Fair Value Analysis Based on Financial Articles Research Paper

Background

Value for shareholders is determined solely by exposure to market prices, with no performance involved by the firm. This strict condition can be relaxed in the case of active investing in marketable securities when the following conditions hold:

• The investment manager can sell the security at the market price on call at any time that is, no performance is necessary to find a customer.
• Performance involves only a timing issue, that is, when to sell.
• Prices are not informed by historical cost accounting.
• Fair value is determined at an aggregate level of net assets that are jointly employed under a business plan.
• State your overall conclusion regarding the findings in the five papers.

The objective of the accounting required by FASB Statement Accounting for Stock-Based Compensation as it would be amended by this proposed Statement, is to recognize in an entity’s financial statements the cost of employee services received in exchange for valuable equity instruments issued, and liabilities incurred, to employees in share-based payment transactions.

Future Prospects. The issuance of the ED of amendments to IFRS 3 in 2005 as a result of phase two indicates that the business combinations project will help achieve convergence between U.S. GAAP and IFRS. In one major change to IFRS 3, the ED proposes that an acquirer measure the f air value of the acquiree, as a whole, as of the acquisition date. This full goodwill method recognizes not only the purchased goodwill attributable to an acquirer as a result of the purchase transaction, but also the goodwill attributable to a noncontrolling interest in the subsidiary. The IASB believes that this method is appropriate because it is consistent with the control and completeness concepts underlying the preparation of consolidated financial statements.

Introduction

Some debate regarding the most appropriate method of accounting for the goodwill that arises from an acquisition (commonly referred to as “purchased” or “acquired” goodwill) raged during the early 1990s and again during the early 2000s. During 1993, the International Accounting Standards Board (IASB) amended an International Accounting Standard (IAS), namely IAS 22, Business Combinations (IASB 1993), by removing the option of writing off purchased goodwill (hereafter referred to merely as goodwill) immediately on acquisition. The accounting treatment of goodwill that arises from an acquisition took a significant step in a new direction with this amendment, Where by goodwill now has to be recognized as an asset and amortized over its useful life. A number of alternative treatments were used in South Africa at that time, as there was no definitive accounting standard for the accounting treatment of goodwill before the introduction of the new accounting statement, AC 131, Business Combinations (SAICA 1999). AC 131 was based on IAS 22 and covered all periods commencing on or after 1 January 2000. The Financial Accounting Standards Board (FASB) in the United States of America (USA) sparked an international debate during 2001 when it adopted a Statement of Financial Accounting Standards (SFAS), SFAS 142, Goodwill and other intangible assets (FASB 2001a), thereby replacing the existing requirement to amortise goodwill with an impairment testing approach.

The IASB, seeking international convergence and global harmonization, followed the FASB, and issued a new International Financial Reporting Standard (IFRS), namely IFRS 3, Business Combinations (IASB 2004a) in March 2004. The South African Institute of Chartered Accountants (SAICA) adopted IFRS 3 at the same time. According to IFRS 3, from the beginning of the first annual period beginning on or after 31 March 2004, all entities must discontinue amortizing goodwill and must test the goodwill for impairment annually instead.

Article #1

“What You Need to Know About New FASB Pronouncements that Target Business Combinations and Goodwill” by Eugene DeMark

According to several sources, the non-amortization of goodwill and the related impairment tests should “increase representational faithfulness” relative to income and “improve the transparency of accounting.” These benefits are assumed to occur because (1) the balance sheet will provide a better indication of the remaining value of goodwill; (2) the income statement will be void of arbitrarily determined, straight-line amortizations of a potentially still-valid asset (goodwill); and (3) the financial statement and footnote disclosures relative to goodwill will provide “users with a better understanding of the expectations about and changes in those assets over time, thereby improving their ability to assess future profitability and cash flows.”

There were companies which will we effected by the two recent FASB pronouncements business combinations, goodwill, and other acquired intangible assets. SFAS 141, Business Combinations, requires that entities account for all combinations initiated after June 30, 2001, using only the purchase method. SFAS 142, Goodwill and Other Intangibles, eliminates the amortization of goodwill and requires annual impairment testing of goodwill using a complex two – step, fair value method.

