of SFAS 157, Fair Value Measurements
Starting Point for Making Difficult
Jayne Fuglister and Robert Bloom
- Issued by FASB in 2006, SFAS 157, Fair Value Measurements, provides
a comprehensive framework plus specific implementation guidance
on the measurement of fair value and required disclosures. It supersedes
the piecemeal guidance on fair value contained in previous standards.
The 2006 standard helps users assess the reliability of fair value
measures and, although comparability across entities is not assured,
it is improved. SFAS 157 itself does not require that fair value
be applied to specific items; it merely clarifies how to value items
that must be measured as such.
157 includes sections on its scope, fair value measurement, initial
recognition, valuation techniques, inputs to valuation techniques,
fair value hierarchy, disclosures, and transition issues. The
appendices deal with implementation guidance, present-value techniques,
background information and basis for conclusions, and references
to other FASB and Accounting Principles Board (APB) pronouncements.
The implementation guidance contains numerous examples of how
to apply SFAS 157 in practice, several of which are used below
to illustrate the concepts embodied by the standard. The relevant
text, taken directly from SFAS 157, is referenced below with the
corresponding paragraph of the standard.
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”
(para. 5). The orderly transaction is hypothetical at the measurement
date (para. 7). The objective is to determine the cash flows from
selling the asset or settling the liability at the measurement
accordingly, considers multiple valuation techniques, including
those based on quoted market prices, expected cash flows, and
replacement costs. The attributes of the specific asset and liability
and the quality of the inputs determine which valuation technique
is used. An asset’s attributes could be determined by answering
the following questions: Can the asset be replicated? Where is
the asset located and how will it be used? What is the condition
of the asset? Are there legal restrictions on the asset? (para.
of the inputs is based on a hierarchy which presumes that, given
the same economic circumstances, independent market prices are
more reliable and comparable than entity-specific estimates not
based on independent data. Companies are required to disclose
the hierarchy of inputs used, giving users greater knowledge of
the reliability of the fair value estimates the firm makes. Comparability
across different businesses, however, may still be difficult for
should aim for the most representative and reliable estimate,
while maximizing the quality of the inputs and considering the
particular attributes affecting the fair value.
values. Ideally, fair values would be based on observable
prices in the appropriate principal market, meaning the market
with the greatest volume and level of activity. Sometimes there
is no principal market for an asset or liability, in which case
fair values are based on prices in the most advantageous market;
that is, the market where the entity receives the best price,
net of transaction costs (para. 8). Such costs do not affect the
recorded value because they are not characteristic of the asset
or liability in question (para. 9). In principal and most advantageous
markets, the participants are buyers and sellers who are independent
of the entity in question, knowledgeable about the asset/liability,
and able and willing to transact for the asset/liability (para.10).
If there is no principal or most advantageous market, an entity
can use pricing models to estimate fair values.
the fair value of assets and liabilities, it is the selling price
that is of significance, according to SFAS 157. The rationale
for emphasizing this price is that it reflects the expected cash
flows that could be received or paid from either selling the asset
or settling the liability. The selling price and the acquisition
price are not necessarily the same. For example, if the original
transaction were between related parties, or if the seller were
under financial distress, the acquisition price may be different
from the selling price.
The fair value measure assumes the highest and best use of the
asset, in view of its characteristics, legal considerations, and
cost factors. SFAS 157 (para. 14) states:
the highest and best use is determined based on its use by market
participants, the fair value measurement considers the assumptions
that market participants would use in pricing the assets, whether
using an in-use or an in-exchange valuation premise.
