Fair Value Accounting. Course #6205A/QAS6205A Course Material

Transcription

1 Fair Value Accounting Course #6205A/QAS6205A Course Material

2 Introduction Numerous FASB Standards have been issued requiring certain items to be measured and reported at fair value on the Balance Sheet. Prior to the release of ASC 820 Fair Value Measurements and Disclosures (formerly known as SFAS 157), the concept of fair value had never been formally defined in U.S. accounting literature. Since its issuance in September 2006, ASC 820 has become one the most controversial accounting standards ever released. This course provides a conceptual review of fair value accounting, as outlined in ASC 820 and other U.S. accounting standards. This review includes discussions on the ongoing controversy surrounding its impact on the global economy, as well as the current FASB and IASB proposals that will potentially require fair value accounting for all financial instruments. Finally, this course will provide an overview of the authoritative guidance for auditing fair value measurements and disclosures, SAS No Author s Bio Michael J. Walker is a New England-based Certified Public Accountant with over fourteen years of accounting experience in the financial services, information technology services, and construction industries. He is currently a vice president at one of the largest financial institutions in the world. He has an extensive technical accounting background that includes hands-on experience with U.S. GAAP, Canadian GAAP, and International Financial Reporting Standards (IFRS). His expertise includes the accounting for derivatives, fixed income investments, and securitizations. He graduated from Bentley University with a B.S. in Finance (1995) and a M.S. in Accountancy (2000). Introduction

3 Fair Value Accounting (Course #6205A/QAS6205A) Table of Contents Page Chapter 1: The Evolution of Fair Value 1.1 Historical Cost The Rising Tide of Fair Value: The S&L Crisis 1-3 Review Questions & Solutions A New Sense of Urgency: The Enron Crisis ASC 820: Fair Value Measurements and Disclosures 1-12 Review Questions & Solutions Chapter 1 Summary 1-16 Chapter 2: Measurement 2.1 Definition of Fair Value 2-1 Review Questions & Solutions Fair Value Framework The Price The Principal (or Most Advantageous) Market Market Participants Attributes of the Asset or Liability Highest and Best Use Unit of Account Fair Value at Initial Recognition 2-9 Review Questions & Solutions Chapter 2 Summary 2-16 Chapter 3: Valuation Techniques and Inputs 3.1 Valuation Techniques Valuation Inputs 3-5 Review Questions & Solutions Fair Value Hierarchy Level 1 Inputs Level 2 Inputs Level 3 Inputs Pricing Services and Broker Quotes Bid-Ask Prices 3-13 Review Questions & Solutions Chapter 3 Summary 3-18 Table of Contents 1

4 Table of Contents (cont.) Page Chapter 4: Auditing Fair Value Measurements and Disclosures 4.1 ASC 820 Disclosures Assets and Liabilities Measured at Fair Value on a Recurring Basis Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis 4-3 Review Questions & Solutions SAS No. 101, Auditing Fair Value Measurements and Disclosures Understanding the Entity s Process for Determining Fair Value Measurements, Disclosures, the Relevant Controls, and Assessing Risk Evaluating Conformity of Fair Value Measurements and Disclosures with GAAP Testing the Entity s Fair Value Measurements and Disclosures Testing Management s Significant Assumptions, the Valuation Model, and the Underlying Data Auditing Disclosures about Fair Values 4-14 Review Questions & Solutions Chapter 4 Summary 4-21 Chapter 5: The Fair Value Option 5.1 The Fair Value Option ASC Financial Instruments: The Fair Value Option Scope Excluded Items 5-2 Review Questions & Solutions Accounting Election Timing Accounting Impact Disclosure Requirements 5-9 Review Questions & Solutions Chapter 5 Summary 5-14 Table of Contents 2

5 Table of Contents (cont.) Page Chapter 6: The Future of Fair Value 6.1 Fair Value Accounting under IFRS 6-1 Review Questions & Solutions The Credit Crisis The Critical Backlash at Fair Value 6-6 Review Questions & Solutions Chapter 6 Summary 6-15 Glossary Index Table of Contents 3

