In May 2011, the Financial Accounting Standards Board (“FASB”) amended its source document describing the generally accepted accounting principles (“GAAP”) used by nongovernmental entities in the United States, the FASB Accounting Standards Codification®. The title of Accounting Standards Update No. 2011-4, Fair Value Measurement (Topic 820) Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, explicitly describes the overall intent of the changes contained in the amendment. Fair Value is still defined as prior to the amendment, “as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” However, changes have been made to the manner in which some of the underlying concepts of valuation are applied to particular types of assets.
A Little History
Accounting Standards Update 2011-4 came about after years of effort by the FASB and the International Accounting Standards Board (“IASB”) to develop nearly identical Fair Value accounting standards. Originally, the FASB and IASB were each separately developing Fair Value measurement and reporting standards.
In 2003, the FASB began developing its Fair Value measurement and reporting standards, eventually issuing FASB Statement No. 157, Fair Value Measurements which provided a Fair Value definition, set up a structure for measuring Fair Value, and established standards for disclosures about Fair Value measurements. (These measurement and reporting standards are now incorporated in ASC Topic 820.) In late 2006, shortly after the issuance of SFAS 157, the IASB began developing its own Fair Value measurement standards, using SFAS 157 as their starting point. The IASB 2009 exposure draft, Fair Value Measurement, contained proposed standards that were similar to those in SFAS 157, although there were differences in wording. The exposure draft evoked numerous comments requesting the IASB and FASB jointly work to develop common Fair Value standards for measurement and reporting.
In October 2009, the FASB and the IASB met and agreed that they would cooperate and develop common requirements. Together, they concluded that the comparability of U.S. GAAP and IFRSs financial statements could be improved if: 1) the term “Fair Value” had the same meaning in U.S. GAAP and IFRSs and 2) U.S. GAAP and IFRSs had essentially the same measurement and disclosure requirements. Such changes would also simplify financial reporting because there would be fewer differences in the application of Fair Value measurement requirements.
In the spirit of developing common standards, the FASB agreed to consider the comments received by the IASB on their Fair Value Measurement Exposure Draft and to propose amendments to U.S. GAAP if necessary. Discussions between the FASB and IASB were held in early 2010 that resulted in a FASB exposure draft of amendments to Topic 820, while the IASB issued an exposure draft on disclosure of a measurement uncertainty analysis. Comments from both exposure drafts were jointly considered and discussed until spring of 2011. The IASB then issued its new standard, IFRS 13 Fair Value Measurement, in May 2011.
At the same time, the FASB issued Accounting Standards Update 2011-4 with changes to the wording of many of its requirements for measuring Fair Value and for disclosing information about Fair Value measurements. According to the FASB, they did not intend for the amendments to change the meaning of Fair Value, the requirements for measuring Fair Value, or how those requirements are applied, but to either clarify their intent regarding the application of existing Fair Value measurement requirements or change a particular principle or requirement for measuring Fair Value or disclosing information about Fair Value measurements.
Among the amendments that clarify the FASB’s intent regarding the application of existing Fair Value measurement requirements are changes in the application of two closely related valuation concepts: highest and best use and the valuation premise. The amendments specify that these two Fair Value measurement concepts are still relevant when determining the Fair Value of nonfinancial assets, but not when valuing financial assets or liabilities.
Changes to Highest and Best Use Concept
The highest and best use concept originated with the valuation of real property, although it is a concept that is also used in personal property appraisal. Basically, the highest and best use concept recognizes that real estate and personal property can have multiple uses, and that the value of an asset may change with a change in its use. Determining the highest and best use of an asset relies on an analysis of the current use and potential alternative uses of the property, considering what is legally permissible, physically possible, financially feasible, and maximally productive.
For example, consider a piece of highly specialized equipment used in the manufacture and assembly of the finned core of an automotive radiator. This very expensive, highly complex, custom designed and constructed piece of equipment is a valuable asset, allowing for the fabrication of hundreds of thousands of cores each year as part of an operating business. Yet, if taken out of that specific production setting, the unique characteristics of the core assembly machine – specific core size, complexity of operation, physical capacity, etc. – change its worth to the amount realized from the sale of its common components (controls, transformers and power supplies) and the scrap value of its metallic components. The change from its current use in radiator manufacturing to an alternate use has drastically affected the value.
Before being amended, Topic 820 specified that the concept of highest and best use was relevant when measuring the Fair Value of assets, but it did not distinguish between financial and nonfinancial assets. Based on the comments in response to the exposures drafts, the FASB concluded that a change was needed to improve consistency in the application of the highest and best use concept.
As amended, the highest and best use concept is no longer relevant when measuring the Fair Value of financial assets or of liabilities because such items do not have alternative uses. The FASB reasoned that because a financial asset has specific contractual terms, it can have a different use only if those contractual terms are changed. Such a change in characteristics would cause that particular asset to become a completely different asset.
For liabilities, the FASB concluded that although an entity might somehow relieve itself of an obligation and change the associated cash flows, doing so would not constitute an alternative use. Even if an entity has specific advantages or disadvantages that allow it to fulfill a liability more or less efficiently than other market participants, those specific factors don’t affect Fair Value.
The highest and best use concept still applies to nonfinancial assets such as real and personal property. The following new paragraphs from Topic 820 contain the now-current language:
820-10-35-10A A Fair Value measurement of a nonfinancial asset takes into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use.
820-10-35-10B The highest and best use of a nonfinancial asset takes into account the use of the asset that is physically possible, legally permissible, and financially feasible, as follows:
a. A use that is physically possible takes into account the physical characteristics of the asset that market participants would take into account when pricing the asset (for example, the location or size of a property).
b. A use that is legally permissible takes into account any legal restrictions on the use of the asset that market participants would take into account when pricing the asset (for example, the zoning regulations applicable to a property).
c. A use that is financially feasible takes into account whether a use of the asset that is physically possible and legally permissible generates adequate income or cash flows (taking into account the costs of converting the asset to that use) to produce an investment return that market participants would require from an investment in that asset put to that use.
