CHAPTER 6

Fair Value in Financial Reporting

Neil J. Beaton

INTRODUCTION

In May 2003, the Financial Accounting Standards Board (FASB) set forth to provide guidance on fair value in its Board Meeting Minutes (BMM). The BMM was a precursor to adding a fair value measurement project to its agenda in order to address fair value measurement issues broadly, and in June 2004, the FASB issued an Exposure Draft (ED), Fair Value Measurements, based on the BMM and opened such for public comment by constituents. Based on such comments, the FASB issued Statement of Financial Standards (SFAS) No. 157, Fair Value Measurements (SFAS 157), in September 2006, based on the ED and subsequent discussions with various stakeholders including business owner, chief financial officers, accountants, and other interested parties. Further, in July 2009, the FASB issued Accounting Standards Codification (ASC) No. 820, Fair Value Measurement (ASC 820), as part of its codification project that brought together various levels of generally accepted accounting principles (GAAP) into a single, unifying pronouncement. This chapter updates the theory and application of the fair value standard used in the preparation of corporate financial statements since the introduction of ASC 820 (formerly SFAS 157). Although the words are identical, the term fair value is not the same as fair value referred to in dissenters' rights and oppression cases, which is discussed in Chapter 3. The fair value standard in accounting literature refers to the measurement of assets and liabilities in financial statements. The current definition of 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.1

This chapter explains the fair value standard and discusses the history of fair value in accounting literature, the use of the standard as it applies to valuations for financial reporting purposes, and an interpretation of how fair value differs from other standards of value, such as fair market value. The focus of this chapter is on fair value measurement in business combinations and asset impairment tests, since valuation practitioners frequently encounter valuations for these types of assignments. The chapter also discusses audit issues related to fair value measurement.

Fair Value in Financial Reporting: What Is It?

Fair value is the standard of value used in valuations performed for financial reporting purposes on a company's financial statements. The terminology comes from accounting literature, including GAAP and Securities and Exchange Commission (SEC) regulations. In short, fair value strives to revalue assets and liabilities on a company's balance sheet to reflect their fair values, that is, the values at which these assets and liabilities would exchange hands in an orderly transaction between market participants.

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 a reporting entity to determine all of the following:

• The particular asset or liability that is the subject of the measurement (consistent with its unity of account)
• For a nonfinancial asset, the valuation premise that is appropriate for the measurement (consistent with its highest and best use)
• The principal (or most advantageous) market for the asset or liability
• 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 fair value hierarchy within which the inputs are categorized

In the background notes to the ED on fair value measurement, the FASB indicated that prior guidance regarding fair value measurement in the accounting literature was developed piecemeal over time and was contained in a number of different accounting pronouncements, which were not necessarily consistent with one another. The FASB indicated a desire to address these inconsistencies by establishing a framework that would be built on current practice but would also clarify fair value measurements in a manner that would be consistently applied to all assets and liabilities.2

ASC 820 (formerly SFAS 157) covers a wide variety of assets and liabilities, including elements of shareholders' equity. Besides typical assets and liabilities that most accountants are familiar with, ASC 820 also applies to financial derivatives, investments in securities available for sale, asset retirement obligations, guarantees, contingent consideration related to business combinations, and other financial instruments. Although there are a number of other applications of fair value for financial reporting, they are beyond the scope of this chapter. The reader is encouraged to obtain other FASB pronouncements, including ASC No. 815-15, Derivatives and Hedging—Embedded Derivatives, ASC No. 825-10, Financial Instruments—Overall, and ASC 860-50, Transfers and Servicing—Servicing Assets and Liabilities.

APPLICATION OF FAIR VALUE

As noted in the introduction, the definition of 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.” Under ASC 820, fair value is based on the exit price (i.e., the price that would be received to sell an asset or paid to transfer a liability), not the transaction price or entry price (i.e., the price that was paid for the asset or that was received to assume the liability). Although entry and exit prices can be the same, most often they are not since exit prices are typically based on current expectations about the sale or transfer price from the perspective of a market participant and not on what the asset or liability was priced at in the initial exchange. It is important to understand various concepts embodied in fair value measurements. A primary consideration in fair value measurements is the unit of account.

ASC 820-10-35-2B through 35-2E points out that fair value measurements relate to a particular asset or liability. As such, in measuring an asset or liability at fair value, an analyst should incorporate specific characteristics such as restrictions on its sale or use if market participants would take those restrictions into account when pricing the asset or liability at the measurement date. In addition to specified assets or liabilities, fair value measurement can be applied to standalone assets or liabilities or a group of related assets and/or liabilities. The determination of how the fair value measurement applies to an asset or a liability depends on the unit of account. The unit of account is determined based on the level at which the asset or liability is aggregated or disaggregated in accordance with GAAP applicable to the particular asset or liability being measured. As is implied by the foregoing statement, the unit of account can vary depending on the circumstances surrounding the asset or liability. As is discussed later, in a goodwill impairment analysis under ASC 350 (ASC 350-30-35-21 through 35-28), the unit of account can be an entire business unit versus individual intangible asset fair value measurement under ASC 805. The analyst must consider all of the facts and circumstances when deciding on the proper unit of account.

