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| March 2008 | A
Service of the NYSSCPA |
Vol.
2, No. 1 |
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A Closer Look at FAS 157 Disclosures
| FAS 157 Fair Value Measurements |
This article summarizes and explores the disclosure elements of the Statement. It is important to note that FAS 157 does not create any new fair value measurements (although for some entities, its application will change current practice) but does create disclosure requirements that are entirely new.
FAS 157 at a Glance
The Statement was issued in September of 2006, because there were varying definitions of fair value and only a limited amount of guidance to apply the concept to comport with GAAP.
The existing guidance was found among various older accounting pronouncements that require fair value measurements. In FASB’s opinion, differences in existing guidance was creating inconsistencies and complexity that were undesirable for GAAP purposes. FASB’s goal in issuing this Statement was to engender increased consistency and comparability in fair value measurements and to expand disclosures about fair value measurements.
Joseph A. Maffia, Member of the NYSSCPA Financial Accounting Standards Committee said of FAS 157’s attempt to provide consistency, “Basically, FAS 157 was trying to [provide] some consistency in practice. It doesn’t dictate what you have to do, but tried to rein in different methods of fair value calculation. It’s trying to add consistency, more for guidance,” he said. “I think consistency in practice is always a good thing.”
For discussion purposes, let us review that, as defined in the Statement:
Level 1 assets have observable market prices.
Level 2 assets do not have observable prices, but have inputs that are based on observable prices.
Level 3 assets have inputs that do not have observable prices.
The Statement clarifies that market participant assumptions also include assumptions about the effect of a restriction on the sale or use of an asset. A fair value measurement for a restricted asset should consider the effect of the restriction if market participants would consider the effect of the restriction in pricing the asset. That guidance applies for stock with restrictions on sale that terminate within one year that is measured at fair value under FASB Statements No. 115, Accounting for Certain Investments in Debt and Equity Securities, and No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations.
Maury Cartine, Chair of the NYSSCPA Taxation of Financial Instruments and Transactions Committee had this to say on “Level1:” “Level one is perhaps significant in that it is the first time that a valuation of an exchange-traded security is mandated. There’s absolutely, unequivocally one price for that security. That is, for the first time, the valuation is mandated.”
Cartine said in the past, an auditor might note that a company’s securities are thinly traded and question the value of the securities. Pricing can change significantly. Cartine compared it to a concept called blockage, where, if a company tried to liquidate or unload a large portion of its shares, the value of those securities would be discounted. Cartine said that according to information from the AICPA, blockage is not taken into account any longer, “except in certain grandfathered cases.”
FAS 157 explains that a fair value measurement for a liability reflects its nonperformance risk (the risk that the obligation will not be fulfilled). Because nonperformance risk includes the reporting entity’s credit risk, the reporting entity should consider the effect of its credit risk on the fair value of the liability in all periods in which the liability is measured at fair value under other accounting pronouncements, including FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities.
This Statement re-affirms the FASB requirement of using fair value for a position in a financial instrument trading in an active market being measured as the product of the quoted price for the individual instrument times the quantity held (within Level 1 of the “fair value hierarchy”). FAS 157 extends the requirement to broker-dealers and investment companies within the scope of the AICPA Audit and Accounting Guides for those industries.
The Statement’s guidance applies to derivatives and other financial instruments measured at fair value under Statement 133 at initial recognition and in all subsequent periods, thus, nullifying the guidance in footnote 3 of EITF Issue No. 02-3, Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities. Statement 133 is amended to remove the similar guidance to that in Issue 02-3, that had been added by FASB Statement No. 155, Accounting for Certain Hybrid Financial Instruments.
A Review of New FAS 157 Disclosures
The Statement begins its discussion of disclosures by requiring “information that enables users of its financial statements to assess the inputs used to develop those measurements and for recurring fair value measurements using significant unobservable inputs and the effect of the measurements on earnings …”
As with required disclosures from throughout GAAP, this is a simple and tall order all at the same time. They are simple items, but deriving the information for each major class of assets and liabilities and both annually and for interim periods, represents a significant amount of work and incurs a large degree of costs.
[Editors’ Note: As the specific elements of the disclosure requirements are detailed, please review the original Statement at the link below. This article is for discussion purposes, and not intended to be all-inclusive.]
