Jeffery Sparling and Celina Jozsi

FICPA Florida Gulf Coast University Conference

October 29, 2010

� Fair Value Review

� Current and Proposed Impairment Guidance

� Applications: � Property, Plant, and Equipment� Intangibles� Financial Instruments

� Auditing Challenges and Scenarios

� Value Types:� investment value� going-concern value� liquidation value� fair value for financial reporting

� Relevant terms/variables: � risk/reward, utility, cash flows, present value, discounts/premiums,

discount rate, risk premiums, weighted average cost of capital, supply/demand.

� Key determinants: cash flows, growth, risk

� Definition and Important Concepts:� “ Price that would be received to sell an asset or paid to transfer a

liability� in an orderly transaction between market participants (not direct

transaction between buyer and seller)� at the measurement date” (information already known- not future

information)

� Risk premium adjustments:� by market participants:� Con 7: even if difficult to determine when identifiable, measurable,

and significant

� Asset or Liability?

� Unit of accounting

� Principal Market:� greatest volume and level of activity; ASU presumption: where entity

would enter the transaction. Different entities may have different principal markets for identical assets or liabilities

� Most Advantageous Market (if no principal market):� where can maximize amounts received or minimize amounts paid

� Exit Price – single measurement basis:� exit price, regardless of entity’s intent or ability to sell asset or transfer

liability at measurement date (despite volatility in prices )� not necessarily transaction price; can have day 1 gains/losses� ignore blockage factors

� Highest and Best Use: � Physically possible; legally permissible; financially feasible� ASU: highest and best use does not apply to financial assets

� Valuation premises of highest and best use:� “in exchange”: stand-alone – financial items (market does not

care about intended use)� “in use”: with other items; maximize value even if different from

current use; relationship to other items does matter (co-variance)� ASU proposal: remove terms of “in exchange” and “in use”;

prohibit financial assets from being measured as part of a group; will provide more guidance if held and managed on a portfolio basis – apply price within bid-ask spread most representative for overall portfolio; effective date not yet known

� Principal Market Determination:� Presume that market in which entity normally enters into transaction

is principal market, or most advantageous market� Different entities may have different principal markets for identical

assets or liabilities

� Instruments Classified in SE:� Require fair value measurement of own equity instruments classified

in SE(other than compensation) to represent exit price from perspective of market participants

� Prohibition on blockage factors:� Keep prohibition on blockage factors to any fair value

measurement using quoted prices� Permit applying premium or discount if market participants would

consider when pricing asset or liability

� Level I:� observable quoted prices for identical assets and liabilities in

active market (independent, knowledgeable, and willing)

� Level 2:� other observable inputs derived directly from or indirectly from

market-corroborated data

� Level 3:� unobservable inputs based on entity’s assumptions of critical

factors applied by market participants (hypothetical market); observable factors not available; least reliable

� 2009 relaxed guidance for “inactive markets”; Levels 1 and 2: most reliable

� Level 1 and Level 2:� Fair Value Measurements at reporting date� Level within FV hierarchy in which measurement falls� Total gains or losses for period included in earnings that are attributable to change

in unrealized gains or losses for those assets and liabilities� Description of where unrealized gains and losses are reported in I/S� Annual reports only: valuation techniques used for FV and discussion of changes

� Level 3: (growing)� Fair Value measurements at reporting date� Transfers in and out; Level within FV hierarchy in which measurement falls� Reconciliation of beginning and ending balances; separately present changes� Purchase, sales, issuances, settlements� Total gains or losses for period included in earnings that are attributable to change in

unrealized gains or losses for those assets and liabilities� Annual reports only: valuation techniques used for FV and discussion of changes

� Techniques:� Market: “market comparables”, include matrix pricing

� Income: present value of future cash flows, option pricing models, excess earnings model; uncertainty and risk premium adjustments to cash flows and/or discount rate

� Cost: asset value not greater than substitute with comparable features and functionality (current replacement cost)

� No prioritization; use all appropriate (multiple); consistency

� If use specialist, ascertain assumptions, etc

� Explain subjectivity of Level 3 fair value measurements

� Required unless scoped out in another standard

� Consider correlation between unobservable inputs (example: revenue, cost, inflation) and effects of each input on fair value

� Does not require statistical analysis

� Correlation analysis does not apply to observable inputs (Level 1 and 2)

• Some familiar arguments in favor:• Relevance, increased comparability, representational faithfulness,

transparency, neutrality (“approximately right vs. precisely wrong”)• Expanded disclosures give effect on earnings and changes in net

assets (“wealth measurement model”) and early warning of potential trouble.