Another important concept under ASC 820, the principal market, is found in ASC 820-10-35-5. Under the concept of a principal market, the transaction takes place either in the market with the greatest volume and level of activity for the asset or liability, or, in the absence of a principal market, in the most advantageous market. The most advantageous market is 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 and transportation costs. It should be noted, however, that the principal market is the market with the greatest volume and level of activity for the asset or liability being measured, not necessarily the market with the greatest volume of activity for the particular reporting entity, assuming the entity has access to that market. If there is no market for a particular asset or liability, a hypothetical market will need to be developed.

As a follow-on to the principal market, the next important concept is that of market participants. Market participants are buyers and sellers in the principal market for the asset or liability. Market participants can be thought of as unrelated parties who are knowledgeable about the asset or liability, are able to enter into a transaction for the asset or liability, and are otherwise willing to enter into a transaction for the asset or liability without compulsion.

One last concept needs to be addressed before turning to the final concept of fair value in this section. Prior to 2011, ASC 820 considered two approaches for determining the highest and best use of an asset: in-use and in-exchange. In-use referred to a valuation premise for an asset that provided maximum value to market participants principally through its use with other assets as a group. In-exchange, on the other hand, referred to a valuation premise for an asset that provided maximum value to market participants on a standalone basis. The amended guidance eliminates the use of these two approaches in favor of other guidance. Under the amended guidance, the concepts of the valuation premise and highest and best use are relevant only when measuring the fair value of nonfinancial assets. Accordingly, the fair value of financial instruments must be measured individually at the level of the unit of account discussed earlier.

The final concept covered in this section is the fair value hierarchy (ASC 820-10-35) from which inputs to valuation techniques used to measure fair value are prioritized into three broad levels, as follows:

Level 1 inputs should be used whenever such evidence is available. Inputs subject to contracts must be observable for substantially the full term to qualify as Level 2. Valuations using Level 3 inputs require significantly more disclosure, and, when material, sensitivity testing. The level designation in the fair value hierarchy is based on the lowest level input that is significant to the fair value measurement, although the term significant is not defined in ASC 820. In assessing the significance of a market input, the appraiser should consider the sensitivity of the asset's or liability's fair value to changes in the input used. Assessing the significance of an input will require judgment considering factors specific to the asset or liability being valued. By the design of the principles-based standard, determining the significance of a market input is a matter of judgment. As such, different practitioners assigning level designations to the same asset or liability using similar unobservable inputs may reach different fair value conclusions.

Although ASC 820 contains a plethora of other guidance, for purposes of this chapter, the focus is on the use of fair value as a standard of value in financial reporting. As such, other concepts contained in the pronouncement are beyond the scope of this chapter. The reader is again encouraged to read the entire ASC 820 and the amendments contained in Accounting Standard Updates (ASUs) to gain a fuller understanding of this comprehensive fair value statement.

History of Fair Value in U.S. Accounting Literature

Fair value is a term that has long been used in the accounting literature. However, the term was often mentioned without providing either a definition or guidance on how to measure it. Therefore, the theory and application of fair value for financial reporting purposes was developed piecemeal over time.3 Early reference to the term fair value dates to 1953 with the issuance of Accounting Research Bulletin No. 43—Restatement and Revision of Accounting Research Bulletins. ARB 43 is itself a restatement of even earlier accounting statements. Other early accounting pronouncements that reference fair value include Accounting Principles Board Opinions APB No. 29, Accounting for Non-monetary Transactions, issued in 1973, and FASB No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, issued in 1977.

Accounting statements in the United States are promulgated by the FASB. Prior to a project that resulted in the 2004 issuance of an ED on fair value measurement, the FASB had formally addressed the definition and usage of the fair value standard primarily in the context of reporting for financial instruments.4 Examples of financial instruments include cash and short- and long-term investments. In 1986, the FASB added a project to its agenda on financial instruments and off-balance-sheet financing, which ultimately led to the issuance in 1991 of SFAS No. 107, Disclosures About Fair Value for Financial Instruments, and the issuance in 1998 of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities. In developing these statements, the FASB adopted a long-term objective of measuring all financial instruments at fair value.5

Use of the fair value standard in business combinations dates to APB 16 and APB 17, which were issued in 1970. These rulings were in effect for over 30 years and provided no definition of the term and little guidance on how to measure it. During the 1980s, there was a significant increase in the amount of merger and acquisition activity. At the same time, the U.S. economy's shift toward service-oriented and information-oriented businesses continued. With these phenomena, the stock of some public companies began trading at increasingly higher multiples of book value. Interest increased in how to explain these phenomena as being the result of intangible value, either developed internally or purchased in a business combination. Intangible assets included intellectual property such as trademarks, trade names, patented technology, knowhow, trade secrets, formulas and recipes, and the value of research and development.

