Fair Value for Healthcare Entities’ Financial Reporting

1. Fair Value for Healthcare Entities’ Financial Reporting Decosimo Advisory Services Shannon Farr, CPA•ABV•CFF

3. Objectives Identify the various standards and standard-setting bodies involved in fair value determinations for healthcare entities Understand the differences between fair value and fair market value – and the circumstances in which each applies Discuss the variety of circumstances healthcare entities encounter requiring a fair value or fair market value determination Accounting for acquisitions – understand the purchase price allocation process Identify specific intangible assets commonly found in healthcare organizations and methods of valuing those assets Evaluate recent guidance on contingent consideration Understand the GAAP impairment requirements and order of testing regarding long-lived assets; goodwill; and specifically-identified, indefinite-lived intangible assets

4. Alphabet Soup: Valuation Credentials and Authoritative Standards and Bodies AF USPAP IRC ASA FASB CPA ABV CFA ASC ASU CBA MCBA AVA AVC CM&AA AICPA NACVA SSVS CVA One of these is not a real organization, set of standards, or credential – do you know which?

5. Fair Value for Financial Reporting Applications in Healthcare • Who? All entities preparing GAAP financial statements • What? • Purchase price allocations (acquisitions): how much did you pay? And, what did you get? • Goodwill impairment: Is it still worth it? • Stock-based compensation: what are these shares I’m issuing to employees and executives worth?

6. What is Fair Value? • Fair value is The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

7. Healthcare Fair Market Value • IRS definition (applies to transactions and agreements of nonprofit entities) the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

8. “Healthcare” Fair Market Value (FMV) The fair market value standard typically applies in a healthcare transaction. Stark Regulation 420 CFR 411.351 defines FMV as follows: …the value in arms-length transactions consistent with the general market value. ‘General market value’ means the price that an asset would bring as the result of bona fide bargaining between well-informed buyers and sellers who are not otherwise in a position to generate business for the other party; or the compensation that would be included in a service agreement as a result of bona fide bargaining between well-informed parties to the agreement who are not otherwise in a position to generate business for the other party, on the date of acquisition of the asset or at the time of the service agreement. Usually, the fair market price is the price at which bona fide sales have been consummated for assets of like type, quality, and quantity in a particular market at the time of acquisition, or the compensation that has been included in bona fide service agreements with comparable terms at the time of the agreement, where the price or compensation has not been determined in any manner that takes into account volume or value of anticipated or actual referrals. With respect to rentals and leases described in §411.357(a), (b), and (l), “fair market value” means the value of rental property for general commercial purposes (not taking into account its intended use).

9. One of these things is not like the other… Healthcare Fair Market Value (regulatory compliance): Acquisitions of healthcare entities, Physician-employment agreements, Physician on-call and coverage arrangements, RVU-based compensation arrangements, Medical director service agreements, Management services contracts between physicians and hospitals, Clinical co-management arrangements, and Joint ventures and “under arrangements.”

10. Or are they? • The Stark Law “general market” concept is very similar to the FASB’s “market participant” concept • So what does that mean? • Fair value and “healthcare fair market value” are both determined without regard to a specific buyer’s synergies

11. Fair Value GAAP FASB Accounting Standards Codification (ASC) Topic 820, Fair Value Measurements and Disclosures Goodwill impairment – ASC Topic 350, Intangibles – Goodwill and Other (formerly SFAS No. 142) Purchase price allocation – ASC 805, Business Combinations (formerly SFAS No. 141R) Stock issued as compensation – ASC 718, Compensation – Stock Compensation Note: While originally excluded from the requirements of SFAS Nos. 141 and 142, ASC 958 (formerly SFAS No. 164) extends the business combination and annual goodwill impairment testing requirements to not-for-profit entities for fiscal years beginning after December 15, 2009.

12. Market Participants Physician medical groups – after 10 or so years, hospitals and integrated delivery systems have been returning as buyers of physician practices: Source: Irving Levin Associates, Inc., The Health Care Services Acquisition Report, Seventeenth Edition, 2011)

13. Market Participants, continued • Home health care – of 43 announced deals during 2010: • 12 publicly-traded corporations announced 26 deals • 10 privately-held and 7 nonprofit organizations announced 1 deal apiece: these organizations were hospitals, senior care companies, and one private equity group. • Laboratory, imaging, and dialysis – of 41 2010 announced deals: • 11 publicly-traded corporations announced 24 deals • 11 privately-held and 4 nonprofit organizations announced 1 deal apiece (1 privately-held company made 2 acquisitions) • 21 imaging deals comprised 51% of the total followed by laboratory services (14 deals/34%) and dialysis (6 deals/15%)

14. Purchase Price Allocation

15. Purchase Price Allocation Purpose Timing GAAP guidance

16. What is the Purchase Price? Now includes not only cash and value of equity issued to the seller at closing, but also the fair value of any “contingent consideration”

