Complete overview 1 best read – Order or production backlog

Order or production backlog

In a Business Combinations, this is a intangible asset and is therefore recognised separately from goodwill, provided that its fair values can be measured reliably. This marketing-related intangible asset meets the definition of an intangible asset because it arises from contractual or other legal rights.

An order or production backlog arises from contracts such as purchase or sales orders. An order or production backlog acquired in a business combination meets the contractual-legal criterion for identification as an intangible asset, even if the purchase or sales orders are cancellable.

Customer backlog calculation model

In using the customer backlog calculation model there are two things of importance:

  1. determine the weighted average cost of capital (WACC), or present value factor/discount rate, and
  2. determine the backlog of firm/confirmed orders at acquisition date.

The weighted average cost of capital Order or production backlog

Generally, the weighted average return determined by the acquired net assets (WARA) should be within a reasonable range of the WACC of IRR contemplated in the acquisition valuation deal, which was the basis of negotiating a transaction price.

The weighted average cost of capital (WACC), or discount rate, should be considered for each entity. Generally, the WACC for acquired entities should have a 100-500 bp premium to Value’s consolidated WACC, given the smaller company size and inherently greater risk. Therefore, if Value’s WACC has averaged 11-12% in recent years, then the acquiree’s WACC would be expected to be higher than this. WACC’s of recent acquirees have ranged from 12.5% to 20%. Order or production backlog

A model to determine the WARA is as follows: Order or production backlog

Order or production backlog

* This should represent the discount rate used to value the subject intangibles in the valuation templates.

Rates of return for each asset class are estimated based on the risk/return characteristics of each asset class. Generally speaking, the rate of return required for working capital, tangible and other assets is less than the WARA, while the rate of return for intangible assets is greater than the WARA.  Order or production backlog

Additionally, the rate of return for intangible assets is generally at a 100-300 bp premium (hypothetical assumption) to the entity WACC based on the risk profile of the asset, and the rate of return for goodwill is typically at a higher premium than the rate of return for identifiable intangible assets since it is inherently more risky. Order or production backlog

The backlog of firm-confirmed orders Order or production backlog

The valuation of backlog is complex since one needs to consider how it relates to any value ascribed to customer relationships and inventory, to ensure that value is not “double counted”. Backlog would typically be valued separately from customer relationships only if there is a significant amount of SPECIFIC committed orders. Order or production backlog

These would need to be signed contracts for specific products/services at specified prices to be delivered at specific times, and would not include generic orders. If cash has already been received for some portion of revenue in backlog, this may already be captured in the deferred revenue value (but if this runs off quickly deferred revenue may not be separately valued).

Essentially, for existing customers, there may be some value ascribed to backlog of firm/confirmed orders at the acquisition date, with other value assigned to the general customer relationship for the value of future orders.

Then, if some portion of the confirmed orders has been billed, this may be contemplated in the deferred revenue value so the only part of backlog to be considered for valuation may relate to that which is still unbilled. Then it is further necessary to adjust the backlog valuation by step-up relating to inventory on hand that will be used for orders in backlog.

Something else -   The acquisition method

A backlog intangible would be amortized to income over the period that the related backlog is realized as revenue.

A model for calculating the net present value of the backlog of firm-confirmed orders is as follows:

Order or production backlog

Order or production backlog Order or production backlog Order or production backlog Order or production backlog Order or production backlog Order or production backlog Order or production backlog

Order or production backlog

(1) Backlog revenue should represent signed purchase orders for specific products/services from customers that have not yet been fulfilled. This should represent backlog revenue existing at the date of acquisition, scheduled out over the periods expected to be realized. So if acquisition took place at the beginning of April, this would represent revenue in backlog to be filled over April-Dec for the first year. Order or production backlog

(2) If an inventory step-up is calculated, a judgment call needs to be made to assess what proportion of the inventory and therefore inventory step-up (on a cost basis) will be used to fill sales reflected in backlog. If it is a high-turnover activity, it might be reasonable to presume that all of the WIP/FG inventory on hand may be used to satisfy backlog, so all step-up should be deducted.

But if the backlog is for very specific products or projects, then an estimate will need to be made as to the portion of the inventory step-up applies, e.g. 25%, 50%, etc. If less than 100% applies to specific backlog revenue, then typically the remaining inventory step-up would be deducted within the general customer relationship valuation model.

(3) Represents estimated EBITDA margin, increased by sales/marketing expense (likely not more than 0% – 2%, given industrial nature of the Value businesses). This is intended to take into account that the selling/marketing expenses related to work in backlog (already under contract) have already been incurred. Order or production backlog

(4) The contributory asset charge represents the cost for the use of other assets of the business such as net working capital, fixed assets, and assembled workforce. For Value, a pre-tax charge of approximately 5% of average revenue is considered reasonable on the basis of past acquisitions. This factor should only be changed if the revenue stream is expected to require a higher or lower than normal use of these assets to be achieved. Order or production backlog

(5) This represents a deduction for the use of other valued intangibles, such as trade names or other technology. In each case, this should be equal to the royalty rate used to value the other intangibles, adjusted if the revenue streams are different. For example, if the trademarked product only relates to 75% of the revenues (i.e. only 75% of the revenue stream used in customer relationships is generated by trademarked product), then only 75% of the royalty rate should be used herein.

(6) Used an estimate of 27.5% of present value of base cash flows as a proxy for the present value of the tax benefit (instead of calculating a benefit over 15 years – typical tax life of intangibles – since this model does not extend beyond a few years). This could be a lower percent if the income tax expense is well below the 30%-35% range, since the tax benefit would be less.

