Fair value basics Camelback Investment Company

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Fair value basics Camelback Investment Company

Fair value basicsCamelback Investment CompanyBackgroundCamelback 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 theshareholders will know what their underlying shares are worth, which facilitates sales of the limited numberof shares.It is early January 2011, and as the junior accountant at CIC, you have been asked by the chief financialofficer (CFO) to work with the chief investment officer (CIO) to evaluate and determine the propriety of fairvalues that the CIO is proposing for a number of investments as of December 31, 2010. In that regard, theCFO asks you to challenge the valuation methodologies that the CIO has assigned to the variousinvestments to ensure they are in compliance with ASU 820 and IFRS 13.The investments are as follows:Marketable equity securitiesCIC has an investment in 100,000 shares of common stock of a large public company whose stock istraded on the NYSE. The stock is currently valued in the accounting records at $25.00 per share ($2.5million), which was the value at the last measurement date of September 30, 2010. The CIO is proposingto measure the fair value of the common stock at the bid price for the stock at the close of business on themeasurement date of December 31, 2010, which is $27.50 per share. This valuation approach is consistentwith what has been used in the past three years by management. Thus, the fair value is $2.75 million atyear-end.Private equity securitiesCIC has an investment in 100,000 shares of common stock of a private company. There are no marketquotes with respect to the fair value of the common stock; however, the private company’s operations, sizeand performance are similar to a company whose stock is traded on the NASDAQ. The CIO has takensome of the similar company’s market metrics, such as the price/earnings ratio of the common stock, adiscounted earnings calculation and a few others, and has adjusted these metrics to reflect performancethat he believes is better and more accurate of the metrics with which to value the private company andrelated investment. However, these revised metrics do not agree with the metrics of the similar publiccompany or other companies in this industry.LandCIC has an investment in a 10-acre parcel of land that is located near downtown Los Angeles that has justbeen remediated from an old oil spill. The carrying value of the land at September 30, 2010, was $1 millionper 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 thearea. The CIO believes that the land can be used to construct either a commercial warehouse or industrialmanufacturing facility; the later requiring rezoning from the city. Recent similar sales of land within the areahave been approximately $800,000 per acre. The CIO is valuing the land at $1 million per acre as heFair value basics – case studies 1© 2011 Ernst & Young Foundation (US). All Rights Reserved.SCORE No. MM4101Ibelieves 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 timeand then sell it for $10 million. He thinks this is the highest and best use of the land.AutomobilesCIC owns a group of 10 automobiles, previously used by the senior executives of CIC, that are currently forsale. The automobiles are currently carried at $15,000 per auto for a total of $150,000. They have lowmileage and could be sold in either the retail market or the dealer market. The dealer market is an activemarket and management could access that market the next day. Management has been told by a reputabledealer that the autos could be sold for approximately $13,000 per auto. The retail market is slightly harderto access and would take some time to dispose of the automobiles. Used car pricing guides put the salesprices of the autos at approximately $15,500. The CIO is proposing to measure the fair value of theautomobiles at December 31, 2010, at $15,000, the current carrying amount, as he believes that throughorderly sales within the next two to three months the automobiles could be sold in the retail market for atleast $15,000 per auto.Real estateCIC has an investment in a condominium project that was completed on September 30, 2010. The carryingamount of the condominium at that date was $25 million and reflected the cumulative investments that CICmade to the developer. Through December 31, 2010, there have not been any sales of any of thecondominium units and the developer has just declared bankruptcy.CIC has taken over the project, hired a management company to oversee the building and amarketing/sales company to sell the individual units. The CIO hired Ace Number One (Ace) real estatevaluation and appraisal experts to measure the fair value of the project as of December 31, 2010. Aceended up valuing the condominium project at $18 million and their report considered a combined approachof 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 exitprice and presented their impeccable qualifications. The CIO believes their valuation is overly conservativeand that given a reasonable period of time, 18 months, the marketing/sales company will be able to sell allthe units at only a 10% haircut to the total amount invested in the project. He is therefore proposing tovalue 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 valuationapproach.–If you agree, state your reasons. Also, determine if there are other valuation approaches that couldbe used.–If you disagree, state your reasons and suggest either a different approach or how you mightchange 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