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FASB Statement No. 157: Fair Value Measurements

Nov. 1, 2009 
FASB Statement No. 157: Fair Value Measurements

Contents

  • Transition Guidance
  • Definition of Fair Value
  • Exit Price Concept
  • Market Based Measurement
  • Fair Value

Issues Related to

  • Liabilities
  • Disclosures
  • Internal Control Considerations

To our clients and other friends:

Since its issuance FAS 157 has been the subject of significant controversy. Amid the current worldwide financial crisis, the backlash against the fair-value accounting standard has even found its way into the $700 billion bank bailout bill recently signed by President Bush. Provisions of the bill instruct the Securities and Exchange Commission (SEC) to study current accounting literature including mark-to-market rules and if necessary suspend the application of FAS 157. Although it is impossible to know what actions, if any, the SEC might take, we believe it is a good time to revisit the substance of FAS 157 including the updates to this literature recently provided by the regulators and standard setters. We hope this publication will be useful in understanding the basic provisions of FAS 157. MHM professionals would be pleased to assist you in your understanding and are just a phone call away.

On September 30, 2008, the SEC Office of the Chief Accountant and the FASB Staff issued a joint communication to provide further clarification on fair value accounting. The communication was necessitated by the current economic environment and is intended to help preparers, auditors, and investors address fair value measurement questions that have been identified as most urgent in the current environment. The communication can be found at www.sec.gov/news/press/2008/2008-234.htm.

On October 10, 2008, the FASB issued FASB Staff Position No. FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active, which largely parallels the aforementioned communication. FSP FAS 157-3 clarifies the application of FAS 157, in a market that is not active and provides an example to illustrate certain key considerations in the determination of fair value of a financial asset when the market for that asset is not active.

Issues related to the application of FAS 157 addressed by FAS 157-3 include the following:

1) How the reporting entity's own assumptions (that is, expected cash flows and appropriately risk-adjusted discount rates) should be considered when measuring fair value when relevant observable inputs do not exist.

2 ) How available observable inputs in a market that is not active should be considered when measuring fair value.

3) How the use of market quotes (for example, broker quotes or pricing services for the same or similar financial assets) should be considered when assessing the relevance of observable and unobservable inputs available to measure fair value.

The FSP reiterates previous guidance provided by paragraph 7 of FAS 157 that in situations in which there is little, if any, market activity at the measurement date, the fair value measurement objective remains the same, i.e. fair value is based on an orderly transaction that is neither a forced transaction nor a distressed sale. Even in times of market dislocation, preparers are cautioned that it is not appropriate to conclude that all market activity is representative of either a forced liquidation or distressed sale. However, (and this is a key point of emphasis of FSP FAS 157-3) it is also not appropriate to automatically conclude that any transaction price is determinative of fair value. The determination of fair value is dependent on the facts and circumstances present and will require the use of professional judgment to determine whether individual transactions represent a forced liquidation or distressed sale.

FSP FAS 157-3 also clarifies that when relevant observable inputs are not available, the reporting entity may use its own assumptions (based on what it believes market participants would use) when pricing an asset in a current sales transaction. In some cases observable inputs may exist, however, they might require adjustment based on unobservable data (rendering a Level 3 fair value measurement). Situations where the volume and level of trading in an asset have significantly declined or where prices are not current are examples of circumstances where adjustment to observable inputs might be required. Additionally, FAS 157 discusses a range of information and valuation techniques that can be used when observable inputs are not available. However, an entity must always include appropriate risk adjustments that market participants would make for both nonperformance and liquidity risks.

Broker (or pricing service) quotes may be an appropriate input when measuring fair value. However, such quotes are not necessarily determinative if an active market does not exist for the financial asset. In an active market, a broker quote should reflect market information from actual transactions. Conversely, when markets are not active, brokers may rely on models using unobservable inputs known only to the broker. Therefore, entities need to exercise judgment on the amount of reliance they place on quotes that do not reflect the result of market transactions (presumably less reliance). Additionally, the nature of the quote (either an indicative price or binding offer to transact) should also be considered when evaluating the available evidence.

