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Fair Value Measurement Third Edition

Mark L. Zyla

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FairValueMeasurement

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SubsequentAccountingforGoodwillandOtherIntangibleAssets99 Conclusion100 Notes101

Chapter4:TheNatureofGoodwillandIntangibleAssets103

HistoryofIntangibleAssets104 IntellectualProperty105 EconomicBasisofIntangibleAssets106 IdentificationofIntangibleAssets106 UsefulLifeofanIntangibleAsset111 IntangibleAssetsandEconomicRisk112 Goodwill112 EconomicBalanceSheet114 Conclusion116 Notes117

Chapter5:Impairment119

EvolutionofImpairmentTesting120 ApplicableFASBGuidanceforImpairmentTesting122 AccountingfortheImpairmentofLong-LivedAssets123 GoodwillImpairmentTesting—PublicCompanies125 GoodwillImpairment—One-StepImpairmentLoss138 TestingOtherIndefinite-LivedIntangibleAssetsforImpairment139 AmortizationofGoodwill139 Conclusion140

Economic(External)Obsolescence173 ApplyingtheCostApproach174 TaxesUndertheCostApproach178 LimitationsoftheCostApproach179 Conclusion179 Notes180

Chapter7:TheMarketApproach183 ApplyingtheMarketApproachWhenMeasuringtheFairValueofanEntityor aReportingUnitofanEntity184 Conclusion213 Notes213

Chapter8:TheIncomeApproach215 Introduction215 DiscountedCashFlowMethod216 MultiperiodExcessEarningsMethod223 FASBConceptsStatement7239 RatesofReturnUndertheIncomeApproach244 TheIncomeIncrement/CostDecrementMethod245 ProfitSplitMethod246 Build-Out,orGreenfield,Method251 WeightedAverageCostofCapitalCalculation251 Conclusion258 Notes259

Chapter9:AdvancedValuationMethodsforMeasuringtheFairValue ofIntangibleAssets261 Introduction261 LimitationsofTraditionalValuationMethods261 RealOptions263 UsingOptionPricingMethodologiestoValueIntangibleAssets266 Black-ScholesOptionPricingModel269 BinomialorLatticeModels272 MonteCarloSimulation277 DecisionTreeAnalysis280 Conclusion281 Notes281

Chapter10:MeasuringtheRemainingUsefulLifeofIntangibleAssets inFinancialReporting283 FASBGuidanceonDeterminingtheRemainingUsefulLife283 ConsiderationsinMeasuringUsefulLivesofIntangibleAssets285 PracticalGuidanceforEstimatingandModelingtheUsefulLife289 Conclusion295 Notes295

Chapter11:FairValueMeasurementforAlternativeInvestments297 Introduction297 InvestmentsinCertainEntitiesThatCalculatedNetAssetValueperShare299 AICPATechnicalPracticeAid300 AICPAGuidanceforDeterminingtheFairValueofInvestment301 AICPAAccountingandValuationGuide, ValuationofPortfolioCompany InvestmentsofVentureCapitalandPrivateEquityFundsandOther InvestmentCompanies 305 InternationalPrivateEquityandVentureCapitalValuationGuidelines306 CommonValuationMethodologiesofMeasuringtheFairValueoftheFund’s InvestmentPortfolio307 Conclusion308 Notes308

Chapter12:ContingentConsideration311

ContingentConsideration:Earn-outsinBusinessCombinations311 AccountingforContingentConsideration312 Conclusion324 Notes324

Appendix12A:MeasuringtheFairValueofaNonfinancialContingent Liability—ExampleofaLoanGuarantee327 TheJordanLeeFundGuaranteeofTownsendFarmDevelopment,LLC328 Notes334

Chapter13:AuditingFairValueMeasurement335

AuditingStandards336 TheAuditProcess338 EvolutionofAuditStandardsforFairValueMeasurementsandDisclosures342 AuditingStandard2501, AuditingAccountingEstimates,IncludingFairValue Measurements 344 AuditingStandardsforAuditor’sUseoftheWorkofSpecialists349 ProposedInternationalStandardonQualityManagement1354 PracticalGuidanceforAuditors354 PCAOBStaffAuditPracticeAlertNo.9, AssessingandRespondingtoRiskin theCurrentEconomicEnvironment 356 AICPANonauthoritativeGuidance358 TheAppraisalFoundation359 Conclusion359 Notes360

Preface

FAIRVALUEMEASUREMENTSANDDISCLOSURES continuestobeanareaof tremendousinterestinfinancialreporting.AlthoughtheFairValueMeasurements frameworkisfullyconvergedunderU.S.GAAP(ASC820 FairValueMeasurements) andIFRS(IFRS13 FairValueMeasurements),bestpracticesofthemeasurementsthemselves havecontinuedtoevolve.Overthepast10years,organizationssuchastheAICPAandthe AppraisalFoundationhavedevelopedvariedguidanceonbestpracticesonmeasuringfair valueforvaluationspecialists.InDecember2018,thePCAOBfinalizedAS2501, Auditing AccountingEstimates,IncludingFairValue,andAS1201,Auditor’sUseofaSpecialist,toprovide additionalguidancetoauditorsinauditingfairvalue.Thevaluationprofessionrecently developedaFairValueQualityInitiativetoenhancethatprofession’sinvolvementinfinancial reporting,resultinginthenewCertifiedinEntityandIntangibleValuation(CEIV)credential andtheMandatoryPerformanceFramework(MPF).

InDecember2018,theInternationalAccountingStandardsBoardissuedareporton theirpostimplementationreviewofIFRS13, FairValueMeasurements.BoththeIASBand theFASBregularlyconductreviewsofnewlyimplementedaccountingstandardstoassess whetherthestandardsareworkingasintended.TheFASBconductedapostimplementation reviewin2014andconcludedthatthethen-titledFASBStatement157“metitsobjectives.”1 TheIASBconcludedthattheinformationrequiredbyIFRS13is“usefultousersoffinancial statements.”2

Investor-focusedorganizationssuchastheCFAInstitutehaveconcludedfromaseriesof surveysoftheirmembersthat“wherefairvaluehasbeenimplementedoverthepast15–20 yearsthereisgreateracceptanceastoitsappropriateness,relevanceandreliability.”3 A2013 CFAISurveyonFairValueAccounting&Long-TermInvestinginEuropesummarizesthe importanceoffairvaluemeasurementsinfinancialreportingtoinvestorsacrosstheglobe.

Simplyputallinvestorsbuy,sell,andholdtheirinvestmentsbasedonfairvalueinformation.Fairvalueinformationisnecessarytojudgecurrentfinancialhealth,isan inputtopredictingfutureperformance,andhelpsinthejudgmentofhoweffectively managementisfulfillingitsstewardshipfunction.4

Clearly,fairvaluemeasurementsenhancethepublictrustinfinancialreporting. Thethirdeditionof FairValueMeasurement:PracticalGuidanceandImplementation,which includessubstantialnewdiscussionmaterialandmanynewcomprehensiveexamples,isorganizedasfollows: xiii

Chapter1:TheHistoryandEvolutionofFairValueAccounting

◾ Providesahistoricallookatthedevelopmentoffairvalueconceptsandaccounting standards.

◾ Includesmilestonesrelatedtothedevelopmentoffairvalueforfinancialinstrumentsand fairvaluemeasurementofnonfinancialassetsandliabilities.

◾ Explainshowtheeconomiccrisisshapedfairvaluemeasurementandhowthecrisisled totherefinementofseveralaccountingstandards.

◾ DiscusseshowtheproposedconvergenceofU.S.GAAPwithIFRShasshapedfairvalue measurementconcepts,despitetheunlikelyfullconvergenceofbothstandards.

◾ Introducestrendsthatarelikelytocontinuetoaffectfairvaluemeasurementincluding differentlevelsofdisclosuresforpublicandprivatelyheldentities.

