FAIR VALUE MEASUREMENT IN THE CORPORATE WORLD: How … · Fair value is based on an exit price, not an entry price, i.e., the price to sell an asset versus the price to buy it. 2.

FAIR VALUE MEASUREMENT IN THE CORPORATE WORLD: How is “Fair Value” Fair?Ralph Nach

ABOUT THE AUTHOR

Ralph Nach is the founder and CEO of SkillSmart LLC, a technical advisory and training firm. Mr. Nach also currently serves as a Senior Course Facilitator and Instructional Designer for 20-20 Services LLC., and as a consulting expert and technical advisor on litigation and financial forensics matters.

Mr. Nach has served the accounting profession for over 35 years in a variety of capacities including auditor, quality control director, and external peer reviewer. He also served as a national office quality control partner for the fifth largest international accounting firm. Mr. Nach is also dedicated to the learning and development profession and served as the U.S. Chief Learning Officer for American Express Tax and Business Services, Inc.

He is a sought-after conference speaker and course facilitator on technical topics including the application of U.S. and international accounting, auditing, financial reporting and quality control standards; forensic accounting; and nontechnical topics related to leadership and interpersonal development.

He has co-authored several books including the popular Wiley GAAP: Interpretation and Application of Generally Accepted Accounting Principles and has served as an adjunct lecturer in accounting and finance at Northwestern University in Evanston, Illinois.

Mr. Nach is a member of the American Institute of Certified Public Accountants and the Illinois CPA Society and an associate member of the Association of Certified Fraud Examiners.

Ralph Nach., CPASkillSmart LLCGlenview, Illinois [email protected]

About the Institute of Singapore Chartered Accountants

The Institute of Singapore Chartered Accountants (ISCA) is the national accountancy body of Singapore. ISCA’s vision is to be a globally recognised professional accountancy body, bringing value to our members, the profession and wider community.

Established in 1963, ISCA shapes the regional accountancy landscape through advocating the interests of the profession. Possessing a Global Mindset, with Asian Insights, ISCA leverages its regional expertise, knowledge, and networks with diverse stakeholders to contribute towards Singapore’s transformation into a global accountancy hub. Our stakeholders include government and industry bodies, employers, educators, and the public.

ISCA is the Administrator of the Singapore Qualification Programme (Singapore QP) and the Designated Entity to confer the Chartered Accountant of Singapore - CA (Singapore) - designation.

It aims to raise the international profile of the Singapore QP, a post-university professional accountancy qualification programme and promote it as the educational pathway of choice for professional accountants seeking to achieve the CA (Singapore) designation, a prestigious title that is expected to attain global recognition and portability.

There are about 28,000 ISCA members making their stride in businesses across industries in Singapore and around the world.

For more information, please visit www.isca.org.sg.

INTRODUCTION 4

BACKGROUND 4

DEFINITION OF FAIR VALUE 5

COMPARABILITY ISSUES 6

AUDITABILITY, OBJECTIVITY AND RELIABILITY CONSIDERATIONS 9

ISSUES ARISING DURING THE “GREAT RECESSION” 13

RECENT DEVELOPMENTS 17

CONCLUSIONS AND RECOMMENDATIONS 18

ADDENDUM: FRS 113 PROVISIONS, DEFINITIONS AND EXAMPLES 18

CONTENTS

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FAIR VALUE MEASUREMENT IN THE CORPORATE WORLD: How is “Fair Value” Fair?

I. INTRODUCTION

A. Few issues in accounting are as controversial as fair value.

1. In the U.S. we learned this lesson dearly during the “Great Recession” as we were struck by the perfect storm at the intersection of accounting complexity and economic stress.

2. We did not have the luxury of an extended period of time to stress-test Statement of Financial Accounting Standards (SFAS) 157, Fair Value Measurements, issued by the Financial Accounting Standards Board (FASB) (subsequently codified in the FASB Accounting Standards Codification®, or ASC, as Topic 820), nor did we know how it should be applied when financial markets were plagued with severely reduced transaction volumes and, in some cases where, overnight, a previously active market ceased to exist.

3. The IASB chose to promulgate its standard (IFRS 13, adopted in Singapore as FRS 113) by essentially fully endorsing SFAS 157, “wrapping around” it a modest amount of explanatory material.

B. The purpose of this session is to:

1. Provide background information and a brief summary of FRS 113, Fair Value Measurement

2. Discuss practical, operational, theoretical, and public policy issues that have arisen based on the implementation of an almost identical standard in the United States in 2008, including some of the difficulties associated with the “Great Recession.”

3. Provide illustrative examples of the application of FRS 113.

II. BACKGROUND

A. The International Accounting Standards Board (IASB) and the U.S. FASB have substantially converged their fair value standards. They had not been aligned at the outset, however, as illustrated by the timetable below:

FAS 157 ASU 2011-04 IFRS 13 FRS 113

Title Fair Value Measurements Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs

Fair Value Measurement

Issuance Date

September 2006 May 2011 September 2011

Effective Date

Fiscal years that began after 15 November 2007 and interim periods in those fiscal years

Public Entities: Interim and Annual Periods that began after 15 December 2011

Nonpublic Entities: Annual periods beginning after 15 December 2011

Annual periods that began on or after 1 January 2013


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B. The primary objectives of the substantially converged fair value standards were to:

1. Establish a consistent definition of “fair value” to be used throughout the professional accountancy literature.

2. Provide a 3-level, hierarchical framework for classifying fair value measurements in disclosures that prioritizes those measurements in accordance with the level of observability of the assumptions used as inputs. The highest level in the hierarchy being directly observable inputs and the lowest level in the hierarchy being unobservable inputs.

3. Provide the users of the financial statements with sufficient, relevant information regarding the financial statement components that have been measured at fair value, the methods and assumptions used in the measurements, and the level in the fair value hierarchy that the measurements represent.

C. Fair value was not a new concept when the Boards adopted their converged standards, as the concept and terminology had been used in various accounting contexts for many years, though not in a uniform, standardized manner.

D. The authoritative accounting literature was, at best, a patchwork of previously issued standards that:

1. Did not set forth a measurement objective,

2. Were not based on a sound conceptual framework of financial reporting,

3. Were not consistent with one another, and

4. Required sparse disclosures that omitted much relevant information regarding the nature of fair value measurements and the uncertainty and level of precision associated with them.

III. DEFINITION OF FAIR VALUE

A. Fair value is defined 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 date1.

B. Close examination of the definition in FRS 113, along with the accompanying explanatory guidance provides that, with respect to measuring assets at fair value:

1. Fair value is based on an exit price, not an entry price, i.e., the price to sell an asset versus the price to buy it.

2. A fair value measurement is asset-specific and is to take into consideration the unique characteristics of the asset that market participants would consider, such as the asset’s location and physical condition as well as whether there are any restrictions on the asset’s sale or use.

3. The asset being measured may be either a standalone asset or a group of assets, such as a cash-generating unit, or a business.

1 Financial Reporting Standard (FRS) No. 113, Fair Value Measurement, Singapore Accounting Standards Council (ASC), September 2011, paragraph 9

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4. A fair value measurement is based on a hypothetical transaction, the price that would be received.

5. The hypothetical transaction used for a fair value measurement must be an orderly transaction under the market conditions that exist at the measurement date. For the transaction to be considered orderly,

a. There must have been a sufficient period of time prior to the measurement date to enable sufficient exposure to the market and the performance of usual and customary marketing activities, and

b. The transaction cannot be a forced transaction arising from a liquidation or a distress sale.

6. The hypothetical transaction is assumed to occur either in the principal market for the asset, or, if there is no principal market, in the most advantageous market.

7. The hypothetical transaction is between market participants, buyers and sellers in the principal (or most advantageous) market for the asset that

a. Are independent of each other (not related parties, as defined in FRS 24),

b. Are knowledgeable with a reasonable understanding about the asset

C. FRS 113 provides a three-level framework for classifying fair value measurements based upon “inputs,” the assumptions that would be used by market participants when pricing the item being measured. Inputs can be either:

1. Observable,

2. Based on data that is readily available, or

3. Unobservable, based on assumptions by management.

The FRS 113 Fair Value Measurement Hierarchy

Level 1Observable

Quoted prices for identical assets (or liabilities) in active markets that the entity can access at the measurement date.

Level 2Indirectly Observable

Inputs other than Level 1 quote prices that are observable for the asset (or liability) either directly or indirectly

Level 3Unobservable

Unobservable inputs that reflect the assumptions that market participants would use when pricing the asset (or liability) including assumptions about risk.

D. FRS 113 also sets forth application guidance with respect to the measurement of the fair value of liabilities, which are beyond the scope of this presentation, although limited examples are included.

