Friendly Accounting at Facebook

This post is courtesy of the Accounting Onion


U. S. Senator Carl Levin recently spoke on the Senate floor, referencing the discrepancy between tax and accounting treatment of stock options in the (then upcoming) Facebook IPO:


"According to its filings, when Facebook goes public, Mr. [Mark] Zuckerberg plans to exercise options to purchase 120 million shares of stock for 6 cents a share. Mr. Zuckerberg's shares, obviously, are going to be worth a great deal more than 6 cents, a total of about $7 million; they will apparently be worth more than 600 times as much, something in the neighborhood of $5 billion.


Here's where the tax loophole comes in. Under current law, Facebook can – perfectly legally – tell investors, the public, and regulators that the stock options he received cost the company a mere 6 cents a share – that's the expense shown on the company's books. [This is wrong – see later.] But the company can also – perfectly legally – later file a tax return claiming that those same options cost the company something close to what the shares actually sell for later on – perhaps $40 a share. And the company can take a tax deduction for that far large [sic] amount. So the books show a highly profitable company – profitable, in part, because of the relatively small expense the company shows on its books for the stock options it grants to its employees. But when it comes time to pay taxes, to pay Uncle Sam, the loophole in the tax code allows the company to take a tax deduction for a far larger expense than they show on their books. …


Now, the end result is that a profitable U.S. corporation – a success story – could end up paying no taxes at all for years, even decades."
To Levin, the Facebook IPO is a dramatic illustration of an inequitable "loophole" in the tax law. As Levin and Sherrod would have it, Facebook's tax deduction for using stock options to compensate executives – as opposed to any other form of compensation – would be essentially zero (that's probably a little dramatic on my part, but the point is the same); yet, Zuckerberg's tax liability when he exercises the options could be somewhere in the area of $3 billion.


The strong implication of Levin's narrative is that the extra amount of expenses would have wiped out every dollar of Facebook's reported net income that it had ever 'earned.' On top of that, there could be other outstanding options held by Zuckerberg and other employees extending way down the organization, which are going to have the same effect on future reported net income.


Which brings me to my second question: For all practical purposes, could Zuckerberg be taking Facebook public at this point in time with no history of profitability, perhaps negative shareholders' equity, and perhaps no hopes for earnings for some for years to come?


My inclination is to say "no," but I can only speculate. So, I will answer that question with another question: Since the FASB's rules understate the economic cost of options granted to employees, did the FASB provide a perverse incentive to Facebook to grant more options (or at terms overly favorable) to employees than it should have?


If one accepts the maxim that "what gets mismeasured gets mismanaged," then the answer to that question should be "YES." The stock option problem lies not with the tax rules that eventually recognize the full cost of the options to shareholders, but with the financial reporting rules that allowed Facebook to grant options without recording their full cost.


Surely, the senators can see that different accounting rules would have wrought different compensation policies from Facebook. Senator Levin would not have had a story to tell and Mark Zuckerberg would be a few billion dollars poorer.


Footnote: It is my distinct pleasure to provide Senator Levin (and his staff) with yet another accounting lesson. The amount of expense to be reported by Facebook is not, as the senator claims, the exercise price of the options (i.e., 6 cents per share). Assuming that the options were issued without any intrinsic value, then their "grant-date present value" (i.e., the amount upon which periodic option expense is measured) could end up being more or less than 6 cents per share. Although this technical correction to Senator Levin's story it doesn't fundamentally change the message, it once again reveals a lack of understanding that makes one question if Senator Levin has an adequate grasp on the issues.

Like LIFO?

Below is a very informative article from CFO.comSucking the LIFO Out of Inventory

The government sees billions of dollars in potential tax revenue sitting on the shelves of company warehouses.

Explaining accounting to Congress is never easy. But last spring, Bill Jones, vice chairman of O'Neal Industries, says he witnessed a few "aha" moments as he went door-to-door on Capitol Hill to lobby against the elimination of "last-in, first-out" (LIFO) accounting.

As Ron Travis, O'Neal's vice president of tax, explained to members of Congress why the majority of companies use LIFO, "lightbulbs started going off," recalls Jones. Until then, he says, "they thought LIFO was just a funny-sounding acronym."

LIFO allows companies to calculate the cost of goods sold based on the price of the most recently purchased ("last-in") inventory, rather than inventory that was purchased more cheaply in the past and has been sitting on the shelf. That boosts the cost of goods sold, which lowers profits — and, thus, taxable income. LIFO is particularly important to companies that have slow-moving inventory — such as industrial manufacturers and distributors — and are therefore vulnerable to rising prices. O'Neal, a manufacturer and distributor of metals and metal products, has used LIFO for 63 years, almost as long as the method has been allowed for tax purposes (the Internal Revenue Service first sanctioned it in 1939).

"We normally replace every piece of inventory we sell with a higher-priced piece of inventory," explains Travis. "Under LIFO, all of the inflation that is built into our product is not recognized for tax or book purposes."

Jones and Travis breathed a sigh of relief last year when Congress quietly dropped plans to eliminate LIFO. But it didn't take long before the funny-sounding acronym was back in the taxman's sights. The 2011 federal budget proposed by the Obama Administration again includes a provision to repeal LIFO accounting. The government estimates that the move would boost federal coffers by $59 billion over 10 years.

Even if LIFO somehow survives another year of federal budgeting, it still faces the long-term threat of being wiped out if the United States adopts international financial reporting standards (IFRS), which do not allow LIFO. That would stop companies from using LIFO entirely, because companies that use the method to reduce taxable income reported to the IRS must also use it for financial reporting, rather than potentially more-flattering methods, such as FIFO (first-in, first-out) or average cost.

A Bad Match?
Companies like LIFO because it stifles inflationary effects by matching current expenses and current sales more closely than other methods. The accounting convention "protects us from having to pay taxes on what are not really profits," contends Jones. Indeed, proponents of LIFO — 120 of which have formed the LIFO Coalition to lobby against its repeal — don't consider the methodology a tax break. "There is an economic reason for using LIFO, and that is lost on the folks in Washington," says Beatty D'Alessandro, CFO of Graybar, a distributor of electrical and industrial components that has been using LIFO since the early 1980s. Without LIFO, he says, there is a "mismatch between what it's going to cost us to put inventory back on the shelf and what we bought it for six months ago, when it may have cost less."

To understand the mismatch, consider how LIFO works: Say, for example, that a company has an industrial compressor in its inventory that it bought for $5,000. It sells the compressor for $5,500, and replaces it in inventory for $5,200. From an economic perspective, the profit is only $300, not the $500 difference between the historic and current price. LIFO allows companies to use that "last-in" price to record $300 in taxable income. The remaining $200 in income is deferred until the company shutters its business and is forced to liquidate the inventory, at which time it strips off years of "LIFO layers." The $200 — the difference between the taxable income recorded under LIFO and another methodology — is referred to as the LIFO reserve.

In a liquidation, notes O'Neal's Travis, the sell-off of old inventory generates revenue to pay the taxes. But if LIFO is simply repealed, he says, then deferred taxes will be due without the benefit of any additional revenue. "In effect, the repeal of LIFO is going after our equity," the tax director says.

Under the Obama budget proposal plan, companies would be required to "true up" their retained earnings in the year they stop using LIFO, explains Jason Cuomo, a senior analyst with Moody's Investors Service. They would then make annual cash tax payments on the profits stored in the LIFO reserve over a 10-year period, beginning in 2012.

Graybar's D'Alessandro argues that LIFO accounting is a "timing issue," rather than a tax gimmick, and emphasizes that LIFO accounting reverses itself when demand drops. "You burn through LIFO layers as you burn through your inventory," explains D'Alessandro, who notes that Graybar reached lower-cost inventory layers last year as demand slowed. At that point, profits rose under LIFO accounting and the company had to pay more in taxes. The same is true when deflation sets in, says Scott Rabinowitz, a director in PricewaterhouseCoopers's national tax practice. As the price of replacement inventory drops, taxable income increases, and so does a company's tax obligation.


A Cash-Flow Issue
Not all companies agree with the mismatch theory. Proponents of FIFO, who tend to be retailers and manufacturers of fast-moving inventory such as electronics or perishable goods, say FIFO better reflects the current value of inventories. For example, in December, packaging giant Pactiv Corp. switched from LIFO to FIFO, telling investors that the change provides "better matching of sales and expenses." Officials at the company, which makes Hefty brand plastic bags, noted that this is particularly true during periods when the price of their primary raw material, resin, is volatile.

