Bob Jensen's Threads on Return on Business Valuation, Business Combinations, 
Investment (ROI), and Pro Forma Financial Reporting

Bob Jensen at Trinity University

Introduction to Fair Value Accounting

Introduction to P/E Ratios and Business Valuation

Business Valuation Blunders by the Pros

Controversial Issues in Pro Forma Financial Reporting

E-Business and E-Commerce  ROI Complications

Putting ROI Through The Wringer 

Fair Value and Fair Value Hedges

Forecasting  

KPMG's Business Valuation and Risk Measurement

Measuring Value of Products and Services

Free Online Real Estate Valuations

Business Valuation References and Resources (Including Business Combinations) 

Valuation Issues Related to Derivative Financial Instruments and FAS 133, FAS 138, and IAS 39
Bob Jensen's documents, cases, and glossaries on FAS 133, FAS 138, and IAS 39 are linked at http://www.trinity.edu/rjensen/caseans/000index.htm 

Bob Jensen's theory document related to valuation of intangibles is at 
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm 

Real Options, Option Pricing Theory, and Arbitrage Pricing Theory 
http://www.trinity.edu/rjensen/realopt.htm

Things to Consider When Valuing Options ---
http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm

Bob Jensen's theory documents related to valuation are linked at 
http://www.trinity.edu/rjensen/theory

Bob Jensen's Documents on e-Commerce and e-Business 
http://www.trinity.edu/rjensen/ecommerce.htm 

Bob Jensen's threads on fair value accounting are at various links:

http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#UnderlyingBases

http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#TheoryDisputes

http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue

http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#F-Terms

Interest Rate Swap Valuation, Forward Rate Derivation, and Yield Curves for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments ---
http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm

Fair Value Accounting Book Review (Meeting the New FASB Requirements)

From SmartPros on May 1, 2006
Fair Value for Financial Reporting by Alfred King highlights the accounting and auditing requirements for fair value information and offers a detailed explanation of how the FASB is going to change "fair value," from determining the fair value of intangible assets to selecting and working with an appraiser --- http://accounting.smartpros.com/x35458.xml

Fair Value for Financial Reporting: Meeting the New FASB Requirements
by Alfred M. King
ISBN: 0-471-77184-8
Hardcover 352 pages April 2006

This is what Professor Jim Mahar says about ERisk in the March 24, 2003 edition of TheFinanceProfessor (an absolutely fabulous newsletter) --- www.FinanceProfessor.com 

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 Introduction to Fair Value Accounting

This Statement amends FASB Statements No. 133, Accounting for Derivative Instruments and Hedging Activities, and No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. This Statement resolves issues addressed in Statement 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.”

This Statement:

Permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation

Clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133

Establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation

Clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives

Amends Statement 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument.

Reasons for Issuing This Statement

In January 2004, the Board added this project to its agenda to address what had been characterized as a temporary exemption from the application of the bifurcation requirements of Statement 133 to beneficial interests in securitized financial assets.

Prior to the effective date of Statement 133, the FASB received inquiries on the application of the exception in paragraph 14 of Statement 133 to beneficial interests in securitized financial assets. In response to the inquiries, Implementation Issue D1 indicated that, pending issuance of further guidance, entities may continue to apply the guidance related to accounting for beneficial interests in paragraphs 14 and 362 of Statement 140. Those paragraphs indicate that any security that can be contractually prepaid or otherwise settled in such a way that the holder of the security would not recover substantially all of its recorded investment should be subsequently measured like investments in debt securities classified as available-for-sale or trading under FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, and may not be classified as held-to-maturity. Further, Implementation Issue D1 indicated that holders of beneficial interests in securitized financial assets that are not subject to paragraphs 14 and 362 of Statement 140 are not required to apply Statement 133 to those beneficial interests until further guidance is issued.

How the Changes in This Statement Improve Financial Reporting

This Statement improves financial reporting by eliminating the exemption from applying Statement 133 to interests in securitized financial assets so that similar instruments are accounted for similarly regardless of the form of the instruments. This Statement also improves financial reporting by allowing a preparer to elect fair value measurement at acquisition, at issuance, or when a previously recognized financial instrument is subject to a remeasurement (new basis) event, on an instrument-by-instrument basis, in cases in which a derivative would otherwise have to be bifurcated. Providing a fair value measurement election also results in more financial instruments being measured at what the Board regards as the most relevant attribute for financial instruments, fair value.

Effective Date and Transition

This Statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The fair value election provided for in paragraph 4(c) of this Statement may also be applied upon adoption of this Statement for hybrid financial instruments that had been bifurcated under paragraph 12 of Statement 133 prior to the adoption of this Statement. Earlier adoption is permitted as of the beginning of an entity’s fiscal year, provided the entity has not yet issued financial statements, including financial statements for any interim period for that fiscal year. Provisions of this Statement may be applied to instruments that an entity holds at the date of adoption on an instrument-by-instrument basis.

At adoption, any difference between the total carrying amount of the individual components of the existing bifurcated hybrid financial instrument and the fair value of the combined hybrid financial instrument should be recognized as a cumulative-effect adjustment to beginning retained earnings. The cumulative-effect adjustment should be disclosed gross (that is, aggregating gain positions separate from loss positions) determined on an instrument-by-instrument basis. Prior periods should not be restated.

 

This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, the Board having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. However, for some entities, the application of this Statement will change current practice.

Reason for Issuing This Statement

Prior to this Statement, there were different definitions of fair value and limited guidance for applying those definitions in GAAP. Moreover, that guidance was dispersed among the many accounting pronouncements that require fair value measurements. Differences in that guidance created inconsistencies that added to the complexity in applying GAAP. In developing this Statement, the Board considered the need for increased consistency and comparability in fair value measurements and for expanded disclosures about fair value measurements.

