The Board issued its long-awaited exposure draft (ED), Fair Value Measurement, last month. The ED does not expand the use of fair value or say when to use fair value. It provides a single source of “how to” guidance for measuring fair value where an IFRS requires or permits its use*. Robert Marsh, in Global ACS in the US, and Alberto Vieyra, in the Global ACS Central Team, look at the proposals.
The existing guidance on measuring fair value was developed on a piecemeal basis over many years and is dispersed across numerous standards. This single definition and framework aim to reduce complexity and improve consistency in the application of fair value measurements.
The ED is based on US standard SFAS 157, Fair Value Measurements. The definition of fair value in the ED is identical to that in SFAS 157. The guidance is also largely consistent with US GAAP and the guidance issued by the IASB’s Expert Advisory Panel in September 2008.
The ED proposes an exit-price notion of fair value, defined 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.” It provides additional guidance specifying:
The ED differs from SFAS 157 in that it defines the reference market as the most advantageous market. SFAS 157 assumes that the transaction takes place in the principal market if one exists. However, the ED notes that the entity may assume that the principal market is the most advantageous if there is no evidence to the contrary.
The ED does not change the unit of account prescribed by existing IFRS. The unit of account for financial assets and liabilities, therefore, remains the individual instrument.
The ED proposes that the fair value of a liability reflects non-performance risk (including the reporting entity’s own credit standing). Non-performance risk is also assumed to be the same before and after the transfer of a liability; the definition of fair value assumes that, because the liability is transferred, the liability continues and is not settled with the counterparty or extinguished in any other way. The fair value of a liability is equal, in the Board’s view, to the corresponding asset held by the counterparty. A liability is, therefore, measured using the same method that would be used by the counterparty to measure the asset, even in the absence of an observable market price. This is one area where the proposals might change the way in which some entities measure the fair value of some of their liabilities.
The ED proposes a single fair value hierarchy like that in SFAS 157, which will apply to all fair value measurements. The hierarchy has three levels, based on the type of inputs to the valuation techniques used.
The ED does not prescribe the use of bid prices for assets and ask prices for liabilities; it requires the use of judgment in determining which price within the bid-ask spread is most representative of fair value in the circumstances. This holds true no matter where in the hierarchy the inputs, based on the bid and ask prices, reside. This is a change from existing guidance.
There are enhanced disclosure requirements, which could result in significantly more work for reporting entities. These requirements are similar to those in IFRS 7 but apply to all assets and liabilities measured at fair value, not just financial assets and liabilities. The disclosures requirements include:
The proposals include a requirement for financial instruments to have the same disclosures in interim statements as for annual statements. This is likely to have the biggest impact on financial institutions.
The Board decided at its meeting last month that the replacement standard for IAS 39 will be exposed in three drafts. The first will focus on the classification and measurement of financial instruments (expected July 2009); the second and third will deal respectively with impairment (expected October 2009) and hedging (expected Q1, 2010).
Classification and measurement
The IASB tentatively decided that the two measurement categories will be fair value and amortized cost. Basic financial instruments (as set out in IFRS for Small and Medium-sized Entities) will qualify for amortized cost; all other financial instruments will be measured at fair value. Entities may then have an option to fair value some of those basic financial instruments if, for example, the entity’s business model was to trade the instrument. This might be a free choice or may be subject to constraints. There might be other items that are required to be fair valued — for example, those basic financial instruments that are quoted in an active market.
These issues will be considered at future meetings. The IASB will propose to prohibit reclassifications between the fair value and amortized cost categories; eliminate tainting rules (but require separate presentation of gains and losses on disposals of amortized cost instruments); and allow presentation of fair value changes in other comprehensive income but without recycling or impairment (although the basis on when this would be permitted was not discussed).
The Board discussed the various approaches to impairment. The staff is currently discussing the mechanics of an expected loss approach (by contrast to the current incurred loss model) to impairment with various stakeholders. The Board is expected to ask for views from interested parties via the website posting in July in anticipation of issuing an ED on impairment in October 2009.
The Board has published an ED proposing amendments to IFRIC 14, IAS 19 — The Limit on a Defined Benefit Asset, Minimum Funding Requirements and their Interaction. The proposed amendment is aimed at correcting an unintended consequence of IFRIC 14. Some entities will not be permitted to recognize as an asset certain prepayments for minimum funding contributions. The proposals will remedy this by requiring prepayments in appropriate circumstances to be recognized as assets. There is a 60-day comment period ending on July 27, 2009.
