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The Evolution of Fair Value Accounting

The SEC has not stated how or whether it will choose to implement IFRS, but the
process by which FASB and IASB have worked together to issue common
guidance on fair value measurement illustrates how change may be effected.

Elizabeth A. Evans and Hong Qiao
MBA, CPA, CFA, is a manager in the Los Angeles office of Analysis Group.

This article was originally published in Valuation Strategies;10:14 (July/August 2011)

2011 Thomson Reuters/RIA. All rights reserved.

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In May 2011, the Financial Accounting Standards Board (FASB) and the International
Accounting Standards Board (IASB) amended their rules so that the term fair value would
have the same meaning under U.S. generally accepted accounting principles (GAAP) and
international financial reporting standards (IFRS).1 FASB and IASB also used the opportunity to
clarify the meaning of fair value and to require additional disclosure. Two weeks later, the
Securities and Exchange Commission (SEC), the ultimate decision-maker regarding financial
accounting standards for public companies in the United States, issued a paper describing a
possible future role for FASB in light of the SEC's previously stated belief that one set of highquality accounting standards for all companies was desirable 2
FASB and IASB both assert that their most recent guidance on fair value accounting does not
affect the scope of fair value accountingthat is, they claim that they did not expand the use of
fair value accounting to new assets or liabilities. Rather, they state that they simply were more
clearly defining fair value to ensure a comprehensive disclosure process and to standardize
language so that GAAP and IFRS would be consistent. The SEC, in its most recent guidance,
does not indicate how, or whether, it will choose to implement IFRS.
How will these new and proposed rules affect valuations based on the financial statements of
publicly held companies? And what do these changes reveal about the manner in which
standards may change in the future? In this article, the authors will provide an overview of the
current state of fair value accounting; highlight the recent changes; consider the implications for
publicly held companies; and consider how standards may be set in the future, based on how
the recent guidance on fair value has unfolded.
An Overview of Fair Value Accounting
FASB Accounting Standards Codification Topic 820 (ASC 820), Fair Value Measurements and
Disclosures, defines fair value as 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. A firm should base this price on the amount at which market participants would transact,
and not on the price at which the firm would transact. Because the fair value standard focuses
on the sale of an asset or the transfer of a liability, a firm should use an exit price, unadjusted for

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transaction costs, and not an entry or acquisition price. Further, because the transaction should
occur in an orderly market, it may not be a forced transaction (or a distress sale) nor may it
occur in an illiquid market.
Whether the reporting firm measures the asset or liability as a stand-alone item, or as a group,
depends on the unit of account specified in the codification topic for that asset or liability. (For
more information about the levels and methods of fair value accounting, and the associated
disclosure requirements, see the accompanying sidebar What Is Fair Value Accounting?)
Similarly, whether a firm must use fair value accounting at all depends on the codification topic
for a particular type of asset or liability. The topic may base the requirement for fair value
accounting on several factors, including the form of an asset or liability and the firm's intended
use of it. For example, a firm holding a publicly traded debt security generally reports the value
of that security using fair value accounting, while the firm records a loan using its amortized
cost. A firm will use amortized cost to report the value of even a publicly traded debt security if
the firm intends to hold that security to maturity.
Other categories of assets and liabilities that require fair value accounting include interests in
variable interest entities, accounts receivable, goodwill, and accounts payable. Some assets
and liabilities that do not use fair value include inventories, leases, and pension assets and
The question of when a firm must use fair value accounting and make the subsequent required
disclosures remains an area of debate. Users of the information contained in financial
statements want to be assured that management is making reliable assessments, and they
want firms to use the most relevant data. For its part, management may believe that it is being
held to too high a standard for information that can change rapidly and that users can interpret
incorrectly, especially in cases where the value of assets or liabilities varies greatly.
In addition, users of financial statement information remain disconcerted by the fact that firms
can report increased income even when their credit worthiness slips because of a drop in the
fair value of the firm's liabilities. For example, in 2008 Citigroup reported a net loss of $27.7


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billion but also a $4.6 billion gain related to changes in the fair value of debt liabilities caused by
changes in its own credit risk.
Recent Changes in Common Guidance
With the May 2011 common guidance related to fair value accounting, FASB and IASB are
recommending the following:

When measuring an asset, a liability, or an instrument classified within shareholders'

equity, a firm should focus on the principal market (or most liquid market) for the item, not
on the reporting firm's transactions related to that item in a particular market.

When an observable market price for the transfer of a liability does not exist, the fair value
of the liability should equal the fair value of an asset whose features mirror the liability
(assuming an exit value in the same market and an efficient market).

A firm should measure the fair value of instruments classified in shareholders' equity (for
example, any equity interests issued as consideration in a merger) in the same way that it
would measure the fair value of liabilities.

When a firm holds a group of financial assets and liabilities and manages its financial
assets and liabilities on the basis of the net exposure to market risks or to a particular
credit risk, it should measure a net long position as an asset and a net short position as a

A firm should incorporate a premium or discount into its fair value measurements only if it
does not have Level 1 data (quoted prices), and if market participants would take
premiums or discounts into account in the transaction for the asset or liabilityfor example,
a control premium or a noncontrolling interest discount. A firm should not include a
blockage factor, which relates to an insufficient market volume for the sale or transfer of the
entire position.