Differences between This Statement and Current Practice

The changes to current practice resulting from the application of this Statement relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements.

The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. 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 asset or owes the liability. Therefore, the definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price).

This Statement emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, this Statement establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from sources independent of the reporting entity (observable inputs) and (2) the reporting entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The notion of unobservable inputs is intended to allow for situations in which there is little, if any, market activity for the asset or liability at the measurement date. In those situations, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. However, the reporting entity must not ignore information about market participant assumptions that is reasonably available without undue cost and effort.

This Statement clarifies that market participant assumptions include assumptions about risk, for example, the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and/or the risk inherent in the inputs to the valuation technique. A fair value measurement should include an adjustment for risk if market participants would include one in pricing the related asset or liability, even if the adjustment is difficult to determine. Therefore, a measurement (for example, a “mark-to-model” measurement) that does not include an adjustment for risk would not represent a fair value measurement if market participants would include one in pricing the related asset or liability.

This Statement clarifies that market participant assumptions also include assumptions about the effect of a restriction on the sale or use of an asset. A fair value measurement for a restricted asset should consider the effect of the restriction if market participants would consider the effect of the restriction in pricing the asset. That guidance applies for stock with restrictions on sale that terminate within one year that is measured at fair value under FASB Statements No. 115, Accounting for Certain Investments in Debt and Equity Securities, and No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations.

This Statement clarifies that a fair value measurement for a liability reflects its nonperformance risk (the risk that the obligation will not be fulfilled). Because nonperformance risk includes the reporting entity’s credit risk, the reporting entity should consider the effect of its credit risk (credit standing) on the fair value of the liability in all periods in which the liability is measured at fair value under other accounting pronouncements, including FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities.

This Statement affirms the requirement of other FASB Statements that the fair value of a position in a financial instrument (including a block) that trades in an active market should be measured as the product of the quoted price for the individual instrument times the quantity held (within Level 1 of the fair value hierarchy). The quoted price should not be adjusted because of the size of the position relative to trading volume (blockage factor). This Statement extends that requirement to broker-dealers and investment companies within the scope of the AICPA Audit and Accounting Guides for those industries.

This Statement expands disclosures about the use of fair value to measure assets and liabilities in interim and annual periods subsequent to initial recognition. The disclosures focus on the inputs used to measure fair value and for recurring fair value measurements using significant unobservable inputs (within Level 3 of the fair value hierarchy), the effect of the measurements on earnings (or changes in net assets) for the period. This Statement encourages entities to combine the fair value information disclosed under this Statement with the fair value information disclosed under other accounting pronouncements, including FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, where practicable.

The guidance in this Statement applies for derivatives and other financial instruments measured at fair value under Statement 133 at initial recognition and in all subsequent periods. Therefore, this Statement nullifies the guidance in footnote 3 of EITF Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities.” This Statement also amends Statement 133 to remove the similar guidance to that in Issue 02-3, which was added by FASB Statement No. 155, Accounting for Certain Hybrid Financial Instruments.

How the Conclusions in This Statement Relate to the FASB’s Conceptual Framework

The framework for measuring fair value considers the concepts in FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information. Concepts Statement 2 emphasizes that providing comparable information enables users of financial statements to identify similarities in and differences between two sets of economic events.

The definition of fair value considers the concepts relating to assets and liabilities in FASB Concepts Statement No. 6, Elements of Financial Statements, in the context of market participants. A fair value measurement reflects current market participant assumptions about the future inflows associated with an asset (future economic benefits) and the future outflows associated with a liability (future sacrifices of economic benefits).

This Statement incorporates aspects of the guidance in FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, as clarified and/or reconsidered in this Statement. This Statement does not revise Concepts Statement 7. The Board will consider the need to revise Concepts Statement 7 in its conceptual framework project.

The expanded disclosures about the use of fair value to measure assets and liabilities should provide users of financial statements (present and potential investors, creditors, and others) with information that is useful in making investment, credit, and similar decisions—the first objective of financial reporting in FASB Concepts Statement No. 1, Objectives of Financial Reporting by Business Enterprises.

 

This site has great sections on corporate finance, investments, valuation, spreadsheets, research, etc. For example, take a look at the helpers on valuation --- http://pages.stern.nyu.edu/%7Eadamodar/

From The Wall Street Journal Accounting Weekly Review on September 22, 2006

TITLE: FASB to Issue Retooled Rule for Valuing Corporate Assets
REPORTER: David Reilly
DATE: Sep 15, 2006
PAGE: C3
LINK: http://online.wsj.com/article/SB115828639109763950.html?mod=djem_jiewr_ac 
TOPICS: Accounting, Advanced Financial Accounting, Fair Value Accounting

SUMMARY: On 9/15/2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements. The standard "...provides enhanced guidance for using fair value to measure assets and liabilities. The standard also responds to investors' requests for expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings." (Source: FASB News Release available on their web site at http://www.fasb.org/news/nr091506.shtml) This new standard must be used as guidance whenever reporting entities use fair value to measure value assets and liabilities as a required or acceptable method of applying GAAP.

QUESTIONS:
1.) What is the purpose of issuing Statement of Financial Accounting Standards No. 157? In your answer, describe how this standard should help to alleviate discrepancies in practice. To help answer this question, you may access the FASB's own news release about the standard, available at http://www.fasb.org/news/nr091506.shtml or the new standard itself, available on the FASB's web site.

