Create the JOURNAL ENTRY that should be made by Big Steve Company to record the acquisition of Little Lily for $10 million cash. Here are three hints. Hint 1: Each of the three identifiable assets that have been acquired should be recorded on Big Steve?s books at fair value. Hint 2: Debits equal credits. Hint 3: You should start by crediting cash for $10 million.

ACG 6138 Fall 2013 Fair Value Measurements and Disclosures I. Fair values: Basics A. Assets and liabilities are carried on the balance sheet at a variety of attributes. ASC 820.10 (previously SFAS 157 & 159) expands the scope of fair value application and provides more guidance on the measurement of fair values. B. The shift to fair value reflects a tradeoff between relevance and reliability. C. Fair value is 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. 1. Fair value applies to both assets and liabilities. 2. The exit price to be received/paid in the principal (or most advantageous market in the absence) market of the asset/liability. 3. In application to non-financial assets, fair value measurement assumes highest and best use of the asset by market participants. 4. In application to liabilities, fair value is the cost to transfer (not to settle) the liability to another party without affecting the nonperformance risk. D. Where are fair values used? 1. Allocation of the purchase price in accounting for mergers and acquisition 2. Valuation of assets and liabilities: a. Fair value option for financial instruments (previously SFAS 159) ASC 825.10 defines financial instruments as: Cash, evidence of an ownership interest in an entity, or a contract that both: Imposes on one entity a contractual obligation either: 1) To deliver cash or another financial instrument to a second entity 2) To exchange other financial instruments on potentially unfavorable terms with the second entity. Conveys to that second entity a contractual right either: 1) To receive cash or another financial instrument from the first entity 2) To exchange other financial instruments on potentially favorable terms with the first entity. b. Others: 3. Determination of revenue and expense items a. Impairment of long-lived assets b. Certain stock-based compensation 4. Buy vs. lease vs. build 5. Audit fair values II. Fair value measurement A. Fair value hierarchy (previously SFAS 157) 1. Level 1 inputs: quoted market prices in active markets for identical assets or liabilities 2. Level 2 inputs: observable inputs other than quoted prices in active markets for identical assets/liabilities 1 ACG 6138 Fall 2013 Examples: quoted prices for similar assets and liabilities, quoted prices for identical assets in inactive markets, interest rates, and etc. 3. Level 3 inputs: unobservable inputs (such as proprietary data of the company) 4. Level 1 (3) has the highest (lowest) priority. However, an observable market price is not always better than a fair value measure generated from a level 3 process such as discounted cash flow analysis. B. Valuation techniques 1. Market approach: use prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. Examples: use of multiples and matrix pricing. 2. Income approach: convert (discount) future amounts to a single present amount a. Multiple present value techniques are acceptable. Capitalized cash flow approach Example: A business has net cash flow of $250,000 to be received at the end of current year and the long-term growth rate is 3%. The appropriate discount rate is 15% based on the risk and industry. Value of the business =? Traditional discounted cash flow analysis: determine the most likely cash flow scenario and use a risk-adjusted discount rate. Expected cash flow approach: probable cash flows are weighted by associated probabilities and then discounted at the risk-free rate. Example: Consider a 4%, 5,000,000 bond, interest payable semi-annually with three years left. Company is experiencing financial difficulties - 80% probability pay all contractual amounts timely - 10% probability that after two more interest payments, followed by liquidation where the principal is received in two more years - 10% probability that after two more interest payments, no further payments are received Assume all cash flows occur at the end of each period. Risk-free rate = 2.5%, risk-adjusted rate = 5.0 %. (Both are semi-annual rates.) Present value under traditional discounted cash flow approach vs. expected cash flow approach. 2 ACG 6138 Fall 2013 b. Option pricing models that incorporate present value techniques are also an example of income approach. 3. Cost approach: use current replacement cost. 4. The appropriate valuation technique varies depending on circumstances. However, valuation techniques used to measure fair value should be consistently applied. III. Disclosures A. Fair values of financial instruments are required to be disclosed whether recognized or not. B. For recognized fair values, the following should be disclosed: Fair values measurements by type and levels of inputs in a tabular format. Additional reconciliation for fair value measurements using level 3 inputs. A description of valuation techniques used (level 2 & 3) and explanation for the change in valuation techniques, if any. Transfers between levels and the reasons for the transfers. Acknowledgement of the fact and the reason why the current use of a nonfinancial asset/liability recognized at fair value differs from its highest and best use. IV. IFRS differences A. As part of the convergence, IFRS 13 was issued in 2011 to provide better guidance on fair value measurements. IFRS 13 is similar to ASC 820.10 