Forensics Journal - Stevenson University 2014

STEVENSON UNIVERSITY In particular, the IASB focused on disclosures for Level 3 inputs due to the increased amount of subjectivity used in applying valuation techniques (KPMG). Level 3 inputs require the following disclosures: can be developed, capital expenditure estimations can be risky because they are discretionary in nature (Harman). Not all equipment burdens can be predicted, and the value of an asset can be over-appreciated by estimating cash flows. Growth rates also require many assumptions; in particular, using a perpetual growth rate can lead to an overstatement of value. The assumption that a growth rate will remain constant is highly unlikely as markets are usually volatile and company earnings can change dramatically from year to year (Harman). Each year’s predicted cash flow is multiplied by these growth rates, so the methods are very sensitive to small changes in the growth rate. a) A description of valuation processes applied. b) Quantitative information about significant unobservable inputs. c) Narrative disclosure of the sensitivity of the fair value mea surement to significant reasonably possible alternative unob servable inputs (KPMG). U.S. AND FAIR VALUE ACCOUNTING Therefore, lower inputs in the fair value hierarchy require a greater extent of disclosure. Over the years, the Financial Accounting Standards Board (FASB) has extended fair value accounting to valuing debt and equity securities held for sale, derivatives, and reporting changes in fair value in the income statement and comprehensive income (Lefebvre, Simonova and Scarlat). In recent years, FASB and IASB have been working together to converge U.S. GAAP with IFRS. The American Institute of Certified Public Accountants (AICPA) distinguishes the meaning of convergence and adoption: convergence involves the U.S. and IASB working together to develop “high quality, compatible” financial statements whereas adoption would require the SEC to set a specific time in which public companies would be required to issue financial statements based upon international standards (“International Financial Reporting Standards”). As of this writing, the Securities and Exchange Commission (SEC) is only focused on convergence, with the expectation that it will make a determination on whether or not the U.S. will incorporate IFRS into U.S. financial reporting. Since IFRS relies heavily on fair value accounting when valuing assets, convergence could involve the U.S. adopting these same rules. Despite such specific requirements for disclosure and guidance when classifying assets among the fair value hierarchy, IASB does not establish specific valuation techniques that companies must use under Level 3. However, there are certain valuation methods that are generally accepted in practice, and even though IASB doesn’t provide specific guidance, generally accepted practices give accountants some guidance as to how to value assets at Level 3 (KPMG). LEVEL 3 VALUATION METHODS Two commonly used methods are applicable to assessing the value of fixed assets: the discounted cash flow method and capitalized cash flow method (Putra). The discounted cash flow method involves estimating the future cash flow the asset is expected to provide, which can involve either a short or long period of time. After determining what future cash flow the asset will bring in, a discount rate is established. Then, by multiplying expected future cash flow by the determined discount rate, the fair value for the asset will be determined (Putra). THE U.S. FINANCIAL CRISIS In response to Enron and other accounting scandals, the SEC issued many regulations in an attempt to provide more meaningful information to investors. The Sarbanes Oxley Act of 2002 helped fund further FASB efforts to develop new accounting standards through new funding (“The Sarbane-Oxley Act”). Through this Act, the SEC increased accounting regulation and facilitated development of more accurate accounting standards. FASB reformed U.S. accounting standards by implementing fair value accounting because officials believed market values would provide investors with more relevant information than historical cost was providing (Shorter). The SEC wanted to switch to fair value accounting because historical cost may have kept potentially worthless assets on the books of companies. Specifically, many investors were worried about mortgage-backed securities (Shorter). Under historical cost, these mortgages may still have some value on the financial statements of banks, but under fair value accounting, these mortgages must be marked down to the actual amount the bank expected to collect. The capitalized cash flow method is very similar to the discounted cash flow method: the future cash flow must be determined and the discount rate must be applied. However, the difference between the capitalized cash flow method and the discounted cash flow method is that the capitalized cash flow method assumes that the discount factor stays constant throughout the period in which the future cash flow has been determined (Putra). Under the discounted cash flow method, the discount factor can change from period to period and thus, requires a greater degree of calculation. While most valuation analysts prefer the discounted and capitalized cash flow methods, applying them can be difficult in certain situations (Harman). First, estimating future cash flows can be very uncertain; some valuations project cash flows for five to ten years. As the time period involved becomes longer, the cash flow projection becomes more uncertain (Harman)

Forensics Journal - Stevenson University 2014 | Page 39