The Financial Accounting Standards Board has issued a proposed statement, Fair Value Measurements, which would provide guidance for how to measure fair value. The proposed statement seeks to establish a framework that would improve the consistency, comparability and reliability of fair value measurements and would apply broadly to financial and nonfinancial assets and liabilities that are measured at fair value under other authoritative accounting pronouncements. The FASB expects that the guidance provided by the proposed statement will be applied together with applicable valuation standards and generally accepted valuation practices, where appropriate. The changes to current practice resulting from the application of this proposed statement relate principally to the methods for measuring fair value and expanded disclosure requirements. In particular, the proposed statement would require:

oThe fair value of financial instruments traded in active dealer markets where bid and asked prices are more readily and regularly available than closing prices be estimated using bid prices for long positions and asked prices for short positions, except as otherwise specified for offsetting positions.

oThe fair value of restricted securities be estimated using the quoted price of an otherwise identical unrestricted security, adjusted for the effect of the restriction.

oIn the absence of quoted prices for identical or similar assets or liabilities, fair value be estimated using multiple valuation techniques consistent with the market approach, income approach and cost approach whenever the information necessary to apply those techniques is available without undue cost and effort.

oClarify and incorporate the guidance in FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, for using present value techniques to estimate fair value, thereby elevating that guidance to Level A GAAP.

oExpanded disclosures about the use of fair value to remeasure assets and liabilities recognized in the statement of financial position, including information about the fair value amounts, how those fair value amounts were determined and the effect of the remeasurements on earnings (including unrealized gains and losses).

The proposed statement would be effective for financial statements issued for fiscal years beginning after June 15, 2005, and interim periods within those fiscal years. Earlier application would be encouraged. Initial application of the statement should be as of the beginning of an entity’s fiscal year. The provisions of this proposed statement are to be applied prospectively, except for the change in accounting principle relating to bid-asked spread measurements. For that change, this proposed statement would require a retroactive transition approach applied by reporting a cumulative-effect adjustment.

Definition of Fair Value

The proposed statement defines fair value as “the price at which an asset or liability could be exchanged in a current transaction between knowledgeable, unrelated willing parties.” The objective of the measurement is to estimate the price for an asset or liability in the absence of an actual exchange transaction for that asset or liability. Thus, the estimate is determined by reference to a current hypothetical transaction between willing parties. Willing parties are presumed to be marketplace participants representing unrelated buyers and sellers that are (a) knowledgeable, having a common level of understanding about factors relevant to the asset or liability and the transaction and (b) willing and able to transact in the same market, having the legal and financial ability to do so.

Valuation Techniques

Valuation techniques consistent with the market approach, income approach and cost approach should be considered for all estimates of fair value. In the absence of quoted prices for identical or similar assets or liabilities in active markets, fair value should be estimated based on the results of multiple valuation techniques whenever the information necessary to apply those techniques is available without undue cost and effort. Key aspects of these approaches are as follows:

a.The market approach requires observable prices and other information generated by actual transactions involving identical, similar or otherwise comparable assets or liabilities. The estimate of fair value is based on the value indicated by those transactions.

b. The income approach uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present amount. The estimate of fair value is based on the value indicated by marketplace expectations about those amounts. Those valuation techniques include present value techniques and option-pricing models, such as Black-Scholes-Merton.

c. For an asset, the cost approach considers the amount that currently would be required to replace its service capacity (that is, current replacement cost). The estimate of fair value considers the cost to acquire a substitute asset of comparable utility, adjusted for obsolescence.

Valuation techniques used to estimate fair value should be consistently applied. A change in the valuation technique used is appropriate only if the change results in a more reliable estimate of fair value, for example, as new markets develop or as new and improved valuation techniques become available.

Market Inputs

Market inputs are the assumptions and data that marketplace participants would use in their estimates of fair value. Valuation techniques used to estimate fair value should emphasize market inputs, including those derived from active markets, whether using the market approach, income approach or cost approach. In an active market, such as the New York Stock Exchange, quoted prices that represent actual transactions are readily and regularly available; readily available means that pricing information is currently accessible and regularly available means that transactions occur with sufficient frequency to provide information on an ongoing basis. In determining whether a market is active, the emphasis is on the level of activity for a particular asset or liability.

Market inputs should be determined based on information that is timely, originated from sources independent of the entity and used by marketplace participants in making pricing decisions. Examples of market inputs that may be used, directly or indirectly as a basis for deriving other relevant inputs, include the following:

a.Quoted prices (completed transactions, bid/asked or rates), adjusted as appropriate. The fair value hierarchy specifies whether adjustments to those prices are appropriate, and if so, when.

b.Information about interest rates, yield curve, volatility, prepayment speeds, default rates, loss severity, credit risk, liquidity and foreign exchange rates.

c.Specific and broad credit data and other relevant statistics (industry and other), including a current published index.

