Understanding Fair Value Accounting by ccx17723


									 Session 222

  Fair Value

                    Dr. Ray Thompson, CMA, CFM, CBA
Dr. Ray Thompson, CMA, CFM, CBA, is an associate professor in the Department of
Accounting & Finance at the University of Pittsburgh-Johnstown. He also is certified in
financial management, a Certified Management Accountant and a Certified Business

In addition to teaching at UPI, Dr. Thompson has acted as a consultant for the college's
Entrepreneurial Development Assistance Project, providing a variety of consulting
services to start-up businesses in the area. His private consulting experience includes a
variety of manufacturing, service and technology-based companies in areas of financial
analysis and planning, cash flow management and loan proposal development. He also
provides business valuation services and expert testimony in economic damage and
marital dissolution cases.

Dr. Thompson is a member of the Institute of Business Appraisers' Qualifications Review
Committee, which provides peer reviews of business appraisals.

With George Letcher Jr., he authors and conducts professional development seminars for
CPAs in a number of states throughout the country. He is a member of the Institute of
Management Accountants, the Financial Management Association and the Institute of
Business Appraisers, and is a candidate member of the American Society of Appraisers.

Dr. Thompson received his B.S. and M.S. degrees in economics and systems dynamics
from the University of Bradford in the United Kingdom, his M.B.A. in accounting from
Xavier University of Ohio, and his doctor of business administration from Nova
University. He lives in Bedford County, Pa.
                                     CHAPTER FOUR

                          FAIR VALUE ACCOUNTING


4.1 INTRODUCTION ...........................................................................................2

4.2 SFAS NO. 157: FAIR VALUE MEASUREMENT .......................................5

4.3 SFAS No. 159: THE FAIR VALUE OPTION .............................................12
Fair Value Accounting                                             Chapter Four


      Over the past 15 years GAAP has steadily evolved from a system based
largely on cost-based measures to one where fair market value plays an
increasing role. To some it has moved too far and too quickly; to others it has not
moved far enough or fast enough. Financial analysts claim to need information
based on current values. They argue that traditional accounting measures are
based upon sunk costs and multiple-year allocations that do not reflect the
underlying economic consequences. As such, they are of questionable value for
decisions. Capital markets want up-to-the-minute values and want to know how
changes in these numbers and the assumptions underlying them will affect the
entity’s financial position and operating statement. By contrast, preparers and
auditors typically have limited training and experience with numbers that are
based on modeling techniques. Many believe that major areas of fair value are so
subjective as to not be verifiable – tweak the model and you can get the result you
want. This fear is, of course, reinforced by looking over one’s shoulder at
regulators and others in a position to use 20:20 hindsight to second-guess the
CPA. There seems to be general agreement that if such numbers are to be
reported, then some means of protecting preparers and auditors must be devised.
So far, little has been accomplished in this area, however. Despite a general
presumption favoring fair value, standard setters acknowledge that it is impossible
to assert that much fair value information is exact. It always involves a
considerable degree of judgment, subjectivity and uncertainty. There has always
been a trade off in accounting between relevant (market) and reliable (cost)
measurements. It is now an even greater and growing issue. The problem is even
more difficult when the benefit-to-cost ratio for fair value information seems to be
different for small, closely held companies, as compared to their larger, publicly
held counterparts.

      At the present time most financial information is provided on a cost, rather
than a fair market, basis. The picture is a complex one, however. For many items
historical cost can be assumed to approximate market (e.g., short-term receivables
or payables). There are also a number of measurement bases used in GAAP that
incorporate elements of both cost and fair value (current value, current
replacement cost, net realizable value, discounted cash flow, etc.) Until recently,
however, entities have only been allowed to use fair value where the standards
explicitly require or permit it. The existing accounting literature contains over 50
authoritative pronouncements that refer to fair value measurement or disclosure.
FASB has taken a consistent position that fair value is typically the most relevant
measure – at least for financial assets and liabilities. This is consistent with
IASB, whose standards are also evolving to increasingly require fair value. SEC
is also active in “encouraging” FASB to move toward fair value measurement.

