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By Robyn E. Sachs, CPA, CIA, CISA, CFE
Posted on 9/11/08
NEW YORK -- Much has been written about the Financial Accounting Standards Board’s (FASB) Financial Accounting Statement (FAS) 157, but what exactly does it aim to do and why do some blame it for the current credit crisis?
FAS 157 attempts to alleviate much of the variation among the fair value methodologies currently used for different balance sheet items by providing a standard framework for measuring fair value, guidance for applying this definition in U.S. generally accepted accounting principles (GAAP), and an expansion of required disclosures about fair value measurements.
Previously, definitions were dispersed among many pronouncements that require fair value measurements, and application guidance was limited.
The standard introduces a fair value measurement framework that is characterized by the following main points: use of the exit price, principal versus most advantageous market, highest and best use, three valuation techniques, and a fair value hierarchy.
Use of the Exit Price
Key to the definition of fair value is the concept of the exit price, the price that would be received to sell an asset or paid to transfer a liability. Exit prices are considered from the perspective of a market participant that holds the asset or owes the liability, and applied regardless of a reporting entity’s intent and/or ability to sell the asset or transfer the liability.
An exit transaction is defined by FASB as an “orderly transaction” among willing buyers and sellers, not a forced transaction, such as one with a financially distressed participant. At the measurement date, the most advantageous price should be used, which assumes marketing activities have been conducted, and information about the asset or liability has been disseminated to the market.
A question to keep in mind when valuing assets versus liabilities is which credit rating to use. For assets held by a company, the counterparty’s credit rating is used, but for liabilities owed by a company, the company’s own credit rating is used.
Another assumption of fair value measurement is that the exit transaction occurs in the principal market for the asset or liability, or in the absence of a principal market, the most advantageous market.
Principal Versus Most Advantageous Market
The principal market is defined by FASB as “the market in which the reporting entity would sell the asset or transfer the liability with the greatest volume and level of activity for the asset or liability” over a period of time. The characteristics of market participants are also considered in determining which market is the principal market.
Since the principal market is determined from the perspective of the reporting entity, there may be different valuations of similar or identical assets among different entities.
For example, two companies, A and B, may both own gold bars. Company A, which transacts its commodities principally in Hong Kong, would be able to sell its gold for $920 per ounce. But Company B, which buys and sells its commodities in Frankfurt, would value its gold at the price gold sells for in that market, $950 per ounce.
Thus, each company would report different fair values for identical assets. It is important to keep in mind that Company A should not value its gold at $950 per ounce, the price gold sells for in Frankfurt, because that is not Company A’s principal market—the principal market is not necessarily the most advantageous market at the measurement date.
While the definition of a principal market is fairly straightforward, further steps are required to identify what is the most advantageous market in the absence of a principal market. The most advantageous market is defined as the “market in which the reporting entity would sell the asset or transfer the liability with the price that maximizes the amount that would be received for the asset or minimizes the amount that would be paid to transfer the liability” from the perspective of the reporting entity.
To identify the most advantageous market, entities need to consider the effects of transportation and transaction costs on net proceeds. Transportation costs would be incurred to move the asset or liability to or from its most advantageous market, and are included in the calculation of fair value.
But transaction costs are incremental direct costs to transact in the market, and are not an attribute of the asset or liability. Transaction costs are not considered in the calculation of fair value, even though they impact the net proceeds received by an entity from the transaction.
Highest and Best Use
Yet another key element in measuring fair value is to assume the highest and best use of an asset by market participants, which may not be the reporting entity’s intended use of the asset. For example, if an entity operates a facility as retail space, but the market considers the highest and best use of the building as office space, the reporting entity should use the office space valuation in its fair value measurement.
In determining an asset’s highest and best use, it’s also important to decide whether the asset is “in-use” or “in-exchange.”
In-use assets are typically tangible, non-financial assets, such as machinery or equipment. In determining the fair value of these assets, one must consider costs incurred by the buyer to configure the asset, other assets that need to be used in conjunction with the asset, the availability of such items to market participants, and synergies the buyer can expect to gain from the new asset.
