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Fair Value January 27, 2009 - The SEC recommended against suspending fair-value accounting rules, instead suggesting improvements to deal with illiquid markets and reducing the number of models used to measure impaired assets. In a 211-page report to U.S. lawmakers, the SEC recommended that fair-value and mark-to-market not be eliminated or suspended. "The abrupt elimination of fair value and market-to-market requirements would erode investor confidence." The banking lobby has argued that financial institutions have been forced to write off as losses still-valuable assets because the market for them had dried up, creating a spiral of write-downs and asset sales. The report said that staff found no evidence to suggest that the accounting rules had played a significant role in the collapse of U.S. financial institutions. "While the application of fair value varies among these banks...in each case studied it does not appear that the application of fair value can be considered to have been a proximate cause of the failure." Additionally, the SEC suggests that FASB narrow the number of accounting models firms can use to assess the impairment for financial instruments. FASB has said that its long-term goal is to have all financial assets and liabilities recognized in statements of financial position at their fair values rather than at amounts based on their historical cost. There are two important reasons to work toward a financial reporting system based on fair values of financial assets and liabilities:
While descriptive and quantitative information about the nature and risks of a financial asset or liability is important, a measure of its amount clearly is needed if the asset or liability is to be included in financial statements. But which measure? The fair value of a financial instrument represents the amount at which the instrument could be bought or sold in a current transaction between willing parties. Fair value is measured based on a quoted price in an active market, if one is available. If a market price is not available, fair value is measured based on the information and techniques that provide the best available estimate of a current market price. Opponents to 'fair value' accounting say that historical-cost-based information is more relevant because it focuses on the decisions and resulting actions to buy or sell assets and to incur or settle liabilities. They say that fair value information, with its focus on current market prices, is less relevant because it reflects the effects of transactions and events in which the entity did not directly participate. Unrealized gains and losses on financial assets and liabilities can, of course, be described as related to lost opportunities-opportunities either to sell or settle at a relatively high price or to acquire or incur at a relatively low price. But are lost opportunities on existing assets and liabilities really irrelevant in evaluating an entity's financial position and performance? Some people suggest that relevant information about an asset-liability matching strategy would result from recognizing the fair values of both financial liabilities and financial assets. But others would prefer to achieve consistent measurement bases for financial assets and liabilities by not recognizing the fair values of either assets or liabilities. Some people say that the result of measuring financial assets and liabilities based on current prices is a "liquidation" measurement basis rather than a "going-concern" measurement basis. If all financial instruments were measured at fair value with the related gains and losses included in income when they arise, far fewer special requirements would be necessary for the financial statements to depict the success or lack thereof of risk-management strategies, no matter how complicated. If both the hedged item and the hedging instrument are measured at fair value, the degree to which the hedging strategy succeeded in mitigating the risk would be readily apparent. The following comments summarize fair value arguments:
The following comments summarize historical cost arguments:
In June 2003, FASB added a separate fair value measurement project to its agenda to address those concerns. The Board also formed the Valuation Resource Group (VRG) to provide a standing resource on fair value measurement issues. On June 23, 2004, the Board issued an Exposure Draft of a proposed Statement, Fair Value Measurements. The comment period ended on September 7, 2004. The Board plans to issue a final FVM Statement in the 4th quarter 2005. The FVM Statement will be effective for financial statements issued for fiscal years beginning after December 15, 2006. The provisions of the FVM Statement should be initially applied prospectively. Pronouncements that require measurements using vendor-specific objective evidence (VSOE) of fair value are excluded from the scope of the FVM Statement (including AICPA Statement of Position 97-2, Software Revenue Recognition, as modified by AICPA Statement of Position 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions, and EITF Issues No. 00-3, "Application of AICPA Statement of Position 97-2 to Arrangements That Include the Right to Use Software Stored on Another Entity's Hardware," and No. 00-21, "Revenue Arrangements with Multiple Deliverables"). The FVM Statement will not eliminate the practicability exceptions to fair value in other pronouncements. Those pronouncements include FASB 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. Definition Fair value is "the price at which an asset or liability could be exchanged in a current transaction between knowledgeable, unrelated willing parties." That definition emphasized the exchange price notion included, either explicitly or implicitly, in earlier definitions of fair value. In its redeliberations, the Board further