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
Erisk.com. I simply
love the site. I know it has been site of the week before, but it is so good,
it earned it again. Try it, you’ll love the case studies and the newsletter!
http://www.erisk.com
ERisk --- http://www.erisk.com/
ERisk is the leading
provider of strategic solutions for risk and capital management. We deliver a
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risk management expertise, risk transfer advice and risk information.
You can find out more
about our products and services in the Overview section. On this page, you can
find out more about the people and ideas that power our company.
The ERisk Report
--- http://www.erisk.com/about/about_company.asp?ct=n#report
The ERisk
Report is a concise monthly briefing for senior financial executives.
Every month, contributors from ERisk's team of risk management experts address
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1.5: Putting the real value on customer relationships; rolling out
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Vol
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Vol
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The ERisk Portal --- http://www.erisk.com/portal/home.asp
Resources for Enterprise Risk Management
ERisk today
continues to successfully develop and install its analytics
at client sites, conduct high-value consulting
engagements, offer unbiased advice on risk
transfer alternatives, and attract thousands of readers to the ERisk portal.
Introduction to Fair Value Accounting
Bob Jensen's threads on fair value accounting are at various other links:
Bob Jensen's threads on fair value accounting ---
http://www.trinity.edu/rjensen/Theory01.htm#FairValue
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
May 17, 2006 message from Peter Walton
I would like to take this opportunity to let
you know about a forthcoming book from Routledge:
The Routledge Companion to Fair Value and
Financial Reporting ---
Click Here
Edited by Peter Walton
May 2007: 246x174: 406pp
Hb: 978-0-415-42356-4: £95.00 $170.00
Jensen Comment
Even though I have a paper published in this book, I will receive no
compensation from sales of the book. And since I'm retired, lines on a
resume no longer matter.
FASB Statement No. 107
Disclosures about Fair Value of Financial Instruments
(Issue Date 12/91)
[Full Text]
[Summary]
[Status]
This Statement extends existing fair value disclosure
practices for some instruments by requiring all entities to disclose the
fair value of financial instruments, both assets and liabilities
recognized and not recognized in the statement of financial position,
for which it is practicable to estimate fair value. If estimating fair
value is not practicable, this Statement requires disclosure of
descriptive information pertinent to estimating the value of a financial
instrument. Disclosures about fair value are not required for certain
financial instruments listed in paragraph 8.
This Statement is effective for financial statements
issued for fiscal years ending after December 15, 1992, except for
entities with less than $150 million in total assets in the current
statement of financial position. For those entities, the effective date
is for fiscal years ending after December 15, 1995.
FASB Statement No. 115
Accounting for Certain Investments in Debt and Equity Securities
(Issue Date 5/93)
[Full Text]
[Summary]
[Status]
This Statement addresses the accounting and reporting
for investments in equity securities that have readily determinable fair
values and for all investments in debt securities. Those investments are
to be classified in three categories and accounted for as follows:
Debt securities that the enterprise has the positive
intent and ability to hold to maturity are classified as
held-to-maturity securities and reported at amortized cost.
Debt and equity securities that are bought and held
principally for the purpose of selling them in the near term are
classified as trading securities and reported at fair value, with
unrealized gains and losses included in earnings.
Debt and equity securities not classified as either
held-to-maturity securities or trading securities are classified as
available-for-sale securities and reported at fair value, with
unrealized gains and losses excluded from earnings and reported in a
separate component of shareholders' equity.
This Statement does not apply to unsecuritized loans.
However, after mortgage loans are converted to mortgage-backed
securities, they are subject to its provisions. This Statement
supersedes FASB Statement No. 12, Accounting for Certain Marketable
Securities, and related Interpretations and amends FASB Statement No.
65, Accounting for Certain Mortgage Banking Activities, to eliminate
mortgage-backed securities from its scope.
This Statement is effective for fiscal years beginning
after December 15, 1993. It is to be initially applied as of the
beginning of an enterprise's fiscal year and cannot be applied
retroactively to prior years' financial statements. However, an
enterprise may elect to initially apply this Statement as of the end of
an earlier fiscal year for which annual financial statements have not
previously been issued.
