< PreviousA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 30 MAY | JUNE 2020 t h e v a l u e e x a m i n e r Valuation analysts can choose to use one method or a combination of methods for valuing intangibles. There is no one-size-fits-all valuation method for intangible assets, and so it is important that valuation experts document why they chose a specific method or methods. The table below summarizes commonly used approaches to intangible valuation.6 AssetPrimarySecondaryTertiary PatentsIncomeMarketCost TechnologyIncomeMarketCost CopyrightsIncomeMarketCost Assembled workforceCostIncomeMarket Internally developed softwareCostMarketIncome Brand namesIncomeMarketCost Customer relationsIncomeCostMarket Impairment loss. After the fair value of the asset or reporting unit has been calculated, that amount is compared to the carrying value for the asset or reporting unit. The amount by which the carrying value of the asset or reporting unit exceeds the fair value of the asset or reporting unit is equal to the impairment loss. Fair Value of Asset/Reporting Unit $100,000 Less Carrying Value of Asset Reporting Unit ($300,000) Impairment Loss ($200,000) Inventory. Disruptions to sales and supply chains resulting from the fallout from COVID-19 should be accounted for at the same time impairment losses from indefinite-lived assets are calculated. A decline in sales, causing the utility or value of inventory to fall, should be recognized in the period in which it occurs.7 If the decline in inventory value or utility is temporary—that is, likely to reverse itself in the near future—it is not recognized as a charge in the current period. It is important not to defer the charge to a period beyond the period in which the decline occurs.8 The inventory method normally used will dictate how inventory is valued by an analyst for purposes of calculating impairment loss (outlined in the table below). Inventory MethodValue Using FIFO (first-in, first-out)Lower of cost or net realizable value Average CostLower of cost or net realizable value LIFO (last-in, first-out)Lower of cost or market Retail Inventory Lower of cost or market Equity method investments. Under ASC 323, Investments—Equity Method and Joint Ventures, if the carrying amount of an investment, including a joint venture, is not recoverable, then it can be tested for impairment on an interim basis. If the fallout from COVID-19 results in the carrying amount of an investment not being recoverable, then the investor must determine 6 Robert Reilly, “Effective Intangible Asset Valuation Reports,” Business Appraisal Practice (Spring 2007). 7 ASC 330, Inventory. 8 ASC 270, Interim Reporting. The cost approach uses the principle of substitution, where historical cost is the actual cost of the asset, and replacement cost is the current cost of a similar asset. A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r MAY | JUNE 2020 31 if the decrease in value is other than temporary. Losses from temporary declines in investment value are not recognized, as they generally reverse themselves over time. Investments are recorded on the books and records at their fair value; the difference between the fair value and the carrying value of the investment is the impairment loss amount.9 For purposes of calculating impairment losses, investors must test the entire investment rather than separate and test its underlying assets. One issue that is not addressed in ASC 323 is how an impairment loss could affect the investor’s basis differences; this is problematic as it is bound to create diversity in practice.10 It is advisable, therefore, for an investor to document clearly the accounting policy and rationale used to record any impairment loss and highlight where the loss is reported in the financial statements. 2. Long-Lived Assets to be Held and Used (ASC 360) The second category of assets to be tested for impairment is long-lived assets to be held and used. This category specifically excludes long-lived assets that are held for sale. Long-lived assets include buildings, machinery, land, and intangible assets without indefinite life.11 If management believes that the current economic climate brought about by COVID-19 provides indicators that the carrying value of its long-lived assets are not recoverable, then it should conduct interim impairment testing as follows: 1 Impairment Indicators Impairment indicators include a decline in fair value, changes in the market environment, or other factors that negatively affect the value of the long-lived asset to be held and used. Do impairment indicators exist? If Yes: go to 2 If No: stop, no impairment exists 2 Test for Recoverability Compare the carrying value of the long-lived asset to its estimated undiscounted cash flows or fair value. Does the carrying value of the long-lived asset exceed its estimated undiscounted cash flows? If Yes: go to 3 If No: stop, asset is recoverable 3 Impairment Loss The amount by which the carrying value of the long-lived assets exceeds fair value is the amount of the recognized impairment loss. 9 See ASC 820, Fair Value Measurement, which provides additional guidance on calculating fair value. 10 This is the difference between the carrying amount of the investment and the investor’s share of the net assets of the investee. 