The Fair Value Litany

FASB's list of situations when a market is illiquid enough for companies to rely on internal models to estimate fair value gives management a lot of wiggle room.

Bob Willens 2

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

 

Inactive Markets
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…”

Orderly Transactions

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:

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