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Fair Value Measurement

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Fair Value MeasurementThird Edition

Practical Guidance and Implementation

MARK L. ZYLA

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To my wife, Jo Ann, and my son, Jack.You make this all possible …And to my dad, Larry Zyla,

Thank you … for everything.

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Contents

Preface xiii

Acknowledgments xix

Chapter 1: The History and Evolution of Fair Value Accounting 1

Why the Trend Toward Fair Value Accounting? 2History and Evolution of Fair Value 5Fair Value Accounting and the Economic Crisis 12The FASB and IASB Convergence Project 17The Future of Fair Value Measurement 23Fair Value Quality Initiative for Valuation Specialists 24Conclusion 26Notes 26

Appendix 1A: The Mandatory Performance Framework 31

Performance Requirements 31Conclusion 33Notes 46

Chapter 2: Fair Value Measurement Standards and Concepts 47

FASB ASC 820, Fair Value Measurement 48Disclosures 67Fair Value Option 70Standards in the Valuation Profession and Fair Value Measurements 77Conclusion 79Notes 80

Appendix 2A: Taxes and Fair Value Measurements 81

Summary of Changes under 2017 TCJA 81

Chapter 3: Business Combinations 85

Mergers and Acquisitions 86Accounting Standards for Business Combinations—A Brief History 88ASC 805, Business Combinations 90Other Business Combination Highlights 95

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viii ◾ Contents

Subsequent Accounting for Goodwill and Other Intangible Assets 99Conclusion 100Notes 101

Chapter 4: The Nature of Goodwill and Intangible Assets 103

History of Intangible Assets 104Intellectual Property 105Economic Basis of Intangible Assets 106Identification of Intangible Assets 106Useful Life of an Intangible Asset 111Intangible Assets and Economic Risk 112Goodwill 112Economic Balance Sheet 114Conclusion 116Notes 117

Chapter 5: Impairment 119

Evolution of Impairment Testing 120Applicable FASB Guidance for Impairment Testing 122Accounting for the Impairment of Long-Lived Assets 123Goodwill Impairment Testing—Public Companies 125Goodwill Impairment—One-Step Impairment Loss 138Testing Other Indefinite-Lived Intangible Assets for Impairment 139Amortization of Goodwill 139Conclusion 140Notes 140

Appendix 5A: Example of a Qualitative ImpairmentAnalysis—PlanTrust, Inc. 143

Financial Accounting Standards Board ASC 350, Intangibles—Goodwill and Other 143

PlanTrust, Inc. 144Notes 159

Chapter 6: The Cost Approach 161

The Cost Approach under FASB ASC 820, Fair Value Measurement 162Economic Foundation for the Cost Approach 164Cost versus Price versus Fair Value 164The Role of Expected Economic Benefits in the Cost Approach 166Reproduction Cost versus Replacement Cost 167Components of Cost 168Obsolescence 169The Relationships Among Cost, Obsolescence, and Value 170Physical Deterioration 171Functional (Technological) Obsolescence 172

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Contents ◾ ix

Economic (External) Obsolescence 173Applying the Cost Approach 174Taxes Under the Cost Approach 178Limitations of the Cost Approach 179Conclusion 179Notes 180

Chapter 7: The Market Approach 183

Applying the Market Approach When Measuring the Fair Value of an Entity ora Reporting Unit of an Entity 184

Conclusion 213Notes 213

Chapter 8: The Income Approach 215

Introduction 215Discounted Cash Flow Method 216Multiperiod Excess Earnings Method 223FASB Concepts Statement 7 239Rates of Return Under the Income Approach 244The Income Increment/Cost Decrement Method 245Profit Split Method 246Build-Out, or Greenfield, Method 251Weighted Average Cost of Capital Calculation 251Conclusion 258Notes 259

Chapter 9: Advanced Valuation Methods for Measuring the Fair Valueof Intangible Assets 261

Introduction 261Limitations of Traditional Valuation Methods 261Real Options 263Using Option Pricing Methodologies to Value Intangible Assets 266Black-Scholes Option Pricing Model 269Binomial or Lattice Models 272Monte Carlo Simulation 277Decision Tree Analysis 280Conclusion 281Notes 281

Chapter 10: Measuring the Remaining Useful Life of Intangible Assetsin Financial Reporting 283

FASB Guidance on Determining the Remaining Useful Life 283Considerations in Measuring Useful Lives of Intangible Assets 285Practical Guidance for Estimating and Modeling the Useful Life 289Conclusion 295Notes 295

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Chapter 11: Fair Value Measurement for Alternative Investments 297

Introduction 297Investments in Certain Entities That Calculated Net Asset Value per Share 299AICPA Technical Practice Aid 300AICPA Guidance for Determining the Fair Value of Investment 301AICPA Accounting and Valuation Guide, Valuation of Portfolio Company

Investments of Venture Capital and Private Equity Funds and OtherInvestment Companies 305

