Last month, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) got together to hammer out a final definition for the term ‘fair value’. They agreed that it means an “exit price” in most markets, but in illiquid markets or those that are less active this involves the consideration of a number of variables that they have “tentatively” agreed upon. This, of course, has a significant impact on the levels of data that need to be provided alongside each price, but the lack of definitive standards is likely to prove a headache for valuations departments for some time to come.
With regards to less active markets, the accounting bodies tentatively decided that an entity should consider observable transaction prices when measuring fair value, unless there is evidence that the transaction is not “orderly”. If an entity does not have sufficient information to determine whether a transaction is orderly, it therefore needs to perform further analysis to measure fair value. And so we get to the tricky part.
The FASB and IASB tentatively (so the industry is still lacking any solid ground) confirmed that a fair value measurement is market based and reflects the assumptions that market participants would use in pricing the asset or liability. Market participants should be assumed to have a reasonable understanding about the asset or liability and the transaction based on all the available information, including information that might be obtained through due diligence efforts that are usual and customary. A price in a related party transaction may be used as an input to a fair value measurement if the transaction was entered into at market terms.
According to a statement on the subject released by the FASB at the end of January: “The boards tentatively decided: that in the absence of a quoted price in an active market representing the transfer of a liability, an entity measures the fair value of a liability as follows: using the quoted price of the identical liability when traded as an asset (that is, a Level 1 measurement), if that price is available. If that price is not available, using quoted prices for similar liabilities or similar liabilities when traded as assets (that is, a Level 2 measurement). If observable inputs are not available, using another valuation technique such as: an income approach (for example, a present value technique) or a market approach (for example, using the amount that a market participant would pay to transfer the identical liability or receive to enter into the identical liability).”
The full list of decisions are available to view in detail on the FASB website here, but due to their tentative nature, there is no guarantee that they won’t be altered as the dialogue progresses.
So, fair value is here to stay and firms have to worry a lot more about providing data transparency around these three levels of measurement. But, due to this lack of definitive (rather than tentative) decision making, the pricing and valuations space is likely to face yet more disruptions as the discussions continue.
The process has also seemingly been slowed down by a game of catch up, as the IASB waits for the FASB before it makes any more changes. Both parties committed in September last year to achieve convergence of their respective accounting standards by June 2011 and to have the market comply to these newly reconfigured standards by 2013. Given the progress so far, they’ll be lucky to achieve agreement for convergence by the second deadline. In fact, at Davos last week a number of speakers from the accountancy world suggested that 2020 would be the more likely convergence date.
The issue of how (apart from when) the industry is to globally converge on a harmonised set of fair value standards has still yet to be decided, after all it’s only taken them two years to get to this stage.
However, all is not lost, the talks have managed to inspire those previously sceptical about fair value to appreciate its value to the market. This week, for example, Gerald Corrgan, managing director of Goldman Sachs, testified before the US Committee on Banking, Housing, and Urban Affairs and stated that he had experienced a “sharp departure” from his earlier mindset and now acknowledged the importance of mark to market accounting.
Come what may, fair value is sure to be making the headlines in 2010. This week’s slew of valuations and pricing news items is just the start.