FAIR VALUE ACCOUNTING TOPICS Randy Gregg, CPA, BDO Assurance Partner Darren Cordier, CFA, President FV Specialists, Inc. OVERVIEW – FAIR VALUE ACCOUNTING TOPICS • Fair Value Accounting Refresher • Selected Topics • Goodwill • Intangible Assets • Interest Rate Swaps Page 2 FAIR VALUE ACCOUNTING REFRESHER OVERVIEW OF FAIR VALUE ACCOUNTING ASC 820 Fair Value Measurement: • Defines fair value under GAAP • Provides a framework for measuring fair value • Requires certain disclosures about fair value measurements ASC 820 Fair Value Measurement: • DOES NOT require measurement at fair value • Note : FASB ASC 825, The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115 (SFAS No. 159), provides additional flexibility on assets and liabilities that are not required to be fair valued on a recurring basis. Page 4 MANY STANDARDS REQUIRING FAIR VALUE MEASUREMENTS FASB ASC 958 and 805, Not-for-Profit Entities: Mergers and Acquisitions (SFAS No.164) FASB ASC 944, Financial Services–Insurance (SFAS No. 163) FASB ASC 815, Derivatives and Hedging (SFAS No. 161) FASB ASC 810, Consolidations (SFAS No. 160) FASB ASC 805, Business Combinations (SFAS No.141R) FASB ASC 825, Financial Instruments (SFAS No. 159) FASB ASC 715, Compensation–Retirement Benefits (SFAS No. 158) FASB ASC 820, Fair Value Measurements and Disclosures (SFAS No. 157) FASB ASC 860, Transfers and Servicing (SFAS No. 156) FASB ASC 815, Derivatives and Hedging (SFAS No. 155) Page 5 Page 5 MANY STANDARDS REQUIRING FAIR VALUE MEASUREMENTS FASB ASC 958, Accounting for Contributions Received and Contributions Made (SFAS No. 116) FASB ASC 958, Financial Statements of Not-for-Profit Organizations (SFAS No. 117) FASB ASC 958, Accounting for Certain Investments Held by Not-forProfit Organizations (SFAS No. 124) FASB ASC 845, Non-monetary Transactions (SFAS No. 153) FASB ASC 480, Distinguishing Liabilities from Equity (SFAS No. 150) FASB ASC 420, Exit or Disposal Cost Obligations (SFAS No. 146) FASB ASC 360, Property, Plant, and Equipment (SFAS No. 144) FASB ASC 410, Asset Retirement and Environmental Obligations (SFAS No. 143) FASB ASC 350, Intangibles–Goodwill and Other (SFAS No. 142) Page 6 Page 6 EXCLUSIONS FROM SCOPE OF ASC 820 The following are excluded from the scope of ASC 820: • Share based payment transactions • Stock compensation (Topic 718) • Equity based payments to non-employees (Subtopic 505-50) • Measurements similar to fair value but not intended to measure fair value • VSOE for software revenue recognition (Subtopic 985-605) and • VSOE for multiple element revenue recognition (Subtopic 605-25) • Inventory pricing (Topic 330) • Fair value measurements for purposes of lease classification (Topic 840) • Practicability exceptions (listed in ASC 820-15-3) Page 7 DEFINITION OF FAIR VALUE 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 Elements of Fair Value: •Exit price notion, from market participant perspective •Hypothetical transaction with a market participant •“Market participants are unrelated parties, knowledgeable of the asset or liability given due diligence, willing and able to transact for the asset/liability, and may be hypothetical” •For a particular asset and liability •Highest and best use for assets, credit standing for liabilities (physical, legally and financially feasible) •The most advantageous market is the market in which the price obtained maximizes the amount received. A Roadmap to Applying FASB ASC 350 Page 8 Page 8 WHEN TRANSACTION PRICE ≠ FAIR VALUE A transaction price might not represent the fair value of an asset or liability under the following conditions: • Transaction is between related parties • Transaction occurs under duress • Seller forced to accept price, experiencing financial difficulty • Different units of account • Asset/liability is only one element in the transaction • Different markets • Market in which the transaction occurs is not the principal or most advantageous market • Market differs from the one in which the reporting entity would transact Page 9 HOW IS FAIR VALUE DETERMINED? By answering the following questions: • What is the unit of account? • What is the exit market (i.e., principal or most advantageous market from the perspective of the reporting entity) • Who are the market participants? • What is the highest and best use (assets) or nonperformance risk (liabilities)? • What is the appropriate valuation premise (assets)? • What is the unit of valuation? • What are the valuation techniques? • What are the valuation