6 Learning Objectives: Chapter 1: The Evolution of Fair Value After studying this chapter, participants should be able to: Define the historical cost method of accounting and calculate the current amortized cost of assets and liabilities accounted for under this method. Define the fair value method of accounting for assets and liabilities and recognize accounting practices consistent with this method. Recognize the differences between the historical cost and fair value methods of accounting. It is axiomatic that it is better to know what something is worth now than what it was worth at some moment in the past... Historic cost itself is in reality historic market value, the amount of a past transaction engaged in by the firm.... Historic cost data are never comparable on a firm-to-firm basis because the costs were incurred at different dates by different firms (or even within a single firm). There is no financial analyst who would not want to know the market value of individual assets and liabilities. - CFA Institute, 1993 The above quote highlights a point that has been rigorously debated in the financial and accounting communities for decades. This debate centers on the proper measurement basis for a company s assets and liabilities historical cost or fair value. Depending on whom you ask, the answer to this question can vary. 1.1 Historical Cost Historical cost accounting is a method that presents an asset/liability on the balance sheet at the price paid/received at the time of its acquisition. Historical cost accounting includes recording revenue, expenditure and asset acquisition, and disposal at historical cost: that is, the actual amounts of money, or money's worth, received or paid to complete the transaction. The historical costs of physical assets (e.g., Property, Plant and Equipment) generally include: Purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates; Any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating. These can include site preparation, delivery and handling costs, installation, assembly, testing, professional fees and the costs of employees directly involved in these activities. The Balance Sheet carrying value of the historical cost of an asset is generally reduced to reflect depreciation, which represents the systematic reduction in the value of the asset due to usage, passage of time, wear and tear, etc. The Evolution of Fair Value 1-1

7 The concept of historical cost also applies to financial assets and liabilities (a.k.a. financial instruments). Examples of financial (i.e. non-physical) assets and liabilities include loans, deposits, securities, derivatives, and many other instruments. - The historical cost basis of a financial asset generally includes the amount of consideration (e.g., cash) given up in exchange for the instrument and the costs incurred to acquire the asset. - The historical cost basis of a financial liability generally includes the amount of consideration received as part of a financing agreement with a third party and the costs incurred to issue the liability. Similar to depreciation, the concept of amortization generally applies to financial assets, financial liabilities and intangible assets. Amortization refers to the allocation of an asset s acquisition cost (or liability s issuance cost) in a systematic manner over the estimated useful economic life so as to reflect its consumption, expiration, obsolescence or other decline in value as a result of use or the passage of time. Examples of amounts associated with financial assets and liabilities that are amortized include: Purchase/issuance premiums and discounts 1 Nonrefundable fees and costs associated with lending activities and loan purchases (e.g., origination fees) Methodologies for allocating amortization to each accounting period vary depending on the asset/liability. The term amortized cost refers to a bond s historical cost less the cumulative amortization (or plus the cumulative accretion) recorded on the instrument. The historical cost method has been subject to many criticisms, mainly because it only considers the acquisition cost of an asset while ignoring the asset s current market value. The historical cost method focuses primarily on allocating the cost of an asset over its useful life on the Income Statement, rather than presenting that asset on the Balance Sheet at its current market value. While this method informs the financial statements user of the asset s acquisition cost and the associated depreciation/amortization in the following years, it ignores the possibility that the current market value of that asset may be higher or lower than it suggests. 1 The term accretion is generally used when referring to the systematic recognition of income associated with a purchase discount received. The term amortization generally is used when referring to the systematic allocation of a financial asset/liability s acquisition cost (e.g. purchase premium/discount, origination cost, etc.). The Evolution of Fair Value 1-2

8 Historical Cost Example Q: A 10 year fixed income security with a par value of $100 million is purchased at a premium on 1/1/2010 for $105 million. There was $1 million of acquisition costs associated with acquiring the security. The total premium (including the acquisition costs) is amortized on a monthly basis at $50,000/month. The market price of the bond on 3/31/2010 is $107 million. A: 1. What was the original cost basis of the security? 2. What is the amortized cost of the security as of 3/31/2010? 1. The original cost basis of the security was $106 million. This includes the $100 par value of the security, the $5 million purchase premium and the $1 million acquisition costs. 2. The amortized cost of the security as of 3/31/10 is $105,850,000. This equals the original cost basis ($106 million) minus the cumulative amortization recorded ($3 $50,000/month). The historical cost method also ignores a fundamental economic principle that affects the true value of any asset: inflation. An asset purchased at a point in time may be more expensive in the future. The traditional accounting principles record all assets at an original cost and continue to use these historic figures throughout the asset's life, thus ignoring the impact of the time value of money. Furthermore, the theory of historic accounting assumes that the currency in which transactions are recorded remains stable, i.e. its purchasing power remains the same over a period of time. This most certainly isn t the case in many situations, as currency valuations can fluctuate frequently and materially. Despite its limitations, there are many benefits to the historical cost method of accounting. Historical cost is based on definitive records of the actual transactions, thus making the Balance Sheet carrying values of the items reliable. The historical cost method also provides managers with a significant range of alternatives in recognizing, reporting and measuring economic information. One other advantage is that it helps managers forecast future operational costs based on past data. The basic function of historical accounting is to tell a user "the cost of a thing." Without knowing the original costs, future income and expenses become very difficult to project. Historical costs can play an important role in providing this necessary information. 1.2 The Rising Tide of Fair Value: The S&L Crisis Although not formally defined in accounting literature until 2006, the concept of fair value has always been synonymous with the terms current value and market value. Fair value has historically referred to the value for which the asset could be sold for in the current market (i.e. the exit price). The Evolution of Fair Value 1-3

