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Article Author:

FAS 157 Changes Fair Value Definition, Measurement and Disclosure

Jeffery A. Dertz, CPA
Partner, Insurance Practice
jdertz@BlackmanKallick.com, 312-980-3224

In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 157, "Fair Value Measurements" (FAS 157). This new standard is effective for fiscal years beginning after Nov. 15, 2007 and for interim reports prepared in that initial fiscal year. The exception is for nonrecurring, nonfinancial, assets and liabilities, which have a one-year deferral period.

What does FAS 157 do?

• Defines fair value as "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." The focus is on exit price versus entry price and on the highest and best use of the item being valued.
• Establishes the fair value hierarchy. FAS 157 requires applying a priority to the possible inputs to fair value measurements from a market participant's point of view.
• Expands disclosures about fair value measurements.

Understanding exit price vs. entry price

•  The exit price is the amount a company would receive to sell an asset or pay to transfer a liability.
• The entry price is the amount the reporting entity would pay to purchase the asset or receive to assume the liability. Entry price is not acceptable under FAS 157.

When determining exit price, management would first use its principal market, which is the market with the greatest activity that has typically been used by the company. If no principal market exists, management needs to default to the most advantageous market to which the company has access.

Example
	Market "A"	Market "B"
Stock price	$100	$ 98
Less fees	-  10	-   6
Net cash received	$ 90	$ 92

Under this scenario, if Market A were the principal market, the fair value would be $100. However, if Market A is not a principal market and the company has access to both markets, the fair value would be $98, as this market nets the company the highest cash value.

Highest and best use

FAS 157 requires using the perspective of the marketplace in the valuation process, thereby ignoring how the reporting entity is using or intends to use the asset or liability.

How is fair value measured under FAS 157?

FAS 157 does not specify a valuation technique in any particular circumstance. However, it does describe approaches to be incorporated in the valuation techniques for measuring fair value: the market approach, income approach and/or cost approach. It is up to the company to determine the appropriateness of the valuation techniques. 

• The market approach is used first. This approach utilizes market transactions and quotes for prices for identical or similar assets or liabilities. For example, market approach techniques often use market multiples derived from comparables. Multiples might lie in ranges with a different multiple for each comparable. The selection of where in the range the appropriate multiple falls requires judgment.
  
  Matrix pricing is also used under the market approach. This mathematical technique is used primarily to value debt securities without relying solely on quoted market prices for the specific securities.
• The income approach uses valuation techniques to convert future amounts, such as cash flows or earnings, to a single present amount. The measurement is based on the value indicated by current market expectations about those future amounts. Valuation techniques include option-pricing models, such as the Black-Scholes-Merton formula, lattice models or present-value techniques.
• The cost approach is based on the amount currently required to replace the service capacity of an asset. This amount is the price the seller would receive for an asset based on the cost to a buyer to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence.

Valuation techniques used to measure fair value should be consistently applied. However, a change in a valuation technique or its application is appropriate if the change results in a measurement that is equally or more representative of fair value.

Using observable and unobservable inputs 

When utilizing the above methods, observable and unobservable inputs are used in pricing the asset or liability.

• Observable inputs reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the reporting entity.
• Unobservable inputs reflect the reporting entity's own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances.

Valuation techniques used to measure fair value should maximize observable inputs and minimize unobservable inputs.

Applying the fair value hierarchy

Under FAS 157, management must measure fair value according to a three-level hierarchy established by FASB. Under this hierarchy, management is required to use the highest level possible in determining fair values.

The three levels are as follows:

• Level 1—Quoted market prices for identical assets or liabilities to which the entity has access at the measurement date.
• Level 2—Inputs other than quoted market prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include the following:
  • Quoted prices for similar assets or liabilities in active markets
  • Quoted prices for identical or similar assets in markets that are not active
  • Observable inputs other than quoted prices for the asset or liability
  • Inputs derived principally from or corroborated by observable market data by correlation or other means
• Level 3—Unobservable inputs for the asset or liability. Unobservable inputs should be used to measure fair value to the extent that observable inputs are not available, allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date

What disclosures does FAS 157 require?

• Fair value measurements at the reporting date
• The level in the fair value hierarchy—Level 1, 2 or 3
• Additional disclosures required for Level 3 items
• In annual reports, the valuation technique(s) used to measure fair value and a discussion of changes in valuation techniques, if any, during the period

View image of decision tree, which is helpful in determining which input to use

What should management do to prepare for FAS 157 compliance?

• Set up controls and procedures to assist in fair value determination and disclosure.
• Have discussions with outside vendors, such as auditors, investment advisors and/or investment custodians. If management intends to use its investment advisor or custodian for FAS 157, it should inquire about obtaining a SAS 70 report on internal controls that covers the vendor's fair value pricing.
• Be able to demonstrate to external auditors that it understands the SAS 70 report, including the controls in place. This will greatly assist in year-end audits.

FAS 157 and the National Association of Insurance Commissioners (NAIC) 

It is highly unlikely that the NAIC will adopt FAS 157 for year-end 2008 reporting requirements. The NAIC's working group has completed much of its work and is hoping to produce an exposure draft of a new, all-encompassing Statutory Statement of Accounting Procedures (SSAP) on fair value that will include aspects of FAS 157. The exposure draft should be available for the NAIC Winter Meeting being held in Dallas the first week of December. Adoption of a new fair value SSAP is expected to occur sometime in 2009.

For more information on FAS 157, contact Jeff Dertz at 312-980-3224.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.