Fair Value Accounting: Insights and Issues

This article first examines the accounting principles and the framework underlying fair value measurements and clarifies the difference between mark-to-market accounting and fair value accounting. The article then examines the application of fair value accounting in inactive or illiquid markets, and in doing so, raises certain thematic issues that have surfaced in regard to this topic:

• What are the difficulties in distinguishing an active market from an inactive market?
• Can the consistent use of fair value methodologies be ensured in markets that are inactive?
• Is fair value accounting an equitable standard given that its application is limited to valuing certain classes of assets and liabilities in an entity's balance sheet?
• Did/Does auditor bias exist as it relates to using third-party data to determine fair values predicated on market prices in illiquid markets as opposed to using internal data?

Fair Value Accounting: A Summary

SFAS 157 defines fair value 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.” In formulating this definition, the FASB signaled its preference for the use of the notion of “exit price” ' determined in an orderly market, that is, in the principal or most advantageous market for the asset or liability ' and for market-based measurements as opposed to entity-specific measurements. As such, a fair value measurement for assets assumes the highest and best use of the asset in question; for liabilities, SFAS 157 assumes that the liability is transferred to a market participant and the risk of non-performance is the same before and after the transfer.

The following valuation techniques can be used to measure fair value:

• Market approach: uses prices and other information from market events involving identical or comparable assets and liabilities;
• Income approach: uses present-value techniques to convert future amounts ' such as cash flows or earnings ' to the present time; and,
• Cost approach: uses current replacement cost, that is, the amount currently needed to replace the service capacity of the asset.

SFAS 157 postulates a fair value hierarchy wherein “valuation techniques used to measure fair value shall maximize the use of observable inputs and minimize the use of unobservable inputs,” as follows:

• Level 1: unadjusted market price in active markets for identical assets and liabilities and is generally the most reliable evidence of fair value;
• Level 2: observable inputs other than quoted prices, including market prices for similar assets in active markets and market prices for identical or similar assets in inactive markets; and,
• Level 3: unobservable inputs generated by the reporting entity which may include the derivation of assumptions by the entity using its own specific data.

It is important to note that fair value accounting is not mark-to-market accounting, although the two terms are sometimes used interchangeably. The main reason for the interchangeable use arises due to viewpoints expressed in some quarters that SFAS 157 requires entities to value assets and liabilities using market values irrespective of whether the underlying markets are active or inactive. Fair value is not necessarily “market value,” and accordingly, mark-to-market accounting represents only one of the proxies of applying fair value; the other notable proxy is commonly referred to as mark-to-model accounting wherein a company's management uses its own assumptions and inputs in its models (e.g., present-value techniques) to determine fair value.

Fair Value in Inactive Markets

A reading of SFAS 157 reveals that the pronouncement itself clearly contemplates the valuations of assets and liabilities in inactive markets for such assets and liabilities:

• ” ' the notion of unobservable inputs is intended to allow for situations in which there is little, if any, market activity for the asset or liability at the measurement date”;
• “A fair value measurement assumes ' an orderly transaction between market participants ' An orderly transaction ' is not a forced transaction (for example, a forced liquidation or distress sale)”; and
• “Level 3 inputs are unobservable inputs ' Unobservable inputs shall be used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity ' at the measurement date.”

Both the SEC and the FASB have attempted to clarify their positions on SFAS 157 in recent months through the release of letters of comment and staff positions. A joint letter issued by the SEC Office of the Chief Accountant and FASB Staff on Sept. 30, 2008 explains that expected cash flows and management's internal assumptions can be used to measure fair value when relevant market evidence does not exist. Additionally, it states that in inactive markets, unobservable (level 3) inputs may be more appropriate than observable (level 2) inputs. According to the letter, “Transactions in inactive markets may be inputs when measuring fair value, but would likely not be determinative” of fair value.

