Fair Value Measurements: Valuation Principles and Auditing Techniques (Portfolio 5127)

Bloomberg Tax Portfolio 5127-2nd, Fair Value Measurement: Valuation Principles and Auditing Techniques, is a comprehensive examination of the use of fair value measurements in financial reporting.

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Bloomberg Tax Portfolio 5127-2nd, Fair Value Measurement: Valuation Principles and Auditing Techniques, is a comprehensive examination of the use of fair value measurements in financial reporting. It specifically discusses how reporting entities use fair value measurement to report assets and liabilities.
For a considerable time, standard setters (i.e., the Financial Accounting Standards Board, or FASB, and its predecessors) have either permitted or required reporting entities to use fair value measurements in specific instances, as the concept of fair value measurements is found throughout the professional literature. This literature, however, had not produced a comprehensive set of principles for defining and implementing fair value measurements. To remedy this gap, in September 2006, the FASB issued principle-based guidance in the form of FASB Statement No. 157, Fair Value Measurements, which has been codified in FASB Accounting Standards Codification (ASC) Topic 820-10. ASC 820-10 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The FASB's rationale for creating these fair value measurement principles was to create consistency among reporting entities that use fair value measurements and to improve the reliability of those measurements.
This Portfolio defines fair values, explains the instances in which they are used in financial reporting, and illustrates their application to assets and liabilities in the context of the fair value measurement principles. This Portfolio also explains the markets in which reporting entities conduct transactions that are subject to fair value measurements. FAS 157 introduced the concept of a fair value hierarchy into the professional literature to help reporting entities determine which types of estimates (i.e., inputs) to use to compute the most reliable fair value measurements. The fair value hierarchy prioritizes the inputs to the valuation process. Under this hierarchy, Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable by third parties for the asset or the liability. Level 3 inputs are created by reporting entities to estimate a fair value of the asset or liability, and thus are unobservable by third parties.
This Portfolio also details the valuation techniques that use the inputs from the hierarchy: the market approach, the income approach, and the cost approach. The market approach relies on observable market prices and uses valuation multiples and multiple regression. The income approach employs a discounted cash flow methodology. The cost approach estimates replacement costs.
Finally, this Portfolio discusses how auditors should audit fair value measurements. The primary guidance in this area is AICPA Statement on Auditing Standards No. 101, Auditing Fair Value Measurements and Disclosures, published by the AICPA's Auditing Standards Board in 2003.
This Portfolio may be cited as Bloomberg Tax Portfolio 5127-2nd, Ketz and Zyla, Fair Value Measurement: Valuation Principles and Auditing Techniques (Accounting Policy and Practice Series).


J. Edward Ketz

J. Edward Ketz, Ph.D., a member of the Penn State faculty since 1981, has authored and edited 17 books, including Hidden Financial Risk (Wiley, 2003) and Accounting Ethics (Routledge, 2006). Professor Ketz has been cited frequently in the popular and business press, including The Wall Street Journal, The New York Times, The Washington Post, Business Week, Fortune, USA Today, and Chicago Tribune, on topics such as accounting for stock compensation, business combination accounting, accounting for derivatives, and evaluations of specific corporate accounting practices at Enron, Tyco, Rite Aid, HealthSouth, AIG, CVS, Starbucks, Krispy Kreme, and others. He also has appeared as an accounting commentator on CNBC, CNNfn, and National Public Radio. Dr. Ketz writes a column about financial reporting issues, “Accounting Cycle: Wash, Rinse, and Spin,” which appears on SmartPros.com.

Mark L. Zyla

Mark L. Zyla, CPA/ABV, CFA, ASA, provides valuation consulting for various types of entities for the purposes of mergers and acquisitions, financial reporting, tax planning, and corporate recapitalizations, as well as valuing various types of intellectual property and other intangible assets. Mr. Zyla is a member of the American Society of Appraisers (“ASA”), the American Institute of Certified Public Accountants (“AICPA”), the CFA Institute, and the Atlanta Society of Financial Analysts. He is a former member of the Business Valuations Committee of the AICPA and a current Chairman of the ABV Examination Committee of the AICPA. He is also a current member of the Business Valuation Standards Subcommittee of the ASA. He is also a member of the Atlanta Venture Forum, a professional organization of the venture capital community. He is one of the authors of the International Glossary of Business Valuation Terms which has been adopted by the major valuation organizations. Mr. Zyla co-authored Valuation for Financial Reporting: Intangible Assets, Goodwill and Impairment Analysis, SFAS 141 and 142, published by John Wiley & Sons, Inc. He also co-authored the course, “Valuing Goodwill and Other Intangible Assets”, published by the AICPA.