820-10-35-10C Highest and best use is determined from the perspective of market participants, even if the reporting entity intends a different use. However, a reporting entity’s current use of a nonfinancial asset is presumed to be its highest and best use unless market or other factors suggest that a different use by market participants would maximize the value of the asset.
820-10-35-10D To protect its competitive position, or for other reasons, a reporting entity may intend not to use an acquired nonfinancial asset actively, or it may intend not to use the asset according to its highest and best use. For example, that might be the case for an acquired intangible asset that the reporting entity plans to use defensively by preventing others from using it. Nevertheless, the reporting entity shall measure the Fair Value of a nonfinancial asset assuming its highest and best use by market participants.
Changes to Valuation Premise Concept
Previously, Topic 820 used the terms “in use” and “in exchange” to describe the premise of valuation for a Fair Value measurement. Those terms were also used by the IASB when they issued their Fair Value Measurement Exposure Draft and were as follows:
a. In-use. The highest and best use of the asset is in-use if the asset would provide maximum value to market participants principally through its use in combination with other assets as a group (as installed or otherwise configured for use). For example, that might be the
case for certain nonfinancial assets.
b. In-exchange. The highest and best use of the asset is in-exchange if the asset would provide maximum value to market participants principally on a standalone basis. For example, that might be the case for a financial asset.
Apparently, many respondents to the IASB Exposure Draft thought the terms “in use” and “in exchange” were confusing, particularly to a layman. Comments were made that the terms did not accurately describe different valuation premises because an asset is being exchanged (sold) in both cases. In addition, some respondents thought that the “in use” valuation premise could be confused with the term value in use, which was already used in IAS 36, Impairment of Assets. As used in IAS 36, value in use specifically refers to the present value of the future cash flows derived from an entity’s intended use of the asset/asset group without adjustment to reflect the different cash flows that might arise from a third party market participant’s use of the asset/asset group.
Like the highest and best use concept, the FASB has deemed the valuation premise as no longer relevant when measuring the Fair Value of financial assets or of liabilities because their Fair Values do not depend on their use within a group of other assets or liabilities.
However, the valuation premise concept still applies for nonfinancial assets. Under the Amendment, the terms “in use” and “in exchange” are gone. Although suggestions of alternative terms were provided by respondents, the FASB instead chose to simply describe the objective of the valuation premise in a narrative format.
820-10-35-10E The highest and best use of a nonfinancial asset establishes the valuation premise used to measure the Fair Value of the asset, as follows:
a. The highest and best use of a nonfinancial asset might provide maximum value to market participants through its use in combination with other assets as a group (as installed or otherwise configured for use) or in combination with other assets and liabilities (for example, a business).
1. If the highest and best use of the asset is to use the asset in combination with other assets or with other assets and liabilities, the Fair Value of the asset is the price that would be received in a current transaction to sell the asset assuming that the asset would be used with other assets or with other assets and liabilities and that those assets and liabilities (that is, its complementary assets and the associated liabilities) would be available to market participants.
2. Liabilities associated with the asset and with the complementary assets include liabilities that fund working capital, but do not include liabilities used
to fund assets other than those within the group of assets.
3. Assumptions about the highest and best use of a nonfinancial asset shall be consistent for all of the assets (for which highest and best use is relevant) of the group of assets or the group of assets and liabilities within which the asset would be used.
b. The highest and best use of a nonfinancial asset might provide maximum value to market participants on a standalone basis. If the highest and best use of the asset is to use it on a standalone basis, the Fair Value of the asset is the price that would be received in a current transaction to sell the asset to market participants that would use the asset on a standalone basis.
820-10-35-11A The Fair Value measurement of a nonfinancial asset assumes that the asset is sold consistent with the unit of account specified in other Topics (which may be an individual asset). That is the case even when that Fair Value measurement assumes that the highest and best use of the asset is to use it in combination with other assets or with other assets and liabilities because a Fair Value measurement assumes that the market participant already holds the complementary assets and associated liabilities.
Timing for the Amendments
For public entities, the changes in Amendment 2011-4 become effective during interim and annual periods beginning after December 15, 2011. For nonpublic entities, the amendments become effective for annual periods beginning after December 15, 2011.
The FASB and IASB have made significant strides with respect to converging standards and in particular Fair Value standards and measurement requirements. As a result, the comparability of U.S. GAAP and IFRS financial statements will be improved and overall financial reporting simplified for multinational companies.
For valuation experts, the previously mentioned changes will be more a matter of form than function. While a highest and best use analysis is now irrelevant to valuation professionals focusing on financial assets and liabilities, it will continue to be applicable to tangible asset professionals.
While dropping the valuation premise terms “in use” and “in exchange” will not change the appraisal process for tangible asset professionals, the report language and descriptions will need to be revised accordingly. The regulatory bodies may have clarified the valuation premise concept to the layperson and also helped to more clearly align multiple promulgations and the spirit associated with each, but the actual definitions have been significantly expanded without the benefit of concisely defined terms. As such, the “in use” valuation premise is now described as “the premise that assumes that an asset would be used in combination with other assets or with other assets and liabilities.” And the “in exchange” premise has now become “the premise that assumes that an asset would be used on a standalone basis.”
“The premise that assumes that an asset would be used in combination with other assets or with other assets and liabilities”? It brings to mind the musician Prince, who changed his name in 1993 to an unpronounceable symbol. Maybe we should just use “The Premise Formerly Known as In Use.”