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).

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."

(6) A direct measure of the fair value of goodwill is impracticable since goodwill is measured as a residual amount at the moment of a business combination. Accordingly, SFAS 142 requires calculating the implied fair value of goodwill using a method similar to that used in the allocation of the purchase price to the net assets at the moment of a business combination and initial recognition of goodwill, i.e., subtracting the fair value of the net assets of a reporting unit from the fair value of the reporting unit as a whole, to determine the implied fair value of that reporting unit's goodwill.

Omar Esquivel, Deloitte & Touche LLP

Sylwia Gornik-Tomaszewski, The Peter J. Tobin College of Business, St. John's University Exhibit 1: HIERARCHY OF INPUTS TO VALUATION TECHNIQUES Level 1 Unadjusted quoted prices in active market for identical assets and liabilities Level 2 Quoted prices for similar assets or liabilities in active markets Quoted prices for identical or similar assets or liabilities in markets that are not active Inputs other than quoted prices that are observable for the asset or liability, e.g., interest rates and yield curves observable at commonly quoted intervals, volatilities, prepayment speeds, credit risk, and default rates Market-corroborated inputs; that is, inputs that are derived from or corroborated by observable market data, by correlation or other means Level 3 Unobservable inputs based on the reporting entity's own assumptions about the assumptions that market participants would use, based on the best information available in the circumstances Exhibit 2. FAIR VALUE IN THE MEASUREMENT OF IMPAIRMENT OF ASSETS Asset How Fair Value Details of Impact of Category is Used Impairment Test SFAS157 Long-lived Fair value is If carrying amount is Provides

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