As intangible value became more important to the enterprise value of corporations, discussions on how to account for intangible value increased. Internally developed intangible assets are not recorded on a company's balance sheet for financial reporting purposes, but intangible assets purchased in a business combination are. However, lack of sufficient guidance on how to measure the fair value of assets in business combinations led to diversity of practice and the potential for different results in the measurement of comparable assets across a broad spectrum of businesses. For example, some companies combined their intangible assets, purchased in a business combination with goodwill, whereas other companies did not.

In some cases abuses were alleged, for example, in the valuation and write-offs of large amounts of in-process research and development (IPR&D) for business combinations in the technology sector in the mid-to-late 1990s. In a 1998 letter from the SEC to the American Institute of Certified Public Accountants (AICPA), then–chief accountant of the SEC, Lynn Turner,

challenged the AICPA to take a larger leadership role, by developing detailed, broad-based guidance on valuation models and methodologies used (a) to measure fair value, under the oversight of the FASB, and (b) in auditing fair value estimates.6

The AICPA responded by forming a task force of accountants and valuation professionals to study the issue. In 2001, the AICPA Practice Aid, Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus on Software, Electronic Devices, and Pharmaceutical Industries (IPR&D Practice Aid), was issued. The introduction to the IPR&D Practice Aid cites that its purpose was:

to bring together a task force to determine best practices in the valuation of IPR&D for financial reporting in business combinations.7

Meanwhile, the SEC continued to voice its opinion by also offering comments on the application on the fair value of assets in financial reporting to a variety of other topics, including segregation of identifiable intangible assets from goodwill, goodwill impairment charges, customer-related intangible assets, and amortization of finite-lived intangible assets. In a 2000 speech at the Annual Conference on Current SEC Developments, a member of the SEC staff suggested:

Standard-setters must provide more detailed, how-to accounting, valuation, and auditing guidance.

The profession must work together and with others outside the profession including users and valuation experts.

Preparers, auditors, and users must become better educated about fair value accounting.8

Whereas that speech specifically referred to fair value for financial instruments, its guidance has broader application to all assets that require fair value measurement for financial reporting.

The SEC also commented on valuators' and auditors' responsibilities. In a 2001 speech at a securities conference, Mr. Turner stated:

Whether it is in conjunction with the acquisition of a business, the performance of the impairment test, or the evaluation of recorded intangible assets at transition, in almost every instance, companies will be required to obtain the assistance of a competent and knowledgeable professional to assist in the valuation of these intangible assets. Based on the staff's past experiences . . . I have concerns about the results of this process due to the lack of any meaningful guidance on valuation models and methodologies used to measure fair value and the auditing of those measurements.9

Accounting organizations and rulemaking bodies have responded to these challenges in recent years. As a result, the guidance on fair value for financial reporting has increased.

In 2000, the FASB issued FASB Concepts Statement No. 7, Using Cash Information and Present Value in Accounting Measurements, which was the result of a project the FASB had added to its agenda in 1988 to consider present value issues in accounting measurements.10 And, citing increased amounts of merger and acquisition activity as a principal reason, the FASB undertook a new project in 1996 related to accounting for business combinations. This resulted in the issuance in 2001 of SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. Both of these statements provide more specific guidance on fair value than did APB 16 and 17. Of course, since that time, SFAS 141 has been replaced by ASC 805 and SFAS 142 by ASC 350.

In 2003, the FASB formed the Valuation Resource Group (VRG), made up of preparers, auditors, and valuation specialists, to provide a standing resource to the FASB on fair value measurement issues.11 Also in 2003, the Auditing Standards Board issued Statement of Auditing Standards (SAS) No. 101, Auditing Fair Value Measurements and Disclosures.

In the background notes to the ED on fair value measurement that was issued in June 2004, the FASB indicated that prior guidance regarding fair value measurement in the accounting literature was developed piecemeal over time and was contained in a number of different accounting pronouncements, which were not necessarily consistent with one another. The FASB indicated a desire to address these inconsistencies by establishing a framework that would be built on current practice but would also clarify measurement of fair value measurements in a manner that can be consistently applied to all assets and liabilities.12 After an open comment period and further deliberations by FASB, working drafts of the proposed new accounting standard were issued in October 2005 and in March 2006. The adopted version of the new accounting standard on fair value measurement was issued in September 2006. Finally, in July 2009, the FASB launched the ASC discussed in detail in the foregoing sections. The ASC didn't change GAAP, but rather provided a new structure for organizing accounting pronouncements by accounting topic. ASC 820 is now the sole source for guidance on how entities should measure and disclose fair value in their financial statements. Since July 2009, the FASB has made several updates to ASC 820 and other fair value guidance through ASU amendments.

