The fair value guidance in FAS 157 does not represent, as many perceive, a radical departure from previous accounting rules.  FAS 157 is the result of a natural evolution that has been taking place for more than 30 years.

Many who oppose FAS 157 do so because of the current economic environment.  However, today’s economy, during which many hedge funds and other institutional investors face significant other-than-temporary write-downs on illiquid assets, is an anomaly.  Any valuation method that does not require significant write-downs in the current environment would fail to provide a reasonable representation of fair value for those illiquid assets.  When it was introduced in 2007, FAS 157 amended, deleted or otherwise affected more than 40 areas of accounting guidance, including FAS 13, Accounting for Leases.  FAS 13, issued in 1976, introduced the fair value concept when it described an asset being sold in an “arm’s length transaction between unrelated parties.”  Since then, the accounting framework has continued to move away from a historical cost model and toward a fair value model.

Throughout this transition, accounting standards were issued that discussed fair value in different contexts for different situations.  FAS 157 was designed primarily to provide a uniform definition of fair value and a universal measurement framework. Contrary to popular perception, FAS 157 does not require any new fair value measurements.

Along the Way

Many accountants were educated during an era when colleges taught the tenets of historical cost as part of the fundamental framework of accounting.  It may seem like a change in thinking to those watching the fair value model slowly supplant the cost model during the past 30 years, but much of this shift is attributable to the ongoing development of accounting standards and rules, rather than a change in approach.

The first wide-spread application of fair value occurred between 1985 and 1990 with the overhaul of accounting for pensions and post-retirement benefits.  Prior to FAS 87, Accounting for Pensions, and FAS 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions, many companies paid for these benefits on a pay-as-you-go cash basis, with little attention given to the fair value of plan assets that were needed to be set aside to cover the cost of such benefits or to accounting on an accrual basis.  For the first time, FAS 87 and 106 required companies to factor in the fair value of plan assets when determining their benefit obligations.

The next sweeping influence of fair value took place when companies began to adopt FAS 133, Accounting for Derivatives and Hedging Activities, in 1999.  Prior to FAS 133, companies were not required to put all derivatives on their balance sheet at fair value; derivatives were not even defined yet.  For the first time, complex financial instruments, many of which were entangled in hedging relationships, were subject to fair valuation.  Soon after, FAS 140, Transfers of Financial Assets, gave rise to difficult-to-value securitized financial assets, such as residential and commercial mortgage-backed securities (RMBS and CMBS), which in turn gave rise to collateralized debt obligations (CDOs) and CDOs squared.  A barrage of higher-math-based valuation techniques designed to account for securitization followed.

FAS 157 had a significant impact on fair value accounting for illiquid securities, which are typically among the most difficult assets to value.  Prior to FAS 157, companies often cherry picked information to support valuations for illiquid positions, regardless of accuracy.  Now, they are required to consider all “reasonably available” information and to have the best data available to support their market assumptions and parameters.
Regardless, many illiquid assets are still being valued based on previous methodologies that are clearly inaccurate – even though FAS 157 has been in effect for more than a year.

Today’s Environment

In the current economic environment, fair value accounting is engaged in a perfect storm of intensified scrutiny, challenging situations and significant opposition.  Attention is especially focusing on three areas:

• Other-than-temporary write-downs
• Fresh-start accounting
• Illiquid securities

Other-than-temporary write-downs.  With Level One securities, determining when to record an other-than-temporary impairment can be as straightforward as deciding how much time has passed since impairment began.  When the tech bubble burst, for example, companies often realized after six to nine months that asset values weren’t going to recover any time soon, if at all.

