The Rest of Fair Value’s Problems

While regulators are bowing to demands for more guidance on fair-value accounting in relation to the credit crisis, many other questions surrounding fair-value measurement will be left for the markets to sort out themselves.

The Financial Accounting Standards Board has made clear that it wants to end the once-common practice of providing guidance around every obscure detail of a new accounting rule in its pursuit of a more principles-based approach to accounting. Instead, it wants the accounting and corporate finance professions to use their own judgment and settle into their own interpretations.

The number of questions raised around Financial Accounting Standard No. 157, Fair Value Measurement, coupled with the few other pieces of guidance now in development, would suggest FASB isn’t planning to budge. FASB has put a small number of FAS 157 questions into the guidance development pipeline, but has apparently deflected far more.

Beyond the guidance now in development to address illiquid markets—proposed last week in response to the bailout bill enacted by Congress—FASB did not respond to Compliance Week’s requests to discuss any other FAS 157 guidance that may (or may not) be in development.

The Board has already taken up a question on how to value liabilities under FAS 157 using the notion of an “exit price,” or the price an asset would fetch in the open market. FASB published a proposed staff position on the matter, studied comment letters, and tweaked the planned guidance with its staff.

FASB’s Emerging Issues Task Force also is working on a project to answer questions regarding how to value “defensive assets” acquired in a merger or acquisition, such as a competitive brand name or trademark. While hypothetical market participants might place a value on such an asset (which requires companies to assign an upfront value to it), companies wonder how to revalue that asset over time when their intention is to shelve it. The EITF also is looking at questions around how to account for liabilities measured at fair value when a third-party credit enhancement is involved.

FASB had anticipated questions and problems with implementing FAS 157, and formed a Valuation Resource Group when it adopted FAS 157 to collect input from a diverse group on any stumbling blocks as they were discovered in the market. When FASB agreed late last year to defer the effective date for some portions of FAS 157, board members said it was in part to allow more time for the VRG to inform the implementation process.

The VRG is not an authoritative group, so it doesn’t issue guidance directly. Instead, it meets with FASB staff periodically to discuss FAS 157 interpretation in a way that helps the staff spot potential trouble spots that could be corrected with guidance.

Anita Ford, director of assurance services for audit firm Clifton Gunderson and a member of the VRG, says FASB is walking a fine line in trying to stick to its principles-based approach. “They don’t want to issue detailed guidance that would be interpreted as rules,” she says. “Nevertheless, they don’t want a lot of confusion and divergence in practice either.”

Hart

Since it’s not an authoritative group, VRG meetings are closed to the public. That facilitates open dialogue, says Jolene Hart, another member of VRG and a partner with audit firm McGladrey & Pullen. But it also limits the extent to which the markets can learn directly from the broad-based group’s debate, she admits.

“I’m learning a ton,” she says. “I’m getting the benefit of discussions I couldn’t facilitate on my own. I’m worried about the thousands of firms that don’t hear this.”

FASB doesn’t provide minutes to VRG meetings, but unofficial minutes have emerged from other sources, most notably Big 4 firms Deloitte and PricewaterhouseCoopers. They describe a number of issues the VRG has discussed as questions, but the staff has determined are either adequately explained in FAS 157 or should be worked out in practice.

A prominent example is an issue involving how to value inventory acquired in a business combination, according to Matthew Pinson, managing director in the transaction services group at PwC. Pinson says the interplay of FAS 157 and FAS 141R, Business Combinations, has led to questions about how to value such inventory.

FAS 157 ACTION

Background Information & Decisions Reached

Paragraph 15 of Statement 157 provides the following guidance for estimating fair value of a liability:

A fair value measurement assumes that the liability is transferred to a market participant at the measurement date (the liability to the counterparty continues; it is not settled) and that the nonperformance risk relating to that liability is the same before and after its transfer. Nonperformance risk refers to the risk that the obligation will not be fulfilled and affects the value at which the liability is transferred. Therefore, the fair value of the liability shall reflect the nonperformance risk relating to that liability. Nonperformance risk includes but may not be limited to the reporting entity's own credit risk. The reporting entity shall consider the effect of its credit risk (credit standing) on the fair value of the liability in all periods in which the liability is measured at fair value. That effect may differ depending on the liability, for example, whether the liability is an obligation to deliver cash (a financial liability) or an obligation to deliver goods or services (a nonfinancial liability), and the terms of credit enhancements related to the liability, if any.