On Oct. 10, 2008, the FASB issued a final staff position (“FSP”) FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active. FSP 157-3 provides an example that illustrates the following SFAS 157 principles in determining the fair value of a financial asset or liability in an inactive market:

• Determination of transaction price in inactive or dislocated markets depends on the underlying facts and circumstances and may require significant judgment. Specifically, ” ' it is not appropriate to conclude that any transaction price is determinative of fair value”;
• The use of a reporting entity's own assumptions is acceptable when relevant observable inputs might not be available; and
• Broker quotes that may result from models with inputs available only to the broker rather than inputs resulting from market transactions may be relied upon to determine fair value in inactive markets.

In distressed situations, fair values are determined using valuation techniques based primarily on management's internal assumptions about future cash flows and appropriately risk-adjusted discount rates. Appropriate risk adjustments should be made for credit and liquidity risks that market participants would consider. Ultimately, any valuation technique used should consider the current market conditions.

Issue 1: What are the difficulties in distinguishing an active market from an inactive market?

There is no clear-cut demarcation between an active and an inactive market. As discussed earlier, determining fair value in inactive markets depends on the facts and circumstances and may require the need for significant judgment. Examples of characteristics of inactive markets including those provided in FSP FAS 157-3 are as follows:

• Significant decline in the volume and level of trading activity;
• Available prices vary significantly over time or among market participants;
• Prices are not current;
• Wide spreads between bid and ask price quotes;
• Volatility in stock and credit markets;
• Marked increase in market call redemption requests.

In today's business climate, changes in market condition can occur almost instantaneously, and thus a valuation methodology used in one reporting period that contemplated a market approach using level 1 inputs may no longer be appropriate in other reporting periods when those markets are no longer active. Accordingly, it is incumbent upon management to be vigilant of the markets and market conditions that exist for determining fair values of various assets and liabilities. Management must also clearly identify the reasons why it determines a market for a given asset or liability to be inactive. This can be achieved through the development of processes and procedures to monitor market conditions and controls to adjust inputs and disclosures when such changes occur.

Issue 2: Can the consistent use of fair value methodologies be ensured in markets that are inactive?

It is worthwhile to examine the landscape of fair value accounting prior to the promulgation of SFAS 157. Prior to SFAS 157, there were different definitions of fair value, and the guidance for applying those definitions was inconsistent and limited. In fact, there were four Accounting Principles Board Opinions and 37 Statement of Financial Accounting Standards that referred to fair value. The rationale for FASB to issue SFAS 157 was to establish consistency and comparability in fair value measurements and related disclosures.

One of the main challenges facing the application of SFAS 157 lies in the potential for its inconsistent application. As the application of fair value requires judgment, two entities may arrive at different estimates of fair value for the same asset or liability even though both meet the objective of fair value measurement. Therefore, the need for appropriate disclosures about the techniques and inputs used, assumptions, and judgments made are critical to users of financial statements. The International Accounting Standards Board provides that a single entity should apply judgment consistently (across time and type of instrument) when measuring fair value.

Issue 3: Is fair value accounting an equitable standard given that its application is limited to valuing certain classes of assets and liabilities in an entity's balance sheet?

Generally accepted accounting principles provide for the use of various methods of valuing different assets and liabilities. For example, inventory is valued at lower of cost or market; property, plant, and equipment is valued at historical cost less accumulated depreciation; receivables are accounted for at net realizable value; held-to-maturity securities are reported at amortized cost. This begs the question as to whether one standard of accounting, such as fair value accounting, should be used for the valuation of all assets and liabilities in an entity's balance sheet. Given the disparate characteristics exhibited by different assets and liabilities, the use of one standard of accounting for measuring them is neither correct nor practical.

Issue 4: Did/Does auditor bias exist as it relates to using third-party data to determine fair values predicated on market prices in illiquid markets as opposed to using internal data?