Under FIFO, they said, "the lag between resin-price changes and selling-price changes will be reduced by approximately two months."




Moreover, not everyone agrees that LIFO elimination would be such a dire event for companies with slower-moving inventory. The elimination of LIFO "is a cash-flow issue," argues Moody's Cuomo, who co-authored a recent report on the subject. His report, which examined 176 companies rated by Moody's that use LIFO, points out that larger companies with strong cash flows likely will weather the one-time charge of converting from LIFO to FIFO or another methodology without much problem (see the chart at the end of this article). That's because for the largest companies, the charge represents a small percentage of their annual cash flow. However, smaller companies with high LIFO reserves and low cash flows could run into problems.

But some large companies say the change would still hurt. Graybar, with $4.3 billion in revenue, reported a LIFO reserve of $107 million in its most recent 10-K. Assuming a 35% tax rate, and a single payment that is not stretched out over time, D'Alessandro estimates that Graybar's tax bill would amount to $37.5 million on the day it converted from LIFO to FIFO — or a $19 million tax obligation if the company switched to average-cost accounting. More important, a switch from LIFO could mean up to 500 fewer jobs, says the CFO, who figures that, on average, salary and benefits cost the company $70,000 per person. "If we pay it in taxes, we can't pay it in wages. It is as simple as that. [LIFO repeal] is an anti-employment move," insists D'Alessandro.

The demise of LIFO also could affect a company's net operating losses — the deferred tax asset that is recorded by a company and held to offset taxable income in the future. Rabinowitz notes that taking the LIFO reserve into income could reduce the amount of NOL carryforwards.

The sting of LIFO repeal also will be felt by smaller companies that don't have robust information-technology systems, says Stephanie Anderson, a managing director at consultancy AlixPartners. That's because sorting and valuing layer after layer of LIFO inventory is a complex task. That kind of "unwinding" is mandatory before an accurate valuation can be recorded for book and tax purposes. Anderson says companies may also need to hire more cost accountants to ferret through the inventory layers.

Is the End Near?
The brightest hope for LIFO proponents is the possibility that the accounting method could yet survive. It is too early yet to tell how strong industry pushback will be on the Administration's proposed repeal, but lobbying efforts have stopped it before. Similarly, if the Securities and Exchange Commission does make IFRS the accounting system of the land, nonpublic companies won't have to use the standards. Indeed, if the IRS itself isn't the force behind a LIFO prohibition, it might even prove willing, as it has in the past, to water down conformity regulations requiring that certain methods be used consistently for both tax and financial reporting.

Perhaps the biggest wild card affecting the government's decision will be the economy. "It's always a terrible time to look at repealing LIFO," says Jones, "but right now it's just another nail in many corporate coffins."

Marie Leone is senior editor for accounting at CFO.

FASB in Midst of "Religious War" on Fair Value

This is a posting on a blog called "Finance Director" about a n article by Mario Christodoulou, Accountancy Age, 22 Jul 2010.

Attempts to bring in fair value standard "almost like a religious war" board member claims.

A member of the US accounting standard setter has likened attempts to bring in fair value to a “religious war” in a speech with regulators this week.

Lawrence Smith, board member with the Financial Accounting Standards Board (FASB), made the comment in a panel discussion with US audit regulator, the Public Company Accounting Oversight Board, in the midst of a far ranging consultation on the accounting principle.

FASB is pushing ahead with plans to bring in a full fair value measurement model which would force banks to value their financial assets at market prices. The proposals are being fought by banks who argue the rules would add volatility to balance sheets.

Smith said he is not a "fair value zealot", but was swayed to the model when he saw the effect on deposits.

"That’s what threw me over the edge," he said.

“Some people have advised us that we shouldn’t say this, but I’ll say it – fair value, to some of us, is almost like a religious war out there and we are trying to deal with that as best we can.”

FASB is attempting to harmonise its accounting rules with international standards, despite clear differences in their approach to fair value. Whereas FASB’s proposal measures assets measured at fair value, the international model allows some loans to be valued at amortised cost.

The contentious proposals was passed by a single vote, with the five-member FASB board split 3-2.

Smith’s comment will likely widen the gap between FASB’s proposal and its international counterpart, the International Accounting Standards Board (IASB). Failure to reach agreement on the standard will undermine US attempts to adopt international rules.

The US Securities and Exchange Commission is currently investigating the impact of international accounting rules on US markets. A key part of their final decision will depend on the level of convergence between US and international accounting rules, with fair value being among the most important project on the table.

New Thoughts on Goodwill Impairment Testing

New thoughts on goodwill impairment testing by Marie Leone of CFO.com

Over two-thirds (68%) of U.S. public companies in the United States wrote down goodwill by taking impairment charges in 2008. Total charges were $260 billion according to a report issued by financial advisory firm Duff & Phelps and the Financial Executives Research Foundation. The report examined 2008 financial statements of nearly 6,000 publicly held companies.

As 2009 results are being filed it appears that goodwill write-downs have declined., says Greg Franceschi, who heads up the global financial reporting practice for Duff & Phelps. Since the worst of the financial crisis ended, company market values have increased and accordingly there are fewer goodwill write-offs.

However a new accounting wrinkle has surfaced related to goodwill impairments. At issue is whether companies should determine the fair value of a reporting unit — and thereby the value of the related goodwill — based on either the unit's equity value or its enterprise value. (In general, enterprise value is the sum of the fair value of debt and equity.)

The question was sparked by a December speech given by Evan Sussholz, an accounting fellow in the Office of the Chief Accountant at the Securities and Exchange Commission. In his speech, Sussholz suggested that in certain situations, using an enterprise-value measurement may provide a more economically accurate picture of the reporting unit. His suggestion left preparers and auditors clamoring for a clarification, as companies have historically applied the equity-value approach to impairment testing, says PricewaterhouseCoopers partner Larry Dodyk.

In response, the Financial Accounting Standards Board and the American Institute of Certified Public Accountants have launched efforts to figure out whether additional guidance on the subject is needed. FASB's emerging issues task force is slated to start discussing potential guidance during the second half of the year, while the AICPA is currently working on completing a practice aid, which is a sort of unofficial manual that discusses best practices and concepts that auditors and preparers may want to apply.

Under U.S. GAAP, companies must perform a goodwill impairment test at least once a year to determine if the current value of an acquired reporting unit is worth more or less than its original price. The test is a two-step process in which the company must first compare the fair value of a reporting unit with its original price — the amount the company carries on its books. If the book value exceeds the fair value, then the asset is impaired and a second step is required to measure the amount of the impairment. If the book value is lower than the unit's fair value, then the asset passes the test and nothing more is required.

The confusion over whether to use equity value or enterprise value stems from the seemingly straightforward first step of the test, because the accounting rule is unclear. Sussholz said that originally, the SEC didn't believe the selection of one approach over the other would affect the test outcome. However, since taking a closer look at the practical implications, SEC staffers have acknowledged one unanticipated situation that is a potential problem: when the book value of a reporting unit measured at the equity level is negative.

Intuitively, it might seem that a negative book value would mean a reporting unit is on the verge of bankruptcy, but that may not be the case. Dodyk explains that a single reporting-unit company, for example, may have negative shareholders' equity as a result of unrecognized assets (such as intangibles) that have significant value but don't figure into the equity equation. Heavy borrowing for a leveraged buyout could also send shareholders' equity into negative territory.

Consider what happens in an equity-value impairment test when a reporting unit's book value is negative. By definition, the fair value of common equity cannot be less than zero, because the equity is essentially a call on the company's operations. That means the fair value of a reporting unit measured at the equity level would always be greater than a negative book value, and therefore always pass step one of the impairment test. That would be the case even if significant goodwill exists and the underlying operations of the reporting unit "may be deteriorating," asserted Sussholz.

On the other hand, says Franceschi, testing for impairment at the enterprise level would include the reporting unit's debt burden, providing what Sussholz claimed was a more accurate picture of the company's financial health. To be sure, his speech opened up the possibility that another testing approach may be permitted or required.

Franceschi doesn't believe the additional guidance will cause a significant increase or decrease in goodwill write-offs. But it may require companies to rethink valuation models and approaches, especially if the guidance recommends that companies use more judgment when determining a reporting unit's fair value. "For valuation issues, you can never have something that says, 'This is the way to do it, and the only way to do it,'" he says. "There may be multiple approaches one needs to consider."

Another concern with tinkering with Topic 350 is that it may spark other changes. "Once you open the rules to the goodwill impairment test, you never know where it is going to go," says Dodyk.

