FASB Fair-Value Proposal Fights Sticky Wicket

In its just-issued staff proposal, the board would steer bondholders away from valuing their holdings according to scattered market sales.

“Constituents have indicated that this emphasis on the use of the so-called last transaction price as the sole or primary basis of fair value even when a significant adjustment may be required,” the staff wrote, “has resulted in a misapplication of Statement 157 when estimating the fair value of certain financial assets.”

Larsen claims that corporate managements and auditors have a longstanding attachment to the use of level 2 data and tend to use it even when the standards indicate that models should predominate.

Last October’s guidance, FAS 157-3, stated, for example, that all available information should be taken into account in coming to a fair-value assessment, the D&P partner noted. It also stressed that “if your broker quotes are not based on real transaction data, they should not be used.” 

Nevertheless, the valuation specialist said, “the stickiness of level 2 has remained.” Using the example of a bond with a par value of $100, Larsen explained how misinterpretations occur.  If the holder of the bond considers the underlying cash flows of the bond during these recessionary times, he might determine that its current worth would be $90 and might further adjust it downward to $80 to take into account a risk premium and the time value of money.

If however, the bondholder observes on Bloomberg that five people have sold the same bond at $20, he might well be prone to value it at that price because of a predisposition to use observable prices.  In an active market, $20 might well be the right value to assign, according to Larsen. But in a distressed market, if the holder has 100,000 bonds, “that might not be the right value,” he said.

The contention that 157 requires fire-sale pricing is “blatantly false,” he said. “In fact, it prevents you from using fire-sale pricing. If you use fire-sale pricing you are not in accord with generally accepted accounting principles.”

The newly proposed FASB staff position on determining whether a market isn’t active and a transaction isn’t distressed purports to help asset holders negotiate the difficult waters between level 2 and level 3. It sets up a two-step process. In step 1, asset holders would assess at least seven factors in gauging whether to pronounce a market inactive. (“Those factors should not be considered all inclusive because other factors may also indicate that a market is not active,” FASB cautions.) The factors are:

—There are few recent transactions in the market.

—Price quotes aren’t based on current information.

—The quotations vary heavily, either over time or among brokers.

—Indexes that in the past were highly linked to the asset’s fair values “are demonstrably uncorrelated with recent fair values.”

—Abnormally big liquidity risk premiums or yields on the assets.

—Abnormally wide bid-ask spreads or big hikes in the spreads.

—Little publicly released information.

 After the asset holder does a thorough evaluation using those factors, it must “use its judgment in determining whether the market is active.” If it concludes in step 1 that the market for the asset isn’t active, then it would proceed to step 2.

In step 2, the asset holder would have to presume that a quoted price stems from a distressed transaction unless the asset holder can prove that there was enough time before the measurement date to allow for normal marketing activities for the asset. There would also have to be many bidders for the asset for the price to be deemed not distressed.



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