Fair ValueGAAP vs. IFRSPresented byAlfred M. King, CMA,CFMOctober 6, 2008

Convergence or Conversion of GAAP-IFRSWorld is going towards one set of accounting standards but is IFRS truly uniform?United States conceded that IFRS is more widely used, so U.S. will change but when?Securities and Exchange Commission:Currently allows foreign filers to use IFRSStarting in 2010-11 voluntary adoption of IFRS by U.S. CompaniesStarting in 2014-15 mandatory adoption of IFRS by all public companies private companies will follow!

Problems with Convergence Principles vs. Rules Is this distinction a myth?Business complexity = complex rulesWill IFRS have to adopt Rules over time?Funding and Membership in IASBWhat happens if our SEC disagrees with IFRS?TransitionTraining of preparers option for early adoption by large companiesTraining of auditors

Fair Value vs. Fair Market ValueThere are real differences among:Fair Market Value (not used for financial reporting)Fair Value GAAPFair Value IFRSDifference in concept of Fair Value between GAAP and IFRS has not been resolved

Exit Value GAAP Concept5. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.This concept works for financial instruments and does not work for tangible and intangible assets

Fair Value IFRS ConceptFair Value is the amount for which an asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged between knowledgeable, willing parties in an arms length transaction [IFRS 2, Appendix A]

Exit ValueGAAP concept of valuing something at what it could be sold for today, to a market participant works only if there is a market with market participantsU.S. and EU experience recently with sub-prime securities indicates that often there is no market, and no market participants willing to make a market

How to Value When There Are No ParticipantsFASB set up levels 1 through 3Level 1 quoted pricesLevel 2 no direct quotes but similar assetsLevel 3 all otherValuation specialists are always working in Level 3Level 3 allows for Income Approach and Cost Approach but these are considered entity specific values and are 2nd class!

Entity Specific ValuesHighest and Best Use is the premise of value in all cases, e.g. parking lot in downtown Manchester has to be valued for developmentHighest and Best Use will depend on who is going to use the asset and what they will do with it Could you develop the site?If not, you would offer less than would a developer who would buy the land based on his assessment of the real estate market

Fair Value - IFRSConsiders both buyer and sellerIASB would like to converge their definition with U.S. SFAS 157About half the IASB members, however, are uncomfortable with how the U.S. definition is working in practiceTheoretically, at least, IASB believes the U.S. concept may be correct but not how it is applied

New FV Definition from IASB? No decision until 2009May not converge with U.S. SFAS 157May stick to its definitionIf that happens, quite likely that U.S. will converge to the IASB (!)FASB is very aware of the problems they have created with Market Participants and Exit value

Defensive ValueCommon problem in Business CombinationSeller and Buyer each have competing brand namesBuyer wants to move Sellers product line to use the Buyer brand nameBuyer wont use the Sellers brandBuyer, however, would not sell Sellers brand name to anyone else

What Is The Value of a Brand Name That Will Not Be Used?A Financial Buyer would use the Sellers brand nameUnder U.S. definition of Fair Value whoever the buyer is we value the brand name on what someone else would pay for it, or a value in use to themNow if the Strategic Buyer will not use it we still have to place a high value on it

Day 2 ProblemSo for the Strategic Buyer we have to value the brand name as though someone would use it, even if it is never going to be used.It is obvious that the real Fair Value, once there is no more advertising and marketing, is going to go down rapidlyThe buyer will have an early impairment!

Solution to the Day 2 ProblemHave to change the definition of Fair Value to get away from rigid application of Exit conceptIASB looks as though their ultimate definition of Fair Value will likely be such that this problem may not be thereValue in Use still makes a lot of sense and may provide better information to usersIASB may permit, or even require in some cases, Value in Use

Fair Value and Impairment: Key Differences FASB vs. GAAPReal Estate Investment property Agricultural/biological

IFRS permits/requires periodic revaluation up or down U.S. GAAP absolutely prohibits write up In U.S. this is a one-way street. Can take impairment loss but never an impairment gain or even write back up to previous amount

IFRS Permits RevaluationsA literal reading of IFRS suggests that if they want to, companies can revalue other assets for example intangiblesBrand NamesPatentsWill U.S. companies take advantage of this?Look at Fair Value Option (SFAS 159)

Fair Value OptionCompanies are permitted to revalue LIABILITIES if they wishBanks and financial institutions have had to write down investments because of credit problems in the economySFAS 159 permits them to designate liabilities for same Fair Value treatmentSo if a companys credit rating drops, they can record a GAIN which may offset the Fair Value loss on the investments Bear Stearns example

Fair Value Option (2)U. S. Investment Banks did take advantage of this rule, and literally wrote down the value of their own bondsIf those debts will be ultimately repaid at Par (100 %) companies will have to reflect a LOSS to write up the liabilityThis accounting is hard to explain!!The worse you do the better you lookThe better you do the worse you look

My ConclusionIf U.S. companies adopt IFRS they will be at least tempted to write up all sorts of intangible assets to reflect their true Fair Value What will this do for valuation specialists? Lots more work! What will this do for the integrity of financial statements?

Asset Impairment Impairment indicators are essentially the same between GAAP and IFRSIFRS writes down to Fair Value when FV is less than carrying valueNo intermediate cash flow testIFRS looks to the higher of:Net selling price (exit value)Value in Use (entity specific)

Asset Impairment (2)United States has three different methodsSFAS 144 for fixed assets and intangiblesSFAS 142 for indefinite life intangiblesSFAS 142 for testing goodwillSFAS 144 calls for a determination as to whether the SUM of all future cash flows, NOT DISCOUNTED is equal to or larger than carrying valueCan never write back up once loss recognized

Research & DevelopmentResearch expensed in both systemsDevelopment is capitalized in IFRS and expensed in GAAPUnder SFAS 141R, purchased In-Process R&D will be capitalized, but further expenditures will be expensedBasic question:Is the true Fair Value of R&D properly measured based on costs incurred?

Valuing Liabilities and ContingenciesRules calling for what you could pay someone to take on your liabilities makes no senseShould allow companies to determine the Present Value or Expected Value of what they anticipate paying to settle liabilities and contingenciesGAAP values contingencies only in a Business Combination

Can We Value Contingencies?Contingent payment in a Business Combination Settle Environmental Liabilities Fair Value of lawsuits New SFAS 141R requires this

Revenue RecognitionGAAP has over 200 items in the literatureIFRS is very generalRevenue Recognition is a big item at least in the U.S.FASB looks to Fair Value as one way of measuring Revenue Recognition.Suzies sweater example

Is There Such a Thing as The Fair Value?The value of an asset depends on who is going to use it, and for what purposeHow can anyone write a set of rules that provides consistency among preparers and yet reflects economic reality?FASB and IASB would like a one size fits all solution in terms of defining Fair ValueThis can not be done!

Where Are We Going?Personal views:Recent problems in valuing subprime assets will slow down move to increased Fair ValueConvergence of IFRS and GAAP will be much harder (and slower) than anticipatedLIFO problemDifferent versions of IFRSDemand for Fair Value by Security Analysts will continue and even increase

The Future of the Valuation Business

Questions? Presentation by:Alfred M. King, CMA, CFMVice Chairman, Marshall & Stevens, Inc.Please feel free to contact me for information at any time:E-Mail: aking@marshall-stevens.com