FASB Statement No. 130
Reporting Comprehensive Income
(Issue Date 6/97)
[Full Text]
[Summary]
[Status]
This Statement establishes standards for reporting and
display of comprehensive income and its components (revenues, expenses,
gains, and losses) in a full set of general-purpose financial
statements. This Statement requires that all items that are required to
be recognized under accounting standards as components of comprehensive
income be reported in a financial statement that is displayed with the
same prominence as other financial statements. This Statement does not
require a specific format for that financial statement but requires that
an enterprise display an amount representing total comprehensive income
for the period in that financial statement.
This Statement requires that an enterprise (a)
classify items of other comprehensive income by their nature in a
financial statement and (b) display the accumulated balance of other
comprehensive income separately from retained earnings and additional
paid-in capital in the equity section of a statement of financial
position.
This Statement is effective for fiscal years beginning
after December 15, 1997. Reclassification of financial statements for
earlier periods provided for comparative purposes is required.
FASB Statement No. 133 and Amendments in FAS 137, 138, 149, and 155
Accounting for Derivative Instruments and Hedging Activities
(Issue Date 6/98)
[Full Text]
[Summary]
[Status]
This Statement establishes accounting and reporting
standards for derivative instruments, including certain derivative
instruments embedded in other contracts, (collectively referred to as
derivatives) and for hedging activities. It requires that an entity
recognize all derivatives as either assets or liabilities in the
statement of financial position and measure those instruments at fair
value. If certain conditions are met, a derivative may be specifically
designated as (a) a hedge of the exposure to changes in the fair value
of a recognized asset or liability or an unrecognized firm commitment,
(b) a hedge of the exposure to variable cash flows of a forecasted
transaction, or (c) a hedge of the foreign currency exposure of a net
investment in a foreign operation, an unrecognized firm commitment, an
available-for-sale security, or a foreign-currency-denominated
forecasted transaction. The accounting for changes in the fair value of
a derivative (that is, gains and losses) depends on the intended use of
the derivative and the resulting designation.
For a derivative designated as hedging the exposure to
changes in the fair value of a recognized asset or liability or a firm
commitment (referred to as a fair value hedge), the gain or loss is
recognized in earnings in the period of change together with the
offsetting loss or gain on the hedged item attributable to the risk
being hedged. The effect of that accounting is to reflect in earnings
the extent to which the hedge is not effective in achieving offsetting
changes in fair value. For a derivative designated as hedging the
exposure to variable cash flows of a forecasted transaction (referred to
as a cash flow hedge), the effective portion of the derivative's gain or
loss is initially reported as a component of other comprehensive income
(outside earnings) and subsequently reclassified into earnings when the
forecasted transaction affects earnings. The ineffective portion of the
gain or loss is reported in earnings immediately. For a derivative
designated as hedging the foreign currency exposure of a net investment
in a foreign operation, the gain or loss is reported in other
comprehensive income (outside earnings) as part of the cumulative
translation adjustment. The accounting for a fair value hedge described
above applies to a derivative designated as a hedge of the foreign
currency exposure of an unrecognized firm commitment or an
available-for-sale security. Similarly, the accounting for a cash flow
hedge described above applies to a derivative designated as a hedge of
the foreign currency exposure of a foreign-currency-denominated
forecasted transaction. For a derivative not designated as a hedging
instrument, the gain or loss is recognized in earnings in the period of
change. Under this Statement, an entity that elects to apply hedge
accounting is required to establish at the inception of the hedge the
method it will use for assessing the effectiveness of the hedging
derivative and the measurement approach for determining the ineffective
aspect of the hedge. Those methods must be consistent with the entity's
approach to managing risk.
This Statement applies to all entities. A
not-for-profit organization should recognize the change in fair value of
all derivatives as a change in net assets in the period of change. In a
fair value hedge, the changes in the fair value of the hedged item
attributable to the risk being hedged also are recognized. However,
because of the format of their statement of financial performance,
not-for-profit organizations are not permitted special hedge accounting
for derivatives used to hedge forecasted transactions. This Statement
does not address how a not-for-profit organization should determine the
components of an operating measure if one is presented.