“highest and best use” of an asset determines whether
the valuation should be “in-use” or “in-exchange”
(para. 13). The highest and best use is in-exchange if the asset
would provide maximum value to market participants principally
on a stand-alone basis. For example, if the highest and best use
of a financial asset is on a stand-alone basis, then the fair
value is measured using an in-exchange premise, such as the price
that would be received in a current sale (para. 13b).
highest and best use of the assets be in conjunction with other
assets (e.g., land with a manufacturing plant offering the maximum
value to market participants), then the fair value would be measured
with an in-use premise—the price from selling the land assuming
it would be used with the building and that the building would
also be available for sale. If the highest and best use of the
land would be for residential or condominium purposes, then the
fair value would be measured with an in-exchange premise, on a
stand-alone basis, net of demolition and other costs. Because
the highest and best use of the land depends on the higher value,
either in-use or in-exchange, market participants determine the
fair value of the land (para. A11).
example of assigning the fair value to a nonfinancial asset, assume
an entity acquires an in-process R&D project during a merger.
The project competes with one of its own projects, so the entity
intends to discontinue the acquired project. If the highest and
best use is its in-use value, which is the price that a buyer
with complementary assets available would pay, then that price
would be the fair value. If the highest and best price is its
in-exchange value, which is the price a buyer would pay as a stand-alone
and then discontinue the project, then that price would be the
fair value (para. A12).
Fair value measurement of liabilities assumes that nonperformance
risk is no different before and after the transfer. Nonperformance
risk, including the entity’s own credit standing, is the
uncertainty that the liability would not be settled, which may
depend on whether the liability is an obligation for goods, services,
or cash, thus affecting its value (para. 15).
that an entity might have advantages or disadvantages relative
to the market about how a liability will be settled. FASB considered
this irrelevant to fair valuation, because the perspective should
be the same whether the entity intends to settle the liability
from its own funds, or the liability is transferred to another
participant. According to FASB, any advantages or disadvantages
would be reflected in earnings over the course of the settlement
of the liability (para. C40).
acknowledged that some liabilities have no quoted prices, so some
entities would use the incremental borrowing rate while others
would use a settlement rate, ignoring part of the credit risk
changes, to estimate value. FASB deferred addressing this comparability
issue (para. C44).
techniques. Valuation techniques include a market
approach, an income approach, and a cost approach.
- The market
approach employs prices from market events with identical or
comparable assets or liabilities, illustrated by a pricing method
that values a debt security based on its relationship to benchmark-quoted
- The income
approach relies on present-value techniques to translate future
amounts to the present time, as illustrated by an option pricing
- The cost
approach is concerned with the amount needed to replace the
service capacity of the asset; that is, its current replacement
cost or the cost to acquire or construct an asset of comparable
utility allowing for obsolescence (para. 18).
In one example
described by SFAS 157, an entity may acquire software for licensing
to customers as part of an asset mix in a merger. To allocate
the cost of the asset mix to the software, the entity applies
fair valuation techniques and determines that the highest and
best use is as an in-use asset (para. A17). Insufficient data
were available to use the market approach, so the entity investigated
the cost and income approaches. The cost approach yielded an estimate
of $10 million, but the software would be very difficult to replicate
because certain aspects were unique and developed using proprietary
information. The income approach yielded a value of $15 million.
In this case the entity should use the income approach (para.
example, an asset group is impaired. One of the machines in the
group was purchased outside but underwent some minor customizations
by the entity. The highest and best use is determined to be in-use
with the other assets as a group. The market approach reflects
quoted prices, considering the condition and location of similar
machines, and yielded an estimate between $40,000 and $48,000.
The cost approach reflects the cost of a substitute machine of
comparable utility and yielded a fair value estimate between $40,000
and $52,000. There was not a separate income stream from the asset,
so the income approach was not applied. In this case, the market
approach should be used, because it is based on quoted prices
for similar machines, the estimated value had a narrower interval
estimate, and there were no unexplained differences between the
entity’s machine and similar machines (para. A16).
In some cases,
one technique is appropriate; in other cases, multiple techniques
are needed (para. 19). Whether the valuation method is based on
the market, income, or cost approach, it should be used consistently.
A change in methods is appropriate only if the new method is at
least as representative as the previous method (para. 20).
value hierarchy. SFAS 157 emphasizes market-based
measurement and, in doing so, stipulates a fair value hierarchy.