17. Contingent Consideration • What is “contingent consideration”? • An obligation of the acquirer to transfer additional assets or equity interest to the selling shareowners of a target if specified future events occur or conditions are met • Commonly referred to as “earn outs” • SFAS 141R (ASC 805) – recognize fair value at acquisition, remeasure as new information becomes available • Remeasurement is required at every balance sheet date • How is fair value at acquisition determined? • Probability distribution of the outcomes • Option pricing methods

18. Contingent Consideration • For acquisitions completed prior to 2009: • Payments of contingent consideration (earnouts) are recorded typically as an increase to goodwill when paid (or conditions are met) • For recent acquisitions (new guidance) • The fair value of the earnout provisions must be determined as of the closing date and recorded with the acquisition

19. Contingent Consideration • In theory, the amount that would be paid to a market participant to assume the contingent consideration liability must be determined. • In practice, a valuation model must be tailored to each contingent consideration agreement considering the specified: • performance metrics, • measurement periods, • performance hurdles, and • payment terms.

20. A Real-life Example • The following disclosure is made by MedNax (formerly Pediatrix) in Note 6, Business Acquisitions, to its 2010 financial statements, as part of its discussion of its 2010 acquisitions of 15 physician group practices: “The contingent consideration of $10.6 million recorded during 2010 is related to agreements to pay additional amounts based on the achievement of certain performance measures for up to five years ending after the acquisition dates. The accrued contingent consideration for each acquisition was recorded at acquisition-date fair value using the income approach with assumed discount rates ranging from 3.0% to 6.0% over the applicable terms and an assumed payment probability of 100% for each of the applicable years. The range of the undiscounted amount the Company could pay under the contingent consideration agreements is between $0 and $12.1 million.”

21. PPA: What Did you Buy? • Working capital assets, net of liabilities • Potential issues in determining the fair value of accounts receivable, if acquired • Fixed assets • Need a fixed asset appraisal of significant land, buildings, and equipment acquired • Identifiable Intangible Assets • Goodwill

22. What is an Identifiable Intangible Asset? It is capable of being separated from the entity and sold, transferred, licensed, rented or exchanged, either individually or with a related contract, identifiable asset, or liability (regardless of whether there is intent to do so) OR It arises from contractual or other legal rights

23. Identifiable Intangibles Common in Healthcare Marketing-related: trademarks or tradenames, internet domain names Patient-related: patient lists or files, referral relationships Contract-based: non-compete agreements, payor contracts, employment contracts, certificates of need, provider numbers, Joint Commission accreditation, management agreements, lease agreements Technology-based: proprietary technology, patents or formulas Workforce-in-place is always considered part of goodwill

24. Approaches to Measuring the Fair Value of Identified Intangible Assets • The Cost Approach • Based on the economic principle of substitution: the value of the intangible asset is the estimated cost to either purchase or construct an asset of equal utility • The Market Approach • The value of the intangible asset is estimated by identifying and analyzing the price at which similar assets have been exchanged between willing buyers and sellers • The Income Approach • The value of the intangible asset is equal to the present value of the expected income to be earned form the ownership of the asset

25. Approaches and Techniques to Measuring the Fair Value of Identified Intangible Assets • The Cost Approach • Replacement cost method • Reproduction cost method • The Market Approach • Relief from royalty method • Comparable transactions method • The Income Approach • The profit split method (25% Rule) • The excess earnings method • Loss of income (scenario) method • Multi-period excess earnings method

26. Assembled Workforce Although the value of the acquired entity’s assembled workforce is always recorded as part of goodwill, it is useful to estimate the value of the assembled workforce and consider that value in relation to the concluded value of goodwill (in other words, the total assigned to goodwill should be at least equal to the value of the assembled workforce). The value includes factors such as: the cost to recruit, hire and train new employees of comparable experience and expertise The value is typically estimated as a percent of total compensation for various classifications of employees (i.e. the % of compensation used in the cost estimate related to employee-physicians and registered nurses will be higher than that used for receptionists and clerical personnel).

27. The Income Approach: Discounted Cash Flows Typically used for the primary (i.e. the perceived most important specifically-identified intangible asset acquired in the deal). Involves estimating an income or cash flow stream and an appropriate discount rate reflecting the risk of the cash lows The most important consideration: The measure of economic income (cash flows) used in the valuation of an intangible asset must relate only to income generated by the subject intangible asset Which begs the question: how are cash flows from a specific intangible asset isolated? The answer: contributory asset charges

28. Contributory Asset Charges The measure of economic income used in the valuation of an intangible asset must relate only to income generated by the subject intangible asset. For example, the primary specifically-identified intangible asset in many deals is a certificate of need. However vital to the success of the acquired entity, a certificate of need must be accompanied by other assets, such as working capital, necessary equipment, and a trained and assembled workforce. To determine the value of the primary intangible asset, first determine the value of the other intangibles, then compute contributory asset changes to isolate cash flows from the primary asset.

