Teaching Fair Value Measurement by forrests

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									Teaching Fair Value Measurement
Background & Overview

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Why teach fair value measurement?
• Fair values are used in many areas of accounting
– Succession planning – Estates and gifts – Corporate structure changes – Internal decision making – Mergers and acquisitions – Financial reporting and auditing
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GAAP and fair values
• Over 40 FASB pronouncements require or permit the use of fair values. Examples include guidance on accounting for: debt derivatives
business combinations

pensions & OPEBs asset retirement obligations contributions received and made
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Statement No. 157
• Defines fair value • Establishes a hierarchy for measuring fair values • Expands disclosures about fair value measurements • It does not require use of fair value if not required by other GAAP Effective in 2008 for calendar year firms
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Definition
• Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. • A fair value is an exit price.

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Why an exit price?
• Fits with the definition of an asset and a liability
– Assets result in cash inflows – Liabilities result in cash outflows

• Reporting entities recognize and measure assets and liabilities

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The objective of a fair value measurement
• To determine the price that would be received to sell the asset or paid to transfer the liability at the measurement date (an exit price)
– Assume sale or transfer in principal or most advantageous market

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Transaction costs are not part of fair value
• A transaction cost is a fee for a service – a period expense • Transportation costs should be considered because the location of an asset may be an important attribute of the asset

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Fair values are market-based
• Fair values are determined based on the assumptions market participants would use in pricing the asset or liability

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Market participants
• Buyers and sellers in the principal (or most advantageous) market
– Independent of the reporting entity – Knowledgeable – Able to transact – Willing to transact – motivated but not forced

• Highest and best use of the asset is assumed: in-use or in-exchange
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Assumptions as valuation inputs
• Market participant assumptions are incorporated in fair value measurement as inputs to valuations • Observable inputs – based on market data • Unobservable inputs – based on assumptions about assumptions of market participants
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Fair value hierarchy – level 1
• Quoted prices (unadjusted) in active markets for identical assets or liabilities Ex. A share of GE

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Fair value hierarchy – level 2
• Quoted prices for similar assets or liabilities in active markets • Quoted prices for similar assets or liabilities in markets that are not active • Inputs other than quoted prices (e.g., interest rates, yield curves, volatilities) • Inputs derived principally from or corroborated by observable market data or other means Ex. Interest-rate swap
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Fair value hierarchy – level 3
• Based on unobservable inputs • Should reflect the reporting entity’s own assumptions about the assumptions market participants would use • Should be based on the best available information in the circumstances

Ex. Intangibles in a business combination
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Valuation techniques
• Market approach: should be used as the primary, or confirmatory approach, if a market is observable • Income approach: most often used when a market is not observable and a hypothetical market must be constructed • Cost approach Multiple approaches may be used
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Disclosure of fair value measures by level of the hierarchy
Fair Value at Reporting Date
Description Trading securities ($ in 000’s) Available-for-sale securities Derivatives Venture capital investments Total 12/31/XX $ 115 75 60 10 $ 260 $ 205 $ 25 Level 1 $ 105 75 25 15 $ 20 10 $ 30 Level 2 $ 10 Level 3

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Disclosure of changes in level 3 measures
($ in 000’s) Level 3 Fair Value Measurements
Venture Capital Investments
$11

Derivatives
Beginning balance Total gains and losses (realized/unrealized) Included in earnings Included in OCI Purchases, issuances, and settlements Transfers in/out of Level 3 Ending balance 11 4 (7) (2) $20 $14

Total
$25

(3)

8 4

2 0 $10

(5) (2) $30

Change in unrealized gains or losses In earnings relating to assets still held

$7

$2

$9

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What should entry-level accountants know about fair value?
• What is risk? What is value? • How to make projections, assess risk value and value a business • Approaches to valuation
– Income – Market – Cost

• How to evaluate the reasonableness of inputs to the valuation process and perform sensitivity analysis • How to compute expected values, present values for partial periods and irregular streams of cash, and EVA

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What should entry level accountants know about fair value?
• How to fair value liabilities as well as assets • Different types of intangibles and differences in accounting for intangibles with finite versus indefinite lives

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Students already know more about fair values than we acknowledge
Lessons from selling items on E-Bay • How market prices are determined • How demand and supply affect prices • What happens to prices when there are few buyers and sellers Marking to market (i.e. re-measuring fair values) may be easier for students to understand than allocating historical cost through amortization

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The rest of the session: classroom cases
• Using investments to demonstrate application of the fair value hierarchy • Introducing students to fair value • Valuing a business • Impairment testing • Auditing fair values

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