IV. COMPARABILITY ISSUES

A. The current uses of fair value in financial reporting present several impediments to comparability between entities, between periods, and even between assets and liabilities of the same reporting entity during the period covered by the financial statements.


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1. Internal consistency; coexistence with other measurement attributes

a. While the new fair value standards changed how fair value is to be measured and disclosed, they did not require that fair value measurement principles be extended to any new assets or liabilities that had previously been measured using different measurement attributes.

b. As a result of the foregoing, the statement of financial position of a reporting entity can potentially contain items measured using a dizzying combination of methodologies, such as:

i) Original cost (Cash and cash equivalents);

ii) Net realizable value (customer accounts receivable);

iii) Lower of cost or market (inventories);

iv) Amortized cost (certain investments), subject to “other than temporary” impairment;

v) Depreciated cost subject to potential impairment (long-lived tangible assets);

vi) Original cost less amounts consumed in operations or allocated to operations based on the passage of time (prepaid expenses); and

vii) Present value of the estimated future settlement amount (contingent liabilities that are probable)

2. Comparability between periods

a. In terms of items measured at fair value, some items, such as trading securities are measured at fair value every period, other items, such as impaired goodwill are only measured at fair value at the end of the period during which the goodwill became impaired.

3. Comparability between reporting entities

a. Property, plant and equipment

i) FRS 16, Property, Plant and Equipment, permits a reporting entity to choose either a cost model or a revaluation model for accounting for tangible, long-lived assets.

ii) Companies that report using the cost model account for those assets at their original cost, less any accumulated depreciation and accumulated impairment losses.

iii) Companies that report using the revaluation model revalue their property and equipment2 on a regular basis. After revaluation, the assets would be stated at their revalued amount less any subsequent accumulated depreciation and subsequent accumulated impairment losses. Upon revaluation of an item of property and equipment, any accumulated depreciation as of the date of revaluation is either:

• Restated in proportion to the gross carrying amount of the asset so that the carrying amount of the revalued asset is equal to the revalued amount, or

2 This accounting treatment is only permitted when fair value can be measured reliably.

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• Eliminated against the gross carrying amount of the asset with the net carrying amount after elimination restated to the revalued amount of the asset.

iv) Decreases in net carrying amount due to revaluations are recognized in profit and loss. Increases in net carrying amount due to revaluations are recognized in other comprehensive income and accumulated in equity under a caption, “revaluation surplus” except to the extent that the increase in net carrying amount represents a reversal of a decrease in net carrying amount from a prior revaluation. The effects of such reversals are recognized in profit and loss.

b. The fair value option

i) FRS 39 provides management of a reporting entity the option to irrevocably designate, upon initial recognition, a financial asset or financial liability (or a group of financial assets, financial liabilities, or both) to be measured at fair value, with subsequent changes in fair value to be recognized in profit or loss. This election can be made on a contract-by-contract basis. Reclassifications of instruments into and out of this category are prohibited.

ii) The flexibility inherent in this election can result in a lack of comparability between entities whose management elect the option and those who do not.

iii) Because the election can be applied selectively, this can cause inconsistency even within an individual reporting entity’s financial statements with respect to how it recognizes and reports financial assets and the resultant unrealized gains and losses.

c. Hedging

i) Similar to the fair value option, management can designate qualifying hedging instruments as fair value hedges.

ii) Upon making this designation, the gain or loss on the hedged item attributable to the hedged risk adjusts the carrying amount of the hedged item and is recognized in profit or loss.

iii) Correspondingly, the gain or loss from remeasuring the hedging instrument at fair value is also recognized in profit or loss.

iv) This treatment results in hedged items that are customarily recognized at cost (or amortized cost) being measured differently as a result of being the underlying of a designated hedge.

d. The acquisition method

i) FRS 103, Business Combinations, requires an acquirer of a business to recognize assets acquired and liabilities assumed at their acquisition-date fair values. The method used to accomplish this is called the acquisition method.

ii) Application of the acquisition method results in the acquirer entity recognizing, at fair value, assets, liabilities and the non-controlling interest (equity) that it would otherwise either recognize using some other measurement attribute or that it would not recognize at all.

iii) It also results in the recognition of either goodwill or negative goodwill that are each governed by specialized recognition and measurement rules.


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iv) Thus, a company that grows by acquisition can present financial statements that are very different from a peer company that grows internally. This highlights a problem with respect to considering whether, in the information age, accounting has evolved sufficiently to reflect the economic reality that leading-edge companies are creating (self-constructing, to use a metaphor) intellectual assets and building their customer lists by means of their research and development and marketing outlays. Acquiring companies are permitted by international financial reporting standards to recognize these assets to the extent they are part of a business combination transaction, yet companies that invest in creating these assets internally are not able to avail themselves of the same accounting treatment.

V. AUDITABILITY, OBJECTIVITY AND RELIABILITY CONSIDERATIONS

A. While it is difficult to argue that fair value is less relevant to users than other measurement methods, it is not quite as difficult to point out that relevance may be a trade-off that is being made at the expense of reliability.

B. The following are areas of subjectivity that are inherent in measuring fair value, or in determining whether an asset is not required to be measured at fair value:

1. Consideration of management’s intention.

a. Under FRS 39, held-to-maturity investments are not measured at fair value; instead, they are measured at amortized cost.

b. A held-to-maturity investment is defined as3 a non-derivative financial asset with fixed and determinable payments and fixed maturity that an entity has the positive intention and ability to hold to maturity except for those (a) designated upon initial recognition as “fair value through profit or loss”; (b) designated as available-for-sale; and (c) meeting the definition of loans and receivables.

c. Obviously, practical challenges exist in designing and performing audit procedures to corroborate management’s intentions with respect to the future.

2. Management’s selection and use of valuation techniques.

a. In fair value measurement situations where observable inputs are not available, management is responsible for using “…valuation techniques that are appropriate in the circumstances and for which sufficient data are available to measure fair value, maximizing the use of relevant observable inputs and minimizing the use of unobservable inputs.”4

b. The three most frequently used approaches used to derive valuation techniques are:

i) Market approach.

• Use of prices and other relevant information generated by market transactions that involve identical or similar assets, liabilities or groupings thereof, such as a business.

• Techniques of this kind typically use market multiples derived from a set of comparables.

3 FRS 39, paragraph 9.4 FRS 113, paragraph 61.

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ii) Income approach.

• Conversion of estimated future amounts (e.g., future cash flows, earnings, EBTDA) to a single, discounted current amount.

• Techniques of this kind include present value techniques (e.g., expected present value, discount-rate adjustment techniques) and option pricing models (e.g., the Black-Scholes-Merton closed-end formula; binomial lattice methods).

iii) Cost approach.

• The amount that would be required to currently replace an asset’s service capacity (frequently referred to as “current replacement cost”).

• The application of a cost approach would consider the costs to a counterparty (the buyer) of acquiring or constructing a substitute asset with comparable service utility, and then adjusting that estimate for obsolescence.

c. The guidance included in FRS 113 regarding whether to use a single valuation technique or multiple valuation techniques when valuing an asset or liability is ambiguous, at best. Management is instructed to consider the reasonableness of the range of values yielded by applying the valuation techniques and apply judgment in selecting the point within that range that is most “representative of fair value.”

d. Guidance included in FRS 113 with respect to the application of present value techniques prescribes the following elements that are to be captured from the perspective of market participants at the measurement date5:

i) Estimated future cash flows for the asset or liability being measured;

ii) Management’s expectations with respect to possible variations in the amount and timing of future cash flows that represent the inherent uncertainty in those cash flows;

iii) The risk-free interest rate, the rate on risk-free monetary assets with maturity dates or durations coinciding with the period covered by the cash flows;

iv) Risk premium, the price for bearing the uncertainty inherent in the cash flows;

v) For a liability, the non-performance risk related to the liability, that includes the entity’s own credit risk; and

vi) Any other factors that market participants would consider in the circumstances.

e. Notably, all of the elements listed, perhaps with the exception of iii), the risk-free interest rate, require the exercise of management judgment and thus are subjective and difficult, if not impossible to audit.

5 FRS 113, paragraph B13.


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3. Risk-adjusted measurements.

a. Many level 3 models use valuation techniques to measure discounted expected future cash flows.

b. Whenever the time value of money is material to the measurement, the expected future settlement amount of, e.g., a liability, would be required to be discounted to its present value. The interest rate used to discount the cash flows is a pre-tax rate reflecting current market assessments of the time value of money as well as the risks specific to the liability.

c. It is important to avoid double-counting the same risk assessments. If the estimated future cash flows have been risk-adjusted, then the interest rate used to discount them would not be risk-adjusted.

d. Determining risk adjustments is inherently a subjective judgment required of management.

e. Furthermore, if the liability being valued is that of the reporting entity, the risk adjustment is to incorporate the entity’s own credit standing, a subject regarding which management can hardly be expected to be unbiased.