Table of Contents

Detailed Analysis

I. Overview of FASB's Fair Value Project

Introductory Material

A. Introduction

1. Examples of Fair Values in CAP Promulgations

a. Valuation of Intangibles

b. Lower-of-Cost-or-Market Rule

c. Business Combinations

2. Examples of Fair Values in APB Promulgations

a. Business Combinations

b. Nonmonetary Exchanges

3. Examples of Fair Values in FASB Promulgations

a. Troubled Debt Restructuring

b. Issues Concerning the Broadcasting Industry

c. Issues Concerning the Banking Industry

d. Issues Concerning the Real Estate Industry

e. Pension Accounting

f. Accounting for Postretirement Benefits Other Than Pensions

g. Disclosures About the Fair Value of Financial Instruments

h. Accounting for Debt and Equity Investments

i. Accounting for Contributions

j. Accounting for Derivatives

k. Valuation of Assets and Liabilities Through a Business Combination When Accounting for Them Under the Purchase Method

l. Use of Present Value Techniques to Approximate Fair Values

m. Amendments Dealing With Financial Instruments and the Servicing of Financial Assets

n. Fair Value Option for Financial Assets and Liabilities

4. Need for Clarification of Fair Value Measurements

5. The Purpose of This Portfolio

B. Overview of the Statement on Fair Value Measurements

1. Definition of Fair Value

2. The Aggregation Problem

3. Estimating Fair Values

4. The Fair Value Hierarchy

5. Present Values and Fair Values

C. Fair Value Measurements Within the FASB Conceptual Framework

1. Objectives of Financial Reporting

2. Qualitative Characteristics

3. Elements and Their Recognition

4. Measurement of the Elements

D. Summary and Conclusion

II. Accounting Measurement Theory

A. Introduction

B. Accounting Measurement in an Ideal World

1. What is Meant by an Ideal World?

2. Asset Valuation and Income Determination Under Certainty

3. Asset Valuation and Income Determination Under Uncertainty

4. Valuation in an Ideal World Versus Valuation in the Real World

C. Accounting Measurement in the Real World

1. Introduction

2. Three Valuation Systems

a. Historical Cost

b. Current Entry Value

c. Current Exit Value

d. Summary of the Accounting Valuation Systems

3. Adjusting for the Effects of Inflation

a. Inflation Adjustments to Balance Sheet Items

b. Inflation Adjustments to Income Statement Items

c. Example: Financial Statements Adjusted for the Effects of Inflation

d. Summary of Constant Dollar Reports

4. Official Literature

D. Summary and Conclusion

III. Present Values and Pricing Models

A. Introduction

B. Present Value as a Proxy for Market Prices

C. Present Values in the Professional Literature

1. How Present Values May Not Mimic Market Prices

2. Convergence of the Present Value and the Market Price

3. Examples in the Professional Literature

a. Present Values That Do Not Approximate Market Values

(1) Interest Amortization

(2) Leased Assets and Obligations

(3) Impairment of a Loan

b. Present Values That Do Proxy Market Values

(1) Imputation of Interest

(2) Receivables and Payables Assumed in a Business Combination

(3) Impairments of Long-Lived Assets

(4) Interest Rate Swaps

(5) Asset Retirement Obligations

(6) Summary of Examples

D. Risk and Uncertainty

1. FASB's Comments About Risk and Uncertainty

2. The Markowitz Model

a. Risk and Return for a Single Asset

b. Risk and Return for a Two-Asset Portfolio

c. Risk and Return for a Portfolio With a Risk-Free Asset

3. The Capital Asset Pricing Model

4. Finding Beta in Practice

5. Valuation of Uncertain Assets With the CAPM

