Remarks before the 2015 AICPA National Conference on Current SEC and PCAOB Developments
Kris Shirley, Professional Accounting Fellow, Office of the Chief Accountant
Dec. 9, 2015
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Good morning everyone. Today I would like to provide some considerations for entities regarding fair value measurement.
Identifying Principal or Most Advantageous Market
First, I would like to discuss some considerations for a company when identifying the principal or most advantageous market. In order to provide some background, let us first revisit the fair value measurement guidance outlined in ASC Topic 820 and consider what it says about the principal or most advantageous market. The guidance states that a fair value measurement assumes that the transaction to sell an asset or transfer a liability takes place either in the principal market or, in the absence of the principal market, the most advantageous market for the asset or liability. The Principal market is defined as the market with the greatest volume and level of activity for the asset or liability. The Most advantageous market is defined as the market that maximizes the amount that would be received to sell the asset or minimizes the amount that would be paid to transfer the liability, after taking into account transaction costs and transportation costs.
The fair value measurement guidance also indicates a reporting entity must have access to the principal or most advantageous market at the measurement date. If the reporting entity cannot transact in a particular market on the measurement date, then that market may not constitute the principal or most advantageous market.
Being able to transact in a market on the measurement date, I would like to point out, is something that may need to be considered even when relying on observable pricing as an input into a fair value measurement. An entity may need to consider any different characteristics associated with its asset or liability being measured at fair value and the observable pricing. Different characteristics may prevent an entity from accessing the observable market on the measurement date at the price observed within the market and may lead to a different principal or most advantageous market for fair value measurement purposes.
Some observations regarding common characteristics that may prevent an entity from accessing a particular price within a market include, but are not limited to, the following:
- a reporting entity’s need to transform the asset or liability in some way to match the asset or liability in the observable market;
- restrictions that may be unique to the reporting entity’s asset or liability that are not embedded in the asset or liability in the observable market; and
- marketability or liquidity differences between the asset or liability in the observable market relative to the reporting entity’s asset or liability.
A reporting entity may not be precluded from using observable prices from a particular market as one input into its fair value measurement (even if the market does not constitute the principal market); however, an entity may need to make appropriate adjustments to the fair value measurement for any differences in the characteristics of the asset or liability being measured and the price observed within a market. For example, an entity that is measuring the fair value of a loan may look to the securitization market when measuring the value of the loan, but would need to make appropriate adjustments to the observed securities prices to reflect the fact that the loan has not been securitized as of the measurement date.
For purposes of determining the reporting entity’s principal or most advantageous market, I would consider starting with the initial transaction. There may be situations when the market in which the initial transaction occurs is different than the principal or most advantageous market. In those situations, a reporting entity may need to consider whether it is able to access the principal or most advantageous market for the asset or liability on the measurement date.
Use of Cost Basis as Fair Value
Fair value is an exit price concept. As a result, when companies use their transaction price to measure fair value (and any variations of the transaction price, such as the transaction price including any capitalized transaction costs), they do not have a measurement at fair value. However, the transaction price may represent a good starting point for measuring fair value. I understand some entities use the initial cost basis of certain illiquid assets or liabilities (including any capitalized transaction costs) as its fair value measurement for a period of time following an initial transaction. As such, I would like to provide some thoughts when considering adjustments to an initial cost basis of an asset or liability to determine fair value.
The fair value measurement guidance specifies that the assumed transaction for an asset or liability is one that is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date under current market conditions. The reference to current market conditions at the measurement date is a key concept in measuring fair value because it is likely that a measurement date’s current market conditions differ from the market conditions when an initial investment was made.
Market conditions may evolve over time due to various factors. These factors may include changes in general macro-economic conditions, such as changes in interest rates. Other factors may include changes in the makeup of the market participants or changes in the principal or most advantageous market. In addition, there may be factors specific to the performance of the asset or liability that explains a change in fair value, such as a change in the expectation of cash flows. Even if none of the aforementioned factors exist, the fair value may differ, depending on the nature of the asset or liability, due to changes in time value from the initial transaction to the measurement date or the initial cost basis included any capitalized transaction costs. Each of these factors influences a fair value estimate and may provide evidence that the fair value of an asset or liability has changed from the initial cost basis for subsequent measurement periods.
In measuring fair value, an entity may consider incorporating observable market pricing for its asset or liability or incorporating comparable assets or liabilities with observable market prices. Specifically, an entity should support its fair value measurement assumptions that a market participant would consider in measuring fair value. An entity may employ the evidence directly into the valuation technique as an assumption or indirectly by using the evidence or changes in the evidence to support the fair value measurement conclusion. By providing the quantitative evidence, an entity may be able to better assess and support its fair value estimate as to why the initial cost basis approximates fair value or why the fair value may have changed from the initial cost basis. Certain qualitative evidence may also provide reasonable support for the fair value measurement conclusion. Nevertheless, I believe it is important for an entity to support their conclusion of fair value with reasonable support.
ICFR for Fair Value Measurements for Illiquid Assets and Liabilities
Finally, I believe it may be useful to consider a 2011 speech regarding the use of pricing service information in informing fair value measurements and disclosures and how the topics discussed may be relevant to fair value measurements for illiquid assets and liabilities. I would like to remind management that they have responsibilities for maintaining a system of internal control over financial reporting that provides reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles, which includes fair value measurements for illiquid assets or liabilities. Additionally, management has to comply with SEC requirements to assess internal control over financial reporting (or ICFR). These responsibilities exist whether a fair value measurement has been estimated by management using internal resources or by using a third-party service provider. The nature of controls may differ depending the risk of material misstatement for the asset/liability, including factors such as complexity of the estimate, whether the estimate was derived internally or by using a third-party service provider, among other factors. Management should be aware of the particular risks associated with its fair value measurement for illiquid assets or liabilities and evaluate whether it has controls placed in operation that adequately address the company’s financial reporting risks.
I hope my remarks today provide some clarification about fair value measurement. That concludes my prepared remarks. Thank you for your attention.