Analysis of SFAS 157, Fair Value Measurements
Starting Point for Making Difficult Valuations

By Jayne Fuglister and Robert Bloom

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SFAS 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.

Fair Value

SFAS 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” (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 date.

SFAS 157, 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. 6)

The quality 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 users.

Management 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.

Analysis

Fair 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.

In measuring 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.

Assets. 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:

Because 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.

Thus, the “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).

Should the 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).

In another 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).

Liabilities. 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).

FASB recognized 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).

FASB also 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).

Valuation 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 securities.
• The income approach relies on present-value techniques to translate future amounts to the present time, as illustrated by an option pricing model.
• 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. A19).

In another 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).

Fair 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.

SFAS 157 (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 1.

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 (para. A20).

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 (para. A25e).

Disclosure

Sample disclosures 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:

a. fair value measurements;
b. the level in the hierarchy in which these measurements are placed;
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.

SFAS 157 (para. 33) states that disclosures required for assets and liabilities valued on a nonrecurring basis are as follows:

a. fair 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.

The effective 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 (para. 37).

Defining Fair Value

SFAS 157 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.

The standard 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.

SFAS 157 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.

©2009 The New York State Society of CPAs. Legal Notices