2.) From your own knowledge, cite an example in which fair value is used to measure an asset or liability in corporate balance sheets. Why is fair value an appropriate measure for including these assets and liabilities in corporate balance sheets?

3.) What is the major difficulty with using fair values for financial reporting that is cited in the article?

4.) Define the term "historical cost." Name two flaws with the use of historical costs, one cited in the article and one based on your own knowledge. Be sure to explain the flaw clearly.

5.) How does this standard help to alleviate the issue described in answer to question 3? Again, you may access the FASB's web site, and the news release in particle, to answer this question.

6.) The article closes with a statement that "The FASB hopes to counter some of [the issues cited in the article] by expanding disclosures required for all balance sheet items measure at fair value..." What could be the possible problem with that requirement?

Reviewed By: Judy Beckman, University of Rhode Island

Accounting rule makers have wrapped up an overhaul of a tricky but important method of valuing corporate assets, despite some critics' warning that the change could reopen the door to abuses like those seen at Enron Corp.

The overhaul, contained in an accounting standard that could be issued as early as today, will repeal a ban put in place after Enron collapsed into bankruptcy court in late 2001 amid an array of accounting irregularities. The ban prohibited companies immediately booking gains or losses from complex financial instruments whose real value may not be known for years.

The Financial Accounting Standards Board's new rule will require companies to base "fair" values for certain items on what they would fetch from a sale in an open market to a third party. In the past, firms often would use internal models to determine the value of instruments that didn't have a readily available price.

FASB prohibited that practice after Enron used overly optimistic models to value multiyear power contracts in a bid to pad earnings. The ban was meant to give the board time to come up with a new approach to determining fair values.

The accounting rule makers say the new standard will give companies, auditors and investors much needed, and more nuanced, guidance on how to measure market values. Companies will have to think, "it's not my own estimate of what something is worth to me, but what the market would demand for this," said Leslie Seidman, an FASB member. While clarifying how to come up with appropriate values for some instruments, the new standard doesn't expand the use of what is known as fair-value accounting.

Critics say the new rule reopens the door to manipulation and possibly fraud by unscrupulous managers. Requiring market values for instruments where there isn't a ready price in a market can be "a license for management to invent the financial statements to be whatever they want them to be," Damon Silvers, associate general counsel for the AFL-CIO, said at a meeting of an FASB advisory group this spring.

Jousting over the standard reflects a deep rift within accounting circles. For decades, accounting values were mostly based on historical cost, or what a company paid for a particular asset. In recent years, accounting rules have moved toward the use of market values, known as fair-value accounting. In some ways this reflects the shift in the U.S. from a manufacturing to a service economy, where intangible assets are more important than the plant and equipment that previously defined a company's financial strength.

Starting in the mid-1980s, companies also began using ever-more-complicated financial instruments such as futures, options and swaps to manage interest-rate, currency and other risks. Such contracts often can't be measured based on their cost. This spurred the use of market values, thought to be more realistic. But these values can be tough to determine because many complex financial instruments are tailor-made and don't trade on open markets in the same way as stocks.

Of course, valuations based on historical cost also have flaws. The savings-and-loan crisis of the late 1980s, for example, was prompted in part by thrifts carrying loans on their balance sheets at historical cost, even though the loans had plummeted in value.

Robert Herz, the FASB's chairman, acknowledges the difficulty in coming up with a market, or fair, value for many instruments. In discussions, he often asks how a company could reasonably be expected to come up with a fair value for a 30-year swap agreement on the Thai currency, the baht, which is a bet on the future value of that currency against another.

The answer, according to Mr. Herz and the FASB, is to base the value on what a willing third-party would pay in the market and possibly include a discount to reflect the uncertainty inherent in the approach.

In an interview earlier this year, Mr. Herz said this valuation approach would reduce the likelihood of a recurrence of problems such as those seen at Enron. "The problem wasn't that Enron was using fair values, it was that they were using 'unfair' values," he said.

Still, "the bottom line is that fair-value accounting is a great thing so long as you have market values," said J. Edward Ketz, an associate accounting professor at Pennsylvania State University, who is working on a book about the FASB's new standard. "If you don't, you get into some messy areas."

The FASB hopes to counter some of these issues by expanding disclosures required for all balance-sheet items measured at fair value, the board's Ms. Seidman said.

October 15, 2006 reply from Bob Jensen

The original 157 Exposure Draft proposed a Fair Value Option (FVO) that would have allowed carrying of virtually any financial asset or liability at fair value rather than just limiting fair value accounting to selected items that are now required to be carried at fair value rather than historical cost. Business firms, and especially banks, generally are against fair value accounting (due to reporting instabilities that arise from fair value adjustments prior to contract settlements). The FASB backed off of the FVO when it issued FAS 157, thereby relegating FAS 157 to a standard that clarifies definitions of fair value in various circumstances. Hence FAS 157 is largely semantic and does not change the present fair value accounting rules.

I asked Paul Pacter (at Deloitte in Hong Kong where he's still very active in helping to set IFRS and FASB standards) for an update on the FVO Project (commenced in 2004) that failed to impact the new FAS 157 standard. His reply is below.

Hi Bob,

Yes, FASB's FV Option (FVO) t is very much active -- an ED on phase 1 was issued in January, and a final FAS is expected before year end.

• Phase 1 addresses creating an FVO for financial assets and financial liabilities.
• Phase 2 addresses creating an FVO for selected nonfinancial items.

Thus phase 2 would go beyond IFRSs, though several IFRSs have FV options for individual types of assets. IAS 16 and IAS 38 allow it for PP&E and intangibles -- though the credit is to surplus, not P&L, no recycling, subsequent depreciation of revalued amounts. IAS 40 gives a FV option for investment property -- FV through P&L. IAS 41 isn't an option, it's a requirement for FV through P&L for agricultural assets.

