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The way companies fair value certain financial statement components is currently changing. This new fair value measurement is going to have a big impact on companies. The most significant changes relate to how companies will disclose fair value in their financial statements and how they will fair value certain assets or liabilities for which there is no market for. This new standard, Statement of Financial Accounting Standards No. 157 – Fair Value Measurements does not require new fair value measurements, however, it merely changes the way fair value is defined, measured and disclosed.

If a survey was done to professionals on the definition of fair value, a multitude of different responses would most likely be received. This inconsistency in definition and lack of guidance for applying those definitions are some of the driving factors of why the FASB issued this new standard. The previous definition of fair value was the price that would be paid to acquire an asset or price received to assume a liability, an "entry price." SFAS 157 changed the definition of fair value to, "the price that would be received to sell an asset or paid to transfer the liability, an "exit price," in an orderly transaction between market participants at the measurement date." This fair value measurement would be a hypothetical transaction measured in the market with the greatest volume and most advantageous prices. Essentially, the exit price is based on the highest and best use of the asset or liability, regardless of the intent or ability to sell it.

The three common valuation techniques are the (1) market approach, (2) income approach, and (3) cost approach. Inputs are the assumptions that market participants would use in pricing an asset or liability. The inputs used in these valuation techniques are broken down into observable and unobservable inputs. Observable inputs are developed based on market data obtained from independent sources. Unobservable inputs are developed based on the best information available in the circumstances. The key is for the valuation techniques to maximize the use of observable inputs and minimize the use of unobservable inputs.

The observable and unobservable inputs are categorized into a fair value hierarchy, as follows:

Level 1 – observable inputs that reflect quoted market prices for identical assets or liabilities in an active market. An example is publicly traded stock on an open market.

Level 2 – observable inputs other than quoted market prices included within level 1 that are observable either directly or indirectly. An example includes real estate property with comparable listings.

Level 3 – unobservable inputs reflect the reporting entity’s own assumptions about market participant assumptions used in pricing an asset or liability. Examples include private company stock that is not publicly traded on an open market, derivatives, or impairment valuations.

Level 3 unobservable inputs will most likely need a valuation done by a specialist, giving rise to a new industry of valuation specialists. Therefore, companies will want to minimize the use of these level 3 inputs, minimizing the cost and time associated with getting a valuation.

SFAS 157 is effective for fiscal years beginning after November 15, 2007 (2008 Calendar year-ends). In order to ensure that companies are provided with the proper guidance for implementing SFAS 157, the FASB decided to defer a portion of the standard giving companies one additional year to apply the new standard. This deferral will be for non-recurring, non-financial instruments. Instruments that will not be deferred include derivatives, servicing assets and liabilities, and loans and debt subject to recurring fair value measurements.

Companies will have to determine how they define fair value and ensure their definition and application of fair value is in accordance with the new standards. If a company has an asset or liability meeting the definition of a level 3 unobservable input, the company will have to assess the need for a valuation to be performed by a specialist. The new fair value standards are going to impact numerous industries, including technology and telecommunications, financial services, banks, accounting firms, valuation companies and any company maintaining assets and liabilities subject to fair value measurement. This new standard will impact technology companies from the standpoint of fair valuing derivatives embedded in debt, valuing intangible assets resulting from business combinations and private company stock price, among other things.

All companies should start the process of identifying and analyzing their financial statements now for how the new standards on fair value will impact you. Fair value is here to stay.

Eric Diamond CPA is a Senior Audit Manager at Amper, Politziner & Mattia, and a member of the firm’s Technology Group. He can reached at 732.287.1000, ext. 1250.