APPLICATION OF THE FAIR VALUE STANDARD TO BUSINESS COMBINATIONS

Use of the fair value standard in business combinations dates to APB 16 and APB 17, which were issued in 1970. APB 16 defines two accounting methods permissible for use in accounting for business combinations: the pooling of interests method and the purchase method. APB 16 compares and contrasts the two methods and delineates the conditions that would trigger the requirement to use one or the other. APB 17 deals with accounting for acquired intangible assets, both identifiable and unidentifiable (i.e., goodwill), which were acquired either singly or in groups, including in business combinations.

In APB 16, fair value is relevant to the purchase method. Fair value is used in connection with the “historical cost” principle as a way to determine the “cost” of the assets acquired.13 In particular, fair value is the standard prescribed to allocate the “cost” of the acquisition to assets that were acquired as a group. APB 16 states:

Acquiring assets in groups requires not only ascertaining the cost of the assets as a group but also allocating the cost to the individual assets which comprise the group. . . . A portion of the total cost is then assigned to each individual asset acquired on the basis of its fair value. A difference between the sum of the assigned costs of the tangible and identifiable intangible assets acquired less liabilities assumed and the cost of the group is evidence of unspecified intangible values.14

Despite providing guidance on using the fair value standard, APB 16 contained no definition of the term, and made no mention of how fair value is to be measured. APB 16 does indicate that independent appraisals could be used as an aid15 in measuring fair value.

APB 17 deals with accounting for intangible assets, both identifiable and unidentifiable (the most common unidentifiable intangible asset being goodwill), that have been acquired by a business. APB 17 describes the characteristics of intangible assets as lacking physical qualities, making evidence of their existence elusive. Furthermore, APB 17 states that the value of an intangible asset is often difficult to estimate and its useful life may be indeterminable.16

The historical cost principle is invoked in APB 17,17 as it is in APB 16. The treatment of acquired intangible assets is to record them at cost on the date they are acquired. Intangible assets acquired as groups are recorded at cost, and the cost is allocated to each identifiable intangible asset in the group based on its fair value.18

APB 17 treats unidentified intangible assets (i.e., goodwill) differently from identifiable intangible assets. Unidentified intangible assets are accounted for using a residual method:

The cost of unidentifiable intangible assets is measured by the difference between the cost of the group of assets or enterprise acquired and the sum of the assigned costs of individual tangible and identifiable intangible assets acquired less liabilities assumed.19

APB 17, like APB 16, does not define the term fair value, and the opinion does not mention how fair value is to be determined. With the lack of a definition for fair value and little guidance in the accounting literature as to how it should be measured, practitioners adapted various methodologies, based on facts and circumstances applicable to particular assignments, including versions of cost, market, and income approaches, to the valuation of tangible and intangible assets for financial reporting purposes in business combinations. As a result, a diversity of practice developed among valuators in the application of fair value to business combinations for financial reporting.

SFAS 141 and SFAS 142 superseded APB 16 and APB 17 in 2001. SFAS 141 reduced the acceptable methods for accounting for business combinations from two to one. The pooling of interests method was eliminated, and effective with the adoption of SFAS 141, all business combinations were to be accounted for using the purchase method. However, SFAS 141 did not fundamentally change the guidance of APB 16 in treating the cost of an acquired entity as its fair value. Absent persuasive evidence to the contrary, the transaction price between buyer and seller was presumed to be the cost of the acquired entity, and hence its fair value. The requirement to allocate cost to the acquired assets based on their fair values remained the same and continues to the present, although now under ASC 805 for business combinations and ASC 350 for goodwill impairment testing.

With a few exceptions, ASC 805 requires the measurement of assets acquired and liabilities assumed at their acquisition-date fair values. ASC 805 uses the same definition of fair value as that used in ASC 820. As such, ASC 820 precludes the use of entity-specific assumptions and requires measurement of fair value based on assumptions from the perspective of market participants (if entity-specific assumptions are inline with the perspective of market participants, such assumptions are allowed to be used in fair value measurement). Accordingly, an acquirer must determine the fair value of assets acquired and liabilities assumed without considering the acquirer's intended use. This often gets tricky, as many companies acquire specific assets for purposes unique to those companies themselves. As a result, the acquirer may be required to develop hypothetical markets and to consider multiple valuation techniques even though these hypothetical markets were not contemplated by the actual acquirer. This is often a complex exercise requiring the use of valuation specialists trained in fair value measurements.

The other key change in SFAS 141 from APB 16 was that it provided additional guidance on the identification of intangible assets that were to be segregated from goodwill and valued separately. These concepts were carried over into ASC 805 but the valuation techniques used to apply fair value measurements were expanded and outlined in greater detail.