11 Right-of-use assets, though less common, are included in this category. See ASC 842, Leases. If the fallout from COVID-19 results in the carrying amount of an investment not being recoverable, then the investor must determine if the decrease in value is other than temporary. Losses from temporary declines in investment value are not recognized, as they generally reverse themselves over time. A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 32 MAY | JUNE 2020 t h e v a l u e e x a m i n e r Long-lived assets can be tested for impairment individually or as a group. Management will again need to use significant judgment, as the salvage value and estimated useful life of the assets will probably be revised. 3. Goodwill (ASC 350-20) Goodwill is a long-term intangible asset that can be internally developed but is most often reported when a business is purchased. Goodwill is the last asset to be tested for impairment purposes. When one entity purchases another entity for a purchase price greater than the fair market value of the assets acquired less the liabilities assumed, the difference is recorded as goodwill on the balance sheet as a noncurrent asset.12 Effective in 2001, U.S. companies were no longer required to amortize goodwill. Instead, impairment testing was required at a minimum annually but more frequently if impairment indicators existed. In 2015, however, private companies were permitted to elect to amortize goodwill over a 10-year period to avoid the costs of impairment testing. Goodwill is tested for impairment on an interim basis if there is a change in circumstances resulting in a more-likely-than-not probability (greater than 50 percent) that it is impaired. If management determines that factors related to COVID-19 have caused a change in circumstances that affect the fair value of goodwill, then quantitative interim impairment testing is necessary.13 Goodwill should only be tested at the reporting unit level within a company; the reporting unit is an operating segment of a business.14 The procedure for interim testing for goodwill depends on whether an entity has adopted Accounting Standards Update (ASU) 2017-04, Intangibles—Goodwill and Other. If an entity has adopted ASU 2017-04, goodwill impairment testing is less complex. ASU 2017-04 became effective on January 1, 2020, and currently applies to impairment tests for calendar year-end public business entities that are SEC filers, excluding “smaller reporting companies.” For smaller reporting companies and non- SEC filers, ASU 2017-04 is effective for periods beginning after December 15, 2022; however, early adoption is permitted. Any entity that has not adopted ASU 2017- 04 may still do so, but it should consider that after adoption, goodwill impairment losses will only be permitted if quantitative impairment testing is complete before the issuance of its financial statements. This caveat means that once ASU 2017-04 is adopted, goodwill impairment can no longer be based on a best estimate, since it is expected that impairment testing will be complete prior to the issuance of the financial statements. For entities that have adopted ASU 2017-04, the goodwill impairment loss is the excess of the goodwill carrying value over its fair value. For entities that have not adopted ASU 2017-04, the goodwill impairment loss is the excess of the goodwill carrying value over its implied fair value. Implied fair value is the reporting unit’s fair value less the fair value of its assets and liabilities. As outlined in ASC 820, fair value of goodwill is most commonly calculated using the cost, income, or market 12 ASC 805, Business Combinations. 13 See the box on page 29 for a list of impairment indicators. 14 ASC 280, Segment Reporting. Given the unpredictability of the fallout from COVID-19, valuation analysts can assist management in identifying possible impairment issues and performing the related calculations and disclosures.A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES MAY | JUNE 2020 33 approach, or a combination of those approaches. Since determining which method or methods to use requires significant judgment, management may engage a valuation analyst for assistance. ASU 2017-04 Adopted ASU 2017-04 Not Adopted 1 Is the fair value of the goodwill reporting unit less than its carrying amount? Is the fair value of the goodwill reporting unit less than its carrying amount? 2Skip This Step What is the implied fair value of the goodwill? (fv of reporting unit less fv of assets and liabilities Impairment Loss = the fair value of the reporting unit less its carrying amount. = the value of implied goodwill less its carrying amount. Disclosure Requirements When an entity recognizes an impairment loss, it is obligated to disclose a detailed calculation of the loss, including the method(s) used to value the impaired asset or reporting unit, in addition to all relevant information that led to the loss. This information should be provided in the financial statements or the footnotes. For intangible asset impairment, a description of the impaired asset and where the loss is recorded should also be included. Other disclosure considerations include identifying additional reporting units that might be at risk for impairment, providing detailed impairment testing policies and procedures, and describing any significant estimates and assumptions made in the calculation of impairment losses. Lastly, any prospective financial information previously provided should be adjusted to reflect impairment losses. Conclusion This article provides a starting point for financial reporting and valuation considerations for businesses affected by COVID-19, concentrating on issues surrounding asset impairment. th e val u e exa m i ne r Rizvana Zameeruddin, JD, LLM, MST, CPA, is