Financial Accounting Standards Board (FASB)

¶ … Financial Accounting Standards Board (FASB) issued statement number 157 in response to the lack of clarity regarding fair value under the generally accepted accounting principles (GAAP). The guidance that was given was incomplete, vague and was not centrally located. This made the issue of determining fair value under GAAP difficult and inconsistent. Given that the objective of GAAP is to have a high degree of comparability between accounting statements, it was evident that a summary statement and guidance needed to be issued with regards to fair value.

Additionally, the board felt that more disclosures were required, particularly with respect the assumptions used in establishing fair value. While reporting entities had some guidance with respect to the establishing fair value, they did not previously need to report all of their assumptions. That made it difficult for users of the financial statements to easily compare the fair value determinations across different items and different companies. Thus, the scope of disclosure of the assumptions for these items has been expanded by Statement No. 157, in order to make it easier to compare fair value determinations across different entities.

The statement came into being in November, 2007. Fiscal years after November 15, 2007 were to apply this statement, including all interim statements as well. It was recommended that reporting entities adopt the measures early, in particular for those entities that were going to require adjustments to be made as a result of these changes in guidance.

New fair value measurements are not set forth in this statement, which is essentially a compendium and clarification of the fair value statements made elsewhere. The significance, however, is that by issuing an official FASB statement on the matter, some reporting entities may be compelled to make alterations to their existing practice, in order to fit their methods within the confines laid out in Statement No. 157.

There were three main changes in the statement, covering "the definition of fair value, the methods used to measure fair value and the expanded disclosures about fair value measurements" (FASB Statement No. 157). The definition clarifies that the fair value price is the hypothetical fair market value price on the day, as opposed to purchase price or the price received to assume the liability. The price, then, must be based on a theoretical market transaction. This means that the price is not specific to any one company -- the hypothetical transaction could reasonably take place between any two entities.

The latter is considered to be an observable input, in which market information is readily available. In such a situation, that market information would be the source of the fair value. If, however, market information is not available for whatever reason, then unobservable inputs can be used. The organization must, under these guidelines, not ignore readily available information that can be used in determining fair value.

The statement further clarifies this, with respect to financial instruments. Such instruments must be valued on the basis of the market price of the instrument multiplied by the amount held. There should be no adjustment to the quoted price on the basis of volume (no volume discount should be assumed).

The statement also addresses assumptions about risk. The statement clarifies that if an adjustment would normally be made to risk by market participants, this is also required of the reporting entity. In other words, if the entity is using a pricing model such as CAPM for a project that bears a different level of risk than the overall company's risk, an adjustment should therefore be made to the discount rate used to calculate fair value in the firm's financial statements.

Market participants typically include restrictions or constraints when determining value as well. For example, if there are constraints on the sale of an asset, the risk of that asset is increased. The reporting entity must therefore include the presumed market impacts of such constraints when determining fair value. It is not sufficient to simply assume that an item subject to constraints has the same risk as an item not subject to constraints. The application of risk to fair value is also to be applied to liabilities. This requires the reporting entity to price into the value of its liabilities non-performance risk. Thus, they must incorporate their own credit rating into the value of their liabilities.

The statement also outlines its scope. For example, it outlines that the rules governing the valuation of financial instruments are to be used, even with investment companies. Though investment companies are subject to other rules and guidelines, they must still use Statement No. 157 guidelines when preparing their financial statements, for the ease of comparability.

The fair value methods should be used quarterly, as per this statement. This is especially true for those items whose value is determined on the market by observable inputs. Even for unobservable inputs, however, it should be disclosed the impact that the assumptions used will have on the firm's earnings or assets. This is important because the assumptions, particularly for unobservable inputs, can have a significant influence on earnings or asset levels. These disclosures regarding the assumptions allow anybody examining the statements to understand the sensitivity of the results to changes in the assumptions.

Statement No. 157 also is to be used for derivative instruments. The main thrust of this statement is that it nullifies guidance that was previously issued and amends other previously issued guidance. This reflects the FASB's objective that Statement No. 157 begins to streamline the guidance with respect to fair value. Fair value guidance had been scattered throughout a number of different statements and 157 is intended to reduce the number of different statements containing fair value guidance.

The previously-issued statements also did not always adhere to the framework that the FASB uses when issuing its statements. That framework was created with consistency in mind, such that financial statements can different issuers can be easily compared with one another. The process of streamlining the guidance with respect to fair value is part of the move towards increased consistency, beginning with consistency at the philosophical level.

This statement has been ascribed by some as a cause of the current financial crisis. The case has been made before government, for example, that the markets for mortgage-backed securities and collateralized debt obligations were driven down by fear and speculation. The markets, therefore, were behaving irrationally, and irrational markets should not be used as the basis to value an asset (Gross, 2008).

For a couple of reasons, however, this argument does not hold water. The first is that financial institutions have long used mark-to-market accounting (Gelinas, 2008). Remember that Statement No. 157 did not introduce new fair value methods, it simply clarified existing practice and provided guidance with respect to technique and disclosure.

The second reason is that for the most part financial institutions' stock had been battered because nobody knew the real value of some of the so-called toxic assets. The mortgage-backed securities became unmarketable, and the value of the underlying assets indeterminate. Financial institutions wrote down some of these assets but the market suspected they did not write them down enough (Ibid). The statement 157 compelled the banks to provide disclosure about their assumptions, which investors were able to read, but the assumptions themselves did not change. Thus, the valuations and writedowns did not change. All that happened was that investors were better informed and able to make better decisions for themselves as a result of the disclosures.