The IASB and IFRIC have appointed new members from next month. Amaro Luiz de Oliveira Gomes, from the Central Bank of Brazil, and analysts, Patrick Finnegan, from the CFA Institute Centre for Financial Market Integrity (CFA Institute), and Patricia McConnell, from Bear Stearns, join the board as a full-time members for five years. Laurence Rivat joins IFRIC for three years from Deloitte in France.
Amaro Luiz de Oliveira Gomes has played a leading role in the adoption of IFRS in Brazil, overseeing the introduction for financial institutions. He has also served as a member of the Brazilian Committee of Accounting Standards and the Steering Committee for Accounting Convergence – Brazil, and on the Accounting Task Force of the Basel Committee on Banking Supervision.
Patrick Finnegan leads a team at CFA Institute (association for investment professionals) providing user input into the standard-setting activities of the IASB, FASB and other regulatory bodies. He has also coordinated the work of the CFA Institute’s Corporate Disclosure Policy Council, which reviews and comments on financial reporting policy initiatives around the world. He was previously managing director in Moody’s Corporate Finance Group.
Patricia McConnell is one of the leading analysts in the US on accounting-related issues. During her 32 years at Bear Stearns’ Equity Research group, she participated in standard setting activities as a member of the IASB’s Standards Advisory Council, the IASC, the CFA Institute’s Corporate Disclosure Policy Council and the New York Society of Security Analysts.
Laurence Rivat is a Deloitte partner in the firm’s IFRS leadership team and heads up one of its IFRS centres of excellence. IFRIC has also announced the reappointment, for three years, of:
Coca-Cola’s secret formula, McDonald’s golden arches, Mickey Mouse, the Times subscriber list — these are all forms of intangible assets. The Spirit of Ecstasy, the famous flying lady that adorns the front of every Rolls-Royce, was at the centre of tussle between VW and BMW that demonstrates the power of a trademark. Coca- Cola’s secret formula is priceless. Disney’s brand power embodied in Mickey Mouse is world class. However, the accounting for these intangible assets can be complicated. It has been made more difficult by the current economic climate. Management has been focusing on these assets and assessing whether their value is recoverable. Larry Dodyk and Eric Kahrl, of PricewaterhouseCoopers’ Accounting Consulting Services in the US, try to make intangible assets a bit more tangible.
An intangible asset is defined as an identifiable non-monetary asset without physical substance. Unlike tangible assets, such as factory equipment or an office building, intangible assets derive their value from the rights and privileges granted to the company using them.
Management frequently expends resources or incurs liabilities on the acquisition, development, maintenance and enhancement of intangible resources. These include scientific and technical knowledge, design and implementation of new processes and systems, licences, intellectual property, market knowledge and trademarks (including brand names and publishing titles).
Intangible assets can take on many forms. They typically fall into one of six categories:
Management has to use judgment to determine if expenditures meet the definition of an intangible asset. An intangible asset must be identifiable, controlled and capable of generating future economic benefits, according to the definition in IAS 38, Intangible Assets. An asset is identifiable if it is separable (that is, it is capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract or asset/liability). An asset is also identifiable if it arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or other rights.
Intangible assets might be internally generated, acquired as part of a business combination or acquired separately. The accounting can be very different, depending on how the asset was acquired. So how does the method of acquisition impact the initial recognition and measurement of intangible assets?
Recognition and measurement of internally generated intangible assets
Many intangible assets are internally generated; that is, they are established and supported by management over a long period of time. Most brand names are internally generated and it can be difficult to spot the moment when a brand moves from a clever marketing idea to a value generator. Brands associated with consumer products tend to be the most valuable, as they can allow management to charge a premium price for a product that would otherwise have little differentiation, such as cigarettes or vodka. Expenditures on brand development cannot be distinguished from the cost of developing the business as a whole; they are not separable. Such items are not, therefore, recognized as intangible assets when developed internally.
Intangible assets of a more technical or scientific nature, such as software or patented drugs, may also be developed internally by a company. The process of generating this type of intangible asset is divided into a research phase and a development phase. Research is the discovery, interpretation and development of knowledge. Development is the application of knowledge to specific problems. No intangible assets arising from the research phase may be recognized. This is because, during the research phase, it is not possible to establish probable economic benefit attributable to the research expenditure.
An entity can, in some instances, identify an intangible asset during the development stage and demonstrate that the asset will generate probable future economic benefits. Intangible assets arising from the development phase are recognized when the entity can demonstrate all of the following:
Examples of development activities that might meet the criteria for capitalization are:
Any expenditure written off during the research or development phase cannot subsequently be capitalized if the project meets the criteria for recognition at a later date. The costs relating to many internally generated intangible items cannot be capitalized but are expensed as incurred. These include research, start-up and advertising costs.
