Fair Value – Inactive Markets and Orderly Transactions

Recently issued “guidance” provides that when determining the fair value of certain assets (liabilities) it is only appropriate to use comparable transactions that were not fire (liquidation) sales where an active market exists.    The recent guidance (pre codification FSP FAS 157-4, codification 820-10-65-65-4), effective for interim and annual periods ending after June 15, 2009, simply provides additional items to consider for adding additional premiums or discounts when developing fair value estimates.

Further, the new guidance continues to reiterate the fair value definition that has been around for several decades, “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.”  Remember, the Company’s intent or ability to hold an asset should not be used in determining fair value as the estimate is market based and not entity specific.

In developing estimates, several factors provide an indication that significant adjustments to fair value (in this case quoted market prices – Level 1 inputs) may be necessary when market activity does not appear to be normal.  Some of those factors include:

  • Declines in recent transactions
  • Price quotations are stale or vary substantially, including significant bid-ask spreads
  • Indexes no longer correlate to values of individual assets or liabilities

After analyzing the market activity in general, the next step is to perform additional analysis to determine the transactions were not forced liquidations or distressed sales.  Factors to consider when a transaction may constitute a distressed sale include:

  • A recent transaction that appears to be an outlier compared to other recent transactions
  • Signs indicate the seller is experiencing significant financial difficulty, e.g. at or near bankruptcy
  • The asset (liability) was not marketed for an appropriate period or to multiple buyers

Three outcomes exist when analyzing transactions to determine if they fall within the fair value definition and require inclusion in estimates.  First, if the transaction is not orderly, it would likely hold little weight in estimating fair value.  Second, if the transaction is orderly, see above market activity analysis when determining how to include in fair value estimates including risk premiums.  Finally, there may not be enough information available to conclude whether the transaction is orderly, in which case, it should still be considered, but not the sole indicator of fair value.

The guidance recognizes that issuers need not undertake undue cost and effort in making these market determinations, but should not ignore information that may be readily available in the public domain.  Further, the degree of difficulty and subjectivity in developing risk premiums does not provide a sufficient basis to exclude risk adjustments to fair value.

At this point, you may be asking yourself – where does one obtain all of this information?  That is a very good question and I am out of time…anyone, anyone, anyone?.!