◾ IntroducestheFairValueQualityInitiativeandtheMandatoryPerformanceFramework.

◾ Includes,inanappendix,achecklistofitemstoconsiderundertheMandatoryPerformanceFramework.

Chapter2:FairValueMeasurementStandardsandConcepts

◾ PresentsanoverviewoffairvaluemeasurementinU.S.GAAPandwithcrossreferences toFASBASC820, FairValueMeasurement

◾ Examinesimportantfairvalueframeworkconceptssuchastheprincipalormostadvantageousmarket,marketparticipants,thehighestandbestusefornonfinancialassets, inputstofairvaluemeasurements,andthefairvaluehierarchy.

◾ DiscussedtheapplicationofFASBASC825, FinancialInstruments,whichprovidesthefair valueoptionforfinancialinstruments.

◾ Includesanexplanationofstandardsinthevaluationprofession,includingadiscussion ofUniformStandardsofProfessionalAppraisalPractice(USPAP)andInternational ValuationStandards(IVS).

◾ Provides,inanappendix,theimpactoftheTaxCutandJobsAct(TCJA)of2017onfair valuemeasurements.

Chapter3:BusinessCombinations

◾ Discussestherolemergerandacquisitiontransactionsplayinoureconomy,including trendsandpitfalls.

◾ Discussesthedevelopmentofaccountingstandardsforbusinesscombinations.

◾ CoverstherequirementsofASC805, BusinessCombinations.

◾ DiscussesprivatecompanyalternativeaccountingunderASU2014-18.

◾ Providescomprehensiveexamples.

Chapter4:TheNatureofGoodwillandIntangibleAssets

◾ Providesabriefoverviewofintangibleassetsandintellectualproperty,includingthe increasinglyprominentroletheseassetscontributetotheoverallbusinessenterprise value.

◾ Touchesonthecriteriaforrecognizinggoodwillandintangibleassetsinfinancialreportingandforestimatingtheirusefullives.

◾ ProvidestheclassificationandexamplesofintangibleassetsfromFASBASC805, Business Combination,aswellasmanyotherexamples.

Chapter5:Impairment

◾ Discussestheevolutionoftestinggoodwillforimpairmentundervariousaccounting standards.

◾ IncludesadescriptionofthealternativeaccountingforprivatecompaniesunderASU 2014-02.

◾ Includesadiscussionofthe“one-step”impairmenttestunderASU2017-04, Simplifying theTestforGoodwillImpairment.

◾ Coversthequalitativegoodwillimpairmenttestaswellasthechallengesoftheprior two-stepquantitativeimpairmenttest.

◾ Discussestheapplicableguidancefortestinggoodwill,intangibleassets,andlong-lived assetsforimpairmentandtheorderoftesting.

◾ Providesinsightintothediscussionaboutwhethergoodwillimpairmenttestingshould beattheequityorenterpriselevel.

◾ Includesanappendixwithacomprehensiveexampleofavaluationspecialist’sreportpreparedforaqualitativegoodwillimpairmentanalysis.

Chapter6:TheCostApproach

◾ Discussesthecostapproachtofairvaluemeasurement,includingtheeconomicbasisfor thecostapproach,theroleofexpectedeconomicbenefits,andeconomicobsolescence.

◾ Distinguishesbetweenreproductioncostandreplacementcost.

◾ Providesexamplesforapplyingthecostapproachusinghistoricaltrending,theunitcost methodandtheunitofcostmethod.

◾ Addresseshowtaxesandotherfactorsmayimpacttheapplicationofthecostapproach.

Chapter7:TheMarketApproach

◾ Coversmeasuringthefairvalueofanentityusingamarketapproachsuchastheguidelinepubliccompanymethodortheguidelinetransactionmethod.

◾ Providesinsighttocontrolpremiumsandsynergiesunderthismethod.

◾ Discussesthedevelopmentandapplicationofequityandinvestedcapitalmultiples.

◾ Coverstheapplicationofthemarketapproachtomeasurethefairvalueofintangible assets.

◾ Providesupdatedexamplesofuseofvarioustechniquesunderthemarketapproach.

Chapter8:TheIncomeApproach

◾ Examinestheworkhorseofvaluationmethods,thediscountedcashflowmethod,includingsingle-periodandmultiperiodvariations.

◾ Providesanin-depthlookatthemultiperiodexcessearningsmethod,includingmarket participantassumptionsinprojectedfinancialinformationandtheroleofcontributory assetsandtheirrequiredreturns.

◾ Providesexamplesofotherincomeapproachmethodsusedinbusinesscombinations, suchastheprofitsplitmethodandthe“withandwithout”method.

◾ Addressestheweightedaveragecostofcapitalanditscalculationunderthebuild-up methodandthecapitalassetpricingmodel.

◾ Providesupdatedexamplesofvariousvaluationtechniquesunderthemarketapproach.

Chapter9:AdvancedValuationMethodsforMeasuringtheFairValueof IntangibleAssets

◾ Introducesadvancedvaluationtechniquessuchastheoption-pricingmethods,Monte Carlosimulation,anddecisiontreeanalysis.

◾ Discussesrealoptionsderivedfromtheownershiprightsofintangibleassetsandhowto measuretheirfairvalue.

Chapter10:TheRemainingUsefulLifeofIntangibleAssets

◾ Distinguishesbetweenfinite-livedassetsandindefinite-livedassets.

◾ Providesfactorstoconsiderwhenmeasuringtheusefullivesofintangibleassets,includingthelegal,contractual,andusefullives.

◾ Providesexamplesofvariousapproachestocalculatingtheremainingusefullivesof intangibleassets.

Chapter11:FairValueMeasurementofAlternativeInvestments

◾ Discussesauthoritativeguidancefordeterminingthefairvaluemeasurementofalternativeinvestments,includingrecentAICPATechnicalPracticeAids.

◾ Addressesthepracticalexpedientforinvestmentsthatcalculatenetassetvaluepershare.

◾ Distinguishesinitialduediligencefeaturesofanalternativeinvestmentfromongoing monitoringfeatures.

◾ DiscussesthenewAICPAAccountingandValuationGuide, ValuationofPortfolioCompany InvestmentsofVentureCapitalandPrivateEquityFundsandOtherInvestmentCompanies

Chapter12:ContingentConsideration

◾ Discussestheaccountingrecognitionofearn-outsandothercontingentconsiderationin businesscombinations.

◾ Discussesthecommonwaysthatearn-outclausesareusedtoresolvepricedifferences betweenbuyersandsellersinabusinesscombination.

◾ Providesexamplesofmeasuringthefairvalueofcontingentconsiderationusinga probability-weightedexpectedreturnmethod,theBlack-Scholesoptionpricingmodel, andMonteCarlosimulation.

◾ AnappendixtoChapter12explainshowtomeasurethefairvalueofaloanguarantee usingtheBlack-Scholesoptionpricingmodelandincludesacasestudyexampletoillustratetheconcepts.

Chapter13:AuditingFairValueMeasurement

◾ DiscussestheguidanceforauditingfairvaluemeasurementsinAU328.

◾ IncludesadiscussiononthePCAOB’snewauditingstandardsAS2501, AuditingAccountingEstimates,IncludingFairValue,andAS1201,Auditor’sUseofaSpecialist

◾ IncludesimportanttopicsfromPCAOBAlertNo.2,includingauditingfairvalue measurements,classificationwithinthefairvaluehierarchy,andusingtheworkofa valuationspecialistorapricingservice.

◾ DiscussesthePCAOBAlertNo.9, AssessingandRespondingtoRiskintheCurrentEconomic Environment

◾ AppendixesAandBprovideexamplesofissuesauditorsmayconsiderwhenauditing businesscombinationsandone-stepgoodwillimpairmenttests.

◾ AppendixCexaminestheresultsofPCAOBinspectionreportsinAcuitas,Inc.’sSurveyof FairValueAuditDeficiencies.