4. Measurement of “best estimate.”

a. Related to the risk-adjusted measurements discussed in 3. above, management often is faced with different courses of action that it anticipates it might take in regards to future expenditures that might be made. When there is uncertainty regarding the amounts of future outlays, estimation techniques are to be used and the following guidance is included in FRS 37, Provisions, Contingent Liabilities and Contingent Assets:6

The best estimate of the expenditure required to settle the present obligation is the amount that an entity would rationally pay to settle the obligation at the end of the reporting period or to transfer it to a third party at that time. It will often be impossible or prohibitively expensive to settle or transfer an obligation at the end of the reporting period.

***

The estimates of outcome and financial effect are determined by the judgment of the management of the entity, supplemented by experience of similar transactions, and, in some cases, reports from independent experts. The evidence considered includes any additional evidence provided by events after the reporting period.

b. Inherently, the process of assigning probability weightings to the cash flows associated with different alternative courses of action is exceedingly subjective and difficult, if not impossible, to audit.

5. Market participants.

a. FRS 113, para. 22, provides that fair value measurements of both assets and liabilities are to be made “using the assumptions that market participants would use when pricing the asset or liability, assuming that market participants act in their economic best interest.”

6 It should be noted that, while the measurements required by FRS 37 are not explicitly required to be fair value measurements, the guidance contained in paragraphs 36 through 41 on how to compute the “best estimate” of the amount required to settle a present obligation at the end of the reporting period closely resemble the methodology prescribed for valuing liabilities under FRS 113.

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b. While, theoretically, the notion of basing fair value on an exit price in an orderly market transaction could be argued to be sound, practically, there are often items that require a fair value measurement (or a measurement similar to fair value) for which markets do not exist and, therefore, market participants do not exist.

i) An example of this is an asset retirement obligation. At the measurement date (the date the obligation is incurred or acquired), there is no market for determining the amount necessary as of that date that would be necessary to settle an obligation to dismantle and remove an asset at the end of its useful life.

ii) Such obligations are not transferred between parties in the real world and estimating a risk premium is not objectively possible if there are no market participants that would enter into such a transaction, irrespective of perceived risk.

6. Susceptibility to fraud.

a. In the book Fair Value Accounting Fraud,7 the author identifies 76 different fair value accounting fraud risks under both IFRS and U.S. GAAP. A significant risk of fraudulent financial reporting arises from the use of fair value estimates in financial statements. Factors contributing to this risk include:

i) High inherent risks due to the complexity of the measurements and their subjectivity, as detailed throughout this discussion.

ii) The frequent lack of controls over non-routine transactions such as entering into derivatives, identifying the need to test assets for impairment, and incurring asset decommissioning or removal costs.

iii) Risk of management override of controls when significant judgments are required to be made by upper management who may have a financial reporting agenda that aligns with incentives to present the financial statements in a favorable light.

iv) The flexibility in the standards regarding choices of valuation techniques and the inputs used in applying those techniques.

v) The ambiguity in the standards regarding weighting the results of using multiple valuation techniques.

b. The Report on 2013 Survey of Inspection Findings issued on 10 April 2014 by the International Forum of Audit Regulators (IFIAR) cited fair value measurement as resulting in the highest number of inspection findings of any issue inspected.

i) Based on inspections conducted worldwide, 989 audits conducted by 113 audit firms were inspected with 217 findings regarding fair value measurement.

ii) 70 audit firms had at least one finding regarding fair value measurements.

iii) Such dismal results require a re-examination of whether the current accounting standards are verifiable, as required by the Conceptual Framework for Financial Reporting.

7 Gerard M. Zack, Fair Value Accounting Fraud: New Global Risks and Detection Techniques (John Wiley & Sons, Inc., 2009).


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8 Adapted with the permission of the publisher from: Wiley GAAP 2010: Interpretation and Application of Generally Accepted Accounting Principles; Barry J. Epstein, Ralph Nach, and Steven Bragg (John Wiley & Sons, Inc., 2009).

9 http://goo.gl/S343XC

10 Securities and Exchange Commission Accounting and Auditing Enforcement Release No. 2132, 4 November 2004; In the Matter of Morgan Stanley, Respondent, Order Instituting Cease-and-Desist Proceedings, Making Findings, and Imposing a Cease-and-Desist Order Pursuant to Section 21C of the Securities Exchange Act of 1934; http://www.sec.gov/litigation/admin/34-50632.htm

VI. ISSUES ARISING DURING THE “GREAT RECESSION”8

A. During 2007 and 2008, the previously active financial markets for many types of securities had suffered substantial declines in trading volume, and in some cases all transactions had ceased and the market was described as having “seized up.” These conditions were virtually unprecedented and financial statement preparers, who were newly implementing the fair value standard in the U.S. experienced application difficulties with respect to certain aspects of ASC 820.

B. Due to the unprecedented market conditions that existed at the time, questions arose regarding whether transactions occurring in less liquid markets with less frequent trading might cause those market transactions to be considered forced or distress sales, thus rendering valuations made using those prices not indicative of the actual fair value of the securities, since fair value is based on “orderly” transactions. In the absence of application guidance, management was essentially left to its own devices to interpret the most appropriate way to implement the new standard.

C. In order to respond to these concerns, the Center for Audit Quality (CAQ), a non-profit group based in Washington, D.C., closely affiliated with the American Institute of Certified Public Accountants (AICPA) issued a white paper on 3 October 2007, entitled Measurements of Fair Value in Illiquid (or Less Liquid) Markets.9

1. The white paper indicated that an imbalance between supply and demand can occur when there are more sellers than buyers for a particular instrument and that such an imbalance can result in “forcing prices down.”

2. Transactions in markets affected by this situation where there is a lack of equilibrium between buyers and sellers are not considered to be forced or distressed transactions as contemplated by ASC 820 (or, for that matter, by the standards that preceded it).

3. The white paper cited a 2004 SEC Accounting and Auditing Enforcement Release10 in which the SEC imposed a cease-and-desist order on a registrant because the registrant departed from using established market-based valuation methods when it believed that supply and demand were not “in reasonable balance.”

a. One of the practices covered by the cease-and-desist order involved the valuation of bonds, primarily in the telecommunications industry, that were contained in a high-yield bond portfolio near the end of 2000, when the telecommunications industry was experiencing significant turmoil (liquidations, reorganizations, and bankruptcy filings resulting from factors such as overexpansion of capacity in anticipation of business growth that never materialized).

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b. The registrant, a financial services firm, believed that market conditions rendered third-party price quotations unreliable and, rather than use such quotations in its fair value measurements, decided to take a “longer view of the market” and use management’s own subjective opinion regarding the value of the bonds.

4. According to the SEC, the registrant, in effect, “valued its positions at the price at which it thought a willing buyer and seller should enter into an exchange, rather than at the price at which a willing buyer and a willing seller would enter into a current exchange.” (Emphasis added.) The situation cited in the release was exacerbated by the fact that the registrant had valued some of the same high-yield bonds held in the portfolios of its own mutual funds using a lower valuation.

D. Under ASC 820 and FRS 113, orderly transactions are occurring in the marketplace for an asset or liability when knowledgeable buyers and sellers independent of the reporting entity are willing and able to transact, and are motivated to transact without being forced to do so.

1. If orderly transactions are occurring in a manner that is usual and customary for the asset or liability, then the transactions are not to be characterized as forced or distress sales.

2. Simply because transaction volume in a market drops significantly from prior periods does not necessarily mean that the market is no longer active.

3. The above-cited white paper asserts that persuasive evidence would be required to establish that an observable transaction is a forced or distressed transaction and, furthermore, it is inappropriate to assume that all transactions in a relatively illiquid market are forced or distressed transactions.

E. On 30 September 2008, a joint press release was issued by the staffs of the SEC Office of the Chief Accountant (OCA) and FASB. The press release, along with an amendment to FASB standards11 that was issued 10 days later on 10 October 2008 attempted to provide additional guidance to the accounting and financial community with respect to the application of fair value to a financial asset when the market for the asset is not active.

F. Also, during 2008 and throughout 2009, FASB, IASB, the U.S. securities regulator, the Securities and Exchange Commission (SEC), and U.S. banking regulators were subjected to intense political pressure by legislators and special interest groups asserting that fair value accounting had somehow either caused the economic crisis or contributed to its downward spiral.

