Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements, an accounting rule requiring companies to reflect an asset or a liability’s current market value on their balance sheets, has faced significant scrutiny. In normal times, fair value is by far the most relevant measure to reflect what an asset is really worth vs. simply reflecting historical cost.
But these are not normal times.
As the markets seized and we faced a financial crisis of historical proportions, there were some calls that SFAS 157 should be repealed. The argument is that institutions, especially financial institutions carrying bad mortgages, were being forced to mark down assets to prices that didn’t reflect their true value and that these mark downs were exasperating the problem.
On Sept. 30, the U.S. Securities and Exchange Commission provided important clarification for companies struggling with fair value under SFAS 157. We believe the SEC acted prudently to uphold fair value and provide further guidance.
The SEC’s fair value guidance is balanced and appropriate. They suggest that in an active, orderly market, the most relevant indication is the transaction price. When the market is inactive or disorderly, management expectations of future cash flows should be considered. Also, the SEC indicated that sometimes unobservable inputs may be more appropriate than observable inputs. For example, the observable value of similar instruments could grossly underestimate the intrinsic fair value of a security or asset. Other valuation methods, such as a company’s model of the value of an asset, may be more meaningful.
Recent arguments for the abandonment of mark-to-market (“MTM”) principles, in our opinion, would be unfortunate. MTM accounting has increased transparency and exposed inaccurate accounting practices. MTM did not cause the financial crisis, it helped identify and, in a sense, measure it.
Realistically, we recognize that the strict rules requiring utilization of market prices from inactive and disorderly markets could have an effect of underestimating the true value of assets and in essence, a company’s capital reserve. On an individual basis, this is problematic. On a macro basis, as we’ve seen recently, this has been extremely challenging. However, the SEC’s guidance provides some leeway allowing for more realistic valuation of assets.
Jeffrey Trader is senior vice president in the Milwaukee office of Valuation Research Corporation (VRC), which provides valuation services public and private firms for financial reporting, mergers and acquisitions.