• Provide confidence to capital markets for decisions

• Some arguments against GAAP guidance: • Should CFO be valuation experts to comply with GAAP? - stress• Reliability of exit prices, estimates of cash flows, risk, etc• Co-variance for nonfinancial assets• Cost-benefit; mixed attribute misunderstanding• Problems with illiquid markets • Value if not on arm’s-length transaction• Impact to entities: counter-cyclical effect; volatility, etc.

� Concept Statement 8: Qualitative Characteristics of “useful financial information”� Relevance: makes difference in user decisions; predictive

value; confirmatory value (feedback, confirms or changes previous evaluations)

� Faithful representation: complete, neutral, free from error; not considered: substance over form; prudence (inconsistent with neutrality); verifiability (lack of verifiability does not necessarily render information useless)

� Blue Ribbon Panel of AICPA: recommended on 10/8/2010 different GAAP for private companies; ”white elephant in the room is fair value” – panel member

� Responsible for fair value measurements, even if use third-party specialists or external appraisals; review assumptions from “market participants” view, valuation techniques, principal or most advantageous market for entity, highest and best use, risk premiums, nonperformance risk for liabilities.

� Review both assets and liabilities. For liabilities involving employee termination costs, analyze fair value measure.

� ASC 410-20 (SFAS 143): include nonperformance credit risk adjustment and may need to incorporate market risk premium adjustment.

� While fair value did not cause crisis (SEC), concerns prevail on ability to rely on fair value:� Buffet: “Rising prices are a narcotic that affects the reasoning

power, up and down the line. Everyone missed the four star bubble.” Will unrealized gains be a future problem again?

� Leverage is what gets people in trouble. People get rewarded for stretching so they stretch more and more. It is the most important thing in the regulatory world.

� Can risk return preferences for an entire company be assessed? No two auditing firms even agree on the price for the most complex derivative.

� Do general purpose users understand FAS 157 definition and the concept of underlying risks? Denver school system example. Were credit agencies fooled or crooked?

� To all FV mentioned in GAAP: including non-financial assets and liabilities� Business Combinations (ASC 805 - SFAS 141R) � Impairments of Long-Lived Assets and Goodwill � Restructuring Liabilities and AROs

� Business combinations:� generally, all acquired assets and liabilities at fair value:� inventories (NRV by market participants)� fair value for in-process R & D; defensive assets (not intended to

use); pre-acquisition contingencies such as warranty obligations� fair value for contingent consideration; non-controlling interest � all above amounts affect goodwill measure

� Assess impairment (recoverability test), measure loss.� For assets held and used: loss = book value of asset group

versus its fair value; cannot reduce individual asset below its individual fair value. Depreciate new book value. Cannot recoverloss.

� For assets held for sale: loss = book value versus net realizable value. Do not depreciate. Can recover loss.

� Cash flows: � for recoverability test - based on entity’s assumptions; for fair

value - based on market participant assumptions. Potential differences: information, preferences, highest and best use.

� Unit:� unit of valuation: for fair value (ASC 820) � unit of account (ASC 360 -10) for impairment; if valuation > account,

reconsider asset group.

Sample of factors to consider for CDO security:� Entity’s implied ROI on last date market was active

� Entity-determined market rates of return that increased since last dateof activity.