9 The movement towards fair value accounting (a.k.a. mark-to-market accounting) began in the mid-to-late 1980 s with the advent of the savings and loan (S&L) crisis. This crisis resulted in the failure of 747 savings and loan associations in the United States. The root cause of the savings and loan crisis is generally considered to be the deregulation and evolution of the financial services industry, as the regulated thrift industry struggled to compete against its unregulated competition. However, many fair value accounting advocates believe the savings and loan crisis and its estimated $500 billion price tag could have been prevented if thrifts had used fair value accounting. More specifically, they believe that the use of historical cost accounting, rather than fair value accounting, failed to expose the industry's true financial condition. If thrifts had used fair value accounting, regulators and investors would have known about the precarious nature of the industry, acted to minimize future losses, and prevented the massive government bailout by the Resolution Trust Corporation. With the increasing concern in the public and private sectors about the adequacy of financial statement reporting by financial institutions, fair value accounting concepts began receiving considerable attention from Congress, the Financial Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC), and others as a possible means to improve financial reporting. Concern began to grow that the use of historical cost accounting by banking institutions had been a contributing factor in masking the true value of their assets, and thus misrepresenting the need for further intervention by regulators. The FASB initiated a project to consider comprehensive disclosures about risk, liquidity, interest rates, and market values of financial instruments. This project resulted in a new FASB Standard that expanded market value disclosure requirements to many types of financial instruments. The final FASB standard, Statement No. 107, Disclosures about Fair Value of Financial Instruments, was issued in December (Note SFAS 107 is now a portion of ASC 825 Financial Instruments as a result of the accounting standards codification that occurred in 2009.) This standard requires entities to supplement their historical cost financial statements with disclosures about the fair values of financial instruments reported in those statements. The fair value vs. historical cost debate has raged on ever since the release of ASC 825. It is widely believed that the FASB themselves are proponents of fair value, as indicated by the numerous Standards that have been released over the past two decades that include the concept. The following is a sample of these standards that permit (or in some cases require) recognition and measurement at fair value: The Evolution of Fair Value 1-4

10 Exhibit 1.1 FASB Standards with References to Fair Value FASB Codification Reference Original Standard Number and Title Issue Date ASC Financial Instruments: The Fair Value Option SFAS 159 The Fair Value Option for Financial Assets and Financial Liabilities Feb-07 ASC Compensation: Defined Benefit Plans ASC 718 Stock Compensation ASC 480 Distinguishing Liabilities from Equity ASC 420 Exit or Disposal Cost Obligations ASC 360 Property, Plant and Equipment ASC Asset Retirement and Environmental Obligations: Asset Retirement Obligations ASC 350 Intangibles: Goodwill and Other ASC 860 Transfers and Servicing ASC 815 Derivatives and Hedging ASC 320 Investments: Debt & Equity Securities ASC Financial Instruments: Disclosure SFAS 158 Employers Accounting for Defined Benefit Pension and Other Postretirement Plans an amendment of FASB Statements No. 87, 88, 106 and 132(R) SFAS 123 (revised 2004) Share-Based Payments SFAS No. 150 Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity SFAS 146 Accounting for Costs Associated with Exit or Disposal Activities SFAS 144 Accounting for the Impairment or Disposal of Long-lived Assets SFAS 143 Accounting for Asset Retirement Obligations SFAS 142 Goodwill and Other Intangible Assets SFAS 140 Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities SFAS 133 Accounting for Derivatives & Hedging Activities SFAS 115 Accounting for Certain Investments in Debt and Equity Securities SFAS 107 Disclosures about Fair Value of Financial Instruments Sep-06 Dec-04 May-03 Jun-02 Aug-01 Jun-01 Jun-01 Sep-00 Jun-98 May-93 Dec-91 The Evolution of Fair Value 1-5