and applies to reporting periods starting on or after January 1, 2013. B. Previously, fair value was defined as the exchange price in IAS 39 (former source of IFRS guidance on fair values) and not the exit price. C. Some minor differences still exist even after the convergence: ASC 820 explicitly allows the recognition of gains/losses at initial recognition when transaction price differs from fair value when applicable, but it is unclear whether the practice is fully acceptable under IFRS. ASC 820 offers more guidance of fair value measurements for certain investments measured at net asset value per share. IFRS 13 requires a sensitivity analysis for financial instruments valued using level-3 inputs. D. 3 ACG 6138 Fall 2013 Using Fair Values to Allocate a Business Purchase Price On January 1, 2009, Big Steve Company purchased Little Lily Company. Big Steve paid $10 million cash to the founders of Little Lily (who were the sole shareholders); those founders are now taking a welldeserved vacation in a mountain resort in Sa Pa, Vietnam. Little Lily Company had just three identifiable assets: a building, a customer list, and a business license. Details about each of these three assets are as follows. To keep things simple, assume that the cash flows from each of the assets are independent of each other. -----------------------------------------------------------------------------------------------------------------------------------Building. Little Lily's building has 32,000 square feet and a capitalization rate of 9.3%. You have assembled the following market data, based on commercial real estate sales in the area in the past six months. Selling Price Square Feet Capitalization Rate 10,000 20,000 30,000 40,000 50,000 7% $700,000 $1,425,000 $2,000,000 $2,500,000 $3,000,000 8% 625,000 1,250,000 1,750,000 2,250,000 2,625,000 9% 550,000 1,100,000 1,550,000 2,000,000 2,300,000 10% 500,000 1,000,000 1,400,000 1,800,000 2,100,000 -----------------------------------------------------------------------------------------------------------------------------------Customer list. You have estimated that the potential future cash flows from the customer list are as follows. Outcome 1 20% probability of cash flows of $1,200,000 at the end of each year for five years. Outcome 2 30% probability of cash flows of $540,000 at the end of each year for four years. Outcome 3 50% probability of cash flows of $270,000 at the end of each year for three years. -----------------------------------------------------------------------------------------------------------------------------------Business license. The business license was issued by the United States government. These licenses are valuable, but they trade infrequently, and the last separate sale of a similar license was 10 years ago. Similar licenses are sometimes sublicensed, or rented, in exchange for a royalty fee based on total business revenue, so a \"relief from royalty\" method can be used to estimate the fair value of the license. You have generated the following data. Royalty rate: 4.0% of total business revenue (before subtracting any expenses) Expected Little Lily revenue in 2009: $15,000,000 Expected growth rate in Little Lily revenue each year from 2010 through 2013: 10.0%. You expect rapid Little Lily revenue growth for the next five years, but then the growth will slow to a sustainable long-term level. Expected growth rate in Little Lily revenue each year after five years (2014 and beyond): 3.0% Income tax rate: 30% Assume that all cash flows occur at the end of the year. ------------------------------------------------------------------------------------------------------------------------------Discount rate. You know that when using an expected cash flow approach, the uncertainty of the situation is built into the expected cash flow estimates; the appropriate discount rate to use in such a case is the risk-free rate which is 5.0% in this case. The appropriate discount rate to use in valuating the business license should be a risk-adjusted rate. Given the uncertainty of Little Lily's future revenues, the appropriate discount rate is 13.0%. 4 ACG 6138 Fall 2013 REQUIRED: Create the JOURNAL ENTRY that should be made by Big Steve Company to record the acquisition of Little Lily for $10 million cash. Here are three hints. Hint 1: Each of the three identifiable assets that have been acquired should be recorded on Big Steve's books at fair value. Hint 2: Debits equal credits. Hint 3: You should start by crediting cash for $10 million. 5% Periods 1 2 3 4 5 6 7 8 9 PV($1) .95238 .90703 .86384 .82270 .78353 .74622 .71068 .67684 .64461 PV(Ann) .95238 1.85941 2.72325 3.54595 4.32948 5.07569 5.78637 6.46321 7.10782 Periods 1 2 3 4 5 6 7 8 9 PV($1) .94340 .89000 .83962 .79209 .74726 .70496 .66506 .62741 .59190 PV(Ann) .94340 1.83339 2.67301 3.46511 4.21236 4.91732 5.58238 6.20979 6.80169 Periods 1 2 3 4 5 6 7 8 9 PV($1) .90909 .82645 .75131 .68301 .62092 .56447 .51316 .46651 .42410 PV(Ann) .90909 1.73554 2.48685 3.16987 3.79079 4.35526 4.86842 5.33493 5.75902 Periods 1 2 3 4 5 6 7 8 9 PV($1) .89286 .79719 .71178 .63552 .56743 .50663 .45235 .40388 .36061 PV(Ann) .89286 1.69005 2.40183 3.03735 3.60478 4.11141 4.56376 4.96764 5.32825 Periods 1 2 3 4 5 6 7 8 9 PV($1) .88496 .78315 .69305 .61332 .54276 .48032 .42506 .37616 .33288 PV(Ann) .88496 1.66810 2.36115 2.97447 3.51723 3.99755 4.42261 4.79877 5.13166 Periods 1 2 3 4 5 6 7 8 9 PV($1) .86957 .75614 .65752 .57175 .49718 .43233 .37594 .32690 .28426 PV(Ann) .86957 1.62571 2.28323 2.85498 3.35216 3.78448 4.16042 4.48732 4.77158 6% 10% 12% 13% 15% 5