1 FASB’s MOVE TOWARDS FAIR VALUE AND ACADEMIC RESEARCH Derivatives Contingencies Financial instruments Stock Options – 123R Guarantees – Int. 45 Fair value.

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Presentation transcript:

1 FASB’s MOVE TOWARDS FAIR VALUE AND ACADEMIC RESEARCH Derivatives Contingencies Financial instruments Stock Options – 123R Guarantees – Int. 45 Fair value hierarchy – FAS 157

2 Today’s Discussion on Fair Value The new fair value standard – FAS 157 The fair value option proposal Business combination procedures – more and more fair value FAS 5 on contingencies – are its days numbered? HOW CAN ACADEMIC RESEARCH HELP?

3 Fair Value FAS 157, Paragraph 5 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. IOU $100 million

4 FAIR VALUE- how not when! FASB STATEMENT 157 Codify all the accounting literature on fair value Developed a common definition, increased disclosures Establish a 3 category hierarchy for measuring fair value – market quotes are always the best! A “market participant” view! Effective year ends – beginning after 11/15/07 What will the impact be and what warrants further research????

5 FAS New terms to learn! Market – principal or most advantageous market Fair value hierarchy (3 levels – use the highest) Observable inputs -Wall Street Journal - Derived from markets Unobservable inputs – discounted cash flows Types of valuations (market, income, cost approaches)

6 MARKET PLACE PARTICIPANTS Buy software & customer list - $10 million: Company plans Market participant - Have customers use -Would sell software buyer’s software and use customer list - Scrap seller’s software (Buyer’s allocation) FV (FASB allocation) FV Customer list $ 10 Customer list $ 2 Software 0 Software 8 Day two accounting?

7 The Fair Value Option Proposal Applicable to almost all financial instruments If elect to use fair value – changes thru income! Elect at inception – irrevocable and document it Choose contract by contract Debt - consider credit rating in calculation Prospective, cum catch up through retained earnings at the same time FAS 157 is adopted.

8 Discussion Points Why is the FASB adopting a fair value option? More alternatives vs. eliminating alternatives Credit rating goes down – big gain??? (hmm) How will companies react? How will users react? Research ideas?

9 BUSINESS COMBINATIONS- the procedures proposal! Many proposed “fixes” to how we do purchase accounting When there is a choice – the winner is use FAIR VALUE ! PROPOSALS ARE VERY CONTROVERSIAL! Could research help? Historical cost Fair value

10 Contingent Liabilities Company A buys Co. B for $50,000,000 Company B is being sued for $10,000,000 Chance of B losing - 40% (i.e., losing is not probable) How much should A record as part of purchase price allocation as a liability for lawsuit?? Zero? $4,000,000? More? (Answer fair value!) What if B eventually wins the lawsuit?

11 Contingent Consideration Company C buys Company D from Mr. Jones for cash of $10 million. Further, if earnings of D in next two years exceed $4 million, Company C must pay another $2 million to Mr. Jones How should Company C account for this contingency at the date of acquisition? Can an amount be objectively estimated? (Answer -fair value!)

12 In-Process R&D FAS 141 -Continue to require immediate write-off New Thinking: - Capitalize at fair value - Subsequent R&D – expense - Amortize – eventually But what about FAS 2?

13 ACQUIRE LESS THAN 100% Fair Value of Company X - $100 million Fair value of identifiable net assets - $30 million If buy 100% of X – goodwill is $70 million ($100-30) Assume company only buys 60% for $60 million: TEST – How much is goodwill? $42 million ($70 x 60%)? WRONG! “Correct” answer - $70 million A FAIR VALUE MODEL!

14 WHAT ABOUT FASB No. 5 - CONTINGENCIES Remote Reasonably Possible Probable Accrue – Probable & Estimable Disclose – Reasonable Possible Do Nothing – Remote IS THIS STILL OK?? (e.g., $100 Million lawsuit)

15 FAIR VALUE VS. FAS 5 FASB’s Invitation to Comment --Assets & Liabilities With Uncertainties The role of probability and uncertainty and the conceptual framework – big potential impact! The FASB is considering whether the FAS 5 model for contingencies (i.e., recognize when “probable”) is becoming obsolete! Research???

16 Recognition vs. Measurement Company A is being sued for $100 million—Record anything? More likely than not ______20%__________ 51%________80%_______ Remote Reasonably possible Probable Today we ask when should liability be “recognized” (probable threshold) IASB thinking – there is a liability! – Measure at fair value using expected cash flows (e.g., a 10% chance of losing – book $10 million!). Skip recognition threshold! What about plaintiff – book an asset? (why not!) Should we converge with IASB on uncertainties ?

17 IS FAIR VALUE THE WAY TO GO? More useful to users? Costly for preparers? Auditable? Increase or decrease complexity? Will fair value be used for everything some day ? ACADEMIC RESEARCH– COULD IT HELP STANDARD SETTERS AS THEY KEEP MOVING TOWARDS FAIR VALUE?