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.
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