Mark to Market, or to Myth? FAS 157 Worries

The Bear Stearns hedge fund meltdown put “fair value” on the front pages. Now, Financial Accounting Standard No. 157 is going to put it on your books, and soon.

In case you’ve forgotten, the Financial Accounting Standards Board’s fair value standard will be effective in a couple of months. The standard—known officially as FAS No. 157, Fair Value Measurements—is effective for fiscal years beginning after Nov. 15, 2007, and interim periods within those fiscal years. For calendar year-end companies, that means implementation is required in the first quarter of 2008.

FAS 157 establishes a framework for how fair value should be measured. Prior to the standard, there were many different definitions and applications of fair value. Those inconsistencies, combined with a lack of guidance, created confusion that added to financial reporting complexity.

The new standard attempts to address those issues by, among other provisions, delineating between different “types” of values: those with active markets, and those that rely on more “unobservable” inputs. In the former, known as “Level 1” of the fair value hierarchy, a liquid market exists where buyers and sellers can determine a fair value. For example, a financial asset traded on multiple exchanges might be considered a Level 1 market. At the other end of the spectrum, “Level 3,” no ready market exists to value assets or liabilities. A reporting unit or a business could, for example, qualify as Level 3 in the fair value hierarchy.

The introduction of this Level 3 category into the accounting lexicon has recently led some to cry foul, as it is extraordinarily difficult to ascribe fair value to something nobody has recently tried to sell or buy. It’s even more challenging when the owner of the asset or liability has an inherent conflict in determining the outcome of the valuation. This conflict has led some to joke that such measurements are not

“marked to market,”

but are instead “marked to make believe” or “marked to myth.”

FAS 157 stresses that fair value is a market-based measurement, not a measure of the value to the owner of the asset or the obligor of the liability. In other words, the fair value measurement should be determined based on a hypothetical transaction with a market participant, in contrast to what the entity actually plans to do with the asset or liability (which is instead an “entity-specific” assumption). Certainly, these measurements are a good deal more theoretical than real; whether investors agree that the measurements are better remains to be seen.

The standard introduces other significant changes from current practice as well, including:

Perspective. The fair value 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”);

Transaction Costs. If the initial measurement is at fair value, transaction costs must be expensed as incurred, as such costs are not considered an attribute of the asset or liability;

Disclosure. In addition to the establishment of the fair value hierarchy mentioned above, disclosure of how the assets or liabilities were valued is required. This is intended to illuminate the relative reliability of the values determined;

Credit Risk. The entity’s own credit risk must be included when measuring the fair value of its liabilities;

Block Size. The fair value of a block of financial instruments that trade in an active market should be measured as the product of the quoted market price times the quantity held; no adjustment is permitted based on the size of the block relative to the trading volume.

Determining Fair Value

Determining the fair value of an asset or liability can be tricky. Let’s take a look at some of the steps involved.

The first step in the implementation process is to determine the assets and liabilities that are required to be measured at fair value. Basically, FAS 157 will need to be applied in any instance in the U.S. Generally Accepted Accounting Principles where there is a requirement for an asset or liability to be recorded at fair value. The potential list of such circumstances is immense, since the application of the new standard is ubiquitous—FAS 157 refers to no fewer than 28 accounting statements, opinions, and interpretations published since (gulp) 1971 that have been amended by the new standard. And that doesn’t include the 39 other FASB pronouncements that refer to fair value, the dozens of Emerging Issues Task Force documents that address the issue, the myriad Securities and Exchange Commission bulletins, and other industry documents that are affected by FAS 157. A catalog of the affected pronouncements is included in an appendix of FAS 157, and preparers should carefully review that list to determine where they need to focus their implementation efforts.

In planning for implementation, it is also important to recognize that valuation processes and procedures need to be analyzed under FAS 157, then documented and audited. One of the lessons learned by early adopters has been to start early, and to commit a generous amount of resources, as the process takes a lot longer than one might expect.

With respect to determining the fair value under FAS 157, one must first identify the valuation premise appropriate for the measurement consistent with its “highest and best use.” That phrase has no relationship to how the entity intends to use the asset; rather, assumptions must be made as to what is the “highest and best use” based on its likely use by other market participants. One critical question for which there is no guidance is whether the market participant is a financial buyer (such as private equity) or a strategic buyer (a competitor). The differences in valuation inherent in that choice can be significant.