Generally Accepted Auditing Standards require that in rendering an opinion on a company's financial statements, the company's external auditor must obtain sufficient competent evidential matter that is both relevant and reliable. Evidential matter obtained from independent sources is generally considered more reliable than information obtained from or prepared by the company itself. Thus auditors generally place more weight on outside evidence. As such, it is possible that this bias could have existed or still exists as it relates to the use of market prices in illiquid markets in determining fair value.

Conclusion

In sum, the timing of the adoption of SFAS 157 by entities accompanied by the continued deterioration in the credit markets has created a perfect storm for banks, hedge funds and other financial institutions as well as for the auditors of these companies. The Bank of England recently estimated that the total losses from the current market credit crisis might amount to approximately $2.8 trillion. It is unknown at this time as to whether the losses arose as a result of the global economic meltdown or the misapplication of fair value accounting or both. The SEC has instituted a “Mark-to-market Accounting Study” that is supposed to address, among other issues, the impact of mark-to-market accounting on bank failures. Only the passage of time will provide the necessary answers.

Vijay Sampath is a managing director and Jamal Ahmad is a principal in the forensic accounting practice at LECG, a global expert services and consulting firm. Sampath can be reached at [email protected] or 212-636-4912, and Ahmad at [email protected] or 212-636-4914. The views and opinions expressed are those of the authors and contributors and not necessarily those of LECG, its employees, subsidiaries, and affiliates.

Fair value accounting ' sometimes used interchangeably with mark-to-market accounting ' has been criticized in some quarters as being the main cause of the current credit market turmoil. Proponents of this viewpoint contend that accounting rules were interpreted to mean that entities were required to value certain assets and liabilities, particularly marketable securities (e.g., mortgage-backed securities), at market values despite the fact that those values were established by distressed or fire-sale transactions. Such valuations, these proponents argue, resulted in these securities being written down inappropriately in financial statements significantly below their intrinsic values thereby overstating the losses incurred. These write-downs severely eroded capital in financial services companies, thus curtailing their ability to operate and lend.

To establish context, entities, particularly financial institutions, have recognized significant losses in their financial statements in 2007 and 2008 with respect to fair value write-downs. One estimate put the cumulative losses incurred by financial institutions through the third quarter of 2008 at an amount in excess of $600 billion.

The accounting standard that has been the center of the debate over fair value accounting is Statement of Financial Accounting Standards No. 157 (“SFAS 157″), Fair Value Measurements. SFAS 157 defines fair value and establishes a framework for measuring the fair value of assets and liabilities under different market conditions, both active and inactive. It also discusses the disclosure requirements for fair value measurements. Additionally, the Securities and Exchange Commission (“SEC”) and the Financial Accounting Standards Board (“FASB”) have issued guidance and clarifications, more so lately, about its applicability.

This article first examines the accounting principles and the framework underlying fair value measurements and clarifies the difference between mark-to-market accounting and fair value accounting. The article then examines the application of fair value accounting in inactive or illiquid markets, and in doing so, raises certain thematic issues that have surfaced in regard to this topic:

• What are the difficulties in distinguishing an active market from an inactive market?
• Can the consistent use of fair value methodologies be ensured in markets that are inactive?
• Is fair value accounting an equitable standard given that its application is limited to valuing certain classes of assets and liabilities in an entity's balance sheet?
• Did/Does auditor bias exist as it relates to using third-party data to determine fair values predicated on market prices in illiquid markets as opposed to using internal data?

Fair Value Accounting: A Summary

SFAS 157 defines fair value 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.” In formulating this definition, the FASB signaled its preference for the use of the notion of “exit price” ' determined in an orderly market, that is, in the principal or most advantageous market for the asset or liability ' and for market-based measurements as opposed to entity-specific measurements. As such, a fair value measurement for assets assumes the highest and best use of the asset in question; for liabilities, SFAS 157 assumes that the liability is transferred to a market participant and the risk of non-performance is the same before and after the transfer.