Dealing with Intangibles

As a first step, management should identify all intangible assets acquired in prior business combinations, and evaluate them to determine if they may be recognized apart from goodwill under the provisions of SFAS 141, advises Eric W. Casey, a partner with KPMG’s department of professional practice. “If not, they should be folded into goodwill as of the date SFAS 142 is adopted? Casey adds that the remaining useful lives of all intangible assets should be evaluated as of the date SFAS 142 is adopted.

Impairment Issues

In the SFAS No.142 that calculating the amount of the impairment loss allows the inclusion of any unrecognized intangible assets in determination of fair market value? Such a computation seems to sanction the inclusion of internally generated goodwill even though the Statement does not allow the company to “recognize a previously unrecognized intangible asset as a result of the allocation process.

Improving Transparency

The new pronouncements will influence whether acquisitions are accretive to reported earnings per share and therefore will be important to corporate development personnel, notes Chris McWilton, a partner in charge of KPMG’s information, communications, and entertainment practice in NewYork.

“These two statements represent the first phase of FASB’s attempts to improve the transparency of accounting and reporting of business combinations,” says McWilton. “The increased disclosures that come with the introduction of these pronouncements may prove to be a challenge for CFOs. Given the extent and the complexity of the new rules, companies and their advisors should begin to prepare for them at the earliest available opportunity.”

Article #2

“The Effect of the New Goodwill Accounting Rules on Financial Statements” by Ronald J. Huefner & James A. Largay III

Because the new statement provides significant leeway in regard to managerial judgment and discretion, the quality of earnings figures may be lowered. Determination of the useful life of an identifiable intangible asset, especially when that determination results in the expectation of an indefinite life, has a great potential for impacting an entity’s financial results. Thus, there is a large possibility that management may selectively opt to “manage earnings” through a cursory, rather than intensive, review of goodwill asset impairment.

According to several sources, the non-amortization of goodwill and the related impairment tests should “increase representational faithfulness” relative to income and “improve the transparency of accounting.” These benefits are assumed to occur because (1) the balance sheet will provide a better indication of the remaining value of goodwill; (2) the income statement will be void of arbitrarily determined, straight-line amortizations of a potentially still-valid asset (goodwill); and (3) the financial statement and footnote disclosures relative to goodwill will provide “users with a better understanding of the expectations about and changes in those assets over time, thereby improving their ability to assess future profitability and cash flows.”

Recognizing Impairment at Transition

Step 1 of the impairment test: The carrying amount is the consolidated financial statements is and which is higher than the recoverableamount.

Step 2 of the impairment test: Implied goodwill is calculated as the excess of the recoverable amount of over the identifiable net assets of which would recognise if it acquired at this date. Goodwill is therefore written off to this implied value.

Goodwill Database

Companies that did not write-off their goodwill will have to make annual impairment tests at the operating unit level. This process allows for momentous, critical judgments by management and their appraisal teams. Unfortunately, there have been suggestions that companies might choose the points in time to recognize impairment losses in a manner that selectively “fits” their operating results. Even though companies accounted for many business combinations over the past 10 years or so using the now discontinued pooling-of-interests method-which records no goodwill at all-there were enough purchase-method combinations to produce large goodwill balances on many balance sheets. In many acquisitions, goodwill amounted to 75% or more of the total price paid. For the 100 companies studied, pre-impairment recorded goodwill ranged from AOL Time Warner’s $127.4 billion to Weyerhaeuser’s $1.1 billion. Total goodwill recorded by the 100 companies amounted to $931.5 billion, nearly 11% of those companies’ total assets.

