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Determining the Fair Value of Illiquid Securities & Assets in Today’s Economy

The “Why”

On October 10, 2008 the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active. Its purpose is to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active.

Here’s more about the “why” for those of you interested in specific details about the new staff position. As we have discussed in previous issues of the AccuVal AdVisory™, Statement of Financial Accounting Standards 157 (SFAS 157) establishes a single definition of fair value. It also establishes a framework for measuring fair value in Generally Accepted Accounting Principles (GAAP) that result in increased consistency and comparability. SFAS 157 also expands disclosures about fair value measurements, with the intention being the improvement in the quality of information provided to users of financial statements.

SFAS 157 was issued in September 2006 and is effective for financial assets and liabilities for financial statements issued for fiscal years that begin after November 15, 2007 as well as for interim periods within those fiscal years. SFAS 157-2, Effective Date of FASB Statement No. 157, amended SFAS 157 to delay the effective date for nonfinancial assets and liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). The effective date was delayed until fiscal years beginning after November 15, 2008 as well as for interim periods within those fiscal years.

SFAS 157-3 clarifies the application of SFAS 157, Fair Value Measurements, in a market that is not active. This article largely replicates the key language of SFAS 157-3, as we feel that it is important to state the facts as consistently as possible.

 

The “How”

The FASB staff obtained extensive input from various constituents, including financial statement users, preparers and auditors, on determining fair value in accordance with SFAS 157. There were concerns that the statement does not provide sufficient guidance on how to determine the fair value of financial assets when the market for that asset is not active. Application issues include:

• How the reporting entity’s own assumptions (that is, expected cash flows and appropriately risk-adjusted discount rates) should be considered when measuring fair value when relevant observable inputs do not exist;
• How available observable inputs in a market that is not active should be considered when measuring fair value; and
• How the use of market quotes (for example, broker quotes or pricing services for the same or similar financial assets) should be considered when assessing the relevance of observable and unobservable inputs available to measure fair value.

The Office of the Chief Accountant of the Securities and Exchange Commission (SEC) and the FASB staff jointly issued a press release on September 30, 2008 that addresses similar SFAS 157 application issues. That press release provides financial statement users, preparers and auditors with additional guidance useful in dealing with those issues.

Some Key Points

The key takeaway points from SFAS 157-3 are as follows:

• A fair value measurement represents the price at which a transaction would occur between market participants at the measurement date. As discussed in SFAS 157, in situations in which there is little, if any, market activity for an asset at the measurement date, the fair value measurement objective remains the same. That is, the price that would be received by the holder of the financial asset in an orderly transaction (an exit price notion) that is not a forced liquidation or distressed sale at the measurement date.
  
  Even in times of market turbulence, it is not appropriate to conclude that all market activity represents forced liquidations or distressed sales. However, it is also not appropriate to automatically conclude that any transaction price is determinative of fair value. Determining fair value in a turbulent market depends on the facts and circumstances and may require the use of significant judgment about whether individual transactions are forced liquidations or distressed sales.
  
  In determining fair value for a financial asset, the use of a reporting entity’s own assumptions about future cash flows and appropriately risk-adjusted discount rates is acceptable when relevant observable inputs are not available. SFAS 157 discusses a range of information and valuation techniques that a reporting entity might use to estimate fair value when relevant observable inputs are not available. In some cases, an entity may determine that observable inputs (Level 2) require significant adjustment based on unobservable data and thus would be considered a Level 3 fair value measurement.
  
  For example, in cases where the volume and level of trading activity in the asset have declined significantly, the available prices vary significantly over time or among market participants, or the prices are not current, the observable inputs might not be relevant and could require significant adjustment. Regardless of the valuation technique used, an entity must include appropriate risk adjustments that market participants would make for nonperformance and liquidity risks.

• Broker (or pricing service) quotes may be an appropriate input when measuring fair value, but they are not necessarily determinative if an active market does not exist for the financial asset. In an active market, a broker quote should reflect market information from actual transactions. However, when markets are not active, brokers may rely more on models with inputs based on information available only to the broker. In weighing a broker quote as an input to a fair value measurement, an entity should place less reliance on quotes that do not reflect the result of market transactions. Further, the nature of the quote (for example, whether the quote is an indicative price or a binding offer) should be considered when weighing the available evidence.

SFAS 157 provides guidance to entities on how to determine fair value for financial reporting. AccuVal is intimately familiar with this standard and its major implications with respect to accounting for investments and both tangible and intangible assets. Our financial reporting valuations satisfy this statement in all respects so clients can rest assured that a consistent framework is applied – even in a turbulent economy. Learn how AccuVal’s Corporate Valuation & Advisory Services team can help you with financial reporting requirements.