  Chapter Four                                          Fair Value Accounting

         The table below summarizes the major financial statement items that are
  measured at fair value. The majority involve financial assets which are adjusted
  upward or downward as value changes. Liabilities are rarely adjusted to fair
  value. Other accounts only use fair value when this falls below carrying value
  (e.g., impaired assets). These are lower of cost or market measures that are long
  established in the accounting literature. Changes in fair value are not handled
  uniformly, however. Some are included in regular (net) income, while others are
  displayed initially in comprehensive income.


        Item                                   Typical Basis           Alternate

Short term              SFAS No. 5     Amount to be collected
receivables and

Marketable              SFAS No. 115   Fair value
securities (available
for sale)

Inventory               ARB No. 43     Cost                        Net realizable

Derivatives             SFAS No. 133   Fair value

Long lived assets       SFAS No. 144   Carrying amount             Fair value when

Intangibles and         SFAS No. 141   Fair value when acquired    Fair value when
goodwill acquired       and 142                                    impaired
in business

Assets acquired in      SFAS No. 153   Fair value

Guarantees              FIN No. 45     Fair value

Long-term               APB No. 21     Fair value
receivables and

Fair Value Accounting                                           Chapter Four

     As illustrated above, many financial statement numbers are already
measured at fair value. Most involve financial assets. To date, nonfinancial
items and financial liabilities have rarely been adjusted to fair value. For other
items fair value is only reported in the atypical situation where cost-based
information loses its relevance (e.g., lower of cost or market).

      The major disclosure provisions for fair value were established by SFAS
No. 107. It required disclosure of the fair value of all financial instruments for
which it is practicable to require disclosure. Subsequently, the Board retreated,
concluding that such information was of limited usefulness for many smaller
enterprises and their capital providers. Statement No. 126 made such disclosures
optional for nonpublic entities with assets of less than $100 million. Where
entities use complex financial instruments, such as derivatives, this exemption
would not apply, however.

Chapter Four                                        Fair Value Accounting


      Fair value has achieved increasing prominence in the FASB literature over
the past decade. The Board is on record that, in many cases, it provides an
unbiased, consistent measure that is conceptually sound. Many practicing CPAs
have expressed reservations about using fair value in situations where market
prices are not readily available and judgment and relatively complex modeling
techniques are needed to come up with the numbers. At the moment there is
limited guidance on applying fair value under GAAP. It is dispersed among a
number of pronouncements and is not always internally consistent. The Board is
attempting to remedy this by issuing this Statement to codify the guidance that
has evolved piecemeal. The use of fair value measurement has spread from
relatively straightforward guidance (e.g., Statement No. 115 on Marketable
Securities) to areas where estimation and valuation involve modeling (e.g.,
intangibles and goodwill impairment). Practitioners are wary of using valuation
approaches whose inputs are judgmental and subjective – especially when they
may be “second guessed” when events do not turn out as expected. FASB accepts
that there is a trade off between relevance and reliability but believes that
valuation will play an increasingly prominent role in GAAP. For that reason they
indicate that the Statement should be applied together with applicable valuation
standards and generally accepted valuation practices.

      SFAS No. 157 has an expected effective date for financial statements issued
for fiscal years beginning after 11/15/2007. It applies to a broad range of
financial and nonfinancial assets and liabilities except for:

     •   Share-based payments (stock options)

     •   Practicability exceptions to fair value measures in certain

     •   Revenue recognition using vendor-specific objective evidence
         (VSOE) of fair value

     •   Inventory.

Fair Value Accounting                                              Chapter Four

      SFAS No. 157 defines fair value as the price that would be received for an
asset or paid to transfer a liability between market participants at the
measurement date. All such estimates are hypothetical rather than actual (e.g.,
what we could have sold that marketable security for). The Board uses fair value,
rather than fair market value as used in the valuation literature, to avoid
practitioners becoming involved in the vast body of interpretative case law (e.g.,
Tax Courts). The two concepts are, however, broadly similar. The Statement
provides the following additional guidance on these terms:

     a.    The items are particular assets or liabilities considering their
           condition and location at the measurement date. In most cases
           they consist of separate, standalone items (e.g., a financial
           instrument or an operating asset). In some cases, assets are not
           separable (e.g., a segment of a business) and need to be viewed
           in combination. This grouping for measurement purposes
           (separate or combined) is known as the unit of account.
           Statement No. 157 requires the firm to use the same level of
           aggregation that it uses in applying other accounting
           pronouncements (e.g., impairment testing under SFAS No.

