Fair Value Module

• The Need for Fair Values

• Where Are Fair Values Used in Financial Statements?

• What Is “Fair Value”?

• Key Concepts In Estimating Fair Value

• Examples of Valuation Models

• Fair Value Disclosures

1

Prepared by Jason Wu

The Need for Fair Values

• The debate about reporting historical cost or fair value is not new – SFAS No. 33 (later rescinded in 1986 by SFAS No. 89) required large

companies to report the current value of noncurrent operating assets in a note to the financial statements.

– SFAS No. 115 requires most investment securities to be reported at their fair values.

• This pronouncement was made in response to the savings and loan (S&L) collapse.

– SFAS No. 133 requires that derivatives be reported at their fair values.

– SFAS No. 159 allows a company to report, at each balance sheet date, any or all of its financial assets and liabilities at their fair values on the balance sheet date.

2

The Need for Fair Values (continued)

• There are at least two reasons for the increased interest regarding fair values in financial statements: 1. Global corporations are now exposed to more risk and now manage

those risks through automated trades and derivative contracts.

2. Intangible assets have dramatically increased in importance making the computation of fair values upon a business acquisition more difficult.

• Because accounting has long been founded on a backbone of historical cost, the FASB and IASB are transitioning cautiously, item by item, to fair value.

3

Wh

ere

Are

Fai

r V

alu

es U

sed

in

Fin

anci

al S

tate

men

ts?

4

Wh

ere

Are

Fai

r V

alu

es U

sed

in

Fin

anci

al S

tate

men

ts?

(co

nti

nu

ed)

5

What Is “Fair Value”?

Historical Cost

Replacement Cost Fair Value

Net Realizable

Value Present Value

Advantages Verifiable & objective

Updated purchase price

Most relevant

Reflecting individual skills

One way to determine fair value

Disadvantages Least relevant

Hypothetical No reflection on individual skills

Not generalized

Use Lorien Franklin’s consideration of reporting land as an example:

In paragraph 5 of SFAS No. 157, the FASB defines “fair value” as follows: 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.

6

Key

Co

nce

pts

In E

stim

atin

g Fa

ir V

alu

e

• The hypothetical transaction. – A transaction based upon a price that would be acceptable to a

seller without that particular company’s special skills or unique handicap.

• The principal (or most advantageous) market. – The largest trading volume for the asset in question.

– If no principal market exists, then the most advantageous market price should be used.

• Market participants. – The price that would occur between two unrelated, informed

participants.

• Highest and best use. – A key assumption in appraising an asset is that in an unconstrained

market with ample time given for market participants to consider whether they want to buy an asset, the asset will be sold to the market participant who will use that asset in the most valuable way and who will pay the highest price for the asset.

7

• Valuation techniques.

– Market approach: Uses data from market prices for identical or similar assets.

– Income approach: Based indirectly or directly on discounted cash flow analysis.

– Cost approach: Based on the replacement cost of an asset.

– Often, the replacement cost is estimated based on what it would cost to replace the asset new, and then an adjustment is made for wear and tear to reflect the fact that the asset is used.

• Inputs to valuation techniques.

– In the absence of observable inputs (i.e., data inputs that are independently verifiable such as market prices for shares of stock or selling prices for comparable pieces of commercial real estate), a company must use its own assumptions to generate reasonable estimates of the cash flow forecasts, discount rate assumptions, or other valuation inputs that would be used by market participants. K

ey C

on

cep

ts In

Est

imat

ing

Fair

Val

ue

8

EXAMPLES OF VALUATION MODELS • Market multiples.

– Using pertinent market data to indirectly estimate the selling price.

Estimated fair value of Building 1 = $825,000 = $550,000 + 0.5($1,100,000 - $550,000)

Estimated fair value of Building 2 = $1,080,000 = $1,000,000 + 0.2($1,400,000 - $1,000,000)

9

• Matrix pricing. – Using a matrix of relevant data to estimate the selling price.

Estimated bond price as a percent of par = 95.89 = 100.29 - 0.5(100.29 - 91.49) Estimated price of Bond 1 = 0.9589 × $1 ,000 = $958.90

Estimated bond price as a percent of par = 99.844 = 100.17 - 0.2(100.17 - 98.54) Estimated price of Bond 2 = 0.99844 × $1 ,000 = $998.44

EXAMPLES OF VALUATION MODELS (CONTINUED)

10

• Discounted cash flows, finite period. – Traditional approach.

• Present value is computed using a risk-adjusted interest rate.

– Expected cash flow approach. • A range of possible outcomes is identified, and then the present

value of the cash flows in each outcome is computed and a weighted-average present value is computed.

Traditional Approach Example: Intangible Asset A is the right to receive royalty payments in the future. The future royalty cash flows are $1,000 at the end of each year for the next five years. The risk-free interest rate is 5%; the receipt of these royalty cash flows is not certain, so a risk-adjusted interest rate of 12% is used in computing their present value ($3,605).

