5/7/2008: Understanding Fair Value

Excerpts from Understanding the Issues: Some Facts About Fair Value
By FASB Chairman Robert Herz and FASB Director Linda A. MacDonald

However, the main purpose of this article is not to debate the pros and cons of fair value accounting. Rather, it is to provide some basic facts about fair value accounting that are important in understanding the current debate. Specifically, (1) where fair value is (and where it is not) used in financial reporting currently, (2) what fair value is (and what it is not), and (3) the approach for developing fair value estimates, including in illiquid markets.
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For an asset, the fair value estimate is determined by reference to the price that would be received in an orderly transaction for the asset at the measurement date (an exchange price notion), not, as some have asserted, the price that would be received in a fire sale or forced liquidation transaction for the asset at the measurement date. An orderly transaction is one that involves market participants that are willing to transact and allows for adequate exposure to the market before the measurement date. In contrast, a fire sale or forced liquidation transaction is one that involves market participants that are compelled to transact (under duress) and allows for little (or no) exposure to the market before the measurement date.
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The fair value hierarchy prioritizes observable inputs over unobservable inputs. However, the weighting of the inputs in the fair value estimate will depend on the extent to which they provide information about the value of an asset or liability and are relevant in developing a reasonable estimate of a current exchange price for the asset or liability. In making that determination, many factors need to be considered. Examples include the following:

• The extent to which observable inputs relate to transactions
  involving comparable assets or liabilities, considering both
  the nature of the transactions (orderly vs. forced) and the
  timing of the transactions (current vs. stale)


• The magnitude and subjectivity of adjustments to the inputs


• Factors specific to the market(s) in which the inputs are
  observed, such as a change in the volume of transactions and
  liquidity in a market that previously was active, a change in
  the availability of observable inputs, and a change in bid/ask
  spreads.
  

In some cases, for example, when there is little (or no) market activity for comparable assets or liabilities at the measurement date (illiquid markets) or when information about transactions involving comparable assets or liabilities is not publicly disclosed (principal-to-principal markets), the fair value estimate might rely principally on unobservable inputs (Level 3 estimates).

Sabaziotatos says:

This is an excellent article that provides much guidance from senior people at FASB on how to apply SFAS 157. This article is almost as useful as the SEC's Sample Letter Sent to Public Companies on MD&A Disclosure Regarding the Application of SFAS 157 (Fair Value Measurements) . In particular, FASB provides guidance on what to do in illiquid markets and more information on what an "orderly transaction" is.