an associate professor of law and accounting at the College of Business, Economics, and Computing at the University of Wisconsin— Parkside. She has been teaching there for 23 years and previously taught at DePaul University for four years. Her research focuses on current federal tax law developments and her publications appear in the Journal of Accountancy and Tax Notes. Born and raised in England, she has called the Midwest her home for 30 years. She is an avid Chicago Bears and Liverpool F.C. fan. Email: Given the unpredictability of the fallout from COVID-19, valuation analysts can assist management in identifying possible impairment issues and performing the related calculations and disclosures. VEA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 34 MAY | JUNE 2020 t h e v a l u e e x a m i n e r Academic Research Briefs By Peter L. Lohrey, PhD, CVA, CDBV /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// ACADEMIC REVIEW This column provides summaries of contemporary research in valuation and forensic accounting. Summarized manuscripts—selected from numerous academic research outlets—cover significant developments that affect the ever-changing valuation and forensic accounting landscape. The objective is to increase awareness of recently completed research that advances knowledge of these subjects. As this column evolves, I encourage readers to forward relevant manuscripts or working papers for consideration. Please send links and/or files to: or the subject line. The Most Common Error in Valuations Using WACC Author: Pablo Fernandez, IESE Business School, University of Navarra Source: Summary Fernandez provides an empirical example of the improper use of weighted average cost of capital (WACC) by a well- known investment bank to discount projected expected free cash flows (FCF) to estimate the fair value of a minority interest in a recent business acquisition. He points out that: The present values of (1) expected FCFs discounted with the WACC rate, less the value of debt (Section 1 of the paper) and (2) expected equity cash flows (ECF) discounted by the required return on equity (Ke) (Section 2 of the paper), when correctly used, should be the same. He concludes that the most common error that occurs when using discounted cash flows (DCFs) to value a business is caused by the valuator “not remembering the definition of WACC”—or, in other words, applying the wrong formula for WACC. Design and Execution of the Study Section 1 of Fernandez’s article provides the assumptions used along with the results from a valuation report generated by an investment bank to determine the value of a 22 percent interest in the acquired common shares of a target company. The investment bank’s report used the WACC to discount the projected FCFs, less the value of debt, to conclude “our best estimation of the value of the shares is €6.9 million.” In Section 2 of the article, the present value of ECFs are discounted by Ke to arrive at a value of €4.2 million for the target company’s shares. Fernandez proceeds to ask the following questions: 1. Is the valuation produced by the investment bank valid, or is it worthless? 2. Which value is more reliable: a. The €6.9 million value using WACC to discount projected FCFs less the value of debt, or b. The €4.2 million value using Ke to discount projected ECFs? Note: The tables referred to in the discussion below can be found in Fernandez’s manuscript.1 They are not reproduced here. Section 1—The €6.9 million value using WACC to discount projected FCFs less the value of debt Table 1 provides the projected balance sheet and income statement along with the assumptions used to generate Table 2, which provides the forecasted FCFs for the target company. Table 3 presents the valuation of the 22 percent acquired common shares. Using a risk-free rate (Rf) of 1 percent, a market risk premium (MRP) of 5 percent, and a levered Beta (βL) of 1.75, he arrives at a Ke of 9.75 percent. Ke = Rf + βL*MRP 9.75% = 1% + (1.75 * 5%) For the cost of debt (Kd), he uses a 4 percent rate, a corporate tax rate (T) of 25 percent, and a 50 percent leverage ratio D/(D+E). This in turn leads to a 6.375 percent WACC. 1 A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r MAY | JUNE 2020 35 WACC = [E/(D+E)] Ke + [D/(D+E)] Kd (1-T) 6.375% = (50% x 9.75%) + (50% x 4% x 75%) Fernandez then shows that an enterprise value (EV) of €7.9 million less €1.0 million in debt (D) leads to the valuation of the common shares equaling €6.9 million. EV = (D+E) = PV (FCF; WACC) €7,922.26 = €1,000 + €6,922.26 = €7,922.26 Common Share Value = €7,922.26 – €1,000 = €6,922.26 thousands Section 2—The €4.2 million value using WACC to discount projected ECFs Table 4 takes the forecasted profit after tax (PAT) from Table 1 in Section 1 and adds increases in debt and depreciation less the investments in fixed assets less increases in working capital requirements to project future ECFs. In table 5, Fernandez takes the projected FCFs from Table 2 in Section 1 and adds increases in debt less interest expense multiplied by one minus the tax rate. He then arrives at the very same projections for future ECFs he presents in Table 4. Fernandez then shows that the projected ECFs discounted using a Ke of 9.75 percent leads to the valuation of the common shares equaling €4.2 million E = PV (ECF) E = (€77.5 + €216.0 + €373.0 + €379.85) x (1+ 0.0975) ∑1...4 Common Share Value = €4,239.74 thousands Section 3—Definition of WACC Fernandez illustrates two basic methods used to value companies using discounted