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FASB’s MOVE TOWARDS FAIR VALUE AND

ACADEMIC RESEARCH

Derivatives

Contingencies

Financial instruments Stock Options – 123R

Guarantees – Int. 45

Fair value hierarchy –

FAS 157

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Today’s Discussion on Fair Value

• The new fair value standard – FAS 157

• The fair value option proposal

• Business combination procedures – more and more fair value

• FAS 5 on contingencies – are its days numbered?

HOW CAN ACADEMIC RESEARCH HELP?

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Fair Value

FAS 157, Paragraph 5

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.

IOU $100 million

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FAIR VALUE-how not when!

FASB STATEMENT 157

Codify all the accounting literature on fair value

Developed a common definition, increased disclosures

Establish a 3 category hierarchy for measuring fair value – market quotes are always the best! A “market participant” view!

Effective year ends – beginning after 11/15/07

What will the impact be and what warrants further research????

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FAS 157 - New terms to learn!

Market – principal or most advantageous market

Fair value hierarchy (3 levels – use the highest)

Observable inputs -Wall Street Journal

- Derived from markets

Unobservable inputs – discounted cash flows

Types of valuations (market, income, cost approaches)

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MARKET PLACE PARTICIPANTS

• Buy software & customer list - $10 million: Company plans Market participant - Have customers use -Would sell software

buyer’s software and use customer list - Scrap seller’s software

(Buyer’s allocation) FV (FASB allocation) FV Customer list $ 10 Customer list $ 2 Software 0 Software 8

Day two accounting?

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The Fair Value Option Proposal

• Applicable to almost all financial instruments

• If elect to use fair value – changes thru income!

• Elect at inception – irrevocable and document it

• Choose contract by contract

• Debt - consider credit rating in calculation

• Prospective, cum catch up through retained earnings at the same time FAS 157 is adopted.

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Discussion Points

• Why is the FASB adopting a fair value option?

• More alternatives vs. eliminating alternatives

• Credit rating goes down – big gain??? (hmm)

• How will companies react?

• How will users react?

• Research ideas?

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BUSINESS COMBINATIONS- the procedures proposal!

Many proposed “fixes” to how we do purchase accounting

When there is a choice – the winner is use FAIR VALUE!

PROPOSALS ARE VERY CONTROVERSIAL!Could research help?

Historical cost

Fair value

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Contingent LiabilitiesCompany A buys Co. B for $50,000,000

Company B is being sued for $10,000,000

Chance of B losing - 40% (i.e., losing is not probable)

How much should A record as part of purchase

price allocation as a liability for lawsuit??

Zero? $4,000,000? More? (Answer fair value!)

What if B eventually wins the lawsuit?

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Contingent Consideration

Company C buys Company D from Mr. Jones for cash of $10 million.

Further, if earnings of D in next two years exceed $4 million, Company C must pay another $2 million to Mr. Jones

How should Company C account for this contingency at the date of acquisition? Can an amount be objectively estimated?

(Answer-fair value!)

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In-Process R&D

FAS 141 -Continue to require immediate write-off

New Thinking: - Capitalize at fair value - Subsequent R&D – expense - Amortize – eventually

But what about FAS 2?

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ACQUIRE LESS THAN 100%

Fair Value of Company X - $100 million

Fair value of identifiable net assets - $30 million

If buy 100% of X – goodwill is $70 million ($100-30)

Assume company only buys 60% for $60 million:

TEST – How much is goodwill?

$42 million ($70 x 60%)? WRONG!

“Correct” answer - $70 million

A FAIR VALUE MODEL!

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WHAT ABOUT FASB No. 5 - CONTINGENCIES

Remote Reasonably Possible

Probable

Accrue – Probable & Estimable

Disclose – Reasonable PossibleDo Nothing – Remote

IS THIS STILL OK??

(e.g., $100 Million lawsuit)

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FAIR VALUE VS. FAS 5

FASB’s Invitation to Comment --Assets & Liabilities With Uncertainties

The role of probability and uncertainty and the conceptual framework – big potential impact!

The FASB is considering whether the FAS 5 model for contingencies (i.e., recognize when “probable”) is becoming obsolete!

Research???

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Recognition vs. Measurement

Company A is being sued for $100 million—Record anything?

More likely than not ______20%__________ 51%________80%_______

Remote Reasonably possible Probable

Today we ask when should liability be “recognized” (probable threshold)

IASB thinking – there is a liability! – Measure at fair value using expected cash flows (e.g., a 10% chance of losing – book $10 million!). Skip recognition threshold!

What about plaintiff – book an asset? (why not!)

Should we converge with IASB on uncertainties?

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IS FAIR VALUE THE WAY TO GO?

More useful to users? Costly for preparers? Auditable? Increase or decrease complexity? Will fair value be used for everything some day ?

ACADEMIC RESEARCH– COULD IT HELP STANDARD SETTERS AS THEY KEEP MOVING TOWARDS FAIR VALUE?