Fair Value Definition

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Fair Value Definition

• 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
• Price in hypothetical transaction to sell an
  asset or transfer a liability (exit price)
• NOT price in actual transaction to acquire an
  asset or assume a liability (entry price)
• NOT adjusted for transaction costs

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Fair Value Approach
THE ASSET OR LIABILITY
Unit of Account
Highest and Best Use
Valuation Premise
Exit Market
Market Participant Assumptions
Inputs to Valuation Techniques
Attribute Value to Asset or Liability at Unit of
Account Level
Indicated Value Unit of Valuation
Fair Value Measurement
F/S Presentation and Disclosure
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FAS 157 Valuation Terms in Accounting Literature

• Highest and best use
• Valuation premise
• In use
• In exchange
• Cost, Market and Income Approaches

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FAS 157 Application Issues

• Separation of unit of account and unit of
  valuation
• Interplay within conceptual framework
• Exit markets
• Highest and best use
• Valuation premise
• Market participant type
• Increased rigor and documentation around
  selection of market participant types
• Specific applications
• Selection of market participants
• Abandonment
• Defensive value

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Unit of Valuation

• The unit of valuation depends on the highest and
  best use of the asset, which establishes the
  valuation premise used to measure the fair value
  of the asset

Highest and Best Use
Valuation Premise
Use by market participants that maximizes value
of asset (or asset group)
In-use or in-exchange
Exit Market
Market Participant Assumptions
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FAS 157 - Examples
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Example 1Asset Group

• Entity acquires assets that are used together as
  a group (Assets A, B, C)
• Unit of account is each individual asset
• Unit of valuation is the group of assets within
  which the assets would be used by market
  participants (highest and best use is in-use)
• Exit market is the acquisition market therefore,
  market participants are other bidders for the
  assets (strategic and financial buyers)
• Strategic buyers have related assets that would
  enhance the value of the assets as a group,
  including a replacement asset for Asset C
  (billing software) financial buyers do not

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Example 1 Asset Group (contd)

• Indicated Fair
  Value
• Strategic Financial
• Buyer Buyer
• Assets Group Group
• A 360 300
• B 260 200
• C 30 100
• Total 650 600
• Fair values of Assets A, B, C determined based on
  use within strategic buyer group because that use
  would maximize the fair value of Assets A, B, C
  as a group need not maximize the fair value of
  each asset individually (e.g. Asset C)

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Example 3 IPRD

• Entity acquires IPRD project
• Highest and best use/valuation premise
• In-use if IPRD project would provide maximum
  value to market participants through its use
  together with other assets as a group use
  encompasses use as a completed project or as a
  locked-up project (to provide defensive value)
• In-exchange if IPRD project would provide
  maximum value to market participants through its
  non use (discontinue development)

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Example 7Interest Rate Swap

• Entity B (securities dealer) enters into interest
  rate swap with Entity A (retail counterparty) in
  retail market for no initial consideration (TP
  0)
• Entity B would transfer its rights and
  obligations under the swap to a securities dealer
  counterparty in the inter-dealer market, not a
  retail counterparty in the retail market
• At initial recognition, the transaction price
  (entry price) might NOT represent fair value of
  the swap (exit price)
• FAS 157 nullifies F/N 3 to EITF Issue 02-3

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Example 8Restricted Asset

• Security
• Legal restriction on sale for specified period
• Restriction is specific to the asset and,
  therefore, would transfer to a market participant
  (buyer)
• Fair value measurement would consider effect of
  restriction, even if restriction terminates
  within one year
• FAS 157 applies for restricted securities
  measured at fair value under FAS 115 and FAS 124

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Example 10Liabilities

• Entity A (investment bank with AA credit rating)
  issues 5-yr fixed rate note to Entity B
• Fair value measurement considers
• Nonperformance risk, including credit risk
• Changes in credit spreads generally, even if no
  changes in specific credit risk
• Changes in specific credit risk, even if within
  the AA spread