1494 Luca Pacioli Fair Value Accounting by fhn18015

VIEWS: 262 PAGES: 90

More Info
									                Fair Value Accounting
  FAS 105, 107, 115, 130, 133, 141, 142, 155, 157, 159

                                 Bob Jensen
                      Emeritus Professor of Accounting
                      Trinity University in San Antonio
                            190 Sunset Hill Road
                            Sugar Hill, NH 03586

      Bob Jensen’s Summary of Accounting History and Theory

―Not everything that can be counted, counts. And not everything that counts can
be counted.”
Albert Einstein
The government gave them 105% for their $200,000 subprime mortgage.
               They then sold the house for $37,000,
                         got married, and
                   are escaping from California.

  So are we now that we flipped the doghouse!

         Alternative Accounting Measures of Value
                       of Assets and Liabilities
            ―Skate to where the puck is going, not to where it is.‖
          Wayne Gretsky (as quoted for many years by Jerry Trites )

Historical Cost of Individual Assets and Liabilities
  Summed in Balance Sheet (Book Value)

Historical Cost With Price Level Adjustments (PLA)

Entry Value (Replacement Cost, Current Cost)

          Alternative Accounting Measures of Value
                        of Assets and Liabilities
             ―Skate to where the puck is going, not to where it is.‖
           Wayne Gretsky (as quoted for many years by Jerry Trites )

Exit Value (Net Liquidation Value)

Economic Value (Discounted Cash Flows, FCF, Residual Income)

Market Value of Entire Firm (Cash Versus Stock Trade)

Market Value of All Shares Outstanding

        Alternative Accounting Measures of Value
                      of Assets and Liabilities
             Skate to where the puck is going, not to where it is.
         Wayne Gretsky (as quoted for many years by Jerry Trites )

Graduate student Derek Panchuk and professor Joan Vickers,
who discovered the Quiet Eye phenomenon, have just completed
the most comprehensive, on-ice hockey study to determine where
elite goalies focus their eyes in order to make a save. Simply put,
they found that goalies should keep their eyes on the puck. In an
article to be published in the journal Human Movement Science,
Panchuk and Vickers discovered that the best goaltenders rest
their gaze directly on the puck and shooter's stick almost a full
second before the shot is released. When they do that they make
the save over 75 per cent of the time.
"Keep your eyes on the puck," PhysOrg, October 26, 2006 ---

 FAS 33 from 1979-1984 (ended with FAS 82)

                       Knotted Strings

South American Indian culture apparently used layers of knotted
  strings as a complicated ledger.
   Two Harvard University researchers believe they have uncovered
  the meaning of a group of Incan khipus, cryptic assemblages of
  string and knots that were used by the South American civilization
  for record-keeping and perhaps even as a written language.
  Researchers have long known that some knot patterns represented a
  specific number. Archeologist Gary Urton and mathematician
  Carrie Brezine report today in the journal Science that computer
  analysis of 21 khipus showed how individual strings were combined
  into multilayered collections that were used as a kind of ledger.
   Thomas H. Maugh, "Researchers Think They've Got the Incas'
  Numbers," Los Angeles Times, August 12, 2005
                Origins of Double Entry
                Accounting are Unknown

   1300s A.D. crusades opened the Middle East and Mediterranean
    trade routes
   Venice and Genoa became venture trading centers for commerce
   1296 A.D. Fini Ledgers in Florence
   1340 City of Massri Treasurers Accounts are in Double Entry
   1494 Luca Pacioli's Summa de Arithmetica Geometria
    Proportionalita (A Review of Arithmetic, Geometry and
       Going Concern and Accrual Accounting
               Evolved in the 1500s

   Venture accounting over the life of a venture with interim
    statements evolved in The Netherlands

   1673 Code of Commerce in France requires biannual balance
    sheet reporting

   Charge and Discharge Agency Responsibility and Stewardship
    Accounting in English trust accounting

             Limited liability Corporations
              (divorced professional management
                    from ownership shares)

   1555 A.D. Russia Company
   1600 A.D. East India Company
   1670 A.D. Hudson's Bay Company
   England's Joint Stock Companies Act of 1844 required depreciation
    accounting for railroads, mining, and manufacturing (although the
    concept of depreciation dates back to Roman times).

        Speculation Fever and Stewardship

Fraud and corruption festered and grew with the
trading of joint stock, especially after 1600 A.D. The
South Seas Company scandal (reporting stock sales as
income and paying dividends out of capital) led to
England's Bubble Act in 1720 A.D. that focused on
misleading accounting practices that helped managers
rip off investors, especially by crediting stock sales to

     Laissez-Faire Accounting survived endless
        debates and scandals until the Great
                Depression in 1933
   Much of the debate focused on capital maintenance (e.g., failure to charge off
    depreciation and failure to provide for replacement of operating assets), but
    governments did not legally impose auditing requirements and serious GAAP until
    the U.S. securities laws in the early 1930s. Accountants were vocal in reform
    movements, but governments were slow to react with legislation and courts failed to
    establish consistent GAAP.
   Creation of the SEC in an effort to regain public trust in financial reporting and
    equity investing.
   Many firms did have independent audits and conformed to the best GAAP traditions
    of the day (thereby giving some evidence that Agency Theory works
    sometimes.) Agency theory hypothesizes that it is in the best interest of
    management to contract for protection of investors and avoid scandalous
    asymmetries of information.
      After 1933, the AICPA and the SEC seriously attempted to
     generate accounting standards, enforce accounting standards,
    and provide academic justification for promulgated standards.
   ASRs of the SEC

   In a 3-2 vote the SEC followed George O. May's efforts to mandate external
    audits of securities traded across state lines in the U.S.