clarified that exchange price notion in the context of an exit price. To more clearly convey an exit price objective, the Board revised the definition to refer to an estimate of the price that could be received for an asset or paid to settle a liability in a current transaction between marketplace participants in the reference market for the asset or liability. Estimated Price versus Actual Price The price that forms the basis for a fair value measure is an estimate at the measurement date (the effective valuation date). It is not an actual price at the measurement date. Because events or circumstances occurring subsequently could cause the estimate to change, the actual price is not known until a transaction for the asset or liability occurs. Marketplace Participants A fair value measure is a market based, not an entity specific, measure. Therefore, in developing the estimate, the emphasis is on marketplace participants and the assumptions and data that marketplace participants would use in their estimates of fair value. In broad terms, marketplace participants are presumed to be buyers and sellers for the asset or liability that are (a) unrelated (as that term is used in FASB Statement No. 57, Related Parties), each acting independently, (b) knowledgeable, having a reasonable level of understanding about all relevant factors based on all available information, including but not limited to publicly available information (for example, information obtained through due diligence efforts), (c) able to transact in the reference market for the asset or liability, having the legal and financial ability to do so, and (d) willing to transact in the reference market for the asset or liability, that is, they are motivated but not forced or otherwise compelled to transact (neither party is at a negotiating disadvantage). Current Transaction A fair value measure presumes that an entity is a going concern without intent or need to liquidate. Therefore, a current transaction is not a forced transaction (for example, a liquidation transaction or distress sale). Rather, it is an orderly transaction for an asset or liability that allows for exposure to the market for a period prior to the measurement date that is usual and customary for transactions involving such assets or liabilities and reflects market conditions existing at the measurement date. Most Advantageous Reference Markets A fair value measure presumes rational economic behavior. Therefore, the reference market is the most advantageous market for the asset or liability from the perspective of the entity, that is, the market in which the entity could hypothetically transact for the asset or liability. If there is not an actual market for the asset or liability, the most advantageous market is hypothetical, in effect, constructed from inputs relevant to the asset or liability obtained from various sources. In other words, the most advantageous market is a construct, not a physical place or activity. Therefore, the emphasis is on the inputs, not the market. The most advantageous market (actual or hypothetical) will vary, depending on the unit of account for the asset or liability. The unit of account defines the asset or liability by reference to the level at which it is aggregated (or disaggregated), that is, whether individually or as part of a larger group of assets and (or) liabilities. Because many assets and liabilities are exchanged in different markets with different prices depending on the level at which they are aggregated (or disaggregated), the unit of account can have a significant effect on the estimate and should be considered in selecting the appropriate reference market to use for the estimate. The Board believes that a unit-of-account principle is needed for its use in developing pronouncements that require fair value measurements. Transaction Costs Transaction costs (the incremental direct costs to transact in the most advantageous market) are different from transportation costs (the costs to access the most advantageous market). The price in the most advantageous market should not be adjusted for transaction costs. However, that price should be adjusted for transportation costs in the limited situations in which the location of the asset or liability "as-is" is a characteristic of that asset or liability (for example, that might be the case for a physical commodity). For an asset the most advantageous market is the market with the price that maximizes the amount that could be received for the asset, assuming its highest and best use from the perspective of marketplace participants. In other words, the emphasis is on how marketplace participants would use the asset. Therefore, the price that forms the basis for the estimate is an exit price that provides a direct measure of the market's estimate of the future inflows associated with the asset. Highest and Best Use Highest and best use, considered together with the valuation premise, establishes a framework for developing marketplace participant assumptions in the context of how an asset would be used. Highest and best use is a valuation concept that refers to the most advantageous use of an asset that is physically possible, legally permissible, appropriately justified, and financially feasible. Highest and best use is in use if marketplace participants would continue to use the asset as currently by the entity. Highest and best use generally will be in use when the asset is a nonfinancial asset that provides value (synergies) principally through its use in combination with other assets (for example, certain intangible assets). In that case, the exchange is for an asset that is in use with other assets. Therefore, an in-use (going-concern) valuation premise should be used to estimate the fair value of the asset. Because highest and best use is considered from the perspective of marketplace participants, the estimate that