In general, the reporting entity must disclose the following information:
a. The fair value measurements at the reporting date,
b. The “level” (1, 2 or 3 within the defined “fair value hierarchy”) in which the measurements, segregating fair value measurements using quoted prices in active markets for identical assets or liabilities (Level 1), significant other observable inputs (Level 2) and significant unobservable inputs (Level 3), [Please review the Statement’s fair value hierarchy.]
c. For using significant unobservable inputs (Level 3), a reconciliation of the beginning and ending balances, separately presenting changes during the period attributable to total realized and unrealized gains or losses for the period (including a description of where the gains or losses from earnings are reported); net purchases, sales, issuances, and settlements; and transfers of Level 3,
d. Total gains or losses (or changes in net assets) attributable to the change in unrealized gains or losses relating to those assets and liabilities held at the reporting date and a description of where those unrealized gains or losses are reported, and
e. For annual periods only, the valuation technique(s) used to measure fair value and a discussion of changes in valuation techniques, if any, during the period
For assets and liabilities that are measured at fair value on a nonrecurring basis in periods subsequent to initial recognition, entities must disclose information that enables users of its financial statements to assess the inputs used to develop the measurements.
Cartine added, “The next two levels [Levels 2 and 3] are not really methods in how you value, but merely create reporting obligations. In one way, [FAS 157] mandates a valuation practice for securities traded on an exchange, and secondly it becomes a reporting tool, placing obligations on companies to report in their financial statements the various levels of their securities,” he said.
“Applicable to all businesses, the fair value measurement rules apply to assets not just securities, and even liabilities have to be valued, he said” Cartine used the example of a short sale of stock in the market: you sell your shares for $50 each, then, instead of the price of the stock falling, it goes to $60. Now you have a $10 liability per share sold.
According to FASB, the entities must disclose:
a. The fair value measurements recorded during the period and the reasons for the measurements
b. The level within the fair value hierarchy in which the fair value measurements fall
c. For measurements with unobservable inputs (Level 3), a description of the inputs and the information used to develop the inputs
d. For annual periods only, the valuation technique(s) used to measure fair value and a discussion of changes, if any, in the valuation technique(s) used to measure similar assets and/or liabilities in prior periods
The quantitative disclosures required by FAS 157 must be presented using a tabular format. An example of this format is presented in the Statement’s Appendix A (link provided below).
Understanding the New Disclosure Requirements
The Statement expands disclosures about the use of fair value to measure assets and liabilities in interim and annual periods subsequent to initial recognition. The expanded disclosures is intended to provide third-party financial statement users with better information sooner regarding the extent to which fair value is used, the inputs used and the effect of certain measurements on earnings (or changes in net assets).
The required disclosures center on the “inputs” used to measure fair value and for recurring fair value measurements using significant unobservable inputs. The language used throughout the Statement is more practical than it is theoretical due to the nature of the measurements.
It may be argued that the most significant changes produced by FAS 157 pertain to disclosures and the determination of market values, where in some instances, there is not a market.
Entities are “encouraged” to combine the fair value information disclosed under FAS 157 with the fair value information disclosed under other accounting pronouncements such as FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments and to disclose information about other similar measurements such as inventories measured at market value under ARB 43, Chapter 4. The use of the term “encouraged” might be the subject of debate in the Profession.
The expanded disclosures is intended to provide third-party users of financial statements with useful information in making investment, lending, and other decisions, and, per FASB, ties into the first objective of financial reporting in FASB Concepts Statement No. 1, Objectives of Financial Reporting by Business Enterprises [for those of your who are “standards wonks,” i.e., expert with a detailed knowledge of current or potential accounting policies…].
Better Information Sooner from Early Adoption
Some third-party users have seen the enhanced disclosures based on Level 1, 2, and 3 assets already due to many entities having opted for early adoption of FAS 157. Investors and others were afforded an opportunity to see FAS 157 applied: The largest banks and investment houses such as Goldman Sachs, Merrill Lynch, Citigroup and Bank of America had adopted the Statement early. The early adoption meant that most began making these disclosures from the start of 2007 or (for most brokers), since the start of their current fiscal year, which began in December 2006. The thinking, likely, was two-fold (similar to the integration of “Sarbanes Oxley” implementation): To get a “head start” on implementation to minimize costs and to provide investors with better information.
