Co., Morris Mining is now the legal patent holder and as such is entitled to receive the royalty payments. Sales of the Extract-o-Matic have gone well, as the machines allow mines to significantly reduce the amount of waste during the mineral extraction process. In fact, Morris Mining purchased one of the machines before the acquisition, and it is performing as promised. PHONE CONVERSATION ABOUT FAIR VALUE ESTIMATE The following is a phone conversation between Rob, a new audit manager on the Morris Mining engagement, and Gabriela, the audit senior, regarding Morris Mining’s accounting for the Extract-o-Matic patent. [ROB] Gabriela, I understand you have tracked down more information on the valuation of the patent Morris obtained in the acquisition of King Co. [GABRIELA] Yes, I did. I met with Morris Mining’s CFO, Chris Carter, this morning, and he walked me through their thinking on developing a fair value estimate for the patent on the Extract-o-Matic 1000. [ROB] Well, if the machine is as impressive as its name, it must really be something. I understand the equipment reduces waste and that the company is using the equipment in its operations. I also understand that the company has an agreement to receive yearly patent royalties from sales. Is that correct? [GABRIELA] Right. The company is currently using the equipment and has 10 years left on a royalty agreement with Build-IT, Inc. Under the agreement, Build-IT has the exclusive right to manufacture and sell the Extract-o-Matic and Morris Mining receives a 10 percent royalty payment on the revenue from sales of Extract-o-Matics each year, paid annually at the end of each year. Sales growth in the first couple of years was significant and is expected to continue for at least another few years before leveling out and then declining for the remaining useful life of the patent. Reports back from customers are extremely positive—the Extract-o-Matics are reported to really reduce waste and improve overall yield. The fact that the equipment is performing well, on top of the granting of the patent and the agreement with Build-IT, really has the company excited about the potential royalty cash flows that Extract-o-Matic sales will generate over the next 10 years. [ROB] Okay, the equipment is in production, there is already a track record on sales, and there is positive buzz in the marketplace—that is all good news and suggests the patent is a valuable asset. How is the company proposing to value the patent? I’m guessing no one else has a directly comparable product or patent. [GABRIELA] Correct. Certainly, there are other patents in the industry that we will want to consider in our evaluation of the company’s estimate, but the Extract-o-Matic is definitely unique in the market. The company is using a discounted cash flow approach to estimate the fair value of the patent. Key inputs include: expected life of the asset, discount rate, royalties on sales, and expected sales growth. The machines are not cheap; they sell for about $2 million each. [ROB] Okay, a discounted cash flow approach sounds reasonable. What other approaches did they consider? Did they compute the value using more than one approach? [GABRIELA] The CFO did mention they considered other models before concluding that the discounted cash flow method is the most appropriate approach. As you know, for valuing assets, three common approaches are the market approach, cost approach, and income approach. The market approach would value the patent based on sales of similar assets or patents in the market.The problem with this approach is that patents are so unique that it becomes very difficult to find a comparable sale to base a value on.That’s definitely the case with the Extract-o-Matic.There just doesn’t appear to be a good comparison in the marketplace. [ROB] Okay, makes sense. How about the cost approach? [GABRIELA] The cost approach would measure the fair value of the patent based on the costs that would be necessary to replace it. But this method is generally not used because patents can’t really be replaced like many other assets. Plus, capturing specific development costs is non-trivial, especially because King Co. did not track separately the development costs that led to the patent design. So it doesn’t seem that a replacement cost approach is sensible. After discussing with the CFO, I agree with the use of the income or discounted cash flows approach. [ROB] Yeah, that makes sense. The fair value of the patent is computed by estimating the present value of the estimated cash flows that will be earned in royalty payments. Based on past experience, applying the discounted cash flow approach requires a great deal of effort to ensure that inputs used in the model are reasonable and supportable. Fortunately, it sounds like the company has focused a lot of time and attention on formulating the estimate and providing support for its inputs. I appreciate you walking me through all this. So what amount have they computed for the fair value under the discounted cash flow method? [GABRIELA] Well, it is a pretty big number; the present value of the projected discounted cash flows is just over $25.7 million. Morris Mining obtained estimates from Build-IT regarding the expected future cash flows to be generated from sales of the Extract-o-Matic 1000. These cash flow estimates were then used to value the patent. Build-IT had $30 million in Extract-o-Matic sales last year and expects sales to increase 15 percent per year for the next four years, and then decline at 5 percent per year for three years, and finally decline 15 percent per year for the last three years of the agreement. Morris Mining obtained a 10-year discounted cash flow projection from Build-IT, and based on that they were able to compute the present value of the royalties that will be received each year for the life of the licensing agreement (see Appendix A). While the actual patent grants exclusive rights for up to 20 years, experience in the industry is that the patent will likely produce a competitive advantage for 12 years, as other competing technology will eventually come online. In this situation, the remaining useful life matches up with the 10-year remaining life of the agreement with Build-IT. I’ve looked at the model. They’re using a discount rate of 10 percent and the expected sales trend provided by Build-IT. [ROB] Well, all of those numbers are estimates and they all will impact the fair value estimate and of course the future amortization. What do you think about the inputs, do they seem reasonable to you? [GABRIELA] Well, I did some research, and based on relevant rate indices and industry norms, the discount rate seems to be reasonable, but you know how much rates have fluctuated in the past few years. Given a 10-year remaining useful life, I’m not sure 10 percent is the best rate to use in the valuation model. A reasonable range for the interest rate