Fair Value GAAP vs. IFRS

1. Fair ValueGAAP vs. IFRS Presented by Alfred M. King, CMA,CFM October 6, 2008

2. Convergence or Conversion of GAAP-IFRS • World is going towards one set of accounting standards but is IFRS truly uniform? • United States conceded that IFRS is more widely used, so U.S. will change – but when? • Securities and Exchange Commission: • Currently allows foreign filers to use IFRS • Starting in 2010-11 voluntary adoption of IFRS by U.S. Companies • Starting in 2014-15 mandatory adoption of IFRS by all public companies – private companies will follow!

3. Problems with Convergence • Principles vs. Rules – Is this distinction a myth? • Business complexity = complex rules • Will IFRS have to adopt ‘Rules’ over time? • Funding and Membership in IASB • What happens if our SEC disagrees with IFRS? • Transition • Training of preparers – option for early adoption by large companies • Training of auditors

4. Fair Value vs. Fair Market Value • There are real differences among: • Fair Market Value (not used for financial reporting) • Fair Value – GAAP • Fair Value – IFRS • Difference in concept of Fair Value between GAAP and IFRS has not been resolved

5. Exit Value – GAAP Concept • “¶5. Fair value is 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.” • This concept works for financial instruments and does not work for tangible and intangible assets

6. Fair Value – IFRS Concept • “Fair Value is the amount for which an asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged between knowledgeable, willing parties in an arm’s length transaction” [IFRS 2, Appendix A]

7. Exit Value • GAAP concept of valuing something at what it could be sold for today, to a ‘market participant’ works only if there is a market with market participants • U.S. and EU experience recently with sub-prime securities indicates that often there is no market, and no market participants willing to make a market

8. How to Value When There Are No Participants • FASB set up levels 1 through 3 • Level 1 – quoted prices • Level 2 – no direct quotes but similar assets • Level 3 – all other • Valuation specialists are always working in Level 3 • Level 3 allows for Income Approach and Cost Approach but these are considered “entity specific values” and are 2nd class!

9. Entity Specific Values • “Highest and Best Use” is the premise of value in all cases, e.g. parking lot in downtown Manchester has to be valued for development • Highest and Best Use will depend on who is going to use the asset and what they will do with it – Could you develop the site? • If not, you would offer less than would a developer who would buy the land based on hisassessment of the real estate market

10. Fair Value - IFRS • Considers both buyer and seller • IASB would like to ‘converge’ their definition with U.S. SFAS 157 • About half the IASB members, however, are uncomfortable with how the U.S. definition is working in practice • Theoretically, at least, IASB believes the U.S. concept may be correct but not how it is applied

11. New FV Definition from IASB? • No decision until 2009 • May not converge with U.S. SFAS 157 • May stick to its definition • If that happens, quite likely that U.S. will converge to the IASB (!) • FASB is very aware of the problems they have created with Market Participants and Exit value

12. “Defensive Value” • Common problem in Business Combination • Seller and Buyer each have competing brand names • Buyer wants to move Seller’s product line to use the Buyer brand name • Buyer won’t use the Seller’s brand • Buyer, however, would not sell Seller’s brand name to anyone else

13. What Is The Value of a Brand Name That Will Not Be Used? • A Financial Buyer would use the Seller’s brand name • Under U.S. definition of Fair Value whoever the buyer is we value the brand name on what someone else would pay for it, or a value in use to them • Now if the Strategic Buyer will not use it we still have to place a high value on it

14. “Day 2 Problem” • So for the Strategic Buyer we have to value the brand name as though someone would use it, even if it is never going to be used. • It is obvious that the real Fair Value, once there is no more advertising and marketing, is going to go down rapidly • The buyer will have an early impairment!

