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When true value really isn't true and fair.

The Financial Accounting Standards Board (FASB) is on verge of introducing a fundamental change in how fair value of assets and liabilities will be determined. The forthcoming standard simply titled "Fair Value Measurements" has many of the same words we've all grown used to: that fair value is the price that would be received for an asset or paid for a liability in an exchange between a willing buyer and willing seller. Like most new standards, the devil is in the details.

Unlike the past, the fair value measurement objective prohibits consideration of the entity's intentions or plans and its particular facts and circumstances. Instead, the asset or liability will be valued at a hypothetical price between a hypothetical buyer and a hypothetical seller, with the objective of measuring the "exit" price in contrast to the "purchase" price. Sounds simple, right? If applied broadly throughout the financial reporting model, it will represent whole new mindset on how to measure fair value. Consider the following examples:


* Company A acquires a competitor with the intention of eliminating its brands and redeploying its factories to produce its own products. Company A must record an asset for the brands, tradenames and other acquired intangibles at what a hypothetical market participant would pay with the intention of continuing to use them. It is unclear what should be done on day 2.

* Company B acquires an asset from a bankrupt seller for $500, knowing that a market participant would normally sell the asset for $800. Company A should record the asset at $800 and presumably record a gain of $300. Likewise, if a market participant would sell the asset for lower than the amount paid, a loss would be recorded in earnings.

* Company C has a facility that produces widgets and is running at 30 percent of capacity. It believes that the asset is impaired and intends to write it down to fair value, in accordance with the existing impairment standard. It may be prohibited from doing so, however, if a hypothetical market participant (for example, the most efficient widget-maker) would be able to operate the plant at a higher capacity and with greater efficiency, resulting in a fair value that is in excess of Company C's carrying amount.

* Company D buys a manufacturer that sells to the same customers as it does and must value the acquired customer relationships based on what a market participant, who potentially could have no involvement with those customers, would pay for them.

FEI's Committee on Corporate Reporting (CCR) has written to the FASB objecting to the market participant approach to fair value measurement. CCR disagrees with putting assets on the books at amounts that are different, and potentially radically different, from the present value of future cash flows that those assets will produce. Unlike financial assets with contractually specified cash flows, the value of non-financial assets (like property, plant and equipment) depends on how they are used.

Specifically, the owner's strategy, workforce, distribution channels and market presence will play a significant part in determining the amount and timing of future cash flows. The critical issue is, which is more relevant for investors: a fair value that is based on the entity's specific circumstances and plans, or one based on hypothetical assumptions? We think it is the former.

If the board decides to issue a final standard by this summer, it will do so without addressing a number of fundamental questions about how this new approach works. For example, the draft standard does not address how an asset valued on this basis should be accounted for on day 2. Should it be amortized over some hypothetical useful life, should it be immediately impaired or should the company continue to make assumptions about what a hypothetical market participant would be doing with the asset?

The proposed standard also does not address how tax attributes, which are often incorporated in the value of intangible assets, would be determined. Since the tax attributes of intangibles vary considerably by tax jurisdiction and since the entity is prohibited from using entity-specific assumptions (unless they mirror those of market participants), there are a significant number of alternative tax assumptions to choose from. Add on questions about the auditability of all this, and you begin to appreciate the true scope of the challenge.

There is no question that this proposed model makes determining fair values significantly more complex. After all, most non-financial assets and liabilities do not have active markets. Moreover, with significant doubts about the relevance of recording assets at their hypothetical fair values, it would seem that the interests of investors are not well served if those assets will not actually produce the cash flows that are implied in their carrying amounts. Introducing such radical changes in our reporting model may revive enthusiasm for allowing companies the option not to follow an accounting principle if it does not provide a "true and fair" view of the enterprise, such as has been used in the past in other countries. Let's hope that it won't come to that.
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Title Annotation:Fair Valuation of Assets and Liabilities
Author:Cunningham, Colleen
Publication:Financial Executive
Geographic Code:1USA
Date:Jun 1, 2006
Previous Article:Jonathan Alpert.
Next Article:From the editor.

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