Phase 2 would commence in 2007.

Re possible amendment to FAS 157, I don't think FASB plans to do that, though I suppose there might be some consequential amendment. But I don't think the FVO will change the definition of fair value that's in FAS 157.

Here's FASB's web page: http://www.fasb.org/project/fv_option.shtml

Warm regards,

Paul

Bob Jensen's threads on fair value accounting are at various other links:

I recently completed the first draft of a paper on fair value at http://www.trinity.edu/rjensen/FairValueDraft.htm
Comments would be helpful.

http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue

http://www.trinity.edu/rjensen/roi.htm

http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#UnderlyingBases

http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#TheoryDisputes 

http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#F-Terms

Interest Rate Swap Valuation, Forward Rate Derivation, and Yield Curves for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments ---
http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm

Robert Walker's First Blog Entry is About Fair Value Accounting, October 27, 2006 --- http://www.robertbwalkerca.blogspot.com/

Introduction
I have decided to begin a commentary which expresses my views on accounting. As I begin to do this I envisage the source of my commentary to comprise three different sorts of writing in which I may engage:
§ Simple notes directly to the ‘blog’ such as this.
§ Formal submissions I may make to various bodies including the IASB.
§ Letters or reports I may write for one reason or another that I think might have some general readership.

The expression of my views will stray from the subject matter of accounting per se to deal with matters of enormous significance to me such as corporate or public administration. Such expressions will not be too substantial a digression from the core subject matter because I believe that the foundation of good ‘corporate governance’, to use a vogue term, is accounting.

Source of my ideas on accounting
I would have to confess that the foundation upon which I base my philosophy of accounting is derivative, as much of human knowledge is of course. It is not for nothing that Newtown said that if he can see so far it is because he stands on the shoulders of giants. In my case, that ‘giant’ is Yuiji Ijiri. As I begin a detailed exposition of my views I shall return to the lessons I learned many years ago from Theory of Accounting Measurement, a neglected work that will still be read in 1,000 years or so long as humankind survives whichever is the shorter. As the depredations of the standard setting craze are visited upon us with ever increasing complexity, the message delivered by Ijiri will be heeded more an more.

The basic structure of accounting
Without wishing to be too philosophical about it, I need to begin by outlining what I mean by accounting. Accounting, in my mind, comprises three inter-related parts. These are:
§ Book-keeping.
§ Accounting.
§ Financial reporting.

Book-keeping is the process of recording financial data elements in the underlying books of account. These financial data elements represent, or purport to represent, real world events. The heart of book-keeping is the double entry process. For instance at the most basic level a movement in cash will result in the surrender or receipt of an asset, the incurring or settlement of a liability and so on.

I have no complete and coherent theory of the limits of book-keeping. Clearly cash movement (change of ownership) or the movement of commodity is the proper subject matter of book-keeping. Whether all forms of contract should be similarly treated is not clear to me. I am inclined to say yes. That is to adopt Ijiri’s theory of commitment accounting, but I can foresee that this leads me to conclusions that I may find unpalatable later on. Incidentally I say this because an epiphany I had, based on the notion of commitment accounting, some years ago is beginning to unravel.

Book-keeping goes beyond recording to encompass control. That is the process by which the integrity of the centre piece of book-keeping – the general ledger expressing double entry – is ensured. I will not concern myself with such processes though this is not to say that they are unimportant.

Accounting is the process by which sense is made of what is a raw record expressed in the general ledger. It is the process of distillation and summation that enables the accountant to gain on overview of what has happened to the entity the subject of the accounting. Accounting fundamentally assumes that the accountant is periodically capable of saying something useful about the real world using his or her special form of notation.

Financial reporting is the process by which data is assembled into a comprehensive view of the world in accordance with a body of rules. It differs, in the ideal, from accounting in a number of ways. Most benignly it differs, for instance, by including ancillary information for the benefit of a reader beyond the mere abstraction from the general ledger. Again in the ideal there is an inter-relationship between the three levels in the accounting hierarchy. That is, the rules of financial reporting will, to some degree shape the order and format of the basic, book-keeping level so that the process of distillation and summation follows naturally to the final level of reporting without dramatic alteration.

Perhaps what concerns me is that the sentiment expressed above can be seen, without much effort, to be only ideal and that in reality it does not arise. In short the golden strand that links the detailed recording of real world phenonmena to its final summation is broken.

An example
I was asked recently by a student of accounting to explain IAS 41, the IASB standard on agriculture. As I don’t deal in primary production at all, I had not thought about this subject for years.

IAS 41 admonishes the accountant to apply ‘fair value’ accounting. Fair value accounting is the process by which current sale prices, or their proxies, are substituted for the past cost of any given item.

For instance, you may have a mature vineyard. The vineyard comprises land, the vine and its fruit, the plant necessary to sustain the vine (support structures, irrigation channels etc.). Subsumed within the vine are the materials necessary for it to grow and start producing fruit. This will include the immature plant, the chemical supplements necessary to nurture and protect it, and the labour necessary to apply it.

The book-keeping process will faithfully record all of these components. Suppose for example the plant, fertliser and labour cost $1000. In the books will be recorded:

Dr Vineyard $1000
Cr Cash $1000

At the end of the accounting period, the accountant will summarise this is a balance statement. He or she will then obtain, in some way, the current selling price of the vine. Presumably this will be the future cash stream of selling the fruit, suitably discounted. Assume that this is $1200.