EXAMPLES OF VALUATION MODELS (CONTINUED)

11

Expected Cash Flow Approach Example Intangible Asset B is a secret formula to produce a fast-food cheeseburger that contains 25 essential vitamins and minerals, reduces cholesterol levels, and replenishes the ozone layer. Future cash flows from the secret formula are uncertain; the following estimates have been generated, with the associated probabilities.

• Outcome 1 10% probability of cash flows of $5,000 at the end of each year for 10 years

• Outcome 2 30% probability of cash flows of $1,000 at the end of each year for 4 years

• Outcome 3 60% probability of cash flows of $100 at the end of each year for 3 years

The risk-free interest rate 5% is used in each outcome

EXA

MP

LES

OF

VA

LUAT

ION

MO

DEL

S (C

ON

TIN

UED

)

12

• Discounted cash flows, infinite period.

– Present value = Beginning cash flow ÷ (r – g), where r is the discount rate and g is the expected growth rate.

Example:

• Royalty rate: 6.0% of total taxi cab revenue (before subtracting any expenses);

• Discount rate: 11.0%;

• Expected taxi cab revenue in Year 1 : $1,000;

• Expected growth rate in taxi cab revenue each year for Years 2 through 5: 20.0%;

• The company expects rapid revenue growth for the next five years, but then the growth will slow to a sustainable long-term level;

• Expected long-term growth rate in cab revenue each year after five years (Year 6 and beyond): 4.0%;

• Income tax rate: 40%.

The analysis and computing follow:

EXA

MP

LES

OF

VA

LUAT

ION

MO

DEL

S (C

ON

TIN

UED

)

13

Growth 4.0%

Year 1 Year 2 Year 3 Year 4 Year 5 Year 5+

Total annual revenue $1,000 1,200 1,440 1,728 2,074 Pretax royalty (6%) 60 72 86 104 124

Income taxes (40%) 24 29 35 41 50

After-tax royalty 36 43 52 62 75 $1,109

Discounted cash flow 32 35 38 41 44 Sum of discounted cash flow 191

Present value of perpetuity 658

Total present value of cash flows $849

1

(1 ) (1 ) ( )

t t

t t

FCF FCF

r r r g

EXA

MP

LES

OF

VA

LUAT

ION

MO

DEL

S (C

ON

TIN

UED

)

14

• Adjusted replacement cost. – Replacement cost less decreased value based on usage.

Example:

Kamaraz Company has purchased the site of a ski resort for $10 million. Kamaraz must now estimate the fair values of the assets acquired in the purchase in order to properly record the acquisition. One of the assets is a ski lift system that is still fully functional. Because ski lift systems are of necessity tied to specific resorts and the contours of the resort’s ski runs, there is no practical way to directly determine a selling price for this particular system. However, Kamaraz can estimate how much it would cost to duplicate the system with new construction. That cost is $1,200,000. The existing system has been in use for five years, and such systems are typically assumed to have useful lives of 20 years with a 10% salvage value.

($1,200,000 - $120,000) / 20 years = $54,000 “depreciation” per year 5 years × $54,000 “depreciation” per year = $270,000 total “depreciation” $1,200,000 replacement cost new - $270,000 “depreciation” = $930,000 adjusted replacement cost

EXA

MP

LES

OF

VA

LUAT

ION

MO

DEL

S (C

ON

TIN

UED

)

15

FAIR VALUE DISCLOSURES

• Level 1 inputs. – Quoted prices in active markets for identical assets (or

liabilities). – Most reliable and involves less uncertainty.

• Level 2 inputs. – Observable inputs other than quoted prices in active markets

for identical assets (or liabilities). – Intermediate reliability.

• Level 3 inputs. – Unobservable inputs. – Lowest level of reliability. – Are client generated.

16

• These fair value disclosures fall into two categories. The first category is for assets (and liabilities) that are measured at fair value on a recurring basis.

• Examples are trading securities, available-for-sale securities, and derivatives. These items are reported at their fair values on every reporting date.

• The example below is copied from SFAS No. 157, par. A34.

FAIR VALUE DISCLOSURES (CONTINUED)

17

• The preceding disclosure example highlights that the greatest concern regarding fair value numbers is with the numbers generated using Level 3 inputs. As a result, further disclosure is required for these fair values.

• An example is given in the table below:

FAIR VALUE DISCLOSURES (CONTINUED)

18

• Most balance sheet items are NOT reported at fair value on a recurring basis but are occasionally reported at fair value. A common example is impaired assets.

• The required disclosure for assets reported at fair value on a nonrecurring basis is given below. This table is copied from SFAS No. 157, par. A36.

FAIR VALUE DISCLOSURES (CONTINUED)

19