11 REVIEW QUESTIONS 1.1 The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. 1. Francona Financial owns a portfolio of mortgage-backed securities that it accounts for under the historical cost accounting method. In accordance with U.S. GAAP, these financial assets should be presented on the Balance Sheet at: a) the value for which the asset could be sold in the current market b) the price paid for the security at the time of acquisition (less cumulative amortization, if any) c) the cost to replace them if the assets were sold today d) their intrinsic value 2. Which of the following accounting practices is the most consistent with the concept of historical cost accounting under U.S. GAAP: a) Company A excludes installation costs and delivery fees from its historical cost calculations b) Company B periodically adjusts the historical cost of its assets to reflect changes in market conditions c) Company C immediately expenses purchase premiums paid for their financial assets d) Company D systematically reduces the balance sheet value of its construction equipment to reflect wear and tear 3. A ten year fixed income security with a par value of $100 million is purchased at a discount on January 31, 2010 for $97 million. There was no acquisition costs associated with the security. The same security can be purchased in the market for $99 million on July 31, What is the amortized cost of this security as of July 31, 2010: a) $97,150,000 b) $99,000,000 c) $100,000,000 d) $99,850,000 The Evolution of Fair Value 1-6

12 4. A research analyst is preparing a report on the pros and cons of historical cost accounting. Which of the following statements would most likely appear in the analyst s report to describe the impact that this method had on the savings and loan scandal in the mid-to-late 1980 s: a) the use of historical cost accounting assisted in hiding the S&L industry s true financial condition at the time b) the use of historical cost accounting would have prevented the S&L crisis from occurring c) the historical cost method would have properly reflected the S&L industry s assets and liabilities at their current values d) the fraudulent application of the historical cost method of accounting is what ultimately caused the crisis 5. Which of the following accounting practices is the most consistent with the concept of fair value accounting under U.S. GAAP: a) Company A reports derivative instruments on the balance sheet at their amortized cost b) Company B amortizes purchase premiums paid for their securities over the estimated lives of the assets c) Company C reports loans held-for-sale on the balance sheet at their current value d) Company D deducts the salvage value from the original cost of its auto fleet when performing their depreciation calculations 6. A 20 year fixed income security with a par value of $100 million is purchased at a premium on January 31, 2010 for $102 million. There were no acquisition costs associated with the security. The same security can be purchased in the market for $103 million on July 31, What is the fair value of this security as of July 31, 2010: a) $100,000,000 b) $101,950,000 c) $102,000,000 d) $103,000, Which of the following accounting practices is the most consistent with the fair value accounting requirements of ASC (formerly SFAS 107): a) Company A records all of their derivative instruments on the balance sheet at fair value b) Company B records the changes in fair value associated with its security portfolio in other comprehensive income c) Company C supplements their historical cost financial statements with disclosures about the fair values of financial instruments d) Company D uses the retrospective method when amortizing the purchase premiums associated with their bond positions The Evolution of Fair Value 1-7

13 SOLUTIONS AND SUGGESTED RESPONSES A: Incorrect. A security accounted for under the fair value accounting method (not historical cost) would be presented at its market value. B: Correct. The portfolio would be presented at the price paid for the asset at the time of acquisition (less cumulative amortization, if any). C: Incorrect. This describes the concept of replacement cost which generally does not apply to financial instruments. D: Incorrect. Intrinsic value is a concept that generally applies only to derivatives. It does not apply in this case. (See page 1-1+ of the course material.) 2. A: Incorrect. Installation costs and delivery fees should be included (not excluded) from the calculation of an asset s historical cost. B: Incorrect. The historical cost of an asset would not be adjusted in such a manner. C: Incorrect. Purchase premiums must be amortized over the lives of financial assets under historical cost accounting. D: Correct. This correctly describes the accounting practice of depreciation, which is a key component of historical cost accounting. (See page 1-1 of the course material.) 3. A: Correct. The amortized cost as of July 31, 2010 is $97,150,000. This amount equals the original cost ($97,000,000) plus six months worth of discount accretion ($150,000). B: Incorrect. This amount represents the fair value of the security. C: Incorrect. This amount represents the par value of the security. D: Incorrect. This amount equals the par value of the security ($100,000,000) minus six months of discount accretion, which is incorrect. (See page 1-2+ of the course material.) The Evolution of Fair Value 1-8