ASC 820 states that the transaction price equals fair value under certain circumstances, such as when, on the transaction date, the transaction to buy an asset takes place in the market in which the asset would be sold. However, as discussed in ASC 820-10-30-3A, and noted earlier in this chapter, a transaction price may not represent the fair value of an asset or a liability at initial recognition if certain conditions exist. Some of these conditions include related-party transactions, the transaction is forced, or the transaction is consummated in other than the principal market. To assist in measuring fair value of assets acquired or liabilities assumed, ASC 820 describes three valuation approaches used to measure fair value: the market approach, the income approach, and the cost approach. Since these approaches are more than adequately covered in other texts, this chapter merely highlights their application with specific relevance to business combinations.

ASC 820 does not prescribe the use of a specific income-based methodology to measure fair value. Rather, ASC 820 suggests that a reporting entity should use the appropriate technique based on facts and circumstances specific to the asset or liability being measured and the market in which they are transacted. However, ASC 820-10-55-4 does discuss specific present value techniques, including the discount rate adjustment technique (DRAT) and the expected cash flow (expected present value) technique (EPVT). Again, a detailed explanation of these specific techniques is beyond the scope of this chapter, but the reader is encouraged to review the full narrative of ASC 820. However, an important point to remember is that if the initial recognition of the transaction price is considered fair value and a valuation technique that uses unobservable inputs is used to measure that fair value in subsequent periods, the valuation technique should be adjusted so that, at initial recognition, the result of the valuation technique would be equal to the transaction price.

In utilizing various valuation techniques, valuation inputs are required. These inputs generally refer to the assumptions that market participants use to make pricing decisions. ASC 820 distinguishes between (1) observable inputs, which are based on market data obtained from sources independent of the reporting entity, and (2) unobservable inputs, which reflect the reporting entity's own assumptions about the assumptions market participants would use. As noted earlier, ASC 820 emphasizes that a reporting entity's valuation technique for measuring fair value should maximize observable inputs and minimize unobservable inputs, regardless of whether the reporting entity is using the market approach, income approach, or cost approach. Inputs may include price information, volatility factors, specific and broad credit data, liquidity statistics, and all other factors that have more than an insignificant effect on the fair value measurement.

APPLICATION OF THE FAIR VALUE STANDARD TO ASSET IMPAIRMENT TESTS

Business combinations deal with the “initial recognition” of assets and liabilities. The ongoing accounting treatment for assets and liabilities after their initial recognition deals with depreciation and amortization for wasting assets as well as testing for impairment of both long-lived (wasting) assets and assets with an indefinite or indeterminable life (non-wasting).

In 1995, FASB issued SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. SFAS 121 applied to tangible assets, certain identifiable intangible assets, and goodwill related to those assets. Once it has been determined that an impairment loss should be recognized, the measurement of that loss is to be determined by reference to the fair value of the asset.

As an update to SFAS 121, in 2001 the FASB issued SFAS No. 144, Accounting for the Impairment of Disposal of Long-Lived Assets, which superseded SFAS 121. The discussion of fair value in SFAS 144 was similar to SFAS 121, but was updated to be consistent with guidance included in Concepts 7, issued in 2000.

In 2001, FASB also issued SFAS No. 142, Goodwill and Other Intangible Assets. SFAS 142 addressed intangible assets with indefinite lives.

A key change in SFAS 142 from APB 17 was in the treatment of goodwill and other indefinite-lived intangible assets; they were no longer amortized, but rather were tested at least annually for impairment. The impairment test comprised a two-step testing process. Consistent with the Codification process, the FASB replaced SFAS 142 with ASC 350 and SFAS 144 with ASC 360. Many of the same principles contained in SFAS 142 and 144 were carried over initially into ASC 350 and 360.

However, in September 2011, the FASB issued ASU No. 2011-08 (ASU 2011-08), which stemmed from concerns expressed by preparers of private company financial statements regarding the cost and complexity of complying with ASC No. 350, Intangibles—Goodwill and Other. These preparers suggested a more qualitative approach to impairment testing be adopted to ease the cost and complexity of compliance. Previous guidance under ASC 350 required an entity to test goodwill for impairment at least annually, employing a two-step process (described below). Based on the ASU, companies can now assess goodwill using qualitative factors to determine whether it is “more likely than not” that the fair value of a reporting unit would be less than its carrying value, implying impairment. The more-likely-than-not threshold is defined as having a likelihood of more than 50%. If the fair value of the reporting unit is less than its carrying amount, then the second step of the test must be performed. Although the original cost concerns focused on private companies, public companies also expressed concerns about cost and complexity. As such, the ASU now applies equally to both public and private companies that have goodwill on their financial statements.

Although companies now have the option to first assess qualitative factors for goodwill impairment pursuant to ASU 2011-08, they are free to bypass the qualitative assessment for any reporting unit in any period and proceed directly to performing the first step of the impairment test. Nonetheless, an entity may resume performing a qualitative assessment in any subsequent period. It should also be noted, however, that the practice under SFAS 142 where an entity was permitted to carry forward its detailed calculation of a reporting unit's fair value from a prior year is no longer allowed. These amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011.

