FASB STAFF PROVIDES VALUATION GUIDANCE FOR SECURITIES IN INACTIVE MARKETS
The FASB Staff has issued a Staff Position describing how to determine fair value of an asset in an inactive market under FAS 157. Indications that a market is inactive would include widening of bid-ask spreads, a significant decrease in market trading volume, stale prices, and wide price variations. In such a situation, it may be more appropriate to treat the asset under the Level 3 regime and use “unobservable inputs” such as management internal assumptions about future cash flows and risk-adjusted discount rates. The example provided by the FASB staff indicates that any fair value measurement based on implied rates of return and discounted cash flows should be adjusted to reflect additional risk reflected by the inactive market.
OUR TAKE: Financial statement preparers are left with a great deal of subjectivity. First, they have to make a subjective determination as to whether a market is inactive. Second, if they throw the asset into the Level 3 regime, they still need to discount their cash flow assumptions by some subjective risk factor. We wonder how much a court (or the SEC) will second-guess these subjective determinations.