� Credit spreads that widened and liquidity risk premiums that increased significantly

� Other risks that have not changed� Judgment used to determine discount rate by considering all available

market information “without undue cost and effort”� non-current quoted prices for same or similar CDO securities;

relevant reports issued by analysts and ratings agencies; current interest rates and directional movements in relevant indexes; information about performance of underlying mortgages loans; other relevant observable inputs

� FV of tangible assets: (Cash, A/R, Inventory, Prepaid Assets, Land, Buildings and Equipment): $ 8 million

� FV of intangible assets: (Software, Trade Names, Technology, In-Process R&D, non-compete contracts, customer relationships):

� $ 1 million� Acquisition costs: $ 200,000� FV of defensive assets (Trade-name will not use): $ 400,000� FV of non-contractual contingent liability (70% probability): $ 200,000� FV of contractual obligation (Warranty obligations, etc): $ 600,000� FV of contingent consideration: $ 300,000� FV of AFS Bond investment given as consideration: $ 100,000� FV of non-controlling interest: $ 2 million� FV of common stock given as consideration: $ 7 million� Cash given as consideration:$ 1 million

Acquisition Cost Expenses 200,000Cash, A/R, Inv., Land, Bldg, Equip. 8,000,000In-Process R& D, Software, Contracts 1,000,000Trade-Name 400,000Goodwill 1,600,000

Cash 1,000,000AFS Investment 100,000Contractual Obligation 600,000Contingent Liability 200,000Contingent Consideration 300,000Common Stock 7,000,000Non-Controlling Interest 2,000,000

2008 Houlihan Lokey Study: 256 companies domiciled in U.S. with stock traded on major U.S. exchange

Study results: �Average Goodwill Impairment (GWI) 35.4% of Total Invested Capital (TIC)

�Average GWI 56.6% of Goodwill (GW)

�18.4% reported full impairment of GW

�Technology industry had highest count of GWI, followed by industrial companies

Reference of Goodwill Impairment:� Over 70% announced exact $ for GWI charge; rest - no

dollar amount� Those with exact $- least negative change in stock price� 62%: recorded additional asset impairment charges or

significant non-recurring expenses in addition to GWI

Reasons for taking GWI charges:� Changes in market demand; depressed economic

environment; volatility/decline in worldwide equity markets; decline in company’s market capitalization

General comments from management about GWI:�“No impact on business operations, liquidity, cash earnings, cash expenditures, compliance with financial covenants, or non-GAAP financial information”�“Does not limit or change ability to generate positive future cash flows from intangible assets nor reflect under-performance or impact strategic asset value”�“ Market capitalization today does not reflect true long-term value”. �Reconciliation required cost of capital assumption well above normal market levels. Changes in capital markets resulted in application of higher discount rate to projections -further impairment of goodwill required

Study: Interaction with Analysts:� 61% of companies received no questions� 39% of companies received1 or more questions� No questions asked of companies that recorded

top three GWI charges

Contrast to PCAOB reaction:� recent PCAOB report� Jeff will discuss further

FASB Proposal to Goodwill Impairment Test:� EITF is discussing step 1 changes: comparing FV

and BV of reporting unit: equity-value-based method or enterprise-value-based method

� Judgment

� Control

� Probability weighted

� Representational faithfulness

� More likely than not

� Transparency

� Single model applied to all financial assets such as debt securities and loans (FVOCI) and short-term receivables; replace OTTI and other impairment models

� Model (similar to current incurred loss model for loans):� Based on expected cash flows (for individually evaluated instruments

unless practical expedient of collateral fair value or historical loss factor for assets that are part of a pool

� Contrast to current GAAP: not based on triggering event; do not consider whether credit loss is probable because fv is lower than amortized cost; OTTI could not be recovered

� Recognize allowance for credit losses when do not expect to collect amounts contractually due (at acquisition)

� Credit impairment based on information available at measurement date – not “future expected loss” as IFRS

� Past events and existing conditions information to consider for credit impairment of asset or group (not future events): � financial condition of borrower, credit rating changes, failure to

make scheduled payment, levels of delinquencies, credit concentrations, fair value of collateral, environmental factors such as industry, geographic, and economic data

� Credit impairment for all debt securities even if fair value is > amortized cost; can use fv of loans or of collateral

� Example: � cost $ 200,000; value of security increased $ 20,000 due to interest

rates and other factors not credit related; credit impairment $ 5,000. Fair value must be $ 215,000. Report in net income credit impairment loss of $ 5,000, in OCI fair value gain of $ 20,000, and the debt security at $ 215,000.