While ASU 2011-08 does not address the current guidance for testing other indefinite-lived intangible assets for impairment, the FASB added a separate project to explore alternative approaches for such measurement in September 2011. In January 2012, the FASB issued a proposed ASU for ED on indefinite-lived intangible asset impairment testing, with the intent to simplify complexity and reduce the cost of complying with ASC No. 350, Intangibles—Goodwill and Other. Similar to ASU 2011-08, preparers would be allowed the option to first assess qualitative factors to determine whether it is “more likely than not” that the fair value of an indefinite-lived intangible asset would be less than its carrying value, implying impairment. The more-likely-than-not threshold is consistent between ASU 2011-08 and the proposed ASU for ED. The amendments included in the proposed ASU for ED would be effective for annual and interim impairment tests performed for fiscal years beginning after June 15, 2012, and early adoption would be permitted. The proposed ASU for ED was open for public comment until April 2012, and is expected to be ratified later in 2012. Now, let us turn to the first and second steps in a goodwill impairment test.

The first step of a goodwill impairment test can be described as the identification of potential impairment, and the second step can be described as the measurement of the amount of the impairment loss. The first step in the test for goodwill is performed at the reporting unit level. A reporting unit is defined as a collection of assets that operate together as a going-concern business. A reporting unit can be one level below a reporting segment and is described as the lowest level at which management captures and analyzes the financial data of a business. Additionally, a reporting unit has its own management and contains unique risk relative to other businesses in the reporting segment.

The first step of the test entails fair value measurement of the reporting unit and comparison of the fair value of that reporting unit to its carrying value. Carrying value is the amount of assets net of liabilities recorded on the balance sheet of the reporting unit. If the fair value exceeds its carrying value, no further work is required. However, if the fair value of the reporting unit is below its carrying value, the second step of the test is required. The second step of the test is akin to a valuation assignment for a fair value analysis of assets acquired and liabilities assumed (often, mistakenly for a purchase price allocation). A fair value analysis of assets acquired and liabilities assumed involves identifying and valuing each of the reporting unit's tangible and intangible assets in order to calculate the implied fair value of each reporting unit's goodwill. The amount of goodwill impaired is not necessarily the difference between the fair value and carrying value of the reporting unit, since the fair value of the reporting unit's underlying assets may be more or less than their carrying values. The second step of the test is required to determine the amount of goodwill impairment.

The fair value definition in ASC 350 is identical to the fair value definition in ASC 805, both of which follow ASC 820. ASC 350 also describes the same preference, or hierarchy, of methods for fair value measurement: (1) Quoted market prices in active markets are the best evidence of fair value, if available, and (2) in the absence of quoted market prices, estimates of fair value should be based on the best information available, including prices for similar assets and/or present value techniques.

INTERPRETATION OF FAIR VALUE COMPARED TO OTHER STANDARDS OF VALUE

Fair Value in Financial Reporting versus Fair Value in Dissenters' Rights Cases

Fair value as it is used in accounting literature for valuations in financial reporting is not the same as fair value as it applies to valuations in dissenters' rights and oppression cases. Fair value in dissenters' rights and oppression cases is a judicially created concept that appears in state statutes and case law and was utilized as a factor to distinguish valuation concepts in those cases from fair market value.

Fair Value in Financial Reporting versus Investment Value

Fair value in financial reporting differs from investment value in that:

Fair value reflects value in the market and is determined based on the assumptions of marketplace participants (willing buyers and sellers). In contrast, investment value reflects value to a particular investor (buyer or seller) and is often considered from the perspective of that investor as a basis for making investment (buy and sell) decisions. Differences between fair value and investment value may be attributable to varying factors (including synergies). Synergies refer generally to the benefits of combining two or more assets or asset groups (for example, operating units) and fall into two broad categories: (a) synergies generally available to all marketplace participants (marketplace synergies) and (b) synergies specific to a particular buyer not generally available to other marketplace participants (buyer-specific synergies).20

Fair Value in Financial Reporting versus Fair Market Value

Fair value in financial reporting differs from fair market value in several respects. Fair market value is prevalent in valuations for tax purposes, whereas fair value is required for financial reporting purposes. Although issued years ago, the explanation of the differences between fair value in financial statement reporting and fair market value contained in the ED on fair value measurement still holds:

The definition of fair value used for financial reporting purposes often is confused with the similar definitions of fair market value used for valuation purposes. Specifically, Internal Revenue Service Revenue Ruling 59-60 defines fair market value as “price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.” That definition of fair market value represents the legal standard of value in many valuation situations. Because the definitions of fair market value and fair value are similar, both emphasizing the need to consider the actions of marketplace participants (willing buyers and sellers) in the context of a hypothetical exchange transaction, some constituents asked the Board whether, in its view, they are the same or different. The Board believes that the measurement objectives embodied in the definitions are essentially the same. However, the Board observed that the definition of fair market value has a significant body of interpretive case law, developed in the context of the tax regulation. Because such interpretive case law, in the context of financial reporting, may not be relevant, the Board chose not to simply adopt the definition of fair market value, and its interpretive case law, for financial reporting purposes.21

Some valuators view the practical application of fair market value as a transaction-based approach whereas fair value is used to value an asset or group of assets within the context of a larger transaction (e.g., assets valued in a post-transaction allocation of purchase price). Fair market value is based on a value-in-exchange premise whereas the fair value of assets acquired and liabilities assumed, for example, is often based on a premise of value in-use. The current guidance under ASC 820, however, utilizes a valuation premise based on the highest and best use of the asset (financial assets are treated differently) from the perspective of a market participant, which may be different from the reporting entity's intended use.