(7) Since backlog should be reflective of guaranteed sales, the risk tends to be less than that for the general customer relationships. Therefore, it would be appropriate to use a discount rate that is no more than, and often a bit less than, the discount rate used to value customer relationships. Typically this discount rate would be closer to the WACC or at a slight premium (but less of a premium than for customer relationships). Order or production backlog

Example business combination

Amalgamated Fast Foods Ltd (AFF) is a public company listed on the JSE Limited in South Africa. The company is Africa’s leading fast food restaurant franchisor. In order to expand their business, AFF purchased an 85% shareholding in Shisa Nyama Ltd (Shisa Nyama) on 1 March 20.14. Each share entitles the shareholder to one vote. Order or production backlog

Shisa Nyama is a franchise fast food restaurant specialising in flamed-grilled meals. Shisa Nyama’s restaurants are located all over South Africa. From 1 March 20.14, AFF had control of Shisa Nyama in accordance with IFRS 10 Consolidated Financial Statements. Both companies have a 28 February year end. Order or production backlog

The following draft trial balances as at 28 February 2015 are presented to the Due Diligence experts working on behalf of AFF (the amounts have been investigated and found correct, except where otherwise indicated in the information below):

Something else -   Investments in Joint Ventures Overview

Order or production backlog

Investment in Shisa Nyama

The purchase agreement stipulated that the consideration for the 85% interest in Shisa Nyama consisted of the following:

  • A cash amount of R250 000 which was paid on 1 March 2014.
  • 500 ordinary shares issued by AFF. The market price of AFF’s shares was R800 per share on1 March 2014, and R850 per share on 28 February 20.15. The share issue costs amounted toR50 000. AFF’s accountant, Well & CO, debited the investment in Shisa Nyama account with the R50 000 share issue costs. Order or production backlog
  • A further R300 000 will be paid to the former shareholders on 1 March 2018.
  • The consideration also includes an amount of R375 000 to be paid in cash to the former shareholders on 1 March 20.17, if the profits generated by Shisa Nyama during the period 1 March 2014 to 28 February 2017 increase by 120% above the current level. The fair value of this obligation on acquisition date, taking into account the probability and time value of money, was R285 620. At 28 February 20.15, the sales of Shisa Nyama declined slightly and the fair value was re-estimated at R275 654.
  • An amount of R35 620 was paid to an attorney to draw up the purchase agreement as well as the valuation of the shares. These costs were already included in the cash amount of R250 000 paid by AFF on 1 March 2014.

Well & CO only accounted for the cash payment of R250 000 and share issue costs in the separate financial statements of AFF.

All the assets and liabilities of Shisa Nyama were deemed to be fairly valued on acquisition date, with the exception of the following:

  • Braai equipment with a carrying amount of R761 626 had a fair value of R850 000 on 1 March 2014.  AFF however indicated that after the acquisition they intend to stop the use of this specific braai equipment due to the equipment’s carbon emissions, and subsequently valued the braai equipment only at R800 000 on 1 March 2014. The equipment was originally purchased on 1 September 20.12 and had a useful life of five years on this date. This estimate has not changed since the acquisition of the braai equipment. Order or production backlog
  • Shisa Nyama also distributes bottles of their braai sauce to retailers. Due to a nationwide shortage of the braai sauce’s secret ingredient, Shisa Nyama had a contractual order backlog for 60 boxes of sauce on 1 March 20.14. The fair value of this order backlog amounted to R45 000 on 1 March 2014. The order backlog was completed and distributed by the end of November 2014. The price for a box of sauce remained unchanged for the duration of the current financial year.
  • No additional assets, liabilities or contingent liabilities were identified at the acquisition date.
Something else -   Extra disclosures IFRS 15 contracts

At acquisition the order backlog will be recognised as an intangible asset in terms of IFRS 3 13. Also refer to IFRS 3 IE25 for further guidance on the recognition of intangible assets not previously recognised by the acquiree. Order or production backlog

The order backlog will be included in the acquisition balance sheet as follows (only the two lines of the acquisition balance sheet):

Amounts in R Order or production backlog

DT

CR

BS – Intangible asset – Order backlog Order or production backlog

45,000

BS – Deferred tax on order backlog – 28% tax rate Order or production backlog

12,600

The intangible asset (order backlog) will subsequently be amortised over its useful life (time to complete the order backlog so until end of November 2014) and the following journal will be processed after acquisition, when the backlog is completed (in quarterly or monthly progress depending on the frequency of reporting management information):

Amounts in R Order or production backlog

DT

CR

PL – Amortisation Intangible asset – Order backlog

45,000

BS – Intangible asset – Order backlog Order or production backlog

45,000

BS – Deferred tax on order backlog Order or production backlog

12,600

PL – Deferred tax credit Order or production backlog

12,600


Just to illustrate the sales volume of backlog in some industries some quotes in the Airbus Annual Report 2018 (page 24)

Q. What drove the big increase in underlying profit?
Firstly, as a reminder, we adopted the IFRS 15 accounting standard in 2018 which means we have restated the relevant figures for 2017. In particular, the year-end backlog value of R 460 billion is now measured under IFRS 15 and reflects an assessment of recoverability and net transaction price for air-frame and engines. The significant reduction compared to 2017 – which has not been restated – is mainly due to the use of net prices versus catalogue prices.

Also read: Business Combinations AU Gov

Order or production backlog

Order or production backlog

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Something else -   First IFRS financial statements

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