|EXECUTIVE SUMMARY |
FASB Statement no. 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.”
The standard does not require fair values to be used in any situations not already covered by GAAP that existed when it was issued.
The “Fair Value Hierarchy” is the central component of Statement no. 157. The board identifies an order of preference (Level 1, Level 2 or Level 3 inputs ) that management must apply in estimating the fair values of assets or liabilities.
The standard establishes disclosure requirements that reveal to financial statement users how the fair value estimates were produced because varying degrees of precision result from using different kinds of inputs.
Statement no. 157 is effective for annual statements for fiscal years beginning after Nov. 15, 2007, and for interim reports prepared in that initial fiscal year. Paul B.W. Miller, CPA, Ph.D., is professor of accounting at the University of Colorado–Colorado Springs. Paul R. Bahnson, CPA, Ph.D., is professor of accounting at Boise State University. Their e-mail addresses are firstname.lastname@example.org and email@example.com, respectively.
F ASB issued a standard in fall 2006 with the understated title Fair Value Measurements . On one hand, FASB Statement no. 157 appears to shake the foundation of historical cost measurement. On the other, it appears innocuous because it doesn’t compel greater use of fair values. In fact, the standard does a bit of both. Either way, CPAs should quickly acquaint themselves with the new rule, since it becomes effective for annual statements for fiscal years beginning after Nov. 15, 2007, and for interim reports prepared in that initial fiscal year.
Indeed, Statement no. 157 does not require fair values to be used in any situations not already covered by GAAP that existed at the time it was issued. However, it changes the status quo in three ways:
It raises the bar for practice by specifying new factors to consider when measuring fair values that are already required in GAAP, such that different (and better) numbers will be reported in some situations.
It paved the way for FASB Statement no. 159, The Fair Value Option for Financial Assets and Financial Liabilities, which creates the possibility that fair values will be introduced and used in new ways in financial statements.
It sets the stage for the new Conceptual Framework that FASB is developing.
In particular, we believe the board’s 2006 Preliminary Views document, Objective of Financial Reporting and Qualitative Characteristics of Decision—Useful Financial Reporting Information, indicates that fair value will eventually be the preferred measure for financial statements. For these reasons, then, it made sense to issue Statement no. 157 to clean up and otherwise clarify what fair value means and how it can and should be measured.
Contrary to what many may think, fair value accounting is not a theoretical abstraction that might be put into practice at some indefinite date. Fair values have actually been introduced into GAAP piecemeal over many decades in a large number of standards, including, for example, those dealing with inventory, investments, financial instruments of all kinds, business combinations and stock options. Furthermore, it has also long been required to write impaired assets down to a fair value less than their original cost or book value.
FASB developed Statement no. 157 to bring uniformity and consistency to the literature and, more importantly, to practice. Among its contributions is a phenomenal catalog of existing fair value measurement situations. An appendix to the standard lists more than 60 pronouncements where fair values are measured and reported.
As a result, all CPAs should understand this standard and its implications for practice.
THE BASIC IDEA
The standard states that “[f]air 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.” (Statement no. 157, paragraph 5)
Few may comprehend that this definition is the board’s quiet resolution of the long-standing controversy of whether fair value should be based on what the owner would receive upon selling an asset (exit value) or what it would pay to buy a new one (entry value). The accompanying sidebar, “Entry and Exit Values,” describes more about this issue and how FASB worked around the controversy.
Entry and Exit Values
The difference between entry and exit values has perplexed accounting theoreticians for more than a half century, dividing even those who are strongly committed to fair values over original costs. The classic example that puzzled many is the case of a specialized machine that is purchased by one company at a high price even though it could only be sold to someone else at a substantially lower amount.
The outcome of applying exit value accounting would be an immediate loss to the buyer. On the other hand, reporting the machine at its high replacement cost would conceal the risk inherent in the specialization strategy. At some point, the dialogue among theorists bogged down on this paradox with no further progress.
But the fact remains that differences between entry and exit values are real. Indeed, those differences are actually the source of most income. Specifically, an actor of some kind acquires an asset in one market and then uses or sells it in another, as represented in this diagram:
By selling in the exit market for a higher price than was paid in the entry market, profits are achieved. This can happen only if the actor has relatively unique access to both markets at the same time; if just anyone can buy low and sell high in both markets, the resulting competition squeezes out the difference.
