The Financial Accounting Standards Board (FASB) recently issued a document that purports to clarify the circumstances under which a market is properly regarded as “inactive” and when transactions occurring on that market are not “orderly.” The document retreats, to some extent, from the liberality that animated FASB’s initial proposal on these topics. However, in our judgment, the basic contours of the initial proposal are largely preserved with the result that management will be granted a high degree of flexibility in assessing the fair value of financial assets and liabilities.1
On April 9, FASB issued a staff position related to illiquid markets called FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Has Significantly Decreased and Identifying Transactions That Are Not Orderly. The rule revision applies to all assets and liabilities within the scope of accounting pronouncements that either require or permit fair value measurements.
The FSP provides that a reporting entity should evaluate a battery of factors to determine whether there has been a significant decrease in the volume and level of activity for the asset or liability when compared with “normal market activity” for the asset or liability. These factors include, but are not limited to, the following:
- There are few recent transactions;
- Price quotations are not based on current information;
- Price quotations vary substantially either over time or among market makers;
- Indexes that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability;
- There is a significant increase in implied liquidity risk premiums, yields, or performance indicators for observed transactions or quoted prices when compared with the reporting entity’s estimate of expected cash flows for the asset or liability;
- There is a wide bid/ask spread;
- There is a significant decline or absence of a market for new issuances for the asset or liability; and
- Little information is released publicly.
If the reporting entity concludes that there has been a significant decrease in the volume and level of activity for the asset or liability under scrutiny, the rule stipulates that quoted prices may not be determinative of fair value and a significant adjustment to the quoted prices may be necessary to estimate fair value. As a result, in cases where the market is not active, reporting entities may use a valuation method that does not pay homage to quoted prices. This observation is confirmed by the following passage from the FASB staff position: “if there has been a significant decrease … a change in valuation technique or the use of multiple valuation techniques may be appropriate…”
The proposed staff position contained a presumption that if markets were judged to be inactive, quoted prices produced by those markets would be associated with “distressed” transactions. However, the final document eliminates that presumption. Therefore, FAS 157-4 provides that even if there has been a significant decrease in the volume and level of activity for the asset or liability it is not appropriate to conclude that all transactions are not orderly. The circumstances that may indicate a transaction is not orderly include the following:
- There was not “adequate exposure” to the market for a period before the measurement date to allow for marketing activities that are usual or customary for transactions involving such assets or liabilities under current market conditions;
- The seller is in, or near, bankruptcy or receivership or the seller was required to sell to meet regulatory or legal requirements; and
- The transaction price is an “outlier” when compared with other recent transactions for the same or similar asset or liability.
- If the evidence indicates the transaction is not orderly, company should place little, if any, weight on that transaction price when estimating fair value. By contrast, if the evidence indicates that the transaction is orderly, a company is instructed to “consider” that transaction price in estimating fair value. In all cases, however, regardless of the valuation techniques employed to assess fair value, a company is required to include appropriate “risk adjustments.”
This staff position is effective for interim and annual reporting periods which end after June 15, 2009. However, early adoption is permitted (though not encouraged) with respect to interim and annual periods ending after March 15, 2009. We may be in the minority here but, in our view, the final staff position does not differ materially from the proposed rule revision. Although, admittedly, the final rule does not contain the presumption regarding the distressed nature of transactions occurring in inactive markets.
We believe that the final rule provides management with the tools it will need to cause the “migration” of many financial assets and liabilities into “Level 3″ of the FAS 157 hierarchy. The level that allows companies to base fair value assessments on internal models or estimates.
Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com
1 In addition, FASB issued staff position FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments. This staff position applies to all financial instruments within the scope of FAS No. 107, Disclosures about Fair Value of Financial Instruments, held by publicly-traded companies. Thus, a publicly-traded company shall include disclosures about the fair value of its financial instruments whenever it issues summarized financial information for interim reporting periods. Moreover, this disclosure should include information about the method and significant assumptions used to estimate the fair value of financial instruments and describe changes in the methods and assumptions, if any, during the period. The staff position is effective for interim reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. However, early adoption is permitted only if the reporting entity makes a similar election with respect to the other staff positions FASB concurrently published regarding fair value measurements and other than temporary impairments.