     b.    The price assumes an orderly transaction in the principal
           market. This is the place where the reporting entity would
           normally sell or dispose of the asset or transfer the liability. It
           is the market with the highest level of activity. Where multiple
           markets exist and no one predominates, the CPA should look to
           the most advantageous market.

     c.    Principal (most advantageous) market fair value assumes
           that transactions take place in the market where asset prices
           would be maximized or where liabilities would be minimized.
           This is typically the principal market where most activity and
           volume occurs. If no principal market exists (e.g., the sale of a
           specific group of impaired assets) SFAS No. 157 requires that
           the most advantageous market should be used. Prices in these
           markets are not adjusted for transactions costs, however.

     d.    Market participants are buyers and sellers in the principal
           market. They are independent – not related parties. They are
           also assumed to be knowledgeable about the item, to have the
           legal and financial ability to transact and to be motivated but
           not forced or otherwise be compelled to act.

Chapter Four                                                Fair Value Accounting

     Although the guidance for assets and liabilities is broadly similar, SFAS No.
157 points to the following:

     a.    Asset values are based on highest and best use. This is the
           maximum value in a hypothetical transaction without regard to
           the intended use by the reporting entity. This may be the value
           in the current use or what it could be sold for if it were to be
           purchased and reconfigured for an alternate use.

     b.    Liability values are based on the premise that the liability is
           transferred to an entity of comparable credit standing that
           would assume the obligation. Thus, the reporting entity needs
           to assess its credit standing and the effect on the fair value of
           the liability.

      The Board also seeks to clarify entry and exit prices and their valuation
consequences. Under GAAP, assets or liabilities are initially recorded at the
amount paid to acquire the asset or the amount received to assume the liability.
This is the entry price. Once they are in place, however, fair value is based on an
exit price – what would be received for the asset or paid to transfer the liability.
The Board recognizes that these two prices may differ. They believe, however,
that in many situations the transaction price will represent the fair value of the
asset or liability at initial recognition.

     SFAS No. 157 provides a hierarchy for the various sources of available
information that can be used to arrive at fair value. This fair value hierarchy is
shown below. CPAs would be required to use the highest level approach to
valuation if such data were readily available.
                                 FAIR VALUE HEIRARCHY

                                            LEVEL 1
                                    Quoted prices for identical
                       V              assets or liabilities in
                       A               accessible markets
                       U               Not                           F
                       A             Available                       A
                       T                                             I
                                             LEVEL 2                 R
                                     Quoted prices for similar
                                    assets or liabilities or from    V
             INCOME    N                 similar markets             A
                       M                                             L
                       E               Not                           U
                       T             Available                       E
                       O                       LEVEL 3
                       S                  Limited Market

Fair Value Accounting                                            Chapter Four

       The hierarchy of value is based on the information (market inputs) that
market participants would use in making pricing and valuation decisions. Some
of these values are observable – they are based on independent data on prices that
occur outside the entity (e.g., the value of a publicly traded stock). Other prices
are unobservable – based upon information developed internally by the entity
(e.g., a projection of cash flows associated with an asset). Most estimates involve
some combination of observation and estimation. SFAS No. 155 requires that the
valuation techniques used maximize the use of observable input and minimize the
use of unobservable market input whether using the market, income or cost

A.   Level 1: Quoted Prices for Identical Assets or Liabilities in Active

     In active markets transactions occur with a frequency and volume that
enable price to be set on a continuous basis. The best example would be the
market for stocks of large, public companies. A quoted price from such a source
would provide the most reliable evidence. Level 1 estimates should be used to
measure fair value whenever available. FASB provided two additional

     a.    A quoted market price would not accurately measure fair value
           if significant events occurred after the market closed but before
           measurement date (stale prices). Reporting entities are not
           required to make all possible efforts to obtain information
           about after hours trading. They should not, however, ignore
           information available at reporting date. An entity should set up
           a policy to provide consistency in this area.

     b.    Where an entity holds a large amount of an item (e.g., a
           significant portion of the outstanding stock of another entity)
           they may only be able to dispose of the entire amount by
           depressing market prices – the blockage factor. SFAS No.
           157 makes it clear the prices should not be adjusted for blocks.