29. Noncompete Agreement Valuation Example Noncompete agreements restricting the former owners of an entity from competing within the local market are commonly seen in healthcare transactions Certain legal restrictions may inhibit enforceability The value of a noncompete agreement can be determined based on two factors: 1. The likelihood that the former owner(s) would compete in the absence of the agreement, and 2. The percentage or dollar amount of future revenues that would be lost to that competition.

30. Noncompete Agreement: Simplified Example Step 1

31. Noncompete Agreement: Simplified Example Step 2

32. Common Sense Always Applies All else being equal, a certificate of need acquired through an acquisition in a state or market designated as sufficiently covered (i.e. new certificates of need for that service are not anticipated in the future) will be more valuable than a certificate of need acquired in an area allowing new entrants to compete in the market. FACTS and CIRCUMSTANCES must be considered

33. Other Purchase Price Allocation Issues Calculating the tax amortization benefit associated with each identified intangible asset The excess of purchase price over the values assigned to all identified assets and liabilities is goodwill Estimating the useful lives of identified intangible assets Comparing the Weighted Average Return on Assets (WARA) to the Weighted Average Cost of Capital (WACC) Goodwill and identified intangible assets with indefinite lives must be evaluated annually for impairment

34. Goodwill Impairment

35. Goodwill Impairment Testing Basics Goodwill is tested for impairment at least annually using the two-step test prescribed in ASC 350 However, a recent Accounting Standards Update (ASU) allows a “Step Zero” qualitative assessment

36. The Step-Zero Impairment Assessment • Qualitative factors for management to consider prior to the performance of the two-step impairment test include the following: • Macroeconomic conditions: a deterioration in general economic conditions, limitations on accessing capital, fluctuations in foreign exchange rates; • Industry conditions: a deterioration in the market in which an entity operates, increased competition, a decline in market-dependent multiples or metrics, or a regulatory or political development; • Cost factors: increases in raw materials, labor, or other significant costs; • Overall financial performance: negative or declining cash flows; • Entity-specific events: changes in management or key personnel, changes in strategy, contemplation of bankruptcy, litigation issues, etc.

37. The Step Zero Assessment • If qualitative assessment indicates that “it is more likely than not” that the fair value of a reporting unit is less than its carrying amount, the entity is required to proceed to Step 1 of the goodwill impairment test

38. The Two-Step Goodwill Impairment Test (ASC 350) • Step 1 – identify potential impairment by comparing the fair value of a reporting unit to the carrying value of that reporting unit • New guidance on evaluating reporting units with negative carrying amounts (e.g., debt has been assigned to the RU): an entity cannot assume goodwill is not impaired • Step 2 – if goodwill is potentially impaired, recognize and measure the amount of the impairment loss

39. Reporting Unit (RU) Identification A reporting unit is defined as an operating segment or one level below (also known as a component) A component of an operating segment would be considered a reporting unit if it is 1) a business, 2) has discrete financial information, and 3) segment management routinely reviews that financial information Components that share similar economic characteristics are aggregated

40. Reporting Unit Assets and Liabilities • Assets and liabilities must be thoughtfully assigned to one or more (in the case of shared assets) reporting units considering both of the following criteria: • The asset will be employed in, or the liability relates to The operations of the RU AND • The asset or liability will be considered in determining the fair value of the reporting unit

41. What Does that Mean? If debt or other liabilities are assigned to the RU, decreasing the carrying value (and the potential for impairment) THEN the settlement of that debt or other liabilities must be reflected as a reduction of cash flows in determining the fair value of the reporting unit

42. Common Techniques used to Measure the Fair Value of the RU Discounted cash flow (DCF) method Guideline public company method Guideline transaction method

43. DCF Key Inputs • Prospective financial information (PFI) • Discrete period cash flow (often 3 to 5 years) • Terminal cash flows • Discount rate • Long-term growth rate

44. Prospective Financial Information • Incorporate Recent Developments • Future infrastructure requirements • Healthcare reform effects on revenue • “New era” impacts on profitability

45. Discount Rate Associated with risks facing the RU Determined with consideration to qualitative factors similar to those outlined by the ASU allowing the Step Zero assessment

46. Long-term Growth Rate Represents the long-term growth of net cash flow Must consider the positive effects of increased demand due to the aging population offset by pressure on profits due to decreasing reimbursement rates Very unlikely to exceed long-term anticipated growth of GDP as a whole (around 2.5% - 3%)

47. Guideline Transaction Method Uses information from acquisitions of comparable companies Generally considered of limited use in healthcare valuations because of the relatively extreme differences in local and/or state markets in which healthcare entities operate

48. Guideline Public Company Method The GPC uses information on multiples of similar publically-traded companies to derive a value for the reporting unit Especially useful for hospitals, home health care, and ambulatory surgery centers

49. Current Industry Multiples

50. Applying GPC Multiples Determine which multiples are the most relevant Evaluate whether adjustments to the GPC financial metrics are necessary Apply selected multiples to the RU financial metrics Evaluate results Consider whether a control premium is necessary