Feature Article

Fair Value in a Turbulent Market

The term fair value has been in the news a lot over the last few months, particularly in relation to the credit meltdown. But what exactly is fair value and how is it used in financial reporting?

Fair value had many definitions, even as it related to financial reporting, until the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements, in 2006. SFAS 157 was implemented to take effect for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The effective date of the standard was later deferred to fiscal years beginning on or after November 15, 2008 and interim periods within those fiscal years. Early application was highly encouraged.

SFAS 157 itself does not require fair value reporting. Rather, other accounting standards require what is broadly known as fair value accounting. SFAS 157 was established to provide guidance on and address a number of issues in fair value reporting, including: 1) the definition of fair value; 2) valuation techniques and methodologies; 3) fair value hierarchy; and 4) required disclosures.

SFAS 157 provides a single, authoritative definition of fair value for financial reporting purposes. The standard defines fair value as:

Fair value is 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.¹

For purposes of this discussion, we will concentrate on assets and, in particular, intangible assets. Within the definition are several new concepts for valuation standards. The fact that the price is what would be received to sell an asset indicates that it is an exit price. In other words, the price paid for an asset is irrelevant. The fair value is to be determined by what a market participant would pay for that asset as of the valuation date. To understand the nuances of this concept, consider that a business (including intangible assets) typically gets sold to the highest bidder. However, the fair value of that business (and its assets), immediately after the transaction, may be only what the next highest bidder would pay for that business (and assets), not what it actually sold for.

To understand this further, consider the concept of market participant. Market participants are buyers and sellers in the principal, or most advantageous, market for an asset. Market participants may be competitors, strategic investors, financial investors, or any number of potential buyers and sellers of a particular asset. Market participants should be independent or unrelated parties, should be reasonably knowledgeable about the asset and the market for such asset, and should be willing and able to transact for the asset without compulsion to do so. The market for an asset must be analyzed and understood by company management and the valuation expert in order to determine the potential market participants and the effect on fair value.

SFAS 157 also introduced the concept of the fair value hierarchy. In short, the hierarchy approach to determining fair value is as follows:

• Level 1. Inputs are observable in the market as quoted prices for identical assets in active markets.
• Level 2. Inputs are observable in the market as quoted prices for similar assets in active markets or identical assets in inactive markets.
• Level 3. Inputs are considered to be unobservable market inputs. Level 3 inputs must be extrapolated or interpolated from observable market data. Unobservable market inputs are used when observable market inputs are not available. For most intangible assets, Level 3 inputs are required, as most of the assets are not traded in a ready market.

Fair value accounting in general, and SFAS 157 in particular, came under attack in the fall of 2008 when the banking and credit crisis hit its peak. Many observers believed that fair value accounting caused the failure of financial institutions since numerous assets had to be written down drastically. The Emergency Economic Stabilization Act of 2008 (EESA) signed into law on October 3, 2008 mandated that the U. S. Securities and Exchange Commission (SEC) conduct a study on mark-to-market accounting standards (fair value accounting) as provided by FASB's SFAS 157.

The SEC released its 211-page (plus appendixes) report in December 2008. In its report, the SEC made several recommendations as it relates to SFAS 157 and fair market accounting. These recommendations include the following:

1. SFAS 157 should be improved, but not suspended;
2. Existing fair value and mark-to-market requirements should not be suspended;
3. Additional measures should be taken to improve the application of existing fair value requirements;
4. The accounting for financial asset impairments should be addressed;
5. Implement further guidance to foster the use of sound judgment;
6. Accounting standards should continue to be established to meet the needs of investors;
7. Additional formal measures to address the operation of existing accounting standards in practice should be established, and;
8. Address the need to simplify the accounting for investments in financial assets.

Within its recommendations, the SEC touched on some issues that valuation experts have been confronted with in determining fair value under current market conditions. The SEC indicated the need to improve the application of existing fair value requirements. Specific recommendations included the need for additional application guidance for determining fair value in illiquid or inactive markets. In particular, it was recommended that additional guidance is warranted when determining: when markets become inactive; if a transaction or group of transactions is forced or distressed; how and when liquidity should be considered in the valuation of an asset or liability; how the impact of a change in credit risk on the value of an asset or liability should be estimated; when observable market information should be supplemented with and/or reliance placed on unobservable information in the form of management estimates; and how to confirm that assumptions utilized are those what would be used by market participants and not just by a specific entity.

This information prepared by the Valuation Group at Habif, Arogeti & Wynne, LLP. For more information, contact Michael S. Blake, CFA, ASA at michael.blake@hawcpa.com.

¹Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 157, Fair Value Measurements (2006), at 5.

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