SEC and Goodwill Impairment

In the current economic environment, the SEC continues to ask issuers to support their assertions around goodwill impairment. SEC staff comments often arise when a company’s revenues significantly decline or when market capitalization significantly declines below book value, since such declines may indicate impairments in intangible assets and goodwill.

SEC staff also request additional disclosures about goodwill impairments. SEC staff have indicated that in future they will request even more disclosures about how the conditions that caused impairment will affect a company’s business in the future.

Documentation of support for impairment test results is important as SEC staff includes valuation experts who may request and review a company’s goodwill valuation reports.

The staff has also been asking for more robust and comprehensive disclosures about goodwill impairments, including the following:

• Policies for impairment testing
• Organization of reporting units
• Goodwill allocated to the reporting units
• Description of the steps performed to review goodwill for recoverability
• Nature of the valuation techniques used, including descriptions of the significant estimates and assumptions used to determine the fair value of the reporting units
• Results of the most recently completed impairment tests.

Examples of SEC Comments
Goodwill Impairment Testing — We see that goodwill comprises approximately [XX%] of your assets at [year-end]. We also note that revenues and net income continued to decline in the first quarter of 2009 due to decreases in volume, a slowdown in the economy, declining demand from the [XXX] and [YYY] markets and increased competition from imports. Please tell us how you considered these factors in determining whether goodwill was impaired at [year-end]. In addition, tell us whether these items are indicators of potential impairment that would require you to perform a goodwill impairment analysis subsequent to [year-end].

Goodwill Impairment Testing — We note that you recognized a goodwill impairment charge during the year. . . . In the interest of providing investors with a better insight into management’s judgments in accounting for goodwill impairments, please revise future filings to provide the following disclosures as part of your critical accounting policy:

• The reporting unit level at which you test goodwill for impairment and your basis for that determination;
• Sufficient information to enable an investor to understand how you estimate the fair value of your reporting units and why management selected that method as being the most meaningful in preparing your goodwill impairment analyses;
• A . . . description of the material assumptions used;
• If applicable, how the assumptions and methodologies used for valuing goodwill in the current year have changed since the prior year, highlighting the impact of any changes; and
• If or how you consider your market capitalization relative to your net book value in evaluating goodwill for impairment.

Goodwill Impairment Testing — We note there was a significant decline in your market capitalization during the third quarter. . . . It appears this is a triggering event that could require you to reassess your goodwill for impairment. Please tell us what consideration you gave to reassessing the recoverability of your goodwill in the third quarter. If you did not perform impairment tests, please explain why. To the extent that impairment tests were performed tell us how you determined that no impairment existed including in your response what impact the current economic environment had on your cash flow assumptions.

Long-Lived-Asset Impairment Testing — Please revise to describe the impaired long-lived assets or asset groups, the facts and circumstances leading to the impairments and the segment in which impaired long-lived assets or asset groups are reported.

Wayne Carnall, chief accountant in the SEC’s Division of Corporation Finance, recently observed that even though “registrants have provided voluminous disclosures regarding goodwill impairments within the critical accounting policy section of [MD&A], it is not always clear how the information is meaningful to investors.” The disclosures have often focused on the noncash nature of the goodwill impairment but have not addressed the business and economic conditions that gave rise to the charge. We understand that the SEC staff will be asking for more disclosures in MD&A about what the conditions that resulted in impairments mean to the registrant’s business as well as for more forward-looking information about the risk of future impairments, such as:

• Percentage by which the fair value of the reporting unit exceeds its carrying value as of the most recent step 1 test
• Goodwill allocated to the reporting unit
• Assumptions that drive the estimated fair value and a discussion of the uncertainty associated with the key assumptions
• Discussion of any potential events, circumstances, or both, that could have a negative effect on the estimated fair value
• Carnall also stated that the SEC staff “is considering providing . . . guidance in the near-term to provide registrants with a better understanding of its expectations in this area.”

Control Premium and Goodwill Impairment

Robert Fox, a professional accounting fellow in the SEC’s Office of the Chief Accountant, recently raised several points about goodwill impairment. For example, he remarked that the market capitalization of a registrant may not fully reflect the aggregate fair values of all the registrant’s reporting units. Mr. Fox pointed to ASC 350-20-35-22 and 35-23 (formerly paragraph 23 of Statement 142), noting that “an entity might derive ‘substantial value’ from the ability to obtain control.” Accordingly, this control premium may cause the fair value of all the registrant’s reporting units to exceed the registrant’s market capitalization. He also indicated that while it would be “prudent” for an entity to reconcile the aggregate fair value of its reporting units to its market capitalization, the entity should also consider other factors when assessing goodwill for impairment.

New IFRS Fair Value Standard will be released In November

International Accounting Standards Board chairman, Sir David Tweedie, said thath the IASB will release a new fair value accounting rule by November.

In an address to a meeting of European Finance Ministers, which have in the past been critical of the IASB’s response to the financial crisis, Tweedie has sought to ease concerns by announcing that he is on track to deliver a new fair value standard by the end of this year.

“I gave a commitment to deliver on this timetable. We will publish the new standard in November,” he said.

Fair value accounting came under fire from banks and governments in the European Union and the U.S. after the financial crisis.

Tweedie said he will not require loan books to be held at fair value which has now become a potential sticking point between the IASB and the FASB.

FASB's proposal will see all assets measured at fair value. The IASB's mixed measurement model would see banks' loan books valued on an amortized cost basis.

The two standard setters are trying to converge US and international accounting rules, in the hope that the US will eventually adopt the new rules. But the fair value standard has now emerged as a significant obstacle, highlighted by Tweedie who said he simply did have the time to co-ordinate efforts with FASB in the revision of fair value, in the wake of the financial crisis.

“As I said in June, given the urgency of the fundamental issues surrounding IAS 39, none of us can afford the potential protracted back-and-forth resulting from piecemeal changes in international and US standards that would undermine the comprehensive and desperately needed reform that is under way,” he said.

“In our discussions with the FASB aiming to reach a common global approach, we will emphasise our position in favour of a mixed measurement model over one that requires full fair value measurement on the balance sheet… I remain optimistic that we can overcome our current differences.”

Little Economic Benefit in U.S. to Adopting IFRS: MIT Study

Back a few months this blog reported that the IFRS Roadmap calling for replacement of U.S. GAAP with IFRS by 2014 is coming under increased scrutiny. We cited a paper written by academics from Wharton, MIT, and other reputable universities discussing the implications on the U.S. economy of adopting IFRS.

The last nine months have been controversial for both U.S. GAAP and IFRS. Political pressures have been brought against both the U.S. standards and IFRS as a result of controversy over fair value/mark to market accounting.

The specter of political issues haunting accounting essentially could pit the SEC and the FASB against with the International Accounting Standards Board (IASB). In announcing the roadmap a few months back, the SEC called for improvements to funding and governance of the IASB. In more recent statements, the SEC has criticized IFRS as inadequate.

The same sources now argue in another paper that there are reasons to slow down the change to IFRS.

The new paper examines the economic consequences of mandatory IFRS reporting around the world. It analyzes the effects on market liquidity, and cost of capital and market value of a company's stock compared to a company's equity book value in 26 countries using a large sample of 3,100 firms that are mandated to adopt IFRS.

Some findings at the time of adoption of IFRS:

Market liquidity increases “In our firm-year analyses, the effects range in magnitude from 3% to 6% for market liquidity relative to levels prior to IFRS adoption,”

Cost of capital decreases

Equity valuations increase

However the authors find that IFRS adopters that are cross-listed on U.S. exchanges experience lower, if any, liquidity benefits. That is because “In countries like the U.S., there may be minimal room for improvement because U.S. GAAP is already considered a high-quality accounting regime.”

The authors note that while some argue that adopting IFRS in the U.S. would make it easier for investors to compare firms with those in other countries and decrease costs of reconciliations, this study provides “weak” evidence of any comparability benefits. “This is an area where more research will occur, but as of now there is no general agreement as to how large this type of benefit could be. The adoption of IFRS is a hot topic and it will take a few more years to get a full understanding of the long-term consequences.”

Capital-market benefits occur only in countries where firms have incentives to be transparent and where legal enforcement is strong, underscoring the central importance of firms' reporting incentives and countries' enforcement regimes for the quality of financial reporting.