1. The argument centered on the assertion that reporting declining fair values of loans and other financial instruments caused “pro-cyclicality”.

2. It was theorized that the reporting of sudden significant declines in fair value would cause market participants to panic and the panic would result in further declines in prices and market liquidity in a veritable “race to the bottom”.

3. In effect, the behavior that was theorized was that of a vicious circle whereby the reporting of bad news would beget actions that would cause the reporting of worse news until, ultimately and inevitably, financial markets collapsed.

11 FASB Staff Position (FSP) FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active; FASB, Norwalk, CT; 10 October 2008


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G. On 3 October 2008, the Emergency Economic Stabilization Act of 2008 (EESA) was enacted.

1. Section 133 of EESA required the SEC, in consultation with the U.S. Treasury and the Board of Governors of the Federal Reserve System to conduct a study on “mark-to-market” accounting.

2. The study was conducted with due haste, and on 30 December 2008, a 259-page report, entitled Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-to-Market Accounting was submitted to the U.S. Congress.

3. The overriding purpose for Congress mandating the study was to respond to critics that asserted that fair value measurements contributed to the financial market instability due to what the critics believed to be inappropriate write-downs in the value of investment holdings of financial institutions in markets that were inactive, illiquid, or what the critics believed to be irrational.

4. The critics further asserted that alleged “irrational” write-downs caused regulatory capital shortfalls and failures of financial institutions. The most militant of the critics actually called for the accounting equivalent of declaring martial law, the temporary suspension of the application of fair value accounting.

5. Strong counter-arguments were made by other market participants, in particular investors. These proponents of fair value accounting argued that:

a. Fair value accounting improves the transparency of information provided to the public;

b. Fair value information is vital in times of economic stress;

c. Any suspension of fair value would weaken investor confidence in the financial system and result in further market instability; and

d. Fair value accounting was being unjustly blamed when, in fact, the causes of the financial crisis were poor lending decision, inadequate risk management, and shortcomings in the U.S. patchwork regulatory structure largely designed in the 1930s and gutted by successive rounds of deregulation legislation in recent years.

6. In conducting its study, the SEC reviewed the financial statements of 50 banks and other financial institutions of varying sizes.

a. The review revealed that the use of mark-to-market accounting was generally limited to investments held for trading purposes and certain derivative instruments and that, for many financial institutions, those affected investments represented a minority of their total investment portfolio.

b. The review also revealed that over 90% of investments marked to market were based on observable (Level 1) inputs such as market quotes obtained from active markets. Consequently, the SEC concluded that fair value accounting did not appear to have played a meaningful role in 2008 in the difficulties suffered by, and failures of, banks and other financial institutions.

7. The report attributed the failures to the result of growing probable credit losses, concerns about asset quality, and in some cases, erosion of confidence by lenders and investors.

8. The report contained the following recommendations:

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a. ASC 820 should not be suspended but rather improved.

b. Additional measures should be taken to improve the application and practice related to existing fair value requirements, particularly as they related to both Level 2 and Level 3 estimates in the fair value hierarchy.

c. The accounting for the impairment of financial assets should be re-addressed.

d. Further guidance needed to be implemented in order to foster the use of sound judgment.

e. Accounting standards should continue to be established to meet the needs of investors.

f. Additional formal measures to address the operation of existing accounting standards in practice should be established.

g. The need to simplify the accounting for investments in financial assets should be addressed.

H. In February 2009, a coalition of 31 banks, credit unions, insurance company trade associations and other financial services industry advocates launched “The Fair Value Coalition” whose stated goal was to change the accounting rules.

1. Members of the coalition were reported by the Wall Street Journal to have incurred $27.6 million of lobbying expenses in the first quarter of 2009.

2. Coalition members reportedly directed one-quarter million dollars in campaign contributions to legislators on the U.S. House of Representatives Financial Services Committee. Of this amount, the largest donor was the American Bankers Association, which provided $74,500 to the campaign coffers of 33 committee members in the first quarter.12

I. On 12 March 2009, in an extraordinary hearing held by the Subcommittee on Capital Markets, Insurance and Government-Sponsored Enterprises of the Financial Services Committee of the U.S. House of Representatives, the Subcommittee exerted pressure on SEC Acting Chief Accountant James L. Kroeker (now a member and Vice-Chair of FASB) and FASB Chairman Robert Herz to act quickly with respect to the SEC’s recommendations, seemingly ignoring the fact that the report largely exonerated fair value from having any meaningful role in causing the distressed conditions that existed at the time. The transcript of the hearings reveals that, in fact, the committee gave FASB marching orders and threatened to take action itself if FASB failed to.

J. Succumbing to Congressional pressure, FASB issued three exposure documents on 17 March 2009, with comment periods ending 1 April 2009, and called a special meeting on the following day where the three documents were approved as final amendments to U.S. GAAP.

1. These rushed standards were published in final form on the FASB website on 9 April 2009.13 The entire process took just 22 days from the hearings until the approval and another seven days to publish the standards.

12 Congress Helped Banks Defang Key Rule; The Wall Street Journal; 3 June 2009; Page A113 The standards that amended ASC 820 were:

• FSP FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly (ASC 820-10-35)

• FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments (ASC 825-10-50 and ASC 270-10-50), and• FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments (ASC 320)


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2. These new standards provided precious little time for accountants to implement them, as they were effective for interim reporting periods ending after 15 June 2009, with early adoption permitted for periods ending after 15 March 2009, if adopted together.

K. Besides attempting to resolve practical issues that had arisen regarding determining whether transactions were orderly, the new standards dealt with another contentious issue that arose during the economic turmoil, the recognition of other-than-temporary impairment (OTTI) of debt securities.

1. In response to Congressional bullying and in response to the SEC’s recommendation that the accounting for impaired financial assets be readdressed, FASB permitted, under certain specified circumstances, that the holder of impaired debt securities divide the impairment loss into two separate elements: (1) the credit loss14, and (2) the remaining portion of the impairment related to “all other factors.”

2. The credit loss was to be recorded in profit or loss, however the portion of the impairment loss arising from “all other factors” was to be recorded as a component of other comprehensive income (OCI).

3. There was no credible theoretical argument to support this practice, which resulted in artificial “smoothing” of the earnings of financial institutions and others holding debt instruments.

L. It is important to note that the IASB and the Singapore Accounting Standards Council have not, to date, adopted this bifurcated approach to recognizing impairment of financial assets and, in the author’s opinion, they would be well-advised to hold their ground while conducting their current deliberations on changes to the accounting for financial assets and liabilities.

VII. RECENT DEVELOPMENTS

A. On 25 February 2014, the Financial Accounting Foundation (FAF), which is responsible for overseeing FASB’s standards-setting process, issued a report as a result of having conducted a post-implementation review (PIR) of ASC 820.

B. In this report, FAF generally gave high marks to the standard, indicating that ASC 820 largely resolved the issues in practice that it had been intended to address. The report went on, however to point out:

Our research indicates that some investors have difficulty understanding fair value information provided in the financial statements and their level of satisfaction with that information varies. Additionally there are varying views about the consistency of the fair value information in the financial statements. There are indications from some participants in each of the stakeholder groups included in our research that the volume and extent of disclosures may be beyond what is necessary for investors and other users of financial statements. ***

…certain requirements are difficult for specific types of entities to apply (particularly employee benefit plans, not-for-profit organizations, and private companies). Those difficulties relate to valuations requiring significant use of judgment, the absence of observable markets for the assets being valued, inconsistent application of measurement and disclosure requirements across entities, and resource constraints. Those application difficulties appear to be magnified by the (small) size of the entity and their business model.***

Some stakeholders believe the ongoing costs to comply with Statement 157 (ASC 820) are significant. The most significant cost drivers are the incremental increase in audit fees and audit requirements and the incremental increase in the use of their-party pricing services and valuation specialists.

14 The credit loss would be measured as the difference between the amortized cost basis of the debt security and the present value of the cash flows expected to be collected.

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VIII. CONCLUSIONS AND RECOMMENDATIONS

A. Clearly, fair value is here to stay. The author offers these ideas to mitigate the shortcomings noted above:

1. There should be a comprehensive re-examination of the lack of collaboration between accounting standards-setters and the audit profession. Auditability concerns have not been adequately addressed and the results of that neglect reflect poorly on the accountancy profession that is shared by accountants and auditors.

2. Practical research should be conducted into how best to satisfy users’ seemingly insatiable appetite for relevant, timely, and accurate information, but balanced with the realities that companies do not have unlimited resources to bring to bear on financial reporting and that the users are being overwhelmed with a plethora of financial information that, due to its sheer volume, may detract from conveying a concise portrait of the reporting entities financial condition, financial performance, and future prospects.

