FAS 157, 141R: Tricky Combination for Non-Financials

As chaotic as the new rules for fair-value accounting have been so far, the financial reporting community can expect still more heartburn ahead.

A double-whammy looms in early 2009. First, certain portions of Financial Accounting Statement No. 157, Fair Value Measurement, that had been delayed for a year will finally go into effect. Those deferred portions deal with non-recurring, non-financial items such as intangible assets, contingencies, asset retirement obligations, goodwill—items that usually crop up in mergers or acquisitions.

Then comes the second punch: At the same time, companies will start applying FAS 141R, Business Combinations, a revised standard for how to book a merger or acquisition. That is, Corporate America will need to value mergers according to new accounting rules and use new methods to determine what that fair value actually is.

Loughry

“People are just starting to think about the next phase,” says Sam Loughry, a partner at Deloitte. “There’s a little bit of apprehension, as there is with anything new. They want to make sure they’ve thought through everything prior to adoption.”

Parts of FAS 157 went into effect at the start of this year, mostly applying to financial assets and liabilities. That was difficult enough for companies to master, and they pleaded with the Financial Accounting Standards Board to delay the other portions of FAS 157 until 2009.

FAS 157 doesn’t require any new use of fair value unless some other accounting standard requires it—but FAS 141R does require new fair-value calculations. That means companies will be doing some new reporting that’s never been done before, valuation and accounting experts say.

To some extent the experience gained in applying FAS 157 to financial assets and financial liabilities will be helpful to companies as they consider how to apply the measurement approach to non-financial assets and non-financial liabilities, Loughry says. In particular, companies are getting a handle on what it means to value an asset or liability from the perspective of a hypothetical “market participant,” a key element of FAS 157’s approach.

FAS 157 requires companies to use some conjecture about how a market participant would value a given asset or liability, and factor those assumptions into the fair-value calculation. Companies have long been accustomed to valuing such assets from their own perspective, so developing assumptions about market participant views implies a great deal more judgment.

“To what extent a company’s auditor is going to demand documentation is somewhat of an unknown ... The nature and extent of documentation is something companies should be thinking about.”

— Gary Roland,

Managing Director,

Duff & Phelps

Contingencies, for example, represent perhaps the most vexing area, experts say. Contingencies include events or circumstances for which the future outcome is unknown at the reporting date; it most often includes pending litigation or potential environmental cleanup. The new requirement under FAS 141R to measure additional contingencies at fair value, coupled with the new fair-value measurement approaches under FAS 157, requires extensive judgment.

“This is still honestly an evolving area,” says Matthew Pinson, managing director at PricewaterhouseCoopers. “What that means and how to measure it is still something that’s being wrestled with.”

Dwindling Latitude

Under existing rules, companies have a lot more latitude simply to decline to place a value on certain contingencies if their future outcome is too uncertain. “To a certain extent, the ability to say it’s too difficult to measure or you just can’t get your arms around them so you’re not putting them on the balance sheet—that freedom has been reduced,” says Gary Roland of Duff & Phelps, an investment banking and financial advisory firm.

King

Alfred King, vice chairman at valuation and appraisal firm Marshall & Stevens, says valuing contingencies is uncomfortable for preparers because of the imprecision. “As an appraiser, I have no problem in putting a supportable number on virtually any of these contingent liabilities,” he says. “The issue will be when somebody else equally qualified is given the same assignment, and their supportable number might be significantly different than mine. It’s not that one or the other is wrong. When you evaluate these things, you can get quite a different number.”

Greg Rogers, an environmental attorney with Advanced Environmental Dimensions and a frequent speaker on environmental issues and financial reporting, says companies aren’t prepared to apply FAS 157 and FAS 141R to environmental contingencies.

VALUATION CALCULATION

From FASB’s Emerging Issue’s Task Force—Accounting for Defensive Intangible Assets:

… With the issuance of FAS141(R) and FAS 157, the two Statements work in

combination to require that an intangible asset be recognized at a value that reflects the asset's highest and best use based on market participant assumptions. First, paragraph A59 of FAS 141(R) clarifies that while an acquirer may intend not to use an acquired asset or intends to use the acquired asset in a way that is not consistent with its highest and best use, the acquirer is still required to measure the asset at fair value determined in accordance with FAS 157. Second, FAS 157 emphasizes the use of an exit value and market participant assumptions in measuring fair value. As such, an acquirer needs to consider how market participants would value the asset when estimating its fair value.

An asset an entity does not intend to actively use has been commonly referred to as a

“defensive asset” or a “locked-up asset” because while the asset is not being actively used, it is likely contributing to an increase in the value of other assets owned by the acquiring entity. Paragraph A12(b) of FAS 157 acknowledges the notion of defensive asset value by specifically indicating that a locked-up asset generates value from its ability to maximize the value of other assets.

Upon the effective date of both FAS 141(R) and FAS 157, acquirers will generally assign a greater value to a defensive asset than would have typically been assigned under FAS 141 (that is, if market participants would continue to use the asset or would use the asset defensively). As a result, the FASB staff has received questions from constituents regarding how defensive assets should be accounted for subsequent to their acquisition and whether defensive assets should be considered finite-lived or indefinite-lived intangible assets. In addition, this issue was discussed with constituents in December 2007 and February 2008. Because FAS 141(R) is not yet effective, constituents could only provide their predictions on how the issue will be addressed by preparers after adoption of FAS 141(R). However, there were divergent views among constituents as to how defensive assets should be accounted for subsequent to acquisitions accounted for under FAS 141(R).