Next, one must identify the principal market—or, if there is no principal market, the most advantageous market—for the asset or liability. A question being asked a lot these days is whether that market is determined at the end of the reporting period, historically, or on a forward-looking basis. With the current dislocations in the credit markets, a number of additional questions are getting a lot of attention as to which date to use for the market information.

Finally, one must determine the valuation techniques appropriate for the measurement of the asset or liability. This is complex, as one must consider the availability of data that can help develop measurement “inputs,” and where in the fair value hierarchy those inputs fall. (That is, are they observable or unobservable?) In addition, the inputs should represent the assumptions that market participants would use in pricing the asset or liability.

One must also ensure that appropriate disclosure is made regarding the assumptions used, the measurement techniques, and the level in the hierarchy of the related inputs.

The most challenging of these is the “roll forward” of current-year changes in the fair value assets and liabilities determined to be Level 3 in the hierarchy. For most companies, the information systems that can provide the data elements to facilitate this process don’t exist.

Leases and Contracts

One major implementation issue that I keep hearing about from companies relates to leases. The original FASB exposure draft for fair value measurements excluded leasing transactions from its scope. But FASB included them in the final standard, noting that some respondents believed the fair value measurement objective for leasing transactions is generally consistent with the principles in the standard. It is not clear how much thought the respondents gave to making those comments, but it’s likely they didn’t anticipate the major changes in practice that will result from applying FAS 157 to leases.

One critical question for which there is no guidance is whether the market participant is a financial buyer (such as private equity) or a strategic buyer (a competitor).

Much of the problem stems from how FAS 157 changes the determination of lease residual values. Changes here, in turn, can affect everything from lease classification (for both lessees and lessors) to the treatment of lease revenues and gains or losses on disposal. Many lessors determine residual values based on a probabilistic weighting of markets into which the leased asset will be sold (wholesale, retail, release by customer). FAS 157 requires selection of a single primary market, which can result in overstatement or understatement of the recognized lease residual when compared to its economic value (the value on which pricing is based).

For example, let’s assume the primary market is determined to be retail, which offers the highest selling price and presumably is the most advantageous. In our scenario, too much lease revenue will be accrued over the life of the lease. That might be OK, we would assume, because we can recognize an impairment charge to the extent that the lease residual is not recoverable.

Wrong.

We will have a loss on disposal—perhaps a very significant one—but we won’t be able to recognize it under FAS 144, Accounting for the Impairment or Disposal for Long-lived Assets, because the fair value under FAS 144 is determined under FAS 157 as well. So we have a guaranteed loss on disposal that we cannot recognize, but we know it’s unavoidable. The best we can do is disclose these facts to investors and hope they understand.

Another implementation issue relates to whether executory contracts should be included in determining the FAS 157 fair value measurement. The latest FASB thinking on executory contracts is that they are their own unit of account under GAAP and cannot be combined with other assets. So, let’s say we have a power plant that sells all of its output under long-term contracts, and that those contracts are below market. If the plant’s undiscounted cash flows—which are determined on an entity-specific as opposed to market participant basis—are insufficient to recover the asset, how should we determine the fair value of the asset?

There are at least three options: (1) exclude all cash flows from the long-term contract; (2) exclude only the degree to which the contract is in or out of the money; or (3) include the whole fair value of the contract.

I have heard accounting firms argue for each of these three views, and the issue is not yet settled.

But perhaps the most vexing issue is one FASB knew about and decided not to address: how to account for assets and liabilities measured under FAS 157 on “Day 2.”

Take the example of an acquired trade name that will be abandoned by the acquirer. It is measured at fair value to a market participant that will presumably continue to invest in it. Should it be amortized over the useful life of the market participant? Should it be written off immediately, as it will produce no cash flows to the reporting entity? Should it be impaired to the extent that the value to the market participant has declined, leading to step impairment charges? All three approaches have support among practitioners.

The examples above are just a few of the challenges that have followed in the wake of FAS 157. As the implementation of the new standard reaches its final stages, more are likely to surface in areas that companies have yet to delve into. Surprisingly, there is very little in the way of guidance from the accounting firms, and

new issues

don’t seem to have ready answers.

Which leads to the inevitable question: Are we really ready for FAS 157?