Click here to download pdf file (828 KB)
By G. Dennis Bingham, Appraiser
In September 2006, the Financial Accounting Standards Board (FASB) issued Statement 157 (Fair Value Measurements). Statement 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007.
This Statement applies to 67 FASB pronouncements that require or allow fair value measures and amends over 20 previously issued accounting announcements, including Statements 141 (Business Combinations) and 142 (Goodwill and Other Intangible Assets). It applies to both financial assets (for example, securities and derivative instruments) and non-financial assets (for example, land and intangible assets) as well as to liabilities. Statement 157 does not apply to (1) share-based payment transactions (Statement 123R), (2) accounting pronouncements that permit practicability exceptions, and (3) inventory pricing.
This article discusses the changes to current practices, from a valuation viewpoint, resulting from the implementation of this Statement.
FAIR VALUE DEFINITION
The main purpose of Statement 157 is to increase the consistency and comparability of fair value measurements by providing a single definition of fair value. Fair value is defined in Paragraph 5 as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date."
Historically, fair value has been determined from a buyer's perspective ("entry price") based on what a company would pay to acquire an asset or would receive to assume a liability. The new standard now determines fair value from a seller's perspective ("exit price") based on the price a company would receive if it were to sell an asset or be paid if it were to transfer a liability.
The fair value measurement assumes the transaction to sell an asset, or transfer a liability, occurs in the principal or most advantageous market for the asset or liability. The principal market is defined in Paragraph 8 as "the market in which the reporting entity would sell the asset or transfer the liability with the greatest volume and level of activity for the asset or liability." An example of possible principal markets for the sale of financial instruments would include exchange markets, dealer markets, broker markets, and principal-to-principal markets.
Market participants are assumed to be buyers and sellers in the principal or most advantageous market and are assumed to be unrelated parties, knowledgeable, as well as able and willing to transact for the asset or liability. Market participants may be strategic and/or financial buyers.
The orderly transaction is assumed to be a hypothetical transaction that has been placed for sale on the open market for a reasonable amount of time (for customary marketing) and that the asset or liability is exchanged between market participants.
FAIR VALUE OF AN ASSET
The fair value measurement of an asset assumes the highest and best use of the asset from the perspective of the market participants, "even if the intended use of the asset by the reporting entity is different".
The highest and best use of an asset may be measured using either an "in-use" or an "in exchange" premise. The "in-use" premise is generally appropriate if the assets being valued are used in combination with other assets (for example, non-financial assets); while the "in exchange" premise is generally appropriate if the assets are valued on a stand-alone basis (for example, financial instruments).
Example: Assume a reporting company acquires land as part of a business combination. The land is currently being used as a manufacturing site and is zoned as for industrial use and has a fair value of $2.5 million. However, the reporting entity determines the land could be developed for residential use and neighboring land has been developed for condominiums. If zoned residential, the land would have a fair value of $5 million.
Statement 157 indicates the highest and best use of the land would be based on the higher of the values. Therefore, the fair value of the land would be $5 million.
FAIR VALUE OF LIABILITY
The fair value measurement of a liability assumes the liability is transferred to a market participant and the entity's nonperformance risk of the liability is the same before and after the exchange. "Nonperformance risk refers to the risk that the obligation will not be fulfilled and affects the value at which the liability is transferred." (Paragraph 15)
Example: Nonperformance risk includes consideration of the reporting entity's credit risk.
VALUATION TECHNIQUES
Traditional income, market, and cost approaches shall be used to measure fair value. In some cases, a single valuation method may be appropriate and in other cases multiple methods may be appropriate; it depends upon the circumstances. If multiple approaches are used the fair value measurement should be the point within the range that is most representative of the given circumstances.
Example: Assume a reporting entity acquires a group of assets that includes income-producing software that was internally developed for license to customers. It is determined that sufficient information is available to use an income approach and a cost approach but not a market approach.
The fair value determined by the income approach is $15 million while the cost approach indicates the fair value is $10 million. The reporting entity determines that the software cannot be readily replicated due to the use of proprietary technology. Therefore, the reporting entity believes the fair value of the software is $15 million-using only the income approach.
FAIR VALUE HIERARCHY
To increase the consistency, comparability, and reliability of fair value estimates, Statement 157 establishes a fair value hierarchy that prioritizes the inputs used in determining fair value from most reliable (Level 1) to least reliable (Level 3). Inputs refer to the assumptions used by market participants in pricing the asset or liability. Statement 157 requires report ing entities to maximize the use of observable inputs and minimize the use of unobservable inputs. A brief description of the types of inputs follows:
Most business appraisers will be valuing assets and liabilities using Level 3 inputs.
DISCLOSURES
Statement 157 requires separate disclosures for items measured on a recurring basis versus items measured on a non-recurring basis.
DISCOUNTS
Block discounts, adjustments to quoted market prices based on the size of the units held versus the total daily trading volume, are now prohibited.
RESTRICTED ASSETS
The fair value of an asset with restrictions on the sale or use of that asset may differ depending on how a market participant would consider the restrictions in determining the fair value of an asset.
CONCLUSION
Statement 157 addresses the need for consistency and comparability of fair market value measures by defining fair value, establishing a framework for measuring fair value, and expanding disclosures. However, the Statement introduces several new and difficult questions:
Clearly, valuation experts and reporting entities must work together to determine the most reasonable, defensible answers to these questions.
If you would like information concerning how this Statement may impact you, please contact us.
Shenehon Company
88 South 10th Street, Suite 400
Minneapolis, Minnesota 55403
Phone: 612.333.6533 / Fax: 612.344.1635
ValuationSpecialist@shenehon.com
