Better late than never - FASB issues long-awaited fair value standard

The Financial Accounting Standards Board (FASB) finally unveiled Statement No. 157, Fair Value Measurements, in September 2006 — more than two years after the release of its exposure draft in June 2004.  This important development affects how appraisers approach fair value — as opposed to fair market value.

This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years.  Delayed application of this Statement is permitted for nonfinancial assets and nonfinancial liabilities, except for those items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until fiscal years beginning after November 15, 2008, and interim periods within those fiscal years.

Fair Value vs. Fair Market Value

In Statement 157, FASB 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.

For comparison purposes, Treasury Revenue Ruling 59-60 defines fair market value as:

The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.

FASB’s definition of fair value is similar to conventional definitions of fair market value in many ways.  Both standards represent an exchange price between informed, unrelated entities.  And both assume a customary exposure period to the market before the measurement date.  Moreover, neither buyers nor sellers are under compulsion to transact, as is the case in a forced liquidation or distress sale.

Beyond Semantics

Although similar in many respects, there are several key differences between fair value and fair market value.  For instance, fair value focuses on the perspective of the market participant that holds the asset or owes the liability.  In other words, fair value anticipates an exit (rather than an entry) price.

Accordingly, in Statement 157, FASB allows restricted stock discounts for issue-specific restrictions, such as Rule 144 limitations and transportation costs for location-specific assets (such as commodities), in its definition of fair value; however, FASB considers transaction costs related to asset-holder restrictions to be an entity-specific cost of entry and, therefore, specifically excludes them from fair value estimates.

Another difference between fair value and fair market value lies in the prospective pool of buyers and sellers.  Appraisers typically interpret fair market value to represent an all-encompassing “universe” of hypothetical buyers and sellers.

Conversely, fair value considers market participants active in the principal (or most advantageous) market, which may vary among entities owning similar assets but operating in different industries.

In other words, fair value assumes a pool of buyers that can exploit the asset to its “highest and best use.”  Moreover, fair value includes generic synergies available to all market participants but excludes buyer-specific synergies, which FASB categorizes as goodwill for financial reporting purposes.

A Three-Tiered Hierarchy

The fair value hierarchy is intended to increase consistency and comparability by requiring disclosures that will enable users to assess the inputs used to develop fair value measurements.  It prioritizes inputs to valuation techniques, not the valuation techniques themselves.

Level 1 – Quoted prices in active markets for identical assets and liabilities (unadjusted); no blockage factors (P x Q).

Level 2 – Other observable inputs, including quoted prices for similar assets and liabilities (adjusted) and market corroborated inputs.

Level 3 – Unobservable inputs; entity’s own assumptions about market participant assumptions, including assumptions about risk, developed based on the best information available in the circumstances (subject to cost benefit analysis); might include entity’s own data.

However, users must remember that the Statement favors the use of higher level inputs and their associated valuation techniques.

Observable Inputs

Although FASB favors observable inputs over unobservable ones, sometimes real-life transactions don’t represent fair value.  Thus, companies cannot automatically assume that a transaction price (an entry price) represents fair value (an exit price).

Although exit and entry prices may often converge, several situations can cause a difference.  For example, a transaction price may not represent fair value if:

• The parties are related.
• The seller is under duress (perhaps due to financial difficulties).
• The transaction price includes transaction costs, buyer-specific synergies, control premiums, or other unstated rights and privileges (which should be valued separately).
• The transaction occurs in a market different from the entity’s principal (or most advantageous) market.

As is evident, the subtle — but important — differences between fair value and fair market value underscore the importance of seeking outside appraisal expertise for financial reporting purposes.  Although Statement 157 strives to clarify fair value measurements, practical applications remain subjective and complex.

The Unfortunate Minority

Already, Statement 157 has had a material impact on financial statements for those companies with significant financial assets, such as those in the financial services sector.  As well, Statement 157 will have numerous and far-reaching effects for many companies, the scope of which is not yet fully appreciated.  The most notably affected areas of application include derivatives, investments, asset impairment and determination, assets and liabilities resulting from business combinations, and asset retirement obligations.

The information contained in this article is provided as general guidance and may be affected by changes in law or regulation. This article is not intended to replace or substitute for accounting or other professional advice. Please consult a CBIZ professional. This information is provided as-is with no warranties of any kind. CBIZ shall not be liable for any damages whatsoever in connection with its use and assumes no obligation to inform the reader of any changes in laws or other factors that could affect the information contained herein.

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