Valuation for Financial Reporting

Fair Value, Business Combinations, Intangible Assets, Goodwill, and Impairment Analysis

Michael J. Mard, James R. Hitchner, Steven D. Hyden

• Publisher: Wiley
• Year: 2010
• ISBN:
  9780470933350
• Edition: 3
• Topic: Business
• Subtopic: Valuation
• Index: Business

Now in a third edition, Valuation for Financial Reporting provides practical implementation guidance for practitioners, auditors, and their clients in the private and public sectors. This one-stop resource clearly explains SFAS 141R, Business Combinations; SFAS 160, Noncontrolling Interests in Consolidated Financial Statements; and SFAS 157, Fair Value Measurements. The new edition furthers the elements of fair value in financial reporting in accordance with recent standards, providing primary emphasis on fair value measurements and reporting, and the valuation and impairment analysis of intangible assets and goodwill.

Written by leading experts in the valuation field, the Third Edition features:

• Invaluable tools including flowcharts for SFAS 157 and SFAS 141R, a checklist for implementing the fair value measurement standard, and a preparer's worksheet
• Discussion of the valuation aspects of the new financial reporting requirements, including how to identify and measure contingent considerations
• Interpretations of the accounting requirements with application of the requirements to specific facts and circumstances
• Specific guidance for determining fair value in a business combination
• Guidance for determining fair value measurement, including fair value definition, transaction costs, transportation costs, market participants, and highest and best use

Now featuring an accompanying Website, Valuation for Financial Reporting, Third Edition is practical and easy to follow, with detailed examples of an impairment analysis as well as a business combination in which tangible and intangible assets are identified and valued. It is the authoritative reference every valuation professional must have.

Chapter 1

Fair Value Measurements and Financial Reporting

Financial Reporting and the Current Environment

Fair value is here to stay and fair value measurements are becoming a pillar of accounting and auditing. The accounting model has changed. No longer is accounting based solely on historical cost; in fact, it never was. It has always been a mixed-attribute system; a little historical cost here and a little fair value there. The more pronounced change, however, has been from hierarchal guidance that was predominantly rules-based to principles-based guidance. Accounting has always been regulatory driven. Until now, professionals could cite a specific rule to document compliance, a “one size fits all.” Now, though, the citations must be principles driven—“do what's right given the circumstances.”

Financial accounting and reporting are in the midst of one of the most significant revolutionary changes in modern history…. We are moving from an accounting paradigm that existed in the age of an industrial economy to an accounting paradigm that fits the economy in an information age. This redirection has resulted in the following: a change in the conceptualization and application of relevance and reliability, an increased use of fair value versus historical cost measurements, a renewed emphasis on principles versus rules, and an evaluation of the composition of the basic financial statements.¹

In the paper Understanding the Changes in Accounting Thought, Professors of Accountancy Rebecca Toppe Shortridge and Pamela A. Smith state:

Currently, accounting is undergoing a revolutionary change in thought regarding the core fundamentals upon which financial accounting is based. The catalysts for the transformation can be attributed to the movement from an industrial economy to an information economy, increased globalization, improvements in data availability, and increased information processing capabilities.

We refer to the change in accounting fundamentals as a paradigm shift. The old paradigm, hereafter referred to as the industrial paradigm, existed during the industrial economy and was based on the FASB's (Financial Accounting Standards Board's) original conceptual framework. It emphasized historical cost measurements, was rules-based, and was focused on transactions and allocations [Exhibit 1.1]. This paradigm reflected rules that allowed estimates and judgments but thrived on the certainty and precision garnered from historical cost measurements. The application of industrial age accounting practices in the new economy resulted in several anomalies in financial reporting that spurred significant changes in accounting thought. As a result of these developments, a new financial reporting paradigm emerged.

Exhibit 1.1 Paradigms Depicted

© Reprinted from Research in Accounting Regulation, Volume 21, Shortridge, Rebecca Toppe and Smith, Pamela A. Understanding the Changes in Accounting Thought (April 2009), with permission by Elsevier.

