Fair Value Measurements

Practical Guidance and Implementation

Mark L. Zyla

• Publisher: Wiley
• Year: 2009
• Print ISBN: 9780470500248
• eBook ISBN: 9780470588772
• Edition: 1
• Topic: Business
• Subtopic: Contabilità
• Index: Business

A hands-on volume for financial executives with guidance on the fair value measurement process

In today's dynamic and volatile markets, whether buying or selling, what corporate officers need to know is the worth of an asset today, a task that for many has become complex and at times confusing. Fair Value Measurements: Practical Guidance and Implementation demystifies this topic, offering you a nuts-and-bolts guide of the most recent developments in preparing financial statements using fair value measurements. This straightforward book covers the best practices on measuring fair value in a business combination and how to subsequently test the value of these assets for impairment.

• Filters complicated insider concepts into easy-to-understand information on the valuation specialist's function
• Discusses the many new FASB pronouncements involving fair value
• Instantly familiarizes you on the ins and outs of fair value financial disclosure

Well-written, conversational in tone, and filled with valuable insights, Fair Value Measurements: Practical Guidance and Implementation lifts the veil of confusion from the substantial and growing requirements for fair value disclosures.

CHAPTER 1

Fair Value Accounting

Welcome to the new world of accounting! Where once financial statement preparation involved primarily the use of historical cost information, accounting now involves the use of judgment as to the current value of assets and liabilities. Fair value—or as it is sometimes referred to, mark-to-market accounting—has become the preeminent issue in financial reporting today. The concepts introduced by fair value accounting change the way financial information is presented. An increasing amount of information in financial reporting is presented at current or market values on the reporting date rather than historical costs, which has been the bedrock of traditional accounting.

Advocates of fair value accounting believe that this presentation best represents the financial position of the entity and provides more relevant information to the users of the financial information. Detractors of fair value accounting point to its complexity and inherent use of judgment. Either way, fair value accounting is becoming more prominent in financial statement presentation and will continue to be the fundamental basis for accounting in the future.

Introduction

Fair value has been a standard of measurement in financial reporting for decades. The Financial Accounting Standards Board (FASB) has issued more than three dozen statements that use the term fair value as the measurement of value. Most prominent among these pronouncements is the recently issued revised FASB ASC 805, Business Combinations (SFAS No. 141(R)),¹ which incorporates fair value as the fundamental standard of measurement in accounting for business combinations. Fair value is also the standard of measurement used in subsequent testing for impairment of the acquired assets under FASB ASC 350, Goodwill and Other Intangible Assets (SFAS 142) and SFAS 144, Testing for Impairment of Long Lived Assets. The concept of fair value is interesting because each of these statements about the measurement of fair value is the value to the market as of the measurement date, not necessarily the value to the preparer of the financial statement. As such, measuring fair value for participants in those markets requires some judgment.

The FASB issued FASB ASC 820, Fair Value Measurements and Disclosures (Statement of Financial Accounting Standard (SFAS) No. 157), to clarify the concepts related to its measurement. According to the FASB, the purpose of the statement is to define fair value, establish a framework for measuring fair value, and expand disclosure about fair value measurements.² Fair Value Measurements does not introduce any new accounting per se. Fair Value Measurements was issued by the FASB to provide one uniform statement under which the concept of fair value in all financial reporting is more fully explained.

FASB ASC 820, Fair Value Measurements and Disclosures (SFAS No. 157), was not initially universally accepted without some controversy. The day before its scheduled implementation, the FASB delayed the full implementation date of the statement in response to concerns by certain preparers of financial statements. The statement was revised to become effective for just financial assets and liabilities for the first year. The statement became fully effective for all items, both financial and nonfinancial for fiscal years beginning after November 15, 2008. The reason provided by the FASB for the partial implementation was “to allow the Board and constituents additional time to consider the effect of various implementation issues that have arisen, or that may arise, from the application of Statement 157.”³ Even the partial implementation did not allay all of the controversy. Some critics of fair value accounting claimed that the credit crisis that began in 2008 was at the very least exacerbated by the statement’s implementation by financial institutions.