This Statement precludes designating a nonderivative
financial instrument as a hedge of an asset, liability, unrecognized
firm commitment, or forecasted transaction except that a nonderivative
instrument denominated in a foreign currency may be designated as a
hedge of the foreign currency exposure of an unrecognized firm
commitment denominated in a foreign currency or a net investment in a
foreign operation.
This Statement amends FASB Statement No. 52, Foreign
Currency Translation, to permit special accounting for a hedge of a
foreign currency forecasted transaction with a derivative. It supersedes
FASB Statements No. 80, Accounting for Futures Contracts, No. 105,
Disclosure of Information about Financial Instruments with
Off-Balance-Sheet Risk and Financial Instruments with Concentrations of
Credit Risk, and No. 119, Disclosure about Derivative Financial
Instruments and Fair Value of Financial Instruments. It amends FASB
Statement No. 107, Disclosures about Fair Value of Financial
Instruments, to include in Statement 107 the disclosure provisions about
concentrations of credit risk from Statement 105. This Statement also
nullifies or modifies the consensuses reached in a number of issues
addressed by the Emerging Issues Task Force.
This Statement is effective for all fiscal quarters of
fiscal years beginning after June 15, 1999. Initial application of this
Statement should be as of the beginning of an entity's fiscal quarter;
on that date, hedging relationships must be designated anew and
documented pursuant to the provisions of this Statement. Earlier
application of all of the provisions of this Statement is encouraged,
but it is permitted only as of the beginning of any fiscal quarter that
begins after issuance of this Statement. This Statement should not be
applied retroactively to financial statements of prior periods.
FASB Statement No. 142
Goodwill and Other Intangible Assets
(Issue Date 6/01)
[Full Text]
[Summary]
[Status]
This Statement
changes the subsequent accounting for goodwill and other
intangible assets in the following significant respects:
- Acquiring
entities usually integrate acquired entities into
their operations, and thus the acquirers'
expectations of benefits from the resulting
synergies usually are reflected in the premium that
they pay to acquire those entities. However, the
transaction-based approach to accounting for
goodwill under Opinion 17 treated the acquired
entity as if it remained a stand-alone entity rather
than being integrated with the acquiring entity; as
a result, the portion of the premium related to
expected synergies (goodwill) was not accounted for
appropriately. This Statement adopts a more
aggregate view of goodwill and bases the accounting
for goodwill on the units of the combined entity
into which an acquired entity is integrated (those
units are referred to as reporting units).
- Opinion 17
presumed that goodwill and all other intangible
assets were wasting assets (that is, finite lived),
and thus the amounts assigned to them should be
amortized in determining net income; Opinion 17 also
mandated an arbitrary ceiling of 40 years for that
amortization. This Statement does not presume that
those assets are wasting assets. Instead, goodwill
and intangible assets that have indefinite useful
lives will not be amortized but rather will be
tested at least annually for impairment. Intangible
assets that have finite useful lives will continue
to be amortized over their useful lives, but without
the constraint of an arbitrary ceiling.
- Previous
standards provided little guidance about how to
determine and measure goodwill impairment; as a
result, the accounting for goodwill impairments was
not consistent and not comparable and yielded
information of questionable usefulness. This
Statement provides specific guidance for testing
goodwill for impairment. Goodwill will be tested for
impairment at least annually using a two-step
process that begins with an estimation of the fair
value of a reporting unit. The first step is a
screen for potential impairment, and the second step
measures the amount of impairment, if any. However,
if certain criteria are met, the requirement to test
goodwill for impairment annually can be satisfied
without a remeasurement of the fair value of a
reporting unit.
- In
addition, this Statement provides specific guidance
on testing intangible assets that will not be
amortized for impairment and thus removes those
intangible assets from the scope of other impairment
guidance. Intangible assets that are not amortized
will be tested for impairment at least annually by
comparing the fair values of those assets with their
recorded amounts.
- This
Statement requires disclosure of information about
goodwill and other intangible assets in the years
subsequent to their acquisition that was not
previously required. Required disclosures include
information about the changes in the carrying amount
of goodwill from period to period (in the aggregate
and by reportable segment), the carrying amount of
intangible assets by major intangible asset class
for those assets subject to amortization and for
those not subject to amortization, and the estimated
intangible asset amortization expense for the next
five years.