But what about Level Two or Level Three assets that are valued using sophisticated modeling techniques?  Prior to FAS 157, companies and their auditors might have agreed to hold off or postpone making an adjustment, due to a lack of information that could be considered relevant and reliable.  FAS 157 has driven companies to consider new types and sources of information, and to work harder to support valuations for Level Two and Level Three assets.  Companies are now expected to support their Level Two and Level Three assets almost as if they were categorized as Level One.  In evaluating goodwill for other-than-temporary impairment, FAS 157 suggests that the stock price, if available, is the best indicator of fair value.  But even when the stock price is available, other more traditional methods of fair value, such as discounted cash flow, must also be considered. The challenge lies in supporting these other methods in the current environment of declining stock prices.

With the release of FAS 115-2, Recognition and Presentation of Other-Than-Temporary Impairments in April 2009, companies will be able to bifurcate certain losses on debt securities classified as held-to-maturity or available-for-sale between the portion that relates to credit conditions and the portion that relates to non-credit conditions. The non-credit portion will get hung up on the balance sheet until the debt security matures or is sold. In many situations, the amount reclassified to the balance sheet will include losses previously recognized in other periods. This new rule has caused controversy among practitioners and standard setters, primarily because it delays the inevitable recognition of those losses in earnings when the debt security is sold or matures.

Fresh-start accounting.  Companies petitioning for Chapter 11 bankruptcy need to know whether they will qualify for fresh-start accounting based on their reorganization value according to the provisions of AICPA Statement of Position 90-7, Financial Reporting by Entities in Reorganization Under the Bankruptcy Code.  SOP 90-7 provides a two-step test.

The first step requires a comparison of reorganization value with the value of post-petition claims and obligations immediately prior to court confirmation.  This balance sheet solvency test is a moving target throughout bankruptcy proceedings, as there may be large fluctuations in reorganization value and claims until the plan is implemented.  The second step requires that holders of existing common shares immediately before confirmation, as a group, have less than 50% of the new company’s shares upon emergence. The challenge here involves the negotiations that take place between debtor and creditor committees and the company, which is then subject to final court approval.

Illiquid securities.  When determining fair value, companies are required to consider the frequency with which securities are traded.  Fair value is more readily supportable for a frequently traded security than for one that is thinly traded, because FAS 157 emphasizes the importance of observable prices.

Today, a company’s desire to hold a position, together with its requirement to value that position, is causing a unique anomaly in the valuation world, as securities that would otherwise have a normal trading environment are threatened by write-downs.

A good valuation model must take into account all facts and circumstances in light of the current situation.  For example, when the market is dry for a specific illiquid security, the valuation methodology must consider any widening credit spreads, liquidity premiums from the time of the last active trading activity to the then-current indications, and discount rates implicit in nonbinding broker quotes.

With the finalization in April 2009 of FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly, companies are now subject to additional disclosure requirements and must carefully support how observable prices from inactive markets are used in valuations. Companies may also need to explain significant differences between different indications of value.

The rule did not come about without opposition, generating nearly 400 comment letters within a short comment period. We are not aware of any other proposed accounting rule that generated so many comment letters within a relatively short comment period and that underwent such a drastic turnaround before being finalized.

Tomorrow’s Environment

U.S. companies are facing an inevitable changeover to International Financial Reporting Standards (IFRS).  Fair value rules under U.S. Generally Accepted Accounting Principles (GAAP) are primarily rules-based, while fair value guidance under IFRS is based on principles.  Principles often evolve into rules, but in this case rules appear to be reverting back to their origin as principles.

Fair value guidance under FAS 157 and IFRS are different in several respects.  For example, IFRS does not define the term “market participants,” does not include the concepts of principal market or highest-and-best-use, and does not generally permit mid-market pricing.  While there will be convergence to eliminate many differences, IFRS will emerge as a principles-based standard that companies will need to embrace and understand.  Fair value will continue to generate challenges to practitioners and valuation firms, especially as IFRS is adopted.  The sooner companies assess the impact of fair value accounting under IFRS, the better, because fair value is here to stay.

Espen Robak, CFA is President of Pluris Valuation Advisors of New York City and is a nationally recognized expert on valuation of financial instruments, restricted securities, securities design, levels of value, and discounts for lack of liquidity.  He can be reached at erobak@pluris.com.