3. There needs to be exploration by all stakeholders of alternatives for simplifying and streamlining fair value requirements whereby sufficient tools and models and market data are readily available in the public domain and designed and constructed in a manner that alleviates the need to engage specialists to either compute fair value or audit it.

4. Efforts need to be directed at the development of practical expedients and fair value proxies that can be used to meet financial reporting objectives while reducing cost and complexity.

5. It remains largely a matter of speculation whether wider use of fair value measurements, if not mandated by FRS or other standards, would be elected, if available, for non-financial assets and obligations. Research suggests that, even where the option exists (e.g., for investment property under FRS 40), few reporting entities adopt fair value reporting, with the moderate exception of real estate estates, for which fair value data is relatively obtainable. This suggests that the cost/benefit equation, in the eyes of preparers, is not seen as favorable, notwithstanding that fair value is widely seen as being more relevant information for users.

IX. ADDENDUM: FRS 113 PROVISIONS, DEFINITIONS AND EXAMPLES

A. Key definitions under FRS 113.

Active market. A market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis.

Exit price. The price that would be received to sell an asset or paid to transfer a liability

Fair value. 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.

Highest and best use. The use of a non-financial asset by market participants that would maximize the value of the asset or the group of assets and liabilities (e.g. a business) within which the asset would be used.

Most advantageous market. The market that maximizes the amount that would be received to sell the asset or minimizes the amount that would be paid to transfer the liability, after taking into account transaction costs and transport costs.

Principal market. The market with the greatest volume and level of activity for the asset or liability.


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B. Major provisions of FRS 113.

1. FRS 13 seeks to increase consistency and comparability in fair value measurements and related disclosures through a fair value hierarchy. The hierarchy categorizes the inputs used in valuation techniques into three levels. The hierarchy gives the highest priority to (unadjusted) quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs.

2. If the inputs used to measure fair value are categorized into different levels of the fair value hierarchy, the fair value measurement is categorized in its entirety in the level of the lowest level input that is significant to the entire measurement (based on the application of judgment).

3. Regarding Level 1 inputs:

a. Level 1 inputs are quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date.

b. A quoted market price in an active market provides the most reliable evidence of fair value and is used without adjustment to measure fair value whenever available, with limited exceptions.

c. If an entity holds a position in a single asset or liability and the asset or liability is traded in an active market, the fair value of the asset or liability is measured within Level 1 as the product of the quoted price for the individual asset or liability and the quantity held by the entity, even if the market’s normal daily trading volume is not sufficient to absorb the quantity held and placing orders to sell the position in a single transaction might affect the quoted price.


a. Level 2 inputs are inputs other than quoted market prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

b. Level 2 inputs include:

i) Quoted prices for similar assets or liabilities in active markets.

ii) Quoted prices for identical or similar assets or liabilities in markets that are not active.

iii) Inputs other than quoted prices that are observable for the asset or liability, e.g.:

• Interest rates and yield curves observable at commonly quoted intervals;

• Implied volatilities; and

• Credit spreads.

iv) Inputs that are derived principally from or corroborated by observable market data by correlation or other means (“market-corroborated inputs”).


a. Level 3 inputs inputs are unobservable inputs for the asset or liability.

b. Unobservable inputs are used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for

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the asset or liability at the measurement date. An entity develops unobservable inputs using the best information available in the circumstances, which might include the entity’s own data, taking into account all information about market participant assumptions that is reasonably available.

6. The objective of a fair value measurement is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions. A fair value measurement requires an entity to determine all of the following:

a. The particular asset or liability that is the subject of the measurement (consistently with its unit of account);

b. For a non-financial asset, the valuation premise that is appropriate for the measurement (consistently with its highest and best use);

c. The principal (or most advantageous) market for the asset or liability; and

d. The valuation technique(s) appropriate for the measurement, considering the availability of data with which to develop inputs that represent the assumptions that market participants would use when pricing the asset or liability and the level of the hierarchy within which the inputs are categorized.

7. Regarding measurement:

a. An entity takes into account the characteristics of the asset or liability being measured that a market participant would take into account when pricing the asset or liability at measurement date (e.g. the condition and location of the asset and any restrictions on the sale and use of the asset) Fair value measurement assumes an orderly transaction between market participants at the measurement date under current market conditions.

b. Fair value measurement assumes a transaction taking place in the principal market for the asset or liability, or in the absence of a principal market, the most advantageous market for the asset or liability.

c. A fair value measurement of a non-financial asset takes into account its highest and best use.

d. A fair value measurement of a financial or non-financial liability or an entity’s own equity instruments assumes it is transferred to a market participant at the measurement date, without settlement, extinguishment, or cancellation at the measurement date.

e. The fair value of a liability reflects non-performance risk (the risk the entity will not fulfil an obligation), including an entity’s own credit risk and assuming the same non-performance risk before and after the transfer of the liability.

f. An optional exception applies for certain financial assets and financial liabilities with offsetting positions in market risks or counterparty credit risk, provided conditions are met (additional disclosure is required).


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8. Regarding valuation techniques that may be applicable:

a. An entity uses valuation techniques appropriate in the circumstances and for which sufficient data are available to measure fair value, maximizing the use of relevant observable inputs and minimizing the use of unobservable inputs.

b. The objective of using a valuation technique is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants and the measurement date under current market conditions. Three widely used valuation techniques are:

i) The market approach – uses prices and other relevant information generated by market transactions involving identical or comparable (similar) assets, liabilities, or a group of assets and liabilities (e.g. a business).

ii) The cost approach – reflects the amount that would be required currently to replace the service capacity of an asset (current replacement cost).

iii) The income approach – converts future amounts (cash flows or income and expenses) to a single current (discounted) amount, reflecting current market expectations about those future amounts.

c. In some cases, a single valuation technique will be appropriate, whereas in others multiple valuation techniques will be appropriate.

9. Expanded disclosure requirements:

a. FRS 13 requires an entity to disclose information that helps users of its financial statements assess both of the following:

i) For assets and liabilities that are measured at fair value on a recurring or non-recurring basis in the statement of financial position after initial recognition, the valuation techniques and inputs used to develop those measurements; and

ii) For fair value measurements using significant unobservable inputs, the effect of the measurements on profit or loss or other comprehensive income for the period.

b. The disclosure requirements are not required for:

i) Plan assets measured at fair value in accordance with FRS 19;

ii) Retirement benefit plan investments measured at fair value in accordance with FRS 26; and

iii) Assets for which recoverable amount is fair value less costs of disposal in accordance with FRS 36.

c. Where disclosures are required to be provided for each class of asset or liability, an entity determines appropriate classes on the basis of the nature, characteristics and risks of the asset or liability, and the level of the fair value hierarchy within which the fair value measurement is categorized.

d. Determining appropriate classes of assets and liabilities for which disclosures about fair value measurements should be provided requires judgment.

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i) A class of assets and liabilities will often require greater disaggregation than the line items presented in the statement of financial position.

ii) The number of classes may need to be greater for fair value measurements categorized within Level 3.

e. Some disclosures are differentiated on whether the measurements are:

i) Recurring fair value measurements – fair value measurements required or permitted by other FRSs to be recognized in the statement of financial position at the end of each reporting period; or

ii) Non-recurring fair value measurements are fair value measurements that are required or permitted by other FRSs to be measured in the statement of financial position in particular circumstances.

10. Specific minimum disclosure requirements for each class of assets and liabilities measured at fair value in the statement of financial position after initial recognition:

a. The fair value measurement at the end of the reporting period;

b. For non-recurring fair value measurements, the reasons for the measurement;

c. The level of the fair value hierarchy within which the fair value measurements are categorized in their entirety (Level 1, 2 or 3);

d. For assets and liabilities held at the reporting date that are measured at fair value on a recurring basis, the amounts of any transfers between Level 1 and Level 2 of the fair value hierarchy, the reasons for those transfers and the entity’s policy for determining when transfers between levels are deemed to have occurred, separately disclosing and discussing transfers into and out of each level;

e. For fair value measurements categorized within Level 2 and Level 3 of the fair value hierarchy, a description of the valuation technique(s) and the inputs used in the fair value measurement, any change in the valuation techniques and the reason(s) for making such change (with some exceptions);

f. For fair value measurements categorized within Level 3 of the fair value hierarchy, quantitative information about the significant unobservable inputs used in the fair value measurement (with some exceptions);

g. For recurring fair value measurements categorized within Level 3 of the fair value hierarchy, a reconciliation from the opening balances to the closing balances, disclosing separately changes during the period attributable to the following:

i) Total gains or losses for the period recognized in profit or loss, and the line item(s) in profit or loss in which those gains or losses are recognized – separately disclosing the amount included in profit or loss that is attributable to the change in unrealized gains or losses relating to those assets and liabilities held at the end of the reporting period, and the line item(s) in profit or loss in which those unrealized gains or losses are recognized.