Fair Value Hierarchy

The proposed statement establishes a hierarchy that groups into three broad categories (levels) the inputs that should be used for all estimates of fair value, considering the relative reliability of the resulting estimates. In general, the more market inputs, the more reliable the estimate. Accordingly, the fair value hierarchy gives the highest priority to market inputs that reflect quoted prices in active markets and the lowest priority to entity inputs that reflect an entity’s own internal estimates and assumptions.

Level 1 Estimates. Level 1 requires the use of quoted prices for identical assets or liabilities in active reference markets whenever that information is available. The reference market is the active market to which an entity has immediate access (in many cases, the principal trading market) or, if the entity has immediate access to multiple markets with different prices, the most advantageous market. Quoted prices used for a Level 1 estimate should not be adjusted. For a Level 1 estimate, a quoted price in an active market represents the sole market input.

The AICPA Audit and Accounting Guide for Investment Companies permits fair value to be estimated using blockage factors (adjustments to quoted prices) in limited (and then only if the policy existed prior to May of 2000) circumstances for large positions of unrestricted securities with quoted prices in active markets, based on an assessment of various factors, including the size of the positions held and the liquidity of

the market. The proposed statement does not change that existing guidance.

Level 2 Estimates. If quoted prices for identical assets or liabilities in active markets are not available, Level 2 requires that fair value be estimated using quoted prices for similar assets or liabilities in active markets, adjusted as appropriate for differences, whenever that information is available. For a Level 2 estimate, the price effect of the differences must be objectively determinable, otherwise the estimate is a Level 3 estimate.

Level 3 Estimates. If quoted prices for identical or similar assets or liabilities in active markets are not available, or if differences between similar assets or liabilities are not objectively determinable, Level 3 requires that fair value be estimated using multiple valuation techniques consistent with the market approach, income approach and cost approach whenever the information necessary to apply those techniques is available without undue cost and effort. Level 3 estimates rely on the results of other valuation techniques (pricing models and methodologies) and require judgment in the selection and application of valuation techniques and relevant inputs. They are more subjective than Level 1 and Level 2 estimates. The FASB concluded that because different valuation techniques tend to provide independent indications of fair value, an estimate based on the results of multiple valuation techniques is likely to be more reliable than an estimate based on the results of a single valuation technique. If multiple valuation techniques are used, the results of those techniques should be evaluated, considering the relevance and reliability of the inputs used. If information necessary to apply multiple valuation techniques is not available without undue cost and effort, the valuation technique that best approximates what an exchange price would be in the circumstances should be used.

Bid-Asked Spread Measurements

In active dealer markets, bid and asked prices generally are more readily and regularly available than closing prices. In a dealer market, multiple identical exchange units are traded. Over-the-counter markets (where prices are publicly reported by the National Association of Securities Dealers Automated Quotations systems or by the National Quotation Bureau) are dealer markets. The market for U.S. Treasury securities is a dealer market. Dealer markets also exist for financial instruments and commodities.

Current accounting guidance allows flexibility for investment funds in selecting the method to estimate fair value within a bid-asked spread, provided that the method is consistently applied. As a result, there is diversity in practice among investment funds in the methods used to develop those estimates. Methods generally considered appropriate include (a) bid prices for long positions and asked prices for short positions, (b) average prices, determined using bid prices, bid and asked prices (mid-point price) and, for securities traded over the counter, a representative selection of broker-dealer quotes for a particular security and (c) valuation within the bid-asked spread considered best to represent value in the circumstances. In the proposed statement the FASB decided to require bid prices for long positions and asked prices for short positions but only for Level 1 estimates. In less active markets, the FASB decided that other methods within the bid-asked spread should be considered (similar to other Level 3 estimates).

For offsetting risk positions, entities could use mid-market prices to determine fair value, and thus, may apply the bid or asking price to the net open position, as appropriate. The FASB believes that when an entity has offsetting risk positions, using the mid-market price is appropriate because the entity (a) has locked in its cash flows from the asset and liability and (b) potentially could sell the matched position without incurring the bid-ask spread.

Restricted Securities

Restricted securities often are purchased at a discount from the quoted price of otherwise identical unrestricted securities, reflecting the lack of liquidity relating to the inability to access that market for the specified period. In estimating the fair value of restricted securities, the quoted price of an otherwise identical unrestricted security should be adjusted for the effect of the restriction, considering factors such as the nature and duration of the restriction, the volatility of the unrestricted security and the risk-free interest rate. The proposed statement includes general guidance for determining the discount amount that incorporates the relevant guidance in SEC ASR No. 113, Statement Regarding “Restricted Securities.”

The proposed statement requires disclosures about the use of fair value to remeasure asset and liabilities recognized in the statement of financial position. The disclosures apply to assets and liabilities that are remeasured at fair value during the period, whether on a recurring or nonrecurring basis. These disclosures would include, in one place, the similar disclosures required under other pronouncements.

Stuart Cohen is a principal in Ernst & Young’s Global Hedge Fund Practice, based in New York.

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.