The application of the guidance provided by the FSP FAS 157-3 is accounted for as a change in accounting estimate pursuant to FASB Statement No. 154, Accounting Changes and Error Corrections. However, the disclosure provisions of Statement 154 for a change in accounting estimate are not required for revisions resulting from a change in valuation technique or its application.

FAS 157: Fair Value Measurements, was issued by the Financial Accounting Standards Board in September 2006. It provides clarification of the definition and premise of "fair value" when another standard requires or permits the use of a fair value measurement. FAS 157 also attempts to simplify the application of generally accepted accounting principles by using the same principle for fair value when a fair value measurement is required or permitted.

FAS 157 does not provide or require any new fair value measurements. However, given the significant number of fair value measurements throughout generally accepted accounting principles, the impact of FAS 157 is likely to be significant and far reaching.

Transition Guidance

Companies are required to adopt Statement No. 157 for financial statements issued for fiscal years beginning after November 15, 2007 (2008 for calendar year-end companies).

FAS 157 is generally to be applied prospectively as of the first interim period for the fiscal year in which it is initially adopted. Early application is encouraged. However, FAS 157 identifies three items which require a limited form of retrospective application:

1) The use of blockage factors.

2) Financial Instruments that were measured at fair value using the transaction price (pursuant to EITF 02-3).

3) Valuation of a hybrid financial instrument that was measured at fair value using the transaction price (pursuant to FAS 155).

The transition adjustment is measured as the difference between the carrying amounts and the fair value of the assets and liabilities at the date of adoption and is recognized as a cumulative-effect adjustment to the opening balance of retained earnings.

However, the FASB has issued FSP 157-2 which defers the effective date of FAS 157 for one year for nonfinancial assets and liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually).

FAS 157 is applicable when assets and liabilities are required to be measured at fair value for either recognition or disclosure purposes pursuant to existing generally accepted accounting principles with certain exceptions. The exceptions to FAS 157 are as follows:

. Existing standards that address share-based payments, including FAS 123R, FAS 123 and APB Opinion No. 25 (and related interpretations).

. Revenue recognition for transactions that require the use of vendor specific objective evidence (VSOE).

. Accounting Research Bulletin No. 43, Restatement and Revision of Accounting Research Bulletins, Chapter 4, "Inventory Pricing."

. Loss contingencies under FAS 5.

. FAS 13 and its related interpretations.

FAS 157 does not eliminate the practicability exceptions to fair value measurements in accounting pronouncements within the scope of this statement.

 

Definition of "Fair Value"

FAS 157 provides the following definition of "fair value": 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 presumes an "orderly transaction" that is - assets and liabilities are exposed to the market for usual and customary marketing activities. A fair value measurement is not the result of a transaction that is either a forced sale, liquidation or a distress sale.

FAS 157 presumes an "orderly transaction" that is - assets and liabilities are exposed to the market for usual and customary marketing activities. A fair value measurement is not the result of a transaction that is either a forced sale, liquidation or a distress sale.

Exit Price Concept

FAS 157 clarifies that the basis for a fair value measurement is the price that a company would sell or dispose of its assets or transfer a liability. This is an "exit price" concept and differs significantly from pre FAS 157 practice which relied more on an "entry price" concept.

An exit price concept is based on the company's current expectations about future cash inflows or outflows from the perspective of a market participant.

The exit price concept applies regardless of the company's actual intent and/or ability to sell the asset or transfer the liability at the measurement date. It is a hypothetical transaction at the measurement date.

 

Definition of a Market Participant

A market participant is a buyer or seller in the principal (or most advantageous) market for the asset or liability that is:

. Independent of the reporting entity; that is, they are not related parties, as defined by FAS 157.

. Knowledgeable; having a reasonable understanding about the assets or liabilities and the transaction is based on all available information that might be obtained through due diligence efforts that are usual and customary.

. Able to transact for the asset or liability.

. Willing to transact for the asset or liability; that is, they are motivated but not forced or otherwise compelled to do so.

