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

The third use of fair value includes impairment testing of assets. (4) Impairment models under U.S. GAAP vary depending on the asset subject to the impairment test. The impairment model for long-lived assets to be held and used, and intangibles with a finite useful life, includes, for practical reasons, a recoverability test that uses undiscounted cash flows as a first step to determine impairment. For intangible assets that are not amortizable, impairment is only based on the fair value of the asset, with no recoverability test performed since the indefinite useful lives of the assets could render such test unlikely to fail. For goodwill impairment testing, the model also uses a two-step process to lessen the cost of performing the test, and the implied fair value of goodwill is used to measure impairment. Finally, for long-lived assets that are to be disposed of by sale, rather than recovered through operations, the valuation process uses the fair value of the asset less cost to sell.

As summarized in Exhibit 2, fair values used in impairment testing must rest on assumptions that market participants would use in pricing the asset or liability. SFAS 157 did not change this requirement, but does place additional emphasis on market participant assumptions. The following example will illustrate some of the concepts included in SFAS 157.

Company ABC, a bottler of beverages, is testing its bottling operation for impairment in accordance with Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144). The bottling operation is held and used and has identifiable cash flows that are largely independent of the cash flows of other assets. The carrying amount of the bottling operation is $1,000. ABC estimates $900 of future cash flows (used to assess recoverability in step 1) that arise as a direct result of the use of the assets in its operations. Since the carrying amount is greater than the expected undiscounted cash flows from operations, ABC must proceed to step 2. ABC determines that the fair value in accordance with the guidance provided in SFAS 157 of the bottling operation is $800. The fair value was determined considering the highest and best use of the bottling operation, which was determined to be in-use in this case.

This is because there were no other market participants who would use the bottling operation in a different manner. Therefore, the fair value was determined by discounting the estimated future cash flows from step 1, considering information reasonably available without undue cost and effort about the assumptions that market participants would use in pricing the bottling operation. ABC would recognize an impairment charge of $200 ($1,000 carrying value, less fair value of $800). In accordance with SFAS 144, the $200 loss would be allocated to the individual long-lived assets of the bottling operations on a pro rata basis using the relative carrying amounts of those assets, without reducing them below their individual fair value, whenever it is determinable without undue cost and effort. SFAS 157 does not clarify how ABC should allocate the fair value of the bottling operation ($800) to the individual assets (such as land, plant and equipment, etc.) for accounting purposes.

Changing the facts in the example above slightly, assume that in determining the fair value under step 2, ABC determines that the bottling facility is located in an area that has recently seen development for commercial purposes (e.g., a retail shopping mall). Further assume that ABC determines that the highest and best use of the bottling operation would be in-exchange (i.e., assuming that a market participant would demolish the bottling facility and make necessary adaptations to use the land for commercial purposes). Based on recent sales of land in the area (adjusted for costs to use for commercial purposes), ABC estimates that an in-exchange fair value of the bottling operation is $1,200, primarily driven by the value of land. SFAS 157 requires ABC to consider the highest and best use from a market participant perspective, even if ABC does not intend such use of the asset. Consequently, no impairment would be recognized, since the fair value of $1,200 exceeds the carrying amount of $1,000. SFAS 157's highest and best use concept does present some practical issues. For instance, how much effort does ABC have to put forth in determining possible alternative uses of the asset(s), as well as whether the alternatives are physically possible, legally permissible, and financially feasible, as required by SFAS 157? The statement does indicate that undue cost and effort is not required to be put forth; however, undue cost and effort is not defined--professional judgment is required.

Conclusions

SFAS 157 does not require additional fair value measurements; however, it may impact current practice for some entities. In particular, as it relates to fair-value-based impairment testing models, SFAS 157 clarifies that entities should use a market participant perspective in determining fair value.

Questions and issues will arise through the implementation of SFAS 157, but once these are resolved by the profession and valuation specialists, by establishing a framework for measuring fair value and increasing disclosure requirements, the statement is expected to improve consistency, comparability, and provide additional transparency in financial reporting.

References

1. Financial Accounting Standards Board. Statement of Financial Accounting Standards No. 107, Disclosure about Fair Value of Financial Instruments, CT: FASB, December 1991.

2. Financial Accounting Standards Board. Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets. Norwalk, CT: FASB, June 2001.

3. Financial Accounting Standards Board. Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Norwalk, CT: FASB, June 2001.

4. Financial Accounting Standards Board. Statement of Financial Accounting Standards No. 157, Fair Value Measurements. Norwalk, CT: FASB, September 2006.

5. Martin, R.D., J.S.Rich, and T.J.Wilks. "Auditing Fair Value Measurements: A Synthesis of Relevant Research," Accounting Horizons, Vol. 20, No. 3, September 2006, 287-303.

6. Mills, A. and L. Delfini. "Deloitte & Touche: Heads Up." FASB Issues Standard on Measuring Fair Value, Vol. 13, Issue 12, September 27, 2006, 1-4.

Endnotes

(1) Unaffected by SFAS 157 are measurements that are: (1) related to share-based payments; (2) based on (or that otherwise use) vendor-specific objective evidence of fair value, and (3) related to inventory.

(2) The principal market is the market in which the reporting entity would sell the asset (transfer the liability) with the greatest volume and level of activity for the asset (liability). If an entity has no principal market for the asset (liability), it would determine its most advantageous market. The most advantageous market is the market in which the reporting entity would sell the asset (transfer the liability) with the price that maximizes the amount that would be received for the asset (minimizes the amount that would be paid to transfer the liability), considering transaction costs in the respective market(s). Transaction costs, however, are not included in the fair value measurement.

(3) The highest and best use of an asset will result in either an in-use premise, when the fair value is determined based on its use together with other assets as a group; or an in-exchange premise, when the fair value is determined as the price that would be received to sell the asset on a stand-alone basis.

(4) In Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144), the FASB discussed its basis for concluding that fair value is the best measurement for impairment of assets. When an entity determines that an asset is impaired, it is faced with the decision to sell or continue using the asset, similar to an investment decision. Management's decision process presumably will maximize the expected future cash flows between: a) selling the asset and reinvesting the proceeds on alternative uses, or b) continuing to use the asset. The decision to continue to use the asset is equivalent to a new investing decision, and consequently the FASB concluded that a new basis of fair value is appropriate. The FASB also concluded that a fair value measurement of impairment is consistent with the historical cost principle, and is an easily understood concept.

(5) Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142), defines a reporting unit as "an operating segment or one level below an operating segment (referred to as a component)." The determination of whether a component is a reporting unit "is a matter of judgment based on an entity's individual facts and circumstances." The reporting unit is intended to be "the level of internal reporting that reflects the way an entity manages its business or operations and to which goodwill naturally would be associated."