History of Fair Value in Financial Reporting

Even though it has become more prominent recently, fair value has been a standard of measurement in financial reporting for some time, particularly in measuring certain financial assets and liabilities. One of the first prominent accounting statements to use fair value as the standard of measurement in financial reporting is APB (Accounting Principles Board) 18, which was issued in the early 1970s. APB 18 introduced the equity method of accounting in financial statement reporting for investments. APB 18 described the financial statement treatment and measurement of investments losses considered other than temporary as requiring recognition if the investment’s fair value declined below its carrying value. APB 29, Accounting for Nonmonetary Transactions, introduced in early 1973, actually outlined ways to measure fair value in those types of transactions. Financial Accounting Standard 15 (FAS 15) in the late 1970s defined fair value as a willing buyer and willing seller and described market value and discounted cash flows in accounting in troubled situations. Fair value measurements were introduced in pension accounting in a couple of statements in the 1980s. In 1991 FAS 107, Disclosures about Fair Value in Financial Instruments, required the disclosure of fair value in financial instruments. FAS 115, Accounting for Certain Investments in Debt and Equity Securities, was introduced in 1999. FAS 115 requires fair value as the standard of measurement for many types of debt and equity securities. In 2000, the FASB introduced FAS 133, Accounting for Derivative Instruments and Hedging Activities, which required fair value as the measurement for derivative securities. SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities—Including an Amendment of FASB Statement No. 115, which allowed certain entities to elect to measure selected assets and liabilities at fair value, was implemented by the FASB in 2007. Although many accounting pronouncements refer to fair value and have been a part of financial reporting for a long time, the concept of what exactly is meant by fair value became most prominent in financial reporting in accounting measurements in business combinations.

During the technology boom in the late 1990s—brought on by the initial commercialization of the Internet—FASB began a project to update the Accounting Principles Board’s Opinion No. 16, Business Combinations (APB 16). APB 16 was the accounting standard at that time for acquisitions and other business combinations. The FASB observed during the 1990s that many mergers and acquisitions were transactions where most of the economic value was created by the technology and other intangible assets of the acquired company. However, under the accounting at the time (APB 16) much of the value of the transaction showed up on the balance sheet as goodwill. The FASB’s project was the result of the conclusion that APB 16 did not fairly represent the economic substance of those business combinations. The project concluded that the value of intangible assets in business combinations had dramatically increased, particularly when compared to the value of tangible assets. Yet these results were not being fairly presented on the resulting financial statements.

The board determined that under the old APB 16, companies had too much leeway in reporting the value of intangible assets in acquisitions, and financial statements were not fairly representing the allocation of the acquisition price to the acquired assets. Under the old accounting rules, most of the value in allocation of purchase price was being recorded as goodwill, which could then be amortized for up to 40 years.

On June 29, 2001, the FASB issued SFAS 141, Business Combinations, the original FASB standard on business combinations, which has since been superseded by FASB ASC 805, Business Combinations (SFAS 141(R)). Business Combinations placed stricter requirements on the acquirer to recognize acquired intangible assets in the financial statements. Paragraph 39 in SFAS 141 requires that “An intangible asset shall be recognized as an asset apart from goodwill if it arises from contractual or other legal rights or, if not contractual, only if it is capable of being sold, transferred, licensed, rented or exchanged. An assembled and trained workforce, however, is not valued separately from goodwill.”⁴ Under SFAS 141, only purchase accounting was allowed. The pooling of an interests accounting method for acquisitions where one entity combines with another at book value, if the acquisition met certain criteria, was no longer allowed. The FASB believed that the purchase method of accounting provided a better representation of the true economics of the underlying transaction than the pooling method that presented the combined transaction on a pure historical cost basis.

As part of the convergence of U.S. Generally Accepted Accounting Principles (GAAP) with international accounting standards, the FASB revised SFAS 141 for fiscal years beginning after December 15, 2008. Under FASB ASC 805, Business Combinations (SFAS No. 141(R)), purchase accounting is replaced by the Acquisition Method. Under the Acquisition Method the fair value of acquired assets are no longer determined by an allocation of the purchase price. The fair value of those assets acquired in the business combination is independent of the price that was paid in the transaction.

