Fair value not to blame for current crisis

“It’s a myth that numbers in any form can replace judgment,” said Jack Friedman, Chairman of Directors Roundtable, at its sold-out conference on fair value in New York City last week.  “It’s also a myth that auditors or lawyers [or their appraisers] can guarantee others’ good and bad judgments.”  The debate over fair value—its reliability and usefulness compared to historical cost-accounting—rages on, according to all of the Roundtable speakers, especially as market analysts try to pinpoint the cause (and cure) of the current economic turmoil.  But the two sides are not all that far apart, said Robert Herz, current FASB Chair (whose opinions were not necessarily those of the FASB.  “They are, however, the opinions of the chairman of FASB,” he joked).  “There are a lot more judgments buried in the cost-based income statements and balance sheets of your traditional tangible goods company than most CFOs would care to admit,” he said.  Neither cost accounting nor mark-to-market elections entirely eliminate the assumptions that can broadly alter the information that financial statements and their disclosures provide.  

What everyone agreed on: Fair value accounting is not to blame for the current crisis.  Herz doesn’t even blame quality of the assets; he believed mortgage-backed securities were problematic before valuation concerns stopped active trading.  “You have complex securitizations creating synthetic and magnified exposures related to the same loans,” he said.  “In difficult market conditions, accounting judgments can be challenging but reported results must reflect what is happening in the market.  This is not about fair value accounting,” he repeated. 

Fair value could have mitigated the mess?  The same theme was heard at last week’s “Fair Value Media Roundtable” sponsored by the CFA Institute Centre for Market Integrity, also in New York.  “It’s clear we’ve got ourselves a serious problem,” said Jeffrey Diermeier, CFA’s President and CEO, in his opening remarks.  “But the problem is not fair value.”  In fact, fair value in the current environment has been “more helpful than hurtful,” he says.  The accounting standards introduced “a high dose of realism,” and “if we’d had more transparent disclosures using fair value for financial reporting, we wouldn’t be in the depths of the mess we’re currently in.”  A full write-up of the discussion will be in the next (May 2008) issue of the Business Valuation Update™.

Too much talk of fair value?

“I have always looked forward to reading the BVWire™ and consider it a ‘must-read,’” writes Charles Schreiber Jr. (Walnut Creek, CA).  But according to one of the ‘Wire’s earliest reader polls (see issue # 49-2), just over half (51%) of respondents dealt on a daily basis with companies with sales between $1 million and $5 million.  “The BVWire that once had a great deal of practical information seems to have been redirected to FASB and international accounting standards,” Schreiber says.  “Those of us dealing with companies under $5 million may find [this] interesting from an academic prospective but useless from a practical prospective.”  BVWire should reevaluate its content, he suggests, to align more closely with the needs of its audience. 

We agree: Our mission has always been to provide timely news, information, events, and practical advice to BV professionals and those whom business valuation impacts, including members of the legal, financial, corporate, and investment communities.  Please take just a few moments to answer our latest survey about the content you’d most like to see in the weekly BVWire.

To include (or not include) a negative control premium

When using the Mergerstat®/BVR Control Premium Study™, not quite half (40%) of BV respondents to a recent poll use the negative premiums in their analysis.  Only 17% exclude the negatives entirely, however.  Nearly a quarter (21%) of those who use the negative control premium cite the mean, while the clear majority (66%) use the median.  “This is the crux of the issue when using the database,” comments Adam Manson, BVResources Financial Analyst, who also participated in the recent BVR/NACVA webinar on “Getting the Most from the Mergerstat/BVR Control Premium Study,” with Shannon Pratt, Alina Niculita, and Rob Stutz.  “This is not a topic you want to avoid,” Manson says.  “The practitioner needs to have an opinion.”

“We like to include the negative premiums in the analysis,” offers Niculita, in response to our request for additional comment.  “Since the inception of the Mergerstat data, about 15% of companies were taken over at a discount over the public trading price.  Because the negative premiums are part of the dataset, they need to be taken into account.”  Also, she adds, “ignoring these transactions will have the effect of overstating the median control premium.”

“Any time there is data available and you exclude it for whatever reason, we feel that you are hindering full disclosure,” comments Stutz.  “At the same time, “When you are doing an SIC search for an industry that trades consistently at a certain control premium (or in a close range) and one deal is at a negative, it suggests that that company had a specific issue.”  In that case, the information might not be relevant to the industry, and Stutz would most likely discard any negative control premiums (discounted price paid for a control position).  For the complete transcript and CD of the webinar, terrific for training purposes, click here.

Does Rev. Rul. 59-60 need an updated definition of FMV?

Last week’s “Global Financial Stability Report: Containing Systemic Risks and Restoring Financial Soundness” by the International Monetary Fund (IMF) takes a comprehensive look at current economic woes.  Its Executive Summary notes these causes: 1) a collective failure to appreciate the extent of leverage taken on by a wide range of financial institutions; 2) particular failures by private and public regulators to keep pace with rapid shifts in business models; 3) overestimates in the amount of risk transferred off balance sheets; and 4) continuing strain in the financial markets.  And about accounting, the IMF says:

The absence of active markets for complex structured credit products and the observed sales at values below the theoretical value of their underlying cash flows have presented challenges to financial institutions as to the degree to which they could be considered 'orderly sales' and hence depended on as a measure of fair value….The major audit firms have argued collectively that the presence of a price below theoretical valuation does not necessarily represent a distressed sale.  In such cases, the auditors require firms to demonstrate why a sale price is not indicative of fair value before accepting a reclassification of an asset to level three. 