14 4. A: Correct. Many critics believed that the use of historical cost accounting failed to expose the industry's true financial condition. B: Incorrect. Historical cost accounting was considered a cause of the S&L crisis. C: Incorrect. Fair value accounting (not historical cost accounting) recognizes assets and liabilities on the balance sheet at their current values. D: Incorrect. The S&L s were not criticized for fraudulently applying historical cost accounting. Rather, the historical cost basis itself was criticized as inherently flawed. (See page 1-3+ of the course material.) 5. A: Incorrect. The concepts of historical cost and amortized cost pertain to the presentation of assets and liabilities on the balance sheet at their original cost. They are not synonymous with (or related to) the concept of fair value, which pertains to the presentation of assets and liabilities on the balance sheet at their current value. B: Incorrect. The concepts of depreciation and amortization are related to the concept of historical cost (not fair value). C: Correct. The concept of fair value is synonymous with current value. Therefore, this accounting practice is the most consistent with the concept of fair value accounting. D: Incorrect. The concepts of depreciated value and salvage value are related to the concept of historical cost (not fair value). (See page 1-3 of the course material.) 6. A: Incorrect. This amount represents the par value of the security. B: Incorrect. This amount represents the amortized cost of the security as of July 31, This amount equals the original cost ($102,000,000) minus six months worth of premium amortization ($50,000). C: Incorrect. This amount represents the original cost (purchase price) of the security. D: Correct. The fair value of the security equals the market price as of July 31, 2010, which is $103,000,000. (See page 1-3 of the course material.) The Evolution of Fair Value 1-9

15 7. A: Incorrect. ASC 815 (formerly SFAS 133) pertains to the accounting for derivatives and hedging activities. B: Incorrect. ASC 320 (formerly SFAS 115) pertains to the accounting for securities. C: Correct. ASC (formerly SFAS 107) requires entities to supplement their historical cost financial statements with disclosures about the fair values of financial instruments reported in those statements. D: Incorrect. ASC (formerly SFAS 91) pertains to the amortization of fees (including premiums and discounts on securities). (See page 1-4 of the course material.) The Evolution of Fair Value 1-10

16 1.3 A New Sense of Urgency: The Enron Crisis As mentioned previously, the concept of fair value had existed for many years in Generally Accepted Accounting Principles without ever being formally defined by the FASB. The reason for this lack of guidance is uncertain, but its impact would be widely felt early in the new millennium. The Enron Corporation, an energy company based in Houston, TX, stunned the financial world by declaring bankruptcy in late The earliest revelations about Enron indicated that the company s financial statements were seriously misleading. When the company announced massive write-offs and restatements in October and November 2001, it seemed that fraud must have been involved. As the Enron story unfolded, it was revealed that the company had pursued so many accounting loopholes in its financial reporting that its financial statements bore little resemblance to its actual financial condition or performance. 2 It could even be argued that Enron resembled an organized crime syndicate, as efforts to mislead investors required the coordinated efforts of many people. As a result of their combined efforts, equity losses to Enron shareholders were $65 billion and losses to creditors were $51 billion. The most frequently criticized accounting issue at Enron was the company s use of offbalance-sheet financing. The principal contention of the prosecution was that Enron hid losses through improper and misleading use of special-purpose entities (SPE) and outside partnerships. Enron also made extensive (and questionable) use of fair value accounting. Despite its likely overstatement of fair value assets, Enron s use of fair value accounting was never an issue in the criminal case against former CEOs Kenneth Lay and Jeffrey Skilling. However several financial journalists questioned the Company s use of fair value accounting and criticized the FASB for unknowingly enabling the massive fraud through its loose definition of fair value. The extent of Enron s faulty fair value accounting was realized during the Company s bankruptcy court proceedings. According to The CPA Journal (November 2006), Enron should have had almost $70 billion in total assets to satisfy the $63 billion in creditor claims. However, their bankruptcy plan revealed that only $12 billion was expected from the sale of Enron s power-generating and gas-transmission utility businesses. What happened to the other $58 billion in assets? The most obvious explanation was that the balance sheet contained assets that had little or no real value. Enron s balance sheet included current and non-current accounts described as price risk management assets (PRMA). Enron persuaded the SEC in January 1992 to allow them to use fair value accounting to value these long-term gas contracts and derivatives. However, no market existed for these assets, and thus Enron was free to value them as they saw fit. As a result, the SEC handed Enron the tools to abandon traditional principles and introduce the bookkeeping analogue of financial engineering into non-financial companies. Enron eagerly applied the tools and soon began discounting to present value as much as 29 years of income from customer contracts. The result, after considerable manipulation, was instantaneous increases in 2 Third Interim Report of Neal Batson, Court-Appointed Examiner, U.S. Bankruptcy Court, S.D.N.Y., In re: Enron Corp., et al., Debtors, Chapter 11, Case No (AJG), Jointly Administered, June 20, 2003 The Evolution of Fair Value 1-11