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ii) Total gains or losses for the period recognized in other comprehensive income, and the line item(s) in other comprehensive income in which those gains or losses are recognized.

iii) Purchases, sales, issues and settlements (each of those types of changes disclosed separately).

iv) The amounts of any transfers into or out of Level 3 of the fair value hierarchy, the reasons for those transfers and the entity’s policy for determining when transfers between levels are deemed to have occurred. Transfers into Level 3 are to be disclosed and discussed separately from transfers out of Level 3.

h. For fair value measurements categorized within Level 3 of the fair value hierarchy, a description of the valuation processes used by the entity;

i. For recurring fair value measurements categorized within Level 3 of the fair value hierarchy:

i) A narrative description of the sensitivity of the fair value measurement to changes in unobservable inputs if a change in those inputs to a different amount might result in a significantly higher or lower fair value measurement.

• If there are interrelationships between those inputs and other unobservable inputs used in the fair value measurement, the entity also provides a description of those interrelationships and of how they might magnify or mitigate the effect of changes in the unobservable inputs on the fair value measurement

ii) For financial assets and financial liabilities, if changing one or more of the unobservable inputs to reflect reasonably possible alternative assumptions would change fair value significantly, an entity is to state that fact and disclose the effect of those changes.

• The entity is to disclose how the effect of a change to reflect a reasonably possible alternative assumption was calculated

j. If the highest and best use of a non-financial asset differs from its current use, an entity is to disclose that fact and why the non-financial asset is being used in a manner that differs from its highest and best use.

11. Quantitative disclosures are required to be presented in a tabular format unless another format is more appropriate.

C. Selected examples of application of FRS 113 (adapted from illustrative materials produced by IASB for IFRS 13).

Example #1 — Identifying an Asset Group for Valuation Purposes

An entity acquires assets and assumes liabilities in a business combination. One of the groups of assets acquired comprises Assets A, B and C.

Asset C is billing software integral to the business developed by the acquired entity for its own use in conjunction with Assets A and B (the related assets). The entity measures the fair value of each of the assets individually, consistently with the specified unit of account for the assets. The entity determines that the highest and best use of the assets is their current use and that each asset would provide maximum

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value to market participants principally through its use in combination with other assets or with other assets and liabilities (its complementary assets and the associated liabilities).

There is no evidence to suggest that the current use of the assets is not their highest and best use.

The reporting entity would sell the assets in the market in which it initially acquired the assets (that is, the entry and exit markets from the perspective of the entity are the same). Market participant buyers with whom the entity would enter into a transaction in that market have characteristics that are generally representative of both strategic buyers (such as competitors) and financial buyers (such as private equity or venture capital firms that do not have complementary investments) and include those buyers that initially bid for the assets.

Although market participant buyers might be broadly classified as strategic or financial buyers, in many cases there will be differences among the market participant buyers within each of those groups, reflecting, for example, different uses for an asset and different operating strategies.

Differences between the indicated fair values of the individual assets relate principally to the use of the assets by those market participants within different asset groups:

(a) Strategic buyer asset group. The reporting entity determines that strategic buyers have related assets that would enhance the value of the group within which the assets would be used (i.e., there would be market participant synergies). Those assets include a substitute asset for Asset C (the billing software), which would be used for only a limited transition period and could not be sold on its own at the end of that period. Because strategic buyers have substitute assets, Asset C would not be used for its full remaining economic life. The indicated fair values of Assets A, B and C within the strategic buyer asset group (reflecting the synergies resulting from the use of the assets within that group) are S$360, S$260, and S$30, respectively. The indicated fair value of the assets as a group within the strategic buyer asset group is S$650.

(b) Financial buyer asset group. The entity determines that financial buyers do not have related or substitute assets that would enhance the value of the group within which the assets would be used. Because financial buyers do not have substitute assets, Asset C (the billing software) would be used for its full remaining economic life. The indicated fair values of Assets A, B and C within the financial buyer asset group are S$300, S$200 and S$100, respectively. The indicated fair value of the assets as a group within the financial buyer asset group is S$600.

The fair values of Assets A, B and C would be determined on the basis of the use of the assets as a group within the strategic buyer group (CU360, S$260 and S$30). Although the use of the assets within the strategic buyer group does not maximize the fair value of each of the assets individually, it maximizes the fair value of the assets as a group (S$650).


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Example #2 — Valuing a Research and Development Project

The reporting entity acquires a research and development (R&D) project in a business combination. The entity does not intend to complete the project.

If completed, the project would compete with one of its own projects (to provide the next generation of the entity’s commercialized technology). Instead, the entity intends to hold (i.e., to lock up) the project to prevent its competitors from obtaining access to the technology. In doing this, the project is expected to provide defensive value, principally by improving the prospects for the entity’s own competing technology.

To measure the fair value of the project at initial recognition, the highest and best use of the project would be determined on the basis of its use by market participants.

For example:

(a) The highest and best use of the R&D project would be to continue development if market participants would continue to develop the project and that use would maximize the value of the group of assets or of assets and liabilities in which the project would be used (i.e., the asset would be used in combination with other assets or with other assets and liabilities). That might be the case if market participants do not have similar technology, either in development or already commercialized. The fair value of the project would then be measured on the basis of the price that would be received in a current transaction to sell the project, assuming that the R&D would be used with its complementary assets and the associated liabilities and that those assets and liabilities would be available to market participants.

(b) The highest and best use of the R&D project would be to cease development if, for competitive reasons, market participants would lock up the project and that use would maximize the value of the group of assets or of assets and liabilities in which the project would be used. That might be the case if market participants have technology in a more advanced stage of development that would compete with the project if completed and the project would be expected to improve the prospects for their own competing technology if locked up. The fair value of the project would be measured on the basis of the price that would be received in a current transaction to sell the project, assuming that the R&D would be used (i.e., locked up) with its complementary assets and the associated liabilities and that those assets and liabilities would be available to market participants.

(c) The highest and best use of the R&D project would be to cease development if market participants would discontinue its development. That might be the case if the project is not expected to provide a market rate of return if completed and would not otherwise provide defensive value if locked up. The fair value of the project would be measured on the basis of the price that would be received in a current transaction to sell the project on its own (which might be zero).

Example #3 — Valuation of a Machine to be Held and Used in the Business

An entity acquires a machine in a business combination. The machine will be held and used in its operations. It was originally purchased by the acquired entity from an outside vendor and, before the business combination, was modified by the acquired entity for use in its operations. However, the modification of the machine was not extensive.

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The acquiring entity determines that the asset would provide maximum value to market participants through its use in combination with other assets or with other assets and liabilities (as installed or otherwise configured for use). There is no evidence to suggest that the current use of the machine is not its highest and best use. Therefore, the highest and best use of the machine is its current use in combination with other assets or with other assets and liabilities.

The entity determines that sufficient data are available to apply the cost approach and, because the customization of the machine was not extensive, the market approach. The income approach is not used because the machine does not have a separately identifiable income stream from which to develop reliable estimates of future cash flows. Furthermore, information about short-term and intermediate-term lease rates for similar used machinery that otherwise could be used to project an income stream (i.e., lease payments over remaining service lives) is not available.

The market and cost approaches are applied as follows:

(a) The market approach is applied using quoted prices for similar machines adjusted for differences between the machine (as modified) and the similar machines. The measurement reflects the price that would be received for the machine in its current condition (used) and location (installed and configured for use). The fair value indicated by that approach ranges from S$40,000 to S$48,000.

(b) The cost approach is applied by estimating the amount that would be required currently to construct a substitute (modified) machine of comparable utility. The estimate takes into account the condition of the machine and the environment in which it operates, including physical wear and tear (i.e., physical deterioration), improvements in technology (i.e., functional obsolescence), conditions external to the condition of the machine such as a decline in the market demand for similar machines (i.e., economic obsolescence) and installation costs. The fair value indicated by that approach ranges from S$40,000 to S$52,000.

The reporting entity determines that the higher end of the range indicated by the market approach is most representative of fair value and, therefore, ascribes more weight to the results of the market approach. That determination is made on the basis of the relative subjectivity of the inputs, taking into account the degree of comparability between the machine and the similar machines. In particular:

(a) The inputs used in the market approach (quoted prices for similar machines) require fewer and less subjective adjustments than the inputs used in the cost approach.