A firm using a present-value analysis may adjust for risk by changing the expected cash
flows or the discount rate but not both. In either method, the firm adjusts for systematic
(nondiversifiable) risk based on portfolio theory.


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For Level 2 (observable) and Level 3 (unobservable) measurements of recurring and

nonrecurring assets or liabilities, the firm must describe the valuation technique and data it
used. For Level 3 measurements, ASC 820 now explicitly requires quantitative, not
qualitative, information in a tabular format about significant unobservable data.

A firm must disclose how it selects the valuation policies used for Level 3 measurements
and how it analyzes changes in those fair value measurements from period to period.

The firm must provide a narrative that describes, by class of asset or liability, the sensitivity
of recurring fair value measurements using Level 3 data to changes in the inputs, if a
change in the inputs would result in significantly different measurements. The firm must
also describe any interrelationships among Level 3 data.

The firm must report any transfers of assets or liabilities into or out of Levels 1 and 2.

For financial instruments not measured at fair value in the financial statements, the firm
must disclose their fair value. Hence, for loans reported at amortized cost, the firm must
also disclose their fair value in the financial statement's notes. For all assets and liabilities
not measured at fair value, the firm must disclose which level of inputs it would have used
to measure fair value.

This common fair value guidance is effective after 12/15/2011 for all firms, but some of the new
disclosure requirements do not apply to U.S. private firms.
Effects on Valuations
One result of the new guidance from FASB and IASB is that analysts preparing business
valuations will know more about firms and their risk profiles. They will also know more about the
subjectivity of firms' fair value measurements. If, for example, a firm has venture-capital
investments that it values using discounted cash flows, market comparables, and Level 3
(unobservable) data, the firm may need to disclose:

The weighted average cost of capital.

Long-term revenue growth.

Long-term pretax operating margin.


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Discounts for lack of marketability.

Control premiums.

EBITDA3 multiples.

Revenue multiples.

A firm holding residential mortgage-backed securities that it values using discounted cash flows
may need to disclose the constant prepayment rate, probability of default, and loss severity. The
firm will also need to disclose other information that will help users of its financial statements
understand the quantitative information. That might include:

Whether the underlying loans were prime or subprime.

The collateral involved.

Any guarantees or credit enhancements.

The seniority level of the tranche of securities.

The weighted-average coupon rate.

The weighted-average maturity.

The geographical concentration of the underlying loans.

Credit ratings.

Finally, the firm may need to disclose the sensitivity of its fair value measurements to changes
in prepayment rates, probability of default, and loss severity in the event of default, and to
describe any interrelationships among those factors.
Valuation preparers may not be able to replicate the firm's Level 3 measurements, but they will
be able to compare their own assumptions and data (e.g., weighted average cost of capital and
probability of default) with those used by the firm. Additionally, they will have more information
about the firm's valuation processes (e.g., the frequency with which it calibrates and tests its
models) and any changes in management's views on valuing various assets or liabilities. They
will also be better able to compare the data of one firm with that of another firm owning the
same assets or liabilities.


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The Convergence of GAAP and IFRS

Despite FASB and IASB's new common guidance around fair value accounting and disclosure,
there are still major hurdles to overcome before the SEC can realize its stated goal of creating a
single, high-quality set of global accounting standards. The common guidance for fair value lists
differences in measuring the fair value of investments in investment companies and deposit
liabilities, as well as differences related to disclosures for derivatives categorized as Level 3
For several years, the SEC has indicated that IFRS might be the basis for universal accounting
standards. Further, it has stated that it will decide before the end of 2011 whether to incorporate
IFRS into the U.S. financial reporting system. (In 2010 the Office of the Chief Accountant of the
SEC issued a work plan on how the current U.S. financial reporting system might change to a
system based on IFRS.)4
At the same time, the SEC's role is to protect U.S. investors, maintain the capital markets, and
facilitate capital formation under the federal securities laws; thus, it must decide how (or
whether) adoption of IFRS would be in the best interests of investors, markets, and
corporations. To that end, the SEC has been exploring several possible approaches to
incorporating IFRS in the reporting standards for issuers of U.S. securities, including the

The SEC could require full adoption of IFRS, as issued by IASB, on a specified date.

The SEC could require full adoption of IFRS, as issued by IASB, following a several-year
transition period. For example, in the SEC's 2008 report, Roadmap for the Potential Use of
Financial Statements Prepared in Accordance with International Financial Reporting
Standards by U.S. Issuers, it proposed that large accelerated filers begin IFRS filings for
fiscal years ending on or after 12/15/2014, accelerated filers begin IFRS filings for years
ending on or after 12/15/2015, and non-accelerated filers, including smaller reporting
companies, begin IFRS filing for years ending on or after 12/15/2016.

The SEC could allow (but not require) U.S. issuers to prepare financial statements in
accordance with IFRS. Because not all U.S. issuers will prepare their financial statements


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in accordance with IFRS, however, financial statements based on IFRS and those based
on GAAP would coexist.