Article #3

“In-Process R&D in Business Acquisitions — More Disclosure Needed for Transparency and Comparability” by Nathan S. Slavin & Abu Ryan Khan

In a September 1998 speech at the NYU Center for Law and Business, then–SEC chairman Arthur Levitt brought attention to practices of earnings management that he considered to be abuses of accounting judgment. One of the abuses Levitt spoke about was the substantial amount of in-process research and development (IPR&D) charges reported by acquiring companies in business acquisitions. Levitt noted: “[Companies] classify an ever-growing portion of the acquisition price as ‘in-process’ research and development, so—you guessed it—the amount can be written off in a ‘one-time’ charge—removing any future earnings drag.” During this same period, the SEC began monitoring companies that took this special charge. A 2004 study by Thomas D. Dowdell and Eric G. Press found that, following the SEC’s scrutiny, acquiring companies reported significantly less IPR&D charges.

Current Accounting Rules for IPR&D

Purchased IPR&D represents the estimated fair value assigned to R&D projects, acquired in a business combination (purchase method), that have not been completed at the date of acquisition and that have no future alternative use. SFAS 2, Accounting for Research and Development Costs, issued in 1975, required companies to expense R&D costs in the period in which the costs were incurred.

This created a special problem for business combinations. An acquiring company often purchases complete and incomplete research and development projects with substantial market value. FASB subsequently clarified the accounting for the acquired completed and in-process research projects by issuing FASB Interpretation.

The competitive business of disclosure

The latest developments in insurers financial reporting offer a valuable opportunity to enhance investor understanding and improve relationships with key stakeholders. Improving the quality, clarity and comparability of disclosure could be especially beneficial for an industry whose reporting is often regarded, rightly or wrongly, as arcane and opaque. However, it would appear that more work may be needed to realize this objective. In particular, concerns about the comparability of financial reporting suggest that insurers may need to look at how to bring greater consistency into how they value their business and communicate these evaluations to the market. Where methodologies are potentially unclear, it will be necessary to explain why and how this affects the resulting numbers. Looking ahead, companies need to embed flexible and cost-effective systems capable of responding to reform. They also need to be able to anticipate and respond to analysts, investors and other key stakeholders’ rapidly increasing appetite for information. While there is naturally a risk in openness, companies that fail to meet analyst expectations may face the greater risk of undervaluation and higher cost of capital.

Findings

The findings of the study were as follows:

• The mean proportion of acquisition cost allocated to IPR&D decreased significantly after the SEC’s scrutiny in late 1998.
• The mean proportion of acquisition cost allocated to IPR&D did not change significantly after the issuance of SFASs 141 and 142.
• The mean proportion of acquisition cost allocated to goodwill increased significantly after the SEC’s scrutiny in late 1998.
• The mean proportion of acquisition cost allocated to goodwill did not change significantly after the issuance of SFASs 141 and 142.

The results of the study are summarized in Exhibit 2. The mean proportion of acquisition cost allocated to IPR&D declined by more than half, from 56.45% in Period 1 to 24.94% in Period 2. This is consistent with the results found by Dowdell and Press. As expected, because of the decrease in the mean proportion reported for IPR&D, the mean proportion of acquisition cost allocated to goodwill increased dramatically, from 12.81% in Period 1 to 35.44% in Period 2.

The results of the study suggest that the SEC’s intervention significantly reduced the valuation of IPR&D in business acquisitions. The mean proportion of acquisition cost allocated to IPR&D decreased slightly from 24.94% in Period 2 to 24.80% in Period 3. The amount allocated to goodwill, however, continued to increase from Period 2 to Period 3, rising from 35.44% to 42.79%. This suggests that the introduction of SFASs 141 and 142 was a nonevent for the reporting and measurement of IPR&D. The effect of SFASs 141 and 142 on goodwill is beyond the scope of this study. The sample chosen was not representative of all business combinations, but of business combinations that involved IPR&D charges.

Article #4

“IFRS 3 and the Project’s Impact on Convergence with U.S. GAAP” by Christoph Watrin, Christiane Strohm, and Ralf Struffert

JANUARY 2006 – Starting in 2005, the public corporations in all 25 European Union nations must comply with International Financial Reporting Standards (IFRS)/International Accounting Standards (IAS). The motivation to converge IFRS/IAS and U.S. Generally Accepted Accounting Principles (GAAP) as part of the ongoing internationalization of accounting is stronger than. Every effort is being made to keep joint projects on a “similar” time schedule at each standards-setting body. The main goal is to achieve greater comparability among consolidated financial statements, which are still prepared using different accounting concepts.