Chapter Four                                           Fair Value Accounting

B.   Level 2: Quoted Prices for Similar Assets or Liabilities

      Absent information on identical items, SFAS No. 157 requires the use of
information from the closest external market. Because the markets are not
identical, it may be appropriate to adjust values (e.g., for condition or location).
Extensive adjustments could, however, make the estimate a Level 3. The sources
for Level 2 estimates are:

     a.    Quoted prices for similar assets in active markets

     b.    Quoted prices for identical or similar assets in nonactive
           markets. These are markets with less trading activity.
           Quotations vary between brokers and from time to time. They
           are also markets where little information is released to the

     c.    Market data, other than prices, that are directly observable
           (e.g., interest rates, yield curves)

     d.    Estimates that start with observable market data and then make
           adjustments (extrapolation and interpolation) to arrive at a
           value estimate.

C.   Level 3: Limited Market Activity

      This refers to situations where the information used is so limited in
availability that it cannot be corroborated by observable market data. This
approach should only be used if observable market information is not available.
The goal of the valuation remains the same – estimating exit price from the
seller’s perspective. Level 3 estimates should, therefore, incorporate the same
assumptions that market participants would use. If factors specific to the entity
affect value and there is alternative information available suggesting that outsiders
would use differing assumptions, the latter should be used to arrive at fair value.

Fair Value Accounting                                           Chapter Four

     There are three widely accepted approaches to valuation: market, income
and cost. SFAS No. 157 requires that the techniques used for fair value are
consistent with these approaches.

     a.    The market approach uses observable prices for identical or
           comparable assets or liabilities.

     b.    The income approach uses valuation techniques to convert
           future amounts (e.g., cash flow, earnings) to a single present
           value. This includes not only discounted cash flow but also
           option pricing models (Black-Scholes-Merton, binomial) and
           multi-period excess earnings models (used in valuing
           intangible assets).

     c.    The cost approach estimates the amount required to replace
           the service capacity of the asset (…replacement cost). It is
           limited upward by the cost to acquire or construct a substitute
           asset of comparable utility and is then adjusted for
           obsolescence.     This is a much broader concept than
           depreciation and includes physical deterioration as well as
           functional and economic obsolescence.

     SFAS No. 157 requires the disclosures described below. They should
enable statement users to understand where fair value is being used and the types
of data that underpin the measurement. More specifically, the following should
be provided separately for each major category of asset and liability each time a
balance sheet is presented.

     a.    For items remeasured on a continuing basis, such as trading
           securities: aggregate fair values at reporting date

     b.    For items measured on a nonrecurring basis, such as impaired
           assets: fair value and the reason for the measurement

     c.    How these measurements fit into the fair value hierarchy set
           out above

     d.    Annually: the valuation techniques used to make the fair value

Chapter Four                                            Fair Value Accounting

      SFAS No. 157 also requires entities to disclose information enabling users
to understand the effects of fair value on income. These are to be presented in
tabular form.

     a.    Total gains and losses (realized and unrealized) by major
           category of assets and liabilities remeasured at fair value on a
           recurring basis. The disclosure should segregate any amounts
           included in comprehensive income. Gains and losses should be
           presented separately (gross) if the related items are reported
           separately on the balance sheet.

     b.    The change in unrealized holding gains or losses relating to all
           assets remeasured at fair value if the measurements fall, in their
           entirety, within Level 3.

      Subsequently, the Board has issued an invitation to comment on the need for
valuation guidance for financial reporting. It raises a number of questions on
the need to develop, on an ongoing basis, implementation literature to accompany
FASB’s evolution toward fair value accounting. Among the issues raised are the

     •    Is there a need for guidance on valuation to be developed for
          financial reporting purposes?

     •    How detailed and specific should such guidance be?

     •    Should existing appraisal organizations be involved in developing
          this literature?

     •    What process should be used to issue the guidance?

     •    Who would have ultimate responsibility for this guidance?

     •    Should it be created at the national or international level?

