Introduction to Teaching Fair Value in Accounting Earl K. Stice PricewaterhouseCoopers Professor of Accounting Brigham Young University 3 August 2008

Key Points 1. Teach the use of basic valuation models. 2.Teach where fair value numbers are used in financial reporting. 3.Teach the Level 1, 2, and 3 disclosures required in SFAS No. 157. 4. Instructors, and then their students, must learn more about the basics of derivatives.

Table of Contents

Questions to Consider (page 2) a.Should accounting professors teach FAIR VALUE, or should we subcontract this to finance professors? Current coverage of time value of money is a good model. Discuss and use in both accounting and finance. In accounting classes, come back to it over and over.

Questions to Consider (page 3) b. Where can we fit this material in an already-crowded accounting curriculum? Sprinkled in various courses where appropriate Examples are given in your packet. Yes, some of our favorite old topics are going to have to be cut back or even eliminated.

Questions to Consider (page 3) c. Where should accounting students learn about spreadsheet modeling? Chicago voting is a good model – early and often. The practitioners told us that this is extremely important.

Table of Contents

Introductory Financial Accounting Important to change what we teach, and the way we teach, in the very first accounting class.

Introductory Financial Accounting We have been saying for years that our students need more Unstructured problems Business focus Fair value is a perfect setting in which to do this.

a. Purchased land for $220,000 one year ago. Introductory Financial Accounting Example A (page 5) – At What Amount Should Land Be Recorded? a. Purchased land for $220,000 one year ago. b. Lorien would have to pay $260,000 to buy an equivalent piece of land now (but she has special skills). c. She can sell this land for $310,000 less $20,000 in various fees to finalize the sale. Comparable land sales data 13,000 square feet Average sales price = $21.55 per square foot Low sales price = $20.06 per square foot High sales price = $24.78 per square foot

Introductory Financial Accounting Example A – At What Amount Should Land Be Recorded? Question: Lorien can use only a single number to report the value of the land in her balance sheet; at how much should Lorien report the land?

reflects the general rise in prices Introductory Financial Accounting Example A – At What Amount Should Land Be Recorded? Historical cost = $220,000 very reliable Replacement cost = $260,000 reflects the general rise in prices updated purchase price (with Lorien’s skill) But it is a hypothetical price

Net realizable value = $290,000 Includes a profit Introductory Financial Accounting Example A – At What Amount Should Land Be Recorded? Net realizable value = $290,000 Includes a profit Reflects Lorien’s special skill Fair value = $280,150 (= $21.55 × 13,000) Does NOT reflect Lorien’s special skill Hypothetical arms’-length price

Yes, but what is the answer? Introductory Financial Accounting Example A – At What Amount Should Land Be Recorded? Yes, but what is the answer?

4. Investment securities 5. Land 6. Building Introductory Financial Accounting Example B (page 7) – Does Measuring Asset Amounts Depend on the Type of Asset? Assets 1. Cash 2. Accounts receivable 3. Inventory 4. Investment securities 5. Land 6. Building

Introductory Financial Accounting Example B – Does Measuring Asset Amounts Depend on the Type of Asset? Measurement alternatives a. Historical cost: amount paid to acquire an asset (adjusted for depreciation) b. Replacement cost: amount that would have to be paid to acquire the same or an equivalent asset c. Fair value: the price that would be received to sell an asset in an orderly transaction between market participants d. Net realizable value: amount of cash into which an asset is expected to be converted in due course of business less direct costs, if any, necessary to make that conversion

Introductory Financial Accounting Example B – Does Measuring Asset Amounts Depend on the Type of Asset? Question: For each of the six assets, state which one of the four measurement alternatives should be used. Explain your choice.

the “hypothetical” sales price is not so hypothetical and Introductory Financial Accounting Example B – Does Measuring Asset Amounts Depend on the Type of Asset? Student insight For investment securities, FAIR VALUE is a good measurement when there are active markets because the “hypothetical” sales price is not so hypothetical and market participants approximate price takers so there isn’t much difference between entry and exit prices.

Introductory Financial Accounting Example C (page 9) – Valuing Buildings With Market Multiples

Introductory Financial Accounting Example C – Valuing Buildings With Market Multiples

Question: Estimate the fair value of each of the five buildings. Introductory Financial Accounting Example C – Valuing Buildings With Market Multiples Question: Estimate the fair value of each of the five buildings.

Numerical solution on page 10. Introductory Financial Accounting Example C – Valuing Buildings With Market Multiples Numerical solution on page 10. Student insight: These “fair values” are NOT simply pulled out of thin air.

Introductory Financial Accounting Example D (page 11) – Valuing of Bonds Held as Investment Securities

Introductory Financial Accounting Example D – Valuing of Bonds Held as Investment Securities

Question: Estimate the fair value of each of the five bonds. Introductory Financial Accounting Example D – Valuing of Bonds Held as Investment Securities Question: Estimate the fair value of each of the five bonds.