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FASB Statement No. 155
Accounting for Certain Hybrid Financial Instruments—an amendment of FASB
Statements No. 133 and 140
(Issue Date 02/06)
[Full Text]
[Summary]
[Status]
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.
FASB Statement No. 157
Fair Value Measurements
(Issue Date 09/06)
[Full Text]
[Summary]
[Status]
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.
FASB Statement No. 159
The Fair Value Option for Financial Assets and Financial
Liabilities—Including an amendment of FASB Statement No. 115
(Issue Date 02/07)
[Full Text]
[Summary]
[Status]
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Why Is the FASB Issuing This Statement?
This Statement permits entities to choose to measure many
financial instruments and certain other items at fair value. The objective
is to improve financial reporting by providing entities with the opportunity
to mitigate volatility in reported earnings caused by measuring related
assets and liabilities differently without having to apply complex hedge
accounting provisions. This Statement is expected to expand the use of fair
value measurement, which is consistent with the Board’s long-term
measurement objectives for accounting for financial instruments.
What Is the Scope of This Statement—Which Entities Does
It Apply to and What Does It Affect?
This Statement applies to all entities, including
not-for-profit organizations. Most of the provisions of this Statement apply
only to entities that elect the fair value option. However, the amendment to
FASB Statement No. 115, Accounting for Certain Investments in Debt and
Equity Securities, applies to all entities with available-for-sale and
trading securities. Some requirements apply differently to entities that do
not report net income.
The following are eligible items for the measurement
option established by this Statement:
Recognized financial assets and financial liabilities
except:
An investment in a subsidiary that the entity is required
to consolidate
An interest in a variable interest entity that the entity
is required to consolidate
Employers’ and plans’ obligations (or assets representing
net overfunded positions) for pension benefits, other postretirement
benefits (including health care and life insurance benefits), postemployment
benefits, employee stock option and stock purchase plans, and other forms of
deferred compensation arrangements, as defined in FASB Statements No. 35,
Accounting and Reporting by Defined Benefit Pension Plans, No. 87,
Employers’ Accounting for Pensions, No. 106, Employers’ Accounting for
Postretirement Benefits Other Than Pensions, No. 112, Employers’ Accounting
for Postemployment Benefits, No. 123 (revised December 2004), Share-Based
Payment, No. 43, Accounting for Compensated Absences, No. 146, Accounting
for Costs Associated with Exit or Disposal Activities, and No. 158,
Employers’ Accounting for Defined Benefit Pension and Other Postretirement
Plans, and APB Opinion No. 12, Omnibus Opinion—1967
Financial assets and financial liabilities recognized
under leases as defined in FASB Statement No. 13, Accounting for Leases
(This exception does not apply to a guarantee of a third-party lease
obligation or a contingent obligation arising from a cancelled lease.)
Deposit liabilities, withdrawable on demand, of banks,
savings and loan associations, credit unions, and other similar depository
institutions
Financial instruments that are, in whole or in part,
classified by the issuer as a component of shareholder’s equity (including
“temporary equity”). An example is a convertible debt security with a
noncontingent beneficial conversion feature.
Firm commitments that would otherwise not be recognized at
inception and that involve only financial instruments
Nonfinancial insurance contracts and warranties that the
insurer can settle by paying a third party to provide those goods or
services
Host financial instruments resulting from separation of an
embedded nonfinancial derivative instrument from a nonfinancial hybrid
instrument.
How Will This Statement Change Current Accounting
Practices?
The fair value option established by this Statement
permits all entities to choose to measure eligible items at fair value at
specified election dates. A business entity shall report unrealized gains
and losses on items for which the fair value option has been elected in
earnings (or another performance indicator if the business entity does not
report earnings) at each subsequent reporting date. A not-for-profit
organization shall report unrealized gains and losses in its statement of
activities or similar statement.
The fair value option:
May be applied instrument by instrument, with a few
exceptions, such as investments otherwise accounted for by the equity method
Is irrevocable (unless a new election date occurs)
Is applied only to entire instruments and not to portions
of instruments.
How Does This Statement Contribute to International
Convergence?