cash flows. Method 1: Using the ECFs discounted by the required return of equity (Ke) First, he illustrates the relationship between ECF and FCF with the following three equations. [1] E0 = PV0[Ket; ECFt] Where the value of equity (E) is the present value of the expected equity cash flows (ECF) discounted by the required return on equity, [2] D0 = PV0[Kdt; CFdt] The value of the debt (D) is the present value of the expected debt cash flows (CFd) discounted by the required return on debt, and [3] ECFt = FCFt + Δ D t – It (1 – T) Δ D t is the increase in debt, and It is the interest paid by the company. CFdt = It - Δ D t The free cash flow is the hypothetical equity cash flow when the company has no debt, and this links the FCF with the ECF. Method 2: Using the FCFs discounted by WACC Second, Fernandez shows that present value of debt plus shareholders’ equity equals FCF discounted by WACC. [4] E0 + D0 = PV0 [WACCt ; FCFt] The WACC is the discount rate that causes the FCF in equation [4] to equal the sum of equations [1] and [2], so [5] WACCt = [Et-1 Ket + Dt-1 Kdt (1-T)/ [Et-1 + Dt-1] T is the effective tax rate applied to interest in equation [3], and Et-1 + Dt-1 are not market or book values; they are the values Et-1 and Dt-1 obtained when the formulas [1], [2], or [4] are used for the valuation. Conclusions and Implications WACC is the discount rate that equates the present value of FCF to the present value of ECF. The two ways to value shareholders’ equity are: 1. The present value of FCFs discounted by the WACC less the value of debt, or 2. The present value ECFs discounted by the required rate of return for equity. Both methods must provide the same value because they both use the same assumptions. The only difference is the type of cash flows selected as the starting point for each approach. Fernandez points out that in many instances, analysts, consultants, and investment bankers do not arrive at the same value under each method. He concludes that the most common error that occurs when using discounted cash flows (DCFs) to value a business is caused by the valuator “not remembering the definition of WACC”—or, in other words, applying the wrong formula for WACC. How to Value a Company by Analyzing Its Customers Authors: Daniel McCarthy, Emory University and Peter Fader, Wharton School of the University of Pennsylvania Source: Harvard Business Review, January–February 2020, A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 36 MAY | JUNE 2020 t h e v a l u e e x a m i n e r McCarthy and Fader (M&F) present their new valuation approach, called customer-based corporate valuation (CBCV). They believe that it provides a better way to measure the value of a firm in what they call the new loyalty economy. CBCV uses fundamental accounting rules to make sales projections from the bottom up instead of the top down. Simply stated, CBCV places more emphasis on how individual customer behaviors affect revenue forecasts used to value a business. M&F point out that two things are needed to implement CVCV: (1) a customer behavior model, which they call “the customer-base model,” and (2) customer data entered into the model. The customer-base model contains four interacting sub-models that predict how each customer of a firm will behave. The four sub-models are: 1. The customer acquisition model, which estimates the arrival of new customers; 2. The customer retention model, which estimates how long customers will stay committed; 3. The purchase model, which estimates how often customers buy from a firm; and 4. The basket-size model, which estimates how much customers will pay for each purchase. To understand the essential actions of every customer, M&F bring these four models together to predict who will acquire when, how much they will spend over a period of time, etc. Quarterly sales projections are then calculated by adding all of the projected expenditures together across customers. M&F firmly believe that these four models can be utilized to produce much more accurate estimates of future revenues and, as a result, enable one to make better estimates of a company’s value. M&F’s fundamental model is universal. However, the way it is applied depends on whether the subject company’s business model is subscription-based or not. They point out that the managers of subscription-based companies, such as fitness centers or telecommunications companies, usually know approximately how much customers will spend each month, and they also clearly see when customers cancel their contracts. This in turn simplifies how the retention and purchasing models are made. On the other hand, most companies are non-subscription, or sell their goods on a discretionary basis, with no way to observe when customers stop buying from them. M&F provide Amazon as an example of this type of business, where an individual could have an Amazon account but never buy anything from the company again. They assert that these types of companies require more complicated sub-models, but that marketers have developed predictive models that perform extremely well. M&F provide two examples of how to apply the CBCV approach. In the first example, they use a subscription-based meal company, and in the second example, a firm that has tiered pricing. They suggest that readers consult two different academic studies they published, “Valuing Subscription- Based Businesses Using Publicly Disclosed Customer Data”2 and “Customer-Based Corporate Valuation for Publicly Traded Non-Contractual Firms.”3 One important factor that affects