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Is fair value accounting one of the factors resulting in the significant decline of capital in our financial system today?

Many people blame fair value accounting for the demise of certain financial institutions and the subsequent current economic crisis. Their position is based on the premise that an investor analyzing the financial statements of a company is viewing certain financial instruments as being undervalued, merely due to the lower current market value as result of today’s economy. However, this position may not take into consideration the period of time (short-term versus long-term) that the company intends to hold these financial instruments.

Other people disagree. They believe the fair value accounting merely served its purpose and made investors more aware of a company’s financial position. They support the purpose of fair value accounting as it brings to light and fully discloses all facts and circumstances to the investor.

This ongoing debate continues, adding complexity and obstacles for many companies in the process of analyzing the impact of fair value accounting. A longer-standing discussion concerns the definition of fair value.

Although the Financial Accounting Standards Board (FASB) issued No. 157 – Fair Value Measurements (SFAS 157) in September 2006, many companies still struggle with determining fair value. As a result, the Securities and Exchange Commission (SEC) continues to offer amendments intended to more fully define the standard and improve implementation.

The Emergency Economic Stabilization Act of 2008 authorized the SEC to conduct a study on “mark-to-market” and fair value accounting. The results of this study were released on December 30, 2008. Some of the areas identified in this study included: (1) the effects these accounting standards have on a financial institution’s balance sheet, (2) the impact of fair value accounting on 2008 bank failures, (3) the impact of fair value accounting on the quality of financial information available to investors, (4) any alternatives to fair value accounting standard, as well as a few other items.

In an attempt to provide further additional guidance to assist companies comply with SFAS 157, the FASB released additional FASB Staff Position’s (FSP) in April 2009 including FSP FAS 157-4, 115-2, 124-2 and 107-1. These FSP’s address the following: (1) fair value considerations for inactive markets and distressed transactions, (2) other-than-temporary impairment of debt securities, and (3) frequency of fair value disclosures of financial instruments. In May 2009, the FASB released a proposed staff position for comment that is developed to assist companies in determining the fair value of a liability.

The most important changes under SFAS 157 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. It merely changes the way fair value is defined, measured and disclosed.

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 or 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 require professional valuation. Therefore, companies may want to minimize the use of these level 3 inputs, avoiding or eliminating associated costs and time.

SFAS 157 is effective for fiscal years beginning after Nov. 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. As previously mentioned, 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.