6. Shortcomings of the CAPM

E. FASB's Two Present Value Approaches

1. One-Period Risk-Free Cash Flow

2. One-Period Risky Cash Flow

3. Multiperiod Risk-Free Cash Flows

4. Multiperiod Risky Cash Flows

F. Liabilities and Creditworthiness

G. Summary and Conclusions

IV. Valuation Fundamentals Under FAS 157

A. Introduction

B. Fair Value Premise

1. Application to Assets

2. Application to Liabilities

3. Fair Value at Initial Recognition

C. Valuation Techniques, the Fair Value Hierarchy, and Disclosures

1. Valuation Techniques

2. Fair Value Hierarchy

3. Fair Value Measurement Disclosures

D. The Unit-of-Account Issue (The Aggregation Problem)

E. The Market Approach: Adjustments to Quoted Prices

1. Restricted Securities: Lack of Control and Lack of Marketability Discounts

2. Empirical Studies Into Lack of Marketability Discounts

F. The Market Approach: Multiples and Regression Analysis

1. Valuation Multiples

2. Multiple Regression

G. The Income Approach: The DCF Model

1. DCF of a Business Enterprise

2. Valuing Intangibles Under the Income Approach

a. Before and After DCF (Valuing a Noncompete Agreement)

b. Relief-From-Royalty Method (Valuing a Trade Name)

c. Multiperiod Excess Earnings (Valuing Technology and IPR& D)

H. The Income Approach: Forwards and Options

1. Forwards

2. Options

I. The Cost Approach

J. Applying FAS 157 in Inactive Markets

K. Summary and Conclusion

V. Evolution of the Standard on Fair Value Measurements

A. Introduction

B. Scope Restrictions

C. Comments on the Exposure Draft and FASB Revisions

1. Definition of Fair Value

2. Valuation Techniques (Present Value)

3. Active Markets

4. Valuation Premise

5. Fair Value Hierarchy

6. Level 1 Reference Market

7. Pricing in Active Dealer Markets

8. Measurement of Blocks

9. Level 3 Estimates

10. Restricted Securities

11. Fair Value Disclosures

12. Other Issues

a. EITF Issue 02-3 and FAS 133

b. Marking to One's Own Credit Standing

c. Reliability of Fair Values

D. Summary and Conclusion

VI. Auditing Fair Value Measures: Working With a Valuation Specialist

A. Introduction

B. Auditing Fair Value Measurements

C. Why Is Auditing Fair Value Measurements Unique?

1. Setting the Context for Auditing Fair Value Measurements

2. AICPA Statement on Auditing Standards 101

3. Fair Value Hierarchy

4. Planning the Audit of Fair Value Measurements

D. Understanding Fair Value Measurements From the Viewpoint of a Valuation Specialist

1. Definition of Fair Value

2. Marketplace Participants

3. Identification of Specific Assets to Be Valued

4. Valuation Approaches

5. Amortization of Intangible Assets

E. Conclusion

Working Papers

Working Papers


Worksheet 1 Glossary

Worksheet 2 Relevant FASB Pronouncements

Worksheet 3 Relevant CAP and APB Pronouncements

Worksheet 4 Relevant SEC and AICPA Pronouncements

Worksheet 5 Issues for Public Comment in the Exposure Draft on Fair Value Measurements

Worksheet 6 SEC "Dear CFO" Letter to Public Companies on MD& A Disclosure Regarding the Application of FAS 157 (Mar. 2008)

Worksheet 7 SEC "Dear CFO" Letter to Public Companies on MD& A Disclosure Regarding the Application of FAS 157 (Sept. 2008)

Worksheet 8 FASB Staff Position No. FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active






AICPA Accounting Research Bulletins

AICPA Statements on Auditing Standards

AICPA Statements of Position


APB Opinions

APB Statements


EITF Issues


FASB Concepts Statements

FASB Interpretations

FASB Staff Positions

FASB Statements of Financial Accounting Standards

FASB Working and Exposure Drafts