The trek toward a fair-value system of accounting—which critics have said sometimes feels like a forced march—took another step forward last week, as accounting rulemakers finally approved a way to establish fair value where it’s already required or permitted in existing accounting literature.
The Financial Accounting Standards Board has issued Financial Accounting Standard No. 157, Fair Value Measurements, to define how the fair value of assets and liabilities should be measured in more than 40 other accounting standards where it is allowed or required.
In addition to defining fair value, the statement establishes a framework within Generally Accepted Accounting Principles for measuring fair value and expands required disclosures surrounding fair-value measurements. While it will change the way companies currently measure fair value, it does not establish any new instances where fair-value measurement is required.
FAS 157 defines fair value as an amount that a company would receive if it sold an asset or paid to transfer a liability in a normal transaction between market participants in the same market where the company does business. It emphasizes that the value is based on assumptions that market participants would use, not necessarily only the company that might buy or sell the asset.
The new rule also helps steer the assumptions that must be made to establish fair value, by prioritizing the information that should be used in developing those assumptions. That information hierarchy is meant to address the difference between assets or liabilities that can be traded readily on an open market (and find their fair value in short order) compared with assets and liabilities that are not actively traded (where finding fair value can be difficult).
FAS 157 takes effect for fiscal years beginning after Nov. 15, 2007, and interim periods within those fiscal years, with early adoption allowed.
FASB says the new approach will enable investors and others who read financial statements to make more informed decisions about the potential effect of fair-value measurements on a company’s financial performance. The Board says it is responding to investors’ calls for expanded information about the extent to which companies measure assets and liabilities at fair value, how they arrive at those fair values, and how the values affect earnings.
Sherman
“This statement is actually a very general set of guidelines that will impact many valuation issues,” says David Sherman, an accounting professor at Northeastern University. “It adds to the dramatic change toward fair value accounting, but is not in itself as dramatic as, for example, the requirement of expensing stock options.”
FAS 157 does, however, represent another step in the convergence process. The movement toward fair value is an important point in the “memorandum of understanding” between U.S. and international regulators in the quest to make U.S. and international accounting rules more comparable. The International Accounting Standards Board is working on a fair-value standard of its own, and hopes to illuminate its views on the subject in a discussion paper by the end of the year.
EXCERPT
The excerpt below is from a section of FAS 157 titled, "Differences Between This Statement And Current Practice:"
The changes to current practice resulting from the application of this Statement relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements.
The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement 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 market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to
acquire the asset or received to assume the liability (an entry price).
This statement emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, this Statement establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from sources independent of the reporting entity (observable inputs) and (2) the reporting entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The notion of unobservable inputs is intended to allow for situations in which there is little, if any, market activity for the asset or liability at the measurement date. In those situations, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. However, the reporting entity must not ignore information about market participant assumptions that is reasonably available without undue cost and effort.
This statement clarifies that market participant assumptions include assumptions about risk, for example, the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and/or the risk inherent in the inputs to the valuation technique. A fair value measurement should include an adjustment for risk if
market participants would include one in pricing the related asset or liability, even if the adjustment is difficult to determine. Therefore, a measurement (for example, a
“mark-to-model” measurement) that does not include an adjustment for risk would not represent a fair value measurement if market participants would include one in pricing the related asset or liability …
Source
Statement Of Financial Accounting Standards No. 157, Fair Value Measurements (FASB, September 2006)
Worries About Application
Preparers have some concerns about how FASB’s statement will work in practice.
Cheryl Ingram, assistant controller with Time Warner, says the company agrees with the need for a more uniform approach to measuring fair value given how often it appears in new accounting rules. “However, as with any newly issued standard, it remains to be seen how the provisions of FAS 157 will work in practice and whether it will result in more uniform approaches to determining fair value,” she says.
What keeps financial reporting executives awake at night, she adds, is how the new statement will apply for assets and liabilities where no market activity naturally exists. FAS 157 focuses on the assumptions that would be made by a typical market participant, but Ingram worries that those assumptions may be overly subjective and difficult to apply.
“Can an entity ever really know the assumptions that a typical market participant would use in valuing assets and liabilities that … do not have established markets?” she says. “Who is the typical market participant? A financial buyer? A strategic buyer? When can a company determine that market participant information is not available without undue costs or effort?”
Ingram says applying the new definition will be tough in certain merger or acquisition scenarios, such as where a company may buy a whole business operation with plans to keep only certain assets. “Market participants” might place a higher value on certain assets that the actual buyer doesn’t even want or plan to use, she says.
Albert King, a member of the Financial Reporting Committee for the Institute of Management Accountants, says that kind of scenario may result in very different accounting under FAS 157 because companies will be required to book and write down much higher values than they traditionally have.
King
“The way the FASB has defined fair value is different—totally different—from the way appraisers and the Internal Revenue Service and the courts have defined fair value in the past,” he says. “It’s going to give quite different answers from what we have developed in the past. I can’t say it’s wrong; it’s just different. Investors are going to get very different answers than they did before.”
Noll
Dan Noll, director of accounting standards for the American Institute of Certified Public Accountants, says FAS 157 gives more guidance on how to measure fair value than the market has ever seen before, “and that’s a good thing, in my opinion. It defines in one location, once and for all, what GAAP means by fair value.”
Noll says it also will help “reduce the language barrier” between accountants and valuation specialists because it defines what fair value means within the context of GAAP, yet still leaves plenty of room for professional judgment.
“It does not tell people ‘here are assumptions to use in a given fact pattern and therefore here is your fair value,’” he says. “That’s where judgment is going to come in, and that judgment will always be needed.”
Anand
The allowance for judgment causes some to wonder if it doesn’t also create an allowance for gamesmanship. “These are just guidelines and therefore they are still open to interpretation,” says Sanjay Anand, chair for the Sarbanes-Oxley Institute. “Despite FAS 157, those who are committed to fraud in mark-to-market and off-balance sheet transactions will find a way.”
Still, Anand says the market will be better off with the consistent approach for measuring fair value for assets and liabilities that FAS 157 establishes.
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