The Difference Between "Fair Value" and "Fair Value"

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By Ezriel Milun CA (SA), CFE, CVA

Definitions – FAS 157

With the current global financial crisis much has been heard about “mark to market” or “mark to model”, referring to the accounting methodology included in the recent Financial Accounting Standards Board (“FASB”) Statement known as “FAS 157”. This FASB Statement, effective for fiscal years beginning after November 15, 2007, provides guidance for the measurement of financial assets and liabilities using the Fair Value method of accounting and establishes the following definition of Fair Value for financial reporting:

“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.”

FAS 157 expands on its definition and introduces new concepts such as “Exit Price”, “Principal Market” and “Fair Value Hierarchy” and provides considerable detail utilizing new terms such as “Level 1 Inputs”, “Active Markets” and “Observable Inputs”, amongst numerous others, in clarifying the Statement’s meaning of  Fair Value.

Definitions – Business Valuations

In the business valuation context, Fair Value can have several meanings depending on the purpose of the valuation and the particular state’s statutory standard of value.

In New Jersey, for example, the standard of value in matrimonial cases is Fair Value, which is summarized as Fair Market Value without discounts for lack of control or lack of marketability, barring “extraordinary circumstances”.

The authors of Ibbotson SBBI 2008 Valuation Yearbook include the following in the last part of their definition of Fair Value:

“...Fair Value is a legal term left to judicial interpretation. Many consider fair value to be fair market value without discounts.”

A definition for Fair Value applicable in shareholder dissent and oppression cases included in the Model Business Corporation Act 2000/01/02 Supplement, 3rd Edition at 13.01 (4) is as follows:

 “Fair value” means the value of the corporation’s shares determined:

  1. Immediately before the effectuation of the corporate action to which the shareholder objects;
  2.  Using customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal; and
  3. Without discounting for lack of marketability or minority status except, if appropriate, for amendment to the articles pursuant to section 13.02.(a)(5).”

The International Glossary of Business Valuation Terms does not provide a definition for Fair Value , which is indicative of the irreconcilable differences between the various business valuation definitions of Fair Value. The only thread of consistency in the various definitions of Fair Value appears to be the omission of discounts for lack of marketability and lack of control.

The above mentioned definitions reflect substantial differences between the two Fair Value terms, but the lack of a satisfactory, single, business valuation definition and the complexity of the FAS 157 definition, requires alternate analysis to understand the separate utilization and different meanings of the two terms.

Practical Application

We offer the following practical application differences between these two Fair Value terms:

Fair Value – FAS 157

  1. Primarily used by publicly traded companies;
  2. It is currently applied only to financial assets or liabilities (or groups of financial assets or liabilities);
  3. It changes historical cost based accounting by adjusting “cost” to Fair Value;
  4. It is based on market related inputs and is therefore similar to “fair market value”;
  5. The end product is an adjusted value for financial assets or liabilities on the balance sheet and a corresponding adjustment to the entity’s earnings;
  6. Disclosures are required about the valuation techniques and inputs used to measure Fair Value especially when “unobservable inputs” are used, and their effect on the earnings and the changes in net assets for the period. The level within the fair value hierarchy into which the inputs fall, must also be disclosed.

Fair Value – Business Valuations

  1. Primarily applied to valuation of privately held companies;
  2. It applies to the value of the entity as a whole not specific assets or liabilities;
  3. Primarily utilizes historical cost based accounting except:
  4. when applying the “Adjusted Net Asset Method” which requires fair market value adjustments to the assets and liabilities;
  5. when applying the “Discounted Cash Flow Method” which requires the use of a projection of earnings and cash flow;
  6. It is different from fair market value as, in arriving at a value, Fair Value typically ignores the effect of discounts for lack of marketability and lack of control which are integral to the value determination of fair market value:
  7. The end product is a report on the value of the entity as a whole (or a prorated value of the fractional ownership of the entity being valued);
  8. The Fair Value valuation report must comply with the reporting standards of the professional organizations to which the valuation analyst belongs, such as, amongst others, AICPA and/or NACVA.

Conclusion

“Statement 157 establishes a single definition of fair value and a framework for measuring fair value in generally accepted accounting principles (GAAP) that result in increased consistency and comparability in fair value measurements. Statement 157 also expands disclosures about fair value measurements, thereby improving the quality of information provided to users of financial statements.”

Fair Value as used in business valuations is dependent on the purpose of the valuation and its use also varies from state to state based on the local statutory standard of value. In New Jersey, for example, Fair Value is utilized in matrimonial matters and in shareholder dissent cases. Fair Value in business valuations determines a value for the entity as a whole, as opposed to FAS 157’s valuation of financial assets or liabilities only.

Ezriel Milun, CA (SA), CFE, CVA

Ezriel Milun is a Manager – Business Valuations / Litigation Support with WISS & Company, LLP, Livingston, NJ and has been providing forensic accounting, business valuation and litigation support for over 6 years in matrimonial matters, shareholder disputes, damages calculations, fraud investigations, valuations of closely-held businesses and professional practices and has testified as an expert witness in the state of New Jersey. Prior to that he served as a chief financial officer in private industry for over 20 years and owned and operated a manufacturing business and a computer school.

Mr. Milun can be contacted at WISS & Company, LLP at (973) 994-9400 extension 1158 or by e-mail at emilun@wiss.com.