   1939-1959 A.D.: Accounting standards were generated by the AICPA's
    Committee on Accounting Procedure (CAP) that issued Accounting Research
    Bulletins (51 ARBs) --- but the tendency was to overlook controversial issues
    such as off-balance sheet financing, public disclosure of management forecasts,
    price-level accounting, current cost accounting, and exit value
    accounting. Controversial items avoided by the CAP included management
    compensation accounting, pension accounting, post-employment benefits
    accounting, and off balance sheet financing (OBSF). The CAP did very little to
    restrain diversity of reporting.
      After 1933, the AICPA and the SEC seriously attempted to
     generate accounting standards, enforce accounting standards,
    and provide academic justification for promulgated standards.
   1960-1972 A.D.: Accounting standards in the U.S. were generated by the AICPA's Accounting
    Principles Board (APB) that had more members than the CAP and a mandate to attack more
    controversial reporting issues. The APB attacked some controversial issues but often failed to resolve
    their own disputes on such issues as pooling versus purchase accounting for mergers.

   1972-???? A.D. Accounting standards in the U.S. were, and still are, being generated by the Financial
    Accounting Standards Board (FASB) that has seven members, including required members from
    industry, academe, and financial analysts in addition to members from public accountancy. FASB
    members must divorce themselves from previous income ties and work full time for the FASB. The
    formation of the FASB was a desperation move by CPA's to stave off threatened takeover of accounting
    standards by the Federal Government (there were the Moss and Metcalf bills to do just that under
    pending legislation in the U.S. House and Senate). Unlike the CAP and APB, the FASB has a full-time
    research staff and has issued highly controversial standards forcing firms to abide by pension accounting
    rules, capitalization of many leases, and booking of many previous OBSF items (capital leases, pensions,
    post-employment benefits, income tax accounting, derivative financial instruments, pooling accounting,
    etc.). The road has been long and hard on some other issues where attempts to issue new standards (e.g.,
    expensing of dry holes in oil and gas accounting and booking of employee stock options) have been
    thwarted by highly-publicized political pressuring by corporations.
            In 2007 International Harmonization
                    is Becoming a Reality

   In Year 2008 foreign corporations may file reports with the SEC
    and be listed on U.S. stock exchanges using IASB standards
    rather than FASB standards without reconciling the two.

   The U.S., Canada, and other nations are working toward
    adoption of IASB standards in place of domestic accounting

     Fair Value Accounting Under the IASB & FASB

   IASB is exploring with FASB accounting for fair-value accounting as
    part of a wider project on measurement. It is in the context of this
    long-planned effort, and not some recent reaction, that the IASB is
    planning to and will explore issues related to fair-value accounting.

   IAS 32 and 39 Require Fair Value Accounting for Financial
    Instruments in Many Instances

 Fair Value Accounting Under the IASB & FASB

The main problem of fair value adjustment is that many
(most?) of the adjustments cause enormous fluctuations
in earnings, assets, and liabilities that are washed out
over time and never realized. The main advantage is
that interim impacts that ―might be‖ realized are
booked. It’s a war between ―might be‖ versus ―might
never.‖ The war has been waging for over a century
with respect to booked assets and two decades with
respect to unbooked derivative instruments,
contingencies, and intangibles.

     Fair Value Accounting Under the IASB & FASB

   Holder, Hopkins, and Wablen (The Accounting Review, 2004, pp.
    453-472) found, in a sample of 200 banks, that fair value
    accounting gave rise to more than five times more earnings
    volatility than traditional GAAP earnings.

   Much of the volatilty washes out over time such that earnings
    increases and decreases from fair value adjustments have zero
    effect on cash in most instances. This is misleading for going

     Fair Value Accounting Under the IASB & FASB

   Hirst and Hopkins (Journal of Accounting Research, 1998, pp. 47-
    75) found, in a sample of 200 banks, that fair value accounting
    improved bank equity analyst judgments about risk and value.

   Ahmed, Kilic, and Lobo (The Accounting Review, 2006, pp. 567-
    588) found that fair value booking of derivatives after FAS 133
    was far more important than mere disclosures in footnotes for
    banking financial statements.

   More study needed for non-financial business firms.

                   Fair Valuing Debt
        Better/Worse Credit Standing = Loss/Gain

Barge (James Barge, senior vice president and controller
for Time Warner) also cited as problematic the
hypothetical case of a company whose creditworthiness
is downgraded by the rating agencies. By marking down
the debt's value on its balance sheet, the company would
realize more income, a scenario Barge called
"nonsensical." He warned of a host of such effects
arising under fair value when a company changes its
capital structure.

                       Fair Valuing Debt
            Better/Worse Credit Standing = Loss/Gain

   Actually there is potential gain from buying back debt
    cheaper due to lowered credit rating.

   Actually there is potential loss from buying back debt
    cheaper due to improved credit rating.