 

Principal (or Most Advantageous) Market

A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for that asset or liability or, in the absence of a principal market, the most  advantageous market for the asset or liability.

 

Market Based Measurement

FAS 157 emphasizes that fair value is a market-based measurement, not an entity-specific measure. However, market participants should not consider the synergies that impact the value to a strategic buyer. Accordingly, a fair value measurement is determined based on the assumptions that market participants would use in pricing the asset or liability.

Determining the assumptions of a market participant is very subjective and will require the use of a significant amount of judgment. Market participant assumptions are incorporated in fair value measurements through the inputs to valuation techniques.

Definitions:

The principal market is the market in which the company would sell the asset or transfer the liability with

the greatest volume and level of activity for the asset or liability. The most advantageous market is the market in which the company would sell the asset or transfer the liability with the price that maximizes the amount that would be received for the asset or minimizes the amount that would be paid to transfer the liability, considering transaction costs in the respective market(s).

As a basis for considering market participant assumptions in fair value measurements, FAS 157 establishes a fair value hierarchy that distinguishes between the following:

. Market participant assumptions developed based on market data obtained from sources independent of the Company (observable inputs).

. The Company's own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs).

The FAS 157 fair value hierarchy prioritizes observable market data and input in valuation approaches as compared to company derived data that is based on unobservable inputs. Therefore, fair value measurement should maximize the use of observable inputs and minimize the use of unobservable inputs to valuation techniques. The fair value hierarchy also significantly impacts the disclosures related to fair value.

Level 1 - unadjusted quoted prices in active markets for identical items.

Level 2 - observable inputs (prices for similar items, rates, etc.) for the item, including market corroborated inputs, that might need adjustment.

Level 3 - entity's own assumptions about the assumptions a market participant would use, developed based on best information available without incurring undue cost and effort.

 

Fair Value Measurement

A fair value measurement should consider attributes specific to the asset or liability. For example, an asset or liability might be considered "standalone" (as in the case of a financial instrument or operating asset) or as a group of assets and/or liabilities (for example, an asset group, reporting unit or business).

Unit of Account

Whether an asset or liability is standalone or part of a group is dependent on its unit of account. The unit of account determines what is being measured by reference to the level of aggregation or disaggregation. The unit of account is determined in accordance with the provisions of other applicable accounting standards.

 

Fair Value Premise

FAS 157 presumes that fair value of an asset is based on the highest and best use of the asset based on the perspective of the market participant which will maximize the future cash inflows related to the asset. The company's intended use may not be indicative of the highest and best use of the asset from the view of the market participant.

When an asset provides maximum value to a market participant primarily when used with other assets as a group, for example an operating asset used in combination with other assets of the company, its highest and best use is considered "in-use." However, even if the "in-use" premise is applicable, the fair value measure is still based on the use of the asset by a market participant.

If an asset provides maximum value to a market participant on a stand-alone basis, for example, a financial asset, its highest and best use is considered "in-exchange."

To illustrate the fair value premise, consider the following:

A company purchases property and intends to operate it as a drive-in movie theater, while a market participant would consider the highest and best use of the property as a parking lot. In this case, the property's fair value is based on its market participant determined highest and best use, as a parking lot.

Issues related to Liabilities

A fair value measurement of a liability assumes that the liability is transferred to a market participant at the measurement date and that the risk related to nonperformance is unchanged before and after the transfer.

Nonperformance risk is the risk that the obligation will not be fulfilled and it affects the fair value of the liability that is transferred. Therefore, a fair value measurement for a liability must reflect the consideration of the risk of nonperformance. Nonperformance risk includes, but may not be limited to, the company's own credit risk. For liabilities that are required to be remeasured at fair value, the company should reflect the changes in the company's credit standing. Companies should also consider the terms of any collateral and/or other credit enhancements contractually specified for the liability being measured or remeasured.

Many observers have commented on the requirement for a company to consider its own credit standing; noting that the requirement could lead to counter-intuitiv  results. For example: a poorly performing company that experiences a deterioration in the quality of its credit might record a "gain" based on the concept that its liability is now worth less.