17 assets and offsetting equity and, of course, income. It soon became apparent that there was nothing fair about Enron s use of fair value, and that the mark-to-market accounting of their price risk management assets was very likely used to obscure the depth of their problems. Once these issues came to light in the fall of 2001, Enron collapsed like the proverbial house of cards. The political fallout of the Enron debacle was tremendous: The Company s auditing firm, Arthur Andersen LLP, shared the blame for the accounting scandal. On June 15, 2002, Andersen was convicted of obstruction of justice for shredding documents related to its audit of Enron. This conviction subsequently led to the firm surrendering its CPA licenses and its right to practice before the U.S. Securities and Exchange Commission on August 31, effectively putting them out of business. The Sarbanes-Oxley Act of 2002 was passed by the U.S. Government in response to a number of major corporate and accounting scandals, including those affecting Enron, Tyco International, Adelphia, Peregrine Systems and WorldCom. This legislation established new or enhanced standards for all U.S. public company boards, management, and public accounting firms. The Act also established a new quasi-public agency, the Public Company Accounting Oversight Board, or PCAOB, which is charged with overseeing, regulating, inspecting, and disciplining accounting firms in their roles as auditors of public companies. The Act covers issues such as auditor independence, corporate governance, internal control assessment, and enhanced financial disclosure. Upon signing the Act into law, President George W. Bush referred to it as "the most far-reaching reform of American business practices since the time of Franklin D. Roosevelt. 1.4 ASC 820: Fair Value Measurements and Disclosures In June 2003, the Financial Accounting Standards Board added a fair value measurement project to its agenda to address fair value measurement issues broadly. The project had never been formally linked to the accounting scandals of the new millennium; however it was clear that new accounting guidance was necessary to prevent future irregularities resulting from the fraudulent use of fair value accounting. In 2003, the Board agreed that, conceptually, the definition of fair value and its application in GAAP should be the same for all assets and liabilities. The result of this project was the Statement of Financial Accounting Standards No. 157, Fair Value Measurements, issued in exposure draft form in June This new Statement was issued in order to: - Define fair value - Establish a framework for measuring fair value - Expand disclosures about fair value measurements - Simplify and codify the related guidance that currently exists for developing fair value measurements - Eliminate differences that have added to the complexity in GAAP. The Evolution of Fair Value 1-12

18 The final version of SFAS 157 became effective for fiscal years beginning after November 15, 2007 (that is, January 1, 2008 for calendar year entities). SFAS 157 became known as ASC 820 Fair Value Measurements and Disclosures in 2009 as part of the FASB s Accounting Standards Codification project. The Statement applies under other accounting pronouncements that require or permit fair value measurements, with the exception of ASC 718 Stock Compensation. The Statement does not require any new fair value measurements. The Evolution of Fair Value 1-13

19 REVIEW QUESTIONS 1.2 The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. 1. A research analyst is preparing a report on the Enron scandal of the early 2000 s. Which of the following GAAP-related issues would the analyst most likely cite as enabling the fraud perpetrated by The Enron Corporation: a) the vague definition of historical cost b) the permitted use of the cash method of accounting c) the inconsistent guidance on the accrual method of accounting d) the lack of specific guidance on the concept of fair value 2. Ellsbury Corp. is planning to apply the U.S. GAAP concepts of fair value to their year-end financial statements. Under the guidance of ASC 820, the definition of fair value and its application should be: a) unique for each individual class of assets and liabilities b) the same for all assets and liabilities c) the same for all assets, but unique for each individual liability class d) the same for all liabilities, but unique for each individual asset class 3. Which of the following statements accurately summarizes the FASB s reasoning for issuing ASC 820 Fair Value Measurements and Disclosures: a) this FASB wished to prohibit the use of historical cost accounting b) the FASB wanted to reduce the required disclosures about fair value measurements c) the FASB wanted to require several new fair value measurements that were previously not included in existing FASB literature d) this FASB wished to define fair value and establish a framework for measuring fair value The Evolution of Fair Value 1-14

20 SOLUTIONS AND SUGGESTED RESPONSES A: Incorrect. The lack of formal accounting guidance on the definition of fair value (not historical cost) has been blamed (in part) for enabling the Enron accounting scandal in B: Incorrect. The cash method of accounting was not considered a primary factor in the Enron fraud. C: Incorrect. The accrual method of accounting was not considered a primary factor in the Enron fraud. D: Correct. Many critics believed that fair value cost accounting enabled Enron to commit fraud on a massive scale in the early 2000 s. (See page of the course material.) 2. A: Incorrect. The FASB did not determine that the definition of fair value and its application in GAAP should be unique to various classes of assets and liabilities. B: Correct. The FASB determined that the definition of fair value and its application in GAAP should be the same for all assets and liabilities. C: Incorrect. The FASB determined that the definition of fair value should be the same for all assets and liabilities. The FASB did not determine that the definition should be unique to various classes of liabilities. D: Incorrect. The FASB determined that the definition of fair value should be the same for all assets and liabilities. The FASB did not determine that the definition should be unique to various classes of assets. (See page 1-11 of the course material.) 3. A: Incorrect. ASC 820 does not prohibit the use of historical cost accounting. B: Incorrect. ASC 820 expands (not reduces) disclosures about fair value measurements. C: Incorrect. ASC 820 does not require several new fair value measurements that were previously not included in existing FASB literature. D: Correct. The Financial Accounting Standards Board (FASB) issued ASC 820 Fair Value Measurements and Disclosures in order to define fair value, establish a framework for measuring fair value, expand disclosures about fair value measurements, simplify and codify the related guidance that currently exists for developing fair value measurements, and eliminate differences that have added to the complexity in GAAP. (See page of the course material.) The Evolution of Fair Value 1-15

