Teaching Fair Value Measurement Background & Overview

Why teach fair value measurement? Fair values are used in many areas of accounting Succession planning Estates and gifts Corporate structure changes Internal decision making Mergers and acquisitions Financial reporting and auditing

GAAP and fair values Over 40 FASB pronouncements require or permit the use of fair values. Examples include guidance on accounting for: debt derivatives business combinations pensions & OPEBs asset retirement obligations contributions received and made

Statement No. 157 Defines fair value Establishes a hierarchy for measuring fair values Expands disclosures about fair value measurements It does not require use of fair value if not required by other GAAP Effective in 2008 for calendar year firms

Definition Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. A fair value is an exit price.

Why an exit price? Fits with the definition of an asset and a liability Assets result in cash inflows Liabilities result in cash outflows Reporting entities recognize and measure assets and liabilities

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

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

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

Market participants Buyers and sellers in the principal (or most advantageous) market Independent of the reporting entity Knowledgeable Able to transact Willing to transact – motivated but not forced Highest and best use of the asset is assumed: in-use or in-exchange

Assumptions as valuation inputs Market participant assumptions are incorporated in fair value measurement as inputs to valuations Observable inputs – based on market data Unobservable inputs – based on assumptions about assumptions of market participants

Fair value hierarchy – level 1 Quoted prices (unadjusted) in active markets for identical assets or liabilities Ex. A share of GE

Fair value hierarchy – level 2 Quoted prices for similar assets or liabilities in active markets Quoted prices for similar assets or liabilities in markets that are not active Inputs other than quoted prices (e.g., interest rates, yield curves, volatilities) Inputs derived principally from or corroborated by observable market data or other means Ex. Interest-rate swap

Fair value hierarchy – level 3 Based on unobservable inputs Should reflect the reporting entity’s own assumptions about the assumptions market participants would use Should be based on the best available information in the circumstances Ex. Intangibles in a business combination

Valuation techniques Market approach: should be used as the primary, or confirmatory approach, if a market is observable Income approach: most often used when a market is not observable and a hypothetical market must be constructed Cost approach Multiple approaches may be used

Disclosure of fair value measures by level of the hierarchy Fair Value at Reporting Date Description 12/31/XX Level 1 Level 2 Level 3 Trading securities $ 115 $ 105 $ 10 Available-for-sale securities 75 Derivatives 60 25 15 $ 20 Venture capital investments 10 Total $ 260 $ 205 $ 25 $ 30 ($ in 000’s)

Disclosure of changes in level 3 measures ($ in 000’s) Level 3 Fair Value Measurements Derivatives Venture Capital Investments Total Beginning balance $14 $11 $25 Total gains and losses (realized/unrealized) Included in earnings 11 (3) 8 Included in OCI 4 Purchases, issuances, and settlements (7) 2 (5) Transfers in/out of Level 3 (2) Ending balance $20 $10 $30 Change in unrealized gains or losses In earnings relating to assets still held $7 $2 $9

What should entry-level accountants know about fair value? What is risk? What is value? How to make projections, assess risk value and value a business Approaches to valuation Income Market Cost How to evaluate the reasonableness of inputs to the valuation process and perform sensitivity analysis How to compute expected values, present values for partial periods and irregular streams of cash, and EVA

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

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

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