Fair Value Accounting                                            Chapter Four


      FASB has issued SFAS No. 159 which permits, but does not require, entities
to carry most financial assets and liabilities at market. The election would be
made on a contract-by-contract basis, would be irrevocable and would need to be
supported by concurrent documentation. The fair value election would typically
be made at initial acquisition and would continue throughout the life of the item.
Changes in value would be recognized in earnings. The Board’s approach is
broadly similar to that of IASB. It is also consistent with FASB’s long-term goal
of using fair value for at least all financial assets and liabilities. They believe
that more work is needed before fair value would become required for all
financial instruments. A second phase of this project will address using fair value
for nonfinancial assets and liabilities.

      Under current GAAP various financial contracts are carried at different
versions of cost or market – the problem of differing measurement attributes. As
a consequence, there may be earnings volatility, not because of the underlying
economics, but because of the mismatch caused when related items are measured
differently. Many of these difficulties can be overcome by using hedge
accounting under SFAS No. 133 (Derivatives). FASB has become increasingly
concerned with the ever-increasing complexity of hedge accounting and its
burdensome documentation requirements. A fair value option enables companies
to achieve offset accounting (matching changes in value for assets and liabilities
in earnings) without the formalities of hedge accounting. It would also simplify
accounting guidance in some areas. This is illustrated below.

Chapter Four                                                 Fair Value Accounting


          Value at Inception

          Receivable                                        Debt (Payable)
          Annual Amount               $     5,000           Annual Amount          $     4,750
          Years                                  5          Years                             5
          Implicit Rate                       10%           Implicit Rate                   8%

          Fair (Present) Value            $18,954           Fair (Present) Value       $18,965

          Assume rates change by 2% upward

          Receivable                                        Debt (Payable)
          Annual Amount               $     5,000           Annual Amount          $     4,750
          Years                                  5          Years                             5
          Implicit Rate                       12%           Implicit Rate                  10%

          Fair (Present) Value            $18,024           Fair (Present) Value       $18,006

          Gain (loss)                       ($930)                                       $959

          Assume asset is at market, debt is not
  Asset   Loss (Income Statement)            $930
            Asset Adjusted to Market                 $930
  Debt    No Entry

          Assume Asset and Debt are both Marked to Market
  Asset   Loss (Income Statement)         $930
            Asset Adjusted to Market                $930
  Debt    Debt Adjusted to Market        ($959)
            Gain (Income Statement)                ($959)

     The Statement is effective as of the first fiscal year that begins after
11/15/2007. Upon adoption, an entity can elect the fair value option for any
financial instruments it chooses. The transition would be accomplished through a
cumulative effect adjustment of retained earnings as of the effective date.
Retrospective application is not permitted, however.

Fair Value Accounting                                             Chapter Four

      The fair value option is available to both public and nonpublic entities. This
includes those who elected to use Statement No. 126’s exemption to disclosing
fair value as required by SFAS No. 107. It applies to all financial (but not
nonfinancial) assets and liabilities except for the items listed below. In a major
departure from current practice, marketable securities designated as available for
sale or held to maturity (Statement No. 115) may now be carried at market with
changes in fair value shown in earnings. The list of items excluded from SFAS
No. 159 is relatively narrow. It includes:

     •   Investments in subsidiaries and variable interest entities that
         require consolidation

     •   Pension and post-retirement obligations

     •   Lease contracts (SFAS No. 13)

     •   Liabilities for demand deposit accounts.

      At the time of initial recognition (typically acquisition) the entity may elect
to use fair value as (both) the initial and subsequent measurement attribute. The
election is permitted on a contract-by-contract basis and is irrevocable. It would
need to be supported by concurrent documentation. Periodic changes in value
would be recognized in earnings. Fair value could also be recognized in
situations where an entity is permitted to use new basis accounting. The most
common of these arise during business combinations or significant modifications
of debt contracts. Thus, in a business combination, an entity could elect fair value
for any financial assets acquired and liabilities assumed. The Board has also
permitted certain firm commitments to be recorded at fair value. These involve
legally binding purchase obligations whose quantity, price and delivery date are
fixed. Under present guidance such items would typically not be recognized at
inception. Certain insurance and reinsurance contracts and some warranty rights
and obligations may also be carried at market.