Comparing mandatory and voluntary adopters, the capital market effects are most pronounced for firms that voluntarily switch to IFRS, both in the year when they switch and again later, when IFRS become mandatory. They however caution that the former result is likely due to self-selection, and that the latter result is a caution to attribute the capital-market effects for mandatory adopters solely or even primarily to the IFRS mandate.

Many adopting countries have made concurrent efforts to improve enforcement and governance regimes, which likely play into the findings. Consistent with this interpretation, the estimated liquidity improvements are smaller in magnitude when analyzed on a monthly basis, which is more likely to isolate IFRS reporting effects.

The paper is: Mandatory IFRS Reporting Around the World: Early Evidence on the Economic Consequences

Contrary Views on Liability Measurement

GAAP introduced in FAS 157 and elsewhere supports a view that an entity’s own credit risk is a determinant in measuring fair value of a a liability.

Some financial statement preparers don’t like the idea that a reduction in an entity’s credit rating would create a gain. How does this work? If a company’s credit rating dropped, the likelihood that it would repay its liabilities decreases, resulting in an entry such as:

Dr Liability
Cr Gain

If later the company’s credit rating was raised, then a loss would result:

Dr Loss
Cr Liability

If an entity’s credit rating increased above the rating when the liability was set up, the liability would be carried at an amount in excess of the amount that was required to be repaid, resulting in a gain if early repayment occurred.

In June, the FASB sought comments proposed FSP Measuring Liabilities under FASB Statement
No. 157 (FSP 157-f).

The Government Relations Committee (GRC) of the Association of financial Professionals sent a comment letter to FASB to voice its concerns with the guidance.

The GRC generally supports the FASB in its efforts to issue timely guidance on fair value measurement. However the GRC takes the position that the FASB’s current model for measuring liabilities is significantly flawed for the following reasons:

1. The inability to actually realize the fair value at the reporting date should be considered.


2. The fair value calculation of a liability should not exceed the contractual value of the debt a company actually owes.


3. Gains arising from a company’s own credit impairments should not be allowed.


4. Any restrictions on a debt should be taken into consideration in subsequent measurement.

Check out the AFP's site: http://www.afponline.org/

Flaws in FASB’s Proposed Fair Value Proposal

The Association of Financial Professionals (AFP) Government Investor Relations Task Force has sent a comment letter to the FASB on the proposed FASB Staff Position titled “Measuring Liabilities under FASB Statement No. 157” (FSP FAS 157-f).

While AFP supports the FASB in its efforts to issue timely guidance on fair value measurement, AFP’s view is that the FASB’s model for measuring liabilities in this FSP is significantly flawed because:

1. The inability to actually realize the fair value at the reporting date should be considered;
2. The fair value calculation of a liability should not exceed the contractual value of the debt a company actually owes;
3. Gains arising from a company’s own credit impairments should not be allowed; and
4. Any restrictions on a debt should be taken into consideration in subsequent measurement.

AFP says that the FSP assumes that the company has the ability to take advantage of market pricing (e.g., as a result of changes in interest rates) and repurchase its own debt in the open market, which in most cases it does not. The market performance of a company’s debt trading as an asset is not directly correlated to the economic value of the liability associated with its issued debt. A company is only liable for the stated value of the debt upon maturity or early retirement – nothing more or less. Thus, why would a company hypothetically report a fair value measurement above or below the face amount of the debt if the company does not have the ability to actually realize that pricing at the reporting date?

Read the full comment letter here.

Valuations for Financial Reporting in Today's Market

Great article on valuation in financial reporting in the Journal of Accountancy--reproduced below.

The current economic environment has presented unprecedented circumstances for members of the business valuation profession. Those who perform valuations for financial reporting are grappling with issues surrounding impairment, market capitalization versus fair value determinations, reasonable rates of return, and active versus distressed and inactive markets, to name a few.

The JofA hosted a virtual round-table discussion with valuation professionals from the financial reporting sector to gauge how they are handling such issues in today’s climate and what their outlook is for the near future.

THE PANELISTS
Dave Dufendach, CPA/ABV, ASA, is a partner in Grant Thornton’s Seattle valuation practice. His primary focus is fair value for financial reporting: performing reviews for audit purposes in addition to valuations for nonaudit clients.

Walter McNairy, CPA, is a Raleigh, N.C.-based member in charge of Dixon Hughes PLLC’s public company practice.

Mike Morhaus, CPA/ABV/CFF, CVA, ASA, is a senior manager in the Forensic and Valuation Services department of Anders Minkler & Diehl in St. Louis. He specializes in the valuation of closely held business and other financial assets and has testified in the courts of Missouri and Illinois on a variety of business valuation and forensic accounting issues.

Bernard Pump, CPA/ABV/CFF, is a partner in Deloitte’s Chicago location, specializing full time in the valuation of closely held businesses.

Carolyn Worth, CPA/ABV, is a partner with KPMG LLP in the San Francisco office. She has been doing valuations for about 30 years, dealing mostly with public companies and fair value accounting.

Kevin R. Yeanoplos, CPA/ABV/CFF, ASA, is the director of valuation services for Brueggeman and Johnson Yeanoplos PC of Tucson, Ariz. He is currently a commissioner on the AICPA’s National Accreditation Commission and the immediate past chair of the ABV Credential Committee.

JofA: Have you ever faced a similar environment, and if so, what kind of lessons did you learn from it?

Carolyn Worth: A lot of economists are making comparisons to the Japanese banking crisis of 1990. I see similarities with a lack of understanding by the investor on the risks that the banks were taking in a very difficult credit environment. Now a lot of companies are relying more heavily on the income approach and ignoring the market approach, because they’re seeing dislocation between the two methodologies. If you ignore the market approach, then you’re ignoring other investors’ understanding of what they think the future economic benefits of the cash flow will be from these companies. The best thing to do is try to reconcile the two.

Bernard Pump: There’s an interesting parallel to the tech boom when we couldn’t explain the market pricing of companies. Through valuation techniques, you couldn’t get as high as the market with some of these tech stocks. The situation is similar today where in many industries, especially financial services, you can’t force the valuations low enough to replicate the market pricing of some of these companies.

Dave Dufendach: Another difference between that environment and today is we didn’t have FAS 157 (FASB Statement no. 157, Fair Value Measurements) back then with its laser-focus on market observations, so that adds a new element to the current situation.

Pump: It’s a wonderful thing that we have companies embracing income approaches under the FASB guidance because you can see the potential for that downward spiral if you are relying exclusively on the market approaches. Many of my clients are private-equity firms that have always used a market multiple in pricing their securities under FAS 157. Now they’re looking to the income approach, and I find it somewhat amusing that they’ve fully embraced the income approach as opposed to the market approach.

COMPARABILITY CHALLENGES
When pricing multiples drop significantly, challenges arise on how to perform services in light of not having a normal, usual market to turn to for comparability. The market is valuing companies at an all-time low, resulting in market approach valuations that are lower than the income approach valuations. The market approach uses pricing multiples of similar public companies as a benchmark to value the subject company, while the income approach tends to rely on a discounted cash flow methodology. Generally, when the market is “properly” priced, these two methods should result in a similar estimate of value for the subject company, assuming all factors are held equal.

However, in today’s environment, valuation analysts are seeing a wide spread between these two estimates of value that cannot be easily reconciled. As one panelist suggests, the intrinsic value of the subject company is greater than the indication under the market value, causing problems for the valuation analyst, particularly with respect to impairment testing under FASB Statement no. 142, Goodwill and Other Intangible Assets, since intrinsic value is not fair value.

JofA: Are you able to reconcile values or is it impossible to get back to reconciliation between the market method and an income approach?

Pump: We’re performing FAS 142 impairment tests. The SEC requests that you reconcile the market capitalization of the company to the summed-up value of the business reporting units, the business as a whole. The difference between those is called an implied control premium with the market value usually being a little bit less than the overall value through the other methods. And that number’s been in the range of 10% to 20% historically. Right now it’s not uncommon to see 100% implied control premium (acquisition premium). It’s a real challenge, because even after you’ve drilled down on the projections and put as much risk premium as you can into the discount rate, you can’t get very close to the publicly traded stock price.

Walter McNairy: When our clients are ready to write down goodwill impairment, they want to write it down to their market cap versus some interim valuation between market cap and book value. Getting clients to realize that they may have impairment and that the market cap is significantly less than book value has been a difficult task.

Pump: I’ve got clients that are trading below their liquidation value, yet some of them are currently profitable. So it’s a challenge to understand how the market is pricing some of these businesses.