appears to be 8 to 11 percent, but it seems the lower end of the range is more likely and probably more supportable. They are at the higher end of that range, which decreases the net present value of the asset and thus the future amortization they will be recognizing. It also increases the amount recorded as goodwill, as compared to what it would be if they used a lower discount rate. As for the growth rate in the first four years, Chris tells me that the President of Build-IT doesn’t believe the growth rate of 25 percent in the first couple of years is sustainable, but based on his experience with sales of equipment like this he is confident that they can achieve a 15 percent growth rate over the first four years. He also believes that sales will then start to decline because technological improvements in mining have limited useful lives. [ROB] Well, I’m glad Chris and the President of Built-IT feel comfortable with the forecasts, but unfortunately it doesn’t seem like there’s enough support for us to buy-off on the estimated growth and subsequent decline projections. Do you or the company have any benchmark data for similar mining machinery that’s been patented and sold in recent years? [GABRIELA] I’ve done some research on that as well, and given my preliminary findings, I think the 15 percent growth rate that’s been suggested for the first four years may actually be too conservative given the rapid growth in the first two years and the other information I found. Several years ago, another mining company in the western U.S. manufactured and sold newly patented equipment that represented a pretty big step over existing technology at the time. The company was quite successful in marketing and selling the equipment, and in the first few years averaged just over 22 percent growth, with the highest years at about 25 percent, which is about what Build-IT experienced in the first two years of sales. The decline in the middle and later years of the useful life seem reasonable, although in the last year or two I think it could drop more than 15 percent. [ROB] We’ll need to do some more research on this and we’ll have to challenge the client to provide additional support for the expected pattern of cash flows in terms of initial growth and subsequent decline. The chosen discount rate and sales growth in the early years relative to what you have determined so far as reasonable ranges will tend to reduce the net present value of the cash flows. What do you think about the estimated length of the asset’s useful life? [GABRIELA] Their numbers seem reasonable in that regard. In researching footnotes of other mining companies’ financials, it seems pretty common for patent assets to have a useful life of 10 to 12 years. In this case, it seems reasonable to estimate the remaining useful life at 10 years, which as I mentioned is the same as the term remaining in the royalty agreement with Build-IT. I also gathered more evidence from Chris on how they are supporting the estimated life. [ROB] Gabriela, you’ve done a great job on the patent valuation so far. Thanks for your good work. Now we need to make sure we can get comfortable with the model and the inputs. To the extent we disagree with Morris on any of the inputs, we will want to compute our own estimated value and then look at the sensitivity of the estimated value to changes in inputs. We’ll want to see how big the ranges are relative to materiality. [GABRIELA] Right. Even slight changes in the input estimates the Company is using could have a significant impact on the financial statements. I’ll continue researching the projected growth rate and discount rate and I’ll run some sensitivity analyses and keep you posted. REQUIRED  What is the definition of fair value according to ASC 820? Do you believe the discounted cash flow method is capable of computing an estimate that would be considered a reasonably reliable fair value for the patent held by Morris Mining? Why or why not?  Should Gabriela and Rob be concerned about the fair value estimate Morris Mining has computed? Why? What incentive does the company likely have in terms of valuing the patent (over or understatement)? Explain your answer.  Research auditing standards and describe the typical procedures that an auditor would perform in auditing a fair value estimate such as the value of Morris Mining’s patent. Is the patent a Level 1, Level 2, or Level 3 fair value asset? Why?  Examine the 10-year discounted cash flow analysis provided by the client in Appendix A and also available electronically at www.pearsonhighered.com/beasley and verify that the model is producing a mathematically sound fair value estimate based on the inputs used by Morris Mining. Assuming planning or performance materiality for Morris Mining is $10 million, answer the following questions: [a] How sensitive is the fair value estimate to changes in the discount rate? How much would the discount rate estimate have to change for it to have a material impact on the financial statements? [b] How sensitive is the fair value estimate to changes in the estimated growth rates? How much would the estimated growth percentages have to change to have a material impact on the fair value estimate? Do rate changes in early years or later years have a larger impact? Why?  Now, assuming planning or performance materiality at Morris Mining is $600,000, answer the following questions. (Note: as indicated earlier, you can obtain an electronic copy of the 10-year discounted cash flow analysis at www.pearsonhighered.com/beasley) [a] How sensitive is the fair value estimate to changes in the discount rate? How much would the discount rate estimate have to change for it to have a material impact on the financial statements? [b] How sensitive is the fair value estimate to changes in the estimated growth rates? How much would the estimated growth percentages have to change to have a material impact on the fair value estimate? Do rate changes in early years or later years have a larger impact? Why?  What are the most significant audit risks associated with the fair value estimate of the patent? Assuming performance materiality of $600,000, what additional steps can the auditor take to improve the sufficiency and appropriateness of the evidence gathered to support the fair value estimate for the patent? PROFESSIONAL JUDGMENT QUESTION It is recommended that you read the Professional Judgment Introduction found at the beginning of this book prior to responding to the following question.  A great deal of judgment often is required when estimating fair values, and sometimes a "reasonable range" for the possible estimate value is very large relative to materiality. Considering the sensitivity highlighted in question 4, what implications do the estimate's sensitivity to small changes in input values, and the related judgments and potential biases, have when it comes to auditing fair value estimates?