The SEC could retain GAAP but have FASB make efforts to converge GAAP with IFRS
over time. The People's Republic of China uses this convergence approachit has moved
its standards closer to IFRS but has not incorporated IFRS completely.

The SEC could require that FASB, after some study, incorporate IFRS into GAAP,
assuming, however, that FASB found that IFRS met the stated criteria, designed to protect
investors and other stakeholders. The European Union and Australia use this endorsement
approach. There is always the risk, however, that a local endorsing body might change an
IFRS, which could create a non-uniform set of global standards that may or may not be
high-quality and could prompt lags in adoption.

After a transition period in which FASB could eliminate differences between existing IFRS
and GAAP, FASB could incorporate newly issued or amended IFRS into GAAP, pursuant
to an established endorsement protocolwhat the SEC staff refer to as the condorsement
approach. This approach is different from convergence because there would be an end
date associated with the transition. It differs from endorsement because FASB would no
longer have the principal responsibility for developing or modifying accounting standards
under GAAP. Instead, FASB would participate in the process for developing IFRS. In the
end, however, the SEC would retain its ability to set accounting standards for U.S. publicly
traded firms.

The SEC has not bound itself to the condorsement approach, or to even adopting IFRS, but the
process by which FASB and IASB have worked together to issue common guidance on fair
value measurement illustrates how convergence might work during the transition period under
the condorsement approach. FASB and IASB will first work on items as to which common
ground exists under a memorandum of understanding, and FASB will issue amendments to
U.S. GAAP. But both FASB and IASB will need much more work and time before a single set of
accounting standards can and will exist.


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ASC 820 permits firms and accountants to use three methods of measurement to determine fair
(1) The market approach. A firm may use prices and other information from market
transactions involving comparable assets or liabilities, including fair values derived from
market multiples or from matrix pricing.
(2) The income approach. A firm may employ discounted cash flows or earnings
modelsfor instance, the Black-Scholes-Merton or multi-period excess earnings
(3) The cost approach. A firm may quantify the current replacement costthat is, the
cost that a market participant would bear to obtain a substitute asset of comparable
utility, adjusted for obsolescence.
ASC 820 arranges the data (or inputs) used in these three approaches to measure fair value on
three levels:

Level 1 inputs are quoted prices from active markets for identical assets or liabilities. For
example, a firm using the market approach might use the price from the New York Stock
Exchange for a share of common stock in IBM as a Level 1 input for valuing its common
share holdings of IBM stock. Because a quoted price in an active market provides the most
reliable measure of fair value, a firm should use that quoted price whenever it is available.

Level 2 inputs include data other than those Level 1 inputs that the firm can observe
directly or indirectly. For example, a firm uses Level 2 inputs in its valuation model if it uses
quoted prices for similar (not identical) assets or liabilities, or if it uses quoted prices for
identical assets or liabilities in an inactive market.

Level 3 inputs include any data that third parties cannot observe; for instance, a firm makes
certain assumptions about data (that others may not) that it then plugs into its valuation
model. A firm should use unobservable data only if observable data do not exist, and it
should base its assumptions on what a market participant would use to measure an exit

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ASC 820 also requires that users of financial statements be able to assess the data used for fair
value measurements. So a firm must report in tabular form:

The fair value measurements for each major category of assets or liabilities.

The fair value measurements categorized by the type of inputs the firm used in its valuation
(Level 1, Level 2, or Level 3).

For fair value measurements using Level 3 inputs (unobservable data), the firm must
disclose how the fair values changed from the beginning to the end of the reporting period,
(1) Total gains or losses, separating gains or losses included in earning or changes in
net assets and describing where it reported those gains or losses in the income
(2) Cash flows in and out (purchases, sales, issuances, and settlements).
(3) The amounts the firm transferred into and out of Level 3.
(4) The amounts related to unrealized gains and losses and a description of where the
firm reported those amounts in the income statement.
(5) For each year, the firm must report the valuation method (market, income, or cost) it

2011 Thomson Reuters/RIA. All rights reserved.

News Release, FASB, 5/12/2011; Accounting Standards Update No. 2011-04 Fair Value
Measurement (Topic 820), Amendments to Achieve Common Fair Value Measurement and
Disclosure Requirements in U.S. GAAP and IFRS, FASB (May 2011); IFRS 13 Fair Value
Measurement (May 2011).
SEC Staff Paper, "Exploring a Possible Method of Incorporation," 5/26/2011.
Earnings before interest, taxes, depreciation, and amortization.
SEC Release, Commission Statement in Support of Convergence and Global Accounting
Standards, 2/24/2010; SEC, Office of the Chief Accountant, Work Plan for the Consideration of
Incorporating International Financial Reporting Standards into the Financial Reporting System
for U.S. Issues, 2/24/2010.


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See note 2,supra; SEC, Office of the Chief Accountant, Division of Corporation Finance,
Progress Report on the Work Plan for the Consideration of Incorporating International Financial
Reporting Standards into the Financial Reporting System for U.S. Issues, 10/29/2010.