Findings

Impairment testing cash-generating units with goodwill and minority interest can be illustrated as follows (see IAS 36, illustrative example 7). Entity D acquires a 70% ownership in entity B for $1,000 on January 1, 2005. At that date, B’s identifiable net assets have a carrying amount of $1,900 and a fair value of $2,300. The carrying amount for liabilities ($900) and contingent liabilities ($100) is equal to the fair value. Therefore, D recognizes in its consolidated financial statements identifiable net assets at their fair value of $1,300 ($2,300 – $900 – $100) and goodwill as follows:

Cost of business combination $1,000

70% of $1,300 – $ 910

Goodwill $ 90

Entity B is the cash-generating unit expecting to benefit from the synergies of the combination, so the goodwill has been allocated to it. This cash-generating unit is tested for impairment at the end of 2005, and the recoverable amount is $1,000. D uses straight-line depreciation over a 10-year useful life for net assets. A portion of B’s recoverable amount of $1,000 is attributable to the unrecognized minority interest in goodwill. The carrying amount of B must be notionally adjusted to include goodwill attributable to the minority interest ($90 x 30%/ 70% = $39), as follows:

The impairment loss of the $299 is allocated to the assets in the unit by first reducing the carrying amount of goodwill to zero, which requires an allocation of $129. Because the goodwill is recognized only to the extent of D’s 70% ownership interest in B, D recognizes only 70% of that goodwill impairment loss ($90). The remaining impairment loss ($299 – $129 = $170) is recognized by reducing the carrying amounts of B’s identifiable net assets, as shown below:

An impairment loss recognized for goodwill cannot be reversed in a subsequent period under IAS 36. This provision is in accordance with the prohibition of internally generated goodwill under IAS 38. European standards setters criticized the prohibition of a reversal of an impairment loss. Some supported a reversal only when the primary external reason for the impairment no longer exists, thus avoiding a reversal for internally generated goodwill. The prohibition of a reversal is in line with SFAS 142.

The effects of the prohibition of the annual amortization of goodwill must be examined in practice. Companies that have amortized large amounts of goodwill in the past, will, assuming no impairment is necessary, have higher net profits but without qualitative improvements. On the other hand, these companies will have higher losses resulting from impairments if the acquired unit does not develop as successfully as first assumed.

“Analysis of SFAS No. 141 and No. 142 shows how financial manager can use the accounting principle to best advantage.”

In-process R&D is still covered under SFAS 2, Accounting for Research and Development Costs. SFAS 2 generally treats in-process R&D as an intangible asset if acquired during a merger or acquisition but requires the value to be immediately expensed except under certain circumstances. Some continue to point out that expensing R&D creates a distorted picture of return on equity, corporate profits and corporate productivity.

The reason the corporate profit share fell in the 1997-1999 boom is simple accounting: accounting profits understated economic profits because corporations were making large intangible investments in the late 1990s that they expensed. Adding intangible investments to accounting profits and to accounting investment implies a very different picture of the U.S. economy.

