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Speech by SEC Staff:
Remarks before the 2008 AICPA National Conference on Current SEC and PCAOB Developments


Muneera Carr

Professional Accounting Fellow, Office of the Chief Accountant
U.S. Securities and Exchange Commission

Washington, D.C.
December 8, 2008

As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the SEC staff.


Warren Buffett was quoted saying, “Price is what you pay. Value is what you get”.1 While many of you may agree with this notion, others may agree with Charles Dudley Warner who said, “There is no such thing as absolute value in this world. You can only estimate what a thing is worth to you.”2 These two very interesting perspectives provide a context for the topic of fair value accounting on which I would like to share my perspectives.

Fair Value Accounting

While the use of fair value as a measurement attribute in accounting is not a new concept, the application of Statement 1573 and the current market turmoil has magnified implementation challenges especially for instruments that trade in markets that have become less active or markets that are no longer active. To provide timely assistance, the staff in the Office of the Chief Accountant worked together with the FASB staff to issue a joint press release which provided clarifying guidance on fair value measurements in the current market environment.4 After this guidance was issued, we heard comments including press reports that suggested that some viewed the guidance as a clarification and others viewed it as an amendment of Statement 157. In my remarks, I’d like to provide some additional perspective on the guidance that was issued.

I would like to lead off with a few comments related to fair value that I believe most people would agree with, regardless of your views on the role of fair value in financial reporting. First, I believe that most people will agree that a fair value measure is generally an estimate. Webster’s dictionary defines estimate as ‘a rough or approximate calculation’. As accountants dealing in numbers, we are accustomed to a sense of preciseness. Though a fair value estimate is based on analysis of numerical data, it is generally understood that there is often not one exact number that definitively represents “the fair value”. Second, I believe that most can agree on the need for judgment in the process of determining and auditing fair value measurements. The word ‘judgment’ is mentioned about a dozen times in Statement 157. Lastly, most everyone will also agree that Statement 157 is clear that in an active market, the quoted price is the most reliable evidence of fair value (with limited exceptions).5 However, in many cases the challenge lies in the determination of what constitutes the best evidence of fair value when a market is not active. Further, there are those who struggle with whether fair value is the appropriate measurement attribute or believe that a different definition of fair value may be more appropriate in those circumstances.

With that as a background, I would like to provide some thoughts on the question of what is the best evidence of fair value when a market is not active. Specifically, the three areas that I would like to discuss are (1) whether unobservable inputs may be more appropriate than observable inputs in certain circumstances (2) considerations on orderly transactions and market participants in markets that are not active and (3) the use of pricing services and broker quotes. However before I do, given the passionate views on the topic of fair value, I feel compelled to add a personal disclaimer in addition to the one already provided that the views I present on the topic of fair value accounting do not indicate my support, rejection, endorsement or opposition of the use of fair value and its current definition.

Statement 157 provides several principles that should be followed including:

  • Estimates of fair values should maximize observable inputs and minimize unobservable ones.6

  • An orderly transaction is a transaction that assumes exposure to the market for a period that is usual and customary and is not a forced liquidation or distressed sale.7

However, Statement 157 does not indicate that these ‘principles’ should stand in the way of sound judgment. That is, Statement 157 does not require the sole consideration of observable inputs applied in the extreme such that any observable price for identical or similar assets regardless of its relevance or the number of adjustments needed is considered to be superior to a valuation based on management’s internally generated estimates using assumptions that willing market participants would use in an orderly transaction. Some may hold the view that any observable price is more relevant than an estimate of value determined using a valuation technique in part because observable information is often more verifiable. The perceived need for verifiability may result in an over emphasis of the principle of maximizing observable inputs while placing less emphasis on the principle that fair value represents an estimate of a orderly transaction between willing market participants. I will discuss some thoughts on willing market participants later in my remarks.

Paragraph 26 of Statement 157 states that there may be situations in which even quoted prices in active markets may not represent fair value. An entity is not required to use quoted market prices if such prices are not current, relevant, available without undue cost and effort, or require significant adjustments. Said differently, in some circumstances, an observable trade or quoted price may not necessarily provide the sole basis for a reasonable estimate of fair value. Accordingly, the clarifying guidance indicated that in some circumstances, a valuation model based on estimates of assumptions of willing market participants may be more appropriate than a measurement that starts with observable data, but then may require significant adjustment to develop the best estimate of fair value.