inputs? Page 10 DETERMINING MOST ADVANTAGEOUS MARKET: REMINDERS Transaction costs • Are the incremental direct costs to sell the asset or transfer the liability in the exit market • Are used to determine most advantageous market • Are not an adjustment to the price used to measure fair value in the exit market • Do not include transportation costs Transportation costs • Fair value is adjusted for transportation costs if location is an attribute of the asset or liability, which is frequently the case—for example, commodities Page 11 LIABILITIES TRANSFERRED Assumes nonperformance risk is the same before and after its transfer. Nonperformance risk is the risk that the obligation will not be fulfilled. May include the reporting entity’s own credit risk. Page 12 Page 12 FAIR VALUE HIERARCHY The fair value hierarchy ranks the inputs to fair value measurements from most reliable (Level 1) to least reliable (Level 3) • ASC 820 describes three levels of inputs: • • • Level 1: Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date Level 2: Inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly Level 3: Unobservable inputs for the asset or liability Valuation techniques must maximize use of relevant observable inputs and minimize use of unobservable inputs A Roadmap to Applying FASB ASC 350 Page 13 Page 13 FAIR VALUE HIERARCHY In practice, an entity may use the following inputs to measure fair value: • Quoted market prices (level 1 or 2) • Market prices for similar assets (level 2 or 3) • Multiples, such as earnings, revenue or performance measures (level 3) • Present value techniques (level 3) A Roadmap to Applying FASB ASC 350 Page 14 Page 14 VALUATION TECHNIQUES Three techniques acceptable under ASC 820: • Market approach • Income approach • Cost approach Page 15 MARKET APPROACH Uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities (including a business) • Use of market multiples derived from a set of comparables • Includes the use of matrix pricing Page 16 INCOME APPROACH Uses valuation techniques to convert future amounts (i.e., cash flows, earnings) to a single present amount (discounted). • The measurement is based on the value indicated by current market expectations about those future amounts. • Techniques include the following: - Present value techniques Option pricing models Multiperiod excess earnings method Page 17 COST APPROACH The amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost). Page 18 FAIR VALUE DISCLOSURES FAIR VALUE HIERARCHY Level 1 – Quoted prices in active markets for identical assets or liabilities. Level 2 – Inputs other than quoted prices that are observable, either directly or indirectly. Level 3 – Unobservable inputs based on best information available in the circumstances. Page 20 Page 20 BASIC DISCLOSURE REQUIREMENTS Information that enables users of the financial statements to assess both: • The inputs and valuation techniques used to develop those measurements. • Their impact on earnings for the period. Applicable to each major class of assets and liabilities measured at fair value. Required for annual and interim reporting periods. Page 21 Page 21 RECURRING BASIS REQUIREMENTS The fair value measurements at the reporting date. The level within the fair value hierarchy used (levels 1, 2, or 3). For transfers between levels 1 and 2, identification of transfers and the reasons for each. For Level 3, a reconciliation between beginning and ending balances and separately presented changes during the period for five items. Page 22 Page 22 NONRECURRING BASIS REQUIREMENTS The fair value measurements recorded during the period and the reasons for the measurements. The level within the fair value hierarchy for the fair value (Levels 1, 2, or 3). If Level 3, a description of the inputs and valuation technique(s) used and the inputs used for each class of assets or liabilities. Page 23 Page 23 TABULAR FORMAT Required for any quantitative disclosures. Provide a reconciliation between beginning and ending balances. Provide information about Level 3 inputs and changes among levels of inputs. Additional Requirements Encouraged Combine the fair value information required . Disclose information about other similar measurements. Page 24 Page 24 GOODWILL Impairment Testing GOODWILL IMPAIRMENT • Impairment is the condition that exists when the carrying amount exceeds the implied fair value: - If the carrying amount of the reporting unit = zero or negative, step two of the impairment test is performed, when it is more