Valuation for Financial Reporting - CMA Ankur Pandey

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Statement of Financial Accounting Standards No. 157 11apply to SFAS 123R (accounting for employee stock options and other sharebasedpayments), SFAS No. 157 still includes present value techniques such asoption-pricing models, binomial models, and the multiperiod excess earningsmethod. 18 Importantly, present value techniques originally presented by the FASBin Statement of Financial Accounting Concepts No. 7 have been included in SFAS No.157 as Appendix B. This means those present value techniques are now Level AGAAP. 19 Appendix B of SFAS No. 157 discusses two methods for present valuecalculations:1. Discount rate adjustment technique, which is the traditional method whereby thedenominator incorporates all risk elements related to the single cash flow beingdiscounted2. Expected present value technique, which is a function of the probability weightedaverage of all possible cash flows discounted at a risk-free rate. There are twomethods:a. Adjusting the expected cash flows for systematic (or market) riskb. Not adjusting the expected cash flows for systematic risk, but instead includingthe risk adjustment in the discount rate 20The market approach uses prices of market transactions involving identicalor similar assets or liabilities. Remember here the fair value hierarchy: Level 1is identical assets or liabilities and Level 2 is similar assets or liabilities. Therefore,the market approach may be either a Level 1 or Level 2 determination. Further,matrix pricing is considered consistent with the market approach. This applies todebt securities that do not rely exclusively on quoted prices for the specificsecurities, but rather rely on the securities’ relationship to other benchmark quotedsecurities.Inputs: Observable and UnobservableInputs refer broadly to the assumptions that market participants would use in pricingthe asset or liability and can be of two types:Observable inputs are based on assumptions market participants would use andbe independent of the reporting entityUnobservable inputs are based on the entity’s own assumptions about the assumptionsmarket participants would use based on the best available information 21Fair value measurements require maximizing observable inputs and minimizingunobservable inputs.Active MarketThe FASB has provided the following, rather vague, definition of active market:
12 Valuation for Financial ReportingAn active market for the asset or liability is a market in which transactions for the assetor liability occur with sufficient frequency and volume to provide pricing informationon an ongoing basis. 22As stated previously, Level 1 inputs are observable market inputs that reflectquoted prices for identical assets or liabilities in active markets. 23 In explaining itsreasoning for referencing quoted market prices, the FASB cited paragraph 57 of SFASNo. 107: 24The Board concluded that quoted market prices provide the most reliable measure offair value. Quoted market prices are easy to obtain and are reliable and verifiable. Theyare used and relied upon regularly and are well understood by investors, creditors, andother users of financial information. In recent years, new markets have developed andsome existing markets have evolved from thin to active markets, thereby increasing theready availability of reliable fair value information (emphasis added).Further, the FASB affirmed:...that its intent was not to preclude adjustments to a quoted price if that price is notreadily available or representative of fair value, noting that in those situations, themarket for the particular asset or liability might not be active. To convey its intent moreclearly, the Board clarified that in those situations, the fair value of the asset or liabilityshould be measured using the quoted price, as adjusted, but within a lower level of thefair value hierarchy (emphasis added). 25While it is clear that the FASB recognizes the distinction between a thin and anactive market, it chose not to provide a clear definition of active market. While theliterature fails to provide a specific definition or objective measures for determiningwhether a market is an active market, it would seem an active market would take intoconsideration the following:1. Narrow range for bid/ask prices2. Homogeneous asset3. Significant trading volume4. Liquid (obvious, but needs to be said)5. Observable (again, obvious)6. Level of activity. A mathematically related definition would speak to bid/askspreads, volume of activity compared to total float or shares outstanding; that is,an active market could handle a certain volume with a limited impact on pricegiven a limited time frame.Whether a market is sufficiently active to satisfy the derivation of price deemed‘‘quoted price’’ will be a matter of judgment and will likely vary from reporting unit toreporting unit.SUBSEQUENT EVENTSIn an effort to obtain the most relevant price available, even if it is after the measurementdate, the FASB is allowing subsequent events to determine such price. 26
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210 IndexBusiness Enterprise Analys
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214 IndexLong-termcapital, 71debt,
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216 IndexSecurities and Exchange Co
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Valuation for Financial Reporting - CMA Ankur Pandey

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