Kevin Yeanoplos: It becomes even more problematic when you’re trying to reconcile the values with a privately held company, because there tends to be more disjointedness between the market approach and the private companies. Every one of these issues that we’ve discussed for public companies becomes even more problematic with the private ones.

Dufendach: With a private company that has multiple reporting units, you don’t have that market cap sitting out there to observe and reconcile to. We often see in place of that an overall value for 123(R) purposes (FASB Statement no. 123(R), Share-Based Payment). We try to diligently ensure that what we’re looking at for impairment is appropriately reconciled with whatever other indications of value might be out there for the overall company.

JofA: Are there any other common problems that you are seeing in valuations for financial reporting purposes?

Yeanoplos: One of the key issues that we are all facing is valuing a company, as of a particular date. Let’s say it was Sept. 30, 2008, a date on which there were significant market issues. Do we address it in terms of liquidity or of risks associated with a future economic benefit?

Dufendach: Related to that is the question of whether or not a triggering event has occurred. Is a drop in the market, whether you’re public or private, sufficient to require an impairment test other than the scheduled date?

The guidance in FAS 142 doesn’t talk about value of reporting units in terms of temporary or other than temporary, leaving it to professional judgment. The seven explicit items in 142 that indicate there might be a triggering event are not all-inclusive, and we have to consider whether a big drop in the market (below carrying value) may fall under the guidance of suggesting an impairment test needs to be performed.

JofA: Do you look at the last year, or do you look at the last 10 years? What kind of experience are you having with that?

Mike Morhaus: Along the lines of the smaller companies, we’re going back more than the traditional three to five years. For some of the construction companies we’re going back 10 years so we can get a better handle on the business cycles to answer the question: Is this low we’re in right now typical for the company? Typically, the DCFs and the single-period models are based on a five-year history, and that’s not sufficient for us anymore.

Worth: One analysis that we’ve added to our review of the financials is to look at actual vs. forecast for the last year, for the last quarters. We’re testing the reliability of management’s historical forecasting capabilities (their ability to forecast in prior periods).

Dufendach: There’s always been a focus on “vetting the forecast,” getting comfortable with the key assumptions, but it’s become even more important. When evaluating an income approach based on a five-year forecast, we are putting a renewed focus on the key assumptions that are embedded in that.

Worth: A lot of valuation professionals are dissatisfied with the equity risk premium, the historical equity risk premium. For the first time I’m seeing a lot of specific company risk adjustments in the weighted average cost of capital (WACC) and the discount rates to try to accommodate the recognition that sees the debt markets are more active, they’re showing more confidence in what the risk is. We are taking the active debt markets as a better indicator of what’s going on in overall risk than some other historical data that we have.

Dufendach: It’s very difficult to know how much we can rely on historical information in this environment. All the key assumptions need to be carefully reviewed.

Pump: Over the past few years, valuation professionals have made a lot of adjustments to the equity risk premium because volatility was very low for a number of years. There were a lot of explanations why equity risk premiums were as high as they were and speculation they need to be adjusted downward. I think that whole philosophy will be re-evaluated under the current market circumstances.

People like Aswath Damodaran, professor of finance at New York University, are talking about looking at forward-estimated equity risk premiums, as opposed to long-term historicals. And the equity risk premiums may fluctuate over time, depending on the markets. For lack of a better road map, many appraisers are putting an adjustment to the equity risk premium in as a specific company risk premium, because there’s no better way to do it right now.

JofA: Some have alleged that the implementation of fair value accounting is the reason for the financial decline. Do you agree or disagree?

Yeanoplos: Fair value may have simply uncovered conditions that already existed. Confusion still exists as to what fair value is or isn’t and understanding the implementation. The confusion is creating some of the market unrest, but I am still uncomfortable saying that fair value caused this. I believe that it’s necessary and is moving us in the right direction.

Pump: Not wanting to recognize the values that might be on the balance sheet—real values— is problematic. The markets tend to focus on short-term results, and to some extent these results may exacerbate the problem in a short-term manner, but I think the market sees past these noncash adjustments.

Worth: A lot of companies are fighting the fair value adjustments because of the violation of debt covenants. It may be that the debt covenant shouldn’t have been tied to the fair value of the assets, but rather, the realization of the assets.

Dufendach: I think that mark-to-market and FAS 157 has been very good in terms of transparency and getting more information to investors. Some of the criticisms of it may come not from the standard itself, but from some of the early applications of it, where perhaps distressed values were observed and taken for fair value and caused some write-downs that might not have been required under a better interpretation of FAS 157. I believe both the FASB and the SEC have made moves to try to clarify those issues.

JofA: The fallout of the economic crisis has had significant impact in many valuation areas other than just determining fair value for financial reporting. Differing levels of value and different standards of value (definitions of value) are involved in valuations prepared for other purposes. For example, estate and gift valuations focus on “fair market value” rather than “fair value.” Given the severe stress and chaos in the financial markets because of illiquidity, excessive leverage and financial mismanagement, how responsive will government agencies such as the IRS be to large valuation discounts assumed in estate valuations, real estate valuations and business valuations?

Pump: In the short run the SEC may be more flexible regarding discounts, simply as a matter of necessity, especially concerning public companies. In the long run I expect that the IRS and the SEC are going to return to the trend that we’ve seen for the past few years, which is requiring more support for the discounts. The SEC has encouraged us to use put option valuations as measures for lack of marketability, and the IRS has pushed for more detailed support for discounts for lack of marketability and control. I don’t see that going away, other than maybe on a temporary basis. On a temporary basis, I don’t think the IRS is going to back down on their discounts.

Yeanoplos: The one thing that’s important to remember with the IRS valuations is that there is definitely a requirement to look at factors that exist as of a particular date.

JofA: If you were talking with a director of a company, would you give them any suggestions on additional due diligence that they should be doing at this point in terms of valuations for financial reporting?

Worth: I wouldn’t hire the company that’s getting a commission on the transactions to do the fairness opinion. There’s an inherent conflict in there. If the SEC wanted to do anything, they should make sure it’s an independent party that provides advice to the board of directors. I believe the advisers should be equally independent of the company or the outcome of the transaction in order to provide unbiased advice.

Yeanoplos: I think that the board of directors should understand the technical aspects of fair value reporting much better, because whether they fully understand fair value or not, they definitely understand that it does have a significant impact on the value of the company. That’s one piece of advice I’d give the directors. If they don’t know it backwards and forwards now, they definitely should.

Dufendach: Awareness of how any transaction will be viewed from a FAS 142 perspective is important to the extent that a big premium is being paid in an acquisition. For example, will that be supportable six, nine, 12 months later, when all the assumptions have to switch over to a market participant standard and a real look at risk premiums and other factors going on in the market? I think that boards of directors would certainly be well-advised to keep in mind how this is going to look from a FAS 142 perspective.

JofA: Is there anything that you want JofA readers, specifically CPAs who are outside of the BV arena, to understand about valuations and the current climate?

Dufendach: The proper focus of valuation is and always should be the long term. We’re all facing the difficulties of assessing what the length of the recession is going to be and the impact it’s going to have on companies’ values. The market is signaling something to us: that the world has gotten much riskier.

Also see sidebars:
Concerns From an Auditor's Standpoint, by Walter McNairy
FASB Updates Fair Value Guidance

Web-exclusive content:
Additional Comments From the Virtual Round Table
Virtual Valuation Round Table: Definitions

Editor's note: The JofA would like to thank Gary Trugman, CPA/ABV, MCBA, ASA, MVS, and Robin Taylor, CPA/ABV, CFE, CVA, CBA, for their contributions to this article. Trugman, president of Trugman Valuation Associates Inc., serves on the AICPA’s ABV Examination Committee, is chairman of the Ethics Committee of the Institute of Business Appraisers Inc., and is an editorial adviser to the JofA. Taylor is a member of Dixon Hughes PLLC in Birmingham, Ala., and is chairman of the AICPA’s Business Valuation Committee.

Push Down Accounting

The Controller's Roundtable is a web site with a vast array of information, discussions and applications that are of great use to both reporting and operations people.

They recently compiled the results of a discussion group on push down accounting. For those not familiar with this term, when a company completes a share acquisition, they will end up paying more that the acquired company's book value for assets acquired and liabilities assumed.

Companies sometimes “push down” the fair value to the acquired subsidiary. On consolidation, nothing changes. The changes affect internal reporting and segment reporting, where asset values are sometimes used for management accounting purposes in calculating asset and earnings based ratios. The additional depreciation or amortization of hard assets and intangibles would affect the subsidiary's earnings.