The accountant will then make the following incremental adjustment:

Dr Vineyard $200
Cr Equity $200

Looked like this there is a connection between the original book-keeping and the periodic adjustment at the end of the accounting period. This is an illusion. The incremental entry disguises what is really happening. It is as follows:

Dr Equity $1000
Cr Vineyard $1000

And

Dr Vineyard $1200
Cr Equity $1200

Considered from the long perspective, the original book-keeping has been discarded and a substitute value put in its place. This is the truth of the matter. The subject matter of the first phase of accounting was a set of events arising in a bank and in the entity undertaking accounting. The subject matter of the second phase is a set of future sales to a party who does not yet exist.

From a perspective of solvency determination, a vital element of corporate governance, the view produced by the first phase is next to useless. However, the disquiet I had in my mind which I had suppressed until recently, relates to the shattering of the linkages between the three levels of accounting in the final reporting process. This disquiet has returned as I contemplate the apparently unstoppable momentum of the standard setting process.

October 28, 2006 reply from Bob Jensen

Hi Robert,

I hope you add many more entries to your blog.

The problem with "original book-keeping" is that it provides no answer how to account for risk of many modern day contracts that were not imagined when "original book-keeping" evolved in a simple world of transactions. For example, historical costs of forward contracts and swaps are zero and yet these contracts may have risks that may outweigh all the recorded debt under "original book-keeping." Once we opened the door to fair value accounting to better account for risk, however, we opened the door to misleading the public that booked fair value adjustments can be aggregated much like we sum the current balances of assets and liabilities on the balance sheet. Such aggregations are generally nonsense.

I don't know if you saw my recent hockey analogy or not. It goes as follows:

Goal Tenders versus Movers and Shakers
Skate to where the puck is going, not to where it is.
Wayne Gretsky (as quoted for many years by Jerry Trites at http://www.zorba.ca/ )

Jensen Comment
This may be true for most hockey players and other movers and shakers, but for goal tenders the eyes should be focused on where the puck is at every moment ---  not where it's going. The question is whether an accountant is a goal tender (stewardship responsibilities) or a mover and shaker (part of the managerial decision making team). This is also the essence of the debate of historical accounting versus pro forma accounting.

Graduate student Derek Panchuk and professor Joan Vickers, who discovered the Quiet Eye phenomenon, have just completed the most comprehensive, on-ice hockey study to determine where elite goalies focus their eyes in order to make a save. Simply put, they found that goalies should keep their eyes on the puck. In an article to be published in the journal Human Movement Science, Panchuk and Vickers discovered that the best goaltenders rest their gaze directly on the puck and shooter's stick almost a full second before the shot is released. When they do that they make the save over 75 per cent of the time.
"Keep your eyes on the puck," PhysOrg, October 26, 2006 --- http://physorg.com/news81068530.html

I have written a more serious piece about both theoretical and practical problems of fair value accounting. I should emphasize that this was written after the FASB Exposure Draft proposing fair value accounting as an option for all financial instruments and the culminating FAS 157 that is mainly definitional and removed the option to apply fair value accounting to all financial instruments even though it is still required in many instances by earlier FASB standards.

My thoughts on this are at the following two links:

http://www.trinity.edu/rjensen/FairValueDraft.htm

http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue

Bob Jensen

October 30, 2006 reply from Robert B Walker [walkerrb@ACTRIX.CO.NZ]

Bob

Thanks for the support. I have answered you in my second installment ( www.robertbwalkerca.blogspot.com ).

 

I shall continue to write if for no other reason than for myself. I have had it in mind to write a book. I shall begin doing so this way.

 

Robert

October 30, 2006 reply from Bob Jensen

I have difficulty envisioning forward contracts as “executory contracts.” These appear to be to be executed contracts that are terminated when the cash finally flows.

Fair value appears to be the only way to book forward contracts if they are to be booked at all, although fair value on the date they are signed is usually zero.

Once you are in the fair value realm, you have all the aggregation problems, blockage problems, etc. that are mentioned at http://www.trinity.edu/rjensen/FairValueDraft.htm 

I guess what I’d especially like you to address is the problem of aggregation in a balance sheet or income statement based upon heterogeneous measurements.

Bob Jensen

Bob Jensen's threads on fair value accounting are at various other links:

I recently completed the first draft of a paper on fair value at http://www.trinity.edu/rjensen/FairValueDraft.htm
Comments would be helpful.

http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue

http://www.trinity.edu/rjensen/roi.htm

http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#UnderlyingBases

http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#TheoryDisputes 

http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#F-Terms

Interest Rate Swap Valuation, Forward Rate Derivation, and Yield Curves for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments ---
http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm

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Fair value is the estimated best disposal (exit, liquidation) value in any sale other than a forced sale.  It is defined as follows in Paragraph 540 on Page 243 of FAS 133:

The amount at which an asset (liability) could be bought (incurred) or sold (settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and should be used as the basis for the measurement, if available. If a quoted market price is available, the fair value is the product of the number of trading units times that market price. If a quoted market price is not available, the estimate of fair value should be based on the best information available in the circumstances. The estimate of fair value should consider prices for similar assets or similar liabilities and the results of valuation techniques to the extent available in the circumstances. Examples of valuation techniques include the present value of estimated expected future cash flows using discount rates commensurate with the risks involved, option- pricing models, matrix pricing, option-adjusted spread models, and fundamental analysis.  Valuation techniques for measuring assets and liabilities should be consistent with the objective of measuring fair value. Those techniques should incorporate assumptions that market participants would use in their estimates of values, future revenues, and future expenses, including assumptions about interest rates, default, prepayment, and volatility. In measuring forward contracts, such as foreign currency forward contracts, at fair value by discounting estimated future cash flows, an entity should base the estimate of future cash flows on the changes in the forward rate (rather than the spot rate). In measuring financial liabilities and nonfinancial derivatives that are liabilities at fair value by discounting estimated future cash flows (or equivalent outflows of other assets), an objective is to use discount rates at which those liabilities could be settled in an arm's-length transaction.