Conversely, the fair value of in-exchange assets is determined based on the sales price of the asset on a stand-alone basis. Most financial assets fall into the in-exchange category.
Three Valuation Techniques
FASB also provides guidance on valuation techniques and provides the framework for three accepted approaches: market approach, income approach, and cost approach.
The market approach uses inputs such as observable prices and other relevant market information for similar or identical assets and liabilities.
Acceptable market approach valuation techniques include the use of market multiples derived from a set of comparables, and matrix pricing, a technique used to value debt securities by relying on the securities’ relationship to other benchmark quoted securities.
The income approach converts future cash flow amounts to a single present value by applying techniques such as present value of future cash flows and option pricing models.
The cost approach, from the perspective of the seller, is equivalent to the cost that would be incurred by a buyer to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence.
One or multiple valuation techniques may be utilized, depending on the circumstances of a particular entity.
Fair Value Level Hierarchy
Finally, another major component of FAS 157 is the fair value level hierarchy. The hierarchy prioritizes inputs to the aforementioned valuation techniques, but not the techniques themselves, into three broad categories. The valuation techniques should maximize the use of observable inputs (Level I), and minimize the use of inputs that are unobservable and subject to management adjustment (Level III).
Level I inputs are independently quoted prices in active markets for identical assets or liabilities. FASB reasoned that market prices are Level I inputs because they are easy to obtain and are reliable and verifiable. For example, an entity’s holding of equity securities of publicly traded companies are valued using quoted prices multiplied by the quantity of the securities held by the reporting entity.
Level II inputs are derived principally from, or corroborated by, observable market data. Examples of Level II inputs are quoted prices for similar or identical assets or liabilities in active or inactive markets, interest rate and yield curves observable at commonly quoted intervals, foreign exchange rates and default rates.
The last level of inputs, Level III, are unobservable inputs that reflect the reporting entity’s own assumptions of factors market participants would use in pricing the asset or liability. Level III assets are typically measured using internally developed models of estimates or forecasts for cash flows.
According to FASB, “the level in the fair value hierarchy within which the fair value measurement in its entirety falls shall be determined based on the lowest level input that is significant to the fair value measurement in its entirety.”
Fair value requirements have garnered some criticism. Notably, Level III assets—which by definition require significant management judgment in their valuation—constitute billions of dollars on the balance sheets of many publicly traded companies with large market capitalizations. Goldman Sachs, for example, reported more than $69 billion of Level III assets as of November 2007 and Lehman Brothers showed $41.9 billion of Level III assets on its 2007 year-end balance sheet. Maintaining the transparency of management’s pricing models and scrutinizing the judgment applied to Level III inputs are key audit considerations and potential targets of criticism due to the potential for obfuscation and manipulation.
“Some of the calculations used to attain the final fair value are very subjective and open to interpretation,” said Javier Tealdi, senior information systems auditor at American International Group, Inc.
Another criticism of the pronouncement is the effect of market volatility on the balance sheets of otherwise stable companies. The balance sheet value of assets may erode even though companies have not realized losses on asset sales. Some have blamed FAS 157 for the volatility because the statement introduces the requirement for the credit value adjustment to be tacked on to fair value measurements of both assets and liabilities. While this adjustment may be large, its size is not due to the calculations required by FAS 157, but caused by current market conditions.
However, the addition of the credit value adjustment may lead to a positive impact on a company’s statement of financial position as a result of a downgrade in its credit rating. As the credit rating of a company decreases, the discount rate the company uses to value its liabilities increases, thus the fair value of debt carried on the balance sheet will decrease as a company’s financial condition worsens, potentially presenting an overly optimistic view of a company’s financial health.
Robyn E. Sachs, CPA, CIA, CISA, CFE, is a Senior Auditor at American International Group, Inc. (AIG), and a member of the Society’s Membership, Taxation of Individuals, Technology Assurance, and Young CPAs committees. She can be reached at rs@sachscpa.com or robyn.sachs@aig.com.
