Fair Value Financial
The Panic of 2008
The Panic of 2008
Press coverage of losses – ostensibly “caused” by fair value
"The only thing fair-value accounting did is force you to tell
investors you made a bunch of very bad loans."
Lynn E. Turner, Former SEC Chief Accountant.
“The concept of fair value, which was intended to help bring
transparency, was scored by some as a villain, exacerbating the
turmoil, and heralded by others as a savior in revealing the
problems on a timely basis.”
Robert Hertz, chair of the FASB, 9/18
% of Assets at Fair Value
(as of FYE 2007)
Financial Markets Turmoil
• Breakdown in underwriting standards
• Erosion of market discipline in securitizations
• Flaw in credit rating agencies assessment of structured products
• Weakness in risk management practices
• Regulatory policies and disclosure practices that failed to
mitigate these weaknesses
Home Prices (Case-Schiller Index)
• What is fair value accounting?
• What are Level 1, Level 2, and Level 3 assets and liabilities?
• What do the new FAS 157 disclosures tell investors that they did
not know before?
• A few words about IFRS
• What should you look for in your client’s financial statements?
Background to FAS 157
Main Principles of FAS 157
What is fair value?
“Fair value is 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.”
• Orderly transaction: No fire sale
• Selling price, not the buying price, in the principal market
• Must consider price in the principal market even if the price is
temporarily higher in some other market
• Excludes transactions costs (which are treated separately)
• Fair value is adjusted downwards for transportation costs
• Independent and knowledgeable parties
• Able and willing, not forced to transact
• Price based on assumptions that market participants would use
• Value in highest and best use of the asset
• As part of a business combination, a buyer acquires certain assets it has
no intensions of using post-acquisition.
• However, the assets would be worth $100,000 to other market participants.
• For competitive reasons, the buyer has no intentions of selling the assets.
Under FAS 157, the buyer should record these assets at $100,000 (market
participant view) and assess for impairment on Day 2 and thereafter.
Exit vs. Entry Prices
• The price that would be received for selling an asset.
• The price that would be paid to transfer a liability.
• As part of a business combination, a buyer acquires a car.
• Could acquire the car from a dealership for $3,500.
• The car could be sold in the same market for $3,200.
Under FAS 157, the buyer should value the car at $3,200 – the exit price.
What if “Market” Prices do not
Reflect Economic Reality?
• In-active or illiquid markets
• Unusually high risk premiums
• Market quote is “indicative pricing” vs. “binding offer”
• Highest and best use
When transaction price can differ
from fair value?
• Related-party transactions
• Seller is desperate to sell the asset
• Asset or liability is bundled with other items, which are not being
• Transaction price includes transaction costs
• When the entity buys in one market (wholesale market) and
sells in another (retail market)
Level 3 Asset Exposure
(% of equity, as of FYE 2007)
Fair Value: Problems/Risks
• Consistent/appropriate valuation methods
• Using values which do not reflect market when they are
available to avoid recognizing losses
• Using values derived from inaccurate or flawed models
• Using internal pricing when external pricing is available
– use of “happy value” instead of market-based values
• Auditor/examiner bias
How should risks of fair value
accounting be managed?
• Strong controls over use of valuation methods/models and fair
value reporting, and periodic in-depth internal assessments of
• Deep and comprehensive disclosures about
– Fair value methodologies
– Assets and liabilities reported at fair value
– How valuation changes have affected financial reports
– How management expects valuation changes to affect future financial
– Clear and unambiguous discussion about the impact of fair value
• Controls over recording the results of pricing
• Controls over the accuracy of model inputs
• Controls over the models used/inputs used to price assets and
• Controls over model design and prospective and retrospective
• Oversight over the above controls
International Financial Reporting
“Allowing filing in IFRS for U.S. issuers is something we want to
accomplish this year.”
SEC Chairman Cox, 2/5/08
• Steps have been made toward the use of IFRS in the U.S.
• Elimination of U.S. GAAP reconciliation for foreign private
issuers who use IFRS as adopted by the IASB
• Concept Release allowing U.S. issuers to file under IFRS
• Canada is adopting IFRS in 2011
• Complete understanding of transaction, including terms,
economics, rights, obligations, risks and rewards
• Adequate accounting resources: knowledgeable, experienced
• Management and Audit Committee involvement
• Potentially more than one correct answer
• Financial statement transparency
Calvetti, Ferguson & Wagner, P.C.
13105 Northwest Fwy, Suite 1250
Houston, TX 77040