On the question of when push down accounting is used, the following was observed from a recent Controller's Roundtable discussion:

- 72% pushed down purchase price allocations (including goodwill, intangibles, and fixed asset fair value changes) to acquired businesses.

- 22% said they generally push down the purchase price allocations in most cases, but this could change depending on whether it's a foreign or domestic acquisition.

Check out the Controllers Roundtable.

S&P: Mark to Market Rule Changes Don’t Help Banks

Standard & Poor's says that changes made by the FASB to mark-to-market rules on valuing securities in illiquid markets and on other-than-temporary-impairment don’t change anything for banks.

S&P said that its ratings of banks won’t change, in spite of the rule changes. U.S. banks lobbied heavily in favour of the new rules.

Related comments by S&P:

• "In our view, the revised fair-value measurement standard provides more flexibility in how banks and other financial institutions will value financial assets,"
• "when market observations are substantially lacking or are meaningfully influenced by temporary supply-and-demand imbalances or market disruptions." This "should be accompanied by relevant financial statement disclosures."
• the key indicator to watch in the upcoming round of quarterly filings from large complex banks will be expansions in the valuation of level 3, or illiquid assets
• They are in favor of the increased transparency of credit losses the “other than temporary impairment losses” rules bring, but that they could result in “reliability issues related to a company’s ability to bifurcate losses into credit and noncredit components because the credit impairment amounts may be difficult to decipher in isolation.”
• Fair value measurement changes will result in increased analysis in evaluating significant adjustments companies make to observable market prices and related assumptions and judgements they apply.
• “This shift [to assets being valued using level 3] ... is a move toward greater use of internally derived measures," Determination of whether a market is active or not will be based on "the highly subjective judgement of each company."

Got Goodwill? Part 21

A few more large goodwill impairments:

HONG KONG -- Ping An Insurance (Group) Co. of China Ltd. an impairment charge of 22.79 billion yuan (US$3.33 billion) on the company's stake in Fortis NV.

First Data Corp. reported goodwill impairment charge of $3.2 billion which resulted from the decline in economic conditions which drove a change in First Data's management projections and an increase in discount rates reflected in First Data's fair value estimates.

MGM MIRAGE reported goodwill and indefinite-lived intangible asset impairment charges of $1.2 billion as a result of global economic conditions and market trends--and that these trends have continued into the first quarter of 2009.

Rite Aid goodwill impairment, store impairment and deferred tax asset write-down that totaled $2.2 billion. The goodwill impairment charge is related to the July 2007 Brooks Eckerd acquisition.

Oshkosh Corporation anticipates recording non-cash impairment charges of $1.2 - $1.5 billion for the write-down of goodwill and other indefinite-lived intangible assets in the second quarter of driven by the short-term economic environment.

Macy's Impairs $5 Billion

Macy's Inc,, the U.S. based department store chain has recorded a goodwill impairment charge of $5.4 billion in the fourth quarter. The impairment charge follows a sharp decline in the company's market capitalization.

Macy's market cap today is about $4 billion, down from about $20 billion at its peak in 2007.

Macy’s had previosuly warned of the impairment charge and said the estimate is subject to further adjustment when it completes its calculations in the first quarter of 2009.

The non-cash write-down should not affect Macy’s financing covenants and accordingly will not cause defaults in bank credit agreements or bond indentures.

Macy’s reported operating income of $1 billion but the impairment charge brings their fiscal 2008 loss to $4.4 billion.

The goodwill arose on Macys' 2005 acquisition of May Co., the economic downturn and the decline in market capitalization.

G--20 to Mess with Accounting Standards?

On April 1, the richest 20 nations in the world--the G20 nations will meet in London to deliberate on the current state of world financial affairs in an attempt to find solutions to the global financial crisis. Given the political attention to mark to market rules in the U.S. and the EU, can political demands to relax the fair value accounting rules to allow banks more lending leeway be far off?

Over the past few months, accounting for financial instruments has been controversial with opposing views circulating. Bankers and their lobbyists continue to push lawmakers to force accounting standard setters to relax the rules as to whether financial instruments in inactive or distressed markets should be recorded on balance sheets at fair value. Current rules force mark-to-market accounting in illiquid/distressed markets, even for securities that are being held to maturity. The rules also provide guidance on how to use inputs other than trading prices — including internal models in situations where no other information is available.

Bankers hate fair value and are receiving more support from U.S. and international lawmakers, who say financial instruments that are held to maturity should be allowed to be valued without reference to current market prices.

The U.S. Congress last week pressured the FASB to fast track a proposal that would provide added guidance on fair value requirements to generally give the banks what they want. The comment period for the IASB/FASB proposal ends on April 1, after being out for an unusually short 15-day period. The comment period on the IASB's proposal is 30 days.

In addition to the fair value rules, banks also want action on reserve rules. Banks are limited in what they can lend based on their asset and equity positions. Lawmakers may want to change these rules to loosen up lending practices. Banks and lawmakers blame the current credit crisis on mark to market and bank reserve rules. International rules on the current regulatory capital ratios for banks were set up in the Basel II agreement.

Different ideas exist on this:

• IASB chairman David Tweedie has suggested using the insurance company model of catastrophic reserves, i.e. banks would establish a non-distributable reserve on the balance sheet, i.e. not on the income statement. The balance sheet asset would be clearly marked as being non-distributable so investors understood its purpose. If catastrophe hit — such as a credit crisis — the company would be allowed to tap the reserve to keep the event from decimating company earnings.
• Other experts have suggested using what is known as dynamic provisioning, a reserve technique used by banks in Spain. In this case, reserves are increased during good times so they can be drawn down when losses pile up. Dynamic provisioning, also referred to as the "cookie jar" method, smoothes earnings when cash is released from the reserve and fed through the profit and loss statement. However, some companies have used earnings smoothing to manage and inflate earnings, as the release of reserves can be masked on financial statements.
• A third method, involving two net income lines, has also been discussed. The concept here is to create a second line representing regulatory net income to show a company's profit minus its capital reserve. Along with separating the cash reserve from the earnings calculation, a company could use this line to calculate performance-based executive compensation. In that way, executives would not be getting rich off of inflated profit numbers.

With information from Maria Leone at CFO.com

Investors vs. Bankers--Who will Win?

Recently the IASB and the FASB issued for comment changes to accounting rules that would allow looser mark to market accounting. This has sparked opposition to the changes from consumer and investor groups that who are advancing their previously expressed arguments that the rules give management (banks?) too too much freedom in valuing assets in distressed or illiquid markets.

Opposition comes from such places as the Consumer Federation of America, the CFA Institute and the FASB's Investors Technical Advisory Committee. The opposition may also have an impact on proposed changes to financial institutions' regulatory capital levels, which the banks claim are needed to ease the existing credit crunch and to avoid future credit messes like we have had in the past year.

Banks have claimed for years that mark-to-market rules force them to place unrealistically low values on illiquid or otherwise difficult to trade assets (known in mark-to-market accounting terms as "Level 3 Financial Instruments".)

The FASB/IASB proposals require "significant judgment" on the part of management in determining when a market isn't active. Once determined inactive, it would effectively allow management to ignore trading prices when coming up with a value for a security.

Those who have recently voiced opposition to the proposed rules say that they make it too easy for companies to reduce write-offs on impaired assets and make it easier for banks to keep their regulatory capital at unrealistic levels, allowing unstable financial institutions to make bad credit choices.

Mark-to-market accounting is under increasingly fierce attack by bankers who are lobbying hard for U.S. Congress to suspend or repeal mark to market rules. Bankers blame the rules for the current financial crisis.

Those who oppose the rules are against the banking industry's ability to make the statutory and regulatory regime work in their favour. They claim that the banks want accounting rules to change to fix irresponsible banking activity. While they agree that mark to market rules are not perfect, they do provide transparency in valuing assets and that such transparency helps investors.

Got Goodwill? Part 20: More on Market Cap

Following is a good article form the Globe and Mail on how market cap and goodwill are related. The profiled company files under Canadian GAAP, which is the same as U.S. GAAP in the area of goodwill impairment calculations.

By late 2008, David Adams could tell with one glance at his books that the market had handed him a problem.

The chief financial officer at Groupe Aeroplan Inc. was carrying almost $3-billion in goodwill on the flight-reward company's balance sheet, most of it residue from its 2005 spinoff from ACE Aviation Holdings Inc. But the entire market capitalization of Aeroplan's stock, which had been close to $5-billion in early January, had tumbled to $1.3-billion by late November. According to the market, the entire company was worth less than half of the value of its goodwill alone.