International Private Equity and Venture Capital Valuation Guidelines 306Common Valuation Methodologies of Measuring the Fair Value of the Fund’s

Investment Portfolio 307Conclusion 308Notes 308

Chapter 12: Contingent Consideration 311

Contingent Consideration: Earn-outs in Business Combinations 311Accounting for Contingent Consideration 312Conclusion 324Notes 324

Appendix 12A: Measuring the Fair Value of a Nonfinancial ContingentLiability—Example of a Loan Guarantee 327

The Jordan Lee Fund Guarantee of Townsend Farm Development, LLC 328Notes 334

Chapter 13: Auditing Fair Value Measurement 335

Auditing Standards 336The Audit Process 338Evolution of Audit Standards for Fair Value Measurements and Disclosures 342Auditing Standard 2501, Auditing Accounting Estimates, Including Fair Value

Measurements 344Auditing Standards for Auditor’s Use of the Work of Specialists 349Proposed International Standard on Quality Management 1 354Practical Guidance for Auditors 354PCAOB Staff Audit Practice Alert No. 9, Assessing and Responding to Risk in

the Current Economic Environment 356AICPA Nonauthoritative Guidance 358The Appraisal Foundation 359Conclusion 359Notes 360

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Contents ◾ xi

Appendix 13A: Auditing Fair Value Measurement in a BusinessCombination 363

Auditor Questions 363General 363Income Approach 364Cost Approach 366Market Approach—General 367

Appendix 13B: Auditing Fair Value Measurement in a GoodwillImpairment Test 369

General 369Income Approach 370WACC 371The Market Approach 372

Chapter 14: Fair Value Measurement Case Study 373

Learning Objectives 373Business Background and Facts—Dynamic Analytic Systems, Inc. 374Notes 406

Appendix 14A: Suggested Case Study Solutions 407

Note 437

Appendix 14B: Model Fair Value Measurements Curriculum 439

Acknowledgments 439AICPA Staff 440About Us 440Preface 440Model Fair Value Measurement Curriculum 440Appendices and Examples 448Note 451

Glossary of International Business Valuation Terms 453

Bibliography 463

About the Author 475

Index 477

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Preface

F AIR VALUE MEASUREMENTS AND DISCLOSURES continues to be an area oftremendous interest in financial reporting. Although the Fair Value Measurementsframework is fully converged under U.S. GAAP (ASC 820 Fair Value Measurements)

and IFRS (IFRS 13 Fair Value Measurements), best practices of the measurements themselveshave continued to evolve. Over the past 10 years, organizations such as the AICPA and theAppraisal Foundation have developed varied guidance on best practices on measuring fairvalue for valuation specialists. In December 2018, the PCAOB finalized AS 2501, AuditingAccounting Estimates, Including Fair Value, and AS 1201, Auditor’s Use of a Specialist, to provideadditional guidance to auditors in auditing fair value. The valuation profession recentlydeveloped a Fair Value Quality Initiative to enhance that profession’s involvement in financialreporting, resulting in the new Certified in Entity and Intangible Valuation (CEIV) credentialand the Mandatory Performance Framework (MPF).

In December 2018, the International Accounting Standards Board issued a report ontheir postimplementation review of IFRS 13, Fair Value Measurements. Both the IASB andthe FASB regularly conduct reviews of newly implemented accounting standards to assesswhether the standards are working as intended. The FASB conducted a postimplementationreview in 2014 and concluded that the then-titled FASB Statement 157 “met its objectives.”1

The IASB concluded that the information required by IFRS 13 is “useful to users of financialstatements.”2

Investor-focused organizations such as the CFA Institute have concluded from a series ofsurveys of their members that “where fair value has been implemented over the past 15–20years there is greater acceptance as to its appropriateness, relevance and reliability.”3 A 2013CFAI Survey on Fair Value Accounting & Long-Term Investing in Europe summarizes theimportance of fair value measurements in financial reporting to investors across the globe.

Simply put all investors buy, sell, and hold their investments based on fair value infor-mation. Fair value information is necessary to judge current financial health, is aninput to predicting future performance, and helps in the judgment of how effectivelymanagement is fulfilling its stewardship function.4

Clearly, fair value measurements enhance the public trust in financial reporting.The third edition of Fair Value Measurement: Practical Guidance and Implementation, which

includes substantial new discussion material and many new comprehensive examples, is orga-nized as follows:

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xiv ◾ Preface

Chapter 1: The History and Evolution of Fair Value Accounting◾ Provides a historical look at the development of fair value concepts and accounting

standards.◾ Includes milestones related to the development of fair value for financial instruments and

fair value measurement of nonfinancial assets and liabilities.◾ Explains how the economic crisis shaped fair value measurement and how the crisis led

to the refinement of several accounting standards.◾ Discusses how the proposed convergence of U.S. GAAP with IFRS has shaped fair value

measurement concepts, despite the unlikely full convergence of both standards.◾ Introduces trends that are likely to continue to affect fair value measurement including

different levels of disclosures for public and privately held entities.◾ Introduces the Fair Value Quality Initiative and the Mandatory Performance Framework.◾ Includes, in an appendix, a checklist of items to consider under the Mandatory Perfor-

mance Framework.