This is old news, but it does provide some questions for students to ponder.  The main problem of fair value adjustment is that many ((most?) of the adjustments cause enormous fluctuations in earnings, assets, and liabilities that are washed out over time and never realized.  The main advantage is that interim impacts that “might be” realized are booked.  It’s a war between “might be” versus “might never.”  The war has been waging for over a century with respect to booked assets and two decades with respect to unbooked derivative instruments, contingencies, and intangibles.

CFA analysts' group favors full fair value reporting
The CFA Centre for Financial Market Integrity – a part of the CFA Institute – has published a new financial reporting model that, they believe, would greatly enhance the ability of financial analysts and investors to evaluate companies in making investment decisions. The Comprehensive Business Reporting Model proposes 12 principles to ensure that financial statements are relevant, clear, accurate, understandable, and comprehensive (See below).
"Analysts' group favours full fair value reporting," IAS Plus, October 31, 2005 --- http://www.iasplus.com/index.htm

CFA Institute Centre for Financial Market Integrity Comprehensive Business Reporting Model – Principles 1. The company must be viewed from the perspective of a current investor in the company's common equity. 2. Fair value information is the only information relevant for financial decision making. 3. Recognition and disclosure must be determined by the relevance of the information to investment decision making and not based upon measurement reliability alone. 4. All economic transactions and events should be completely and accurately recognized as they occur in the financial statements. 5. Investors' wealth assessments must determine the materiality threshold. 6. Financial reporting must be neutral. 7. All changes in net assets must be recorded in a single financial statement, the Statement of Changes in Net Assets Available to Common Shareowners. 8. The Statement of Changes in Net Assets Available to Common Shareowners should include timely recognition of all changes in fair values of assets and liabilities. 9. The Cash Flow Statement provides information essential to the analysis of a company and should be prepared using the direct method only. 10. Changes affecting each of the financial statements must be reported and explained on a disaggregated basis. 11. Individual line items should be reported based upon the nature of the items rather than the function for which they are used. 12. Disclosures must provide all the additional information investors require to understand the items recognized in the financial statements, their measurement properties, and risk exposures.

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Standards of Value: Theory and Applications
Standards of Value covers the underlying assumption in many of the prominent standards of value, including Fair Market Value, investment value, and fair value. It discusses the specific purposes of the valuation, including divorce, shareholders' oppression, financial reporting, and how these standards are applied.
Standards of Value: Theory and Applications, by Jay E. Fishman, Shannon P. Pratt, William J. Morrison Wiley:  ISBN: 0-471-69483-5 Hardcover 368 pages November 2006 US $95.00) --- http://www.wiley.com/WileyCDA/WileyTitle/productCd-0471694835.html

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"Will Fair Value Fly? Fair-value accounting could change the very basis of corporate finance," by Ronald Fink, CFO Magazine September 01, 2006 --- http://www.cfo.com/article.cfm/7851757/c_7873404?f=magazine_featured

Much has changed in financial reporting since Andrew Fastow and Scott Sullivan, the finance chiefs of Enron and WorldCom, respectively, brought disgrace upon themselves, their employers, and, to a degree, their profession. Regulators and investors have pressed companies to be more open and forthcoming about their results — and companies have responded. According to a new CFO magazine survey, 82 percent of public-company finance executives disclose more information in their financial statements today then they did three years ago. But that positive finding won't quell calls for further accounting reform.

The U.S. reporting system "faces a number of important and difficult challenges," Robert Herz, chairman of the Financial Accounting Standards Board, told the annual conference of the American Institute of Certified Public Accountants in Washington, D.C., last December. Chief among those, said Herz, is "the need to reduce complexity and improve the transparency and overall usefulness" of information reported to investors. ad

Critics contend that generally accepted accounting principles (GAAP) remain seriously flawed, even as companies have beefed up internal controls to comply with the Sarbanes-Oxley Act. "We've done very little but play defense for the last five to six years," charges J. Michael Cook, chairman and CEO emeritus of Deloitte & Touche LLP. "It's time to play offense."

Cook, a respected elder statesman in the accounting community, goes so far as to pronounce financial statements almost completely irrelevant to financial analysis as currently conducted. "The analyst community does workarounds based on numbers that have very little to do with the financial statements," says Cook. "Net income is a virtually useless number."

How can financial statements become more relevant and useful? Many reformers, including Herz, believe that fair-value accounting must be part of the answer. In this approach, which FASB increasingly favors, assets and liabilities are marked to market rather than recorded on balance sheets at historical cost. Fair-value accounting, say its advocates, would give users of financial statements a far clearer picture of the economic state of a company.

"I know what an asset is. I can see one, I can touch one, or I can see representations of one. I also know what liabilities are," says Thomas Linsmeier, a Michigan State University accounting professor who joined FASB in June. On the other hand, "I believe that revenues, expenses, gains, and losses are accounting constructs," he adds. "I can't say that I see a revenue going down the street. And so for me to have an accounting model that captures economic reality, I think the starting point has to be assets and liabilities."

More than any other regulatory change, fair value promises to end the practice of earnings management. That's because a company's earnings would depend more on what happens on its balance sheet than on its income statement (see "The End of Earnings Management?" at the end of this article).

But switching from historical cost would require enormous effort from overworked finance departments. Valuing assets in the absence of active markets could be overly subjective, making financial statements less reliable. Linsmeier's confidence notwithstanding, disputes could arise over the very definition of certain assets and liabilities. And using fair value could even distort a company's approach to deal-making and capital structure.

