Fair Value Measurement for Financial Reporting

Companies that are required to prepare financial statements for external reporting face complex and serious issues. Failing to timely file financial statements or comply with the reporting requirements could lead to fines, lawsuits, or other damaging consequences. Moreover, with fair value accounting (also known as the mark-to-market accounting practice) becoming more prevalent today, financial executives responsible for filing the financial statements have a more demanding role than ever before. While fair value accounting might provide a more accurate asset and liability valuation on an ongoing basis to users of the financial statements, financial executives are not necessarily prepared to accurately determine fair value of all assets and liabilities.

So, why is accurate reporting so important? Aside from just legal reasons, audited financial statements provide investors, creditors, and members of management the data they need to make critical business and investment decisions. An investor will want to know how well the company is performing according to a set of standardized rules and measurements that a company has not fabricated to make it look good. Similarly, creditors and banks that have lent money or are considering lending money to a business, need an accurate assessment or understanding of cash flow and how likely they are to be paid back.

For internal management, this information is just as important. Accurate and consistent reporting of critical financial data forms the backbone for planning, analyses, benchmarking, and decision making. If the financial data is fragmented or incorrect, businesses would surely fall apart.

Why Does Fair Value Matter?

In recent years, fair value accounting has become an important measurement basis in financial reporting. Under fair value accounting, companies measure and report the value of certain assets, liabilities, and expenses at fair value. Changes in asset or liability values over time generate unrealized gains or losses for assets held and liabilities outstanding, increasing or reducing net income, as well as equity in the balance sheet.

Fair value reporting issues are as important for private companies as they are for public companies. Even private equity firms and other institutions that communicate essential financial information to their stakeholders, investors, and creditors must adhere to these standards.

Fair value measurements are required by the Financial Accounting Standards Board (FASB) for many reasons, but are most commonly required in the following situations:

Equity Compensation (ASC 718)

Equity-based awards are commonly used incentive plans by which companies compensate employees. They are an increasingly important component of a competitive compensation package. Within fair value accounting, employee stock-based compensation is expensed on the income statement through specific accounting rules under ASC Topic 718, Compensation-Stock Compensation. For financial executives new to equity compensation, supporting the determination of fair value, let alone accounting for the expense associated with the equity award, can be a daunting task.

Aside from just the accounting aspects, the determination of fair value of equity issued to employees is also required for tax compliance. Stock, stock options, stock appreciation rights, and other similar equity instruments might be issued as part of nonqualified deferred compensation plans regulated by the IRS.

Equity compensation is one of the most regulated activities, internationally and in the US. Most companies and financial executives will require advisors who are knowledgeable in the valuation of equity instruments issued as compensation.

Allocation of Purchase Price (ASC 805)

When a company has completed an acquisition, those responsible for preparing the financial statements have the responsibility of reporting all items related to the transaction on their financial statement. Commonly referred to as a purchase price allocation (PPA), the acquiring company allocates the purchase price of the acquisition to all assets and liabilities acquired. The PPA is conducted in accordance with ASC Topic 805, Business Combinations, and applies to all transactions and related events in which a business obtains control of another entity.

Under the guidance, a business is responsible for determining the fair value of all identifiable tangible and intangible assets acquired and liabilities assumed, including the fair value determination of any contingent consideration included in the purchase price. Not all financial statement preparers have the resources or skill set, however, to determine fair value and support the allocation of the purchase price. An experienced valuation firm, with knowledge of the accounting guidance and expertise in determining fair value of assets in a business combination, will be required most often. Financial executives will want a firm that has the personnel and experience in providing purchase price allocation valuations that will withstand scrutiny from audit firms, the Securities and Exchange Commission and even the Internal Revenue Service.

Fresh Start Accounting (ASC 852 & ASC 805)

Companies emerging from bankruptcy adopt accounting rules as governed by ASC Topic 852, Reorganizations, which allow those companies to present their assets, liabilities, and equity as a “new company” on the day they emerge from bankruptcy protection. These rules are commonly referred to as “fresh start accounting” and resemble the rules of purchase accounting under ASC Topic 805, Business Combinations. As part of fresh start accounting, the company reviews its balance sheet and operating structure with accounting and valuation experts in order to begin the process of applying fair value concepts in determining its reorganization value and restating the balance sheet to fair value.

Similar to the allocation of purchase price, a company adopting fresh start accounting is responsible for determining the fair value of all identifiable tangible and intangible assets, and liabilities on the balance sheet. Financial statement preparers will want a valuation firm with knowledge and experience in these complex financial reporting matters.

Goodwill Impairment (ACS 350)

When looking at the financial statements of a company, most items are relatively straightforward and easily explained, such as revenue, expenses, receivables, and payables, but what is goodwill and how did it get on the balance sheet? Goodwill is the result of an acquisition (Business Combination) where the purchase price paid for an acquired company is higher than the fair value of all the assets acquired. In other words, goodwill represents the value of the acquired company’s ongoing business.

Once goodwill has been recorded as an asset on a company’s balance sheet, a test for impairment under ASC Topic 350, Intangibles – Goodwill and Other, should be performed at least annually. It should be noted that there is an exception to this rule, and it applies if the acquiring company adopts the accounting alternative as outlined in Accounting Standards Update (ASU) 2014-18. Under these relatively new rules, private companies that adopt the accounting alternative for amortizing goodwill are no longer required to test goodwill for impairment.