   Chasteen and Ransom (Acctg. Horizons, June 2007, pp.
    119-136) advocate immediate recognition of such gains
    & losses and future carrying of debt at risk free rates.

 Fair Value Accounting Under the IASB & FASB

Barge also cited where the acquisition of intangible assets that a
company does not intend to use as a further example of fair
value's potentially worrisome effects. Under current GAAP, their
value is included in goodwill and subject to annual impairment
testing for possible write-off. But if, as FASB is contemplating, the
value of those assets would be recorded on the balance sheet along
with that of the associated tangible assets that were acquired,
Barge worries that an immediate write-off would then be required
— even though it would not reflect the acquiring company's

     Key FASB Standards on Fair Value Acctg.

   FAS 105 --- Disclosure of OBSF and market risks of instruments
   FAS 107 --- Requirements for disclosure of FV
   FAS 115 --- HTM vs. AFS vs. Trading
   FAS 130 --- OCI offset instead of current earnings
   FAS 133 --- FV required for derivative instruments
   FAS 141 --- Identify and FV intangibles in acquisitions
   FAS 142 --- Must est. FV of ―Goodwill‖ remaining
   FAS 155 --- Requires FV acctg. for hybrid securities
   FAS 157 --- Defines FV and hierarchy of meas. pref.
   FAS 159 --- FVO for financial instruments
     "How to Save the Financial System," by William M.
      Isaac, The Wall Street Journal, September 19, 2008

   Suspend the Fair Value Accounting rules
    ―Biggest culprit for banking collapse‖ is FAS 115 that in bad
    times requires markdowns to ―fire sale‖ values

   Clamp down on abuses by short sellers
    Short sellers are engaged in abuses such as purchasing credit
    default swaps on corporate bonds (essentially bets on whether a
    borrower will default)

   Withdraw the Basel II capital rules (2007)
    Allow high leverage capital ratios in good times, but require much
    higher ratios for banks losing money.
     Key FASB Standards on Fair Value Acctg.

   FAS 105 --- 1990
   FAS 107 --- 1991 to be effective in 1993
   FAS 115 --- 1993 to be effective in 1994
   FAS 130 --- 1997 to be effective in 1998
   FAS 133 --- 1998 but later delayed until 2000
   FAS 141 --- 2001
   FAS 142 --- 2001
   FAS 155 --- 2006
   FAS 157 --- 2006
   FAS 159 --- 2007 to be effective in 2008
                          FAS 105 in 1990
            Disclosure of OBSF Market and Credit Risk
   The face, contract, or notional principal amount
   The nature and terms of the instruments and a discussion of their credit and
    market risk, cash requirements, and related accounting policies
   The accounting loss the entity would incur if any party to the financial
    instrument failed completely to perform according to the terms of the contract
    and the collateral or other security, if any, for the amount due proved to be of
    no value to the entity
   The entity's policy for requiring collateral or other security on financial
    instruments it accepts and a description of collateral on instruments presently
   This Statement also requires disclosure of information about significant
    concentrations of credit risk from an individual counterparty or groups of
    counterparties for all financial instruments.
                FAS 107 effective in 1993
       Disclosure of Fair Value of Fin. Instruments

       This Statement extends existing fair value disclosure
       practices for some instruments by requiring all entities
       to disclose the fair value of financial instruments, both
       assets and liabilities recognized and not recognized in
       the statement of financial position, for which it is
       practicable to estimate fair value. If estimating fair
       value is not practicable, this Statement requires
       disclosure of descriptive information pertinent to
       estimating the value of a financial instrument.
       Disclosures about fair value are not required for
       certain financial instruments listed in paragraph 8.
               FAS 115 effective in 1994
    FV Reporting of AFS Investments in Debt/Equity

   Debt securities that the enterprise has the positive intent and
    ability to hold to maturity are classified as held-to-maturity
    securities and reported at amortized cost.
   Debt and equity securities that are bought and held principally
    for the purpose of selling them in the near term are classified as
    trading securities and reported at fair value, with unrealized gains
    and losses included in earnings.
   Debt and equity securities not classified as either held-to-maturity
    securities or trading securities are classified as available-for-sale
    securities and reported at fair value, with unrealized gains and
    losses excluded from earnings and reported in a separate
    component of shareholders' equity.
                 FAS 130 effective in 1998
       Reporting Other Comprehensive Income (OCI)

  This Statement requires that an enterprise

(a)   classify items of other comprehensive income by
      their nature in a financial statement and
(b)    display the accumulated balance of other
      comprehensive income (AOCI) separately from
      retained earnings and additional paid-in capital
      in the equity section of a statement of financial
                      FAS 133 effective in 2000
                  Amended by FAS 137, 138, 149, 155, and 159
     Accounting for Derivative Financial Instruments and Hedging Activities

   Financial Derivatives & Scandals Explode in the Early 1990's
   Video or Audio clip from CBS Sixty Minutes SIXTY01.avi or SIXTY01.mp3
   Audio clip from John Smith of Deloitte & Touche in August
    1994 SMITH01.mp3
   Examples of derivative contracts that even the professional analysts could not
         The derivatives that Merrill Lynch wrote that drive Orange County into
         Other derivatives fraud summaries are at
   Video and audio clips of FASB updates on FAS 133
         Audio 1 --- Dennis Beresford in 1994 in New York City BERES01.mp3
         Audio 2 --- Dennis Beresford in 1995 in Orlando BERES02.mp3
   Derivative Financial Instrument Frauds --- Off line --- Click Here
                    FAS 133 effective in 2000
                 Amended by FAS 137, 138, 149, 155, and 159
    Accounting for Derivative Financial Instruments and Hedging Activities

   Requires booking of most derivative financial instruments at fair
    value (with some exceptions for NPNS, regular-way, insurance
    contracts, weather derivatives, short sales, interest-strips, etc.)
   Derivatives are to be marked to current fair value at least every
    90 days and on reporting dates. Changes in fair value are to be
    charged or credited to current earnings unless the derivatives
    qualify for hedge accounting treatment as cash flow, fair value,
    or FX hedges. Not all economic hedges qualify for hedge
    accounting relief from current earnings.