the viability of the CBCV approach is the amount of internal company data available to the valuator. M&F point out that many large, well-respected firms have recently begun to disclose their C3, or customer cohort chart. The authors believe that access to a firm’s C3, along with the number of active customers and the total number of orders, provides adequate data for the analyst to gain a suitable understanding of a firm’s customer behavior. If a firm will not provide its C3, the analyst should ask for four crucial metrics: (1) the total number of active customers, as well as the proportion of customers who have been with the company for more than a year; (2) gross acquired customers for the most recent period; (3) total revenue, as well as the percentage of revenue from customers who have been with the company for more than a year; and (4) total number of orders, as well as the percentage of orders from customers who have been with the company for more than a year. Three to four years of this information would provide enough data to run a CBCV model. In closing, M&F acknowledge that not many companies are willing to provide all the data that analysts need to apply the CBCV approach, for a variety of reasons. First, most companies do not feel any pressure to make C3 available. Second, there is not much agreement about which customer metrics are the most useful, nor how to analyze or report them. Finally, both policymakers and regulators alike have been mostly quiet about these matters, which leaves disclosure up to a company’s choice. Going to Pieces: Valuing Users, Subscribers, and Customers Author: Aswath Damodaran, Stern School of Business at New York University. 2 Daniel McCarthy, Peter S. Fader, and Bruce G.S. Hardie, “Valuing Subscription-Based Businesses Using Publicly Disclosed Customer Data,” Journal of Marketing 81, no. 1 (January 2017): 17–35. 3 Daniel McCarthy and Peter S. Fader, “Customer-Based Corporate Valuation for Publicly Traded Non-Contractual Firms,” Journal of Marketing Research 55, no. 5 (October 2018): 617–35.A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r MAY | JUNE 2020 37 Source: Summary Damodaran begins by stating that businesses are usually valued across various lines of operations that are combined together when using normal valuation methods. Traditional accounting metrics, such as total revenue, earnings, and cash flows are estimated across the different business lines and then discounted using a rate that reflects the weighted average risk for the whole company. He cites two reasons for this: (1) the information found in financial statements is usually for the combined company and not for the different lines of operations, and (2) investors finance entire companies, not their individual product lines. Against this backdrop, several companies are now using business models that are built around their various lines of operations. Hence, many of these businesses argue that traditional valuation models no longer reflect proper values. Damodaran disagrees with this line of thinking and presents inherent value and pricing approaches to value users, subscribers, or members. By using examples—such as Uber, Amazon Prime, Spotify, and Netflix—to expose some of the information disclosure gaps, Damodaran investigates the subtleties that guide the valuation of users and subscribers. Design and Execution of the Study Damodaran begins by explaining the differences between aggregated valuation versus disaggregated valuation. First, aggregated valuation has been the primary approach historically for two reasons: (1) investors purchase entire companies, not their disaggregated parts; and (2) most of the financial disclosure is on an aggregated basis. Next, he points to four occasions when it may be appropriate to value an entire company by valuing its parts and then adding them all together: 1. There are fundamental differences in the geographic location of different business lines, which may warrant different risk, cash flow, and growth profiles; 2. There are growth differences among the different business lines in one company, which may prevent the use of a bottom-up beta to measure risk across the different lines that are growing at different rates; 3. There are transactional differences, which may require a different value for the business line being spun off; and 4. Management reasons warrant the valuation of the different business lines in order to monitor the performance of different division managers. Damodaran points out that over the last 10 to 15 years, we have moved to a stage where companies measure their achievements based on the number of subscribers, customers, or users they have, rather than the historic metrics of revenue and cash flows. He also remains committed to the idea that while value ultimately comes from cash flows, the way that we build up to those cash flows for companies like Uber, Facebook, and Netflix is through their users or subscribers. Furthermore, many investors are pricing social media companies based on the number of users they have, and not by traditional metrics, such as revenue and earnings. Damodaran looks at the downside to the recent shift to the use of subscribers, customers, or users to value companies, and offers his ideas about better ways to value and price users or subscribers. He identifies several weaknesses in the methods presented by Gupta, Lehmann, and Stuart,4 and McCarthy, Fader, and Hardie5 and points out that there are operating costs that are not related directly to users—he calls this “corporate drag”—that need to be included somewhere in the valuation. The study proceeds to illustrate the various weaknesses found in the use of disaggregated valuation by applying it to value Uber in June 2017, Netflix in April 2018, and Amazon Prime in April 2018. Conclusions and Implications Damodaran closes by arguing that the weaknesses he finds in disaggregated valuation should motivate investors to push user-, subscriber-, and customer-based companies to provide more user-based information that would better address the questions he raises. He also states that even when an investor does get more access to user-level data, she or he should also cross-check it with a top-down, aggregate valuation. If the values are very different, the analyst should try to isolate the variables that cause the difference(s) and consider which approach uses more realistic assumptions. Peter L. Lohrey, PhD, CVA, CDBV, is an assistant accounting professor at Montclair State University. He is also the director of the Forensic and Valuation Services Department for Prager Metis CPAs, LLC, an accounting firm located in Hackensack, NJ. Dr. Lohrey specializes in commercial damage calculations and business valuation for tax, litigation, forensic, and financial reporting purposes. Email: lohreyp@ montclair.edu or 4 Sunil Gupta, Donald R. Lehman, and Jennifer Ames Stuart, “Valuing Customers,” Journal of Marketing Research 41, no. 1 (February 2004): 7–18. 5 McCarthy, Fader, and Hardie, “Valuing Subscription-Based Businesses” (see n. 2). VEA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 38 MAY | JUNE 2020 t h e v a l u e e x a m i n e r By Todd A. Zigrang, MBA, MHA, FACHE, CVA, ASA, and Jessica L. Bailey-Wheaton, Esq. Valuations at Center of False Claims Act Lawsuit /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// HEALTHCARE INSIGHTS On January 6, 2020, the U.S. Department of Justice (DOJ) intervened in a whistleblower False Claims Act (FCA) lawsuit1 premised on violations of the Stark Law. Indianapolis- based Community Health Network (CHN), an integrated healthcare system,2 is alleged to have violated the Stark Law by participating in above fair market value (FMV) compensation structures that were partly established on the referrals that the physicians made to the hospital system.3 The complaint places at the focal point of the alleged Stark Law violations (and subsequent FCA violations) the involved valuation firms’ statements to CHN, valuation techniques, and professional opinions prepared for CHN.4 This article will review CHN’s allegedly illegal compensation arrangements with its specialists and its incentive compensation structure, as well as the role of the valuations in the fact pattern set forth by the government. Stark Law Background The Stark Law governs those physicians (or their immediate family members) who have a financial relationship (i.e., an ownership investment interest or a compensation arrangement) with an entity, and prohibits those individuals from making Medicare referrals to those entities for the provision of designated health services (DHS).5 Notably, the 1 United States’ Complaint in Intervention at 1, U.S. ex rel. Fischer v. Community Health Network, Inc., No. 1:14-cv-1215 (S.D. Ind. Jan. 6, 2020). Note that the government only intervened in part, and not in all of the allegations made by the whistleblower. “United States files False Claims Act complaint against Community Health Network,” U.S. Department of Justice, 2 “About Community Health Network” Community Health Network, 2020, 3 United States’ Complaint in Intervention at 1, U.S. ex rel. Fischer v. Community Health Network, Inc., No. 1:14-cv-1215 (S.D. Ind. Jan. 6, 2020). 4 Id. at 15–30, 36–44, 46–54, 67. 5 Limitation on Certain Physician Referrals, 42 U.S.C. § 1395nn(a). law contains a large number of exceptions, which describe ownership interests, compensation arrangements, and forms of remuneration to which the Stark Law does not apply.6 Most of these exceptions require, in part, that compensation not exceed FMV.7 In litigation, these exceptions often function as an affirmative defense for the defendant. Significantly, a violation of the Stark Law can trigger a violation of the FCA.8 FCA imposes liability on any person who knowingly submits a false or fraudulent claim or uses false records to induce payment from the U.S. government.9 The FCA also allows for private individual whistleblowers, called qui tam relators, to enforce FCA violations.10 The government may seek to intervene in FCA qui tam cases.11 Allegations Against CHN CHN is accused of recruiting and then paying breast surgeons, cardiovascular specialists, and neurosurgeons sizeable compensation amounts that often exceeded FMV.12 The compensation amounts were intended to facilitate the integration of these providers into CHN’s health network.13 The complaint claims that the salaries provided to physicians were significantly higher than what the physicians were previously receiving when they operated as private practices;14 6 Id. 7 See Exceptions to the referral prohibition related to compensation arrangements, 42 C.F.R. § 411.357. 8 False Claims, 31 U.S.C. § 3729. 9 Id. 10 Civil actions for false claims, 31 U.S.C. § 3730. 11 Id. 12 Because the allegations regarding the neurosurgeons’ compensation is so similar to those of the other specialists, this article will not discuss those arrangements. United States’ Complaint in Intervention at 25–26, U.S. ex rel. Fischer v. Community Health Network, Inc., No. 1:14-cv-1215 (S.D. Ind. Jan. 6, 2020). 