Fair value accounting introduces the valuation process to financial reporting in a number of areas. In certain of these areas, the use of fair value accounting is mandatory. For companies not subject to investment company accounting rules, these areas focus primarily on financial instruments and include derivative accounting (as applied to hedge accounting as well as non-hedge accounting for freestanding and embedded derivatives) and equity-linked transactions that are not classified in equity.

The valuation process as applied to financial instruments can quickly become complex. Plain vanilla options and warrants in which the option can be exercised into a fixed number of shares at a fixed price do not present particular problems for most companies. Often the Black-Scholes-Merten (BSM) option pricing model is perfectly adequate for this purpose. Any company that issues stock-based compensation to employees and nonemployees is probably well-versed in the use of the BSM model. For those new the BSM model, there is a substantial amount information available in a quick internet search.

Probably the biggest challenge encountered by a private company is there is usually no readily available stock fair value measurement. In the absence of recent private stock transactions, the company will have to perform a valuation of its stock. This usually involves a discounted cash flow analysis based on financial forecasts prepared by management. This type of valuation is complex and beyond the ability of most companies. Once you have a stock valuation, you still have the BSM pricing model to apply. Developing the inputs takes time and effort, particularly the process of identifying comparable companies for the purpose of calculating stock price volatility, one of the BSM model inputs.

If the BSM model seems challenging, the methods used to value more complex financial instruments such as convertible debt, embedded features, equity forward contracts and so forth can be overwhelming. These instruments necessitate the need for lattice models (e.g., binomial), Monte Carlo simulations and other complex calculations. In other words, these require a valuation expert. Don;t even think about trying to take these on yourself.

Bottom line here is every company needs to understand the cost and effort of fair value accounting before entertaining the idea of issuing financial instruments that are going to require its use. These valuations are required at inception and at every subsequent valuation date until the instrument expires. For public companies, this means at inception and then every quarter. Private companies avoid the quarterly valuations, but the annual calculations are much more complex due to the lack of a listed stock that would provide a value for the stock as well as historical volatility data.