(b) The range indicated by the market approach overlaps with, but is narrower than, the range indicated by the cost approach.

(c) There are no known unexplained differences (between the machine and the similar machines) within that range.

Accordingly, the entity determines that the fair value of the machine is S$48,000.

If modification of the machine had been extensive, or if there were not sufficient data available to apply the market approach (e.g., because market data reflect transactions for machines used on a stand-alone basis, such as a scrap value for specialized assets, rather than machines used in combination with other assets or with other assets and liabilities), the entity would apply the cost approach.

When an asset is used in combination with other assets or with other assets and liabilities, the cost approach assumes the sale of the machine to a market participant buyer with the complementary assets


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and the associated liabilities. The price received for the sale of the machine (i.e., an exit price) would not be more than either of the following:

(a) the cost that a market participant buyer would incur to acquire or construct a substitute machine of comparable utility; or

(b) the economic benefit that a market participant buyer would derive from the use of the machine.

Example #4 — Implication of a Restriction Imposed on the Use of the Asset

A donor contributes land in an otherwise developed residential area to a not-for-profit neighborhood association. The land is currently used as a playground. The donor specifies that the land must continue to be used by the association as a playground in perpetuity.

Upon review of relevant documentation (e.g., legal and other), the association determines that the fiduciary responsibility to meet the donor’s restriction would not be transferred to market participants if the association sold the asset, i.e., that the donor restriction on the use of the land is specific to the association. Furthermore, the association is not restricted from selling the land.

Without the restriction on the use of the land by the association, the land could be used as a site for residential development. In addition, the land is subject to an easement (i.e., a legal right that enables a utility to run power lines across the land).

Following is an analysis of the effect on the fair value measurement of the land arising from the restriction and the easement:

(a) Donor restriction on use of land. Because in this situation the donor restriction on the use of the land is specific to the association, the restriction would not be transferred to market participants. Therefore, the fair value of the land would be the higher of its fair value used as a playground (i.e., the fair value of the asset would be maximized through its use by market participants in combination with other assets or with other assets and liabilities) or its fair value as a site for residential development (i.e., the fair value of the asset would be maximized through its use by market participants on a stand-alone basis), regardless of the restriction on the use of the land by the association.

(b) Easement for utility lines. Because the easement for utility lines is specific to (i.e., a characteristic of) the land, it would be transferred to market participants with the land.

Therefore, the fair value measurement of the land would take into account the effect of the easement, regardless of whether the highest and best use is as a playground or as a site for residential development.

Example #5 — Fair Value of a Liability

Assume that Entity X and Entity Y each enter into a contractual obligation to pay cash (S$500) to Entity Z in five years. Entity X has a AA credit rating and can borrow at 6 per cent, and Entity Y has a BBB credit rating and can borrow at 12 per cent.

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Entity X will receive about S$374 in exchange for its promise (the present value of S$500 in five years at 6 per cent). Entity Y will receive about S$284 in exchange for its promise (the present value of S$500 in five years at 12 per cent).

The fair value of the liability to each entity (i.e., the proceeds) fully reflects that entity’s credit standing. The following example illustrates the measurement of liabilities and the effect of non-performance risk (including an entity’s own credit risk) on a fair value measurement.

On 1 January 20X7 Entity A, an investment bank with a AA credit rating, issues a five-year fixed rate note to Entity B. The contractual principal amount to be paid by Entity A at maturity is linked to an equity index. No credit enhancements are issued in conjunction with or otherwise related to the contract (i.e., no collateral is posted and there is no third-party guarantee).

Entity A designated this note as at fair value through profit or loss under applicable FRS. The fair value of the note (i.e., the obligation of Entity A) during 20X7 is measured using an expected present value technique. Changes in fair value are as follows:

(a) Fair value at 1 January 20X7. The expected cash flows used in the expected present value technique are discounted at the risk-free rate using the government bond curve at 1 January 20X7, plus the current market observable AA corporate bond spread to government bonds, if non-performance risk is not already reflected in the cash flows, adjusted (either up or down) for Entity A’s specific credit risk (resulting in a credit-adjusted risk-free rate). Therefore, the fair value of Entity A’s obligation at initial recognition takes into account non-performance risk, including that entity’s credit risk, which presumably is reflected in the proceeds.

(b) Fair value at 31 March 20X7. During March 20X7, the credit spread for AA corporate bonds widens, with no changes to the specific credit risk of Entity A. The expected cash flows used in the expected present value technique are discounted at the risk-free rate using the government bond curve at 31 March 20X7, plus the current market observable AA corporate bond spread to government bonds, if non-performance risk is not already reflected in the cash flows, adjusted for Entity A’s specific credit risk (ie resulting in a credit-adjusted risk-free rate). Entity A’s specific credit risk is unchanged from initial recognition. Therefore, the fair value of Entity A’s obligation changes as a result of changes in credit spreads generally. Changes in credit spreads reflect current market participant assumptions about changes in non-performance risk generally, changes in liquidity risk and the compensation required for assuming those risks.

(c) Fair value at 30 June 20X7. As of 30 June 20X7, there have been no changes to the AA corporate bond spreads. However, on the basis of structured note issues corroborated with other qualitative information, Entity A determines that its own specific creditworthiness has strengthened within the AA credit spread. The expected cash flows used in the expected present value technique are discounted at the risk-free rate using the government bond yield curve at 30 June 20X7, plus the current market observable AA corporate bond spread to government bonds (unchanged from 31 March 20X7), if non-performance risk is not already reflected in the cash flows, adjusted for Entity A’s specific credit risk (i.e., resulting in a credit-adjusted risk-free rate). Therefore, the fair value of the obligation of Entity A changes as a result of the change in its own specific credit risk within the AA corporate bond spread.


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Example #6 — Fair Value of Decommissioning Obligation

On 1 January 20X1 Entity A assumes a decommissioning (i.e., asset retirement) liability in a business combination. The entity is legally required to dismantle and remove an offshore oil platform at the end of its useful life, which is estimated to be 10 years. On the basis of FRS 113, Entity A uses the expected present value technique to measure the fair value of the decommissioning liability. Entity A was contractually allowed to transfer its decommissioning liability to a market participant, and in this regard Entity A concludes that a market participant would use all the following inputs, probability-weighted as appropriate, when estimating the price it would expect to receive:

(a) Labor costs;

(b) Allocation of overhead costs;

(c) The compensation that a market participant would require for undertaking the activity and for assuming the risk associated with the obligation to dismantle and remove the asset. Such compensation includes both of the following:

i) Profit on labor and overhead costs; and

(ii) The risk that the actual cash outflows might differ from those expected, excluding inflation;

(d) The effect of inflation on estimated costs and profits;

(e) The time value of money, represented by the risk-free rate; and

(f) The non-performance risk relating to the risk that Entity A will not fulfill the obligation, including Entity A’s own credit risk.

The significant assumptions used by Entity A to measure fair value are as follows:

(a)Labor costs are developed on the basis of current marketplace wages, adjusted for expectations of future wage increases, required to hire contractors to dismantle and remove offshore oil platforms.

Entity A assigns probability assessments to a range of cash flow estimates as follows:

Cash flow estimate (S$) Probability assessment Expected cash flows (S$)

100,000 25% 25,000

125,000 50% 62,500

175,000 25% 43,750

S$131,250

The probability assessments are developed on the basis of Entity A’s experience with fulfilling obligations of this type and its knowledge of the market.

(b) Entity A estimates allocated overhead and equipment operating costs using the rate it applies to labor costs (80% of expected labor costs). This is consistent with the cost structure of market participants.

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(c) Entity A estimates the compensation that a market participant would require for undertaking the activity and for assuming the risk associated with the obligation to dismantle and remove the asset as follows:

(i) A third-party contractor typically adds a mark-up on labor and allocated internal costs to provide a profit margin on the job. The profit margin used (20%) represents Entity A’s understanding of the operating profit that contractors in the industry generally earn to dismantle and remove offshore oil platforms. Entity A concludes that this rate is consistent with the rate that a market participant would require as compensation for undertaking the activity.

(ii) A contractor would typically require compensation for the risk that the actual cash outflows might differ from those expected because of the uncertainty inherent in locking in today’s price for a project that will not occur for 10 years. Entity A estimates the amount of that premium to be 5 per cent of the expected cash flows, including the effect of inflation.

(d) Entity A assumes a rate of inflation of 4% over the 10-year period on the basis of available market data.