   Hedge accounting rules under FAS 133 and its
    amendments are very complex.
                            Key FAS 133 and IAS 39 Terms

Notional | Underlying | Net Settlement | Little or No Initial Investment

Financial Instrument            | Derivative Instrument

Purchase Commitment | Firm Commitment | Forecasted Transaction | Speculation

Stand Alone | Cash Flow Hedge | Fair Value Hedge | FX Hedge

Purchased Options | Written Options | Long Forwards | Short Forwards | Swaps | Futures Contracts
European versus American versus Asian options

Spot Price, Forward Price, Strike Price, Premium, Intrinsic Value, Time Value

Freestanding, Embedded, Structured (tailormade rather than convential financing)

OCI versus Firm Commitment | Delta

              FAS 141 effective in 2001
    Purchase Method Req. for Business Combinations
   In contrast to Opinion 16, which required separate recognition of intangible
    assets that can be identified and named, this Statement requires that they be
    recognized as assets apart from goodwill if they meet one of two criteria—the
    contractual-legal criterion or the separability criterion. To assist in identifying
    acquired intangible assets, this Statement also provides an illustrative list of
    intangible assets that meet either of those criteria.

   In addition to the disclosure requirements in Opinion 16, this Statement
    requires disclosure of the primary reasons for a business combination and the
    allocation of the purchase price paid to the assets acquired and liabilities
    assumed by major balance sheet caption. When the amounts of goodwill and
    intangible assets acquired are significant in relation to the purchase price paid,
    disclosure of other information about those assets is required, such as the
    amount of goodwill by reportable segment and the amount of the purchase
    price assigned to each major intangible asset class.
                FAS 142 effective in 2001
      Goodwill and Other Intangible Assets Acquired
   Purchased goodwill and other intangibles in business combinations are to be
    revalued each reporting date and written down to the extent that its historical
    cost valuation has been impaired. The historical cost is no longer to be
    amortized except in the case of intangibles with finite lives. In theory the cost of
    purchased intangibles could stay on the books for many, many years.

   This Statement provides specific guidance for testing goodwill/ingangibeles for
    impairment. Goodwill will be tested for impairment at least annually using a
    two-step process that begins with an estimation of the fair value of a reporting
    unit. The first step is a screen for potential impairment, and the second step
    measures the amount of impairment, if any. However, if certain criteria are
    met, the requirement to test goodwill for impairment annually can be satisfied
    without a re-measurement of the fair value of a reporting unit.

                        FAS 155 effective in 2006
               Accounting for Certain Hybrid Financial Instruments

   Permits fair value re-measurement for any hybrid financial instrument that
    contains an embedded derivative that otherwise would require bifurcation
   Clarifies which interest-only strips and principal-only strips are not subject to
    the requirements of Statement 133
   Establishes a requirement to evaluate interests in securitized financial assets to
    identify interests that are freestanding derivatives or that are hybrid financial
    instruments that contain an embedded derivative requiring bifurcation
   Clarifies that concentrations of credit risk in the form of subordination are not
    embedded derivatives
   Amends Statement 140 to eliminate the prohibition on a qualifying special-
    purpose entity from holding a derivative financial instrument that pertains to a
    beneficial interest other than another derivative financial instrument.

                                 FAS 155

   Permits fair value measurement for certain hybrid financial
    instruments that contain an embedded derivative that would
    otherwise require bifurcation under Statement 133.
   Amends Statement 133 to require evaluation of all interests in
    securitized financial assets. thus eliminating the exemption in
    Statement 133 accounts for certain hybrid instruments. As a
    result, entities will have to determine if such interest may be:
        1. Freestanding derivatives,
        2. Hybrid financial instruments containing embedded
           derivatives requiring bifurcation, or
        3. Hybrid financial instruments containing embedded
           derivatives that do not require bifurcation
   Clarifies that only the simplest and most direct separation of
    interest and principal cash flows need not be evaluated for
    embedded derivatives
                                   FAS 155

   Clarifies that concentrations of credit risk in the form of
    subordination are not embedded derivatives.
   Amends Statement 140 to allow a QSPE to hold passive derivative
    instruments that pertain to beneficial interest that are or contain
    a derivative financial instrument
   Irrevocable election on an instrument by instrument basis with all
    changes in fair value recognized in earnings.
   The fair value election should be made at the time the financial
    instrument is acquired, issued or there is a new basis in a
    previously recognized financial instrument.
           Upon adoption, applies to existing hybrid financial
            instruments that had been bifurcated under the requirements
            of Statement 133.