FASB ASC 805, Business Combinations (SFAS 141(R)), still requires that the acquirer recognize the identifiable intangible assets acquired in a business combination separately from goodwill. SFAS 141 introduced a comprehensive list of intangible assets, and lists the criteria for recognition of intangible assets acquired, which was extended in FASB ASC 805, Business Combinations. An intangible asset is considered identifiable in a business combination if it meets either the separability criterion or the contractual-legal criterion. An intangible asset meets the separability criterion if it meets one of two criteria:

1. Is separable, that is, capable of being separated or divided from the entity and sold, transferred, licensed, rented, or exchanged, either individually or together with a related contract, identifiable asset, or liability, regardless of whether the entity intends to do so

2. Arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations⁵

In the initial 1999 exposure draft of SFAS 141, the FASB proposed that goodwill be identified in the business combination and amortized over its remaining life. However, in response to numerous comments to the initial exposure draft suggesting that the useful life of goodwill would be difficult to determine thus difficult amortize, the FASB changed its mind and introduced an alternative to the amortization of goodwill. So, goodwill was not amortized under SFAS 141. Instead, goodwill received an alternative accounting treatment: It must be tested annually for impairment.

To reinforce the impairment testing alternative, the FASB also issued FASB ASC 350, Goodwill and Other Intangible Assets (SFAS 142), in 2001. FASB ASC 350 (SFAS 142) provides guidance on determining whether goodwill recorded after the acquisition becomes impaired. FASB ASC 350 (SFAS 142) was introduced by the FASB as the result of comments by various respondents to the initial exposure draft of Business Combinations. Under FASB ASC 350 (SFAS 142), goodwill that is recorded as the result of a business combination is tested annually for impairment under a two-step test. The first step is to estimate the fair value of the appropriate reporting unit by comparing the fair value to its carrying value (book value). If the fair value is greater than book value, then goodwill is not impaired. If the fair value is less than the carrying value, then the goodwill may be impaired and a second step is required.

The second step is to estimate the fair values of all of the assets of the reporting unit as of the testing date. This step is similar to the allocation of purchase price under Business Combinations. The new goodwill is then compared to the current carrying value of the goodwill. If the fair value of the new goodwill is less than the fair value of the current goodwill, the difference is the amount of impairment and must be written off. As such, fair value is the standard of measurement in both tests under FASB ASC 350, Goodwill and Other Intangible Assets.

FASB ASC 805, Business Combinations, and FASB ASC 350, Goodwill and Other Intangible Assets, are the two statements where fair value measurements of assets other than financial instruments are most often seen in practice. Since these statements were introduced, both the accounting profession and the valuation profession have begun projects to de...

Table of contents

• Title Page
• Copyright Page
• Dedication
• Preface
• Acknowledgements
• About the Author
• CHAPTER 1 - Fair Value Accounting
• APPENDIX 1A - Fair Value Accounting and the Current Economic Crisis
• CHAPTER 2 - Fair Value Measurements in Business Combinations and Subsequent ...
• CHAPTER 3 - The Nature of Intangible Assets
• CHAPTER 4 - The Cost Approach
• CHAPTER 5 - The Market Approach
• CHAPTER 6 - The Income Approach
• CHAPTER 7 - Advanced Valuation Methods for Measuring the Fair Value of ...
• CHAPTER 8 - Measuring the Remaining Useful Life of Intangible Assets in ...
• CHAPTER 9 - Fair Value Measurements of Private Equity and Other Alternative Investments
• CHAPTER 10 - Fair Value Measurements under IFRSs
• CHAPTER 11 - Disclosures in Fair Value Measurements
• CHAPTER 12 - Auditing Fair Value Measurements
• CHAPTER 13 - Fair Value Measurement Case Study
• APPENDIX 13A - Suggested Case Study Solutions
• Information Request—SFAS 142
• Information Request for Business Combinations—SFAS 141R
• Glossary of International Business Valuation Terms
• Bibliography
• Index