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How do you gauge the fair value of a liability that couldn't be sold in any market?
David M. Katz, CFO.com | US
April 17, 2008
With its twists and turns through the entire range of financial reporting, the transition to fair-value accounting is throwing off a plethora of brain-busting problems. There is, however, a logical place for senior finance executives to go for guidance: the body that spawned the rules, the Financial Accounting Standards Board.
But logic may be hard to find in the rush to comply with the new standards, even at FASB. With Statement No. 157, Fair Value Measurements, just now going into effect for fiscal years starting after Nov. 15, 2007 and for periods within those years, the board itself is still ironing out some of the details—sometimes contentiously.
At an unusually heated FASB meeting last week, for instance, the members debated how companies should estimate the market value of liabilities when there's no actual market on which to base the estimate.
During one point in the discussion, which concerned a proposed guidance by FASB's staff on how to mark liabilities to market under 157, chairman Robert Herz seemed, to member Leslie Seidman, to be contemplating an overhaul of the brand-new standard itself. Matters got so confusing that the board ordered its staff to go back and summarize the members' positions so that they could understand what they themselves had said.
At issue was the question of how to measure the fair value of a liability for "which there is little, if any, market activity," according to 157. The standard defines fair value as "the price that would be received ... to transfer a liability in an orderly transaction between market participants at the measurement date." The question that FASB struggled with was: How do you determine the fair value of a liability that can only be settled, rather than sold?
The problem arises from the word "transfer" in the definition. To most FASB members, that implies that instead of merely recording the liability of a settlement as zero, the settling company must estimate what price it would have to pay to persuade another market participant to assume the liability.
To Herz, however, transferring a liability and settling it are one and the same. In requiring preparers of financial statements to perform the exercise of estimating a transfer value for a market that doesn't exist, "we're forcing people to do mental gyrations in parallel universes," he said. "I don't see the cost benefit of that."
Such "conjuring," as Herz calls it, is made necessary under the third, most cloudy measurement of fair value according to a hierarchy FASB set up under 157. According to the hierarchy, there are three levels of fair-value estimates in a descending order based on the relative amounts of market information available: In level 1, an asset or liability can be valued based on a quoted price in an active market; in Level 2, it can be valued based on information other than quoted prices but with "observable market data"; and in Level 3, it can be valued only through "unobservable inputs" and the best available information under the circumstances.
When observable market data can't be had, companies can make their own calls about the fair value of a transaction based on how they think market participants would price the liability. Nevertheless, the standard says, "the fair value measurement objective remains the same, that is, an exit price from the perspective of a market participant that ... owes the liability."
A company may be severely restricted from transferring a liability, however. Often, for instance, when a company borrows money, it can't transfer its obligation to another party without an agreement from the bank. Or a market may not exist for transferring such liabilities.
In such cases, on what basis can the issuer estimate the fair value of the liability? "I would have thought settlement value would be exit value," Herz said at the meeting. "It's the best measure of exit value in those circumstances."
That line of thinking, however, seemed to exasperate Seidman, who thought Herz was suggesting a complete "overhaul" of 157 by changing the basic definition of fair value to include the concept of settlement. "If you say we should never have required fair value accounting," she said to Herz at one point, "that water is under the bridge."
For his part, the chairman suggested that he was only trying to make things easier for preparers and users. Referring to a shortcut permitted under 157 for Level 3 estimates, Herz sought a way out of the impasse. In using the shortcut, a corporation estimates what it would accept as payment for assuming its own liability.
But using such an estimate might violate the statement under 157 that fair value is "not the price that would be paid to ... assume the liability." That would be using an "entry price" rather than the "exit price."
For that reason, Herz proposed labeling the shortcut as a "practical expedient" because it really doesn't conform with the fair-value standard. "While it would help people get to a transfer notion, I don’t think it's hypothetically correct," he said.
By the end of the meeting, with the "practical expedient" language still on the table, the board seemed to be closer to an accord on the staff's proposed guidance. CFOs trying to figure out what fair value to attribute to loans or derivative obligations that have no markets will be watching closely.