Chapter 2: Fair Value Measurement Standards and Concepts◾ Presents an overview of fair value measurement in U.S. GAAP and with cross references

to FASB ASC 820, Fair Value Measurement.◾ Examines important fair value framework concepts such as the principal or most advan-

tageous market, market participants, the highest and best use for nonfinancial assets,inputs to fair value measurements, and the fair value hierarchy.

◾ Discussed the application of FASB ASC 825, Financial Instruments, which provides the fairvalue option for financial instruments.

◾ Includes an explanation of standards in the valuation profession, including a discussionof Uniform Standards of Professional Appraisal Practice (USPAP) and InternationalValuation Standards (IVS).

◾ Provides, in an appendix, the impact of the Tax Cut and Jobs Act (TCJA) of 2017 on fairvalue measurements.

Chapter 3: Business Combinations◾ Discusses the role merger and acquisition transactions play in our economy, including

trends and pitfalls.◾ Discusses the development of accounting standards for business combinations.◾ Covers the requirements of ASC 805, Business Combinations.◾ Discusses private company alternative accounting under ASU 2014-18.◾ Provides comprehensive examples.

Chapter 4: The Nature of Goodwill and Intangible Assets◾ Provides a brief overview of intangible assets and intellectual property, including the

increasingly prominent role these assets contribute to the overall business enterprisevalue.

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Preface ◾ xv

◾ Touches on the criteria for recognizing goodwill and intangible assets in financial report-ing and for estimating their useful lives.

◾ Provides the classification and examples of intangible assets from FASB ASC 805, BusinessCombination, as well as many other examples.

Chapter 5: Impairment◾ Discusses the evolution of testing goodwill for impairment under various accounting

standards.◾ Includes a description of the alternative accounting for private companies under ASU

2014-02.◾ Includes a discussion of the “one-step” impairment test under ASU 2017-04, Simplifying

the Test for Goodwill Impairment.◾ Covers the qualitative goodwill impairment test as well as the challenges of the prior

two-step quantitative impairment test.◾ Discusses the applicable guidance for testing goodwill, intangible assets, and long-lived

assets for impairment and the order of testing.◾ Provides insight into the discussion about whether goodwill impairment testing should

be at the equity or enterprise level.◾ Includes an appendix with a comprehensive example of a valuation specialist’s report pre-

pared for a qualitative goodwill impairment analysis.

Chapter 6: The Cost Approach◾ Discusses the cost approach to fair value measurement, including the economic basis for

the cost approach, the role of expected economic benefits, and economic obsolescence.◾ Distinguishes between reproduction cost and replacement cost.◾ Provides examples for applying the cost approach using historical trending, the unit cost

method and the unit of cost method.◾ Addresses how taxes and other factors may impact the application of the cost approach.

Chapter 7: The Market Approach◾ Covers measuring the fair value of an entity using a market approach such as the guide-

line public company method or the guideline transaction method.◾ Provides insight to control premiums and synergies under this method.◾ Discusses the development and application of equity and invested capital multiples.◾ Covers the application of the market approach to measure the fair value of intangible

assets.◾ Provides updated examples of use of various techniques under the market approach.

Chapter 8: The Income Approach◾ Examines the workhorse of valuation methods, the discounted cash flow method, includ-

ing single-period and multiperiod variations.

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◾ Provides an in-depth look at the multiperiod excess earnings method, including marketparticipant assumptions in projected financial information and the role of contributoryassets and their required returns.

◾ Provides examples of other income approach methods used in business combinations,such as the profit split method and the “with and without” method.

◾ Addresses the weighted average cost of capital and its calculation under the build-upmethod and the capital asset pricing model.

◾ Provides updated examples of various valuation techniques under the market approach.

Chapter 9: Advanced Valuation Methods for Measuring the Fair Value ofIntangible Assets

◾ Introduces advanced valuation techniques such as the option-pricing methods, MonteCarlo simulation, and decision tree analysis.

◾ Discusses real options derived from the ownership rights of intangible assets and how tomeasure their fair value.

Chapter 10: The Remaining Useful Life of Intangible Assets◾ Distinguishes between finite-lived assets and indefinite-lived assets.◾ Provides factors to consider when measuring the useful lives of intangible assets, includ-

ing the legal, contractual, and useful lives.◾ Provides examples of various approaches to calculating the remaining useful lives of

intangible assets.

Chapter 11: Fair Value Measurement of Alternative Investments◾ Discusses authoritative guidance for determining the fair value measurement of alterna-

tive investments, including recent AICPA Technical Practice Aids.◾ Addresses the practical expedient for investments that calculate net asset value per share.◾ Distinguishes initial due diligence features of an alternative investment from ongoing

monitoring features.◾ Discusses the new AICPA Accounting and Valuation Guide, Valuation of Portfolio Company

Investments of Venture Capital and Private Equity Funds and Other Investment Companies.