15. Solution to the Day 2 Problem • Have to change the definition of Fair Value to get away from rigid application of Exit concept • IASB looks as though their ultimate definition of Fair Value will likely be such that this problem may not be there • “Value in Use” still makes a lot of sense and may provide better information to users • IASB may permit, or even require in some cases, Value in Use

16. Fair Value and Impairment: Key Differences FASB vs. GAAP • Real Estate • Investment property • Agricultural/biological • IFRS permits/requires periodic revaluation up or down • U.S. GAAP absolutely prohibits write up • In U.S. this is a one-way street. Can take impairment loss but never an impairment gain – or even write back up to previous amount

17. IFRS Permits Revaluations • A literal reading of IFRS suggests that if they want to, companies can revalue other assets – for example intangibles • Brand Names • Patents • Will U.S. companies take advantage of this? • Look at Fair Value Option (SFAS 159)

18. Fair Value Option • Companies are permitted to revalue LIABILITIES if they wish • Banks and financial institutions have had to write down investments because of credit problems in the economy • SFAS 159 permits them to designate liabilities for same Fair Value treatment • So if a company’s credit rating drops, they can record a ‘GAIN’ which may offset the Fair Value loss on the investments – Bear Stearns example

19. Fair Value Option (2) • U. S. Investment Banks did take advantage of this rule, and literally wrote down the ‘value’ of their own bonds • If those debts will be ultimately repaid at Par (100 %) companies will have to reflect a LOSS to write up the liability • This accounting is hard to explain!! • The worse you do the better you look • The better you do the worse you look

20. My Conclusion • If U.S. companies adopt IFRS they will be at least tempted to write up all sorts of intangible assets to reflect their ‘true’ Fair Value • What will this do for valuation specialists? • Lots more work! • What will this do for the integrity of financial statements?

21. Asset Impairment • Impairment indicators are essentially the same between GAAP and IFRS • IFRS writes down to Fair Value when FV is less than carrying value • No intermediate cash flow test • IFRS looks to the higher of: • Net selling price (exit value) • Value in Use (entity specific)

22. Asset Impairment (2) • United States has three different methods • SFAS 144 for fixed assets and intangibles • SFAS 142 for indefinite life intangibles • SFAS 142 for testing goodwill • SFAS 144 calls for a determination as to whether the SUM of all future cash flows, NOT DISCOUNTED is equal to or larger than carrying value • Can never write back up once loss recognized

23. Research & Development • ‘Research’ expensed in both systems • ‘Development’ is capitalized in IFRS and expensed in GAAP • Under SFAS 141R, purchased In-Process R&D will be capitalized, but further expenditures will be expensed • Basic question: • Is the true Fair Value of R&D properly measured based on costs incurred?

24. Valuing Liabilities and Contingencies • Rules calling for what you could pay someone to take on your liabilities makes no sense • Should allow companies to determine the Present Value or Expected Value of what they anticipate paying to settle liabilities and contingencies • GAAP values contingencies only in a Business Combination

25. Can We Value Contingencies? • Contingent payment in a Business Combination • Settle Environmental Liabilities • ‘Fair Value’ of lawsuits • New SFAS 141R requires this

26. Revenue Recognition • GAAP has over 200 items in the literature • IFRS is very general • Revenue Recognition is a big item at least in the U.S. • FASB looks to ‘Fair Value’ as one way of measuring Revenue Recognition. • Suzie’s sweater example

27. Is There Such a Thing as The Fair Value? • The value of an asset depends on who is going to use it, and for what purpose • How can anyone write a set of rules that provides ‘consistency’ among preparers and yet reflects economic reality? • FASB and IASB would like a “one size fits all” solution in terms of defining Fair Value • This can not be done!

28. Where Are We Going? • Personal views: • Recent problems in valuing subprime assets will slow down move to increased Fair Value • Convergence of IFRS and GAAP will be much harder (and slower) than anticipated • LIFO problem • Different versions of IFRS • Demand for Fair Value by Security Analysts will continue and even increase

29. The Future of the Valuation Business

30. Questions? Presentation by: Alfred M. King, CMA, CFM Vice Chairman, Marshall & Stevens, Inc. Please feel free to contact me for information at any time: E-Mail: aking@marshall-stevens.com