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FASB’s MOVE TOWARDS FAIR VALUE AND ACADEMIC RESEARCH

Guarantees – Int. 45. Financial instruments. FASB’s MOVE TOWARDS FAIR VALUE AND ACADEMIC RESEARCH. Stock Options – 123R. Derivatives. Fair value hierarchy –FAS 157. Contingencies. Today’s Discussion on Fair Value. The new fair value standard – FAS 157 The fair value option proposal

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FASB’s MOVE TOWARDS FAIR VALUE AND ACADEMIC RESEARCH

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

  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 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 approaches)

  6. MARKET PLACE PARTICIPANTS • Buy software & customer list - $10 million: Company plansMarket 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! Fair value Historical cost 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?

  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? (Answer -fair value!) Can an amount be objectively estimated?

  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. A FAIR VALUE MODEL! 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

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

  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?

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