Chapter 12: Contingent Consideration◾ Discusses the accounting recognition of earn-outs and other contingent consideration in

business combinations.◾ Discusses the common ways that earn-out clauses are used to resolve price differences

between buyers and sellers in a business combination.◾ Provides examples of measuring the fair value of contingent consideration using a

probability-weighted expected return method, the Black-Scholes option pricing model,and Monte Carlo simulation.

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Preface ◾ xvii

◾ An appendix to Chapter 12 explains how to measure the fair value of a loan guaranteeusing the Black-Scholes option pricing model and includes a case study example to illus-trate the concepts.

Chapter 13: Auditing Fair Value Measurement◾ Discusses the guidance for auditing fair value measurements in AU 328.◾ Includes a discussion on the PCAOB’s new auditing standards AS 2501, Auditing Account-

ing Estimates, Including Fair Value, and AS 1201, Auditor’s Use of a Specialist.◾ Includes important topics from PCAOB Alert No. 2, including auditing fair value

measurements, classification within the fair value hierarchy, and using the work of avaluation specialist or a pricing service.

◾ Discusses the PCAOB Alert No. 9, Assessing and Responding to Risk in the Current EconomicEnvironment.

◾ Appendixes A and B provide examples of issues auditors may consider when auditingbusiness combinations and one-step goodwill impairment tests.

◾ Appendix C examines the results of PCAOB inspection reports in Acuitas, Inc.’s Survey ofFair Value Audit Deficiencies.

Chapter 14: Fair Value Measurement Case Study◾ Provides a new streamlined comprehensive business combination case study with valu-

ation models illustrating the measurement of fair value for intangible assets.◾ Covers important topics such as the acquisition price, contingent consideration, business

enterprise value, the weighted average cost of capital, identifying intangible assets, good-will, a bargain purchase, and subsequent testing for impairment of goodwill.

◾ Highlights important case study concepts through a question-and-answer format withsuggested solutions.

As I noted in the preface of the first two editions, some have voiced concerns about thecost-benefit associated with measuring fair value in financial reporting. However, as reportedby the accounting standard setters and the CFA Institute, the benefits of fair value in financialreporting are clearly evident. Fair value measurements, however, do require a certain amountof judgment and expertise. Clearly, there are some challenges. However, the benefits to users offinancial statements that include fair value measurements vastly outweigh those challenges.Hopefully this third edition will continue to help with those challenges.

MARK L. ZYLAAtlanta, Georgia

May 2019

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NOTES

1. Response of the Financial Accounting Standards Board on the Post-Implementation Review ofFAS 157, letter from Russ Golden, Chair of the FASB, to the Financial Accounting Foundation,dated March 10, 2014.

2. Post-Implementation Review of IFRS 13, Fair Value Measurement, December 2018, www.ifrs.org.

3. “Summary of CFA Institute Member Surveys,” September 2010, www.cfa.institute.org.4. “Value Accounting & Long-Term Investing in Europe,” CFA Institute, September 2013, www

.cfainstitute.org.

http://www.cfa.institute.org

http://www.cfainstitute.org

http://www.cfainstitute.org

www.ifrs.org

www.ifrs.org

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Acknowledgments

M OST IMPORTANTLY, I want to thank Lynn Pierson for her assistance with thisbook. Without Lynn’s efforts, this third edition as well as the first and second,would not have been completed with nearly the quality and depth.

Finally, thank you to those who provided comments and suggestions on various aspectsof fair value measurements which were instrumental in preparing this third edition as wellas the first and second, including: Bill Kennedy of Duff & Phelps; Julie Delong of AnkuraConsulting Group LLC; Teresa Thamer of Brenau University; Brian Steen of Dixon HughesGoodman LLP; Brent Solomon of the University of Maryland; Tara Marino of the CohnReznickLLP; Mark Edwards of Grant Thornton International Ltd; Michael Blake of Arpeggio Advisors;John Lin of McKesson Corporation; Adrian Loud of Censeo Advisors LLC.; Tracy Haas ofRoark Capital Group; Harold Martin, Peter Thacker and Brian Burns of Keiter; BernardPump of Deloitte LLP; Jim Dondero of Andersen; Ellen Larson of FTI Consulting; SteveHyden of Washington Partners; David Dufendach of Alverez & Marsal; Ed Ketz of Penn StateUniversity; Neil Beaton of Alvarez & Marsal; Tom Ryan of the Leventhal School of Accountingat University of Southern California and Professor Mauro Bini of Bocconi University andChairman of the Management Board of OIV—Organismo Italiano di Valutazione.

These individuals’ comments, as well as those of many others, were invaluable in mypreparation of this book. Any errors, however, are my own.