                                         FAS 155

 The Bifurcation Model
 Paragraph 12 of Statement 133:

       1. Is the hybrid         2. Would the             3. Is it clearly
        carried at fair   No      embedded         Yes     and closely      No
                                 feature be a

        value through                                     related to the
          earnings?             derivative if it         Host contract?
          (Par 12b)            was freestanding?            (Par 12a)
                                   (Par 12c)

                Yes                      No                        Yes

                                Do Not Bifurcate

                            FAS 155

Paragraph 14 of FAS 133
However, interest-only strips and principal-only
strips are not subject to the requirements of this Statement
provided they

(a) initially resulted from separating the rights to receive
contractual cash flows of a financial instrument that, in and
of itself, did not contain an embedded derivative that
otherwise would have been accounted for
separately as a derivative pursuant to the provisions of
paragraphs 12 and 13 and

(b) do not incorporate any terms not present in the original
financial instrument described above.
                              FAS 155

However, interest-only strips and principal-only strips are not subject
to the requirements of this Statement provided those strips (a)
represent the rights to receive only a specified proportion of the
contractual interest cash flows of a specific debt instrument or a
specified proportion of the contractual principal cash flows of that
debt instrument and (b) do not incorporate any terms not present in the
original financial debt instrument described above. An allocation of a
portion of the interest or principal cash flows of a specific debt
instrument as reasonable compensation for stripping the instrument or
to provide adequate compensation to a servicer (as defined in
Statement 140) would meet the intended narrow scope of the
exception provided in this paragraph. However, an allocation of a
portion of the interest or principal cash flows of a specific debt
instrument to provide for a guarantee of payments, for servicing in
excess of adequate compensation, or for any other purpose would not
meet the intended narrow scope of the exception.
                               FAS 155

•      Nullified Issue D1 Application of Statement 133 to
       Beneficial Interests in Securitized Financial Assets. Impact
       of Issue D1 was to defer the bifurcation requirements of
       Statement 133

•      Holders of beneficial financial interests must analyze
       arrangements that govern the payoff structure and the
       subordination status of the financial instrument
       Prepayment risks in such structures could result in meeting
          the 13(b) requirements of Statement 133

                FAS 157 effective in 2006
               Fair Value Measurements
 The changes to current practice resulting from
 the application of this Statement relate to

 the    definition of fair value,
 the    methods used to measure fair value, and
    expanded disclosures about fair value
 the
                                            FAS 157

All accounting pronouncements that require or permit fair value
    measurement and include such items as:
       Investment securities –                  Certain assets and liabilities
        Statement 115                             measured at fair value in a
       Derivatives – Statement 133               business combination –
                                                  Statement 141:
       ―Short sales‖ of securities –
        AICPA Audit Guides for certain                   Intangible assets
        industries                                       In process R&D
       Investments carried at fair value        Assets measured at fair value for
        by investment companies                   an impairment test – Statements
                                                  142 and 144:
                                                         Long-lived assets held for
                                                         Reporting units
                                                         Goodwill

                Differences Between Statement 157 and
                           Current Practice

       Issue                     Current Practice                              Statement 157
       Definition                Various definitions of fair value –           Price that would be received for an
                                 Amount at which an asset or liability         asset or paid to transfer a liability
                                 could be bought or sold in a current          between market participants at the
                                 transaction between willing parties, that     measurement date.
                                 is, other than in a forced liquidation sale

       Transaction Entry Price   Presumed equal to fair value                  May not be representative of fair
                                                                               value; provides indicators of when
                                                                               the transaction price may not be
                                                                               fair value.

       Highest and Best Use      Current practice is to value assets in        Independent of the reporting
                                 continued use unless identified for           entity’s intent: considered from
                                 disposition                                   market participant perspective

       Use of Market Data in     Use of market data encouraged. In             Valuation techniques must
       Valuations                some circumstances entity intent              maximize use of market observable
                                 permitted to be considered in                 data and minimize use of
                                 valuations.                                   unobservable data
       Hierarchy                 No current mandated hierarchy.                Three levels distinguished between
                                                                               observable and unobservable
1-52   SOURCE: DELOITTE                                                        inputs.
   Differences Between Statement 157 and Current
Issue                                  Current Practice                       Statement 157
Defensive Value                                 -                   New concept

Principal/Most Advantageous Market              -                   Newly defined concept

Market Participants                  Current guidance on            Buyer-specific intent should be
                                     market participants is         dismissed if different from that of other
                                     unclear. Buyer-specific        multiple market participants
                                     intent may be considered

Block Discounts                      Broker-dealers and             Eliminated for all companies in relation
                                     investment companies           to actively traded securities
                                     permitted to apply block

Restricted Securities                Restrictions on marketable     Fair value measurement should include
                                     securities not required to     the effect of a restriction, if the
                                     be considered in the           restriction is an attribute of the security
                                     valuation if the restriction   which would pass to market
                                     terminated within one year.    participants.

Model Risk                                      -                   Assessed as a component of the fair
                                                                    value measurement

            Statement 157 – Valuation Hierarchy

  Statement 157 provides three main approaches to measuring fair value.