Numerical solution on page 12. Introductory Financial Accounting Example D – Valuing of Bonds Held as Investment Securities Numerical solution on page 12. Student insight: Some “fair values” are more reliable than others.

Introductory Financial Accounting We have been saying for years that our students need more Unstructured problems Business focus Fair value is a perfect setting in which to do this in the very first accounting class.

Introductory Managerial Accounting (page 13) Capital budgeting special case of discounted cash flow analysis good setting in which to help students hone (or learn) their spreadsheet skills

Introductory Managerial Accounting Capital Budgeting Spreadsheet Assignment I show them a completed sample. I require them to make their own spreadsheet using mine as a model and do sensitivity analysis using their spreadsheet.

Introductory Managerial Accounting Capital Budgeting Spreadsheet

Introductory Managerial Accounting Capital Budgeting Spreadsheet

Introductory Managerial Accounting Capital Budgeting Spreadsheet You have the assignment and the solution on pages 13 through 18. We will make the spreadsheet itself available to you.

Introductory Managerial Accounting Capital budgeting special case of discounted cash flow analysis good setting in which to help students hone (or learn) their spreadsheet skills

Intermediate Financial Accounting This is where the fair value “heavy lifting” occurs. It will be a lot easier if students have been prepared with concepts and tools in the introductory courses.

Intermediate Financial Accounting Business Valuation and Impairment-Related Asset Valuation

Three important skills Financial statement articulation Intermediate Financial Accounting Cash Flow Projection Models (page 20) Three important skills Financial statement articulation Spreadsheet modeling Cash flow projection

Intermediate Financial Accounting Cash Flow Projection Models (page 21)

Intermediate Financial Accounting Cash Flow Projection Models (page 22)

Intermediate Financial Accounting Cash Flow Projection Models Pages 23 and 24 Series of questions to be distributed (after they have constructed their spreadsheets) and discussed in class.

Intermediate Financial Accounting Cash Flow Projection Models (Question 1)

Intermediate Financial Accounting Cash Flow Projection Models (Question 6)

Intermediate Financial Accounting Cash Flow Projection Models Three important skills Financial statement articulation Spreadsheet modeling Cash flow projection

long-dated currency swap three-year option on exchange-traded shares Intermediate Financial Accounting Introduction to Derivatives (page 25) From paragraphs A24 and A25 of SFAS No. 157: long-dated currency swap three-year option on exchange-traded shares receive-fixed, pay-variable interest rate swap based on the LIBOR swap rate

Intermediate Financial Accounting Introduction to Derivatives Pages 25 through 34 1. Understand what a derivative is and how derivatives can be used to help manage risk. 2. Identify the different types of risk faced by a business. 3. Describe the characteristics of the following types of derivatives: swaps, forwards, futures, and options. Define hedging, and outline the difference between a fair value hedge and a cash flow hedge. 5. Understand the basics of accounting for derivatives

Intermediate Financial Accounting Introduction to Derivatives (pages 33,34)

Intermediate Financial Accounting Introduction to Derivatives Students completing intermediate financial accounting should know 1. What a derivative is 2. The different types of risk faced by a business 3. Characteristics of swaps, forwards, futures, and options What hedging is 5. The basics of accounting for derivatives

Intermediate Financial Accounting The Fair Value Option (page 35) Under SFAS No. 159, a company has the option to report, at each balance sheet date, any or all of its financial assets and liabilities at their fair values on the balance sheet date. Why? – “Mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions.”

Intermediate Financial Accounting The Fair Value Option (page 35) Simple balance sheet One asset, a bond investment One liability, a bond payable No equity Both bonds issued at par and are $1,000 face value 20 years 10% coupon rate

Intermediate Financial Accounting The Fair Value Option (page 35)

Intermediate Financial Accounting The Fair Value Option (page 36)

Intermediate Financial Accounting The Fair Value Option (page 37)

Intermediate Financial Accounting The Fair Value Option Student insight In spite of all of the criticism about “fair value accounting,” it looks like the FASB’s ideas aren’t all bad.

Intermediate Financial Accounting Fair Value Disclosures (page 41) Level 1 inputs – quoted prices in active markets for identical assets (or liabilities). Level 2 inputs – observable inputs other than quoted prices in active markets for identical assets. Level 3 inputs – unobservable inputs.

Intermediate Financial Accounting Fair Value Disclosures (page 42)

Intermediate Financial Accounting Fair Value Disclosures Student insight After the background exposure to valuation models of all sorts, the division into these three levels makes perfect sense.

Key Points 1. Teach the use of basic valuation models. 2.Teach where fair value numbers are used in financial reporting. 3.Teach the Level 1, 2, and 3 disclosures required in SFAS No. 157. 4. Instructors, and then their students, must learn more about the basics of derivatives.

eks@byu.edu Email me if you want soft copies of this material.