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Thursday, September 22, 2011

“Fair Value” in a Troubled Economy


There’s no question that the struggling economy has had a negative impact on the value of many businesses and investments. But it also influences the business valuation process itself. Because economic conditions may affect the relative reliability of certain valuation methods and approaches, it’s important for you to discuss the potential implications with your valuation experts. In particular, the troubled economy has caused a recent accounting rule change — governing how “fair value” should be measured — to garner a lot of attention.

Fairness Doctrine
Recently, Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 157 took effect. The statement, Fair Value Measurements, provides guidance on measuring fair value for purposes of several accounting standards. SFAS 157 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” The underlying measurement objective, according to the FASB, is “generally consistent with similar definitions of fair market value for valuation purposes.”

In an effort to promote more accurate and consistent valuations, the statement establishes a “fair value hierarchy” that emphasizes market-based valuation methods. In valuing an entity under SFAS 157, a valuator should:

  1. Give top priority to Level 1 inputs — quoted prices in active markets for identical assets or liabilities;
  2. Give next priority, when Level 1 inputs aren’t available, to Level 2 inputs — quoted prices in active markets for similar assets or liabilities, or other “observable” inputs; and
  3. Give lowest priority to Level 3 inputs — unobservable inputs, such as the reporting entity’s own data.

This approach to fair value measurement has created much controversy in recent months. Critics argue that, in the current economic climate, focusing on market prices requires an entity to value its assets at “fire-sale” prices even if it has no plans to dispose of them.

Market Prices Not Always a Reliable Measure
Regardless of the merits of SFAS 157, the courts, as well as regulators, recognize that the current economic turmoil may require some adjustment to the usual valuation methods. Last fall, for example, the FASB and the SEC issued a joint statement advising companies that they can use internal assumptions, such as expected cash flows and appropriately risk-adjusted discount rates, to value securities when relevant market data is unavailable. Later, the FASB published FASB Staff Position (FSP) 157-3 to provide “guidance on how to determine the fair value of financial assets when the market for that asset is not active.”

The FSP explains that, in times of “market dislocation,” valuators shouldn’t automatically assume that market prices are determinative of fair value. Rather, valuations “may require the use of significant judgment about whether individual transactions are forced liquidations or distressed sales.”

Case in Point
In ASARCO v. Americas Mining Corp., the U.S. District Court for the Southern District of Texas found that market prices are sometimes unreliable. The case involved a claim by a Chapter 11 debtor that its parent corporation’s purchase of the debtor’s controlling interest in a Peruvian mining company was a fraudulent transfer.

The court addressed a number of issues regarding the valuation of the debtor’s mining company stock. Although the parent company’s expert believed that the best evidence of value was the stock’s price on the day of the sale, the court observed that market price isn’t always the best indicator of value.

In this case, even though the shares were traded on the New York Stock Exchange, its low trading volume and other factors overcame the usual presumption of market efficiency. The court concluded that, under these circumstances, a discounted cash-flow analysis was the most reliable method of valuing the stock.

What Would a Buyer Do?
The principles discussed above aren’t new. For years, the widely accepted definition of “fair market value” has been “the price at which property would change hands between a willing buyer and a willing seller when neither is compelled to buy or sell, and both have reasonable knowledge of the relevant facts.”

It’s reasonable to assume that a prospective buyer would consider the economy and other factors that affect the reliability of market prices in valuing a business. Similarly, valuators should consider these factors in determining the most appropriate valuation methods.

By shifting the emphasis — in some cases — from more objective, market-based approaches to more subjective, company-specific ones, it becomes evident that the economic downturn is having a significant impact on the business valuation process.

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