21 CHAPTER 1 SUMMARY There is an ongoing debate regarding the proper measurement basis for a company s assets and liabilities historical cost or fair value. Historical cost accounting values an asset (liability) on the balance sheet at the price paid (received) for the asset (liability) at the time of its acquisition (issuance). Fair value accounting values assets and liabilities on the balance sheet at their current (or market values). The concept of fair value was not formally defined in accounting literature until The historical cost method has been subject to many criticisms, mainly because it fails to consider several factors that impact the true value of an asset or liability, such as exchange rates and inflation rates. The use of historical cost accounting has been blamed for enabling the Savings and Loan (S&L) crisis of the 1980 s by failing to expose the industry's true financial condition at the time. The lack of formal accounting guidance on the definition of fair value has been blamed (in part) for enabling the Enron accounting scandal in The Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements, in exposure draft form in June This new Statement (now referred to as ASC 820 Fair Value Measurements and Disclosures) was issued in order to: - Define fair value - Establish a framework for measuring fair value - Expand disclosures about fair value measurements - Simplify and codify the related guidance that currently exists for developing fair value measurements - Eliminate differences that have added to the complexity in GAAP. The Evolution of Fair Value 1-16

22 Chapter 2: Measurement Learning Objectives: After studying this chapter, participants should be able to: Define fair value as outlined in ASC 820 Fair Value Measurements and Disclosures. Recognize accounting practices that are consistent with the fair value framework established in ASC Definition of Fair Value ASC 820 defines fair value as 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. While the definition in ASC 820 maintains the exchange price notion that existed in previous definitions of fair value, the revised definition (and its application in the fair value framework) provides clarity on a number of key points, including: Fair value is the price to sell an asset or transfer a liability and, therefore, represents an exit price, not an entry price. The exit price for an asset or liability is conceptually different from its transaction price (and entry price). While exit and entry price may be identical in many situations, the transaction price is no longer presumed to represent the fair value of an asset or liability on its initial recognition. Fair value is the exit price in the principal market in which the reporting entity would transact (or, if lacking a principal market, the most advantageous market). The price in the exit market should not be adjusted for transaction costs. Fair value is a market-based measurement, not an entity-specific measurement, and as such, is determined based on the assumptions that market participants would use in pricing the asset or liability. The exit price objective of a fair value measurement applies regardless of the reporting entity s intent and/or ability to sell the asset or transfer the liability at the measurement. A fair value measurement contemplates the sale of an asset or transfer of a liability, not a transaction to offset the risks associated with an asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction as of the measurement date and assumes an appropriate period of exposure to the market, such that the transaction is considered orderly. Measurement 2-1

23 REVIEW QUESTIONS 2.1 The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. 1. Which of the following accounting policies is compliant with ASC 820 s definition of fair value : a) Company A values its fair value assets at the historical price paid for each asset b) Company B values its fair value assets at the price paid for the asset in an orderly transaction between market participants at the measurement date c) Company C does not apply the ASC 820 definition of fair value to its derivative instruments d) Company D applies the ASC 820 definition of fair value only to stand-alone assets 2. Which of the following prices would most likely be consistent with the definition of fair value under ASC 820: a) a market-based price to purchase equipment b) a market-based price to sell an investment c) an entity-specific price to purchase equipment d) an entity-specific price to sell an investment 3. Which of the following scenarios depicts the appropriate application of the concept of exit price as it is defined in ASC 820: a) Company A values its machinery at its acquisition cost b) Company B adjusts the fair value of its investments for trading costs c) Company C uses hypothetical transactions to estimate the value that its assets would sell for in its principal market d) Company D bases its fair value calculations on its intent to hold or sell the asset 4. Which of the following would most likely be considered an orderly transaction under the guidance provided in ASC 820: a) a machinery sale made as part of bankruptcy proceedings b) the distressed sale of an auto fleet c) a hypothetical equipment sale that assumes exposure to the market for a customary period d) an investment sale that occurs in an illiquid market Measurement 2-2