                                       Fair Value

                                                        Level 3
                           Level 1      Level 2        Income/FCF
                       Market- based   Extrapolate        Model

               Objective                                            Subjective

                       FAS 157

  Level 1 Inputs --- Paragraphs 24-27
  Quoted prices of identical items in active
  markets (full rather than thin markets)
  Fungible goods
  No timing distress
  Options versus commodities markets

                                    FAS 157

  Level 2 Inputs --- Extrapolations from Markets or Sales
  a. Quoted prices for similar assets or liabilities in active markets
  or reliable component cost markets.

  b. Quoted prices for identical or similar assets or liabilities in markets that
  are not active, that is, markets in which there are few transactions for the
  asset or liability, the prices are not current, or price quotations vary
  substantially either over time or among market makers (for example, some
  brokered markets), or in which little information is released publicly (for
  example, a principal-to principal market)

  c. Inputs other than quoted prices that are observable for the asset or liability
  (for example, interest rates and yield curves observable at commonly quoted
  intervals, volatilities, prepayment speeds, loss severities, credit risks, and
  default rates)

  d. Inputs that are derived principally from or corroborated by observable
  market data by correlation or other means (market-corroborated inputs).

                         FAS 157

  Level 2 Inputs (Examples)
  a. OTC swaps, options, and forward contracts
     Extrapolations from Bloomberg databases

  b. Appraisals based on similar-item sales
      Such as real estate in the same neighborhood
     (Supposed to be full-market estimates rather than
      thin-market estimates such as a single offer)

  c. Jewelry value estimates based upon markets
     for components like gold in the jewelry

                            FAS 157

  Level 2 Enron Energy Services (EES) Example
  a. Long-term contracts for power to companies such as
     Eli Lili. Stripper fanatic Lou Pai was CEO of EES.
  b. Enron sold 7% of EES to institutions for $130 million
  c. Enron thereafter valued EES at $1.9 billion and
     recorded a $61 million profit due to change in FV.
  d. Within two years most of EES contracts became
     liabilities totaling over $500 million. No write downs
     were taken until Enron declared bankruptcy.

                             FAS 157

  Level 2 Enron Energy Services (EES) Example
  a. Fair value accounting may lead to unearned income
     being recognized up front.
  b. Fair value accounting may lead to inconsistencies
     between valuations upward vs. valuations downward
  c. Plunges CPA auditors into valuation’s stormy seas.
     CPAs have no special comparative advantages here!
  d. Assets may flip flop to liabilities and vice versa overnight

                            FAS 157

  Level 3 Inputs in Paragraphs 30-32
  Unobservable inputs shall reflect the reporting entity’s own
  assumptions about the assumptions that market
  participants would use in pricing the asset or liability
  (including assumptions about risk). Unobservable inputs
  shall be developed based on the best information available
  in the circumstances, which might include the reporting
  entity’s own data. In developing unobservable inputs, the
  reporting entity need not undertake all possible efforts to
  obtain information about market participant assumptions

                           FAS 157

  Level 3 Expert Opinion and Value Models

  a. Residual Income (RI) and Free Cash Flow (FCF)
     (Highly sensitive to terminal values & perpetuity)
     (Highly sensitive to missing variables)
     (Intangibles are highly volatile)
     (Highly sensitive to non-stationarity)
     (Competition & Law destroys excess returns over time)

  b. Subjective appraisals with explicit analysis of
     underlying assumptions
     (Subjectivity leads to high variations in opinion)
     (Moral hazard --- scandalous S&L appraisals)
     (Value is so dependent upon unforeseeable events)
                        FAS 157

  Level 3 Examples
  a. Bonds of a bankrupt firm
  b. Asset retirement obligation
  c. Pollution abatement obligation
  d. Enron’s booking of ―fair value‖ of gas contracts

                            FAS 157

  Level 3 Enron ―Mark-to Market‖ Example
  a. Long-term contracts for gas to electric utilities
     such as Scithe Energies.
  b. Estimate gas profits over 10-20 years forward and
     record present value as an asset as current FV earnings.
  c. Increased gas price estimates increased value of asset
     and changes in FV taken into earnings. Eventually, the
     booked receivable from Scithe was $1.5 billion that
     could not possibly be collected ever.
  d. No write down took place until after Enron declared
     bankruptcy in December 2000. Huge bonuses, however,
     were paid to Enron executives all along.

                      FAS 157

 Determining    primary or most advantageous
 Assigningand Monitoring Statement 157
 hierarchy levels
 Credit   risk in valuing liabilities

                           FAS 159 effective in 2008
            The Fair Value Option for Financial Assets and Financial Liabilities

   Allows entities to voluntarily choose to measure eligible financial
    instruments at fair value (the ―fair value option‖)
    (Exceptions for items covered by some other standards such as
    consolidated entities, pensions, post-employment contracts, leases,
    and financial insurance contracts)

   Changes in fair value recognized in earnings. (no OCI)

   Election made on an instrument-by-instrument basis

   Irrevocable

                           FAS 159 effective in 2008
            The Fair Value Option for Financial Assets and Financial Liabilities

FASB issued the FVO to:

   Provide an opportunity to mitigate volatility in earnings
    caused by a mixed attribute accounting model
   Reduce the need for applying complex hedge accounting
   Expand the use of fair value measurements
   International convergence

                           FAS 159 effective in 2008
            The Fair Value Option for Financial Assets and Financial Liabilities

•   Recognized financial assets and liabilities (but not forecasted transactions under FAS

•   Firm commitments that would otherwise not be recognized at inception and that involve
    only financial instruments

•   Written loan commitments

•   Certain rights and obligations under insurance contracts or warranty obligations

•   A financial host contract in a nonfinancial hybrid instrument

•   Certain nonfinancial assets and liabilities

                          FAS 159 effective in 2008
           The Fair Value Option for Financial Assets and Financial Liabilities


   Eliminate arbitrary FAS 115 classifications that can be used by management
    to manipulate earnings (which is what Freddie Mac did in 2001 and 1002.

