Fair value measurements in impairment testing: how SFAS No. 157 increases consistency and comparability.

Abstract

In September 2006, the Financial Accounting Standards Board issued a new standard, Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157). Prior to this Statement, U.S. Generally Accepted Accounting Principles included different definitions of fair value, and limited and dispersed application (measurement) guidance. SFAS 157 seeks to increase consistency and comparability, as well as transparency, in fair value measurements by providing a single definition of fair value, establishing a framework for measuring fair value, and expanding required disclosures about fair value measurements. This article examines how the new standard affects the fair-value-based impairment testing models for tangible assets, such as assets held for sale, and intangible assets, such as goodwill.

Introduction

In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157). The Statement underscores a desire for consistent application of fair value within financial statements. Note that SFAS 157 does not require any new fair value measurements; however, the application of this statement may change current practice for some entities. For example, SFAS 157 may have an impact on fair value in impairment testing of assets. (1) It is expected that this statement will also apply to future FASB pronouncements requiring fair value measurements.

U.S. Generally Accepted Accounting Principles (U.S. GAAP) include many standards that refer to fair value. Most of these pronouncements, however, focus on what to measure at fair value, rather than on how to measure fair value. Consequently, prior to SFAS 157 there were different definitions of fair value, and limited and inconsistent guidance for applying those definitions, dispersed among the many accounting pronouncements. The FASB also wanted to provide users of financial statements with additional information (transparency) about the fair value measurements. To remedy this situation, SFAS 157: (1) provides a single definition of fair value, (2) sets out a framework for measuring fair value, and (3) expands disclosures about fair value measurements [4].

Single Authoritative Definition of Fair Value

By defining fair value in SFAS 157 as "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," the FASB expressed its preference for exit-price based as opposed to entry-price based fair value--measurements, and for market--based as opposed to entity--specific inputs into the valuation process.

The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant holding the asset or owing the liability. Therefore, regardless of whether the entity plans to hold or sell (transfer) the asset (liability), the definition focuses on the price that would be received (paid) to sell the asset (transfer the liability)--that is, the exit price. Using an exit price is consistent with the definition of an asset (liability), as it provides expectations about future inflows (outflows).

SFAS 157 emphasizes that fair value is a market-based measurement, which should be determined based on the assumptions that market participants would use in pricing the asset or liability. In the context of SFAS 157, market participants are buyers and sellers in the principal (or most advantageous) market (2) for the asset or liability that are:

* Independent of the reporting entity;

* Knowledgeable about the asset (or liability) and the transaction;

* Able to transfer the asset (or liability); and

* Willing to transact for the asset (or liability).

The statement also explains that a fair value measurement of an asset assumes its highest and best use by market participants. Such use would maximize the value of the asset or the group of assets within which the asset would be used, (3) regardless of the intended use of the asset by the reporting entity.

SFAS 157 does not remove practicability exceptions that exist in other standards dealing with fair value measurements. Also, the statement requires the use of market participant information when it is reasonably available without undue cost and effort. But it is important to note that even in the absence of market-based information, SFAS 157 reminds preparers that they still must use a market-based perspective.

Valuation Techniques

Three valuation techniques are specified for estimating fair values:

* The market approach -- uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities;

* The income approach -- uses valuation techniques to convert future amounts, such as cash flows or earnings, to a single present-value amount. The measurement is based on expectations developed by current market participants about those future amounts;

* The cost approach -- uses the current replacement cost that is the amount that currently would be required to replace the service capacity of an asset.

Single or multiple valuation techniques may be used, depending on circumstances and availability of data. If multiple valuation techniques are used, the results must be evaluated and weighted appropriately. A fair value measurement is the point within the reasonable range of the results that is most representative of fair value in the circumstances. Valuation techniques should be consistently applied, but can be changed if the change results in a measurement that is equally or more representative of fair value in the circumstances. A change in the valuation technique is a change in accounting estimate, not a change in accounting principle.

Inputs into the Valuation Techniques and Fair Value Hierarchy

In SFAS 157, inputs into valuation techniques used to measure fair value refer to the assumptions that market participants would use in pricing the asset or liability. Some academic research on the relevance and reliability of fair value estimates has concluded that fair value measurements based on inputs from actively traded markets are more closely associated with share prices than fair market measurements derived from entity-specific inputs [5]. According to SFAS 157 inputs may be divided into:

* Observable -- that is, assumptions based on market data obtained from sources independent of the reporting entity. Use of observable inputs should be maximized.

* Unobservable -- that is, the reporting entity's own assumptions based on the best information available in the circumstances. Use of unobservable inputs should be minimized.

In the statement, a hierarchy of inputs is established to use in determining fair value estimates. The hierarchy refers to the reliability of inputs relative to a valuation technique used in arriving at a fair value estimate. Exhibit 1 presents the hierarchy, with Level-1 representing the most reliable inputs, and Level-3 the least reliable inputs. For measurements that use inputs from different levels, professional judgment shall be used to determine the lowest level input that is significant, in which the measurement will fall in its entirety.

The three-level hierarchy is essential to the statement's disclosure requirements, because the lower the level of the fair value measurement input, the more extensive the disclosure requirement.

Additional Disclosures About Fair Value Measurements

SFAS 157 requires the following disclosures to be presented separately for each major category of assets and liabilities at each annual and interim balance sheet date:

* For items that are measured at fair value on a nonrecurring basis, such as an impaired asset: the fair value measurements recorded during the period and the reasons for the measurements, the level within the hierarchy in which the measurement falls, a description of and information used to develop significant Level-3 inputs, and, in annual periods only, the valuation technique(s) used in the measurements.

* For items that are measured at fair value on a recurring basis, such as an investment held for trading: the fair value measurements as of the reporting date and disclosures similar to those for items measured on a nonrecurring basis, above. In addition, if the measurement falls within Level-3, the entity shall disclose a reconciliation of the beginning and ending balances, and the total gains or losses included in earnings (or changes in net assets) attributable to the change in unrealized gains or losses relating to assets still held at the reporting date.

Fair Value Measurements in Impairment Testing of Assets

In certain specified circumstances, U.S. GAAP requires or allows the use of fair value in financial statements in four main ways:

* For the measurement of transactions at initial recognition (e.g., an intangible asset acquired individually);

* For the allocation of the initial amount at which a transaction is recognized among its constituent parts (e.g., in a business combination);

* For the subsequent measurement of assets and liabilities (e.g., an impairment test);

* For disclosure purposes (e.g., disclosure of fair value of financial instruments for which it is practicable to estimate it, in accordance with Statement of Financial Accounting Standards No. 107, Disclosures about Fair Value of Financial Instruments).