Paragraph 19 of Statement 157 states that in determining fair value, companies should use valuation techniques that are appropriate and for which data is available. It discusses that in some circumstances, the determination of fair value may consider multiple valuation techniques with results that have to be evaluated and weighed. The objective of determining fair value measurements remains the same even in a less active market, but the techniques applied may have to be changed when the measurement technique previously applied by management is not available or representative of fair value.8 With respect to the use of valuation techniques, Statement 157 does not state that an income approach may be used only when data necessary to use a market approach is unavailable9. Ultimately, the purpose for evaluating all the information available and considering the use of an appropriate technique is to determine a fair value that is the best estimate of the price and not to obtain the highest price for an asset.

In developing an internal estimate of the assumptions market participants would use, management should include considerations of the factors willing market participants would include in estimating the fair value of an asset. Such factors could include liquidity, uncertainty and nonperformance risk adjustments resulting from current market conditions. The definition of fair value in Statement 157 is based on a hypothetical ‘exit notion’ regardless of whether a company plans to transact at current market prices. Therefore, the recent guidance may be viewed as a relief by those who believed that they had to use observable prices without the ability to use their judgment in considering the relevance of other inputs. However this guidance does not differ from the underlying objective of developing a best estimate of fair value as defined in Statement 157 and thus does not permit companies to use alternative measures that some describe as ‘fundamental, intrinsic or economic value’ based on a long-term view of their intent to hold a particular asset.

The Statement 157 definition of fair value contemplates a hypothetical transaction that is both orderly and conducted between willing market participants. An orderly transaction is one where the asset or liability is marketed to potential buyers for a period that is usual and customary.10 In any environment but especially in the current one, transactions may result in pricing that potential sellers may not view as “favorable”. Unfavorable pricing or reduced liquidity do not constitute, in and of themselves, a distressed sale or a forced liquidation under Statement 157 if the asset can be sold in a period that is usual and customary. Reduced transaction volume and wide bid-ask spreads may be helpful indicators in understanding whether market participants are willing to transact for the asset. However, judgment should be exercised to determine whether buyers and sellers in orderly transactions are those who are motivated but not forced to transact and therefore can be considered ‘willing market participants’. Said differently, while Statement 157’s definition of fair value is based on an orderly transaction, it also states that such transactions should be between market participants11 and market participants are defined as both buyers and sellers willing to transact for an asset or liability because they are motivated rather than because they are forced to do so.12

Management is ultimately responsible for the fair value measurements reported in the financial statements. Prices obtained from both brokers and pricing services can provide useful inputs into management’s fair value analysis. In applying the principle of maximizing observable inputs, some may have perceived that there is a requirement in Statement 157 to use such services. While the guidance in Statement 157 provides examples of inputs which might be considered observable and lists brokered markets or pricing services among such inputs13, there is no requirement to use broker quotes in Statement 157. However, if such a quote is used as evidence of fair value, then before relying on those prices, management should understand how the prices were determined, the source of information and the valuation methodology, binding or non-binding nature of the quote etc. Companies and auditors should guard against placing undue reliance on such quotes solely because they consider the source of the information to be a third party.

Determining the fair value of assets that trade in markets that are not active requires an understanding of the nature and characteristics of the asset, the markets in which the assets trade and the relevance of observed market information for such assets. When markets are not active, such an analysis may lead different people to reach different conclusions on the best estimate of fair value. The use of reasonable judgment and diligence based on an objective analysis in deriving such estimates cannot be over-emphasized. While many may prefer to see detailed examples demonstrating the application of judgment, such examples could be of limited use as the facts and circumstances of each situation vary, and hence my remarks have focused on following and balancing the principles of Statement 157. Finally, given the significant amount of judgment required in this area, companies should provide transparent disclosure that enables users to understand the judgments made by management in arriving at the fair value estimates contained in the financial statements.




Modified: 12/08/2008