� Effective date:� when final ASU issued; nonpublic entities with < 1 billion in assets

deferred for 4 years

� Scope: � all financial instruments except: leases, pensions and other

compensation, insurance contracts, common stock, stock options.,VIEs, loan commitments an standby letters of credit, loan commitmentrelated to revolving line of credit, product warranties.

� included: A/R, A/P and other payables, originated and purchased loans, investments in debt securities, investments in equity securities except equity method, core and noncore deposits, issued debt, hybrid financial instruments, derivatives.

� All equity instruments (not using equity method): � Fair Value Net Income (FVNI)

� Debt instrument assets that meet cash flow, business strategy, hybrid instrument criteria: � may elect FVOCI (otherwise default to FVNI)

� Debt instrument liabilities that meet cash flow, business strategy, hybrid instrument criteria and meet measurement attribute mismatch criteria of asset and liability:� may elect amortized cost; if do not meet measurement attribute

mismatch criteria – may elect FVOCI (otherwise default to FVNI)

� Certain short-term A/R, A/P, and core deposits: (unclear)� Amortized cost if cash given initially; securitizing or factoring-

problem

� Cash flow criteria:� original amount must be recoverable per terms and cannot be prepaid

so investor does not recover substantially initial contractual terms (not probability of repayment)

� convertible debt: FVNI� if can be rolled over, non-cash settlement?� perpetual instrument that is callable by issuer: FVNI� default by issuer not related to contractual terms

� Business strategy criteria:� to collect or pay contractual cash flows (not sell or settle with third

party) – how manage instruments, not intent of individual item� judgmental – “simplification”?; more guidance? enforceable?� hold for significant portion of terms; policies to support

�Financial instruments (not those with specialized measurement guidance)

Financial debt instrument?

Meets: cash flow;business strategy; and hybrid instrument criteria?

Financial liability?

FVTNI

May elect FVTOCI

Meetsthe measurementattributemismatch criteria?

May electamortized cost.

Yes

No

No

Yes

No Yes

Yes

No

� There have been over 1,500 comment letters to FASB, some comments include:

� “The IASB’s mixed attribute classification and measurement model for financial instruments…is generally superior to that of the FASB’s proposed classification and measurement model. FASB’s credit impairment model is impracticable and would be extremely difficult to implement as it mixes together interest income and the allowance for credit losses.” -- Fin REC

� “The ED approach does not eliminate complexities existing in GAAP that should be eliminated and creates unnecessary new complexities. Could we make deciding which financial liabilities can be measured at fair value or amortized initial fair value any harder?”

--- Edward W. Trott

� Impairment based on expected loss model� would use “probability weighted outcome approach”� potential future economic environments in estimating recoverable

cash flows (expectations about future credit losses)� for preparers: extremely complex, burdensome, and costly to apply� for internal and external auditors: challenge as to objectivity,

verifiability, and support (evidence) for the numbers� lack of guidance and illustrative examples (“principles”)

� Instead of fair value for debt instruments, amortized cost (IFRS 9) ; implications for convergence?

� Which achieves better relevance, representational faithfulness, simplification, neutrality, consistency, comparability?

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When does real estate valuation need to be calculated?� Property acquisition; significant changes to property

(e.g. renovation or demolition); development of property; property is used as collateral for loan

Who uses market value appraisals?� Buyers; sellers; corporate acquisitions, mergers, or

dissolutions; courts; mortgage lenders�

Steps: identify appraisal subject; determine required scope of work; collect data (market, comparables, subject); perform market and highest and best use data analysis; apply valuation techniques (sales, cost, income); reconcile

Sale approach:� Comparables; make transactional adjustments (property rights,

financing terms, conditions of sale, expenditures to be made after purchase, market conditions); make property adjustments (location, physical or economic characteristics, use, non-realty items)

Cost approach: � Cost of creating good = value of good; � Book value of building with improvements + estimated value of

site = cost approach value

Income approach: � present value of future income (gross income, vacancy losses,

operating expenses); convert NOI forecast into estimate of property value using direct capitalization models or discounted cash flow models

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Example:

