New fair value standards stress how, not just what: Financial Executives Research Foundation got opinions from users and preparers of financial statements on whether measuring assets and liabilities at fair value--rather than historical cost--provides users with more relevant information for decision-making.

FAS 157--Statement of Financial Accounting Standards No. 157, Fair Value Measurements--defines fair value and establishes a framework for measuring fair value in generally accepted accounting principles (GAAP). While previous pronouncements involving valuation focused on what to measure at fair value, FAS 157--issued by the Financial Accounting Standards Board (FASB) on Sept. 15,2006--focuses on how to measure fair value.

FAS 157 provides this new definition of fair value: "Fair value is 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."

This definition abandons a longstanding practice of using the transaction price for an asset or liability as its initial fair value. In other words, fair value will no longer be based on what you pay for something; it will now be based on what you can sell it for, also known as its "exit price."

Just as important, this definition emphasizes that fair value is market-based--requiring the consideration of what other market participants might pay for something--and is no longer entity-specific. Valuation will now be determined by a skeptical, rather than optimistic, buyer.

In turn, the level of data available to measure fair value will determine how the valuation of an asset or liability is determined. Common valuation techniques identified by FAS 157 are the market approach, income approach and/or cost approach. These models require inputs that reflect assumptions that market participants would use in pricing an asset or liability. Observable inputs would be based on market data obtained from independent sources, such as stock exchange prices.

Meanwhile, in the absence of an active market for an asset or liability, unobservable inputs reflect the reporting entity's own assumptions. The standard provides a fair value hierarchy that gives highest priority to quoted prices in active markets (defined as Level 1) and lowest priority to unobservable inputs (Level 3).

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"Fair value is already a familiar concept and currently used in the financial services industry," says Mary Kay Scucci, CFO of Bear Stearns Asset Management. She adds that fair value is very valuable for financial assets, and that FAS 157 provides an additional benefit for financial services firms, as it eliminates the existing deferral of unrealized day one gains (EITF 02-3) "The enhanced disclosure requirements in FAS 157 will provide useful information for our financial statements," says Scucci.

However, she does see challenges ahead in adopting FAS 157. First, there will be challenges in determining the most advantageous market if there is no principal market for assets, such as a stock that is traded on multiple exchanges.

Secondly, she says there will be complexities in identifying the source data for the Level 3 unobservable inputs then used to determine fair value. Policies and procedures will also need to be developed identifying and documenting the fair values that use unobservable inputs, she explains. Also, she adds, "There will be implementation issues for financial service firms, which use blockage or discount models for valuation."

The new policies and procedures will have to be incorporated into existing information systems. "For many firms, changes to their existing financial systems to support an efficient reporting and footnote disclosures will present a significant undertaking," Scucci says.

Challenges for Measuring Non-Financial Instruments

"Statement 157 makes good sense for valuing financial instruments, but it is bad for the valuation of non-financial assets and liabilities, such as intangibles and hard assets." says Alfred King, vice chairman of Marshall & Stevens, a national valuation firm. The problem, he says, is "when you value a company, or even just an asset, with an exit price that would be paid by a market participant, you lose track of the buyer's intentions for the company or asset."

For example, suppose a large software company, "L," buys a smaller software company, "S." And further suppose that L's reason for the purchase was to acquire S's customer list rather than either its product line or brand name.

L does not intend to either support or further develop S's software products, and L's brand name is already more valuable than that of S, but L was willing to pay a high price for S because L wants S's customer list.

However, when L needs to place a value on S so that it can be included on L's balance sheet, FAS 157 requires that it use an exit price that would be paid by another market participant. Unless L can successfully argue that other market participants, such as private equity firms or other software companies, would only want S's customer list, it would have to assume that S's value is comprised of a product line and a brand name, in addition to the customer list.

So under Statement 141, Business Combinations, the total purchase price would have to be allocated to the tangible assets, which will probably be sold off or scrapped, as well as to the intangible assets of S's brand name and customer lists.

Under Statement 144, Accounting for the Impairment or Disposal of Long-Lived Assets, just about everything, except the customer list, will have to be impaired. And, returning to Statement 157, the customer list will be valued at the price that would be paid by another market participant, and that is the value that will go on the balance sheet.