In the context of fair value of assets in business combinations, each asset of an acquired business is valued based on its contribution to the business as a whole, regardless of whether that asset could individually be bought or sold. An example would be a non-contractual customer relationship. This asset is usually not separable by itself from the business and under the definition of fair market value would have limited value in exchange by itself. Under the definition of fair value, the customers can have considerable value in-use as these relationships could represent the primary income-earning asset of the business.

In applying ASC 805, the price paid for the business is assumed to be the fair value of the acquired business, since it is the result of an arm's-length transaction between unrelated parties (willing buyer and willing seller) akin to the fair market value definition. Absent persuasive evidence to the contrary, it is difficult to successfully argue a fair value for an acquired business other than the transaction price. In this circumstance, fair value is determined by the price paid in one transaction.

Another example of fair value is in the derivation of the fair value of a specific asset in the context of purchase accounting. It is common practice to consider the tax benefits that an asset would generate if the asset were sold on a standalone basis when an income approach is applied to deriving value. The market approach is assumed to already have the tax benefits embedded in the market-based transaction prices. Debate and diversity of practice exist as to whether the application of a cost approach should include the tax benefit consideration.

A final example of an interpretive difference between fair value and fair market value is in the area of “cheap stock.” Cheap stock issues are typically related to private companies that are approaching an initial public offering (IPO). In conjunction with the IPO, financial statements are issued that reflect the historic performance of the subject company for multiple years prior to the offering. A cheap stock expense often requires valuation and is commonly determined based on the difference between the strike price of options issued by the company to its management and others and the fair value of the underlying common equity. Interestingly, the FASB explicitly excluded ASC No. 718, Stock-Based Compensation, from the definition of fair value under ASC 820.

The SEC in its review of the financial statements has sometimes questioned any difference between the IPO price of the shares and the deemed fair value of the shares within six months of the IPO, even though the IPO event is subsequent to the valuation date. Application of marketability and lack of control discounts due to the uncertainty of completion of the IPO are rejected at times. One reason might be the subjective nature surrounding the magnitude of these discounts. Another reason may be a preference to use the subsequent IPO price since it is verifiable (i.e., it is not subjective). Either way, fair value in the context of cheap stock issues may rely heavily on after-the-fact events and sometimes a burden of proof is placed on the company to refute the assumption that a subsequent IPO price differs from fair value.

In contrast, subsequent events (i.e., the IPO price) are not given this same importance in the application of the fair market value standard. Further, marketability and lack of control discounts, changes in risk, and changes in business issues are each expected consideration in arriving at a value conclusion.

AUDIT ISSUES

The rise in accounting pronouncements dealing with fair value has created a need for increased guidance to auditors in their auditing of fair value determinations. In the absence of specific audit guidance, different perspectives among auditors, managements, and valuation specialists created inconsistencies in the auditing of assets and liabilities recorded on the balance sheet at their fair values. In 2003, the Auditing Standards Board (ASB) issued SAS No. 101, Auditing Fair Value Measurements and Disclosures.

SAS 101 notes that GAAP require certain items to be measured at fair value. SAS 101 refers to the definition of fair value contained in Concepts 7. SAS 101 notes that GAAP expresses a preference for using observable market prices to make fair value measurements, but notes that other valuation techniques are also acceptable, especially when observable market prices are not available. Key concepts included in SAS 101 include:

• Management assumptions used in preparing fair value estimates include assumptions developed by management under direction of the board as well as assumptions developed by a valuation specialist.
• Market information and marketplace participants. Valuation methods must incorporate information that marketplace participants would use, whenever market information is available.
• Reasonable basis. The auditor must evaluate whether management's assumptions are reasonable and/or not inconsistent with market information.
• Valuation specialist. The auditor should evaluate the experience and expertise of those making fair value estimates; management should assess the extent to which an entity employs valuation specialists, and auditors should determine whether to engage a valuation specialist in auditing fair value estimates.
• Subsequent events. Events that occur after the balance sheet date but before completion of audit fieldwork may be used to substantiate fair value estimates.

Since SAS 101 was issued, the ASB discontinued its written guidance on audit issues, deferring instead to the FASB for accounting guidance. As such, SAS 101 has not been updated even though it continues to be a source of guidance to the accounting industry.