The fundamentals of the new paradigm, hereafter referred to as the information paradigm, exists in an information economy and is based on the proposed conceptual framework. Further, the new paradigm is principles-based, emphasizes fair value, and focuses on economic events [see Exhibit 1.1]. It is important to note that although the change from historical cost to fair value measurements currently has high visibility, this change alone is not what we are conceptualizing as a paradigm shift. All of the factors presented in the diagram are part of the paradigm shift. In the information model, the FASB (2006a) has proposed that the notion of reliability be replaced with faithful representation. The new terminology is indicative of the FASB's movement to emphasize the substance of economic events over their form. This new focus leads to an increased emphasis on principles versus rules and fair value versus historical cost measures. [Exhibit 1.1] highlights the overlap that is occurring as the financial reporting environment moves from an industrial age to an information age. The shift in accounting paradigms is not complete, and therefore the standards issued during the transition period have characteristics from each paradigm.²

Professors Shortridge and Smith continue their thought analysis by offering their views of a new hierarchy of accounting qualities. The old hierarchy's tension between relevance and reliability is replaced with a sequential process of relevance, faithful representation, comparability, and understandability. As the professors state:

[Exhibit 1.2] depicts the authors’ interpretation of the hierarchy of accounting qualities in the proposed conceptual framework currently being deliberated by the FASB (FASB, 2006a). In this hierarchy, decision-useful information is information that is relevant, faithfully represented, comparable, and understandable. These characteristics are applied sequentially when determining what information is reported, because the application of the characteristics follows a logical sequence (numbered 1, 2, 3, and 4 in [Exhibit 1.2]). The first and most important characteristic is relevance (FASB, 2006a, QC43). Relevance helps “identify which economic phenomena” need to be reported (FASB, 2006a, QC43). Relevant information has predictive and confirmatory value and is timely. Once the relevant information is identified, the second qualitative characteristic requires it to be faithfully represented. This means that the information depicts the economic phenomena in a faithful manner (FASB, 2006a, QC16). Faithfully represented information is verifiable, neutral, and complete. In the 1980 conceptual framework, faithful representation was a component of reliability; in the proposed conceptual framework it stands alone and replaces the term reliability.

Characteristics three and four of the proposed conceptual framework are comparability and understandability. Once it is determined that the information is relevant and faithfully represented, that information must be comparable. “Comparability is the quality of information that enables users to identify similarities in and differences between two sets of economic phenomena” (FASB, 2006a, QC35). This also implies that the same policies are consistently applied through time and across different situations. Finally, the information needs to be understandable. In the 1980 conceptual framework, this characteristic applied to the user of the information. In the proposed conceptual framework, the FASB recognizes that understandable information must be “classified, characterized, and presented clearly and concisely” (FASB, 2006a, QC39).

The transformation of the conceptual framework is just one piece of evidence that there is a paradigm shift. As depicted in [Exhibit 1.1], there are other changes that parallel the changes in the conceptual framework. For example, there is a shift to fair value measurements, an increased emphasis on principles versus rules, and an increased focus on economic events versus transactions. The information economy enables all these changes because there is more information technology, more sophisticated valuation methodology, more globalization, and greater data accessibility.

Exhibit 1.2 Information Paradigm Proposed Conceptual Framework

© Reprinted from Research in Accounting Regulation, Volume 21, Shortridge, Rebecca Toppe and Smith, Pamela A. Understanding the Changes in Accounting Thought (April 2009), with permission by Elsevier.

Change, of course, brings pain and, in the case of fair value measurement, significant controversy. That controversy flooded the financial press and made its way all the way to the U.S. Congress. In The Crisis of Fair-Value Accounting: Making Sense of the Recent Debate, Professor Christian Laux and Professor Christian Leuz state:

The recent financial crisis has led to a vigorous debate about the pros and cons of fair-value accounting (FVA). This debate presents a major challenge for FVA going forward and standard setters’ push to extend FVA into other areas. In this article, we highlight four important issues as an attempt to make sense of the debate. First, much of the controversy results from confusion about what is new and different about FVA. Second, while there are legitimate concerns about marking to market (or pure FVA) in times of financial crisis, it is less clear that these problems apply to FVA as stipulated by the accounting standards, be it IFRS or U.S. GAAP. Third, historical cost accounting (HCA) is unlikely to be the remedy. There are a number of concerns about HCA as well and these problems could be larger than those with FVA. Fourth, although it is difficult to fault the FVA standards per se, implementation issues are a potential concern, especially with respect to litigation.⁴

Two of the bigger complaints of fair value measurement are procyclicality (in booms and busts) and contagion (across industries and markets) in financial markets. Put simply, downward adjustments required by fair value measurement lead to further downward metrics … a continuous downward spiral. It's interesting, however, that few complaints were heard when the economy was booming … only during the recent economic downturn did the objections mount, at certain points rising to a crescendo.

Fair Value Measurements

The FASB is the U.S. accounting standard setter for anyone reporting under generally accepted accounting principles (GAAP). It is the standard setter because the U.S. Securities and Exchange Commission (SEC) effectively recognizes the FASB for establishing GAAP applicable to publicly registered companies (subject to additional SEC requirements). Therefore, the fair value accounting literature issued by the FASB is effectively a regulatory accounting standard.

The FASB continues to move ahead with an agenda that includes fair value accounting. In 2006 it issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157) to take effect for financial statements issued for fiscal years beginnin...