Since the issuance of Statement of Financial Accounting Standards (SFAS) No.
157, Fair Value Measurements, last September, corporations have begun to prepare
for implementation. Additionally, SFAS 157 has led to an increased awareness of
the concept of fair value by the private equity industry.
The Private Equity Industry Guidelines Group (PEIGG) is in the process of
revising its current valuation guidelines to ensure that they are compliant with
SFAS 157. The PEIGG developed valuation guidelines in 2004 in response to the
lack of consistency in valuation methodologies used to value investments in
portfolio companies.
In accordance with SFAS 157, portfolio companies are required to be reported at
fair value, which 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.”
This definition, which focuses on exit values, e.g. the value when an asset is
sold, rather than entrance values, is new to the private equity industry. SFAS
157 has raised other concerns for the PE industry, mainly in the following
areas:
* Valuation approaches
* Fair value hierarchy
* Discounts
* Transaction costs
* Disclosures
Valuation Approaches
A mark-to-market approach is generally used to value investments. In situations
where a mark-to-market approach would not be appropriate, SFAS 157 requires that
valuation techniques consistent with the market approach, income approach and/or
cost approach should be used to estimate fair value.
Typically, venture investments are valued using last round financing. However,
PEIGG guidelines point out that after a period of time, cost or the latest round
of financing becomes less reliable as an approximation of fair value. Managers
are required to assess whether a circumstance has occurred which would require
an adjustment to the value of an investment. One example would be if market or
economic conditions have changed significantly since the time of the original
investment. Other examples are provided in the PEIGG guidelines.Fair Value
Hierarchy
SFAS 157 identifies a fair value hierarchy to rank the reliability of inputs
used in a valuation approach. The first – and highest – level refers to quoted
prices for identical securities in an active market. When those prices are not
available, the second – or middle – level will base fair value estimates on
observable inputs that a market participant would use. If observable inputs are
not available, the third – and lowest – level will require the use of
unobservable inputs.
However, the objective of fair value remains the same and thus even unobservable
inputs will need to incorporate the assumptions a market participant would use
in developing an exit price. The reporting entity’s own data may be used to
develop unobservable inputs, provided that information which shows that market
participants would use different assumptions is not readily available with undue
cost and effort.
Discounts
SFAS 157 requires that fair value of a financial instrument that trades in
active market is measured using the quoted price of the instrument (within level
1 of the fair value hierarchy). The Board states that the price should not be
adjusted by the size of the position relative to trading volume (blockage
factor). This is a change from previous practice; under the grandfather
provisions of the AICPA Audit and Accounting Guide Audits of Investment
Companies, blockage, or liquidity, discounts, were allowed.
Transaction Costs
According to SFAS 157, fair market value should not be adjusted for transaction
costs, such as commissions or due diligence costs. The statement requires that
transaction costs be expensed.
Disclosures
The FASB calls for expanded disclosure requirements under SFAS 157. The new
disclosures are meant to increase transparency for financial statement users
with regards to 1) fair value measurements at the reporting date, 2) the inputs
and assumptions used to arrive at fair value, and 3) the effect of fair value
measurements on earnings. Under SFAS 157, the level used to rank the reliability
of inputs in a valuation approach would need to be disclosed, along with the
assumptions used. The FASB encourages entities to combine fair value disclosures
under SFAS 157 with fair value information disclosed under other accounting
pronouncements, such as SFAS No. 107, Disclosures about Fair Value of Financial
Instruments, if feasible. For more information, contact your Valuation Research
representative or Tony Law at (414) 221-6217. VR
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