The diagram at bottom shows the links between markets and various actors.
In the normal course of commerce, profits are earned by manufacturers and dealers because of their ability to simultaneously access different markets such that their entry values are less than their exit values. However, at the last stage, a consumer can typically sell an asset only in a market that will not pay as much as the purchase price. It is on this paradox that theorists have foundered.
By specifying in Statement no. 157 (and thus in 60 other pronouncements) that fair value is the reporting company’s exit value, FASB risked the possibility that some would be forced to show losses when acquiring assets for use that could be sold only for less than the purchase price. To deal with this potentially confusing outcome, the standard requires owners to value their assets under the presumption of selling them to a buyer who will apply them to the “highest and best use of the asset by market participants, considering the use of the asset that is physically possible, legally permissible, and financially feasible at the measurement date” (paragraph 12). The board explains further: “In broad terms, highest and best use refers to the use of an asset by market participants that would maximize the value of the asset or the group of assets within which the asset would be used. Highest and best use is determined based on the use of the asset by market participants, even if the intended use of the asset by the reporting entity is different.” Regarding the specialized machinery example, the highest and best use will often be the same as the plans of the existing owner. Thus, the exit valuation in this context will converge on the entry value.
This substitution of an expected replacement cost for a true exit value may create some initial head scratching. But, however it turns out, we applaud the board for finding a good practical way to cope with the issue that has for so long vexed theorists.
Level 1. The preferred inputs to valuation efforts are “quoted prices in active markets for identical assets or liabilities,” with the caveat that the reporting entity must have access to that market (paragraph 24). Information at this level is based on direct observations of transactions involving the same assets and liabilities, not assumptions, and thus offers superior reliability. However, relatively few items, especially physical assets, actually trade in active markets.
The central component of Statement no. 157 is its description of the “Fair Value Hierarchy” (paragraphs 22–31). The board identifies priorities that management must follow in estimating the fair values of assets or liabilities. The hierarchy describes inputs to measurement models without actually specifying which models should be used. The relationships among the three levels of inputs are described by the flowchart in Exhibit 1.
Level 2. FASB acknowledged that active markets for identical assets and liabilities are relatively uncommon and, even when they do exist, they may be too thin to provide reliable information. To deal with this shortage of direct data, the board provided a second level of inputs that can be applied in three situations.
The first involves less-active markets for identical assets and liabilities; this category is ranked lower because the market consensus about value may not be strong. The second arises when the owned assets and owed liabilities are similar to, but not the same as, those traded in a market. In this case, the reporting company has to make some assumptions about what the fair value of the reported items might be in a market. The third situation exists when no active or less-active markets exist for similar assets and liabilities, but some observable market data is sufficiently applicable to the reported items to allow the fair values to be estimated.
Specifically for financial assets and liabilities involving fixed-dollar flows, a suitable Level 2 input to a valuation model may be the apparent discount rate for similar assets and liabilities implied by their market value and future cash flows. For example, a company may estimate the value of its untraded liabilities by finding the discount rate that the markets seem to be applying to its traded debt securities. Notably, FASB indicates that assumptions enter into models that use Level 2 inputs, a condition that reduces the precision of the outputs (estimated fair values), but nonetheless produces reliable numbers that are representationally faithful, verifiable and neutral.
Level 3. If inputs from levels 1 and 2 are not available, FASB acknowledges that fair value measures of many assets and liabilities are less precise. The board describes Level 3 inputs as “unobservable,” and limits their use by saying they “shall be used to measure fair value to the extent that observable inputs are not available.” This category allows “for situations in which there is little, if any, market activity for the asset or liability at the measurement date” (paragraph 30). Earlier in the standard (paragraph 21), FASB explains that “observable inputs” are gathered from sources other than the reporting company and that they are expected to reflect assumptions made by market participants.
In contrast, “unobservable inputs” are not based on independent sources but on “the reporting entity’s own assumptions about the assumptions market participants would use.” To clarify that this category excludes fabricated numbers, the board requires them to “be based on the best information available in the circumstances.” Despite being “assumptions about assumptions,” Level 3 inputs can provide useful information about fair values (and thus future cash flows) when they are generated legitimately and with best efforts, without any attempt to bias users’ decisions.