Chapter14:FairValueMeasurementCaseStudy

◾ Providesanewstreamlinedcomprehensivebusinesscombinationcasestudywithvaluationmodelsillustratingthemeasurementoffairvalueforintangibleassets.

◾ Coversimportanttopicssuchastheacquisitionprice,contingentconsideration,business enterprisevalue,theweightedaveragecostofcapital,identifyingintangibleassets,goodwill,abargainpurchase,andsubsequenttestingforimpairmentofgoodwill.

◾ Highlightsimportantcasestudyconceptsthroughaquestion-and-answerformatwith suggestedsolutions.

AsInotedintheprefaceofthefirsttwoeditions,somehavevoicedconcernsaboutthe cost-benefitassociatedwithmeasuringfairvalueinfinancialreporting.However,asreported bytheaccountingstandardsettersandtheCFAInstitute,thebenefitsoffairvalueinfinancial reportingareclearlyevident.Fairvaluemeasurements,however,dorequireacertainamount ofjudgmentandexpertise.Clearly,therearesomechallenges.However,thebenefitstousersof financialstatementsthatincludefairvaluemeasurementsvastlyoutweighthosechallenges. Hopefullythisthirdeditionwillcontinuetohelpwiththosechallenges.

NOTES

1. ResponseoftheFinancialAccountingStandardsBoardonthePost-ImplementationReviewof FAS157,letterfromRussGolden,ChairoftheFASB,totheFinancialAccountingFoundation, datedMarch10,2014.

2. Post-ImplementationReviewofIFRS13,FairValueMeasurement,December2018,www .ifrs.org.

3. “SummaryofCFAInstituteMemberSurveys,”September2010,www.cfa.institute.org.

4. “ValueAccounting&Long-TermInvestinginEurope,”CFAInstitute,September2013,www .cfainstitute.org.

Acknowledgments

MOSTIMPORTANTLY, IwanttothankLynnPiersonforherassistancewiththis book.WithoutLynn’sefforts,thisthirdeditionaswellasthefirstandsecond, wouldnothavebeencompletedwithnearlythequalityanddepth.

Finally,thankyoutothosewhoprovidedcommentsandsuggestionsonvariousaspects offairvaluemeasurementswhichwereinstrumentalinpreparingthisthirdeditionaswell asthefirstandsecond,including:BillKennedyofDuff&Phelps;JulieDelongofAnkura ConsultingGroupLLC;TeresaThamerofBrenauUniversity;BrianSteenofDixonHughes GoodmanLLP;BrentSolomonoftheUniversityofMaryland;TaraMarinooftheCohnReznick LLP;MarkEdwardsofGrantThorntonInternationalLtd;MichaelBlakeofArpeggioAdvisors; JohnLinofMcKessonCorporation;AdrianLoudofCenseoAdvisorsLLC.;TracyHaasof RoarkCapitalGroup;HaroldMartin,PeterThackerandBrianBurnsofKeiter;Bernard PumpofDeloitteLLP;JimDonderoofAndersen;EllenLarsonofFTIConsulting;Steve HydenofWashingtonPartners;DavidDufendachofAlverez&Marsal;EdKetzofPennState University;NeilBeatonofAlvarez&Marsal;TomRyanoftheLeventhalSchoolofAccounting atUniversityofSouthernCaliforniaandProfessorMauroBiniofBocconiUniversityand ChairmanoftheManagementBoardofOIV—OrganismoItalianodiValutazione.

Theseindividuals’comments,aswellasthoseofmanyothers,wereinvaluableinmy preparationofthisbook.Anyerrors,however,aremyown.

TheHistoryandEvolution ofFairValueAccounting

FAIRVALUEACCOUNTING haschangedthewayfinancialinformationispresented.Whereoncefinancialstatementswerebasedprimarilyonhistoricalcosts, undercertaincircumstances,fairvalueisoftenthebasisofmeasurementforreporting forbothfinancialandnonfinancialassetsandliabilities.Measuringfairvalueoftenrequires experienceandjudgment,andithasthepotentialtointroducebiasintofinancialstatements. Atrendtowardincreasingtheamountoffinancialstatementinformationpresentedor disclosedatfairvaluepersistsunderU.S.generallyacceptedaccountingstandards(GAAP) andInternationalFinancialReportingStandards(IFRS).Thetrendawayfromhistorical costs,whichhasbeenthebedrockoftraditionalaccounting,towardfairvalueaccounting hasbeenchallengingforpreparers,auditors,standardssetters,andregulators.

Fairvalueaccountingisafinancialreportingapproachthatrequiresorpermitsentities tomeasureandreportassetsatthepriceassetswouldsellandliabilitiesattheestimatedprice thataholderwouldhavetopayinordertodischargetheliability.Theterm fairvalueaccounting notonlyreferstotheinitialmeasurementbutcanalsorefertosubsequentchangesinfair valuefromperiodtoperiodandthetreatmentofunrealizedgainsandlossesinthefinancial statements.Therefore,fairvalueaccountingaffectsthereportedamountsforassetsandliabilitiesinthebalancesheetandaffectsthereportedamountsforunrealizedgainsorlosses shownintheincomestatementorintheothercomprehensiveincomesectionofshareholders’equity.Infinancialreporting,fairvalueaccountingisoftenappliedtofinancialinstrumentssuchasinvestmentsinstocks,bonds,anentity’sowndebtobligations,andderivative instrumentslikeoptions,swaps,andfutures.Whenunadjustedoradjustedmarketpricesare thebasisforfairvalueestimatesoffinancialassetsandliabilities,theprocessisoftencalled mark-to-marketaccounting.

Fairvalueaccountingisapplicabletononfinancialassetsandliabilitiesaswell,butin morelimitedcircumstances.Forinstance,whenanentityisacquiredinabusinesscombination,allbalancesheetassetsandliabilitiesarerecordedatfairvalue.Subsequenttothe acquisitiondate,fairvalueisthebasisfortestingacquiredgoodwillforimpairment.Likewise, fairvalueisthebenchmarkwhentestingproperty,plant,andequipmentandamortizable intangibleassetsforimpairment.

Fairvaluemeasurementistheprocessfordeterminingthefairvalueoffinancialandnonfinancialassetsandliabilitieswhenfairvalueaccountingisrequiredorpermitted.Therefore, fairvaluemeasurementisbroaderthanmark-to-marketaccounting.Itencompassesestimatingfairvaluebasedonmarketpricesaswellasestimatingfairvalueusingvaluationmodels. TheFinancialAccountingStandardsBoards(FASB)AccountingStandardsCodification(ASC) 820, FairValueMeasurement, providesauthoritativeguidanceformeasuringthefairvalueof assets,liabilities,andequityinterestswhenfairvalueaccountingisrequiredorpermittedin otheraccountingstandards.TheInternationalAccountingStandardsBoard(IASB)hasan identicalstandard,IFRS13, FairValueMeasurements.

Advocatesoffairvalueaccountingbelievethatfairvaluebestrepresentsthefinancial positionoftheentityandprovidesmorerelevantinformationtotheusersofthefinancial information.Detractorsbelievethatfairvaluesareunreliablebecausetheyaredifficulttoestimate.Criticsalsobelievethatreportingtemporarylossesismisleadingwhentheyarelikelyto reverse,andthosecriticsbelievethatreportedlossesadverselyaffectmarketpricesandmarket risk.1 Inspiteofthecriticism,fairvalueaccountinghasbecomemoreprominentinfinancialstatementpresentationandwillcontinuetobeafundamentalbasisforaccountinginthe future.

InDecember2018,theIASBpublishedapostimplementationreviewofIFRS13, Fair ValueMeasurements,whichisconductedperiodicallybyboththeIASBandtheFASBtodeterminewhetheraccountingstandardsareworkingasintended.Inasummaryoftheirfindings, theIASBconcludedthefollowing:

◾ “TheinformationrequiredbyIFRS13isusefultousersoffinancialstatements.