Accounting rules and regulatory directives were crystal clear: The discrepancy between the market value and the goodwill was a flashing red warning signal that the goodwill was probably no longer worth what Aeroplan's books said it was. The company was compelled to run an impairment test. The result: a $1.16-billion writedown against earnings, which the company reported last month.

"It was actually pretty simple," Mr. Adams said. "The securities regulators are driving the bus on this."

Aeroplan is hardly alone: Plunging asset values, slumping earnings prospects, rising borrowing costs and a key 2002 accounting change have left an unprecedented amount of increasingly hard-to-justify goodwill on corporate balance sheets, prompting Canadian and U.S. regulators to remind companies to take a hard look at their goodwill. The result has been a wave of big-money writedowns that might still be in its early stages.

A recent report from Desjardins Securities showed that companies on the S&P/TSX composite index had a combined $168-billion of goodwill on their balance sheets at the end of the third quarter. Since then, TSX companies have announced at least $13-billion in goodwill writedowns, including charges of more than $1-billion each at Aeroplan, Nortel Networks Corp., CanWest Global Communications Corp., Great-West Lifeco Inc. and Gerdau Ameristeel Corp.

Financial executives argue that the writedowns are non-cash charges that don't reflect on a company's operations. But analysts warn that the implications may be more severe.

By definition, a goodwill writedown reflects a permanent impairment in an asset's future cash flow potential, which could imply a risk to dividends. Analysts warn that the writedown of assets may put at risk debt covenants and hurt a company's ability to raise funds, and that it also amounts to an admission by management that it overpaid to acquire assets.

"I would argue that if you're holding the stock [of a company with high exposure to goodwill], you should be concerned about it," said Peter Gibson, vice-chairman and strategist at Desjardins.

While goodwill is a fuzzy concept, in strictly balance sheet terms it represents the gap between the fair value of an asset and the price its owner paid to acquire it. When a company acquires assets at a price above their fair value, the excess is recorded as goodwill - the implication being that the asset's prospects for future growth in cash generation justify the premium paid, and thus have value in themselves.

Goodwill writedowns typically accelerate during bear markets, as companies adjust their assessment of the cash-generating potential of assets purchased during better times to reflect the new, much less rose-coloured reality. But this time around, goodwill charges are headed for unprecedented heights, because regulators changed the rules governing the accounting for goodwill since the last bear market.

Before 2002, companies were required to amortize goodwill on their books annually, so it would eventually shrink to nothing over time. In 2002, U.S. and Canadian accounting regulators decided to allow companies to carry goodwill perpetually on their balance sheets, but required them to run an annual test to determine if there were any underlying change in valuations that had undermined those goodwill estimates, known as a goodwill impairment.

If warning indicators crop up in between annual impairment tests - such as a sharp drop in market value, or a serious deterioration in business conditions - regulators have directed companies to test immediately to see if a goodwill writedown is required.

During the downturn of 2001, before the rule change, goodwill writedowns in the U.S. totalled $51-billion (U.S.). That number has already been easily eclipsed in this recession: Two companies alone - Sprint Nextel Corp. and Courier Corp. - combined for $54-billion in goodwill writedowns.

"I'm not sure there is any historical precedent, " said Karen Parsons, an accountant and business adviser at consulting firm Grant Thornton LLP in Toronto. "This is really the first test."

Compounding the rule change is the fact that during the 2002-07 bull market, companies routinely paid big premiums for acquisitions. Now, many of the growth assumptions that justified those premiums have been turned on their heads, as market values collapsed and economic prospects withered.

This has left many companies carrying goodwill on their books that hasn't been depreciating and, over the space of a few months, has rapidly become impossible to justify.

"If you made an acquisition in the past two or three years and you expected that business to keep growing, or if you paid with your own shares and they have gone down, that could indicate an impairment of goodwill," Ms. Parsons said.

Anthony Scilipoti, an analyst at Veritas Investment Research Corp., thinks resource-based companies look especially exposed to goodwill writedowns because they bought assets in the past few years based on high assumptions for future commodity prices.

Still, he said the current depressed stock prices might already have priced in the risk of goodwill writedowns.

"Very often, it is a lagging indicator," Mr. Scilipoti said. "The stock price has already gotten hit because the underlying business fundamentals have turned sour. Then you question [whether] the goodwill is impaired."

Given the already discounted values for stocks in the markets, some experts feel that companies may be better off absorbing goodwill writedowns now, cleaning up their balance sheets and better positioning themselves for the next upturn - especially since the 2002 removal of the amortization rule for goodwill may have made writedowns ultimately unavoidable.

"At some point in time, most organizations are going to be faced with a goodwill impairment," Aeroplan's Mr. Adams said. "You may as well just get it out of the way."

THE GREAT DEBATE
Canadian and U.S. securities regulators recently reminded companies that they must consider their sinking stock prices as an indicator of a potential impairment of goodwill - a directive that may be accelerating the number and size of goodwill writedowns. Much like the mark-to-market question surrounding troubled mortgage-backed securities in the banking sector, this regulatory position has sparked a debate: Is it fair?

"That's the million-dollar question," said accounting expert Karen Parsons of Grant Thornton LLP. "One viewpoint is that [the market value] is the fair value today, there's an impairment, and if you don't take it, you're not reporting appropriate information to the market.

"On the other end of the spectrum, there are people who would say this is just a very unusual circumstance, it's not an indicator of the market on the long term, and we shouldn't be putting as much emphasis on it," Ms. Parsons said.

Wayne Brownlee, chief financial officer at Potash Corp. of Saskatchewan, said one big concern for companies is that goodwill tests triggered by slumping markets may be feeding a vicious circle.

"It's a continual spiralling down or self-fulfilling prophesy on valuation," he said. "The more you write down, the more the earnings come down, and you have to go back and reassess [goodwill] every quarter. It just keeps pulling [the stock price] down and down."

Some experts, however, argue that the market's pricing of many of these stocks already reflects investors' belief that a goodwill impairment exists - that the business case for the assets has deteriorated sufficiently to have blasted a hole in assumptions about future growth.

"The investor has already decided that an impairment exists. The market is making a determination of value," said Richard Crosson, national head of the business valuation group at Ernst & Young LLP.

"You would need more persuasive reasons [to avoid taking a goodwill writedown] than simply the market is irrational."
DAVID PARKINSON from Globe and Mail March 17, 2009

IASB to Change Fair Value Rules in Lockstep with FASB?

FASB changes to fair value “mark to market” accounting rules could be adopted quickly into IFRS. The IASB agreed on Tuesday to put out documents for comment IASB was getting ready to use the FASB’s exposure document for public comment as its own fair-value rule.

Rumours are that the IASB would have issued a statement on that Tuesday, however dissent among IASB members about the FASB proposal means IASB is debating for another say today (Wednesday).

It has been reported that a majority of IASB members will vote in favor of using the FASB proposal as a basis for IFRS convergece to that standard, with a comment period of 30 days.

Insider comments on the IASB’s move included:

• FASB is allowing companies to "ignore" the traded price of a financial instrument in favor of using internal models to value the instrument. "It's going to be the higher of price or model, that will be the measurement." "What are we going to do when the banks organize a 5000-bank comment letter that says, 'Right-on baby, our earnings will go up, and we'll have no more losses'?"
• "So you had to change the standard because the auditors ignored it?" "What makes you think the new FASB guidance is going to help?"
• "I would ask whether the IASB should even consider whether the FASB proposal is worthy of mention ... Should we even consider doing anything or should we ignore it?"
• "It's not a discussion paper, it's not an exposure draft ... what is it?" "Because we don't know what it is, that's why I wouldn't do it. If I was going to do anything, it would be to write a paper about why we're not doing it."
• "As distasteful as it is, we've got to recognize that there is a crisis on and we can't totally ignore what another standard setter is doing ... it would sound as if we were ignoring the rest of the world."
• IASB chairman David Tweedie hopes that that the IASB will converge global and U.S. standards by releasing the FASB exposure document as an IASB document.
• Lynn Turner, former Securities and Exchange Commission chief accountant, said: “They are taking accounting standard-setting back four decades.” “The reality is that with this proposal, FASB is really suspending fair value accounting. The bottom line is that these type of things never gets reversed.”

FASB Fast Tracks Fair Value Changes

The FASB has opened the door to modifying rules on determining the fair value of assets that are not actively traded.