24 SOLUTIONS AND SUGGESTED RESPONSES A: Incorrect. This is the definition of historical cost, not fair value. B: Correct. ASC 820 defines fair value as the price paid for an asset or liability in an orderly transaction between market participants at the measurement date. C: Incorrect. ASC 820 is applicable to most assets and liabilities accounted for at fair value, including derivative instruments. D: Incorrect. ASC 820 is applicable to most assets and liabilities accounted for at fair value; it is not limited to stand-alone assets. (See page 2-1 of the course material.) 2. A: Incorrect. This description is consistent with the concept of an entry price; fair value represents an exit price, not an entry price. B: Correct. A market-based exit price to sell an investment would be consistent with the ASC 820 definition of fair value. C: Incorrect. ASC 820 states that fair value is a market-based measurement, not an entity-specific measurement. Also, this description is consistent with the concept of an entry price; fair value represents an exit price, not an entry price. D: Incorrect. ASC 820 states that fair value is a market-based measurement, not an entity-specific measurement. (See page 2-1 of the course material.) 3. A: Incorrect. The cost to acquire an asset is consistent with the concept of entry price, not exit price. B: Incorrect. The exit price should not be adjusted for transaction costs. C: Correct. An exit price generally represents a hypothetical transaction price to sell an asset or transfer a liability in the item s principal market. D: Incorrect. The exit price objective of a fair value measurement applies regardless of the reporting entity s intent and/or ability to sell the asset or transfer the liability at the measurement. (See page 2-1 of the course material.) Measurement 2-3

25 4. A: Incorrect. A sale made as part of bankruptcy proceedings would generally be considered a forced transaction under ASC 820. B: Incorrect. A distressed sale would not generally be considered an orderly transaction under ASC 820. C: Correct. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities. D: Incorrect. A transaction to buy or sell a financial instrument that takes place in an illiquid (or inactive) market is not generally considered an orderly transaction under ASC 820. (See page 2-1 of the course material.) Measurement 2-4

26 2.2 Fair Value Framework In addition to providing a revised definition of fair value, ASC 820 also establishes a framework (or approach) for applying this definition in financial reporting. Many of the key concepts used in the fair value framework are connected, and their interaction should be considered in the context of the entire approach. The following diagram summarizes the interdependence of the various components of the fair value approach prescribed in ASC 820. Exhibit 2.1 ASC 820 Fair Value Approach THE PRICE A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction (for example a forced liquidation or distress sale). The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the assets or owes the liability. Therefore, the objective of a fair value measurement is 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). The concept of a hypothetical transaction clarifies that the transaction between market participants does not consider management s intent to actually sell the asset or transfer the liability at the measurement date, nor does it consider the reporting entity s ability to enter into the transaction on the measurement date. To illustrate, consider a hypothetical transaction to sell a security that is restricted from sale as of the measurement date. While the restriction may affect the determination of fair value for the asset, it does not preclude the consideration of a hypothetical transaction to sell the restricted security. Measurement 2-5

27 2.2.2 THE PRINCIPAL (OR MOST ADVANTAGEOUS) MARKET A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The principal market is the market in which the reporting entity would sell the asset or transfer the liability with the greatest volume and level of activity for the asset or liability. The most advantageous market is the market in which the reporting entity would sell the asset or transfer the liability with the price that maximizes the amount that would be received for the asset or minimizes the amount that would be paid to transfer the liability, considering transaction costs in the respective market(s). ASC 820 specifies that if there is a principal market for the asset or liability being measured, the fair value for that asset or liability should represent the price in that market, even if the price in a different market is more advantageous at the measurement date. In other words, the most advantageous market concept is applied only in situations where the reporting entity determines there is no principal market for the asset or liability being measured. The determination of the principal (or most advantageous) market is made from the perspective of the reporting entity. This is an important clarification because it acknowledges that different reporting entities may sell assets or transfer liabilities in different markets depending on their activities. For example, a securities dealer may exit a financial instrument by selling it in the inter-dealer market, while a manufacturing company would sell a financial instrument in the retail market. The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs. Transaction costs represent the incremental direct costs to sell the asset or transfer the liability in the principal (or most advantageous) market for the asset or liability. Transaction costs are not considered an attribute of the asset or liability; rather, they are specific to the transaction and will differ depending on how the reporting entity transacts. However, transaction costs do not include the costs that would be incurred to transport the asset or liability to (or from) its principal (or most advantageous) market. If location is an attribute of the asset or liability (as might be the case for a commodity), the price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall be adjusted for the costs, if any, that would be incurred to transport the asset or liability to (or from) its principal (or most advantageous) market. Measurement 2-6