Presented by Alfred M. King, CMA,CFM October 6, 2008 Fair Value GAAP vs. IFRS Presented by Alfred M. King, CMA,CFM October 6, 2008

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

Problems with Convergence Principles vs. Rules – Is this distinction a myth? Business complexity = complex rules Will IFRS have to adopt ‘Rules’ over time? Funding and Membership in IASB What happens if our SEC disagrees with IFRS? Transition Training of preparers – option for early adoption by large companies Training of auditors

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

Exit Value – GAAP Concept “¶5. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” This concept works for financial instruments and does not work for tangible and intangible assets

Fair Value – IFRS Concept “Fair Value is the amount for which an asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged between knowledgeable, willing parties in an arm’s length transaction” [IFRS 2, Appendix A]

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

How to Value When There Are No Participants FASB set up levels 1 through 3 Level 1 – quoted prices Level 2 – no direct quotes but similar assets Level 3 – all other Valuation specialists are always working in Level 3 Level 3 allows for Income Approach and Cost Approach but these are considered “entity specific values” and are 2nd class!

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

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

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

“Defensive Value” Common problem in Business Combination Seller and Buyer each have competing brand names Buyer wants to move Seller’s product line to use the Buyer brand name Buyer won’t use the Seller’s brand Buyer, however, would not sell Seller’s brand name to anyone else

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

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

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

Fair Value and Impairment: Key Differences FASB vs. GAAP Real Estate Investment property Agricultural/biological IFRS permits/requires periodic revaluation up or down U.S. GAAP absolutely prohibits write up In U.S. this is a one-way street. Can take impairment loss but never an impairment gain – or even write back up to previous amount

IFRS Permits Revaluations A literal reading of IFRS suggests that if they want to, companies can revalue other assets – for example intangibles Brand Names Patents Will U.S. companies take advantage of this? Look at Fair Value Option (SFAS 159)

Fair Value Option Companies are permitted to revalue LIABILITIES if they wish Banks and financial institutions have had to write down investments because of credit problems in the economy SFAS 159 permits them to designate liabilities for same Fair Value treatment So if a company’s credit rating drops, they can record a ‘GAIN’ which may offset the Fair Value loss on the investments – Bear Stearns example

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

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

Asset Impairment Impairment indicators are essentially the same between GAAP and IFRS IFRS writes down to Fair Value when FV is less than carrying value No intermediate cash flow test IFRS looks to the higher of: Net selling price (exit value) Value in Use (entity specific)

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

Research & Development ‘Research’ expensed in both systems ‘Development’ is capitalized in IFRS and expensed in GAAP Under SFAS 141R, purchased In-Process R&D will be capitalized, but further expenditures will be expensed Basic question: Is the true Fair Value of R&D properly measured based on costs incurred?

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

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

Revenue Recognition GAAP has over 200 items in the literature IFRS is very general Revenue Recognition is a big item at least in the U.S. FASB looks to ‘Fair Value’ as one way of measuring Revenue Recognition. Suzie’s sweater example

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

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

The Future of the Valuation Business

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