Wiley Guide to Fair Value Under IFRS

International Financial Reporting Standards

James P. Catty, James P. Catty

• Publisher: Wiley
• Year: 2010
• ISBN:
  9780470597361
• Edition: 1
• Topic: Manuali di studio
• Subtopic: Guide di studio CPA (Certified Public Accountant)

Your one indispensable guide to all the Fair Value requirements of IFRS

Acomplete guide to the complex valuation requirements of IFRS, this book includes chapters on theoretical and practical applications, with extensive examples illustrating the required techniques for each application.

Appropriate for anyone involved professionally with finance—managers, accountants, investors, bankers, instructors, and students—this guide draws on a stellar panel of expert contributors from fourteen countries who provide international coverage and insight into a diverse range of topics, including:

• Fair Value in implementing IFRS
  
  

• Market Approach
  
  

• Income Approach—Capitalization and Discounting Methods
  
  

• Economic and Industry Conditions
  
  

• Cost of Capital
  
  

• Financial Statement Analyses
  
  

• Impairment Testing
  
  

• Intellectual Property Rights (patents, copyrights, trademarks)
  
  

• Projecting Financial Statements
  
  

• Liabilities
  
  

• Customer Relationships
  
  

• Share-based Payment
  
  

• Plant and Equipment
  
  

Guide to Fair Value Under IFRS is the first international valuation book of its kind. Fully compliant with the Certified Valuation Analyst curriculum, it provides detailed guidance as to how fair value is to be determined and fills numerous gaps in common understanding of IFRS requirements.

1 FAIR VALUE CONCEPTS

ALFRED M. KING

UNITED STATES

INTRODUCTION

Being asked to write about fair value concepts for a book with numerous chapters, each dealing with an aspect of fair value for International Financial Reporting Standards (IFRS), by an expert in the field implies that the general editor believes the author has some specialized knowledge of the subject, based on 40 years of active experience. The author will do his best not to disappoint. In this chapter, the terms “fair value” and “fair market value” are capitalized when they refer to the latest definition in the United States.

HISTORIC EXPERIENCE

The concepts underlying fair value for financial reporting draw on the more than 100 years of valuators’ experiences. In that context, our activities today bear only a passing relationship to the work performed by our predecessors. Within the past 10 years, major changes have occurred in our firms, as the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have incorporated their ideas of fair value into financial reporting. At the outset, it should be understood that those concepts, as used in both IFRS and generally accepted accounting principles (GAAP), are merely a subset of the more generalized experience developed in the derivation and application of (fair) market value in tax practice in many countries; while the names are confusingly similar, the concepts are very different.

Taxes

The definitions and underlying concepts of the traditional “standard of value,” fair market value, cover applications designed to provide useful information for a range of disparate purposes—from insurable values at the high end, through tax amounts, to bankruptcy realizations at the low end. Until quite recently, most valuations pertained, in one way or another, to business transactions.

In fact, there have been three distinct waves of interest in valuation. The original use was not for financial reporting but to determine tax liabilities. In the ancient world, Egypt, Babylon, Greece, Rome, Persia, and China all taxed an individual’s or a partnership’s assets, which needed a valuator. In those eras, a valuator, serving as a tax assessor, could be a very important individual. Often, after a king died, his ministers were killed and buried with him; in many cases, the tax valuator was the only one spared, as the heir needed that person’s knowledge. Later, in the year 10 A.D., China introduced an income tax; fortunately, it soon vanished, until the British reintroduced it in 1798 to pay for their fight against Napoleon; after that, it again disappeared for nearly a century. In the United States, the income tax started in 1861 to finance the North in the Civil War; again, after the conflict, it was dropped until 1913. During the past five decades, taxation of capital gains has become almost universal, leading to intensification in the use of tax valuations.

Business Transactions

The second use, which soon followed, was to obtain neutral and unbiased conclusions relating to actual or proposed business transactions. Since, by definition, the valuator had no financial interest in the transaction or its outcome, his initial role was that of “honest broker.” In 1821, the Hudson’s Bay Company, incorporated in 1670, acquired the North West Company, its principal competitor in the Canadian fur trade. As part of the transaction, all the assets of the two entities, in Canada, London, and at sea, had to be valued.

The assistance of a valuator allowed:

• Insurable values to be determined based on professional judgment.

• Buy and sell agreements settled by a neutral observer.

• Purchasers of securities assurance that they were not overpriced.

• Prospective sellers to know the amount at which one asset could be sold, or another item bought, without informing the market about a possible deal.

While there are almost always parties with differing interests in business, when it comes to taxes, appraisers have to be particularly careful not to become advocates. Clients want low figures for property taxes and either high or low, depending on the circumstances, for income taxes. Within the bounds of professional practice, valuators always try to help their clients. By the second half of the twentieth century, the profession in much of the world had split into three branches: real-estate appraisers, business valuators, and security analysts. The contributors to this book include all of them.

Financial Reporting

After centuries, a recent, third step in the use of valuations has arrived: the push by accounting regulators to incorporate fair values into financial statements. Businesses have long been perceived by investors as always looking for the most favorable accounting and financial reporting treatments so as to convey as optimistic an outlook as possible. The increasing use of fair value information is perceived by regulators, analysts, and investors as a more objective approach to financial reporting, a tool that may help or hurt the entity. In turn, this belief has placed great pressure on valuators to arrive at “correct” answers that enhance the objectives of financial reporting.