Adjustments. With the exception of traded securities, it generally will not be possible to find identical assets and liabilities traded in active markets. In these situations, the observed values are adjusted to allow for differences between the reported items and the substitutes that are measurable. These adjustments may reflect different physical conditions and locations as well as other constraints on marketability.
||FASB 157 Hierarchy of Inputs to Valuation Models
Because varying degrees of precision result from using different kinds of inputs, Statement no. 157 establishes disclosure requirements that reveal to financial statement users how the fair value estimates were produced. First of all, managers must provide separate disclosures about assets and liabilities whose fair values are measured repeatedly from those whose values are measured only once or occasionally. For example, fair values of investments and many financial instruments are estimated at every reporting date. Others, such as impaired assets and those acquired in a purchase combination, are not revalued at every date.
For recurring situations, a schedule must reveal how much of the reported fair value was developed using each level of input for each category of asset and liability. Exhibit 2 is taken from Appendix A of the standard as an illustration of this table for assets. This information is relevant because it allows users to assign varying degrees of precision to different categories. For example, a user might consider the Level 1 measures to be precise at +/–1%; Level 2 at +/–5%; and Level 3 at +/–20%. If so, the total market value in Exhibit 2 would likely fall in the interval between $251,000 and $269,000. The $9,000 variation from the reported $260,000 consists of the sum of 1% of the $205,000 at Level 1, 5% of the $25,000 at Level 2, and 20% of the $30,000 at Level 3. The variation would be greater, of course, if more assets are valued with Level 3 inputs, or if greater imprecision is assumed for each category. While imprecision and uncertainty can never be eliminated, users can reduce them by using this tabulation to quantify the potential variability.
To assist users in situations with more significant reliance on Level 3 inputs, Statement no. 157 requires management to provide additional information about changes in these estimated fair values as a reconciliation of the beginning and ending values. The table must also indicate whether the resulting gains and losses appear in the income statement or other comprehensive income on the balance sheet.
For nonrecurring situations, managers will provide more complete disclosures similar to those for recurring measures. Again, the purpose is to provide users with sufficient analytical ammunition to deal with the uncertainty produced by these estimates.
||Example Disclosures About Recurring Fair Value Measures
|($ in thousands)
||Fair Value Measurements at Reporting Date Using: |
||Quoted Prices in Active Markets for Identical Assets
|Significant Other Observable Inputs
|Significant Unobservable Inputs |
|Venture capital investments
WHAT DOES FASB 157 ACCOMPLISH?
The main contribution of Statement no. 157 is to bring many other accounting standards into the 21st century by creating more rigor for estimates of fair value. An appendix not only identifies each affected pronouncement but also shows words that are deleted and added by the new standard. For example, paragraph 5(c) of FASB Statement no. 13 on leases is amended by Statement no. 157 (strikethrough indicates deletion and underlining addition):
Fair value of the leased property.
The price for which the property could be sold in an arm’s length transaction between unrelated parties. The price that would be received to sell the property in an orderly transaction between market participants at the measurement date. Market participants are buyers and sellers that are independent of the reporting entity, that is, they are not related parties at the measurement date.
As this excerpt shows, Statement no. 157 is designed to clarify existing standards, not create new uses of fair value.
SETTING THE STAGE
Any discussion of Statement no. 157 would be incomplete without addressing its second purpose of providing a launch pad for bringing additional usefulness into statements through later new fair value standards and a new conceptual framework that we predict will call for fair value measurements in more situations, either in supplemental disclosures or in the body of the financial statements themselves.
This purpose has already been fulfilled in FASB Statement no. 159, which was issued in early 2007, only six months after Statement no. 157. The details of this standard will be described in a forthcoming issue of the JofA. What should be noted here is that the statement would have been much harder to compose, pass and implement if the groundwork in Statement no. 157 had not been completed.
We are satisfied with the direction taken in Statement no. 159 because it will allow innovative managers to voluntarily bring greater quantities of more useful information to the capital markets through their financial statements. Of course, the risk is that some managers will try to use the flexibility to produce misleading representations of some but not all of their assets and liabilities. These efforts would be both unethical and pointless because the capital markets will sooner or later extract a penalty through lower stock prices and higher capital costs. Looking well ahead, we expect traditional cost-based financial reporting to fade while value-based reporting grows more prominent. This process has actually been under way in one form or another for decades, so it should not come as a surprise. We don’t think statements no. 157 and no. 159 will disrupt this gradual trend.