◾ SomeareasofIFRS13presentimplementationchallenges,largelyinareasrequiring judgment.However,evidencesuggeststhatpracticeisdevelopingtoresolvethese challenges.

◾ NounexpectedcostshavearisenfromapplicationofIFRS13.2

TheIASBfurtherconcludedthatthefindingsofthepostimplementationreviewonfair valuemeasurementsshouldbeincorporatedintotheprojectaboutbettercommunicationin financialreporting.TheBoardalsoconcludedthatitneededtobetterliaisewiththevaluation profession,includingmonitoringnewdevelopmentswithvaluationspecialists.

WHYTHETRENDTOWARDFAIRVALUEACCOUNTING?

Inrecentyears,therehasbeenanincreasingtrendtowardtheuseoffairvalueaccounting infinancialreporting.Evenwhenfairvalueaccountingisnotrequiredandfinancialstatementsarepreparedusingsomeothermeasurementbasis,thereisalikelihoodthatrelated

disclosureswillrequirethepresentationoffairvalueinformation.Severalfactorsareinfluencingthetrendtowardfairvalueaccounting:thegrowingeconomicimportanceofintellectual property,globalization,andinvestors’desireforfinancialstatementsthataremorerelevant andtransparent.

TheChangingEconomy

TheeconomyintheUnitedStateshasundergonetremendouschangesoverthepast quarter-centuryduetoarapidrateoftechnologicalinnovation.Theexplosionintheuseof personalcomputersanddigitalmediahascreatedwholeindustriesthatdidnotpreviously exist.Oneproductoftechnologicalinnovationthatcontributedtoeconomicchangeisthe commercializationoftheInternet,whichresultedinwhatsomecallthe informationrevolution. TheresultofthistechnologicalandeconomicchangeisthatasignificantportionoftheU.S. economyshiftedfrombricks-and-mortarbusinessestoinformation-basedbusinesses.

Thiseconomicchangehasledtoagrowingrecognitionthatthevaluedriverofmany businessentitieslieswithintheirintellectualproperty,notjustintheirinventory,plant,and equipment.Financialstatementusersalsorecognizethatintellectualpropertyhasnotbeen effectivelymeasuredundertraditionalcost-basedaccountingpractices.Thereasonisthat existingaccountingprinciplesrequireinternallycreatedintellectualpropertytobeexpensed asresearchanddevelopment.

OceanTomo,anintellectualcapitalmerchantbankingfirm,producesanAnnualStudy ofIntangibleAssetMarketValuethatbreaksdowntheStandard&Poor(S&P)500’sequity marketvalueintoanimpliedintangibleassetvalueandatangibleassetvalue.In2015, tangibleandfinancialassetsgeneratedapproximately13percentoftheS&P500’smarket value.Whiletangibleandfinancialassetsarereflectedoncompanybalancesheets,the remaining87percentofvalueattributabletointangibleassetsisoftennotrecognizedatall.3

Themarket-to-bookratiofortheS&P500asofDecember31,2018,wasapproximately2.944 Thisratioindicatesthatonlyaboutathirdofthevalueofthemarketcapitalizationonaverage isrecognizedbycurrentaccountingstandards.Thisvaluegaphasincreasedinrecentyears, highlightingtheincreasingimportanceofintangibleassets(includingintellectualproperty) intheoverallmarketcapitalizationofpubliclytradedcompanies.

Globalization

TheInternationalMonetaryFunddefines economicglobalization as“ahistoricalprocess;the resultofhumaninnovationandtechnologicalprocess.Itreferstotheincreasingintegrationof economiesaroundtheworld,particularlythroughthemovementofgoods,servicesandcapitalacrossborders.”Globalizationhasacceleratedsincethe1980sasaresultoftechnological advancesthatmadeinternationalfinancialandtradingtransactionseasierandquicker.5 This increasingglobalizationofbusinesshascreatedaneedforconsistentaccountingstandards acrossnationalboundaries.

TheFASBandtheIASBrecognizethatusersoffinancialstatementswouldbenefitfrom havingonesetofinternationalaccountingstandardsthatcouldbeusedfordomesticand international,cross-borderfinancialreporting.Asaresult,bothorganizationshavebeen workingforseveralyearstojointlycreateaccountingstandardsandtoconvergeU.S.GAAP

withinternationalaccountingstandards(IAS).AccordingtotheFASB, convergence refersto boththegoalofestablishingasinglesetofhigh-qualityinternationalaccountingstandards andthepathtakentoreachthatgoal,whichincludesthecollaborativeefforts“toimprove existingU.S.GAAPandInternationalFinancialStandardsandeliminatethedifferences betweenthem.”6 Historically,IAShavebeenmoreprincipalbased,requiringmorefairvalue measurementthanU.S.GAAP,whichareconsideredmorerulesbased,requiringmore cost-basedmeasurement.Astheaccountingstandardsconverge,U.S.GAAPisrequiring morefairvalueaccountingmeasures.

ThehistoryandevolutionoffairvaluemeasurementencompassestherecentconvergenceofU.S.GAAPandIASpertainingtofairvaluemeasurement.Thefive-yearjointFASB andIASBprojectwasundertakentoimproveandalignfairvaluemeasurementanddisclosure requirementsandtorespondtotheglobalfinancialcrisis.7 Asoriginallypromulgated,the FASB’sStatementofFinancialAccountingStandards(SFAS)157, FairValueMeasurementsand Disclosures,influencedthedevelopmentofInternationalFinancialReportingStandard(IFRS) 13, FairValueMeasurement.ConvergencehasshapedU.S.accountingstandardsthrough updatestoFASBASC820.TheFASB’sAccountingStandardsUpdate(ASU)2011-04, AmendmentstoAchieveCommonFairValueMeasurementandDisclosureRequirementsinU.S. GAAPandIFRS,whichwasissuedinMay2011,eliminatedmostofthesignificantremaining differencesbetweenU.S.andinternationalaccountingstandardsformeasuringfairvalue. ThemoveandsubsequenthaltingoftheConvergenceProjectasitpertainstofairvalue measurementsisdiscussedingreaterdetailinthischapter.

RelevanceandTransparency

Animportantcharacteristicofefficientcapitalmarketsisthatpricesaretheresultofthe market’scorrectassessmentofallavailableinformation.TheFASBrecognizesthatbetter financialreportingleadstostrongercapitalmarketsbyhelpinginvestorsmakeinformed decisions.OneoftheFASB’sstatedgoalsis“tosetaccountingstandardsthatproducefinancial informationusefulinhelpinginvestorsdecidewhethertoprovideresourcestoacompany, andwhetherthemanagementofthatcompanyhasmadegooduseoftheresourcesit alreadyhas.”8

Inanefforttomakefinancialreportingmorerelevanttoinvestors,theFASBhasencouragedinvestorstoparticipateintheaccountingstandardsprocessbyprovidingcommentson discussionpapersandexposuredraftsthatareissuedatvariousstagesoftheFASB’sprojects. TheFASBhasaskedinterestedinvestorstoprovideexpertadvicetotheFASB’sdesignated“investorliaison”staffmembersinconjunctionwithFASBprojects.Thegoalistoimprovethe relevanceofaccountingstandardsforinvestorsinacost-effectivemanner.