The fair value option in this Statement is similar, but
not identical, to the fair value option in IAS 39, Financial Instruments:
Recognition and Measurement. The international fair value option is subject
to certain qualifying criteria not included in this standard, and it applies
to a slightly different set of instruments.
What Is the Effective Date of This Statement?
This Statement is effective as of the beginning of an
entity’s first fiscal year that begins after November 15, 2007. Early
adoption is permitted as of the beginning of a fiscal year that begins on or
before November 15, 2007, provided the entity also elects to apply the
provisions of FASB Statement No. 157, Fair Value Measurements.
No entity is permitted to apply this Statement
retrospectively to fiscal years preceding the effective date unless the
entity chooses early adoption. The choice to adopt early should be made
after issuance of this Statement but within 120 days of the beginning of the
fiscal year of adoption, provided the entity has not yet issued financial
statements, including required notes to those financial statements, for any
interim period of the fiscal year of adoption.
This Statement permits application to eligible items
existing at the effective date (or early adoption date).
Many other U.S. and International Standards directly or indirectly impact on
fair value accounting!
Introduction to Valuation
Bob Jensen's site on The Controversy Over Fair Value
(Mark-to-Market) Financial Reporting ---
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
Damodaran Online: A Great Sharing Site from a Finance Professor at New
York University and Textbook Writer ---
http://pages.stern.nyu.edu/%7Eadamodar/
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/
You can pick the valuation approach that you would like to go to, to
see illustrations, solutions and other supporting material.
|
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Discounted Cash flow Valuation |
| |
Relative
Valuation |
| |
Option
Pricing Approaches to Valuation |
| |
Acquisition Valuation |
| |
EVA,
CFROI and other Value Enhancement Strategies |
Or you can pick the material that you are interested in.
|
|
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|
|
| Spreadsheets |
Overheads |
Datasets |
References |
| Problems & Solutions
|
Derivations and Discussion
|
Valuation Examples |
PowerPoint presentations |
Jim Mahar's finance sharing site (especially note his great blog link)
---
http://financeprofessor.com/
Financial Rounds from an anonymous finance professor ---
http://financialrounds.blogspot.com/
Bob Jensen's threads on fair value controversies in accounting are at
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue
Bob Jensen's finance and investment helpers are at
http://www.trinity.edu/rjensen/Bookbob1.htm
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
"FASB to Issue Retooled Rule For Valuing Corporate Assets New Method
Repeals Limits Spurred by Enron Scandal; Critics Worry About Abuses," by
David Reilly, The Wall Street Journal, September 15, 2006; Page C3
---
http://online.wsj.com/article/SB115828639109763950.html?mod=djem_jiewr_ac
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.
October 31 reply from Paul Pacter (CN - Hong Kong)
[paupacter@deloitte.com.hk]
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
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
"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
"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
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.
Fair value accounting politics in the revised
IAS 39
From Paul Pacter's IAS Plus on July 13, 2005
---
http://www.iasplus.com/index.htm
Also see
http://www.trinity.edu/rjensen//theory/00overview/IASBFairValueFAQ.pdf
-
Why did the Commission
carve out the full fair
value option in the
original IAS 39
standard?
-
Do
prudential supervisors
support IAS 39 FVO as
published by the IASB?
-
When will the Commission
to adopt the amended
standard for the IAS 39
FVO?
-
Will companies be able
to apply the amended
standard for their 2005
financial statements?
-
Does the amended
standard for IAS 39 FVO
meet the EU endorsement
criteria?
-
What about the
relationship between the
fair valuation of own
liabilities under the
amended IAS 39 FVO
standard and under
Article 42(a) of the
Fourth Company Law
Directive?
-
Will the Commission now
propose amending Article
42(a) of the Fourth
Company Directive?
-
What about the remaining
IAS 39 carve-out
relating to certain
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On June 23, 2005, the Financial Accounting Standards Board
issued an Exposure Draft (ED) entitled "Fair Value Measurements." The original
ED can be downloaded free at
http://www.fasb.org/draft/ed_fair_value_measurements.pdf
"Response to the FASB's Exposure Draft on Fair Value Measurements," AAA
Financial Standards Committee, Accounting Horizons, September 2005, pp.
187-195 ---
http://aaahq.org/pubs/electpubs.htm
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