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1CHAPTER ONE

The History and Evolutionof Fair Value Accounting

F AIR VALUE ACCOUNTING has changed the way financial information is pre-sented. Where once financial statements were based primarily on historical costs,under certain circumstances, fair value is often the basis of measurement for reporting

for both financial and nonfinancial assets and liabilities. Measuring fair value often requiresexperience and judgment, and it has the potential to introduce bias into financial statements.A trend toward increasing the amount of financial statement information presented ordisclosed at fair value persists under U.S. generally accepted accounting standards (GAAP)and International Financial Reporting Standards (IFRS). The trend away from historicalcosts, which has been the bedrock of traditional accounting, toward fair value accountinghas been challenging for preparers, auditors, standards setters, and regulators.

Fair value accounting is a financial reporting approach that requires or permits entitiesto measure and report assets at the price assets would sell and liabilities at the estimated pricethat a holder would have to pay in order to discharge the liability. The term fair value account-ing not only refers to the initial measurement but can also refer to subsequent changes in fairvalue from period to period and the treatment of unrealized gains and losses in the financialstatements. Therefore, fair value accounting affects the reported amounts for assets and lia-bilities in the balance sheet and affects the reported amounts for unrealized gains or lossesshown in the income statement or in the other comprehensive income section of sharehold-ers’ equity. In financial reporting, fair value accounting is often applied to financial instru-ments such as investments in stocks, bonds, an entity’s own debt obligations, and derivativeinstruments like options, swaps, and futures. When unadjusted or adjusted market prices arethe basis for fair value estimates of financial assets and liabilities, the process is often calledmark-to-market accounting.

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2 ◾ The History and Evolution of Fair Value Accounting

Fair value accounting is applicable to nonfinancial assets and liabilities as well, but inmore limited circumstances. For instance, when an entity is acquired in a business combi-nation, all balance sheet assets and liabilities are recorded at fair value. Subsequent to theacquisition date, fair value is the basis for testing acquired goodwill for impairment. Likewise,fair value is the benchmark when testing property, plant, and equipment and amortizableintangible assets for impairment.

Fair value measurement is the process for determining the fair value of financial and non-financial assets and liabilities when fair value accounting is required or permitted. Therefore,fair value measurement is broader than mark-to-market accounting. It encompasses estimat-ing fair value based on market prices as well as estimating fair value using valuation models.The Financial Accounting Standards Boards (FASB) Accounting Standards Codification (ASC)820, Fair Value Measurement, provides authoritative guidance for measuring the fair value ofassets, liabilities, and equity interests when fair value accounting is required or permitted inother accounting standards. The International Accounting Standards Board (IASB) has anidentical standard, IFRS 13, Fair Value Measurements.

Advocates of fair value accounting believe that fair value best represents the financialposition of the entity and provides more relevant information to the users of the financialinformation. Detractors believe that fair values are unreliable because they are difficult to esti-mate. Critics also believe that reporting temporary losses is misleading when they are likely toreverse, and those critics believe that reported losses adversely affect market prices and marketrisk.1 In spite of the criticism, fair value accounting has become more prominent in finan-cial statement presentation and will continue to be a fundamental basis for accounting in thefuture.

In December 2018, the IASB published a postimplementation review of IFRS 13, FairValue Measurements, which is conducted periodically by both the IASB and the FASB to deter-mine whether accounting standards are working as intended. In a summary of their findings,the IASB concluded the following:

◾ “The information required by IFRS 13 is useful to users of financial statements.◾ Some areas of IFRS 13 present implementation challenges, largely in areas requiring

judgment. However, evidence suggests that practice is developing to resolve thesechallenges.

◾ No unexpected costs have arisen from application of IFRS 13.2

The IASB further concluded that the findings of the postimplementation review on fairvalue measurements should be incorporated into the project about better communication infinancial reporting. The Board also concluded that it needed to better liaise with the valuationprofession, including monitoring new developments with valuation specialists.

WHY THE TREND TOWARD FAIR VALUE ACCOUNTING?

In recent years, there has been an increasing trend toward the use of fair value accountingin financial reporting. Even when fair value accounting is not required and financial state-ments are prepared using some other measurement basis, there is a likelihood that related


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Why the Trend Toward Fair Value Accounting? ◾ 3

disclosures will require the presentation of fair value information. Several factors are influenc-ing the trend toward fair value accounting: the growing economic importance of intellectualproperty, globalization, and investors’ desire for financial statements that are more relevantand transparent.

The Changing Economy

The economy in the United States has undergone tremendous changes over the pastquarter-century due to a rapid rate of technological innovation. The explosion in the use ofpersonal computers and digital media has created whole industries that did not previouslyexist. One product of technological innovation that contributed to economic change is thecommercialization of the Internet, which resulted in what some call the information revolution.The result of this technological and economic change is that a significant portion of the U.S.economy shifted from bricks-and-mortar businesses to information-based businesses.

This economic change has led to a growing recognition that the value driver of manybusiness entities lies within their intellectual property, not just in their inventory, plant, andequipment. Financial statement users also recognize that intellectual property has not beeneffectively measured under traditional cost-based accounting practices. The reason is thatexisting accounting principles require internally created intellectual property to be expensedas research and development.

