September, 2006 | Issue 9
The Financial Accounting Standards Board (FASB), on September 14, 2006, issued its long-awaited Statement of Financial Accounting Standards No. 157, Fair Value Measurements. The Board issued this statement in order to provide some consistency and comparability in the making of fair value measurements for financial reporting purposes. The concept of fair value in financial reporting has evolved piecemeal over time and is currently referred to in and dispersed among some 60 or more pronouncements of the FASB. Differences and inconsistencies in the guidance provided by these various sources have added to the difficulties and complexities in applying fair value to GAAP. What follow are a few highlights of the Statement.
Definition of Fair Value
FAS 157 provides a new definition of fair value. It reads as follows:
“Fair value is 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.” (Para. 5)
The new definition of fair value retains the exchange price notion contained in earlier definitions of fair value. The new definition, however, clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the principal or most advantageous market for the asset or liability. It assumes that the transaction is not a forced transaction (for example, if the seller is experiencing financial difficulty), and that it includes exposure to the market for long enough to transact at the most advantageous price for the asset or liability.
Exit Price Principle
The hypothetical transaction used to determine fair value is considered from the perspective of the party that holds the asset or owes the liability. Therefore, the objective of the fair value measurement is to determine the price that would be received to sell the asset or paid to transfer the liability (the exit price). In making such a determination, the fair value is not to be adjusted for transaction costs, as these are not attributes of an asset or liability.
Highest and Best Use
A fair value measurement assumes the highest and best use of the asset by market participants. The FAS uses the example of a bowling alley. If the highest and best use of the property is as a parking lot, it should be valued as a parking lot rather than as a bowling alley.
The Liability Anomaly
A fair value measurement of a liability assumes that the liability is transferred to a market participant at the valuation date. The hypothetical buyer of the liability (let’s say the liability is a note of Company X) will, of course, take into account the creditworthiness of the obligor (CompanyX) in deciding how much he would be willing to pay for the note. If Company X is a bad credit risk, the buyer would pay less for the note; therefore, the value of the note would be reduced. This reduction in the fair value of Company X’s note because of its poor credit rating will cause a reduction in the carrying value of the note on Company X’s books. This in turn will result in an increase in its own net worth.
The FASB acknowledges that this is a counter-intuitive result but affirms that, conceptually, credit standing is an essential component of fair value measurement.
Fair Value Hierarchy
The fair value hierarchy conceptualizes that valuation input data falls into one of three levels of priority of use. The highest priority (Level 1) is given to quoted prices in active markets for identical assets or liabilities. Level 1 data should be used to measure fair value whenever available.
Level 2 inputs include quoted prices for similar assets, inactively quoted prices for similar or identical assets, and other observable inputs such as interest rates and yield curves.
Level 3 inputs are unobservable inputs. These should be based on the best information available in the circumstances and might include the reporting entity’s own data.
Effective Date and Exclusion
FAS 157 will be effective for fiscal years beginning after November 15, 2007, and for interim periods within those fiscal years.
The Statement does not apply under accounting pronouncements that address share-based payment transactions, such as FASB Statement No. 123R, Share-Based Payment. The reason is that for certain share-based payment transactions with employees, the measurements at the grant date are fair-value-based measurements, not fair value measurements. Therefore, the Board decided for practical reasons to exclude Statement 123R in its entirety from the scope of Statement 157.
