A market-based measurement: FASB redefines “fair value”

The Financial Accounting Standards Board (FASB) is slowly changing the way companies report some assets and liabilities. As part of its movement away from historical cost reporting and toward “fair value” reporting, FASB issued Statement No. 157, Fair Value Measurements (FASB 157), in September 2006.

Consistency and comparability - FASB 157 doesn’t mandate any new fair value measurements. Instead, it establishes uniform guidelines in order to meet needs for consistency and comparability in fair value measurements. In addition to eliminating inconsistencies in previous statements requiring fair value measurements, it more closely aligns generally accepted accounting principles (GAAP) with International Financial Accounting Standards.

Specifically, FASB 157 redefines fair value. (See “Standards of value at a glance” sidebar.) It emphasizes that fair value is a market-based measurement, not an entity-specific measurement. It also provides guidance on how to measure fair value.

How fair value stacks up - In many ways, fair value is similar to fair market value as defined in IRS Revenue Ruling 59-60. Both standards of value assume:

• An exchange price that involves hypothetical buyers and sellers,
• The parties (both buyers and sellers) are able and willing to transact (that is, no compulsion exists),
• The parties are knowledgeable and unrelated,
• A reasonable exposure period to the market (that is, no forced or orderly liquidation), and
• Buyer-specific synergies are excluded from the company’s value.

Despite these similarities, some experts speculate that FASB intentionally avoided the more familiar term “fair market value,” which is used extensively for state and federal tax purposes. If FASB used fair market value, companies might use IRS guidelines and Tax Court precedent to support and defend their fair value measurements. The term “fair value” has less baggage tied to it and allows FASB to start with a clean slate.

Other differences - There are other subtle differences between the two terms. Fair value contains some elements of investment value. For instance, FASB 157 introduces the concept of “market participants,” which refers to buyers and sellers in the principal (or most advantageous) market for the asset or liability.

Thus, the pool of market participants in a hypothetical fair value transaction may be smaller than the entire “universe of potential buyers and sellers” considered when estimating fair market value. The principal market is also entity-specific and may vary from company to company.

According to FASB 157, fair value includes generic synergies available to all market participants. But it prohibits the use of blockage discounts (for large blocks of stock) as well as consideration of the company’s actual intentions related to the use, sale or disposal of an asset or a liability, to the extent these intentions differ from other market participants’.

Fair value hierarchy - Fair value measurement techniques vary slightly from those employed under other standards of value. FASB 157 provides a fair value hierarchy that prioritizes valuation inputs using three broad levels:

Level 1 - (most desirable). Unadjusted quoted prices in active markets for identical assets or liabilities.

Level 2 - Directly or indirectly observable quoted prices for similar assets or liabilities in active mar-kets (or quotes for identical items in markets that are not active).

Level 3 - (lowest priority). Unobservable inputs that reflect the reporting entity’s own assumptions about the asset or liability.

In turn, this hierarchy affects which valuation techniques the valuator selects. For example, if quoted prices of identical or similar assets and liabilities exist, appraisers need not consider unobservable inputs. Put another way, the fair value hierarchy prioritizes the market approach (which uses Level 1 and 2 inputs) over the income approach (which relies on Level 3 inputs).

But in the absence of reliable comparables, an appraiser must rely on unobservable inputs. FASB requires a review of Level 3 inputs to ensure that the company’s assumptions are in line with market-participant assumptions. Any differences may require adjustment.

Coming soon

FASB 157, effective for financial reporting periods beginning after Nov. 15, 2007, reflects progress in clarifying fair value measurements. But the subtle differences between fair value, fair market value and investment value will likely continue to cause confusion.