results when using an in-use (going-concern) valuation premise is market based (fair value in use); it is not entity-specific (value in use). Liabilities For a liability (a present obligation that entails settlement requiring the future transfer of assets), the most advantageous market is the market with the price that minimizes the amount that could be paid to settle the liability by transferring the liability to a marketplace participant of comparable credit standing, even if it would be more advantageous for the entity settle the liability directly using its own internal resources. In other words, the settlement is from the perspective of a marketplace participant that would similarly perform or, failing that, similarly bear the consequences of not performing. Therefore, the price that forms the basis for the estimate is an exit price that provides a direct measure of the market's estimate of the future outflows associated with the liability. Because a liability entails settlement, the estimate is, in effect, determined using a "settlement" valuation premise (fair value in settlement), similar to the in-exchange valuation premise for an asset (fair value in exchange). The in-use valuation premise for assets does not similarly apply for liabilities. Some entities will estimate fair value by using an incremental rate of borrowing that considers changes in an entity's own credit risk, while others will use a settlement rate that ignores at least part of those credit risk changes. The Board concluded that it should not, at this time, prescribe a single method to be used for all unquoted liabilities. Level 1 Inputs The FVM ED referred to the use of quoted prices for identical assets or liabilities in active markets in which the entity could actually transact for the asset or liability "as-is" at the measurement date. The ability to currently access a Level 1 reference market is important. Because within Level 1 a quoted price for an identical asset or liability ("as-is") represents the sole input used for the estimate, it limits discretion in pricing the asset or liability. Level 2 Inputs The FVM ED referred to quoted prices for similar assets or liabilities in active markets, adjusted for differences between the asset or liability being measured and other similar assets or liabilities that are "objectively determinable." Several respondents raised concerns about the objectively determinable criterion within Level 2. They indicated that because all adjustments involve subjective judgment and estimation, Level 2 would rarely, if ever, be used. Further, an objectively determinable criterion likely would not be consistently applied. In its redeliberations, the Board reconsidered those Level 2 inputs. To more clearly convey a continuum of inputs, the Board decided to broaden Level 2 by (1) including quoted prices for all similar assets or liabilities, whether those prices are quoted in active (liquid) markets or in thin (illiquid) markets and (2) removing the objectively determinable criterion, requiring adjustments based on other market inputs that reflect the assumptions and data that marketplace participants would use in their estimates. Level 3 Inputs The FVM ED included within a single Level 3 all other market inputs together with entity inputs. Many respondents said that Level 3 would be overly broad, especially when used for disclosure purposes. In that regard, respondents indicated that a three-level hierarchy is not as effective as it could be in conveying the relative reliability of the estimates. To more clearly convey a continuum of inputs, the Board expanded the levels within the hierarchy to more clearly convey the inputs within Level 3. Level 3, as clarified, refers to direct market inputs, that is, observable inputs that relate directly to the asset or liability. Those inputs include information about interest rates, yield curves, volatilities, prepayment speeds, default rates, loss severities, credit risks, and liquidities. Level 4 Inputs Level 4 refers to market-based inputs that include extrapolated or interpolated measures that are corroborated through correlation with other market data. Level 5 Inputs Level 5 refers to entity inputs that represent an entity's own internal estimates and assumptions. Those inputs are used as a practical expedient in the absence of market inputs. In Concepts Statement 7 (paragraph 28), the Board similarly concluded that, "The use of an entity's own assumptions about future cash flows is compatible with an estimate of fair value, as long as there are no contrary data indicating that marketplace participants would use different assumptions. If such data exist, the entity must adjust its assumptions to incorporate that market information." The Board decided to retain that hypothetical construct within the fair value hierarchy and consider issues of relevance and reliability as it relates to the selection of possible measurement attributes in its conceptual framework project. Disclosures For each major category of assets and liabilities remeasured at fair value during the period, the disclosures should segregate fair value amounts into three disclosure levels, that is, fair value amounts at the end of the period determined using quoted prices for identical assets or liabilities (Level 1), direct market inputs (Level 2 and Level 3), and indirect inputs (Level 4 and Level 5), and include information about the valuation techniques used. Total gains or losses (unrealized and realized) should be disclosed for each major category of assets and liabilities remeasured at fair value during the period, segregating amounts included in earnings and in other comprehensive income. Unrealized gains or losses related to those assets and liabilities still held at the reporting date should be separately disclosed for each disclosure level below Level 3. |
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