13 United States’ Complaint in Intervention at 17–20, 31–35, 51–53, U.S. ex rel. Fischer v. Community Health Network, Inc., No. 1:14-cv-1215 (S.D. Ind. Jan. 6, 2020). 14 Id. at 14.A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r MAY | JUNE 2020 39 for example, the complaint asserts that CHN employment compensation arrangements “essentially doubled the salaries of all cardiovascular specialists.”15 The complaint places the valuations completed for CHN at the forefront of the fact pattern. Upper-level management at CHN allegedly knew of the high compensation levels and was instructed to utilize professional valuation services to obtain justification for the payment amounts.16 CHN is accused of having “shopped around” for favorable valuation opinions and then providing false information to induce a favorable FMV opinion.17 However, according to the complaint, the valuation firms routinely communicated to CHN that the majority of the compensation structures were far above FMV (describing the compensation structures as “staggering” and “astounding”).18 The complaint alleges that compensation and integration strategies were intended to prevent the “leakage” of 15 Id. 16 Id. at 15. 17 Id. at 16. 18 Id. at 15–16. referrals from physicians to competing hospitals.19 One example is CHN’s 2009 breast cancer surgeon integration.20 The complaint states that the integration was premised on and financed from breast surgeon referrals for ancillary services.21 The complaint quotes an internal document from CHN explaining that the compensation structure of the breast cancer surgeons would be partially based on the “reimbursement differential,” i.e., the difference between what Medicare would pay the physicians for an ancillary service (such as imaging and radiation oncology) and what Medicare would pay the hospital.22 In other words, the “reimbursement differential” is alleged to have been used to “fund the integration and pay the physicians their salaries.”23 19 Id. at 18. 20 Id. at 17–31. 21 Id. at 18. 22 There is a reimbursement differential for certain ancillary services because hospitals receive a higher reimbursement compared to physician practices for those services. Id. at 19. 23 This is significant because the Stark Law prohibits compensating hospital-based physicians for the referral of patients to ancillary services (e.g., diagnostic imaging), save for the personally performed professional component (if applicable). Id. at 20. The Value Examiner®—May/June 2016 CPE Exam Office Use Only: Invoice #: Examiner CPE Rev 7/14/16–Page 1 Earn five hours of NACVA CPE*by reading The Value Examiner and For CPE credit, scan and e-mail to: (801) 486-7500, or mail to: 5217 South , UT 84107 Member cost: $76.50 (Non-Member cost: $85.00) Name: Designations: NACVA Member #: Firm Name: IBA Member #: Address: City: State: ZIP: Tel: Fax: E-mail: Check #: (payable to: NACVA) or VISA MasterCard AMEX Discover lub Credit/Debit Card #: Expiration Date: Credit card billing address: Same, or Address: City: State: ZIP: Authorized Signature‡ Date: ‡By signing, you authorize the National Association of Certified Valuators and Analysts (NACVA) to charge your account for the amount indicated. NACVA can also in the event a credit or correction is due. Your signature authorizes NACVA to confirm the use either for future communication. NACVA will not disclose or share this information * This exam does not qualify for NASBA QAS CPE credit. Important note: Although this exam qualifies for NACVA CPE, it may not be accepted by all state boards or accrediting organizations. Therefore, individuals should contact their state board or accrediting to determine if passing an exam after reading a book/magazine meets their CPE State CPE Sponsor #:_______________. Does the IPCPL Make Sense (Part II) By Richard R. Conn, CMA, MBA, CPA, ABV, ERP 1. The IPCPL methodology is founded upon the premise that there is a direct inverse relationship between the firm size (i.e., Enterprise Value) and cost of capital—the smaller the firm, the higher its risk rate. In Part II of his continuing argument against IPCPL, Conn takes the position that:a. He agrees with the premise b. He disagrees with the premise c. He offers no comments either in support of or against the concept 2. BB&D and Gorshunov are really saying both that smaller EV firms have higher costs of capital and that there is a direct correlation between firm EV and its revenues (e.g., smaller firms have lower revenues). However, Conn’s regressions of the actual IPCPL data has led him to conclude that:a.There is a very strong inverse correlation between firm EV and its cost of capital (i.e., smaller EV firms have higher risk rates) b. There is a very strong direct correlation between firm revenues and EV size (i.e., firms with higher revenues have greater EV’s than firms with lower revenues) c. There is no correlation between firm EV and its cost of capital and, at best, only very weak correlation between firm revenues and EV size d. High degrees of correlation is not necessarily an indication of causality The Value Examiner ®—March/April 2016 CPE Exam Office Use Only: Invoice #: Examiner CPE Rev 5/4/16–Page 1 Earn five hours of NACVA CPE* by reading The and completing this exam. For CPE credit, scan and e-mail to: (801) 486-7500, or mail to: 5217 South State Street, Suite 400, 84107 Member cost: $76.50 (Non-Member cost: $85.00) Name: Designations: NACVA Member #: Firm Name: IBA Member #: Address: City: State: ZIP: Tel: Fax: E-mail: Check #: (payable to: NACVA) or VISA