A Familiar Concept Fair value is by no means unfamiliar to corporate-finance executives, as current accounting rules for such items as derivatives (FAS 133 and 155), securitizations (FAS 156), and employee stock option grants (FAS 123R) use it to varying degrees when recording assets and liabilities. So does a proposal issued last January for another rule, this one for accounting for all financial instruments. FASB's more recent proposals to include pensions and leases on balance sheets also embrace fair-value measurement (see "Be Careful What You Wish For" at the end of this article).

While both Herz and Linsmeier are careful to note that they don't necessarily favor the application of fair value to assets and liabilities that lack a ready market, they clearly advocate its application where there's sufficient reason to believe the valuations are reliable. Corporate accounting, Herz says, is the only major reporting system that doesn't use fair value as its basis, and he points to the Federal Reserve's use of it in tracking the U.S. economy as sufficient reason for companies to adopt it.

The corporate world, however, must grapple with its own complexities. For one, fair value could make it even more difficult to realize value from acquisitions. Take the question of contingent considerations, wherein the amount that acquirers pay for assets ultimately depends on their return. Under current GAAP, the balance-sheet value of assets that are transferred through such earnouts may reflect only the amount exchanged at the time the deal is completed, because the acquirer has considerable leeway in treating subsequent payments as expenses.

Under fair value, the acquirer would also include on its balance sheet the present value of those contingent payments based on their likelihood of materializing. Since the money may never materialize, some finance executives contend those estimates could be unreliable and misleading. "I disagree with [this application of fair value] on principle," James Barge, senior vice president and controller for Time Warner, said during a conference on financial reporting last May. ad

Barge cites the acquisition of intangible assets that a company does not intend to use as a further example of fair value's potentially worrisome effects. Under current GAAP, their value is included in goodwill and subject to annual impairment testing for possible write-off. But if, as FASB is contemplating, the value of those assets would be recorded on the balance sheet along with that of the associated tangible assets that were acquired, Barge worries that an immediate write-off would then be required — even though it would not reflect the acquiring company's economics.

Fair value's defenders say such concerns are misplaced. The possibility that a contingent consideration won't materialize, for starters, is already reflected in an acquirer's bid, says Patricia McConnell, a Bear Stearns senior managing director who chairs the corporate-disclosure policy council of the CFA Institute, a group for financial analysts. "It's in the price," she says.

As for intangibles that are acquired and then extinguished, the analyst says a write-off would not in fact be required under fair value if the transaction strengthens the acquirer's market position. That position would presumably be reflected in the value of the assets associated with those intangibles as recorded on the balance sheet under fair-value treatment.

"It may be in buying a brand to gain monopolistic position that you don't have an expense," McConnell explains, "but rather you have the extinguishment of one asset and the creation of another." Yet McConnell, among others, admits that accounting for intangibles is an area that would need improvement even if FASB adopted fair value.

Deceptive Debt? Another area of concern involves capital structure, with Barge suggesting that fair value may make it more difficult to finance growth with debt. He contends that marking a company's debt to market could make a company look more highly exposed to interest-rate risk than it really is, noting during the May conference that Time Warner's debt was totally hedged.

Barge also cited as problematic the hypothetical case of a company whose creditworthiness is downgraded by the rating agencies. By marking down the debt's value on its balance sheet, the company would realize more income, a scenario Barge called "nonsensical." He warned of a host of such effects arising under fair value when a company changes its capital structure.

Proponents find at least some of the complaints about fair value and corporate debt to be misplaced. Herz notes fair value would require the company to mark the hedge as well as the debt to market, so that if a company is hedging interest-rate risk effectively, its balance sheet should accurately reflect its lack of any exposure.

What's more, fair value could also improve balance sheets in some cases. When, for instance, a company owns an interest in another whose results it need not consolidate, the equity holder's proportion of the other company's assets and liabilities is currently carried at historical cost. If, however, the other company's assets have gained value and were marked to market, the equity holder's own leverage might decrease.

A real-life case in point: If the chemical company Valhi marked to market its 39 percent stake in Titanium Metals, Valhi's own ratio of long-term debt to equity would fall from 90 percent (at the end of 2005) to 56 percent, according to Jack T. Ciesielski, publisher of The Analyst's Accounting Observer newsletter. ad

Still, even some fair-value proponents share Barge's concern about credit downgrades. As Ciesielski, a member of FASB's Emerging Issues Task Force, wrote last April in a report on the board's proposal for the use of fair value for financial instruments, it is "awfully counterintuitive" for a company to show rising earnings when its debt-repayment capacity is declining.

Herz and other fair-value proponents disagree, noting that the income accrues to the benefit of the shareholders, not to bondholders. "It's not at all counterintuitive," asserts Rebecca McEnally, director for capital-markets policy of the CFA Institute Centre for Financial Market Integrity, citing the fact that the item is classified under GAAP as "income from forgiveness of indebtedness." But Ciesielski says investors are unlikely to understand that, and that fair value, in this case at least, may not produce useful results.

Resolving the Issues Even some of FASB's critics agree, however, that the current system needs improvement, and that fair value can help provide it. "Fair value in general is more relevant than historical cost and can lead to reduced complexity and greater transparency," Barge admits, though he has noted that the use of fair value may also lead to "soft" results that "you can't audit."

For much the same reason, Colleen Cunningham, president and CEO of Financial Executives International (FEI), expressed concern in testimony before Congress last March that "overly theoretical and complex standards can result in financial reporting of questionable accuracy and can create a significant cost burden, with little benefit to investors." In an interview, she explains that her biggest concern is that FASB is pushing ahead with fair-value-based rules without sufficient input from preparers. "Let's resolve the issues" before proceeding, she insists.