Interestingly, economic statisticians are looking at this issue in the context of the System of National Accounts. The Bureau of Economic Analysis (BEA) and the National Science Foundation (NSF) are continuing their work on refining the R&D portion of Gross Domestic Product (GDP) numbers. That work includes looking at the issue of treating R&D as an investment (i.e. capitalizing cost over a number of years, similar to what is already done with plant and equipment) rather than expensing it. This movement by economists in charge of macroeconomic statistics toward capitalization of R&D in the national accounts may give a new push for similar capitalization of R&D in business accounting. It should be noted that U.S. GAAP and the IASB standards differ significantly in their treatment of in-process R&D and the capitalization of development costs. In this case, the Committee of European Securities Regulators recommends that companies listed on EU stock exchanges but who report according to U.S. GAAP procedures be required to disclose a “quantitative indication of the impact of an event or transaction, had this event or transaction been accounted for following IAS/IFRS provisions. Such quantification should provide the gross and net of tax effect of the difference on the profit and loss or on the shareholders’ equity of the issuer, as applicable.” These required disclosures will provide a quantitative record of the effect of alternative treatments of R&D on the bottom line. This should provide sufficient evidence to resolve the issue one way or another. Assembled workforce is also specifically excluded from the list of intangibles. However, valuation experts have been valuing assembled workforce and using it to determine value of other reportable intangible assets. If a calculation of the value of assembled workforce is used as an input in reporting other intangibles, shouldn’t it be reported as well (under the Sarbanes-Oxley Act requirements)? Finally, as mentioned at the very beginning of this paper, the different treatment of acquired intangible assets and those generated internally is a major area of concern. As the earlier FASB report on accounting for the New Economy stated:

There is no conceptual basis in the definition of an asset for applying different recognition rules to intangible assets purchased from outsiders and the same assets created internally. Different recognition rules, if appropriate, require some other justification.

The lack of such a requirement is both father to and son of the lack of internal accounting system for capturing investments in other intangibles. In many cases, ongoing investments in human capital, such as expenditures on in-house training, mentoring, etc., are not reported separately as either investments or expenses and apparently not even tracked internally.

Inability to capture such information makes recognition of such ongoing investments difficult – and the lack of a requirement to include such data provides no incentives for creation of such systems. FASB requirements clearly drive, and limit, company responses. The 2004 Accenture survey found that half of the respondents limit the definition of intangibles to those defined by the relevant accounting standards board. The Sarbanes-Oxley Act is pushing companies to upgrade their internal accounting systems. However, as discussed earlier, it remains to be seen whether this will provide any significant incentive for revamping these systems to provide better measures of intangibles.

Findings

Exhibit 4

Conclusion

The accounting treatment of goodwill has been a matter of concern to accountants and accounting standards committees for more than a decade. International standard setters agreed in the early 1990s that goodwill should be recognised as an asset and amortised over its useful life. The issue was re-introduced at the start of the 21st century, resulting in the FASB replacing the amortisation requirement with an impairment testing approach in 2001.

The IASB also adopted this approach with the acceptance of IFRS 3 in 2004. The examination of the nature of goodwill in Section 4 of this article has shown that goodwill exists because the fair value of a business as a going concern exceeds the fair value of its identifiable net assets. If this can be attributed to expectations of high future earnings, amortisation would result in the matching of the cost of the goodwill with expected future earnings from the acquisition. If the excess paid is due to internally generated intangibles that are not recognised as assets, or expected synergies from combining the businesses of the companies involved, the impairment approach would permit the capitalisation of these internally generated intangible assets. This could result in companies’ never having to recognise an impairment of the acquired goodwill, which would give companies growing through acquisitions the advantage of recognising inherent goodwill as an asset.

A comparison between amortisation and impairment revealed that amortisation is well understood and that it is a well-established principle consistent with the approach taken to other tangible and intangible assets with finite useful lives, but that it ignores the fact that some forms of goodwill can have an indefinite useful life. The impairment test approach, on the other hand, seems to involve a very different and much more complex, costly and subjective accounting process. Fair value measurements can be difficult to do and may need to be done by valuation experts. In cases where stock prices are used as estimates for fair values, goodwill might have to be impaired, although the current price at which the company’s stock trades might not reflect its fair value and thus not be representative of the fair value of the reporting unit as a whole. It may therefore be more appropriate to treat goodwill in the same way as other intangible assets: amortising finite life goodwill and subjecting it to an impairment test only where there is an indication that it has been impaired, while subjecting indefinite life goodwill, where the life of goodwill is difficult to assess, to an annual impairment test. This will ensure that accounting for goodwill takes into account the nature of goodwill as an intangible asset, as well as the reasons for its existence, without unnecessarily subjecting it to a complex and costly annual impairment test.

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