FASB has fast-tracked its comment period to 15-days in response to pressure from Congress and by bankers and regulators to modify fair-value accounting rules. The new proposal for comment guides companies on how to determine whether an asset's market can be considered not active, and whether a transaction being used to estimate an asset's value is not distressed. FAS 157 states that fair value of a financial instrument cannot be based on distress sales.

FASB chairman Robert Herz was was repeatedly asked at Congessional hearings last week to “fix” mark-to-market accounting in three weeks. At the same time, Congress stated that they did not want to “interfere with accounting standard setting," Herz stated that that the FASB is preparing some material and that due process is necessary. The members of Congress present threatened Herz with legislation that would “fix” mark to market.

Members of Congress present at the hearings seemed to be of the opinion that changes in accounting rules would suddenly turn the economy around. Herz stated that changes to accounting guidance would not guarantee economic changes.

The emphasis is on FAS 157 Level 3 judgements. Such judgements on measurement of financilal instruments require the most judgment, and are designed for thinly traded or untraded assets that have a value derived from "unobservable inputs." Measurements at Level 3 seem tainted by some readers of financial statemetns. Potenmtitally , the FASB’s new guidance will remove the stigma attached to Level 3.

Level-3 measurements are based on inputs that require more judgment. More judgement means more attention from auditors and regulators and more work on the part of accountiants and possible the need for outside valusators. Approximately 9 percent of financial instruments measured at fair value were classified as Level 3 under FAS 157. Level 1 is at 76 percent and Level 2 15 percent (per SEC study).

Herz stated that "There's not much accounting can do other than help people get the facts and use their best judgment," he said.

FASB expects companies to use "significant judgment," in determining when assets were not trading in active markets or were distressed. This could result in different valuations for the same asset by different companies.

The new guidance requires a two-step approach to determine whether a company is justified in not using observable prices. First is assessing indicators that a market is inactive, i.e. too few transactions to determine prices or the prices are out of date.

Second, if the firsrt step indicates an inactive market, companies will look for indicators of distressed pricing of transactions. If a price is made under distress, then the price cannot be used for estimating fair value and other valuation techniques are required.

The comment period ends on April 1 for adoption for interim and annual periods ending after June 15, 2009.

Here is the actual text of the decision from the FASB web site:

Fair value measurement. The Board discussed the following issues:

Determining when a market for an asset or a liability is not active and determining when a transaction is not distressed. The Board decided to provide additional guidance to help an entity in determining whether a market for an asset is not active and when a price for a transaction is not distressed. The Board meeting handout described the proposed model the Board agreed to.

The Board decided that the changes would be effective for interim and annual periods ending after March 15, 2009. The proposed FSP would be applied prospectively and early adoption would not be permitted.

The Board directed the staff to proceed to a draft of the proposed FSP for vote by written ballot and plans to issue that document for public comment on March 17, 2009, with a comment deadline of April 1, 2009. The Board expects to discuss the comments it receives at its meeting on April 2, 2009.

Other-than-temporary impairments. The Board discussed proposed changes to the guidance for other-than-temporary impairments. Currently, an entity is required to assess whether it has the intent and ability to hold a security to recovery in determining whether an impairment of that security is other than temporary. The proposed FSP would change that guidance as follows:

1. If the entity intends to sell the security or it is more likely than not that it will be required to sell the security before recovering its cost basis, the entire impairment loss would be recognized in earnings as an other-than-temporary impairment.
2. If the entity does not intend to sell the security and it is not likely that the entity will be required to sell the security before recovering its cost basis, only the portion of the impairment loss representing credit losses would be recognized in earnings as an other-than-temporary impairment. The balance of the impairment loss would be recognized as a charge to other comprehensive income.

For securities within the scope of FASB Statements No. 115, Accounting for Certain Investments in Debt and Equity Securities, and No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations, an entity would determine the impairment charge representing credit losses by using its best estimate of the impairment amount arising from an increase in the credit risk associated with the specific instrument. One way of estimating that amount would be to consider the measurement methodology described in FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan.

For a debt security within the scope of EITF Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets,” an entity would estimate the amount of the total impairment charge representing the credit losses in accordance with that Issue.

The proposed FSP would result in a new category within other comprehensive income for the portion of the other-than-temporary impairment that is unrelated to credit losses for held-to-maturity securities. The impairment recognized in other comprehensive income would be amortized over the remaining life of the debt security in a prospective manner based on the amount and timing of future estimated cash flows unless there is an indication of additional credit losses. That amortization would be recognized in other comprehensive income with an offset to the asset and would not affect earnings.

The Board decided that the guidance would be effective for interim and annual periods ending after March 15, 2009, and applied prospectively. The Board directed the staff to proceed to a draft of the proposed FSP for vote by written ballot and plans to issue that document for public comment on March 17, 2009, for a comment period of 15 days. The Board expects to discuss the comments it receives at its meeting on April 2, 2009.

Is there a viable alternative to fair-value accounting?

MANY culprits have been singled out to take the blame for the financial and economic crisis. Fair-value reporting too has been blamed for the depth of the crisis, where troubled companies claim that mark-to-market valuations are forcing them to declare declines in asset values that aren’t real, thereby worsening sentiment in jittery world markets.

Indeed, opponents of fair-value reporting argue that the information provided by fair-value financial statements can be unreliable and hence, financial decisions can be put at risk. But is there a viable alternative to fair value in this highly complex business world?

Although fair-value accounting may have gotten bad press as a result of the crisis, key producers and users of financial reports - such as chief financial officers and accountants - recognise the benefits of fair value.

In a recent survey done by CFO Research Services and ACCA, 128 CFOs stated that adopting global financial standards reporting - including mark-to-market valuations - will be good for their companies.

There are several reasons for their mindset. In this dynamic global environment where valuations can change in the blink of an eye, historical-cost financial statements may no longer be relevant because they are not able to give accurate information on current values.

Traditional accounting rules have not kept pace with sweeping reforms in regulations, customer sophistication, knowledge-based products and the evolving valuation methods of enterprises.

Value creation has also changed, and this has made reforms very necessary to the way we report, interpret and compare with a common set of acceptable standards to meet customers’ demands and protect public interest.

This is where fair value accounting - with its emphasis on mark-to-market valuations - is highly relevant. Historical-cost accounting methods may not work quite so well in measuring current values and in projecting future values.

It needs to be kept in mind that common double-entry accounting worked in systems based on transactions and are most relevant to economies based on buying and selling transactions.

Most sophisticated economies today have evolved beyond that to embrace dynamic value creation and there needs to be a means to reflect and measure this value.

For instance, intangibles including brand, patents, trademarks, intellectual property, and thought leadership towards corporate performance, has become a tremendous asset for the majority of companies, and a key element in valuations.

Most of the information metrics and reporting systems now appearing on the investment radar screen are designed to measure and report financial health, which are a challenge to their immediate users. Again, this is where the fair-value accounting framework comes in handy.

Many companies today also operate globally across many regimes and jurisdictions, thereby increasing the need for better quality disclosures and consistency in understanding and interpretation of complex financial and risk matters in order to better serve their investors and shareholders.

Delivering such quality and consistency is a key tenet of the international financial reporting standards, or IFRS, in which fair-value accounting is fundamental.

One of the biggest benefits of fair value accounting may also be that investors will have the opportunity to better manage the risk of investing in highly leveraged companies.

In other words, it enables investors to use their judgement to describe how to recognise real value.

Therefore, it can be argued that fair-value accounting best fits the bill in the demand for a robust new measurement and reporting framework that can serve the needs of business.

However, since fair-value accounting is a fairly new creature, there will be issues of interpretation and usage as it evolves.

Although the new financial reporting framework is here to stay, it will probably be tweaked to make it more relevant, user-friendly and palatable to all stakeholders in the financial value chain, as well as to critics like French President Nicholas Sarkozy who called for an overhaul of fair-value reporting as part of the solution to the current financial mess.

The International Accounting Standard Board - architect of the shift to fair-value accounting via the international financial reporting standards - has acknowledged that the global financial crisis underlined the importance and urgency of making financial reporting more transparent, comparable and clearer.

At the recent G20 summit, delegates agreed that immediate actions towards a more robust reporting and value measurement will be necessary as part of the global solutions towards addressing current financial woes.

Regardless, reforms must come with greater clarity, comparability and responsibility if the bitter lessons learnt from the current financial and economic crisis are to shape the world into a better place for everybody.
By TAY KAY LUAN at The Star Online