(e) The risk-free rate of interest for a 10-year maturity on 1 January 20X1 is 5%. Entity A adjusts that rate by 3.5% to reflect its risk of non-performance (i.e., the risk that it will not fulfill the obligation), including its credit risk. Therefore, the discount rate used to compute the present value of the cash flows is 8.5%. Entity A concludes that its assumptions would be used by market participants.

In addition, Entity A does not adjust its fair value measurement for the existence of a restriction preventing it from transferring the liability. As illustrated in the following table, Entity A measures the fair value of its decommissioning liability as S$194,879.

Expected cash flows (S$) 1 January 20X1

Expected labor costs 131,250

Allocated overhead and equipment costs (0.80 x S$131,250 =) 105,000

Contractor’s profit mark-up [0.20 x (S$131,250 + S$105,000) =] 47,250

Expected cash flows before inflation adjustment 283,500

Inflation factor (4% for 10 years) x 1.4802

Expected cash flows adjusted for inflation 419,637

Market risk premium (0.05 x S$419,637 =) 20,982

Expected cash flows adjusted for market risk 440,619

Expected present value using discount rate of 8.5% for 10 years 194,879

Example #7 — Estimating Market Rate of Return When Volume or Activity is Slight

Entity A invests in a junior AAA-rated tranche of a residential mortgage-backed security on 1 January 20X8 (the issue date of the security). The junior tranche is the third most senior of a total of seven tranches. The underlying collateral for the residential mortgage-backed security is unguaranteed non-conforming residential mortgage loans that were issued in the second half of 20X6.


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At 31 March 20X9 (the measurement date) the junior tranche is now A-rated. This tranche of the residential mortgage-backed security was previously traded through a brokered market. However, trading volume in that market was infrequent, with only a few transactions taking place per month from 1 January 20X8 to 30 June 20X8 and little, if any, trading activity during the nine months before 31 March 20X9.

Entity A determines whether there has been a significant decrease in the volume or level of activity for the junior tranche of the residential mortgage-backed security in which it has invested. After evaluating the significance and relevance of the factors, Entity A concludes that the volume and level of activity of the junior tranche of the residential mortgage-backed security have significantly decreased. Entity A supported its judgment primarily on the basis that there was little, if any, trading activity for an extended period before the measurement date.

Because there is little, if any, trading activity to support a valuation technique using a market approach, Entity A decides to use an income approach using the discount rate adjustment technique described in FRS 113 to measure the fair value of the residential mortgage-backed security at the measurement date. Entity A uses the contractual cash flows from the residential mortgage-backed security. Entity A then estimates a discount rate (i.e., a market rate of return) to discount those contractual cash flows. The market rate of return is estimated using both of the following:

(a) the risk-free rate of interest, and

(b) estimated adjustments for differences between the available market data and the junior tranche of the residential mortgage-backed security in which Entity A has invested.

Those adjustments reflect available market data about expected non-performance and other risks (e.g., default risk, collateral value risk and liquidity risk) that market participants would take into account when pricing the asset in an orderly transaction at the measurement date under current market conditions. Entity A took into account the following information when estimating the adjustments per FRS 113:

(a) The credit spread for the junior tranche of the residential mortgage-backed security at the issue date as implied by the original transaction price.

(b) The change in the credit spread implied by any observed transactions from the issue date to the measurement date for comparable residential mortgage-backed securities or on the basis of relevant indices.

(c) The characteristics of the junior tranche of the residential mortgage-backed security compared with comparable residential mortgage-backed securities or indices, including all the following:

(i) the quality of the underlying assets, ie information about the performance of the underlying mortgage loans such as delinquency and foreclosure rates, loss experience and prepayment rates;

(ii) the seniority or subordination of the residential mortgage-backed security tranche held; and

(iii) other relevant factors.

(d) Relevant reports issued by analysts and rating agencies.

(e) Quoted prices from third parties such as brokers or pricing services.

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Entity A estimates that one indication of the market rate of return that market participants would use when pricing the junior tranche of the residential mortgage-backed security is 12 per cent (1,200 basis points). This market rate of return was estimated as follows:

(a) Begin with 300 basis points for the relevant risk-free rate of interest at 31 March 20X9.

(b) Add 250 basis points for the credit spread over the risk-free rate when the junior tranche was issued in January 20X8.

(c) Add 700 basis points for the estimated change in the credit spread over the risk-free rate of the junior tranche between 1 January 20X8 and 31 March 20X9. This estimate was developed on the basis of the change in the most comparable index available for that time period.

(d) Subtract 50 basis points (net) to adjust for differences between the index used to estimate the change in credit spreads and the junior tranche. The referenced index consists of sub-prime mortgage loans, whereas Entity A’s residential mortgage-backed security consists of similar mortgage loans with a more favorable credit profile (making it more attractive to market participants). However, the index does not reflect an appropriate liquidity risk premium for the junior tranche under current market conditions. Thus, the 50 basis point adjustment is the net of two adjustments:

(i) The first adjustment is a 350 basis point subtraction, which was estimated by comparing the implied yield from the most recent transactions for the residential mortgage-backed security in June 20X8 with the implied yield in the index price on those same dates. There was no information available that indicated that the relationship between Entity A’s security and the index has changed.

(ii) The second adjustment is a 300 basis point addition, which is Entity A’s best estimate of the additional liquidity risk inherent in its security (a cash position) when compared with the index (a synthetic position). This estimate was derived after taking into account liquidity risk premiums implied in recent cash transactions for a range of similar securities.

As an additional indication of the market rate of return, Entity A takes into account two recent indicative quotes (i.e., non-binding quotes) provided by reputable brokers for the junior tranche of the residential mortgage-backed security that imply yields of 15–17%. Entity A is unable to evaluate the valuation technique(s) or inputs used to develop the quotes. However, Entity A is able to confirm that the quotes do not reflect the results of actual transactions.

Because Entity A has multiple indications of the market rate of return that market participants would take into account when measuring fair value, it evaluates and weights the respective indications of the rate of return, considering the reasonableness of the range indicated by the results. Entity A concludes that 13% is the point within the range of indications that is most representative of fair value under current market conditions. Entity A places more weight on the 12% indication (i.e., its own estimate of the market rate of return) for the following reasons:

(a) Entity A concluded that its own estimate appropriately incorporated the risks (eg default risk, collateral value risk and liquidity risk) that market participants would use when pricing the asset in an orderly transaction under current market conditions.

(b) The broker quotes were non-binding and did not reflect the results of transactions, and Entity A was unable to evaluate the valuation technique(s) or inputs used to develop the quotes.


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About ISCA Technical Standards Development and Advisory

The Technical Standards Development and Advisory (TSDA) team is part of the Technical Knowledge Centre and Quality Assurance division of the Institute of Singapore Chartered Accountants (ISCA). It is committed to supporting the Institute in advancing and promoting technical developments within the profession as part of the effort to transform Singapore into a leading global accountancy hub by 2020.

ISCA TSDA engages external stakeholders in soliciting meaningful feedback on accounting and auditing related issues to develop a consistent approach to addressing industry issues identified. It also prescribes auditing and assurance standards that are closely aligned to international best practices, champions thought leadership initiatives with key stakeholders and drives projects in collaboration with various ISCA technical committees.

It actively engages international standard setters and strives to be an advocate of matters pertinent to the development of Singapore’s accountancy profession. Furthermore, it aims to cultivate a mindset change and raises awareness of new and revised standards through the publication of articles authored by the team.

Additionally, ISCA TSDA seeks to empower members and the profession at large to achieve their aspirations by equipping them with relevant technical expertise and this is achieved through the development of a range of resources that they can tap on.

Knowledge sharing with the accounting community is facilitated through a variety of print and online channels including the sharing of regular updates and thought leadership articles via in-house publications like the journal, “IS Chartered Accountant”, the E-newsletter, “ISCA Weekly”, and various online knowledge centres and a technical forum. Seminars and workshops are regularly organised and ISCA TSDA also provides value added technical clarification services to assist the profession in resolving accounting, auditing and ethics related issues.

© 2014 by Ralph Nach

Disclaimer

This document contains general information only and the author and ISCA are not, by means of this document, rendering any professional advice or services. This document is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a professional advisor. Whilst every care has been taken in compiling this document, the author and ISCA make no representations or warranty (expressed or implied) about the accuracy, suitability, reliability or completeness of the information for any purpose. The author, ISCA, its employees or agents accept no liability to any party for any loss, damage or costs howsoever arising, whether directly or indirectly from any action or decision taken (or not taken) as a result of any person relying on or otherwise using this document or arising from any omission from it.

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FAIR VALUE MEASUREMENT IN THE CORPORATE WORLD: How … · Fair value is based on an exit price, not an entry price, i.e., the price to sell an asset versus the price to buy it. 2.

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