Not even twins are comparable-the difficulties in transfer pricing and valuation

I've taken an elective on transfer pricing taught by PwC tax partner Sanjay Tolia, and he jokingly said once that Not even twins are comparable. That inspired me to write this post, given the similarities between transfer pricing and equities valuation.

Although transfer pricing is a particular subset of valuation, it has many unique issues related to perceived equity, performance measurement, global agreements/standards and other aspects which valuation itself does not have. There are no universally accepted standards for valuing equities/real assets(though credit securities/derivatives are now valued using widely accepted models/curves/metrics). But for transfer pricing itself, there is a lot of guidance available in form of the 2010 OECD guidelines and the United Nations guidance on the same. And many tax administration rulings are publicly available for giving valuers an idea of the latest trends, in opposition to  valuation where valuations themselves are not publicly disclosed-at best a boilerplate apology for a valuation a.k.a fairness opinion, is disclosed. Though activist investors & securities regulators prod companies to disclose their valuation opinions/deal rationale, there is not enough public data on the same, and thus little consistency.

But the purpose of this post was to highlight the difficulties in finding comparable transactions/situations for transfer pricing, and finding peer ratios for valuation. In both cases, one desires to understand the arms length transaction valuation benchmark put by the external market. The main difficulties in my view are

1. Lack of timely updated publicly available data
2. Inherent bias in picking peers-you start with the end in mind to maximize or minimize valuations. Hence, those using the valuations must be mindful of that bias
3. Differences not evident on the surface and needs indepth analysis to justify differences. For example, gross margins are influenced by marketing spend(which can support higher selling price) and so operating net margins better explain differences.
4. Everyone will claim their case is unique and therefore not amenable to comparable-especially those unfavorable to that cause. 

Other points exist but these are the main ones in my opinion

Financial Management examples from Indian annual reports

I'm doing a project involving analysis of corporate reporting practices, so that involves poring through plenty of annual reports, investor presentations and conference call transcripts. At times, it feels like digging for a needle in a haystack, but when you strike gold, it feels good! Below are some examples

1. Contribution per unit of limiting factor:- When resources are scarce, one goes for the project which maximizes contribution per unit of limited factor(like power, raw material, labour etc). In FY 2010-11, the merchant power prices fell, so  the net payback per unit of power  from Chloro-Vinyl products was better  than  from  sale of power, and thus DCM Shriram increased  production  of  Chloro-Vinyl
2. Marginal Costing:- Typically, one assumes that since overheads have been fully absorbed, producing to above normal capacity will result in more contribution margins. But when DCM Shriram produced fertilizer over and above their normal/assessed capacity. The additional production was at very low margin as it was on high cost, spot price gas,for which no long term PPA/gas allocation had been done.
3. Working Capital linkage to business models:-Subcontractors typically have less bargaining power and must operate with positive working capital to finance their main contractors! As Voltas explains in its Mar-11 outlook, the change in business profile has resulted in their being sub-contractor to the turn-key-main-contractors. This results in a longer chain for submission of bills and claims and
   their approval as also the flow of money. This has resulted in the receivable cycle getting
   elongated, and therefore, higher working capital.  
4. Contract costing and measurement:- Companies in infrastructure sector book revenues and profits using percentage completion method, and partly basis their estimated gross profit ratio. In FY2010-11, Voltas noticed for their subsidiary Rohini Industrial Electricals, that contrary to the trend of final margins exceeding estimates used in accounting, there was a negative difference. Hence, it had to reverse some previously booked profits, because the estimated input costs went up etc. This would not have been found out without a good MIS. 
5. Measuring Customer Profitability/Valuing intangibles:- Intangibles testing under AS-28 mandates that companies should check atleast annually whether the goodwill(overpayment during M&A) they paid for is still worth it or not. Even if economic conditions are stable, strategic changes etc may prompt writing it down. For example, HCL Technologies had this note During the quarter and year ended June 30, 2011 the Company tested all intangibles, keeping in mind its strategy for
   investment and focus on few service lines which will drive future growth. It also evaluated  certain customer related intangibles which were being amortized over their useful life. The evaluation was also done with reference to specific customers acquired through acquisition by re-estimating the cost of capital, revenues, profits and the likely period of relationship. Accordingly the Company recorded a onetime impairment charge of Rs. 119.3 Crores. 
6. Data consistency for decision making:- Often, management accounting, R&D and impairment testing operate from different data points, even in an ERP environment. That is why Glenmark's policy for R&D project management ensures this as its policy(in FY201-11 AR) is to require a detailed forecast of sales or cost savings expected to be generated by the intangible asset. The forecast is incorporated into the Group’s overall budget forecast as the capitalisation of development costs commences. This ensures that managerial accounting, impairment testing procedures and accounting for internally-generated intangible assets are based on the same data.
7. Standard Costing of inventory in seasonal business:- In a seasonal industry like tea, the overheads incurred in non plucking season will not reflect the realistic standard costs. That is why the world's largest tea producing company Mcleod Russel explains its inventory costing policy as follows stock of bulk tea has been valued at lower of estimated cost of production(based on estimated production and expenditure for the financial year) and net realizable value.Production of tea not being uniform for the year, stock valuation will be unrealistic if based on actuals. Strictly speaking, this standard cost is nothing but budgeted cost in this case.
8. Pricing in payment delays:- Those dealing with Govt departments would know the 'last quarter effect' and the invariably delayed payments. Educomp, which handles some ICT in Govt schools reveals in its FY11 annual report that As a proactive measure, at the tendering stage only, cost of
   payment delays are being built into the price of product/ services offered. 
9. Operating Leverage:- Educomp offers a 'Smart Class' solution to schools where an entire classroom is digitized. If schools purchase the solution for additional classrooms, the rate is presently(in Aug-11) Rs 2.6Lakh/classroom-year versus Rs 4 lakh for new schools. That is because they do not have to install a fresh server.  These classrooms get plugged on to the existing server in the school and quality assurance person from Educomp deployed at the school, remains the same.

I'll update this with new examples when I chance across them.