It may be a stretch, but the discussion reminds us of the difficulties that BV appraisers have faced for decades in determining fair market value (FMV) in traditional recurring contexts.  “Fair market value, as defined [by Revenue Ruling 59-60], does not necessarily reflect the actual price that one could realize from an actual sale of a company in the real market,” writes Mike Pellegrino (Pellegrino & Associates) in the current Valuation Strategies (March/April 2008): 

Recall that price does not equal value. Rather, the value standard reflects the notional value of the company in an assumed market that considers the historic and prospective value of the asset in light of the business risk associated with the company.  Notional value does not include possible synergistic benefits or economies of scale that might accrue to the potential purchaser but are not already captured in the value opinion.  In the real market, the company could generate as many prices as there are buyers in the market, with each buyer having the ability to pay its own specific price based on its own specific set of circumstances.

FMV semantic fix.  Fortunately, “there is an easy fix” to address the key valuation issues inherent in Rev. Rul 59-60, says Pellegrino.  He suggests a “better” definition for FMV:

Fair market value is a hypothetical transaction that is feasible within a given market environment between a willing and rational buyer and a willing and rational seller, with knowledge of relevant information and equity to both parties.

Adding the words “feasible” and “rational” provides an additional check to validate a fair market value determination, Pellegrino says.  This analysis ties the resulting FMV opinion to the intrinsic value of the asset—which no rational, hypothetical buyer would pay more than, and no rational, hypothetical seller would accept less.

May is BV Month in Manhattan

It’s not official—but May might as well be declared “BV Month” in Manhattan.  First, the New York City Chapter of the ASA meets Monday, May 5^th for its annual “Current Topics in Business Valuation.”  Panelists Ashok Abbott, Espen Robak, and John Finnerty—moderated by Scott Nammacher—will discuss various approaches to marketability discounts.  Stamos Nicholas will update applications of FAS 141R on purchase price allocations, while Nancy Fannon presents S Corp models and Jeffrey Tarbell joins John Paul Hanson on the valuation of financially distressed companies.  Nammacher closes with “Valuing Private Equity and Hedge Fund Interests.”  For more information—and to take advantage of an “early bird” price discount, available before April 25th, click here.

If you can make two days in Manhattan, join the New York State Society of CPAs for its annual BV Conference May 19-20, 2008.  This year boasts a truly impressive lineup:

• First off are Susan Mangiero, Rob Slee, and Aswath Damodaran on “Calculating Risk in Business Valuation.” 
• Nancy Fannon reprises approaches to S Corp valuations—this time with fellow-modelers Chris Treharne and Dan Van Vleet. 
• Robert Cimasi takes on healthcare fraud, while Jim Hitchner tackles the reconciliation of BV Standards.
• Mel Abraham tells how to correlate research data and Jan Tudor provides “cutting-edge” research applications. 
• Lunch speakers include Cathy Reese, the attorney on the Kessler v. Dela. Open MRI case (Dela. Chancery, 2007) and John Porter, the attorney on this year’s reversal in Estate of Jelke. 
• Last but hardly least, Judge David Laro offers his view of BV from the federal bench.

For more information and to register for the NYSSCPA event, click here. 

IVSC call for applications and new members

The International Valuation Standards Committee (IVSC) has just issued a call for applications to several of its boards.  “Suitably qualified candidates” should apply online for vacancies to the Board of Trustees, the International Valuation Standards Board, and the International Valuation Professional Board.  Deadline for receipt of applications is May 9, 2008.

In addition—and in coordination with its restructuring effort, the IVSC has broadened its membership beyond national professional valuation institutes to include valuation companies, government, valuation end-users, academia, and others with an interest in setting valuation standards.  Those who wish to apply for IVSC membership and/or for its Board vacancies should visit the website.  The next meeting of the IVSC is May 20, 2008 in New York City, followed by a Manhattan roundtable the morning of May 21st to discuss responses to its Discussion Paper on intangible asset valuation.  Attendance is limited to those who pre-register; for further details, contact the IVSC executive director: mtissier@ivsc.org.

Clarification: The FASB is 35 (and GAAP isn’t gone)

In last week’s BVWire, a quote from CFO magazine’s editor said that GAAP was thirty-five years old.  But as Ken Becker, CPA (BVR’s former controller) points out, it is the FASB that’s entering middle-age, because APB Opinions pre-date the FASB, “and they had to have something to teach us when I was back in college!”  (Ed Teach, articles editor for CFO, concurs that Becker is correct in aging the FASB, not GAAP, at 35.)

Moreover, referring to “Goodbye GAAP,” the CFO article also cited last week, “’Generally accepted accounting principles’ (or GAAP) are like laws that can vary among jurisdictions,” comments Mike Crain.  So it’s more accurate to portray the current situation as U.S. GAAP vs. “international GAAP,” he says.  While the FASB is now largely responsible for promulgating U.S. GAAP as Statements of Financial Accounting Standards, he says, its counterpart, the London-based International Accounting Standards Board (IASB) now generally promulgates “international GAAP” as the International Financial Reporting Standards.  “Therefore, the SEC is not seeking to abandon GAAP as CFO states,” Crain concludes.  “It is considering whether to require companies that are publicly registered in the U.S. to report under ‘international’ GAAP rather than U.S. GAAP.”

Not happily ever after.  Thanks as always for the continued input from our informed subscribers.  For a break from routine, check out this short, unhappy history of accounting standards.