March 2007 Newsletter

Lease Accounting: Ripe for Change

Source: Today’s CPA – Accounting & Auditing – Lease Accounting: Ripe for Change

Current accounting practice follows an “all or nothing” approach to recording leases. Statement of Financial Accounting Standards No. 13 classifies leases as either capital or operating in nature. If most of the benefits and risks of the leased asset are transferred to the lessee, the assets and liabilities are capitalized. Otherwise, the lease is considered an operating lease and the asset and obligation are kept off the balance sheet. Investors have complained that such accounting understates the lessee’s economic obligations. In July 2006, FASB added a project to reconsider lease accounting. If FASB proposes changes in accounting for leases, companies could report dramatic increases in both non-current assets and liabilities on their balance sheets.

Lost Profits and Business Valuation

Source: Business Valuation and Forensic & Litigation Services Section - Differences Between Lost Profits and Diminution in Business Value as a Measure of Damages

Two common damage models in commercial litigation are lost profits and the diminution in the value of a business. Lost profits measures the difference between the “income or cash flow that would have been earned ‘but for’ the event in dispute” and the “impaired, or actual, stream of income or cash flow that was or is forecasted to be experienced.” The diminution in the value of a business is the difference between the business’s present value of future cash flow projections before the value-impairing event and the value of the business after the value-impairing event.

Methods for calculating damages are not mutually exclusive. The key is to avoid measuring damages under two methodologies that cover the same period and tie to the same wrongful action. Three common business valuations are employed: the income approach, the market approach, and/or the cost approach.

A discount rate, proportional to time and risk, reduces the value of future cash flows. Historic profits may be brought forward to a present value using statutory pre-judgment interest rates. This rate is typically lower than the discount rate since the discount rate accounts for risk.

A business valuation often includes a terminal value which accounts for future cash flows into perpetuity. However, case law on lost profits is critical of terminal value on the basis of reasonable certainty and often limits lost profits to the life of a contract.

Fair Value Gets Fairer

Source: Today’s CPA. Accounting & Auditing - Fair Value Gets Fairer

Effective Nov. 15, 2007, Statement of Financial Accounting (SFAS) No. 157 narrows the 40 official definitions of fair value with respect to financial statements down to one official definition. The new standard defines fair value 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.” SFAS No. 157 defines three acceptable estimation approaches. The market approach uses observable prices, the income approach uses discounted future cash flows, and the cost approach uses replacement cost. SFAS No. 157 further defines the hierarchical framework for the market approach. Level 1 includes quoted prices; Level 2 includes inputs other than quoted prices that are still observable either directly or indirectly; Level 3 includes unobservable prices.

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