Ocean Tomo, an intellectual capital merchant banking firm, produces an Annual Studyof Intangible Asset Market Value that breaks down the Standard & Poor (S&P) 500’s equitymarket value into an implied intangible asset value and a tangible asset value. In 2015,tangible and financial assets generated approximately 13 percent of the S&P 500’s marketvalue. While tangible and financial assets are reflected on company balance sheets, theremaining 87 percent of value attributable to intangible assets is often not recognized at all.3

The market-to-book ratio for the S&P 500 as of December 31, 2018, was approximately 2.944

This ratio indicates that only about a third of the value of the market capitalization on averageis recognized by current accounting standards. This value gap has increased in recent years,highlighting the increasing importance of intangible assets (including intellectual property)in the overall market capitalization of publicly traded companies.

Globalization

The International Monetary Fund defines economic globalization as “a historical process; theresult of human innovation and technological process. It refers to the increasing integration ofeconomies around the world, particularly through the movement of goods, services and capi-tal across borders.” Globalization has accelerated since the 1980s as a result of technologicaladvances that made international financial and trading transactions easier and quicker.5 Thisincreasing globalization of business has created a need for consistent accounting standardsacross national boundaries.

The FASB and the IASB recognize that users of financial statements would benefit fromhaving one set of international accounting standards that could be used for domestic andinternational, cross-border financial reporting. As a result, both organizations have beenworking for several years to jointly create accounting standards and to converge U.S. GAAP


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with international accounting standards (IAS). According to the FASB, convergence refers toboth the goal of establishing a single set of high-quality international accounting standardsand the path taken to reach that goal, which includes the collaborative efforts “to improveexisting U.S. GAAP and International Financial Standards and eliminate the differencesbetween them.”6 Historically, IAS have been more principal based, requiring more fair valuemeasurement than U.S. GAAP, which are considered more rules based, requiring morecost-based measurement. As the accounting standards converge, U.S. GAAP is requiringmore fair value accounting measures.

The history and evolution of fair value measurement encompasses the recent conver-gence of U.S. GAAP and IAS pertaining to fair value measurement. The five-year joint FASBand IASB project was undertaken to improve and align fair value measurement and disclosurerequirements and to respond to the global financial crisis.7 As originally promulgated, theFASB’s Statement of Financial Accounting Standards (SFAS) 157, Fair Value Measurements andDisclosures, influenced the development of International Financial Reporting Standard (IFRS)13, Fair Value Measurement. Convergence has shaped U.S. accounting standards throughupdates to FASB ASC 820. The FASB’s Accounting Standards Update (ASU) 2011-04,Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S.GAAP and IFRS, which was issued in May 2011, eliminated most of the significant remainingdifferences between U.S. and international accounting standards for measuring fair value.The move and subsequent halting of the Convergence Project as it pertains to fair valuemeasurements is discussed in greater detail in this chapter.

Relevance and Transparency

An important characteristic of efficient capital markets is that prices are the result of themarket’s correct assessment of all available information. The FASB recognizes that betterfinancial reporting leads to stronger capital markets by helping investors make informeddecisions. One of the FASB’s stated goals is “to set accounting standards that produce financialinformation useful in helping investors decide whether to provide resources to a company,and whether the management of that company has made good use of the resources italready has.”8

In an effort to make financial reporting more relevant to investors, the FASB has encour-aged investors to participate in the accounting standards process by providing comments ondiscussion papers and exposure drafts that are issued at various stages of the FASB’s projects.The FASB has asked interested investors to provide expert advice to the FASB’s designated “in-vestor liaison” staff members in conjunction with FASB projects. The goal is to improve therelevance of accounting standards for investors in a cost-effective manner.

Two other investor advisory groups provide input to the FASB from the investor perspec-tive, the Investors Technical Advisory Committee (ITAC) and the Investor Task Force (ITF).The ITAC is focused on providing technical accounting advice and increasing investor par-ticipation in standard setting.9 The ITF is made up of institutional asset managers who ana-lyze various sectors of the economy. The ITF provides advice to the FASB about the impact ofvarious accounting standards proposals on specific industry sectors.10


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History and Evolution of Fair Value ◾ 5

The Securities and Exchange Commission (SEC) is equally committed to advancing highquality accounting standards that are responsive to investors’ needs. In testimony before aCongressional subcommittee, SEC Director John M. White said,

An open process that allows standards setters to seek and thoughtfully consider theviews of market participants is critical to establishing, maintaining, and continu-ally improving financial accounting and reporting standards. We are committed tohigh quality accounting standards and a transparent financial reporting system thatmeets the needs of investors and other market participants.11