Chapter Four                                           Fair Value Accounting

       Because SFAS No. 159 permits different accounting for essentially similar
items, FASB requires extensive disclosure when the fair value option is elected.
Items must be presented in a manner that separates those reported values from
the carrying amounts of assets and liabilities subsequently measured using
another measurement attribute on the face of the statement of financial position.
The entity may either display separate line item amounts or present aggregate
amounts and parenthetically disclose those measured at fair value. Cash flow
reporting of fair value changes would be classified as operating, investing or
financing, based on the nature and purpose for which the related assets and
liabilities were incurred (SFAS No. 95). Entities are also required to disclose:

     i.     The difference between the carrying amount of financial
            liabilities reported at fair value and the contractual amount
            payable to holders

     ii.    Sufficient information to allow users to understand the effect
            on earnings of changes in fair value

     iii.   Quantitative information on a line-by-line basis indicating
            where the fair value changes have been reported

     iv.    A description of how interest and dividends are reported on the
            income statement.

      The fair value option is likely to provide larger companies with increased
flexibility in reporting. It can free them from the complexities and documentation
requirements required to qualify for hedge accounting under Statement No. 133.
By allowing entities to elect either fair or some other value on a contract-by-
contract basis, FASB was aware it was reducing comparability, both between
instruments and between entities. The same asset or liability could be accounted
for differently within or between companies. The Board concluded this was a
price worth paying. The benefit – mitigating the current problem of earnings
volatility caused by using fair value for some items but not for others – is believed
to outweigh the costs of noncomparability. The required disclosures are meant to
compensate for this and enable users to compare when different entities have used
different measures for the same items.

Fair Value Accounting                                              Chapter Four

       One further anomaly arises with using fair value that many accountants find
disturbing. When debt is reported at fair value, adverse business events could
cause an entity to report income (gains)! Under the present value model the fair
value of the debt would decline and the company would report income (sic). This
is illustrated below. Some Board members are uncomfortable with such a result
and feel it undermines confidence in the financial reporting model. They believe
it has the potential to mislead users and conceal operating performance issues.
The effect on financial benchmarks (ratios, loan covenant metrics, etc.) also
seems counterintuitive. The remaining Board members considered, but rejected,
limits on a debtor’s ability to recognize any credit deterioration in earnings. They
concluded that there is no justification, conceptual or otherwise, for curtailing the
debtor’s recognition in earnings of the effect of changes in its credit worthiness in
reporting liabilities at fair value. This remains a controversial area.


     Value at inception
              Debt (Payable)
              Annual Amount                $     4,750
              Years                                   5
              Implicit Rate                         8%

              Fair (Present) Value             $18,965

     Assume credit standing of entity declines, rate increases 4%
            Debt (Payable)
            Annual Amount                 $    4,750
            Years                                    5
            Implicit Rate                        12%

              Fair (Present) Value             $17,123

              Gain (loss)                                 $1,843

              Assume Debt is at market
              Debt Adjusted to Market           $1,843
               Gain (Income Statement)                    $1,843

                   Chapter Four                                                        Fair Value Accounting

                         The following example is adapted from SFAS No. 159. It integrates the
                   disclosure requirements of that Statement with those of Statements No. 107 and
                   No. 157.

                                      INTEGRATED FAIR VALUE PRESENTATION EXAMPLE

                                                                       Available                             Private
                                                        Trading        for sale                              Equity      Long Term
                                                        Securities     securities    Loans (net) Derivatives Investments Debt

              Carrying Amount 12/31/X8                         115              75         400          60         125        (200)

              SFAS 107 Fair Value Estimate 12/31/X8            115              75         412          60         138        (206)

              Items Measured at Fair Value 12/31/X8            115              75         150          60          75         (60)

157 Fair      Level 1                                          105              75           0          25           0         (30)
Value         Level 2                                           10                         100          15          25         (10)
Information   Level 3                                                                       50          20          50         (20)

              Trading Gains & Losses                             10                                      5
Changes in    Other Gains & Losses                                                          (3)                     (18)        13
Fair Value    Interest Income on Loans                                                      10
During 20X8   Interest Expense on Long Term Debt                                                                                (4)
              Changes in Fair Value shown in Earnings            10                           7          5          (18)         9

Fair Value Accounting          Chapter Four



To top