The audit environment today is increasingly focused on fair value measurement in general and the auditor's responsibilities regarding fair value measurements. Many of the largest accounting firms have established departments of valuation specialists working with their audit groups to assist with the auditing of fair value measurements. In addition, the FASB has regularly published ASUs to address specific issues and concerns of the accounting industry. The ASCs have provided a tremendous amount of consistency to accounting pronouncements and recent ASUs reflect the FASB's sensitivity to the cost and complexity of various accounting pronouncements.

SUMMARY

In recent years, there has been consistent communication in the accounting literature and GAAP of the use of fair value measurements in financial statements. Prior to the 1990s, the fair value standard for financial reporting was used less frequently, and guidance regarding its definition and measurement was vague and/or inconsistent. From the work done by FASB on financial instruments in the 1990s, to the issuance of Statement of Concepts 7 in 2000, which contains the fair value definition in use today, to the ED on fair value measurement issued in 2004, and finally the ASC in 2009, the use of fair value measurement in financial reporting continues to grow. The FASB has indicated that clearer guidance on fair value in the accounting literature will improve the consistency of its application, thereby improving financial reporting, and the SEC has called for this effort to continue. Although it was not touched on in this chapter, the FASB's initiative for convergence with the International Financial Reporting Standards (IFRS) is ongoing, as detailed in many ASUs. There has been consistent, albeit slow, movement toward total convergence between U.S. GAAP and IFRS, but significant hurdles to full convergence still exist.

Valuation specialists have an opportunity to participate in the growing emphasis on fair value measurement in financial reporting, and the need for valuation specialists in financial reporting has increased significantly. However, it is incumbent upon valuation specialists to understand the various fair value accounting pronouncements to determine consistent and appropriate valuation methodologies for financial reporting valuations. Fortunately, the AICPA has embarked on a number of initiatives to improve the consistency of fair value reporting among valuation practitioners, including practice aids for in-process research and development, goodwill impairment testing, contingent consideration, and share-based compensation.

Trends to watch in the continual evolution of fair value measurement in financial reporting include:

• Expansion of fair value measurement guidance, both in the United States and internationally:
• Recent ASUs have addressed such issues as measuring the fair value of liabilities and investments in certain entities that calculate net asset value per share.
• The FASB continues to work with accounting rulemaking bodies around the world to pursue convergence of U.S. GAAP with international accounting standards. This should increase consistency of U.S. valuation practices with those of other developed nations if full convergence is actually achieved.
• There have been serious attempts by valuation practitioners to develop consistency in the application of valuation techniques to fair value measurements.
• The Appraisal Issues Task Force has been established as an ad-hoc committee of valuation practitioners to discuss the expanding issues related to fair value and to build consensus for the development of consistent practices in the performance of valuations for financial reporting purposes.
• Development of new practices in the auditing of fair value measurements.
• Increasing role of valuation specialists in auditing firms, to assist with the auditing of fair value measurements.

APPENDIX: SOURCES OF INFORMATION

1 FASB ASC Topic No. 820, Fair Value Measurements and Disclosures (ASC 820).

2 June 2004 FASB ED, Proposed Statement of Financial Accounting Standards—Fair Value Measurements, paragraphs C4 and C11.

3 June 2004 FASB ED, Proposed Statement of Accounting Standards—Fair Value Measurements, paragraph C4.

4 Id., at paragraph C6.

5 Id., at paragraph C7.

6 Jackson M. Day, Deputy Chief Accountant, Office of the Chief Accountant, U.S. Securities and Exchange Commission, “Fair Value Accounting—Let's Get Together and Get It Done!” remarks to the 28th Annual National Conference on Current SEC Developments, December 5, 2000.

7 AICPA Practice Aid, Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus on Software, Electronic Devices and Pharmaceutical Industries, Introduction.

8 Day, “Fair Value Accounting.”

9 Lynn E. Turner, Chief Accountant, U.S. Securities and Exchange Commission, “The Times, They Are a–Changing,” remarks to the 33rd Rocky Mountain Securities Conference, May 18, 2001.

10 FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurement, paragraph 2.

11 June 2004 FASB ED, Proposed Statement of Accounting Standards—Fair Value Measurements, paragraph C13.

12 Id., at paragraphs C4 and C11.

13 APB No. 16, Business Combinations, paragraph 66. The purchase method was described as “following principles normally applicable under historical-cost accounting to recording acquisitions of assets and issuances of stock and to accounting for assets and liabilities after acquisition.”

14 Id., at paragraph 68.

15 Id., at paragraph 87.

16 APB No. 17, Intangible Assets, paragraph 2.

17 Id., at paragraph 15.

18 Id., at paragraph 26.

19 Id., at paragraph 26.

20 June 2004 FASB ED, Proposed Statement of Accounting Standards—Fair Value Measurements, paragraph B2.

21 Id., at paragraph C27.