 |
|
In 2006 the U.S. Financial Accounting Standards Board issued a long-awaited pronouncement referred to as SFAS 157 (now Codification Topic 820 of U.S. GAAP Accounting Standards). In addition to defining the term “fair value” which had been used in U.S. GAAP for decades, the FASB also established and expanded on specific guidelines for the valuation of assets and liabilities to comply with fair value standards. (The definition and some of the terms differ from current international accounting standards.) These steps were hailed as revolutionary by many accountants but were badly misunderstood by many who issue financial reports and the markets in which they are used. Even so, SFAS 157 has demonstrated that its valuation components largely comply with Generally Accepted Valuation Principles (GAVP) long recognized in the valuation profession. |
The timing of SFAS 157’s release and implementation occurred as the world began experiencing what has been called the Great Recession. For valuers the FASB pronouncement provided explicit guidelines that proved to be of significant benefit as the bottom fell out of many real estate markets and problems arose as to how all forms of assets and liabilities should be valued in compliance with financial reporting standards. By design and hard work, the FASB standards provided for valuations in any type of market condition and for any type of property. Further, they accomplished that feat by including substantial parts of GAVP, with or without express recognition of their source.
FASB’s definition of Fair Value is worded differently than the typical U.S. definition of Market Value, but seems to arrive at the same destination. Defined as the price received to sell an asset or the price paid to transfer a liability in a transaction taking place in an active and orderly market, the concepts of Fair Value were more fully fleshed out in the considerable language that accompanied a simple definition. By stating that Fair Value would represent an “exit price” for the seller under the terms of the definition, FASB emphasized the role of owners, the supply component of market transactions—for example the inelastic and limited supply of real property. This contrasted with buyers, or demand--which can change at any moment. FASB also provided the concept that the Fair Value transaction was hypothetical as of the measurement date rather than actual and was one that transpired in an orderly market, including the absence of duress.
With demonstrated inefficiencies of real estate markets, it is reasonable to see that prices even in a FASB notion of an orderly market will still be variable due to imperfect buyer-seller data and cost, time, location and other market economic friction due to market inefficiency. Thus, ranges of potentially qualifying “Fair Values” encompass long held notions that market value exists with an uncertainty range. This leads to the practice of many financial reporting entities and their valuers to deal with ranges rather than pinpoint statements of value. The range in itself provides a form of market disclosure as to risk and uncertainty.
With markets deteriorating, and later beginning to recover, SFAS 157 also introduced other GAVP notions in the form of an accounting pronouncement. One of the most important involved the evidence that is needed to support a Fair Value opinion. Developing a hierarchy of evidence, the FASB identified Level One as market participant evidence relating to exactly comparable assets or liabilities. Level Two, which is to be applied only if Level One is not available, is to compare assets or liabilities that are similar to what is being valued. Lacking either of these, Level Three provides for valuations when the “observable” inputs of the first two levels are unavailable and it relies upon “unobservable” inputs for the valuation to be supported.
While these three levels may seem mysterious at first, they are similar to what has happened in valuation since GAVP were developed. What puzzles many, however, is where do you get unobservable inputs? How can they be supported if they cannot be seen? These are great questions, but again answerable through the application of GAVP.
In economics and other applications of scientific principle, tests and “proofs” are often approached by going to the extreme. If one considers a non-market property (one that has NO market, such as some chemical plants, docks, research facilities, and others) or limited market properties (many properties in recently depressed and stressed markets, but at other times specialty properties which have less certainty of price and timing in sale), there is a simple test. Would one assert that either of these two would have NO market value or fair value? A no market value determination is possible for some very problematic properties (an environmentally contaminated property for which there is no known cure), but the most common form of market limitation is fluctuations in the economy, especially as exhibited during the Great Recession.
So, whether market value or fair value, valuers can obtain the necessary inputs for valuation by using FASB’s Level One and Two inputs when they are available, but when they are not, by proceeding to a Level Three examination by (a) determining who make up the property “market” (i.e., the market participant owners); (b) developing information regarding their market understandings and behavior; (c) doing the same for prospective buyers; and (d) processing the information in accordance with GAVP and value definitions. In short, in any market cycle an understanding of market behavior and responses of buyers and sellers is crucial for developing and understanding inputs for any of the three levels.
A surprise for some, but not those who truly understand GAVP, is that the transactions that occur at any given time do represent a type of market, but if they do not meet the definitions of fair value or market value, they may be misleading as value indicators. In any economic period it is imperative that valuers validate the details of actual transactions, but it is equally important that they determine whether each transaction used as valuation evidence meets the definition of value with which it is to be associated. The same processes of market research enable the valuer to determine, for example, whether duress was involved. This simple process has been too often overlooked, misunderstood, or abused. This is only one of the “take aways” from our experiences with the Great Recession and what the U.S. FASB accomplished in SFAS 157.
Written by Don Dorchester FRICS
Senior Director, Cushman & Wakefield Dispute Analysis and Litigation Support specialty practice
Don Dorchester is a veteran of more than 55 years in the real estate industry. A graduate of the University of Oklahoma with degrees in Finance and Accounting, and Masters degree in Economics, and Urban and Regional Planning, Mr. Dorchester has been active at the leadership level serving as National President of the Appraisal Institute, co-founder of the International Valuation Standards Committee, Board of Directors member of the National Association of Realtors, and many civic and other professional organizations. Mr. Dorchester has experience in urban renewal, the nation’s New Towns program, and more than 40-years experience in fair value and related market value issues. His real estate consulting and valuation activities include private, government, and international clients. Examples of his litigation experiences include the Exxon Valdez oil spill, the Rocky Flats nuclear arsenal litigation, the Cayuga Indian litigation with the State of New York, and many other high profile cases. He has won numerous civic and professional awards. Mr. Don has written extensively on economics, valuation, statistics, computers, and other technical topics. He has lectured in many U.S. universities and in many foreign countries. His work in valuation standards began in the 1960s and continues in both the domestic and international arenas. He has developed, written, and taught many professional courses and seminars. Since early 2008, Mr. Dorchester has worked to establish the RICS Americas Valuation Council and currently serves as its Vice Chairman. He is currently a Senior Director in Cushman & Wakefield’s Dispute Analysis and Litigation Support specialty practice.
|
|