TwootherinvestoradvisorygroupsprovideinputtotheFASBfromtheinvestorperspective,theInvestorsTechnicalAdvisoryCommittee(ITAC)andtheInvestorTaskForce(ITF). TheITACisfocusedonprovidingtechnicalaccountingadviceandincreasinginvestorparticipationinstandardsetting.9 TheITFismadeupofinstitutionalassetmanagerswhoanalyzevarioussectorsoftheeconomy.TheITFprovidesadvicetotheFASBabouttheimpactof variousaccountingstandardsproposalsonspecificindustrysectors.10

TheSecuritiesandExchangeCommission(SEC)isequallycommittedtoadvancinghigh qualityaccountingstandardsthatareresponsivetoinvestors’needs.Intestimonybeforea Congressionalsubcommittee,SECDirectorJohnM.Whitesaid,

Anopenprocessthatallowsstandardssetterstoseekandthoughtfullyconsiderthe viewsofmarketparticipantsiscriticaltoestablishing,maintaining,andcontinuallyimprovingfinancialaccountingandreportingstandards.Wearecommittedto highqualityaccountingstandardsandatransparentfinancialreportingsystemthat meetstheneedsofinvestorsandothermarketparticipants.11

Transparencyinfinancialreportingistheunbiased,clear,completepresentationof acompany’sfinancialposition.Informationinthemanagementdiscussionandanalysis (MD&A)sectionofthefinancialstatementsaboutexistingriskanduncertaintyandabout thelikelyfutureimpactofriskanduncertaintyonthecompany’sprospectsfurtherpromotes transparency.Whenfinancialreportingistransparent,investorsarebetterabletomake decisionsandavoidsurprises.Onamacroeconomicscale,transparencyleadstomore efficientallocationofcapitalandstrongercapitalmarkets.Intheaftermathoftheeconomic crisis,therewasadebateaboutwhetherfairvalueaccountingpromotedfinancialstatement transparencyorwhetheritcausedthemeltdown.Ina2008reporttoCongress,theSECfound that“investorsgenerallybelievethatfairvalueaccountingincreasesfinancialreporting transparencyandfacilitatesbetterinvestmentdecision-making.”12 TheCFACenterfor FinancialMarketIntegrityconcurswiththeSEC’sview.Itsupportsfairvalueas“themost transparentmeasurementforinvestorstoanalyzefinancialstatements,”anditsaid,“fair valueisbeingusedasascapegoatbycorporationswhohavemadepoordecisionsorwerenot incompliancewithaccountingstandards.”13

ThefinancialcrisishaspresentedachallengeandanopportunityfortheSECandthe FASBtoreaffirmtheirmissionsandassesstheirsuccessinachievingtheirgoals.TheSEC’s missionisto“protectinvestors,provideforefficientmarkets,andtofacilitatecapitalformation.”14 TheFASB’smissionis“toestablishandimprovestandardsoffinancialaccounting andreportingthatfosterfinancialreportingbynongovernmentalentitiesthatprovides decision-usefulinformationtoinvestorsandotherusersoffinancialreports.”15 TheSECand theFASBhaverenewedtheireffortstoensuregreatertransparencyinfinancialreporting anditsrelevancetoinvestorssincethefinancialcrisisbeganandarelikelytocontinuetodo sofortheforeseeablefuture.

HISTORYANDEVOLUTIONOFFAIRVALUE

TheFASB’sAccountingStandardsCodification(ASC)isthesingle,authoritativesourcefor U.S.GAAPtoday.ASCsupersededallpreviouslyissuedU.S.GAAPaccountingstandardsand reorganizedthembytopic.ASCbecameeffectiveforinterimandannualperiodbeginningafter September15,2009.16 ASC820, FairValueMeasurement (ASC820),supersededtheoriginal FASBaccountingstandardSFAS157thatwasissuedin2006.Inaddition,anyFASBStaff PositionsthatamendedSFAS157havealsobeensupersededbyASC820.FASBAccounting

StandardsUpdatesareincludedintheCodificationoncetheyreachtheireffectivedate.Those thathavenotreachedtheireffectivedatearepresentedinseparate“pendingcontent”sections, adjacenttothesubtopictheywillreplace.ASU2011-04, AmendmentstoAchieveCommonFair ValueMeasurementandDisclosureRequirementsinU.S.GAAPandIFRS, iseffectiveforallentitieswithreportingperiodsbeginningafterDecember15,2011.Sincethisdiscussioninthis sectionpertainstothehistoryoffairvaluemeasurements,thereferencesareasthestandards wereoriginallypresentedunderGAAP,muchofwhichhasnowbeencodifiedundertheASC. Fairvalueaccountingisnotanewrequirementinfinancialreporting.Fairvaluehasbeen astandardofmeasurementinfinancialreportingfordecades.TheFASBhasissueddozensof statementsthatusefairvalueasthemeasurementofvalue.Theconceptofvaluecontained inthesestatementsisfromamarketperspective,notfromtheperspectiveofthereporting entity.Therefore,measuringfairvaluerequiresfinancialstatementpreparerstousejudgmentandtomakeassumptionsconsistentwiththosemadebyothermarketparticipants.The FASBhasalsoissuedafewstatementswithfairvalue–likemeasurementstandardssuchas FASBASC718, Compensation—StockCompensation.Themaindifferencebetweenthesetwo measurementstandardsisthatthefairvalue–likemeasurementstandarddoesnotincorporateanexitpriceassumptionandfairvaluedoes.Theassumptionsunderlyingthefairvalue measurementframeworkofASC820arecoveredinChapter2.

InSeptember2006,theFASBissuedSFAS157(nowcodifiedasASC820)toclarifythe conceptsrelatedtothemeasurementoffairvalueandtoprovidefurtherimplementation guidance.17 AccordingtotheFASB,thereasonforissuingSFAS157wastodefinefair value,establishaframeworkformeasuringfairvalue,andexpanddisclosureaboutfair valuemeasurements.18 SFAS157didnotintroduceanynewaccountingrequirements. Instead,itappliedtoallexistingaccountingstatementsthatrequireassetsorliabilitiestobe presentedordisclosedinfinancialstatementsatfairvalue.Asoriginallypromulgated,the FASBintendedSFAS157toprovideoneuniformstatementunderwhichtheconceptoffair valuewouldbemorefullyexplained.

Whenitwasoriginallyissued,SFAS157becameasourceofcontroversyintheUnited States.Thebankingindustrywasparticularlyvocalinitsobjectionstomark-to-market accounting.Manycriticizeditsapplicationtoliabilities,andpreparersfelttheyneededmore guidancetoapplytheStatementtononfinancialassetsandliabilities.Inresponsetopressures fromfinancialstatementpreparersandotherconstituents,theFASBannouncedthatitwould delayimplementationfornonfinancialassetsandliabilitiesforoneyear.Theannouncement cameafewdaysbeforetheStatement’soriginalscheduledimplementationdate.Thereason citedbytheFASBforthepartialimplementationwas“toallowtheBoardandconstituents additionaltimetoconsidertheeffectofvariousimplementationissuesthathavearisen,or thatmayarise,fromtheapplicationofStatement157.”19

Eventhepartialimplementationdidnotallayallthecontroversy.Somecriticsoffairvalue accountingclaimedthatthecreditcrisisthatbeganin2008wasexacerbatedbyfinancial institutions’implementationofSFAS157.TheStatementbecamefullyeffectiveforfiscalyears beginningafterNovember15,2008,forallitems,includingfinancialandnonfinancialassets andliabilitiesrequiredunderexistingstatementstobemeasuredatfairvalue.

Inordertobetterunderstandfairvaluemeasurement,thissectioncoversthehistoryand evolutionoffairvaluemeasurementinfinancialreporting.Itbeginswithahistoricallook

backatthedevelopmentoffairvalueconcepts.Thenitcoverssomeofthemoreimportant milestonesrelatedtothedevelopmentoffairvalueforfinancialinstrumentsandfairvalue measurementfornonfinancialassetsandliabilities.Theeconomiccrisisshapedfairvalue measurementandledtotherefinementofseveralaccountingstandardsandconceptsasregulatorsandstandardssettersrespondedtothecrisis.ConvergenceofU.S.GAAPandIAShas alsoshapedfairvaluemeasurementconcepts.Finally,thissectionendsbydiscussingsome trendsthatarelikelytoinfluencethefutureoffairvaluemeasurement.