   Reduce problems of applying FAS 133 in hedge accounting where hedge
    accounting is now allowed only when the hedged item is maintained at
    historical cost.

   Provide a better snap shot of values and risks at each point in time. For
    example, banks now resist fair value accounting because they do not want to
    show how investment securities have dropped in value.

                          FAS 159 effective in 2008
        The Fair Value Option for Financial Assets and Financial Liabilities

    Combines fact and fiction in the sense that unrealized gains and losses due to fair value
    adjustments are combined with ―real‖ gains and losses from cash transactions. Many,
    if not most, of the unrealized gains and losses will never be realized in cash. These are
    transitory fluctuations that move up and down with transitory markets. For example,
    the value of a $1,000 fixed-rate bond moves up and down with interest rates when at
    expiration it will return the $1,000 no matter how interest rates fluctuated over the life
    of the bond.
   Sometimes difficult to value, especially OTC securities.
   Creates enormous swings in reported earnings and balance sheet values.
   Generally fair value is the estimated exit (liquidation) value of an asset or liability. For
    assets, this is often much less than the entry (acquisition) value for a variety of reasons
    such as higher transactions costs of entry value, installation costs (e.g., for machines),
    and different markets (e.g., paying dealer prices for acquisition and blue book for
    disposal). For example, suppose Company A purchases a computer for $2 million that
    it can only dispose of for $1 million a week after the purchase and installation. Fair
    value accounting requires expensing half of the computer in the first week even though
    the computer itself may be utilized for years to come. This violates the matching
    principle of matching expenses with revenues, which is one of the reasons why fair
    value proponents generally do not recommend fair value accounting for operating
                         FAS 159 effective in 2008
          The Fair Value Option for Financial Assets and Financial Liabilities

Disadvantages of Auditing FV
 The purpose of this International Standard on Auditing (ISA) is to establish
  standards and provide guidance on auditing fair value measurements and
  disclosures contained in financial statements. In particular, this ISA addresses
  audit considerations relating to the valuation, measurement, presentation and
  disclosure for material assets, liabilities and specific components of equity
  presented or disclosed at fair value in financial statements. Fair value
  measurements of assets, liabilities and components of equity may arise from
  both the initial recording of transactions and later changes in value.

                           FAS 159 effective in 2008
            The Fair Value Option for Financial Assets and Financial Liabilities


   Investments in consolidated entities
   Financial obligations for items such as pension benefits and other deferred
    compensation arrangements
   Income tax assets and liabilities
   Financial assets and liabilities recognized under leases as defined in Statement
   Deposit liabilities, withdrawals on demand, of depository institutions
   Financial instruments that are, in whole or in part, a component of
    shareholder’s equity

                    IASB Discussion Paper

IASB publishes Discussion Paper on fair value
  measurements November 30, 2006 with a May 1,
  2007 Deadline. Expect new standard in 2008.
   The Board’s objectives in this project are to:
   (a) establish a single source of guidance for all fair value
    measurements required by IFRSs,
   (b) clarify the definition of fair value and related guidance in
    order to more clearly communicate the measurement objective,
   (c) enhance disclosures about fair value
                IASB FVO in Amended IAS 39

   The European Commission has published Frequently Asked Questions providing the
    Commission's views on the following questions:
   Why did the Commission carve out the full fair value option in the original IAS 39
   Do prudential supervisors support IAS 39 FVO as published by the IASB?
   When will the Commission to adopt the amended standard for the IAS 39 FVO?
   Will companies be able to apply the amended standard for their 2005 financial
   Does the amended standard for IAS 39 FVO meet the EU endorsement criteria?
   What about the relationship between the fair valuation of own liabilities under the
    amended IAS 39 FVO standard and under Article 42(a) of the Fourth Company Law
   Will the Commission now propose amending Article 42(a) of the Fourth Company
   What about the remaining IAS 39 carve-out relating to certain
         FAS Standards Greatly Affected by FV

FAS 32 --- Financial Instruments
FAS 39 --- Derivative Financial Instruments
FAS 41 --- Agriculture

         IFRS Standards Greatly Affected by FV

IFRS 2 --- Share-based payments
     (Categories of assets and liabilities to be measured at FV)

IFRS 3 --- Business Combinations

                  IFRC 13 and Fair Value

   Question
    What's the status of international accounting for customer loyalty
    incentive awards such as airline miles, first class upgrades, hotel
    discounts, restaurant discounts, etc.?

   Answer
    There is a deferred revenue and liability recognition for future
    cost requirement. Allocation of the original sale is to be based
    upon estimated fair value of components of the sale.

                        IFRC 13 and Fair Value

   1. The main issue addressed in the Interpretation is the recognition and measurement of
    obligations to provide customers with free or discounted goods or services if and when
    they choose to redeem loyalty award credits.