Constituents have indicated to the staff that there is significant diversity in interpretation of the above language. For example, some constituents have suggested that the quoted market price of a publicly traded debt instrument does not represent the fair value of the issuer’s liability. Those constituents observe that the quoted market price of a publicly traded debt instrument represents the price at which an investor could sell the instrument to another investor, so it may constitute a Level 1 fair value measurement for the asset from an investor’s perspective. However, those constituents suggest that such an amount might not represent the amount that the issuer would be required to pay a transferee to assume the debt obligation in a hypothetical exit transaction.

Summary of decisions reached to date by FASB in regard to FAS 157:

1. During rediliberations of the proposed FSP the Board directed the staff to make the following changes to the proposed FSP and its related amendments:

A. Modify paragraph 6 of the proposed FSP to clarify that the exceptions to the use of Level 1 inputs in paragraphs 25 and 26 of FASB Statement No. 157, Fair Value Measurements, continue to be available under the guidance in the proposed FSP.

B. Clarify that when using a quoted price in an active market, an entity should ensure that the item for which the quote pertains is identical to the unit of account for the liability being measured.

C. Modify paragraph 6 of the proposed FSP to clarify that the best measurement of fair value for an entity’s liability is the price at which that liability is traded as an asset.

D. Maintain paragraph 7 of the proposed FSP as written in the exposure draft without including the staff’s revisions related to using entities assumptions about market participant assumptions.

E. Clarify that the effect of initially applying the guidance in the proposed FSP should be included as a change in fair value in the period of adoption.

F. Specify that the final FSP will be effective at the later of (a) the beginning of the first reporting period ending after the issuance date of the FSP or (b) the beginning of the period in which an entity initially applies Statement 157.

Source

Financial Accounting Standards Board (2008).

VRG members debated whether FAS 157’s exit price notion would require a company to value acquired inventory at the retail selling price, which would ignore costs that will be incurred when the inventory is actually sold. FASB staff told the VRG that paragraph A24(f) of FAS 157 already allows companies to use a net figure— meaning the value of the inventory minus expected selling costs—in valuing such inventory. As such, FASB staff doesn’t plan to recommend new guidance, according to PwC’s account of the discussion.

“Nothing is formally published on this,” Pinson says. “It’s all been word of mouth.” Pinson says some are concerned that the same question could be applied to accounts receivable and accounts payable, but so far it hasn’t been discussed at the VRG or at FASB.

The VRG has discussed a variety of other areas where conventional valuation practices have been tripped up by FAS 157’s reliance on an exit price and its command for the highest and best use of an asset or liability to be considered in setting its value.

For example, how should employee benefit plans value participant loans? What happens when a piece of property that contains a building would actually be more valuable if the building were vacant? Should securitized loans be valued based on the entire batch of loans, or the collective value of each individual loan?

Hart says guidance also is tricky since FAS 157 is an accounting standard, not a valuation standard. The Appraisal Foundation, an entity separate from FASB, established a task force in 2007 to help with valuation for financial reporting purposes, said Jay Fishman, a member of the task force representing AF’s board of trustees. The task force has formed two working groups so far and is working on valuation standards for intangibles such as “economic rents” and customer relationships.

The American Institute of Certified Public Accountants, also independent of FASB, is considering whether it should update a few of its practice aids that may assist with valuation under FAS 157, says Dan Noll, the AICPA’s director of accounting standards. However, it hasn’t committed to those projects, he adds.

Alfred King, vice chairman of appraisal firm Marshall & Stevens and active in the Institute of Management Accountants, says he’s frustrated that the work of the VRG can’t be more transparent or accessible to the rest of the market. “The group makes no decisions, publishes no minutes or reports, and in no way is an authoritative body to resolve issues that arise in practice,” he says. “So far we have seen nothing definitive in the way of [guidance].”