Fair Value and FASB 157

Aug. 18, 2010 - PRLog -- By: George D. Abraham
CEO & Chief Appraiser
Business Evaluation Systems


Fair value accounting refers to accounting for the value of an asset or liability based on the current market price of the asset or liability, or for similar assets and liabilities, or based on another objectively assessed "fair" value. Fair value accounting has been a part of US Generally Accepted Accounting Principles (GAAP) since the early 1990s, and has been used increasingly since then.

While most accounting standards that involve fair value focus on what to measure at fair value, Statement 157 focuses on how to measure fair value. Dispersed throughout current GAAP are inconsistent definitions of fair value and only limited guidance on application.

New Definition of Fair Value

Statement 157 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.

While the definition sounds like the same as past definitions, there are some key differences.  First, the definition is based on an exit price (for an asset, the price at which it would be sold) rather than an entry price (for an asset, the price at which it would be bought), regardless of whether the entity plans to hold or sell the asset.  A second key definitional point is that Statement 157 emphasizes that fair value is market based rather than entity specific; fair values must rest on assumptions that market participants would use in pricing the asset or liability. Thus, the optimistic asset owner must be replaced with the skepticism that typically characterizes a dispassionate, risk averse buyer.

FAS 157’s fair value hierarchy supports the concepts of the standard. The hierarchy ranks the quality and reliability of information used to determine fair values, with level 1 inputs being the most reliable and level 3 inputs being the least reliable. Information based on direct observations of transactions (e.g., quoted prices) involving the same assets and liabilities, not assumptions, offers superior reliability; whereas, inputs based on unobservable data or a reporting entity’s own assumptions about the assumptions market participants would use are the least reliable. A typical example of the latter is shares of a privately held company whose value is based on projected cash flows.

The ubiquitous “market participant”: Through the entire statement, homage is paid to the ubiquitous market participants and what they think about risk and will be willing to pay for an asset. In effect, accountants are asked to attach values to assets/liabilities that market participants would have been willing to pay/receive.

Tilt towards relative value: “The definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price).”The hierarchy puts “market prices”, if available for an asset, at the top with intrinsic value being accepted only if market prices are not accessible.

Consideration of illiquidity: Accountants are asked to give consideration to specific restrictions on the sale/use of an asset in valuing it. Presumably, if there are restrictions on selling an asset, the value will have to be discounted for illiquidity.

Statement 157 represents the FASB’s most current leaning on the age-old trade-off between reliability and relevance of financial information. Statement 157 reflects the FASB’s studied conclusion that investors and creditors find fair value measurement relevant, even in the absence of solid market data. As a result of the trade off now favoring relevance, financial statement users need to be apprised of the quality of the information through the meaningful and transparent disclosures required by the new standard.

The principal market is the market in which the reporting entity would sell the asset (transfer the liability) with the greatest volume and level of activity for the asset (liability). If an entity has no principal market for the asset (liability), it would determine its most advantageous market. The most advantageous market is the market in which the reporting entity would sell the asset (transfer the liability) with the price that maximizes the amount that would be received for the asset (minimizes the amount that would be paid to transfer the liability), considering transaction costs in the respective market(s). Transaction costs, however, are not included in the fair value measurement.

Also the highest and best use of an asset will result in either an in-use premise, when the fair value is determined based on its use together with other assets as a group; or an in-exchange premise, when the fair value is determined as the price that would be received to sell the asset on a stand-alone basis.

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Business Evaluation Systems ,since 1973, has been involved in the appraisal of over 16,000 companies,covering almost every industry on a national and international basis, ranging in value from $50,000 to over $7 billion.