"An investor or shareholder in L will justifiably suspect that L overpaid for S," declares King, adding, "You will end up booking something that did not happen, and that never would have happened."

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Another challenge presented by FAS 157, notes King, relates to the valuation of liabilities. Under Statement 5, Accounting for Contingencies, you were not expected to book a liability unless there was a 50 percent chance or greater that it would be due. Now, under Statement 157, any contingent liability must be quantified, regardless of its probability.

Assume a company has a contingent liability of $100 million, related to a pending lawsuit. The company's legal counsel estimates that there is only a 10 percent chance that the company will have to pay the full amount. However, under FAS 157, the company would have to book an expense and a liability of $10 million ($100 million x 10 percent). If the suit is dismissed, the company would then book $10 million in income and write off the $10 million liability.

Allan Cohen, assistant controller for Time Warner, agrees that certain aspects of FAS 157 are easier to apply when valuing financial instruments and more difficult to apply when valuing non-financial assets. Specifically, FAS 157 defines fair value as the price that would be received to sell an asset, which is an "exit price" notion.

Cohen notes that "it is difficult to understand why a company should start thinking about the selling price of a non-financial asset that was just purchased. We don't purchase a company so that we could turn around and sell it."

Determining who are market participants is another principle that could be difficult to apply, and although FAS 157 is not yet effective, auditors and valuation experts have started to look to the market participant guidance in FAS 157 on current transactions as if FAS 157 is effective.

Cohen describes another valuation challenge presented by FAS 157: "defensive value." Suppose Coke buys Pepsi to get its distribution network. Coke might not be interested in keeping the Pepsi trade name out in the public market, but FAS 157 could require Coke to value the Pepsi trade name. He points to "Example 3-IPR & D Project," provided in FAS 157.

"Some might say that Coke bought Pepsi to improve its own competitive position, not just to get its distribution network." According to FAS 157, the Pepsi brand would thus have defensive value. However, Cohen opines, "how one would determine what a market participant would pay for the Pepsi trade name is a tough question."

User View: Relevant for Decision-Making, in Most Cases

So what do users of financial statements think of FAS 157? Craig Emrick, vice president and senior accounting analyst at Moody's Investors Service, says that fair value, as defined by FAS 157, is relevant for decision-making in most situations. "But other measures, or a mix of measures, can have as much or more relevance than fair value, depending on the nature and circumstances of the assets and liabilities being analyzed, and the type of analysis that you are doing," he explains.

Emrick provides several examples to illustrate his point. "When we analyze the trading portfolios of financial institutions, we need to use fair value. It is the only relevant measure." However, he says, when analyzing property held by real estate investment trusts (REITs), a mix of fair value is used, which provides insight into asset quality and historical cost, which is much more appropriate for leverage ratios.

"On the other hand, for credit analysis, fair value is not the most relevant measure for debt. [That's] because, apart from those situations where a company has the ability and motivation to settle its debt in the short term, amortized cost or contractual value is more predictive of the likely cash flow required to service the debt," says Emrick.

He predicts that, as companies introduce more fair value measurement to their financial statements, disclosures--especially disclosures about valuation assumptions--will become more important. "Disclosures of the assumptions underlying fair value numbers will help the reader better understand the nature of the assets and liabilities on the balance sheet," he says. "Disclosures are key, and you can't divorce them from the numbers."

Emrick is optimistic about the future, however. "Over time, we will get more comfortable with fair value," he says, adding, "it will be a learning process."

William M. Sinnett ([e-mail]) is Director of Research for Financial Executives Research Foundation (FERF).

RELATED ARTICLE: takeaways

* FAS 157 establishes a framework for measuring fair value in GAAP that is focused on how to measure fair value; previous pronouncements focused on what to measure.

* FAS 157 is market-based, requiring consideration of what other market participants might pay.

* One challenge of the standards is determining the most advantageous market if there is no principal market.

* Certain aspects are easier to apply when valuing financial instruments and more difficult to apply when valuing non-financial instruments, notes a preparer.