Week 4 Assignment-Fair Value

DUE DATE: Sunday midnight of Week 4, submitted in a MS Word (or Excel if

computations required) document with filename format:

Last First_Week X hwk.doc or .xls Make sure your name appears on each page of the

homework using the header function.

Homework questions:

1. The Fair Value requirement has been blamed by some for the credit market crunch that

started in 2007, worsened in 2008 and continues into 2009. Discuss what effect you

think Fair Value had on financial institutions and why some believe that it precipitated

the current economic recession. Do you agree or disagree that Fair Value caused the

collapse of the mortgage and lending markets? There are a number of good articles and

links to help you with this such as the article in the Web Links page from the January 20,

2009 Boston Globe about the impact on State Street Corporation’s capital from

potentially having to permanently write down the value of assets (it will help you

understand how marking down the value of assets impacts the banks’ capital, and how in

turn, this impacts their ability to lend). Also, the JOA May 2008 3 Articles with view pro

and con about Fair Value vs. Historic Cost. There are a number of other readings to help

with this topic or you may gather your own-please share them if you would on the student

section of the Web Links page.

2. You are the CFO of a publicly traded company and are getting ready to prepare you year-

end financial statements. In your investment portfolio you have:

a. Long-term bank CD’s

b. Stock holdings in 5 publicly traded companies

c. Stock holdings in 2 privately held companies

d. Investment in a real estate trust (REIT) which owns strip malls and other

commercial buildings for retail establishments. This trust trades on a market

with other similar trusts, although the trades are infrequent. Take into account

the current real estate market when evaluating this investment.

e. Private equity investment in a joint venture for the development of a new

green energy method to produce electricity.

f. Complex foreign currency hedges that were custom-designed by an

investment bank for the company, to hedge their exchange rate exposure on

overseas transactions.

What level for evaluation would each fall into and what method(s) would you use to

determine the fair value of each? How easy or difficult would each be and why? The Nov

16, 2008 Financial Week Article on the Web Links page about Illiquid Bank Assets may

help with this question.

3. Find the financial statements of a publicly traded company that has measured assets

and/or liabilities at fair value. You will find this information in the footnotes (just open

up the document and search the page with either Fair Value or FAS 157 as a key word).

What financial ratios (name at least 2) could be affected by the difference between

measuring these assets at historic cost vs. fair value? How would this company’s ratios

differ from the current presentation under fair value than under historic cost? Do the

footnotes tell you if there was an active market for valuing the assets-if so, what was the

basis for the valuation? If there was no active market, what did they base the valuation

on? Does this sound like an appropriate measure of the asset(s) value? What problems

could there be with the measure(s) that was used? If you were a banker preparing to loan

money to the company, how much difference would this make in your decision? Take

risk into account in this decision and not just the difference in value caused by the

methods. Include the annual report with your answer and reference the pages in the report

where you obtained your information. Prepare any computations on Excel and submit as

a separate document (make sure to use the above naming convention for all files).

4. A company’s management and its auditors have the same goal in mind-to prepare

financial statements that fairly present the financial position of the company under US

GAAP (well, at least until we convert to IFRS!) The auditors “opine” on the fair

presentation. For example, here is a statement from the independent auditor’s report of

Mozilla Foundation:

In our opinion, the financial statements referred to above present fairly, in all material

respects, the consolidated financial position of Mozilla Foundation and Subsidiary as of

December 31, 2007 and 2006, and the changes in their net assets and their cash flows for the

years then ended in conformity with accounting principles generally accepted in the United

States of America.

When Fair Value cannot be determined by an actively traded market and management

judgment must be applied, such as with Level 3 assets, discuss where disagreements

might occur between management and the auditors, and why. In other words, what

valuation might management may have computed and the impact it would have on the

reporting year, vs. the role that the audit firm plays and the liability they assume in

providing an unqualified or “clean” opinion-why might they disagree on the inputs and

judgment used by management?

5. So now that you have had 2 full weeks to think about Fair Value, where do you stand on

the topic? Don’t be wishy-washy! Form an opinion and support it with evidence from the

work we have done.