DevelopmentofFairValueConcepts

Theconceptoffairvaluehasbeenevolvingforoveracentury.Inan1898U.S.SupremeCourt caseaboutrailroadrateregulation, Smythv.Ames, theCourtdiscussedsomeoftheconcepts underlying fairvalue bysaying:

Inordertoascertainthatvalue,theoriginalcostofconstructions,theamount expendedinpermanentimprovements,theamountandmarketvalueofitsstocks andbonds,thepresentascomparedtotheoriginalcostofconstruction,theprobable earningcapacityofthepropertyunderparticularratesprescribedbystatute,and thesumrequiredtomeetoperatingexpenses,areallmattersforconsideration, andaretobegivensuchweightasmaybejustandrightineachcase.Wedonot saythattheremaynotbeothermatterstoberegardedinestimatingthevalueof theproperty.20

Thisreferencetofairvaluealludestoseveralfairvaluemeasurementconceptsthat arecurrentlyinuse,suchasacostapproach,amarketapproach,economicvalue,andthe applicationofjudgmenttoweighthevariousindicationsofvalue.

TheFASBinitiallyconsideredadoptingthesamedefinitionof fairmarketvalue usedfortax reportingrequirements,andusingittodescribefairvalueinfinancialreporting.However, theFASBultimatelydecidedonauniquedefinitionfor fairvalue;therefore,theterms fairvalue and fairmarketvalue arenotinterchangeable.Thefairmarketvaluedefinitionfoundinthe InternationalGlossaryofBusinessValuationTerms isthesameasthetaxdefinitionoffairmarket valueinRevenueRuling59-60,whichstatesthatitis

theprice,expressedintermsofcashequivalents,atwhichpropertywouldchange handsbetweenahypotheticalwillingandablebuyerandahypotheticalwillingand ableseller,actingatarm’slengthinanopenandunrestrictedmarket,whenneither isundercompulsiontobuyorsellandwhenbothhavereasonableknowledgeofthe relevantfacts.21

Fairmarketvalueisthestandardofvalueinallfederalandstatetaxmatters.Itisoftenusedto valueownershipinterestsinentities,whichisconsistentwithitstransaction-baseddefinition. Theterm fairmarketvalue hasasignificantbodyofinterpretivecaselaw,whichwastheprimaryreasontheFASBdecidedtoadoptadifferentstandardofvaluewithaspecificdefinition forfinancialreporting.22

Fairvalueisthestandardforfinancialreportingpurposes. Fairvalue isdefinedinthe FASB MasterGlossary as“thepricethatwouldbereceivedtosellanassetorpaidtotransferaliability inanorderlytransactionbetweenmarketparticipantsatthemeasurementdate.”23

Although fairmarketvalue hasarichhistorywithrespecttolegalandtaxmatters,the applicationoffairvaluetofinancialreportingisarelativelynewdevelopment.Thissection looksatthedevelopmentoffairvalueconceptsinfinancialaccountingstandardsfroma historicalperspective.

Oneofthefirstaccountingstatementsrequiringtheuseoffairvalueinfinancialreporting wasAccountingPrinciplesBoard(APB)18, TheEquityMethodofAccountingforInvestmentsin CommonStock, whichwasissuedin1971.APB18introducedtheequitymethodofaccountingforinvestmentsinunconsolidatedsubsidiaries.UnderAPB18,alosswouldberecognized whentheinvestment’sfairvaluedeclinedbelowitscarryingvalueandthelosswasconsidered tobeotherthantemporary.24

APB29, AccountingforNonmonetaryTransactions, introducedin1973,outlinedwaysto measurethefairvalueofnonmonetarytransactions.Itindicatesthatthefairvalueofanonmonetarytransactionshouldbedeterminedbyreferringtocashtransactionsforthesameor similarassets,quotedmarketprices,independentappraisals,andtheestimatedfairvalueof theassetorservicereceived.Anydeterminationoffairvalueusingthesemethodswouldalso havetoconsiderwhethertheestimatedvaluewouldberealized.25

In1977,SFAS15, AccountingbyDebtorsandCreditorsforTroubledDebtRestructurings, establishedsomeimportantfairvalueconcepts.SFAS15specifiesthatfairvalueistheamount determinedthroughacurrentsalebetweenawillingbuyerandawillingseller,otherthanin aforcedorliquidationsale.Italsostates,

Fairvalueofassetsshallbemeasuredbytheirmarketvalueifanactivemarketfor themexists.Ifnoactivemarketexistsfortheassetstransferredbutexistsforsimilar assets,thesellingpricesinthatmarketmaybehelpfulinestimatingthefairvalueof theassetstransferred.Ifnomarketpriceisavailable,aforecastofexpectedcashflows mayaidinestimatingthefairvalueofassetstransferred,providedtheexpectedcash flowsarediscountedataratecommensuratewiththeriskinvolved.26

SFAS15establishedseveralimportantcriteriaforusingamarketapproachandestablished theuseofadiscountedcashflowmethodformeasuringfairvalue.Theseimportantconcepts persistinfinancialreportingtoday.

FairValueofFinancialInstruments

TheFASBhasissuedseveralaccountingstandardsthatapplytofinancialinstrumentsincludingderivatives.OneofthefirstwasSFAS2, AccountingforCertainMarketableSecurities.Issued in1975,SFAS2requiredthatmarketablesecuritiesbecarriedatthelowerofcostormarket value.Italsoestablishedthepracticeofrecordingchangesinthemarketvalueofanentity’s noncurrentassetportfolioinaseparatecomponentofequity.Therefore,itpermittedunrealizedlossestobypasstheincomestatement.

In1991,SFAS107, DisclosuresAboutFairValueinFinancialInstruments, requiredthefair valuedisclosureofanentity’sfinancialinstruments.Therequirementincludedallfinancial assetsandliabilities,whetherrecordedorunrecordedinthefinancialstatements.27

SFAS115, AccountingforCertainInvestmentsinDebtandEquitySecurities,wasintroducedin1993.Itestablishedthreecategoriesofinvestmentsecurities:held-to-maturity

debtsecurities,tradingsecurities,andavailable-for-salesecurities.SFAS115alsorequiresfair valueasthestandardofmeasurementfordebtandequitysecuritiesclassifiedaseithertrading oravailable-for-sale.Unrealizedchangesinthefairvalueoftradingsecuritiesarerecognized inearnings,whereastheunrealizedchangesinthefairvalueofavailable-for-salesecurities areexcludedfromearningsandreportedinaseparatecomponentofshareholdersequity.28

In1994,theFASBissuedSFAS119, DisclosureAboutDerivativeFinancialInstrumentsand FairValueofFinancialInstruments.Itrequiredentitiesthatholdorissuederivativefinancial instrumentsfortradingpurposestodisclosetheaveragefairvalueofthoseinstruments.SFAS 119alsorequiredthatfairvalueinformationbepresentedwithoutcombining,aggregating, ornettingthefairvalueofderivativefinancialinstrumentswiththefairvalueofnonderivative financialinstruments.29

In2000theFASBintroducedFAS133, AccountingforDerivativeInstrumentsandHedging Activities,whichrequiredfairvalueasthemeasurementforderivativesecurities.Theaccountingtreatmentforchangesinthefairvalueofderivativeinstrumentsdependsontheirclassificationasafairvaluehedge,acashflowhedge,aforeigncurrencyhedge,oraderivative instrumentnotdesignatedasahedginginstrument.30

WiththeissuanceofSFAS159, TheFairValueOptionforFinancialAssetsandFinancial Liabilities,in2007,theFASBexpandedfairvaluemeasurementsforfinancialinstruments, whichwasconsistentwiththeBoard’slong-termaccountingmeasurementobjectivesfor financialinstruments.TheFASBnotedintheimplementationguidanceforSFAS159that theobjectiveoftheStatementistoimprovefinancialreporting,“byprovidingentitieswith theopportunitytomitigatevolatilityinreportedearningscausedbymeasuringrelatedassets andliabilitiesdifferentlywithouthavingtoapplycomplexhedgeaccountingprovisions.”31

SFAS159permitsentitiestochoosewhethertomeasurefinancialassetsandliabilitiesat fairvalueorwhethertoretaintheircurrentbasisofmeasurement;thereforethefairvalue optionisanelection.Itcanbeappliedonaninstrument-by-instrumentbasis,andthereisno requirementtoapplyittoallfinancialassetsorliabilities.OnceanelectionismadetomeasureaninstrumentatitsfairvalueunderSFAS159,theelectionisirrevocable(unlessanew electiondateoccurs).ThefinancialinstrumentscoveredbytheStatementarefairlybroad. ThemajorityofentitieselectingthefairvalueoptionunderSFAS159areinthefinancialservicesindustry,primarilycommercialandinvestmentbanks.

