From original (historical) cost, which offers
verifiability, to various measures of fair value,
which offer increased relevance, the interpretation and use of value information has
been confusing. For example, in a business
combination a target company may revalue
at fair value (with some exceptions, such as
recorded goodwill), but the buyer would continue without revaluation.
For some measures, judgment and estimation are required by the parties evaluating
them, increasing risk implications and the
possibility of material misstatements. Managers potentially could misuse their knowledge by selecting methods and estimation
processes in financial reporting for the sole
purpose of benefiting the firm.
Estimation cannot be avoided, and is absolutely required in many cases where there are
uncertainties, such as estimating liabilities
for future warranty services. Auditors must,
therefore, design and use fieldwork procedures to assess risk and provide reasonable
assurance of the absence of material error.
Their job requires special expertise when
they are faced with subjective valuations.
such as condition or environmental factors.
Examples are land, land improvements and
buildings (productive assets).
Level 3, the most subjective and open to
error in estimation, is called the income approach to valuation. Some of these may be
customer lists (which cannot be recorded as
an asset by an acquiree because they are internally developed, but must be valued and
recorded by an acquirer) and various other
intangible assets that are identified usually
as separable (during the business combination process) or arising from a contractual or
legal arrangement. In valuing customer lists,
cash-flow models may be employed using the
present value of discounted estimated future
cash flows. Independent appraisals may be
useful in some circumstances. Certain liabilities, such as warranties payable, also fall into
the category requiring estimation and judgment. As Level 3 valuations are subject to the
most risk of measurement problems, they will
be discussed at some length herein.
Cash, current liabilities, and bonds payable
may be acquired at book or face values, generally. Any problems with valuation for these
accounts are usually considered less serious,
and are examined with long-accepted substantive auditing procedures. For estimated
liabilities, however, a new fair value may replace the existing recorded value. Long-term
liabilities may require adjustment because of
material change in interest rates.
SFAS 159 (ASC 825) gives a fair-value option for financial assets, including certain
investments in stock that had been valued
using the cost or equity method. Election
of this option is irrevocable, and may result
in increased income because of market adjustments.
One report concluded that chief financial
officers of large but less-profitable companies with compensation plans are more willing to choose the irrevocable fair value option of SFAS 159 than those who do not have
compensation plans. Therefore, the CFOs
of more profitable firms also might choose
SFAS 159, being motivated to make accounting choices that benefit profits — and thereby
Measures for measurement
Finding the best method of measuring assets and liabilities has
been both elusive and controversial.
Valuation measurements require careful judgement
SFAS 157 (ASC 820), issued in 2008, presents
a somewhat controversial definition of fair
value. Instead of purchase price, the pro-
nouncement uses a market-based (or exit-
price) approach, which can be expressed in
three tiers. Level 1, which is preferred, uses
quoted exit prices for identical assets in an
active market. Assets that fall into Level 1 in-
clude marketable investments, inventory and
equipment. Level 2 is called adjusted market
value, and uses market value (or possibly oth-
er inputs) for similar assets, which can then
be adjusted for asset-specific information
FASB AND IASB UNITE ON
NORWALK, CONN. — The Financial Accounting Standards Board and the International Accounting Standards Board
have published a joint set of proposals to
account for the impairment of financial
assets such as loans managed in an open
portfolio. FASB had earlier favored using
fair value measurement for impaired
assets, while the IASB favored a “mixed
measurement” model using both fair
value and amortized cost. FASB has now
come around to agreeing more with the
IASB’s approach, although the IASB is
also adopting some of FASB’s proposals.
IFRS and U.S. GAAP currently account
for credit losses using an incurred-loss
model, which requires evidence of a loss
(known as a trigger event) before assets
can be written down. The boards have
proposed moving to an expected-loss
model that provides a more forward-looking approach to accounting for credit
losses, which they believe better reflects
the economics of lending decisions.
The proposals are published as a supplement to an exposure draft published
by the IASB in November 2009, and a
separate FASB draft published in May
2010. The document is open for public
comment until April 1, 2011. During the
consultation period, the IASB and FASB
will undertake further outreach to seek
views on the supplementary document.
Alvino J. Massimini, CPA, is an assistant
professor of accounting at La Salle University in Philadelphia. Reach him at mas-
firstname.lastname@example.org. Reprinted with permission from The Pennsylvania CPA Journal, a
publication of the Pennsylvania Institute of
Using the acquisition method in business
combinations, acquired accounts are valued
with the guidance provided for Level 1, Level
2 and Level 3. If the acquisition cost (
excluding transaction costs, such as outside legal
and accounting, and restructuring costs)
exceeds the determined fair values of the
acquirer’s net assets, goodwill results.
Goodwill becomes the residual portion of an acquisition price (or implied
TEMPLATE OFFERED FOR
NEW YORK — The CFA Institute has released the Compensation Discussion and
Analysis Template, a report that provides
guidance for public companies wishing to
improve the CD&A portion of their proxy
statement. The report and template were
produced in collaboration with issuer and
investor advocates, and in time for the
upcoming 2011 proxy season.
The Compensation Disclosure and
Analysis Template is a first step for issuers who wish to make compensation
communication clearer and more relevant
to investors. It was developed by a CFA
Institute-led working group of issuers,
investors and associations concerned
about this issue.