The following valuation techniques can be used to measure fair value:

• Market approach: uses prices and other information from market events involving identical or comparable assets and liabilities;
• Income approach: uses present-value techniques to convert future amounts ' such as cash flows or earnings ' to the present time; and,
• Cost approach: uses current replacement cost, that is, the amount currently needed to replace the service capacity of the asset.

SFAS 157 postulates a fair value hierarchy wherein “valuation techniques used to measure fair value shall maximize the use of observable inputs and minimize the use of unobservable inputs,” as follows:

• Level 1: unadjusted market price in active markets for identical assets and liabilities and is generally the most reliable evidence of fair value;
• Level 2: observable inputs other than quoted prices, including market prices for similar assets in active markets and market prices for identical or similar assets in inactive markets; and,
• Level 3: unobservable inputs generated by the reporting entity which may include the derivation of assumptions by the entity using its own specific data.

It is important to note that fair value accounting is not mark-to-market accounting, although the two terms are sometimes used interchangeably. The main reason for the interchangeable use arises due to viewpoints expressed in some quarters that SFAS 157 requires entities to value assets and liabilities using market values irrespective of whether the underlying markets are active or inactive. Fair value is not necessarily “market value,” and accordingly, mark-to-market accounting represents only one of the proxies of applying fair value; the other notable proxy is commonly referred to as mark-to-model accounting wherein a company's management uses its own assumptions and inputs in its models (e.g., present-value techniques) to determine fair value.

Fair Value in Inactive Markets

A reading of SFAS 157 reveals that the pronouncement itself clearly contemplates the valuations of assets and liabilities in inactive markets for such assets and liabilities:

• ” ' the notion of unobservable inputs is intended to allow for situations in which there is little, if any, market activity for the asset or liability at the measurement date”;
• “A fair value measurement assumes ' an orderly transaction between market participants ' An orderly transaction ' is not a forced transaction (for example, a forced liquidation or distress sale)”; and
• “Level 3 inputs are unobservable inputs ' Unobservable inputs shall be used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity ' at the measurement date.”

Both the SEC and the FASB have attempted to clarify their positions on SFAS 157 in recent months through the release of letters of comment and staff positions. A joint letter issued by the SEC Office of the Chief Accountant and FASB Staff on Sept. 30, 2008 explains that expected cash flows and management's internal assumptions can be used to measure fair value when relevant market evidence does not exist. Additionally, it states that in inactive markets, unobservable (level 3) inputs may be more appropriate than observable (level 2) inputs. According to the letter, “Transactions in inactive markets may be inputs when measuring fair value, but would likely not be determinative” of fair value.

On Oct. 10, 2008, the FASB issued a final staff position (“FSP”) FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active. FSP 157-3 provides an example that illustrates the following SFAS 157 principles in determining the fair value of a financial asset or liability in an inactive market:

• Determination of transaction price in inactive or dislocated markets depends on the underlying facts and circumstances and may require significant judgment. Specifically, ” ' it is not appropriate to conclude that any transaction price is determinative of fair value”;
• The use of a reporting entity's own assumptions is acceptable when relevant observable inputs might not be available; and
• Broker quotes that may result from models with inputs available only to the broker rather than inputs resulting from market transactions may be relied upon to determine fair value in inactive markets.

In distressed situations, fair values are determined using valuation techniques based primarily on management's internal assumptions about future cash flows and appropriately risk-adjusted discount rates. Appropriate risk adjustments should be made for credit and liquidity risks that market participants would consider. Ultimately, any valuation technique used should consider the current market conditions.

Issue 1: What are the difficulties in distinguishing an active market from an inactive market?

There is no clear-cut demarcation between an active and an inactive market. As discussed earlier, determining fair value in inactive markets depends on the facts and circumstances and may require the need for significant judgment. Examples of characteristics of inactive markets including those provided in FSP FAS 157-3 are as follows:

• Significant decline in the volume and level of trading activity;
• Available prices vary significantly over time or among market participants;
• Prices are not current;
• Wide spreads between bid and ask price quotes;
• Volatility in stock and credit markets;
• Marked increase in market call redemption requests.