Herz concedes that numerous issues surrounding fair value need to be addressed. But important users of financial statements are pressing him to move forward on fair value without delay. As a comment letter that the CFA Institute sent to FASB put it: "All financial decision-making should be based on fair value, the only relevant measurement for assets, liabilities, revenues, and expenses."

Meanwhile, Herz isn't waiting for the conceptual framework to be completed before enacting new rules that embrace fair value. "In the end, we're not going to get everybody agreeing," Herz says. "So we have to make decisions" despite lingering disagreement.

Ironically, one fair-value-based proposal that FASB issued recently may have created an artful means of defusing opposition. The Board's proposal for financial instruments gives preparers of financial reports the choice of using historical cost or fair value in recording the instruments on their balance sheets. That worries some people, who say giving companies a choice of methods will make it harder to compare their results, even when they're in the same industry.

Continued in article

 

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"Guidance on fair value measurements under FAS 123(R)," IAS Plus, May 8, 2006 ---
http://www.iasplus.com/index.htm

Deloitte & Touche (USA) has updated its book of guidance on FASB Statement No. 123(R) Share-Based Payment: A Roadmap to Applying the Fair Value Guidance to Share-Based Payment Awards (PDF 2220k). This second edition reflects all authoritative guidance on FAS 123(R) issued as of 28 April 2006. It includes over 60 new questions and answers, particularly in the areas of earnings per share, income tax accounting, and liability classification. Our interpretations incorporate the views in SEC Staff Accounting Bulletin Topic 14 "Share-Based Payment" (SAB 107), as well as subsequent clarifications of EITF Topic No. D-98 "Classification and Measurement of Redeemable Securities" (dealing with mezzanine equity treatment). The publication contains other resource materials, including a GAAP accounting and disclosure checklist. Note that while FAS 123 is similar to IFRS 2 Share-based Payment, there are some measurement differences that are Described Here.

Bob Jensen's threads on employee stock options are at http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm

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Fair Value Accounting Book Review (Meeting the New FASB Requirements)

From SmartPros on May 1, 2006
Fair Value for Financial Reporting by Alfred King highlights the accounting and auditing requirements for fair value information and offers a detailed explanation of how the FASB is going to change "fair value," from determining the fair value of intangible assets to selecting and working with an appraiser --- http://accounting.smartpros.com/x35458.xml

Fair Value for Financial Reporting: Meeting the New FASB Requirements
by Alfred M. King
ISBN: 0-471-77184-8
Hardcover 352 pages April 2006

 

Click to Download the Comprehensive Business Reporting Model from the CFA Institute website.
Click here for Press Release (PDF 26k).

As you can see below, the war is not over yet.  In fact it has intensified between corporations (especially banks) versus standard setters versus members of the academy.

From The Wall Street Journal Accounting Educators' Review on April 2, 2004

TITLE: As IASB Unveils New Rules, Dispute With EU Continues 
REPORTER: David Reilly 
DATE: Mar 31, 2004 
PAGE: A2 LINK: http://online.wsj.com/article/0,,SB108067939682469331,00.html  
TOPICS: Generally accepted accounting principles, Fair Value Accounting, Insider trading, International Accounting, International Accounting Standards Board

SUMMARY: Despite controversy with the European Union (EU), the International Accounting Standards Board (IASB) is expected to release a final set of international accounting standards. Questions focus on the role of the IASB, controversy with the EU, and harmonization of the accounting standards.

QUESTIONS: 
1.) What is the role of the IASB? What authority does the IASB have to enforce standards?

2.) List three reasons that a country would choose to follow IASB accounting standards. Why has the U.S. not adopted IASB accounting standards?

3.) Discuss the advantages and disadvantages of harmonization of accounting standards throughout the world. Why is it important the IASB reach a resolution with the EU over the disputed accounting standards?

4.) What is fair value accounting? Why would fair value accounting make financial statements more volatile? Is increased volatility a valid argument for not adopting fair value accounting? Does GAAP in the United States require fair value accounting? Support your answers.

There are a number of software vendors of FAS 133 valuation software.

One of the major companies is Financial CAD --- http://www.financialcad.com/ 

FinancialCAD provides software and services that support the valuation and risk management of financial securities and derivatives that is essential for banks, corporate treasuries and asset management firms. FinancialCAD’s industry standard financial analytics are a key component in FinancialCAD solutions that are used by over 25,000 professionals in 60 countries.

See software.

RESPONSES TO SPECIFIC ISSUES

The FASB invited comment on all matters related to the ED, but specifically requested comments on 14 listed issues.  The Committee's comments are limited to those issues for which empirical research provides some insights, or those sections of the ED that are conceptually inconsistent or unclear.  The Committee has previously commented on other fair-value-related documents issued by the FASB and other standard-setting bodies.  This letter reiterates comments expressed in those letters to the extent they are germane to the measurement issues contained in the ED.  However, to better understand our perspective on reporting fair value information in the financial statements and related notes, we refer readers to those comment letters (i.e., AAA FASC 1998, 2000).

Issue 1: Definition of Fair Value

The Committee believes that the ED contains some conceptual inconsistencies between the definition and application of the fair value measurement attribute.  The ED proposes a definition of fair value that is relatively independent of the entity-specific use of the assets held or settlement of the liabilities owed.  In contrast, the proposed standard and related implementation guidance includes measurement that is, at times, directly determined by the entity-specific use of the asset or settlement of the liability in question.

Some of the inconsistencies with respect to fair value measurement might be attributable to the attempt to