likely than not that a goodwill impairment exists. Carrying Amount > Fair Value Page 26 Page 26 GOODWILL IMPAIRMENT TESTING - STEPS • A two-step impairment test performed on reporting units (“RUs”) - Where Step 1 identifies potential impairment and Step 2 measures the amount of impairment (if any) - RUs determined by Management [ASC 350/ASC 280], and assets/liabilities allocated to RUs - Perform annually or if triggered • Impairment is the condition that exists when the carrying amount exceeds the implied fair value: Carrying Amount > Fair Value - If the carrying amount of the reporting unit = zero or negative, step two of the impairment test is performed, when it is more likely than not that a goodwill impairment exists. Page 27 Page 27 GOODWILL IMPAIRMENT TESTING – TRIGGERING EVENTS • Triggering Event – An event or change in circumstances occurs that would more likely than not reduce the fair value below the carrying amount • Examples of such events or circumstances include: - A significant adverse change in legal factors or in the business climate - A loss of key personnel - Unanticipated competition - A more-likely-than-not expectation that a reporting unit will be sold or otherwise disposed of Page 28 Page 28 STEP 1 QUANTITATIVE TESTING • Step 1 test – • Quantitative may use various approaches to derive the fair value of a reporting unit: • Income approach • Projected Free Cash Flows + • Terminal/Residual Value • Market approach • Asset-based approach (rare for majority of BDO companies) Page 29 STEP 1 – QUALITATIVE TESTING • Step 1 – Qualitative i. Whether more likely than not (more than 50% likelihood) ii. Fair value of reporting unit is less than carrying amount iii. If likely that is impaired then determine FV of RU iv. If so, proceed to 2 step test v. Factors to consider include macroeconomic conditions, cost factors, overall financial performance, specific events, others Page 30 MARKET CAP (“MC”) AND GOODWILL IMPAIRMENT • Recommended: Reconcile aggregate FV of RUs to MC - MC based on average stock price determined over a reasonable period of time • SEC Guidance highlights: (1) Appropriate if facts and circumstances evidence that the decline in the stock price is not related to the entity or industry-specific factors or is due to certain extraordinary events; (2) May not be appropriate if the decline in the stock price is due to entity or industry specific factors (i.e. change in growth expectations, cost structure) or if stock price shows a systematic decline • Trends in stock prices subsequent to the valuation date may be considered to evaluate whether the decline in the stock price is other than temporary • Length of the averaging period will depend upon specific facts and circumstances, however, an averaging period exceeding 30 days is expected to be rare Page 31 Page 31 CONTROL PREMIUM AND GOODWILL IMPAIRMENT • Determining FV of RU – Need to consider additional factors! • ASC 350-20-35-23 - Substantial value may arise from ability to take advantage of synergies and other benefits that flow from control over another entity • Thus, an acquiring entity is often willing to pay more (“control premium”) for equity securities that give it a controlling interest • This control premium may cause the FV of RU to then > its market cap - i.e., Market cap of an entity may not fully capture the FV of RU as a whole Page 32 Page 32 CONTROL PREMIUM AND GOODWILL IMPAIRMENT (CONT.) • Determining significance of control premiums? SEC says no bright lines/rules of thumb – need well reasoned valuation! - - Consider recent trends in market cap – e.g., over a reasonable period of time, particularly in light of volatile markets Consider changes in underlying stock prices – e.g., declines may be indicative of factors that should be considered in determination of FV Refer to SEC speech http://www.sec.gov/news/speech/2008/spch120808rgf.htm Page 33 Page 33 STEP 1 CONCLUSION Determine if fair value of the RU is greater than the carrying value of goodwill. If Fair Value of RU > Carrying Amount NO IMPAIRMENT If Fair Value of RU < Carrying Amount Step 2 Page 34 GOODWILL IMPAIRMENT TESTING – STEP TWO PROCESS • Step 2 – determine the implied fair value of reporting unit goodwill and compare to the carrying amount - Implied fair value of goodwill determined by allocating the fair value of the reporting unit to the assets (including unrecognized intangible assets) and liabilities of that reporting unit as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit is the “purchase price” - Excess of fair value over sum of amounts assigned to assets and liabilities is the implied fair value of reporting unit goodwill - If carrying amount of goodwill > implied fair value of goodwill recognize an impairment loss equal to the difference Page 35 35 GOODWILL IMPAIRMENT TESTING – FV OF GOODWILL If Fair Value of GW > Carrying Amount NO IMPAIRMENT If Implied Fair Value of GW < Carrying Amount IMPAIRED • Determined in same manner as goodwill is determined in a business combination - Must consider the concept of “defensive value” when assigning fair value to the assets included in the reporting unit - Defensive value may be created when the highest and best use of an asset by a market participant is different from the intended use of the reporting entity - Defensive value may apply to an intangible asset, such as a trademark, which is the enterprise either: • Does not use or • Uses in a manner other than its highest and best use • Excess = Implied fair value of goodwill Page 36 Page 36 INTANGIBLE ASSETS- WHAT ARE THESE? • ASC definition — “assets (not including financial assets) that lack physical substance” − Identifiable: − “…separable, i.e., capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged…” − “arises from contractual or other legal rights…” • Intangible assets do not include goodwill (ASC 350-20) Page 37 INTANGIBLE ASSETS Intangible asset examples Page 38 INDEFINITE LIVED INTANGIBLES • If there is not a useful life for an intangible asset, the asset is considered to have an indefinite life and thus, is not amortized • Examples of potential indefinite lived assets include: - Taxi cab medallions - Certain trade names - Bridge/tunnel rights Page 39 Page 39 VALUING INTEREST RATE SWAPS BASIC SWAP VALUATION • An interest rate swap is an agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal (“notional”) amount • Inputs – Fixed for Floating Swap - Notional Amount Effective Date Maturity Date Fixed Rate Floating Rate Frequency Non-Performance Risk (Unique to ASC 820) Page 41 Page 41 BASIC SWAP VALUATION Most inputs are provided in the swap agreement (notional amount, effective date, maturity date, fixed rate, underlying floating rate, frequency, and counter-party). • Non Performance Risk – Became an • Floating rate – underlying issue with the implementation of benchmark rate is defined but ASC 820 forward curve must be derived. • Understanding the client and the • Calculation of forward curve counterparty can be time consuming and challenging • Credit risk / analysis • Many sources for forward - Market participant curves. Curve must reflect - Credit default swaps reset rates (bootstrapped - Spreads associated with similar rates). terms and credit ratings - Bloomberg is a common - Synthetic credit ratings – source www.creditmodel.com Page 42 Page 42 BASIC SWAP VALUATION METHODOLOGY • Once inputs are defined, the rest is math • Calculate payments over the life of the agreement using fixed curve and floating rates • Net the payments • Discount the payments using the floating rates plus non-performance risk • Sum the values = Fair Value - Said differently, the Fair Value of the interest rate swap is X and broken out of X is the credit or non performance risk. Page 43 Page 43 BASIC SWAP VALUATION NON PERFORMANCE RISK The risk to each party of a contract that the counterparty will not live up to its contractual obligations. • Determine risk for both parties • Is there non-performance risk when subject company is in asset / liability position? - Most agree that NPR should be considered when a swap is an asset. FASB - “Nonperformance risk refers to the risk that the obligation will not be fulfilled and affects the value at which the liability is transferred. Therefore, the fair value of the liability shall reflect the nonperformance risk relating to that liability. Nonperformance risk includes but may not be limited to the reporting entity's own credit risk. The reporting entity shall consider the effect of its credit risk (credit standing) on the fair value of the liability in all periods in which the liability is measured at fair value. That effect may differ depending on the liability, for example, whether the liability is an obligation to deliver cash (a financial liability) or an obligation to deliver goods or services (a nonfinancial liability), and the terms of credit enhancements related to the liability, if any.” • Papers written on the subject Page 44 Page 44 CONCLUSION QUESTIONS?