Companies that are required to test for impairment, however, often conduct a multistep process. First, there are qualitative procedures that can be considered as to whether there are indications of impairment. Some examples that might indicate impairment would be a significant decline in customer base, increased expenses, decreased cash flows, a deteriorating economy, changes in management, or a decrease in share price. If one or several of these items indicate possible impairment, quantitative procedures that compare the fair value of a company (or reporting unit) with the carrying value should be performed. If the carrying value exceeds the fair value, then it will be necessary to calculate the impairment loss.    

To add to the complexities of these procedures, if there are indications of impairment of goodwill, companies may also need to consider whether the carrying amount of a long-lived asset or asset group might not be recoverable (e.g., market value is significantly less than its carrying value). ASC Topic 360, Property, Plant, and Equipment, provides guidance for the impairment of long-lived assets and includes its own multistep process. Given the sometimes complex nature of impairment testing, preparers of financial statements will want knowledgeable valuation experts who can guide them through the process.

Other Fair Value Measurements (ASC 820)

ASC Topic 820, Fair Value measurements and Disclosures, was originally issued in 2006 as FASB Statement No. 157 and through the principles introduced, the intention was to create consistency and comparability of fair value measurements in financial reporting. The guidance neither addressed what to measure at fair value, nor did it provide any requirements around when to measure fair value. Instead, the principles introduced by the guidance provide for a more consistent framework on how to measure fair value and whether it is appropriate in specific instances.

The framework is based on several key concepts including exit price, highest and best use, principal market, market participant assumptions, the fair value hierarchy, and other elements. The guidance is not intended to be a step-by-step recipe that provides specific procedures in determining fair value, given the wide-ranging types of assets and liabilities. As such, several other accounting standards have been issued. These accounting standards provide specific guidance around financial reporting and fair value issues related to specific assets, liabilities, and investments and are discussed further in the next section.

Complex Financial Instruments and Other Arrangements (ASC 470, ASC 815, ASC 321 and ASC 946)

Complex financial instruments can mean many things to many professionals, but for businesses and investment companies, complex financial instruments can range from assets and liabilities to other financial arrangements that can often be very difficult to value. Financial executives with entities who have elected fair value accounting must use current market values as a basis for recognizing these complex financial instruments.

Businesses and investment companies alike often enter into various financial arrangements as a means of raising capital, investing, hedging, or even as a tool to bridge the gap between valuation differences. These arrangements include options, swaps, warrants, convertible debt, derivatives, preferred equity, and contingent liabilities, to name a few. Each of these various instruments will typically be recognized as an asset, liability, or equity on the balance sheet. There are numerous accounting standards and other pronouncements that have been issued that provide guidance on how businesses and investment companies recognize these instruments on their financial statements. 

For example, businesses that raise capital through debt financing might have a note that is convertible, in which case, it may be necessary for an issuer to bifurcate and determine the fair value of the debt and equity components of that note under ASC Topic 470, Debt. Companies might also enter into certain derivative or hedging transactions as outlined in ASC Topic 815, Derivatives and Hedging, which provides guidance on these types of arrangements. Specifically, the guidance sets forth the definition of a derivative instrument and specifies how to account for it, including derivatives embedded in hybrid instruments.

From an investment perspective, companies may have securities or other ownership interests and may need to account for these equity securities under ASC Topic 321, Investments – Equity Securities. The guidance suggests that certain equity investments within its scope be measured at fair value, with changes in fair value being recognized on the income statement. Similarly, hedge funds, broker-dealers, private equity groups, and other similar entities have their own investments, whether debt or equity. Many of these entities will meet the definition of an Investment Company under ASC Topic 946, Financial Services – Investment Companies, and will have their own set of rules for both recognition and measurement of the various transactions entered into by these companies.

While these are just a few of the accounting standards that have been issued in recent years, these are the most commonly referenced standards when managing valuation issues. This list, however, requires considerable due diligence when determining the appropriate accounting treatment. Companies should use caution and consult with their auditors, as accounting and financial reporting issues can be complex and even lead to a potential restatement, which can be very costly.

Engaging a Valuation Firm

Due to the complex nature of these valuation issues, combined with the standards under fair value reporting, financial executives often engage independent valuation firms, especially when that executive or company lacks the expertise or resources to perform fair value opinions.

Because of our trusted experience and knowledge, audit firms, legal professionals, and tax advisors consistently refer their clients to PCE. We provide a full range of valuation services to support fair value reporting requirements that withstand scrutiny from auditors and other regulatory bodies, such as the SEC.  

We offer a broad range of experience with fair value financial reporting issues. Our professionals have in-depth knowledge and understanding of the reporting requirements and best practices in financial reporting valuations.

PCE provides a full range of fair value measurement services. Our analyses and conclusions have been widely accepted, withstanding the scrutiny of auditors, the SEC, and other regulatory bodies. We have deep experience, providing fair value‒related services to businesses and organizations, including public and private companies, private equity firms, early stage enterprises, and other closely held businesses and partnerships.

With our team’s background in fair value accounting, we assist clients with valuation matters impacting their financial statements and help clients think through certain financial or strategic issues. Because our firm understands fair value issues, local and national accounting firms regularly refer financial reporting valuation assignments to PCE Valuations.

 

Paul Vogt

Valuation

pvogt@pcecompanies.com

Atlanta Office

407-621-2100 (main)

678-641-4760 (direct)

407-621-2199 (fax)