MasterCard AMEX Discover Diners Club Credit/Debit Card #: Expiration Date: Credit card billing address: Same, or Address: City: State: ZIP: Authorized Signature‡ Date: ‡By signing, you authorize the National Association of Certified Valuators and Analysts (NACVA) to charge your account for the amount indicated. NACVA can also initiate credit entries to your account in the event a credit or correction is due. Your signature authorizes NACVA to confirm the above information via e-mail and/or fax and to use either for future communication. NACVA will not disclose or share this information with third parties. * This exam does not qualify for NASBA QAS CPE credit. Important note: Although this exam qualifies for NACVA CPE, it may not be accepted by all state boards or accrediting organizations. Therefore, individuals should contact their state board or accrediting organization to determine if passing an exam after reading a book/magazine meets their CPE requirements. State CPE Sponsor #:______________ _. A New Era for Fair Market Value Physician Compensation By Mark O. Dietrich, CPA, ABV 1. Appraisal practice and government enforcement surveys have been employed as a “gold standard” in measuring fair market value for physician compensation for many years. In this article, the author makes the case that this measurement: a. Is the most efficient and accurate way to measure FMV for physician compensation b. Is based on a series of critically flawed beliefs amongst many regulators and appraisers c. Is flawed, but still useful d. None of the above 2. Regarding the question whether or not all physicians will soon be employed by hospitals, the author suggests: to single specialty physicians in private practice considering are the chief employer of specialty physicians in private practice c. Survey data does not exist to support either conclusion d. More research needs to be done to establish specialty physicians considering private practice The Value Examiner ®—July/August 2016 CPE Exam Office Use Only: Invoice #: Examiner CPE Rev 8/31/16–Page 1 Earn five hours of NACVA CPE* by reading The Value Examiner and completing this exam. For CPE credit, scan and e-mail to: fax to: (801) 486-7500; or mail to: 5217 South State Street, Suite 400, Salt Lake City, UT 84107 Member cost: $76.50 (Non-Member cost: $85.00) Announcing—The Value Examiner CPE exam can now be taken online! Visit the exam. There, you will be able to purchase, complete, and earn five hours of NACVA CPE*. You will instantly receive a certificate of completion for each exam you pass. Name: Designations: NACVA Member #: Firm Name: IBA Member #: Address: City: State: ZIP: Tel: Fax: E-mail: Check #: (payable to: NACVA) or VISA MasterCard AMEX Discover Credit/Debit Card #: Expiration Date: Credit card billing address: Same, or Address: City: State: ZIP: Authorized Signature‡ Date: ‡By signing, you authorize the National Association of Certified Valuators and Analysts (NACVA) to charge your account for the amount indicated. NACVA can also initiate credit entries to your account in the event a credit or correction is due. Your signature authorizes NACVA to confirm the above information via e-mail and/or fax and to use either for future communication. NACVA will not disclose or share this information with third parties. * This exam does not qualify for NASBA QAS CPE credit. Important note: Although this exam qualifies for NACVA CPE, it may not be accepted by all state boards or accrediting organizations. Therefore, individuals should contact their state board or accrediting organization to determine if passing an exam after reading a book/magazine meets their CPE requirements. State CPE Sponsor #:_______________. How the New Leases Standard May Impact Business Valuations By Judith H. O’Dell, CPA, CVA 1. The new leases standard will be effective for private companies in: a.Fiscal years beginning after December 15, 2018 b. It is in effect now c. Fiscal years beginning after December 15, 2019 d. December 15, 2019 2. A lease is classified as a finance lease if: a. It transfers ownership of the underlying asset to the lessee by the end of the lease term b. The lease term is for the major part of the remaining economic life of the underlying asset c.The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term d. All of the above 3. After the effective date of the standard, the initial accounting by a lessee for a new lease is: a.Recognition of a lease liability at the present value of the lease payments discounted using the LIBOR rate and a right of use asset equal to lease liability b. Recognition of the right of use asset as the total cost of the lease and a lease liability in the same amount. c.Recognition of a lease liability at the present value of the lease payments discounted using the discount rate for the lease and a right of use asset equal to the lease liability d. Recognition of an asset equal to the value of item leased and a like liability and log in to access an exam. Online exams are available for The Value Examiner issues from 2014 to current. You will be able to purchase, complete, and earn five hours of NACVA CPE* for each exam. You will instantly receive a certificate of completion for each exam you pass. Earn CPE Online by Reading The Value Examiner®! * This exam does not qualify for NASBA QAS CPE credit. Individuals should contact their state board or accrediting organization to determine requirements for acceptance of CPE credit. To learn more, please visit The Value Examiner CPE exam can now be taken online! Next >