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Fair value basics Camelback Investment Company Background Camelback Investment Company (CIC) is a private company that invests in various financial and nonfinancial assets for its shareholders. Assets are measured at fair value at each reporting date so that the shareholders will know what their underlying shares are worth, which facilitates sales of the limited number of shares. It is early January 2011, and as the junior accountant at CIC, you have been asked by the chief financial officer (CFO) to work with the chief investment officer (CIO) to evaluate and determine the propriety of fair values that the CIO is proposing for a number of investments as of December 31, 2010. In that regard, the CFO asks you to challenge the valuation methodologies that the CIO has assigned to the various investments to ensure they are in compliance with ASU 820 and IFRS 13. The investments are as follows: Marketable equity securities CIC has an investment in 100,000 shares of common stock of a large public company whose stock is traded on the NYSE. The stock is currently valued in the accounting records at $25.00 per share ($2.5 million), which was the value at the last measurement date of September 30, 2010. The CIO is proposing to measure the fair value of the common stock at the bid price for the stock at the close of business on the measurement date of December 31, 2010, which is $27.50 per share. This valuation approach is consistent with what has been used in the past three years by management. Thus, the fair value is $2.75 million at year-end. Private equity securities CIC has an investment in 100,000 shares of common stock of a private company. There are no market quotes with respect to the fair value of the common stock; however, the private company's operations, size and performance are similar to a company whose stock is traded on the NASDAQ. The CIO has taken some of the similar company's market metrics, such as the price/earnings ratio of the common stock, a discounted earnings calculation and a few others, and has adjusted these metrics to reflect performance that he believes is better and more accurate of the metrics with which to value the private company and related investment. However, these revised metrics do not agree with the metrics of the similar public company or other companies in this industry. Land CIC has an investment in a 10-acre parcel of land that is located near downtown Los Angeles that has just been remediated from an old oil spill. The carrying value of the land at September 30, 2010, was $1 million per acre, or $10 million, and is the equivalent of the cost of the land plus the costs to remediate the oil spill. The surrounding area consists of single-story warehouse facilities, which is consistent with the zoning of the area. The CIO believes that the land can be used to construct either a commercial warehouse or industrial manufacturing facility; the later requiring rezoning from the city. Recent similar sales of land within the area have been approximately $800,000 per acre. The CIO is valuing the land at $1 million per acre as he Fair value basics - case studies 1 2011 Ernst & Young Foundation (US). All Rights Reserved. SCORE No. MM4101I believes that with a rezoning and clever marketing, the land will sell for $1 million per acre in the future. Further, he says that management has the intent and ability to hold the land for a reasonable period of time and then sell it for $10 million. He thinks this is the highest and best use of the land. Automobiles CIC owns a group of 10 automobiles, previously used by the senior executives of CIC, that are currently for sale. The automobiles are currently carried at $15,000 per auto for a total of $150,000. They have low mileage and could be sold in either the retail market or the dealer market. The dealer market is an active market and management could access that market the next day. Management has been told by a reputable dealer that the autos could be sold for approximately $13,000 per auto. The retail market is slightly harder to access and would take some time to dispose of the automobiles. Used car pricing guides put the sales prices of the autos at approximately $15,500. The CIO is proposing to measure the fair value of the automobiles at December 31, 2010, at $15,000, the current carrying amount, as he believes that through orderly sales within the next two to three months the automobiles could be sold in the retail market for at least $15,000 per auto. Real estate CIC has an investment in a condominium project that was completed on September 30, 2010. The carrying amount of the condominium at that date was $25 million and reflected the cumulative investments that CIC made to the developer. Through December 31, 2010, there have not been any sales of any of the condominium units and the developer has just declared bankruptcy. CIC has taken over the project, hired a management company to oversee the building and a marketing/sales company to sell the individual units. The CIO hired Ace Number One (Ace) real estate valuation and appraisal experts to measure the fair value of the project as of December 31, 2010. Ace ended up valuing the condominium project at $18 million and their report considered a combined approach of comparable sales figures for comparable condominium units as well as a discounted cash flow approach, adjusted for the current economic conditions. Ace acknowledged their understanding of the definition of fair value under ASC 820 and IFRS 13 as an exit price and presented their impeccable qualifications. The CIO believes their valuation is overly conservative and that given a reasonable period of time, 18 months, the marketing/sales company will be able to sell all the units at only a 10% haircut to the total amount invested in the project. He is therefore proposing to value the investment in the condominium project at $22.5 million ($25 million at 90%). Required For each of the above investments, determine if you agree or disagree with the CIO's valuation approach. - If you agree, state your reasons. Also, determine if there are other valuation approaches that could be used. - If you disagree, state your reasons and suggest either a different approach or how you might change the current approach and what, if any, adjustments should be made to the valuation. For each of the above investments, determine the classification according to the fair value hierarchy. Fair value basics - case studies 2 2011 Ernst & Young Foundation (US). All Rights Reserved. SCORE No. MM4101I