Transparency in financial reporting is the unbiased, clear, complete presentation ofa company’s financial position. Information in the management discussion and analysis(MD&A) section of the financial statements about existing risk and uncertainty and aboutthe likely future impact of risk and uncertainty on the company’s prospects further promotestransparency. When financial reporting is transparent, investors are better able to makedecisions and avoid surprises. On a macroeconomic scale, transparency leads to moreefficient allocation of capital and stronger capital markets. In the aftermath of the economiccrisis, there was a debate about whether fair value accounting promoted financial statementtransparency or whether it caused the meltdown. In a 2008 report to Congress, the SEC foundthat “investors generally believe that fair value accounting increases financial reportingtransparency and facilitates better investment decision-making.”12 The CFA Center forFinancial Market Integrity concurs with the SEC’s view. It supports fair value as “the mosttransparent measurement for investors to analyze financial statements,” and it said, “fairvalue is being used as a scapegoat by corporations who have made poor decisions or were notin compliance with accounting standards.”13

The financial crisis has presented a challenge and an opportunity for the SEC and theFASB to reaffirm their missions and assess their success in achieving their goals. The SEC’smission is to “protect investors, provide for efficient markets, and to facilitate capital forma-tion.”14 The FASB’s mission is “to establish and improve standards of financial accountingand reporting that foster financial reporting by nongovernmental entities that providesdecision-useful information to investors and other users of financial reports.”15 The SEC andthe FASB have renewed their efforts to ensure greater transparency in financial reportingand its relevance to investors since the financial crisis began and are likely to continue to doso for the foreseeable future.

HISTORY AND EVOLUTION OF FAIR VALUE

The FASB’s Accounting Standards Codification (ASC) is the single, authoritative source forU.S. GAAP today. ASC superseded all previously issued U.S. GAAP accounting standards andreorganized them by topic. ASC became effective for interim and annual period beginning afterSeptember 15, 2009.16 ASC 820, Fair Value Measurement (ASC 820), superseded the originalFASB accounting standard SFAS 157 that was issued in 2006. In addition, any FASB StaffPositions that amended SFAS 157 have also been superseded by ASC 820. FASB Accounting


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Standards Updates are included in the Codification once they reach their effective date. Thosethat have not reached their effective date are presented in separate “pending content” sections,adjacent to the subtopic they will replace. ASU 2011-04, Amendments to Achieve Common FairValue Measurement and Disclosure Requirements in U.S. GAAP and IFRS, is effective for all enti-ties with reporting periods beginning after December 15, 2011. Since this discussion in thissection pertains to the history of fair value measurements, the references are as the standardswere originally presented under GAAP, much of which has now been codified under the ASC.

Fair value accounting is not a new requirement in financial reporting. Fair value has beena standard of measurement in financial reporting for decades. The FASB has issued dozens ofstatements that use fair value as the measurement of value. The concept of value containedin these statements is from a market perspective, not from the perspective of the reportingentity. Therefore, measuring fair value requires financial statement preparers to use judg-ment and to make assumptions consistent with those made by other market participants. TheFASB has also issued a few statements with fair value–like measurement standards such asFASB ASC 718, Compensation—Stock Compensation. The main difference between these twomeasurement standards is that the fair value–like measurement standard does not incorpo-rate an exit price assumption and fair value does. The assumptions underlying the fair valuemeasurement framework of ASC 820 are covered in Chapter 2.

In September 2006, the FASB issued SFAS 157 (now codified as ASC 820) to clarify theconcepts related to the measurement of fair value and to provide further implementationguidance.17 According to the FASB, the reason for issuing SFAS 157 was to define fairvalue, establish a framework for measuring fair value, and expand disclosure about fairvalue measurements.18 SFAS 157 did not introduce any new accounting requirements.Instead, it applied to all existing accounting statements that require assets or liabilities to bepresented or disclosed in financial statements at fair value. As originally promulgated, theFASB intended SFAS 157 to provide one uniform statement under which the concept of fairvalue would be more fully explained.

When it was originally issued, SFAS 157 became a source of controversy in the UnitedStates. The banking industry was particularly vocal in its objections to mark-to-marketaccounting. Many criticized its application to liabilities, and preparers felt they needed moreguidance to apply the Statement to nonfinancial assets and liabilities. In response to pressuresfrom financial statement preparers and other constituents, the FASB announced that it woulddelay implementation for nonfinancial assets and liabilities for one year. The announcementcame a few days before the Statement’s original scheduled implementation date. The reasoncited by the FASB for the partial implementation was “to allow the Board and constituentsadditional time to consider the effect of various implementation issues that have arisen, orthat may arise, from the application of Statement 157.”19

Even the partial implementation did not allay all the controversy. Some critics of fair valueaccounting claimed that the credit crisis that began in 2008 was exacerbated by financialinstitutions’ implementation of SFAS 157. The Statement became fully effective for fiscal yearsbeginning after November 15, 2008, for all items, including financial and nonfinancial assetsand liabilities required under existing statements to be measured at fair value.