IASB and FASB have agreed to move toward a convergence of financial reporting standards, with the ultimate objective of GAAP users completely converting to IFRS standards. At the time of writing (March 2009), it appears that the push for rapid convergence, followed by conversion, has slowed down. Nonetheless, it is inevitable that GAAP and IFRS will come together, particularly with respect to fair value information. This chapter deals with the subject as it is currently conceived and used.

IASB, however, has announced that an exposure draft for a new IFRS standard on fair value measurement will be issued in the second quarter of 2009. This is anticipated to follow closely Statement of Financial Accounting Standards (SFAS) 157 with some variations; the expected differences are set out in the appendix to this chapter.

Fair Value

The entire push to fair value accounting and disclosure seems to be predicated on the fundamental assumption that a true estimate of fair value can be developed and disclosed and that the world will be a superior place because of this “better” financial reporting. Unfortunately, that fundamental premise is deeply flawed; massive efforts by many professionals have failed to communicate that valuation involves a vast amount of judgment. Therefore, any fair value conclusions are far from precise and perhaps not even totally reliable.

Analysts, accountants, and standard setters have trouble with the idea that the same asset can have different values for different owners or for different purposes. Accountants consider their activities, though many involve assumptions, estimates, and judgments, to be precise and expect that valuation should have equal “precision.” Of course, as those who actually perform valuations know, the very concepts of Fair Value or Fair Market Value are difficult to pin down.

IMPORTANCE OF JUDGMENT

This section discusses the role of judgment in the determination of each of the two separate concepts, which have many critical differences. After the profession had spent over 100 years developing Fair Market Value, in June 2001, FASB introduced fair value with SFAS 141, followed in September 2006 with a new definition in SFAS 157, which totally changed the fundamental concept and instituted a brand-new approach to value, as discussed subsequently. In general, IASB has been an acquiescent follower.

Professional judgment is always involved in a valuation, even if only with respect to knowledge of the asset or business; no one would hire a real estate specialist to determine the fair market value of antique furniture, nor a financial expert for insurable values of machinery or equipment. However, these distinctions, while well known and understood, deal only with training and experience. A different, also important, kind of judgment, which users of valuation information often disregard, is that normally there is really not a single answer but a range of correct answers in any specific valuation situation, whether for real estate financing, placement of insurance, or an allocation of the purchase price in a business combination.

Valuators have created the regrettable situation where clients receiving an appraisal report feel that the indicated amount is in fact “the” value. Most end up with a single-point estimate, a number that is sometimes carried to five significant figures; such deterministic answers actually promote confidence because of their seeming precision. However, in our view, this aura of precision is the cause of much of the discussion regarding weaknesses in fair value, its determination, and its use in financial reporting.

In the course of an assignment, every skilled appraiser inevitably has to make many individual decisions. These choices—and they are choices—rarely show up in the narrative reports and certainly are invisible to those reading them. If two equally skilled valuators were given the same assignment but did their work entirely independently, it should not surprise anyone that their conclusions may differ. Yet many ordinary nonprofessional recipients are surprised when two seemingly equal valuators come up with conflicting amounts; in this author’s view, they should be within 10 percent of each other, but not necessarily any closer.

The target audiences for the realities of valuation have to be (1) setters of accounting standards; (2) auditors who try to make sure that complex accounting rules are being faithfully followed; and (3) preparers of financial statements. Those groups, however, still generally believe that there is a single “true” fair value, which should be determined and then disclosed. That the same asset can have far differing values to various people for diverse purposes is not yet fully accepted. When preparers of financial statements complain about the difficulty and cost of obtaining fair value information, or protest about its relevance, some security analysts and academics often assert that “the company does not want to disclose Fair Value because they have something to hide.”

There are at least three different premises of value: value in use, value in exchange, and value in liquidation. This fact has not prevented FASB from putting unwarranted emphasis on value in exchange in “active markets.” Fortunately, IASB has not yet followed suit and also includes in its impairment testing “value in use”; this is normally “entity specific” yet often most relevant to actual market participants.

FAIR VALUE VERSUS FAIR MARKET VALUE

For many years, there has been a standard definition of Fair Market Value (slightly different between Canada and the United States) developed for the International Glossary of Business Valuation Terms by a group of North American valuation organizations, including the National Association of Certified Valuation Analysts, IACVA’s U.S. charter and the American Institute of Certified Public Accountants (AICPA). It is:

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. (NOTE: In Canada, the term price should be replaced with the term highest price.)

The International Valuation Standards Council (IVSC) has a definition of Market Value used in much of the rest of the world; this is similar in that it deals with an arm’s-length transaction between a willing buyer and a willing seller:

The estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently, and without compulsion.

The first definition, or one conceptually very close to it, served the valuation profession and clients in the United States and Canada without controversy for over 100 years; in it, “fair” qualifies “market,” not “value.” The very similar concept, called just “market value,” dates back centuries in Europe. These definitions acknowledge that different premises of value can coexist depending on the purpose of the assignment and the interests of the parties while insisting that the perspectives of both buyer and seller had to be explicitly recognized. Therefore, various views about the future outlook still could result in diverse conclusions of value.

Business Combinations

In a business combination, valuators should deal with the actual economics of the specific transaction. “What did the buyer acquire?” “Why did he pay that particular price?” Different buyers for the same business potentially would have distinctive allocations of the same purchase price. That seems both realistic and in accord with the actual decisions implemented by a real exchange of funds; initially FASB and IASB seemed to agree. In 2001, on FASB’s introduction of the term “fair value,” its definition in SFAS 141, Business Combinations , did not mention arm’s length but dealt with willing parti...