What is fair value? That question is one with which bankruptcy and restructuring professionals are well familiar. As to the reply, experience with Exide Technologies, Loral Space and Communications and many other bankruptcy cases would indicate that the answer could be a bit variable.

Valuation and Its Increasing Importance in Financial Reporting

And so it has been the case with Generally Accepted Accounting Principles (GAAP). The conceptual framework for GAAP has largely been historically cost-based. Over the years, however, practitioners and related boards or committees that promulgate GAAP have increasingly provided that fair-value information in financial statements and financial disclosures is useful to the users of financial statements. Fair-value measurement requirements are currently within the scope of more than 40 Accounting Principles Board (APB) and Financial Accounting Standards Board (FASB) pronouncements, ranging from ABP Opinion No. 18 dealing with the equity method of accounting for investments in common stock (1971) to FASB Statement No. 153, "Exchanges of Nonmonetary Assets—An Amendment of APB Opinion No. 29" (2004). While fair-value measurement requirements are within the scope of these 40-plus pronouncements, there has been limited guidance in GAAP on how to apply the fair-value objective, particularly when quoted price information is unavailable. Inconsistencies in the guidance that is available have served to increase the complexity of GAAP and to decrease the consistency and comparability of fair-value information presented.

In June 2003, the FASB added to its agenda a project to codify and improve existing guidance for measuring fair value. The overall objective of the project is to provide a single reference source for how to measure fair value under other accounting pronouncements that require fair-value measurements. At the time the FASB added the project to its agenda, it set a near-term objective of developing a statement of financial accounting standards that would establish the framework for fair-value measurements for assets and liabilities measured at fair value under other accounting pronouncements. The longer-term objective of the project as set by the FASB is to improve related conceptual guidance in FASB Concepts Statement No. 5, "Recognition and Measurement in Financial Statements of Business Enterprises."²

---

Increased fair-value disclosures in interim and annual financial statements based on an established reporting framework is a step in the right direction to providing greater clarity on the reporting entity.

---

One year later, in June 2004, the FASB released for comment an exposure draft for a proposed statement of financial accounting standards entitled "Fair Value Measurements" (the "exposure draft").

Defining Fair Value

The exposure draft defines fair value as "the price at which an asset or liability could be exchanged in a current transaction between knowledgeable, unrelated willing parties."³ This definition, while similar to definitions of fair-market value used for valuation purposes, is intended by the FASB to be distinct for financial reporting purposes.

"Internal Revenue Service Revenue Ruling 59-60," which represents a legal standard of value, defines fair market value as "the price at which a property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts."

Essentially, these two definitions embody the same measurement objectives focusing on an exchange price notion and the action of marketplace participants in a hypothetical transaction. The FASB recognizes this similarity but also wishes to distinguish fair value for financial-reporting purposes from the legal standard of fair market value and its history of interpretative case law that may not be relevant for financial reporting purposes.

The exposure draft recognizes the importance of the concept of the unit of account. The unit of account defines the level at which an asset or liability may be combined or broken down for valuation purposes and recognizes that the valuation of a single loan, for example, may be different from the valuation of a portfolio of loans.

The standard contained in the exposure draft provides background on valuation techniques as well. It covers basic descriptions of the market approach, income approach and cost approach, and requires that all three approaches should be considered in a manner consistently applied for estimates of fair value.

The exposure draft requires that valuations use "market inputs" or assumptions and data that are derived from the marketplace with an emphasis on active markets such as exchanges where quoted prices are readily available and represent actual and observable transactions. In addition to exchange markets, the exposure draft discusses dealer markets, brokered markets and principal-to-principal markets as examples of sources of market inputs with differing levels of activity. Critical to the market-input information used is that it be timely—from sources independent of the entity whose asset or liability is being valued—and information that is used by market participants for making pricing decisions.

The exposure draft uses the term "valuation premise" to define how an asset (or liability) should be viewed in terms of use or conditions and the impact that premise would have on the related assumptions and data that are selected as appropriately applied market inputs. In terms bankruptcy and restructuring professionals typically encounter, the question asked is this: "Is the valuation premise a going-concern or in-use valuation premise, or one of an orderly or ‘fire sale' liquidation?"

The Fair-value Hierarchy

A critical part of the proposed new standard is the guidance provided by the FASB on what it calls the "fair-value hierarchy," which, as provided for in the exposure draft, broadly groups market inputs into three categories and provides specific guidance on how the information in these categories should be applied. The exposure draft requires that where the relevant information exists, the valuation should be based on the highest-priority information.

The highest priority of information to be used under the proposed standard, referred to as Level 1 Estimates, would be quoted prices for identical assets or liabilities in active reference markets. If available, fair value should be estimated using such data without additional adjustment.

Level 2 Estimates are defined as quoted prices for similar assets or liabilities in active markets. The quoted prices should be adjusted for the differences between the characteristics of the assets or liabilities being valued and the characteristics of the assets or liabilities that are the subject of the quoted pricing information. How those adjustments are determined is important to defining where in the fair-value hierarchy the market inputs fall. Unless there is an objective basis for determining the adjustment, the estimate ultimately determined will be considered a Level 3 Estimate.

Level 3 Estimates are those estimates made when quoted prices for identical or similar assets or liabilities are not available or when the bases for the adjustments for differences between similar assets or liabilities cannot be objectively determined. In such cases, fair value should be estimated using the multiple valuation techniques consistent with the market, income and cost approaches.

Disclosures

The new standard requires additional annual and interim disclosures related to assets and liabilities that are remeasured at fair value on a recurring basis such as trading securities, and for assets and liabilities that are remeasured on a nonrecurring basis such as those that occur with an asset impairment. The disclosures required in each category include detailed information on how fair value was determined and the impact of the remeasurement on earnings for the period.

Status of the Proposed New Standard

Since the end of the comment period on Sept. 7, 2004, the FASB has actively considered the comments received and continued deliberations on the proposed standard. Among the expected revisions that will be in the final standard are clarifications on the definition of "fair," clarification on the use of a reference market and an expansion of the fair-value hierarchy from three levels to five. The standard when issued is expected to include a new Level 3 for direct-market inputs other than quoted prices, a Level 4 for indirect market inputs and a Level 5 for entity inputs. For disclosure purposes, a three-level hierarchy will be used segregating estimates that fall within Level 1, Levels 2 and 3, and Levels 4 and 5. The FASB expects to release the new standard during the fourth quarter of this year.

Implications in Restructuring Scenarios

One of the consistent problems with GAAP-based financial information for an entity in decline has been that historical cost-based reporting provides a murky financial picture for assessing value and potential solutions. Increased fair-value disclosures in interim and annual financial statements based on an established reporting framework is a step in the right direction to providing greater clarity on the reporting entity. Whether the FASB's goal of reducing complexity and increasing comparability of fair-value information will be achieved by this effort will only be decided after the new standard is released and has been applied in the marketplace. Nevertheless, a framework against which to evaluate fair-value information and expanded disclosure on how management prepared that information should be of increased usefulness to bankruptcy and restructuring professionals in evaluating the financial position of distressed companies and potential courses of action for turning those entities around.

---

Footnotes

¹ Jim Lukenda is a managing director in Huron Consulting Group's New York office. Return to article

² FASB Board memorandum dated June 6, 2003. Return to article

³ AICPA Financial Accounting Series No.1201-100 (June 23, 2004), Proposed Statement of Financial Accounting Standards, "Fair Value Measurements," paragraph 4. Return to article