   2. One approach used at present is to accrue an expense at the time of the sale, when the
    award credits are granted. The expense is based on the costs the entity expects to incur
    to supply the free or discounted goods or services. The rationale for this approach is
    that loyalty awards are incidental costs of securing the first sale, which should be
    recognised when that sale is made.
   3. A second approach is to divide the proceeds of the first sale into two components—an
    amount that reflects the value of the goods or services delivered in the first sale and an
    amount that reflects the value of the loyalty award credits. Proceeds allocated to the
    first component are recognised as revenue at the time of the first sale. But proceeds
    allocated to the award credits are deferred as a liability until the entity fulfils its
    obligations in respect of the award credits, either by supplying the free or discounted
    goods or services itself when customers redeem the credits, or engaging (and paying) a
    third party to do so.
                   IFRC 13 and Fair Value

   4. The practical difference between the two approaches is the
    measurement of the liability. The first approach measures the
    liability on the basis of expected costs; the second on the basis of
    selling prices.
   5. The Interpretation requires entities to apply the second
    approach. The requirement reflects the IFRIC’s view that loyalty
    awards are separately identifiable goods or services for which
    customers are implicitly paying. The general standard on revenue
    recognition, IAS 18 Revenue, requires separately identifiable
    components of sales transactions to be accounted for separately if
    necessary to reflect the substance of the transactions.

            A Formula to Remember for Later in the Day

   ForwardRate(t) = [1 + y(t)]t/[1 + y(t-1)]t-1 – 1
   The ForwardRate(t) is the forward rate for time period
    t, y(t) is the multi-period yield that spans t periods, and
    y(t-1) is the yield for an investment of t-1 periods --- for
    example, if 6.5% is y(t) and 6.0% is y(t-1). Thus,
    ForwardRate(2), the forward LIBOR for year 2, is
    calculated as follows
   ForwardRate(2) = (1.065)2/(1.06) – 1 = 0.07 or 7.0%

            Checklist for Valuing a Company

Compilation of Financial Information: Financial statements and
  federal income tax returns for the last three to five years should
  be reviewed and the information "adjusted" and/or "weighted"
  to more properly reflect future operations:

   Audited vs. unaudited statements to reflect accurate levels of
    inventories and receivables.

   Determine latest work-in-process value -- particularly where
    production costs have been expensed rather than capitalized.

   Delete extraordinary or non-recurring revenues or expenses.
             Checklist for Valuing a Company

   Adjust for differences in cash vs. accrual methods of reporting income.

   Add back any "excess" owner/employee cash compensation and fringe

   Determine net fair market value for tangible assets (eg., book value vs.
    liquidation value vs. replacement value of equipment, obsolete or slow-moving
    inventory, supplier return privileges, credits, etc.).

   Determine undisclosed and/or disputed liabilities (eg., unfunded past service
    costs or multi-employer obligations for pension plans, deferred compensation
    plans; incentive bonuses; stock options; potential contract or tort claims;
    potential unfunded sales income or payroll tax obligations).
          Checklist for Valuing a Company

  There is usually no "magic" correct value but rather an
  appropriate range of values dependent upon the "fit" of
  buyer and seller and the realism of the assumptions
  utilized in the valuation methodology. Also,
  consideration should be given to internal expressions of
  valuation (eg., buy-sell agreements, insurance
  arrangements, and deferred compensation and
  noncompetition agreements).

          Checklist for Valuing a Company

Obtain Outside Appraisal:
  A qualified business appraiser can offer insights as to
  comparable sales or to appropriate valuation calculation
  assumptions (eg., industry risks and capitalization rates,
  interest rates, etc.) as well as helpful analyses of
  alternative valuation method approaches (eg.,
  discounted cash flow analysis vs. liquidation value vs.
  tangible/intangible asset valuation as set forth in
  Revenue Ruling 59-60 as modified/amplified by Revenue
  Rulings 65-192, 65-193, 68-609, 71-287, 80-213 and 83-
  120; etc.).
            Checklist for Valuing a Company

Strategic and/or Value Added Components:
   Synergies
   Supplementary product lines
   Operating economies and/or vertical integration opportunities
   New supply or distribution avenues
   Limination of price and customer competition
   R&D, Patents, Copyrights
   Skilled and loyal work force
   No huge owner dependencies
           Checklist for Valuing a Company

Reductions or Add-Ons for Contingent Events:
  Sometimes, it is appropriate to reduce or supplement a calculated
  value for future possible contingencies (good and bad) -- eg., labor
  union problems, plan closure obligations, multi-employer pension
  plan obligations, unfunded past service pension costs, product
  liability exposures, tax exposures, short-term lease rights,
  uncertain supply or sales commitments or credit lines, patent
  expirations or other intellectual property uncertainties and/or
  exposures, as well as the prospect of greater profitability from
  new customers, lines, technology or endeavors which have not yet
  been reflected in historical financial results.

             Free Online Real Estate Appraisals
            Local Links --- ..\..\..\Tidbits\2007\tidbits070809.htm

   Eppraisal.com --- http://eppraisal.com/

   Realestateabc.com --- http://realestateabc.com/

   Homegain.com --- http://homegain.com/

   Zillow --- http://www.zillow.com/

            Banking Concerns

BIS Paper 109 --- Online Click Here
                Offline Click Here

       The End


To top