Normal Turbulence or Perfect Storm? Disparity in Fair Value Estimates

The use of fair value measures in financial statements embeds managerial assumptions about the future into the reporting process. This is particularly so for Level 3 measurements that are developed from financial models of future cash flows. This article documents a case where a firm bought a majority stake of 52% in November 2009 of a subsidiary where it already had an equity holding of 29% (i.e., acquired an additional 23%). The proportionate fair value implied for the 48% noncontrolling stake as well as the 29% prior equity holding in the acquired firm using Level 3 methodology was roughly triple the amount reported as Level 1 measures for these very same holdings. The discrepancy in valuation boosted the bargain gain at acquisition wiping out the retained earnings deficit of the parent firm. In addition, the acquirer reported a US$200 million (40%) impairment of the subsidiaries’ primary asset (housing stock) in November 2009 whereas the subsidiary reported the unimpaired value in its year-end financial statements in December 2009. While we agree that Level 3 valuations potentially provide useful information to shareholders, they can fulfill this role only if the disclosures can be effectively audited. Our primary motivation in writing this article is to show that fair value disclosures are not being audited sufficiently rigorously in practice and to make some suggestions on how these rules may be improved.