Reproduction cost improvementLiving area $ xxx Garage area xxxAppliances, porch, patio areas xxx xxx

Less: Depreciation of ImprovementPhysical deterioration xxxFunctional obsolescence xxxExternal obsolescence xxx xxx

Depreciated value of improvements xxxPlus: Value of the site xxxPlus: Depreciated value of site improvement xxx= Cost approach value $ xxx

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Sale price at end of Year 5 = NOI6 ÷ Rt- where Rt is terminal (“going-out”) cap rate, slightly > Ro

Sale price $XXX−Selling expenses XXX= Net sale proceeds $XXX

* Net sales proceeds = Sale price- selling expenses

** Discount rate presumed to reflect required yield in market for unlevered investments of similar risk

� If impairment loss decreases, can recover prior losses

� Increased book amount after reversal cannot be > depreciated cost would have been if impairment had not been recognized

� Only applies to investments measured at cost, not fair value

� Recognize reversal of impairment loss as income and adjust depreciation for future periods

• Rate of constant change: distressed sales, appraisals, income changes, etc

• Foreclosures “mess” GMAC Mortgage, JP Morgan Chase and Bank of America suspended foreclosures to evaluate “errors due to flawed paperwork”. States have challenged foreclosures; Administration does not want to halt foreclosures

• Effect on impairment?

� Triggering event?� Probable losses?

� If debtor does not have access to funds at market rate for similar risk debt � TDR

� If, with restructuring, increase in contractual interest rate, � consider interest rate change with other modifications to determine if TDR

� Restructuring resulting in insignificant delay in contractual cash flows may still be TDR

� Borrower not yet in default could still have financial difficulty when payment default is “probably in foreseeable future” � TDR

Not considered TDR:� Changes in lease or employment-related

agreements, modifications of loans within a pool, or expected cash flows of pool of loans

� Debtors’ failures to pay trade accounts� Creditors’ delays in taking legal action to collect

overdue amounts of interest and principal� Fair value of assets or equity interest accepted >

recorded investment in receivable or > debtor’s BV� Creditor reduces effective interest rate to reflect

general decrease in market interest rates or risk� New debt’s effective interest rate is at/near current

market interest rates

Debtor not in financial difficulties if both:� Debtor currently servicing old debt and can obtain funds to

repay old debt from other than existing creditors at effective rate equal to current market rate

� Creditors agree to restructure old debt solely to reflect decrease in current market rates or positive changes in creditworthiness of debtor

Factors to determine if debtor has financial difficulties� Currently in default on any of its debt; bankruptcy; doubt of

going concern; delisted securities; forecast of entity-specifics cash flows insufficient to serve debt; cannot obtain funds from sources other than existing creditors at effective rate = marketrate; default “probable in foreseeable future”

� Effective date for interim and annual reporting periods ending after June 15, 2011

� Retrospective application required for receivables restructured on or after beginning of earliest period presented

� May result in changing method of calculating impairment on receivable

Comparison of provisions with IFRS� No similar issue exists under IFRS since IFRS does not

have guidance on TDR

Lessee’s “right of use”:

� Asset: liability + any prepaid rent + any recoverable initial direct costs

� Liability: Present value of estimated future lease payments (using probability-weighted expected outcomes approach and include estimates for contingent rentals, residual value guarantees, and termination option penalties) - discounted using lessee’s incremental borrowing rate or rate lessor charges, over longest possible lease term that is “more likely than not” to occur

� Exercise price of purchase option included in lease: not lease payment; excluded from measurement of liability

Right to use asset:� Amortize on systematic basis, usually straight-line,

based on consumption of economic benefits over shorter of lease term or useful life of underlying property; amortization expense on P & L

� Test for impairment right-of-use asset

Liability: � Measured at amortized cost using interest method� Review each reporting period for changes in estimated

future lease payments (estimated contingent rentals, expected payments under termination options, and residual value guarantees)

� Impairment accounting is at critical juncture; much depends on guidance still in progress

� Standard setting uncertainty (IFRS, little GAAP, politics) will play a role

� Environmental factors related to impairments – Jeff

� Auditing - interesting anecdotes - Jeff