Peeling away financial reporting issues one layer at a time

Entry Price vs. Exit Price: One (Really Smart) Appraiser’s Point of View

Whenever I write about valuation or IFRS convergence, I know that an email from Alfred King will be arriving shortly. Alfred has been living and breathing valuation for decades, and he has served on numerous committees of FEI, IMA and the AICPA addressing valuation issues as they affect financial reporting. "Business valuation," Alfred recently wrote to me, "involves trying to understand a company, and while financial reports are only a part of the research we do, nonetheless they are an important component. Consequently, my involvement in accounting has helped in valuation and one hopes that my involvement in valuation has helped accounting standards setters in FASB, IASB and SEC."

I have learned a great deal from my correspondence with Alfred; and although we don't agree on everything, we both will say without hesitation that the FASB's venture into exit prices has been a huge mistake. You can read much of what I have had to say on that from links to some previous postings, below.  Except for that, what follows is all Alfred King.

Entry Price vs. Exit Price: "O what a tangled web we weave…"*
(Sir Walter Scott, Marmion, Canto 6.)

When FASB came out with SFAS 157 they introduced a brand new concept or definition of value into the world of valuation, a definition that has had many unfortunate consequences. Generous observers will assert they were unintended. More cynical observers will assert FASB knew what it was doing and has done what it has set out to accomplish.

One of the standard definitions of Fair Market Value, a definition in use for over 100 years, goes something like this:

Fair Market Value is defined as the price for which property would exchange between a willing buyer and a willing seller, each having reasonable knowledge of all relevant facts, neither under compulsion to buy or sell, and with equity to both.

As I will explain below, this is essentially an entry value concept: what actual participants did, or would do. It accords with both common understanding and common sense.

For a number of reasons FASB, in developing its Fair Value Standard [SFAS 157], did not want to be tied down to a definition that they felt had numerous court interpretations and other 'baggage.' So, in their wisdom, they moved to exit prices and threw out the 'market' in 'Fair Value':

"Fair value 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."[SFAS 157, ¶5]

[Tom's note: If finalized, the proposed converged definition would be: "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." The changes would not affect Alfred's point.]

A simple example will highlight the differences in concepts. At an art auction at Sotheby's a Picasso is up for sale, and the bidding starts at $25 million and goes up in $1 million increments. At $29 million there are two bidders left; one of them raises to $30 million and the other drops out. Now the issue is "What is the value of the Picasso painting at that moment?"

Under the standard and well understood concepts of value most observers would feel the Picasso should be valued on the buyer's balance sheet at $30 million. There was no compulsion and everyone involved is knowledgeable about art. There was an actual transaction for that $30 million.

Now, under the FASB concept of Fair Value, the painting should be valued at only $29 million. How can the painting lose $1 million in value? Very simply because the FASB definition says the value is what the item could be sold for to a 'market participant.' The present owner, if he were to sell the Picasso, would receive only $29 million because there are no market participants (other than himself) at $30 million; but we know for sure there is a market participant willing and able to pay $29 million.

In short, you get a different answer whether you use Fair Market Value or Fair Value, and most observers feel the Fair Market Value definition more closely accords with economic reality. Why, for example, must the winning bidder be forced to record a Day One loss of $1 million – as if he were merely the greater fool?

What Does it All Mean?

This difference in definition works itself out in many ways in financial reporting, and often to the bafflement of investors and financial officers. One simple example here will portray this. When Oracle bought PeopleSoft, Larry Ellison announced on Day 1 that he had no use for the target's software or its trade name. He was buying the company solely for the customer base. If today's accounting had been in place then, we would be required to assign a large value to the software and a large value to the trade name, even though the buyer, Oracle, explicitly said they had no use for these 'assets.' The reason that dollars would be assigned is that the Fair Value definition talks about sale to a market participant, and presumably the day after the transaction someone might be willing to buy the existing PeopleSoft trade name and software even if Oracle had no intention of selling them.

You would have an anomalous situation where the buyer would be forced to value assets he did not want, and would not use or sell. Further, given accounting requirements for impairment, those two assets would decline rapidly in value, since software not updated and a trade name not marketed rapidly depreciate. So under today's accounting, Oracle would have been required to assign a significant part of the purchase price to unwanted assets and then suffer the further ignominy of having to take impairment charges for something they did not want in the first place.

I could cite many other examples in practice where the FASB definition of Fair Value provides answers that do not 'make sense' simply because we as valuation specialists have to follow the 'rules' under penalty of our client not receiving a clean audit opinion.

The basic concepts of financial reporting underlying everything the FASB does is that it is supposed to provide useful information for investors and creditors about the company and its cash flows. I defy anyone to show how assigning dollars to unwanted assets, and then immediately charging for 'impairment,' provides useful information.

*The views expressed are my own, and do not reflect the ideas of any organization I may be associated with.

Thanks, Alfred. I'm honored that took the time to contribute to my blog.

Here are those links:


  1. Reply J January 8, 2011

    As an accounting student set to graduate in a couple of months, your post was concise and insightful, and provided real-life examples. Thanks for helping me understand. How does this benefit the FASB to use a definition that doesn’t fit with reality or common sense?

  2. Reply Tom Selling January 8, 2011

    I’m glad this was helpful to you.
    The FASB places a lot of consideration on what auditors think. Auditors recognize that current values are inherently subjective, and that exposes them to liability. I think the rules were largely designed to limit auditor exposure to liability, while at the same time giving issuers some options for measuring fair value.

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