While the initial measurement of fair value for an acquired intangible asset is based on

market participant assumptions, paragraph 11 of FAS 142 stipulates that the accounting for a recognized intangible asset shall be based on the intangible asset’s useful life to the reporting entity and shall include the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity.

Further complicating the issue is the difference in accounting between a finite-lived

intangible asset and an indefinite-lived intangible asset. Whereas an intangible asset with a finite useful life is amortized, an intangible asset with an indefinite useful life is not amortized. Furthermore, if the defensive asset is determined to have a finite useful life, it is evaluated for possible impairment under FAS 144, while a defensive asset with an indefinite useful life is evaluated for possible impairment under FAS 142. Under FAS 144, an intangible asset with a finite useful life will be evaluated for impairment when events or circumstances suggest that the carrying value of the asset (asset group) may not be recoverable. Under FAS 142, however, an intangible asset with an indefinite useful life must be evaluated for impairment at least annually, as well as when events or circumstances suggest that the asset value may not be recoverable. Additionally, for purposes of recognition and measurement of an impairment loss under FAS

144, an intangible asset is grouped with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. Indefinite-lived intangible assets evaluated for impairment under FAS 142 are evaluated separately unless two or more indefinite-lived intangible assets are deemed to be inseparable from one another in accordance with Issue 02-7 and are combined into a single unit of accounting for impairment testing purposes.

While a defensive asset is measured from a market participant perspective, some

constituents believe that in many instances, the acquired asset becomes indistinguishable from the acquirer’s pre-existing intangible assets. That might be the case when the acquirer obtains additional market share as a result of the removal of a competing trade name. Therefore, some constituents have questioned whether it is more appropriate in certain circumstances to account for the acquired defensive asset as part of the acquirer’s pre-existing intangible assets or separately as a standalone asset.

A similar issue was addressed in Issue 02-7, which addresses whether separately acquired intangible assets that are collectively used in a manner that suggests they represent one asset should be combined as a single unit of accounting for impairment testing purposes. In that Issue, the Task Force concluded that separately recorded indefinite-lived intangible assets, whether acquired or internally developed, should be combined into a single unit of accounting for purposes of testing impairment if they are operated as a single asset and, as such, are essentially inseparable from one another.

Source

Accounting for Defensive Intangible Assets (Aug. 21, 2008).

“When I speak on these things publicly, the response I generally get is ‘How in the world can we possibly do this?’” Rogers says. “That indicates to me that companies haven’t even thought about this. I can’t back it up empirically, but my sense is companies are not really even aware of this.”

Given that non-financial assets and non-financial liabilities will be measured at “Level 3” of the FAS 157 hierarchy—where companies rely on assumptions and models rather than market pricing to establish values—Rogers expects to see valuation firms develop modeling techniques for valuing such assets and liabilities. He’s not aware that such models are emerging, however, and he worries that companies will end up reporting unsupportable figures. That, in turn, could get flagged by auditors or lead to restatements.

Rogers

“So much work remains to be done, and we are rapidly running out of time,” he says. “I’m fully expecting widespread non-compliance with this next year.”

Loughry says the Valuation Resources Group that is advising the Financial Accounting Standards Board on FAS 157 woes has discussed the problems around valuing contingencies. “It was determined [that] we’re really not sure how this is going to work under 157,” he says. “We won’t know until people start applying it. FASB staff said they will monitor to see if we need additional guidance, but my guess is that won’t be until they start seeing early reports.”

FASB is holding a Webcast on FAS 157 on Sept. 29, but it’s not clear whether it will address implementation to date, implementation ahead, or both. A FASB representative said there will be no agenda published in advance of the Webcast that would clarify.

Emerging Problems, Answers

FASB’s Emerging Issues Task Force is toiling on a few issues related to FAS 157, but it’s not clear whether any guidance that might result would be developed in time to aid implementation. The EITF is discussing how companies should account for “defensive intangible assets,” or intangible assets acquired in a business combination that the acquiring company intends to shelve.

Trademarks or brand names, for example, often are acquired by competitors with the intention of making them go away, Pinson says, so companies have typically assigned them little or no value. But FAS 157 requires companies to value and book them based on how a market participant might value them. That especially creates a problem for reporting their value in future periods after the acquisition is complete, the very subject EITF is discussing.

Impairments, or the writedown of intangibles over time, also present some discomfort under the new rules, says Loughry, especially under the current economic conditions. “Now that the market is in decline, there may be potentially more impairment analysis or testing,” he says.

Roland

However companies resolve such gray areas, experts agree that documentation will be critical. “Substantiating and documenting assumptions will be important because it’s all based on market participant assumptions,” Roland says. “To what extent a company’s auditor is going to demand documentation is somewhat of an unknown because we haven’t experienced it yet. The nature and extent of documentation is something companies should be thinking about.”