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FAS 157 - Fair Value Measurements Adopted by the FASB - Part 1 of 2

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP


Red Alert for Buyout and Venture Funds: Fair Value Measurements Adopted by the Financial Accounting Standards Board on September 2006 ("FAS 157")

FAS 157 requires that fair values be based on the perspective of a "market participant." Consideration of the market participant's viewpoint in fair value estimates is not new; the use of market-participant assumptions is mandated in Statements 141, 142, and 144. For example, when determining fair value in the context of an impairment, both Statements 142 and 144 provide for the use of market participant assumptions when that information is "available without undue cost and effort." Otherwise, an entity's own assumptions may be used.

Question: How complex is the Statement, with particular reference to private companies in the portfolio of buyout and venture funds? Does it simply repeat the ancient maxim... "fair value is determined by the board of directors, taking into account all the facts and circumstances"?

Answer: The Statement is highly complex. Thus, while the Statement itself is 15 pages long, the entire document, including five Appendices (counting the summary), is over 150 pages. Perhaps the most extraordinary is Appendix D in terms of complexity, which lists APB and FASB pronouncements existing as of the date of the Statement and which refer to fair value.

Question: How many pronouncements are listed in Appendix D?

Answer: 68. Appendix D goes on to say that, "those pronouncements [of the 68] that are amended by this Statement are indicated by an asterisk."

Question: How many such pronouncements are "amended" by this Statement?

Answer: 28.

Question: Are the amendments indicated in the Appendices?

Answer: Yes, in Appendix E. The amendments make up 52 pages.

Question: Is the rationale behind the amendments such that one can derive lessons from the same? Does the elimination of certain language and substitution of an alternative shed light on the meaning of FAS 157, having in turn the potential to clear up ambiguities?

Answer: Unclear. Take, for example, Amendment to FASB Statement No. 13, Para. 5C, which defines the term, "Fair value of the leased property." It strikes the following language:

“The price for which the property could be sold in an arm’s length transaction between unrelated parties.”

and substitutes the following language:

"The price that would be received to sell the property in an orderly transaction between market participants at the measurement date. Market participants are buyers and sellers that are independent of the reporting entity, that is, they are not related parties at the measurement date."

Question: What's the difference between the two definitions?

Answer: Who knows?

Question:  Do you have to go to extraordinary lengths to establish fair value … spend big bucks?

Answer: Yes. See Para. 86 of Appendix C.

C86. In this Statement, the Board clarified that the reporting entity need not undertake all possible efforts to obtain information about the assumptions that market participants would use in pricing the asset or liability or otherwise establish the absence of contrary data indicating that market participants would use different assumptions. However, the reporting entity must not ignore information about market participant assumptions that is available within reasonable cost-benefit constraints." (Emphasis added.)

In my cynical view, “reasonable” is just this side of “all possible efforts.”

Question: If there are other accounting pronouncements pertaining to the metrics of establishing fair value, need the reporting entity refer to and/or take into account different paths to their value and what those different paths would come up with, distinct from the FAS 157-driven calculation?

Answer: FAS 157 waffles on this issue, which obviously makes the laymen, if not the expert, nervous when things go wrong, e.g: With the help of 20/20 hindsight, plaintiffs' counsel will allege that Fair Value would have been better calculated if the reporting entity had canvassed the entire 68 pronouncements on Fair Value referred to in FAS 157, plus all the other guides out there... the PEIGG, for example.

Thus, the Statement indicates:

"35. The reporting entity is encouraged but not required, to combine the fair value information disclosed under this Statement with the fair value information disclosed under other accounting pronouncements (for example, FASB Statement No. 107, Disclosure about Fair Value of Financial Instruments) in the periods in which those disclosures are required, if practicable. The reporting entity also is encouraged, but not required, to disclose information about other similar measurements (for example, inventories measured at market value under ARB 43, Chapter 4), if practicable." (Emphasis added.)

Query: Can a clever complainant turn the failure to respond to "encouragement," into tortious conduct?