AbusinessentityelectingthefairvalueoptionunderSFAS159isrequiredtoreportunrealizedgainsandlossesresultingfromchangesinfairvalueinearningsateachsubsequent reportingdate.SFAS159wassupersededbyFASBASC825, FinancialInstruments.

FairValueMeasurementforNonfinancialAssetsandLiabilities

Duringthetechnologyboominthelate1990sbroughtonbytheinitialcommercialization oftheInternet,theFASBbeganaprojecttoupdateAPB16, BusinessCombinations.TheFASB observedthatduringthe1990s,muchoftheeconomicvalueinmergersandacquisitionswas drivenbytechnologyandotherintangibleassetsownedbytheacquiredcompany.Yetthese valuableassetswerenotbeingfairlypresentedinthefinancialstatementsbecauseunderAPB 16,muchofthevalueoftheacquiredentitywasreportedonthebalancesheetasgoodwill. Andunderaccountingrulesatthattime,goodwillcouldbeamortizedforupto40years.

TheFASBconcludedthatpurchasepriceallocationtoacquiredassetsandliabilitiesunder APB16didnotfairlyrepresenttheeconomicsubstanceofbusinesscombinations,andthat financialstatementswerenotbeingfairlypresented.TheBoardalsoconcludedthatcompanieshadtoomuchleewayinreportingthevalueofacquiredintangibleassets.Asaresult,the FASBmadesweepingchangestotheaccountingstandardsforbusinesscombinations.

OnJune29,2001,theFASBissuedSFAS141, BusinessCombinations,whichwassupersededbySFAS141(Revised), BusinessCombinations (SFAS141(R)),aboutsixyearslateras aresultofajointFASB/IASBproject.OneofthefirststepsintheFASBandIASBprojectto convergeU.S.GAAPwithinternationalaccountingstandardswastoharmonizetheaccountingstandardsforbusinesscombinations;therefore,theFASBrevisedSFAS141.TheBoards issuedcommonExposureDrafts,whichbecameSFAS141(R)andIFRS3, BusinessCombinations.TheaccountingstandardforbusinesscombinationsisnowcodifiedinFASBASC805, BusinessCombinations,andwillbecoveredingreaterdetailinChapter3.

WhenitwasoriginallyissuedinDecember2007,SFAS141(R)introducedtheacquisitionmethod,whichisbasedondeterminingthefairvalueofallacquiredassetsandliabilities. Thefairvaluesofidentifiableacquiredassetsandliabilitiesintotalmayormaynotequalthe purchaseprice.Whenthefairvalueofallidentifiableacquiredassetsandliabilitiesislessthan thepurchaseprice,thedifferencerepresentsgoodwill.Ifthefairvalueofallacquiredassets andliabilitiesismorethanthepurchaseprice,abargainpurchasewouldbeindicated.

SFAS141(R)containstherequirementsfortheinitialrecognitionofgoodwillandother intangibleassetsinbusinesscombinations.TheStatementalsoindicatesthatSFAS142, GoodwillandOtherIntangibleAssets,providesguidanceforthesubsequenttestingofgoodwill forimpairmentandthatSFAS144, TestingforImpairmentofLong-LivedAssets, provides guidancethesubsequentimpairmenttestingforintangibleassetssubjecttoamortization. Accountingstandardsforthesubsequenttreatmentofgoodwillandotherintangibleassets recognizedinabusinesscombinationarecurrentlycodifiedinASC350, Intangibles—Goodwill andOther,andASC360, Property,PlantandEquipment.

In2001,TheFASBissuedSFAS142,whichprovidesguidanceondeterminingwhether goodwillrecordedinabusinesscombinationbecomesimpairedinsubsequentyears,andit setsforththerequirementsfortheimpairmenttesting.UnderSFAS142,goodwillistested forimpairmentannuallyusingatwo-steptest.Thefirststepistoestimatethefairvalueof theentityorreportingunitbycomparingthefairvaluetoitscarryingvalue(bookvalue). Ifthefairvalueis greater thanbookvalue,goodwillisnotimpaired.Ifthefairvalueis less than thecarryingvalue,goodwillmaybeimpaired,andasecondstepisrequired.

Thesecondstepistoestimatethefairvaluesofalltheassetsandliabilitiesoftheentity orreportingunitasofthetestingdate,includingtheimpliedfairvalueofgoodwill.Thisstep issimilartotheallocationofpurchasepriceunderSFAS141(R).Theimpliedfairvalueof goodwillisthencomparedtothecarryingvalueofthegoodwill.Ifthefairvalueofgoodwill islessthanthecarryingvalueofgoodwill,itisconsideredtobeimpaired,andthedifference mustbewrittenoff.Morerecently,theFASBintroducedaqualitativeimpairmenttest,dubbed “stepzero”inAccountingStandardsUpdate2011-08,whichiscoveredinChapter5.

Theapplicationoffairvaluemeasurementstononfinancialassetsandliabilitiesismost oftenseeninpracticeinSFAS141(R),nowFASBASC805, BusinessCombinations,and SFAS142,nowFASBASC350, Intangibles—GoodwillandOther.Sincethesestatementswere

introduced,theFASBhasissuedclarificationsandupdates,whicharecoveredinsubsequent sectionsofthischapter,inresponsetotheeconomiccrisisandconstituentconcerns.Inaddition,boththeaccountingprofessionandthevaluationprofessionhavebegunprojectsto determinethebestpracticesfortheapplicationoffairvaluemeasurements.Manyofthese projectshavetakenyearstodevelopandsomearestillinprogress.Theyarealsodiscussedin laterchaptersofthisbook.

FairValueMeasurement

Fairvaluemeasurementisdiscussedfromahistoricalperspectivefurtheroninthischapter; thechapterdiscussestheoriginalissuanceofSFAS157anditcoversthesubsequent amendmentscontainedinFASBStaffPositionsandAccountingStandardsUpdates.Thenext chapter,Chapter2,“FairValueFrameworkfromASC820,”willcoverthemoreimportant conceptsandassumptionsformeasuringfairvalue.ThechapterwillfollowASC820’s contents’sequenceanditwillprovidefullreferencestocodificationsubtopics.Inaddition, definitionsfromtheFASB’sMasterGlossarywillbeprovidedforquickreference.

PriortotheimplementationofSFAS157theapplicationoffairvaluemeasurementsin financialreportingvariedamongthreedozenormoreofthepronouncementsthatrequireda fairvaluemeasurement.Thesestatementsreferredtodifferentaccountingconcepts,soover timeinconsistenciesdevelopedinapplyingfairvaluemeasurementsunderdifferentstatements.WiththeintroductionofSFAS141andSFAS142,someofthemorecommonapplicationsoffairvaluemeasurementswereinbusinesscombinationsandthesubsequenttesting ofgoodwillandotherlong-livedassets.Thesestatementsrequiredthefairvaluemeasurementsofassetsthatwerenotreadilymeasureablebythemarketplace.Preparersoffinancialstatementswereconcernedaboutmeasuringfairvalueintheabsenceofquotedmarket prices.SFAS157establishedaframeworkforapplyingfairvaluemeasurements.TheFASB believedthattheimplementationofSFAS157wouldimprovefinancialreportingbyincreasing consistency,reliability,andcomparability.