In today's business climate, changes in market condition can occur almost instantaneously, and thus a valuation methodology used in one reporting period that contemplated a market approach using level 1 inputs may no longer be appropriate in other reporting periods when those markets are no longer active. Accordingly, it is incumbent upon management to be vigilant of the markets and market conditions that exist for determining fair values of various assets and liabilities. Management must also clearly identify the reasons why it determines a market for a given asset or liability to be inactive. This can be achieved through the development of processes and procedures to monitor market conditions and controls to adjust inputs and disclosures when such changes occur.

Issue 2: Can the consistent use of fair value methodologies be ensured in markets that are inactive?

It is worthwhile to examine the landscape of fair value accounting prior to the promulgation of SFAS 157. Prior to SFAS 157, there were different definitions of fair value, and the guidance for applying those definitions was inconsistent and limited. In fact, there were four Accounting Principles Board Opinions and 37 Statement of Financial Accounting Standards that referred to fair value. The rationale for FASB to issue SFAS 157 was to establish consistency and comparability in fair value measurements and related disclosures.

One of the main challenges facing the application of SFAS 157 lies in the potential for its inconsistent application. As the application of fair value requires judgment, two entities may arrive at different estimates of fair value for the same asset or liability even though both meet the objective of fair value measurement. Therefore, the need for appropriate disclosures about the techniques and inputs used, assumptions, and judgments made are critical to users of financial statements. The International Accounting Standards Board provides that a single entity should apply judgment consistently (across time and type of instrument) when measuring fair value.

Issue 3: Is fair value accounting an equitable standard given that its application is limited to valuing certain classes of assets and liabilities in an entity's balance sheet?

Generally accepted accounting principles provide for the use of various methods of valuing different assets and liabilities. For example, inventory is valued at lower of cost or market; property, plant, and equipment is valued at historical cost less accumulated depreciation; receivables are accounted for at net realizable value; held-to-maturity securities are reported at amortized cost. This begs the question as to whether one standard of accounting, such as fair value accounting, should be used for the valuation of all assets and liabilities in an entity's balance sheet. Given the disparate characteristics exhibited by different assets and liabilities, the use of one standard of accounting for measuring them is neither correct nor practical.

Issue 4: Did/Does auditor bias exist as it relates to using third-party data to determine fair values predicated on market prices in illiquid markets as opposed to using internal data?

Generally Accepted Auditing Standards require that in rendering an opinion on a company's financial statements, the company's external auditor must obtain sufficient competent evidential matter that is both relevant and reliable. Evidential matter obtained from independent sources is generally considered more reliable than information obtained from or prepared by the company itself. Thus auditors generally place more weight on outside evidence. As such, it is possible that this bias could have existed or still exists as it relates to the use of market prices in illiquid markets in determining fair value.

Conclusion

In sum, the timing of the adoption of SFAS 157 by entities accompanied by the continued deterioration in the credit markets has created a perfect storm for banks, hedge funds and other financial institutions as well as for the auditors of these companies. The Bank of England recently estimated that the total losses from the current market credit crisis might amount to approximately $2.8 trillion. It is unknown at this time as to whether the losses arose as a result of the global economic meltdown or the misapplication of fair value accounting or both. The SEC has instituted a “Mark-to-market Accounting Study” that is supposed to address, among other issues, the impact of mark-to-market accounting on bank failures. Only the passage of time will provide the necessary answers.

Vijay Sampath is a managing director and Jamal Ahmad is a principal in the forensic accounting practice at LECG, a global expert services and consulting firm. Sampath can be reached at [email protected] or 212-636-4912, and Ahmad at [email protected] or 212-636-4914. The views and opinions expressed are those of the authors and contributors and not necessarily those of LECG, its employees, subsidiaries, and affiliates.