Recognition and measurement of separately acquired intangible assets
A company may purchase an intangible asset from another party. Separately acquired intangible assets are recognized initially at cost. Cost comprises the purchase price, including import duties and non-refundable purchase taxes, and any directly attributable costs of preparing the asset for its intended use. Separately acquired intangible assets are common in the pharmaceutical industry, where both patented drugs and drugs in development will be bought and sold. Desirable take-off and landing times (slots) at a major airport also commonly change hands. Broadcast licences for television, radio and mobile phones may be acquired either from a governmental authority or another entity.
Broadcast rights to movies and television programs are another form of intangible that are bought and sold outside a business combination.
The purchase price of a separately acquired intangible asset incorporates assumptions about the probable economic future benefits that may be generated by the asset. A patented drug that is being actively marketed will have a predictable stream of cash flows and will command a price commensurate with those expected highly probable (not so risky) cash flows. A pharmaceutical compound in early development will sell for a much lower price, reflecting the considerable uncertainty about whether it will be successful. Thus, probability is factored into the initial measurement of a separately acquired intangible asset.
Recognition and measurement of purchased as part of a business combination
The cost of an intangible asset acquired in a business combination is its fair value at the acquisition date. The fair value of an intangible asset reflects expectations about the probability that the expected future economic benefits embodied in the asset will flow to the entity. As discussed above, more certain cash flows will result in a higher fair value and less certain cash flows in a lower fair value.
Most marketing- and customer-type intangible assets are only recognized as part of a business combination, as these types of assets would seldom change hands unless the entire business is sold. What would Coca-Cola be without the Coca-Cola brand?
If an intangible asset acquired in a business combination is separable or arises from contractual or other legal rights, there is sufficient information to measure reliably the fair value of the asset. The reliable measurement criterion is, therefore, also considered to be satisfied for intangible assets acquired in business combinations. If an intangible asset is not separable or does not arise from a contractual or other legal right, the asset is recognized as part of goodwill.
An acquirer recognizes at the acquisition date, separately from goodwill, an identifiable intangible asset of the acquiree, irrespective of whether the asset had been recognized by the acquiree before the business combination. Certain contractrelated intangible assets may not have been recorded by a target in its pre-acquisition balance sheet, such as executory contracts. On acquisition, these contracts may reflect a favourable position relative to current market conditions and may, therefore, represent intangible assets. It may be challenging to identify these assets during a business combination across a large organization.
Intangible assets are amortized unless they have an indefinite useful life. Management amortizes these assets on a systematic basis over their useful lives. An intangible asset has an indefinite useful life when there is no foreseeable limit to the period over which the asset is expected to generate cash inflows for the entity. Indefinite is not the same as infinite (limitless in extent), nor is it the same as indeterminate (having no definable value). The useful life of a finitelifed intangible asset is reviewed at least each financial year-end.
Management chooses either the cost model or the revaluation model as its accounting policy for intangible assets after initial recognition. There must be an active market for the revaluation model to be applied. As few intangible assets are actively traded, revaluation is seldom seen in practice.
Management has been focusing on intangible assets in the economic downturn and whether their value is recoverable. An intangible asset cannot be carried at an amount that is higher than what may be recovered through use (value in use, or VIU) or sale (fair value less costs to sell, or FVLCTS). The higher of VIU or FVLCTS is the recoverable amount. Impairment results when the recoverable amount is less than the carrying amount. The two bases of measurement have similarities and differences, as shown in the table below.
Not all intangible assets have to be tested for impairment every year. Intangible assets with finite lives are tested only when there is an indicator of impairment. However, goodwill, indefinite-lived intangible assets and intangible assets that are not yet ready for use are tested every year and when there are indicators of impairment. Some indicators are operating losses, market downturns, damage and an intended change of use for the asset.
Intangible assets are most often tested for impairment in a cash-generating unit (CGU) or with groups of CGUs. For example, a major brand like Nike would generate cash flows for all branded products. A CGU is the smallest group of assets that generates cash inflows that are largely independent of those from other assets; it can also be a single asset. Typical CGUs are retail stores and factories. A CGU has assets that can be specifically allocated to it (for example, fixed assets within a store) and will include portions of central assets if these can be allocated on a reasonable and consistent basis.
Current economic conditions have brought recorded intangible assets and goodwill into the spotlight. There has been more scrutiny of what may have been routine impairment testing for goodwill and indefinite lived intangible assets. Widespread impairment indicators have results in impairment testing of amortizing intangible assets as many businesses have come under pressure. Good disclosure of impairment charges taken — and those avoided — will be key in the current reporting climate.