Whenoriginallyissued,SFAS157defined fairvalue as“thepricethatwouldbereceivedto sellanassetorpaidtotransferaliabilityinanorderlytransactionbetweenmarketparticipants atthemeasurementdate.”32 Fairvaluemeasurementassumesthattheassetorliabilitycanbe exchangedinanorderlytransactionbetweenmarketparticipantswhowishtoselltheassetor transfertheliabilityatthemeasurementdate.Fairvaluemeasurementsarisefromanorderly transaction,oroneinwhichtherehasbeenexposuretothemarketforasufficientperiodprior tothemeasurementdatetoallowfortheusualandcustomarymarketingactivitiesforsuch assetsorliabilities.Anorderlytransactionisnotaforcedtransaction,suchasaforcedliquidationoradistresssale.33 Bydefinitionanonactivemarketisnotanorderlymarketoronein whichthereissufficientexposuretothemarketforusualandcustomarymarketingactivities. Thus,apriceindicatedinanonactiveorilliquidmarketwouldlikelynotbeanindicationof fairvalue.SFAS157introducedorexpandeduponseveralimportanttopics,asit

◾ Reviseddefinitionoffairvalue

◾ Discussedtheissueofpriceinthemeasurement

◾ Definedmarketparticipants

◾ Expandedontheconceptofprincipalmarketormostadvantageousmarket

◾ Introducedtheconceptofdefensivevalue

◾ Describedvaluationtechnique

◾ Introducedthefairvaluehierarchy

◾ Expandedrequireddisclosures

Theseconcepts,asupdatedforconvergencewithIFRS,arediscussedmorefullyinChapter2.

Aspreviouslymentioned,SFAS157’sfullimplementationwasdelayedbytheFASB.SFAS 157wasoriginallysupposedtobeeffectiveforfiscalyearsbeginningafterNovember15,2007. However,onNovember12,2008,afewdaysbeforethestatementwastobecomefullyeffective,theFASBdelayedimplementationfornonfinancialassetsandliabilities.34 Thesenonfinancialassetsandliabilitiesarerelatedtogoodwill,businesscombinations,anddiscontinued operations,aswellastosomenonfinancialintangibleassets.Oneofthereasonsfordelaywas thatpreparersoffinancialstatementsfelttheydidnotfullyunderstandtheimplicationsfor thestatement’simplementation.

ThestatementwasfullyimplementedforfiscalyearsbeginningafterNovember15,2008. AlthoughtheFASBagreedtoadopttheone-yeardelay,itencouragedtheearlieradoption.

FAIRVALUEACCOUNTINGANDTHEECONOMICCRISIS

Beginninginthelatterpartof2006,anincreaseinthegenerallevelofinterestratescauseda sharpriseinthedelinquencyanddefaultratesbysubprimeratemortgageborrowers.Most oftheunderlyingsubprimemortgageswerebasedonadjustablerates.Asinterestrose,many borrowerswereunabletomakethehigherinterestpaymentsontheirmortgages.Asaresult, thedefaultratesinsubprimemortgagesincreaseddramatically.Theriseininterestrates alsocontributedsignificantlytoadeclineintheoverallhousingmarket,whichcompounded theimpactofthedefaultscausedbylimitedoptionsforsaleoftheunderlyingrealestateby thedefaulter.

Asanincreasingnumberofsubprimemortgageborrowersbegantodefault,manyfinancialinstitutionsandinvestmentbanksholdingmortgage-backedsecuritiesbasedonsubprime mortgagesbegantoexperienceuncertaintyaboutthereliabilityofcashflowsfromthese investments,whichfurthererodedtheirperceivedvalue.Asthelevelofdefaultsincreased, ratingagenciessignificantlydowngradedthesesubprimemortgagesecurities.Thedowngradescausedotherinvestorsandlenderstorefrainfrominvestinginmortgage-backed securities.Thelackofasecondarymarketcreateda“liquiditycrisis,”whichbegantospread throughoutthefinancialmarkets.Theriskofdefaultsintheunderlyingmortgagescaused thesecondarymarketsforsecuritizedmortgagestofreeze,whichimpactedawiderangeof commercialandinvestmentbanksthatheldthesesecurities.

Mark-to-MarketAccounting

Atthecenterofthisliquiditycrisiswasanaccountingissue:Howshouldtheholdersof mortgagesecuritiesmeasurethevalueofthesedebtsecuritiesforfinancialreporting? Tocomplicatematters,manyoftheentitieshadalreadyelectedthe FairValueOption provided bySFAS159,whichpermittedentitiestomeasuremostfinancialassetsandliabilitiesattheir

respectivefairvaluesinfiscalyearsbeginningafterNovember15,2007.The FairValueOption incorporatesthedefinitionoffairvalueaspresentedinSFAS157,whichincludesfeatures suchasthefairvaluehierarchy,marketparticipantassumptions,andthepreferencefor observableinputs.

Amongtheaccountingquestionsatthecenterofthefinancialcrisiswerethesetwo:What isthefairvalueofthesecuritizedsubprimemortgagesthatfinancialinstitutionsandother entitiesshouldreportontheirbalancesheet?Whenthemarketisconsidereddistressed,what istheappropriatelevelfordisclosureinthefairvaluehierarchy?

Criticsoffairvaluemeasurementbelievedthatthecreditcrisiswasmademuchgreater bythemark-to-marketaccountingoffinancialinstitutionsthathadinvestedinthesecuritizedsubprimedebt.Thecriticismoffairvalueaccountingwasbasedonanapparentdifferencebetweenthemarketvalueofcertainsecuritiesindistressedmarketsandthevalue indicatedbyholdingthesecuritiestomaturity.Thecentralissuewaswhetherthefairvalue ofthesesecuritieswouldbethedepressedpriceindicatedbythemarketorthevalueindicatedbythesecurities’expectedfuturecashflowsdiscountedtothepresentatarisk-adjusted rateofreturn.

ManycalledforsuspensionorrevisionofSFAS157duringtheeconomiccrisis.However,theCenterforAuditQualityreaffirmeditspositionontherelevanceoffairvalue measurements,saying,

Suspendingfairvalueaccountingduringthesechallengingeconomictimeswould depriveinvestorsofcriticalfinancialinformationwhenitisneededmost.Investors havearighttoknowthecurrentvalueofaninvestment,eveniftheinvestmentis fallingshortofpastorfutureexpectations.35

ApplicationofFairValueAccountinginIlliquidMarket

Inresponsetowidespreadpubliccriticismofmark-to-marketaccounting,theSECOfficeofthe ChiefAccountantandFASBStaffreleasedastatemententitled“ClarificationsonFairValue Accounting”onSeptember30,2008.36 Thestatementrespondedtoseveralquestionsraised bythecreditcrisis:

◾ Canmanagement’sinternalassumptions(e.g.,expectedcashflows)beusedtomeasure fairvaluewhenrelevantmarketevidencedoesnotexist?

Yes.Whenanactivemarketforasecuritydoesnotexist,theuseofmanagementestimatesthatincorporatecurrentmarketparticipantexpectationsoffuturecashflows,and includeappropriateriskpremiums,isacceptable.

◾ Aretransactionsthataredeterminedtobedisorderlyrepresentativeoffairvalue?When isadistressed(disorderly)saleindicativeoffairvalue?

Theresultsofdisorderlytransactionsarenotdeterminativewhenmeasuringfair value.Theconceptofafairvaluemeasurementassumesanorderlytransactionbetween marketparticipants.Anorderlytransactionisonethatinvolvesmarketparticipantsthat arewillingtotransactandallowsforadequateexposuretothemarket.Distressedor forcedliquidationsalesarenotorderlytransactions,andthusthefactthatatransaction isdistressedorforcedshouldbeconsideredwhenweighingtheavailableevidence. Determiningwhetheraparticulartransactionisforcedordisorderlyrequiresjudgment.

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