1. Teaching Fair Value Measurement
Background & Overview

2. Why teach fair value measurement?
Fair values are used in many areas of accounting
Succession planning
Estates and gifts
Corporate structure changes
Internal decision making
Mergers and acquisitions
Financial reporting and auditing

3. GAAP and fair values
Over 40 FASB pronouncements require or permit the use of fair values. Examples include guidance on accounting for: debt
derivatives
business combinations
pensions & OPEBs
asset retirement obligations
contributions received and made

4. Statement No. 157 Defines fair value
Establishes a hierarchy for measuring fair values
Expands disclosures about fair value measurements
It does not require use of fair value if not required by other GAAP
Effective in 2008 for calendar year firms

5. Definition
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
A fair value is an exit price.

6. Why an exit price?
Fits with the definition of an asset and a liability
Assets result in cash inflows
Liabilities result in cash outflows
Reporting entities recognize and measure assets and liabilities

7. The objective of a fair value measurement
To determine the price that would be received to sell the asset or paid to transfer the liability at the measurement date (an exit price)
Assume sale or transfer in principal or most advantageous market

8. Transaction costs are not part of fair value
A transaction cost is a fee for a service – a period expense
Transportation costs should be considered because the location of an asset may be an important attribute of the asset

9. Fair values are market-based
Fair values are determined based on the assumptions market participants would use in pricing the asset or liability

10. Market participants
Buyers and sellers in the principal (or most advantageous) market
Independent of the reporting entity
Knowledgeable
Able to transact
Willing to transact – motivated but not forced
Highest and best use of the asset is assumed: in-use or in-exchange

11. Assumptions as valuation inputs
Market participant assumptions are incorporated in fair value measurement as inputs to valuations
Observable inputs – based on market data
Unobservable inputs – based on assumptions about assumptions of market participants

12. Fair value hierarchy – level 1
Quoted prices (unadjusted) in active markets for identical assets or liabilities
Ex. A share of GE

13. Fair value hierarchy – level 2
Quoted prices for similar assets or liabilities in active markets
Quoted prices for similar assets or liabilities in markets that are not active
Inputs other than quoted prices (e.g., interest rates, yield curves, volatilities)
Inputs derived principally from or corroborated by observable market data or other means
Ex. Interest-rate swap

14. Fair value hierarchy – level 3
Based on unobservable inputs
Should reflect the reporting entity’s own assumptions about the assumptions market participants would use
Should be based on the best available information in the circumstances
Ex. Intangibles in a business combination

15. Valuation techniques
Market approach: should be used as the primary, or confirmatory approach, if a market is observable
Income approach: most often used when a market is not observable and a hypothetical market must be constructed
Cost approach
Multiple approaches may be used

16. Disclosure of fair value measures by level of the hierarchy
Fair Value at Reporting Date
Description
12/31/XX
Level 1
Level 2
Level 3
Trading securities
$ 115
$ 105
$ 10
Available-for-sale securities 75
Derivatives 60 25 15
$ 20
Venture capital investments 10
Total
$ 260
$ 205
$ 25
$ 30
($ in 000’s)

17. Disclosure of changes in level 3 measures
($ in 000’s)
Level 3 Fair Value Measurements
Derivatives
Venture Capital
Investments
Total
Beginning balance
$14
$11
$25
Total gains and losses (realized/unrealized)
Included in earnings 11
(3) 8
Included in OCI 4
Purchases, issuances, and settlements
(7) 2
(5)
Transfers in/out of Level 3
(2)
Ending balance
$20
$10
$30
Change in unrealized gains or losses
In earnings relating to assets still held $7 $2 $9

18. What should entry-level accountants know about fair value?
What is risk? What is value?
How to make projections, assess risk value and value a business
Approaches to valuation
Income
Market
Cost
How to evaluate the reasonableness of inputs to the valuation process and perform sensitivity analysis
How to compute expected values, present values for partial periods and irregular streams of cash, and EVA

19. What should entry level accountants know about fair value?
How to fair value liabilities as well as assets
Different types of intangibles and differences in accounting for intangibles with finite versus indefinite lives

20. Students already know more about fair values than we acknowledge
Lessons from selling items on E-Bay
How market prices are determined
How demand and supply affect prices
What happens to prices when there are few buyers and sellers
Marking to market (i.e. re-measuring fair values) may be easier for students to understand than allocating historical cost through amortization

21. The rest of the session: classroom cases
Using investments to demonstrate application of the fair value hierarchy
Introducing students to fair value
Valuing a business
Impairment testing
Auditing fair values