 

Other Issues

Use of Investment Blocks

Prior to the issuance of FAS 157, the historical practice for measuring the fair value of large holdings of securities ("block") often included the use of a blockage factor. A blockage factor is a discount to the price of the security to reflect the lack of trading volume in the market. Because the market is unable to absorb the block without impacting the price of the security, the use of a blockage factor was deemed necessary.

FAS 157 does NO T allow the use of a blockage factor. The fair value of securities is simply the price multiplied by the quantity of securities.

 

Restricted Securities

In some cases a company may hold securities of an issuer for which sale is legally restricted for a specified period. Assuming the restriction is transferable to a market participant, the fair value of the securities should be adjusted to reflect what market participants would demand because of the risk relating to the inability to sell the security for the specified period of restriction.

FAS 157 does not exempt securities that are restricted for one year or less. Accordingly, FAS 157 has amended the prior requirement provided by FAS 115, Accounting for Certain Investments in Debt and Equity Securities, for measuring fair value of securities for which sale is restricted for a period less than one year.

Transaction Costs and Transportation Costs

Transaction costs represent the incremental direct cost to sell an asset or transfer a liability (for example, a commission or fee typically charged by a broker in a securities transaction). Because such costs are not considered an attribute of the asset or liability, the price in the principal (or most advantageous) market is not adjusted for the incurrence of transaction costs.

However, transaction costs do not include the cost incurred to transport the asset or liability to/from its principal (or most advantageous) market. Accordingly, the price in the principal (or most advantageous) market is adjusted for the costs incurred to transport the asset or liability to/from its principal (or most advantageous) market.

 

Disclosures

The disclosure requirements in FAS 157 are primarily focused on three main objectives:

. Disclosure of the specific assets and liabilities that are measured at fair value.

. The methods and assumptions that a reporting entity uses to measure fair value.

. The impact that the use of fair value measurement has on earnings.

The disclosure requirements under FAS 157 vary depending on whether the asset or liability is measured on a recurring or non-recurring basis.

For assets and liabilities measured on a nonrecurring basis disclosure should include the fair value measures recorded in the period and the reasons for such measures. If Level 3 inputs are used to measure assets or liabilities, a description of the inputs and the information used by management to develop the inputs must be disclosed.

Assets and liabilities that are measured at fair value on a recurring basis require quantitative disclosures regarding fair value measures for each major category of assets and liabilities. These disclosures should include the fair value measure at the reporting date in total and also by each level of the fair value hierarchy (Level 1, Level 2 or Level 3). Level 3 inputs require a reconciliation of the beginning and ending balances including gains and losses (realized and unrealized). Companies should also disclose the valuation technique used in their fair value measurements and any changes to the techniques used.

In response to concern from observers about the reliability of fair value measures using Level 3 inputs, the FASB has required detailed disclosure related to the use of such measurements aimed at providing financial statement users with information to assess the quality of reported earnings.

 

Internal Control Considerations

As with the adoption of any new accounting standard, FAS 157 will likely require adjustments to a company's system of internal control.

. Risk assessment to determine whether the adoption of FAS 157 represents an increase in risk to accurate and reliable financial reporting.

. Revision to policy and/or procedures in order to comply with FAS 157 and the communication of such policies and procedures.

. Documentation surrounding new or revised policies and procedures.

. Consideration and documentation of new or revised assumptions particularly those pertaining to Level 2 and Level 3 inputs.

 

The Substance of the Standard is a publication of the Professional Standards Group of Mayer Hoffman McCann P. C.

The information presented herein is not intended to provide comprehensive guidance on valuation techniques or theory, the complexity of which is well beyond the scope of this publication. Additionally, the publication does not intend nor does it cover all possible issues that might arise with respect to the application of FAS 157. Companies should refer to the texts of the applicable accounting standards and recognize that as modifications or interpretations to existing standards emerge, this publication may become obsolete. This publication is designed to provide accurate information in regard to the subject matter covered. It is provided with the understanding that it does not constitute legal, accounting or other professional advice. If such assistance is required, the services of a competent professional person should be sought.

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