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New and Timely Guidance on FAS 157

Few pronouncements from the Financial Accounting Standards Board (FASB) have been as controversial as Statement of Financial Accounting Standards No. 157 (FAS 157), "Fair Value Measurements." Some critics blame FAS 157, at least in part, for the country's current financial crisis. Supporters, on the other hand, argue that fair value accounting is merely a reflection of the underlying problem.

Harmful or beneficial, fair value appears to be here to stay. As of this writing, the SEC has resisted calls (by the American Bankers Association and others) to suspend fair value accounting until the financial markets recover. In an effort to ease concerns about FAS 157, however, FASB has issued guidance on the standard's application in situations involving inactive markets.

Three-tier value hierarchy

FAS 157 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." Here, an "orderly" transaction is one that isn't forced such as a forced liquidation or a distress sale.

To help companies determine fair value, FAS 157 establishes a three-tier hierarchy that emphasizes market-based valuation techniques. It gives highest priority to Level 1 inputs—quoted prices in active markets for identical assets or liabilities. If these prices aren't available, the standard makes Level 2 inputs, such as quoted prices in active markets for similar assets or liabilities or other "observable" inputs, the next best choice. It gives lowest priority to Level 3 "unobservable" inputs, such as the reporting entity's own data. FAS 157 emphasizes that even when relying on Level 3 inputs, the objective remains the same: to arrive at an exit price from a market participant's perspective.

Pros and cons

Critics of FAS 157 claim that by focusing on the exit price, the standard requires entities to value assets at "fire-sale" prices, regardless of whether they plan to sell or hold. Further, it presumes that observable inputs, such as market prices, are the most reliable indicators of fair value, while unobservable inputs, such as the entity's own cash flow projections, are the least reliable.

As for the financial crisis, detractors contend that FAS 157 forced financial institutions to value distressed assets much lower than necessary. Lower asset values, they claim, drove such institutions to tighten lending.

Proponents of FAS 157 disagree, asserting that the standard provides a more accurate picture of an entity's financial condition and greater transparency to investors and other financial statement users. Dane Mott, a JPMorgan Chase & Co. analyst, observed that "Blaming fair value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick.'

FASB talks back

To quell concerns about fair value, the SEC and FASB issued a joint statement in September 2008. It advised companies to use internal assumptions, such as expected cash flows and appropriately risk-adjusted discount rates, to value securities when relevant market data is unavailable.

Soon thereafter, FASB issued FASB Staff Position (FSP) 157-3 to provide "guidance on how to determine the fair value of financial assets when the market for that asset is not active." FASB emphasized that the guidance isn't new, but merely clarifies FAS 157's principles-based approach.

According to FSP 157-3, an entity "may determine that unobservable inputs (Level 2) ... require significant adjustment based on unobservable data and thus would be considered a Level 3 fair value measurement." It also notes that "Broker (or pricing service quotes) may be an appropriate input when measuring fair value, but they are not necessarily determinative if an active market does not exist for the financial instrument." Determining fair value under these circumstances, FASB explains, may require the use of significant judgment about whether individual transactions are forced liquidations or distress sales.

Playing fair

As clarified by FSP 157-3, FAS 157 allows some leeway in valuing a company's financial assets. If fair value accounting plays a significant role in your financial reporting, you should review your financial statements in accordance with these new accounting guidelines. 

Questions?
Contact Brian Langham at 312-980-2990.

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.