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— Industry Insight —
The Financial Accounting Standards Board is addressing concerns in the financial community and Congress over the roles of fair-value and mark-to-market rules in today's financial turmoil. The Securities and Exchange Commission submitted a report to Congress in December 2008 concluding fair-value losses were not the primary contributors to bank failures last year; however, the SEC indicated additional guidance on Statement of 157 (codified in ASC 820), which provides the framework for measuring fair value, would be helpful. In response, the FASB adopted a proposal to allow companies more flexibility in pricing illiquid assets. However, this change is not a repudiation of the role of fair value. The FASB's approach to fine-tuning of ASC 820's fair-value and mark-to-market requirements appears to have broad support among regulators, lawmakers and the investment community. Whatever refinements to the rule are in the offing, fair value appears here to stay. What does the continuing expansion of the role of fair value mean for companies? Generally speaking, companies will have to better understand fair value, apply more rigorous analysis to their valuation of assets and liabilities and document their conclusions more extensively.
"Fair value" and its subset of "mark-to-market" have become household words in recent months and to some have become twin symbols of the financial crisis. But they are hardly new notions. Financial institutions have used mark-to-market accounting for decades. And while ASC 820 has only gradually taken effect over the last year and a half, its enactment actually culminates and clarifies years of expanding fair value consideration. For instance, ASC 820 did make a few significant changes to asset valuation. Previously, fair value was considered the amount at which an asset or liability could be bought or sold in a current transaction -- that is, other than in a forced or liquidation sale. Now fair value is the price that would be received for an asset or paid to transfer a liability between market participants at the measurement date. The statement also added some definition around the concept of "market participants," directing that buyer-specific attributes and intent should be dismissed if different from another market participant. In other words, fair value should reflect how market participants would value the asset even if they would use it differently from the owner's intended use. In response to feedback from constituents struggling to apply fair-value principles in the current turbulent market, the SEC's study of mark-to-market accounting and requests from members of Congress to address issues associated with fair-value accounting, the Financial Accounting Standards Board issued FASB Staff Position (FSP) FAS 157-4 (codified in ASC 820). The FSP provides guidance on (1) estimating the fair value of an asset or liability (financial and nonfinancial) when the volume and level of activity for the asset or liability have significantly decreased and (2) identifying transactions that are not orderly. What may be more interesting is what the FSP does not do. It does not change the objective of fair-value measurements when market activity declines. The FSP emphasizes that "fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions" (emphasis added). This emphasis reinforces that fair value is a current market-based measurement, not an entity-specific or hypothetical future market-based measurement. While the SEC determined that accounting rules were not the cause of the current crisis, some believe the rules are an ongoing contributing factor. A notable example of this is in testing for asset impairment. Companies typically test assets for impairment annually or in response to a triggering event. With the economy recently in free fall, triggering events have become much more common, leading companies to test more frequently. This is increasing concerns that accounting contributes to "pro-cyclicality" -- a downward spiral in which impairment leads to write-offs, resulting in further valuation declines, which lead to further write-offs. Adding to companies' consternation, ASC 820 requires that an asset be valued on the assumption that the company would sell it on the day of the test, regardless of whether disposal is planned. In today's environment, a market participant -- a hypothetical purchaser of the asset -- may pay much less for an asset than it is carried at on a company's books. With companies operating on a Dec. 31 fiscal year having announced 2008 year-end results, there has been a wave of goodwill and intangible write-offs. Some observers suggest that the impact of impairments is already factored into market valuations. Others, however, see continuing declines as fear fuels further pro-cyclicality. ASC 820 also alters the calculation of asset values based on how they are used. In the past, the "highest and best use" of an asset was considered to be the way in which it was currently being used, unless the asset had been identified for disposition or some alternative use. Under ASC 820, highest and best use is the valuation premise used to value all assets and liabilities. Fair value assumes the highest and best use that is, as of the measurement date, physically possible, legally permissible and financially feasible. Whether in-use or in-exchange, the fair value is determined based on the use of the asset by market participants, even if the subject entity's intent is different. Previously, in an acquisition, the acquirer might have discounted the value of certain acquired assets, particularly intangibles, due to its significant market position. ASC 820 introduces the notion of "defensive value." A defensive asset is one that has value to market participants, but the owner intends to hold the asset. The fact that the acquirer is protecting the asset from being utilized by another entity instills a value, which the acquirer must consider under ASC 820. The acquirer needs to consider whether the asset has value to a market participant, whether the acquirer is putting the asset to its highest and best use and the life of the asset. ASC 820 elevates the importance of exercising professional judgment in asset valuation. The move from traditional rules-based accounting models to principles-based frameworks is likely to prove challenging for companies. Professional judgment can be defined as a process used to reach a well-reasoned conclusion based on the relevant facts and circumstances available at the time of the conclusion. Professional judgment will become an even greater priority as International Financial Reporting Standards -- a heavily principles-based accounting framework -- spreads across the globe. ASC 820, a principle-based standard issued by the FASB, provides a framework to assist companies in performing fair-value estimates. However, the move to fair-value accounting, particularly in today's unpredictable and turbulent market, has presented new challenges and may demand greater rigor during the valuation process. Investors, regulators and lawmakers are focusing more intently than ever on how companies value assets and where in the three-level hierarchy such asset values are disclosed. Many companies are finding impairment concerns, highest and best-use considerations, and determining market participants to be difficult and challenging aspects of ASC 820 that are likely to significantly impact the valuation of their company's assets. As the financial landscape continues to change, accurate valuations -- documented thoroughly -- will be critical to retaining shareholder and regulatory confidence. As companies navigate this critical period, they should stay alert to ongoing changes as well as to the potential impact that these changes could have on their businesses. Senior management may want to work closely with accounting, tax and valuation professionals to understand the future implications of fair value, since it appears that this rule is here to stay. Greg Forsythe is a director in the Deloitte Financial Advisory Services LLP (Deloitte FAS) Valuation Practice and serves as Deloitte FAS' business valuation technical specialist and valuation learning leader. Doug Sweeney is a senior manager in the Deloitte Financial Advisory Services LLP (Deloitte FAS) Valuation Practice and serves clients in a wide range of industries. |
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