In order to better understand fair value measurement, this section covers the history andevolution of fair value measurement in financial reporting. It begins with a historical look


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History and Evolution of Fair Value ◾ 7

back at the development of fair value concepts. Then it covers some of the more importantmilestones related to the development of fair value for financial instruments and fair valuemeasurement for nonfinancial assets and liabilities. The economic crisis shaped fair valuemeasurement and led to the refinement of several accounting standards and concepts as reg-ulators and standards setters responded to the crisis. Convergence of U.S. GAAP and IAS hasalso shaped fair value measurement concepts. Finally, this section ends by discussing sometrends that are likely to influence the future of fair value measurement.

Development of Fair Value Concepts

The concept of fair value has been evolving for over a century. In an 1898 U.S. Supreme Courtcase about railroad rate regulation, Smyth v. Ames, the Court discussed some of the conceptsunderlying fair value by saying:

In order to ascertain that value, the original cost of constructions, the amountexpended in permanent improvements, the amount and market value of its stocksand bonds, the present as compared to the original cost of construction, the probableearning capacity of the property under particular rates prescribed by statute, andthe sum required to meet operating expenses, are all matters for consideration,and are to be given such weight as may be just and right in each case. We do notsay that there may not be other matters to be regarded in estimating the value ofthe property.20

This reference to fair value alludes to several fair value measurement concepts thatare currently in use, such as a cost approach, a market approach, economic value, and theapplication of judgment to weigh the various indications of value.

The FASB initially considered adopting the same definition of fair market value used for taxreporting requirements, and using it to describe fair value in financial reporting. However,the FASB ultimately decided on a unique definition for fair value; therefore, the terms fair valueand fair market value are not interchangeable. The fair market value definition found in theInternational Glossary of Business Valuation Terms is the same as the tax definition of fair marketvalue in Revenue Ruling 59-60, which states that it is

the price, expressed in terms of cash equivalents, at which property would changehands between a hypothetical willing and able buyer and a hypothetical willing andable seller, acting at arm’s length in an open and unrestricted market, when neitheris under compulsion to buy or sell and when both have reasonable knowledge of therelevant facts.21

Fair market value is the standard of value in all federal and state tax matters. It is often used tovalue ownership interests in entities, which is consistent with its transaction-based definition.The term fair market value has a significant body of interpretive case law, which was the pri-mary reason the FASB decided to adopt a different standard of value with a specific definitionfor financial reporting.22

Fair value is the standard for financial reporting purposes. Fair value is defined in the FASBMaster Glossary as “the price that would be received to sell an asset or paid to transfer a liabilityin an orderly transaction between market participants at the measurement date.”23


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Although fair market value has a rich history with respect to legal and tax matters, theapplication of fair value to financial reporting is a relatively new development. This sectionlooks at the development of fair value concepts in financial accounting standards from ahistorical perspective.

One of the first accounting statements requiring the use of fair value in financial reportingwas Accounting Principles Board (APB) 18, The Equity Method of Accounting for Investments inCommon Stock, which was issued in 1971. APB 18 introduced the equity method of account-ing for investments in unconsolidated subsidiaries. Under APB 18, a loss would be recognizedwhen the investment’s fair value declined below its carrying value and the loss was consideredto be other than temporary.24

APB 29, Accounting for Nonmonetary Transactions, introduced in 1973, outlined ways tomeasure the fair value of nonmonetary transactions. It indicates that the fair value of a non-monetary transaction should be determined by referring to cash transactions for the same orsimilar assets, quoted market prices, independent appraisals, and the estimated fair value ofthe asset or service received. Any determination of fair value using these methods would alsohave to consider whether the estimated value would be realized.25

In 1977, SFAS 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings,established some important fair value concepts. SFAS 15 specifies that fair value is the amountdetermined through a current sale between a willing buyer and a willing seller, other than ina forced or liquidation sale. It also states,

Fair value of assets shall be measured by their market value if an active market forthem exists. If no active market exists for the assets transferred but exists for similarassets, the selling prices in that market may be helpful in estimating the fair value ofthe assets transferred. If no market price is available, a forecast of expected cash flowsmay aid in estimating the fair value of assets transferred, provided the expected cashflows are discounted at a rate commensurate with the risk involved.26

SFAS 15 established several important criteria for using a market approach and establishedthe use of a discounted cash flow method for measuring fair value. These important conceptspersist in financial reporting today.

Fair Value of Financial Instruments

The FASB has issued several accounting standards that apply to financial instruments includ-ing derivatives. One of the first was SFAS 2, Accounting for Certain Marketable Securities. Issuedin 1975, SFAS 2 required that marketable securities be carried at the lower of cost or marketvalue. It also established the practice of recording changes in the market value of an entity’snoncurrent asset portfolio in a separate component of equity. Therefore, it permitted unreal-ized losses to bypass the income statement.

In 1991, SFAS 107, Disclosures About Fair Value in Financial Instruments, required the fairvalue disclosure of an entity’s financial instruments. The requirement included all financialassets and liabilities, whether recorded or unrecorded in the financial statements.27

SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, was intro-duced in 1993. It established three categories of investment securities: held-to-maturity

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