The hierarchy is based on the type of inputs applied (the data
used) to measure fair value, not the type of model.
(para. 21) requires that: “Valuation techniques used to
measure fair value shall maximize the use of observable inputs
and minimize the use of unobservable inputs.” The fair value
hierarchy is summarized below and in Exhibit
Level 1 lies
at the top of the hierarchy, where inputs are quoted prices in
active markets. Level 1 inputs may be observable in markets such
as the New York Stock Exchange, Nasdaq, electronic communication
networks, and principal-to-principal markets, where prices are
negotiated independently between the parties with no intermediary
Level 2 inputs
are in the middle of the hierarchy, where data are adjusted from
similar items traded in active markets, or from identical or similar
items in markets that are not active. Level 2 inputs do not stem
directly from quoted prices. For example, the fair value of finished
goods at a retail outlet acquired in a business acquisition could
be based on the price expected to be received in selling the inventory
at retail, or the value at wholesale, adjusted for differences
between the condition and location of the items. Conceptually,
fair value should be the same whether adjustments are made to
a retail price or a wholesale price, but the fair value estimate
that maximizes inputs in the higher level of the hierarchy is
the one that should be used to estimate the price to be received
in selling the inventory (para. A24f).
Level 3 inputs
are unobservable and generated by the entity itself. An asset
retirement obligation for an oil well, for example, would include
expected risk-adjusted cash flows, using the company’s own
data (par. A25d). Another example of a Level 3 input is a financial
forecast developed using the reporting entity’s own data
are furnished in Exhibit
2. SFAS 157 (para. 32) states that the entity is required
to report for each interim and annual period for assets and liabilities
measured in terms of fair values on a recurring basis:
b. the level in the hierarchy in which these measurements are
c. for Level 3 unobservable inputs, a reconciliation of beginning
and ending balances showing realized and unrealized gains and
losses, purchases, sales, issuances, and settlements;
d. the gains and losses from (c) included in earnings due to
changes in the unrealized gains and losses in the assets and
liabilities in question; and
e. for annual periods, the valuation techniques used and a discussion
of any changes in those techniques.
(para. 33) states that disclosures required for assets and liabilities
valued on a nonrecurring basis are as follows:
value measurements and reasons for them;
b. hierarchy level of those measurements;
c. for Level 3 inputs, a description and the information employed
to obtain them;
d. for annual periods, the valuation techniques used and a discussion
of any changes in those techniques.
date for application of this standard is for fiscal years starting
after November 15, 2007, including interim periods in these fiscal
years (para. 36). Generally, the standard will be applied prospectively
breaks new ground as an accounting standard because it provides
answers to the following questions: What does fair value mean?
How should fair value be measured? What should be disclosed about
fair value measurements? With this standard, FASB has asserted
that a fair value is an exchange amount, which is a market-based
measure stemming from a non-distress, hypothetical liquidation.
introduces a hierarchy for evaluating assumptions about market
participants in measuring fair values. The hierarchy differentiates
between observable and nonobservable assumptions or inputs to
techniques for measuring fair values. These inputs, which include
risk factors, restrictions on sale or use of assets, and the nonperformance
risk of a liability, among many others, accommodate extensive
or nonextensive market activity in the asset/liability. The valuation
techniques, in turn, are market-, income-, or cost-based. The
market technique deals with prices from market transactions. The
income technique reflects present values. The cost technique relies
on the development of current replacement costs.
offers a single definition of fair value that will assist in the
assessment of the reliability of fair value measures and could
enhance consistency and comparability in financial reporting.
Whenever a determination of fair value is called for, this standard
will be used by accountants to make their measurements.
Fuglister, DBA, is a professor of accounting at the Nance
College of Business Administration, Cleveland State University,
Robert Bloom, PhD, is a professor of accountancy and Wasmer
Fellow at John Carroll University, University Heights, Ohio.