FASB’s MOVE TOWARDS
FAIR VALUE AND
ACADEMIC RESEARCH
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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?
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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
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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????
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FAS 157 - 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
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approaches)
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
Customer list
$ 10
Software
0
Day two accounting?
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(FASB allocation) FV
Customer list
$2
Software
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The Fair Value Option Proposal
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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.
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Discussion Points
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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?
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?
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Historical
cost
Fair value
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?
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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
(Answer
-fair value!)
How should Company C account for this
contingency at the date of acquisition?
Can an amount be objectively
estimated?
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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?
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ACQUIRE LESS THAN 100%
A FAIR
VALUE
MODEL!
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
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WHAT ABOUT FASB No. 5 CONTINGENCIES
(e.g., $100 Million lawsuit)
Remote
Reasonably
Possible
Accrue – Probable & Estimable
Disclose – Reasonable Possible
Do Nothing – Remote
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IS THIS STILL OK??
Probable
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???
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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?
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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?
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