Question: Is the trick for the reporting entity to find the appropriate valuation methodology and stick with it?

Answer: Not necessarily. Implementation Guidance is contained in Appendix A. In Para. 13, the Guidance states that:

"In some cases, a single valuation technique will be appropriate. In other cases, multiple valuation techniques will be appropriate. If multiple valuation techniques are used, the reporting entity should evaluate the results (respective indications of fair value), considering the reasonableness of the range indicated by those results. The fair value measurement is the point within that range that is most representative of fair value in the circumstances."

Question: Historically, private equity and venture funds have carried portfolio positions at the lower cost or "market," "market" meaning a write down in case the company is running on the rocks... an event which is often objectively observable because Newco is not meeting plan, projections are in the dumpster, the founder/CEO has been fired, etc. Write ups are infrequent because, absent a liquidity event or a financing at a valuation which is established by non-insiders, it is very hard to cut through internal optimism and establish realistic upticks. Is that practice still acceptable?

Answer: No. The idea of holding a portfolio position at cost for any period of time is no longer an acceptable practice. Thus, in Appendix A, the Statement is made:

"This Statement clarifies that in many cases the transaction price, that is, the price paid (received) for a particular asset (liability), will represent the fair value of that asset (liability) at initial recognition, but not presumptively." (Emphasis added.)

Question: Is cost not even presumed to represent fair value? In other words, can the reporting entity simply say that: "the best judgment of board of directors on fair value of portfolio company x is $[____], taking into account all the facts and circumstances" ... and leave it at that?

Answer: Apparently not. Thus, the Guidelines state:

"Qualitative (narrative) disclosures about the valuation techniques used to measure fair value are required in all annual periods."

Question: Does the Statement, including the Guidelines, indicate what kind of narrative disclosures are required?

Answer: No. At least not for what the Statement and Guidelines refer to as "venture capital investments." The thrust of the entire statement, if measured by the number of words used and descriptive phrases deployed, is focused on positions for which some market, perhaps more than one market, exists. Obviously, in view of the recent events there is extraordinary pressure to come up with methodologies which fairly value structured finance products and derivatives. Failures accurately and transparently to value such items have disrupted credit markets around the world. Thus, in the Guidelines, Para. 25, talking about Level 3 Inputs which are "unobservable," there are five examples given, three of which being: long-dated currency swaps; three year options on exchange - traded shares; and interest rate swaps.  With respect to all others, the Guidelines suggest finding the present value of discounted cash flows based on the reporting entity's (i) own data or (ii) forecasts.

Question: If it is not practicable to measure fair value of a portfolio company, is it acceptable to say so?

Answer: It does not appear to be likely that the auditing firm will issue its certificate if the reporting entity has thrown up its hands on a material asset in its portfolio. See Para. 22 in Appendix C, Background Information and Basis for Conclusions.

Question: The Statement uses the term "exit price" throughout. This is deliberate, as I understand it.

Answer: Yes. Quite clearly, in the buyout and venture fund context, this means the price (based on whatever methodologies are used) the fund would receive (not taking transaction costs into account) were it to sell its position to a willing buyer.

Question: What happened to the old rules of thumb... lower of cost or market? That is clearly conservative, and thus, should avoid controversy, should it not?

Answer: The notion of staying on the right side of the line by being conservative... i.e. carrying a portfolio company's securities at cost even though there is evidence that the business is on plan... is no longer acceptable. Indeed, no rules of thumb can be deemed controlling. The thought, up until FAS 157, was that you could not go wrong if you carried your investments at the lower of cost or a marked down value if, in the latter case, there was objective evidence that things were not on plan. Who could complain if the recording entity was ultra conservative? That notion is now out the window. You have to mark up as well as mark down. If you don't, you will not get the accountants' certificate.


Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com

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Look for part 2 of this article in the next Buzz.

To read the entire article, please go to 10.15.7 FAS 157 Fair Value of Portfolio Companies of the Encyclopedia of Private Equity and Venture Capital.