More specifically, “Level 1” refers to assets that have observable market prices such as a stock traded on the NYSE. “Level 2” assets do not have an “observable price” but do have inputs that are based on such prices such as an interest-rate swap in which components have observable data points such as the price of a 10-year Treasury bond. “Level 3” refers to assets in which one or more of the inputs do not have observable prices. This is, of course, the category in which there is the most uncertainty as these estimates derive from the judgment of the company’s management.
Overall, entities that have adopted FAS 157 early gave more detailed information to third-party users.
What’s the Point of FAS 157(?)
FASB maintains that third-party financial statement users might pay more attention to the way companies price “hard-to-value” (Level 3) assets even though FAS 157 does not require companies to write down prices due to existing market turbulence. More aptly put, the new disclosures should prompt third-party users such as investors and regulators to examine more closely the adequacy of corporate “write-downs.” Current market pricing and conditions would a consideration.
“[FAS 157] doesn’t solve any of the problems of ‘hard to value’ assets,” Cartine said, “but it alerts the reader of financial statements to assets that may [be] more difficult to value than might otherwise be expected.”
In past years, entities might represent that an asset’s value was strong in the face of a market downturn because its long-term value had not been impaired. Under FAS 157, reporting entities must consider current value if sold presently. Consequently, some companies might have to take large write-downs earlier due to the cash flows resulting from an investment, but this is deemed, by FASB, to better information for third-party decision makers.
FASB Determines the Cost/ Benefit Analysis for Financial Reporting and Disclosure
FASB intended FAS 157’s framework for measuring fair values to build on current practice even though, for some entities, this meant that large-scale systems and other changes had to be made in order to comply.
There are always attendant costs in applying new requirements regardless of their origin. FASB always had to consider the traditional cost/benefit analysis before approving a new standard. FASB concluded, in the matter of fair value measurements, that the benefits outweigh the costs.
The provisions of FAS 157 changed fair value measurement from an “entrance price” approach to an “exit price” approach based on the transactions between market participants. This concept is largely different than what entities have been used to under GAAP in determining fair value. The new fair value determinations might result in a more rigorous review process because the FAS 157 principles apply to recurring measurements of items recorded at fair value (such as available-for-sale or trading securities and lower-of-cost-or-market determinations), nonrecurring measurements (such as purchase price allocations), impairment tests and disclosures of fair value (such as those required by FAS 107).
Investors and other third-party users will soon see all affected entities’ disclosures related to it when companies report their first-quarter 2008 results.
How FAS 157 Relates to FASB’s Conceptual Framework [for the “Standards Wonks” Among Us]
The framework for measuring fair value relates to FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information. Concepts Statement 2 emphasizes providing comparable information to enable financial statement users to identify similarities and differences of two sets of economic events.
The definition of fair value relates to FASB Concepts Statement No. 6, Elements of Financial Statements, as the subject pertains to market participants. A fair value measurement should reflect future economic benefits and the future outflows associated with a liability.
FAS 157 integrates the guidance of FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, although it does not revise it. FASB will consider the need to revise Concepts Statement 7 in its conceptual framework project. [Look for that in the far-off future. FASB has scheduled “Preliminary Views” for the first quarter of 2009, and the final document has yet to make its calendar.]
How the Changes in This Statement Improve Financial Reporting
As FASB designed things, a solitary definition of fair value in the standards combined with a framework for measuring it should result in increased consistency and comparability in GAAP. The amendments made by the Statement advance the Board’s initiatives to streamline the accounting literature and eradicate differences generating complexity.
With complex standards such as FAS 123R in 2006 and FAS 157 and 159 when adopted in 2007 or 2008, an entity’s auditors may effectively apply audit procedures during their review of the first quarter Form 10-Q.
FASB Project Updates Including the Most Recent on Leases
Statement 157 was issued on September 15, 2006, and as issued, was effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Some preparers and others observe, however, that in many areas they are having difficulty resolving implementation issues related to non-financial assets and non-financial liabilities (a) that are acquired in a business combination or (b) in the determination of impairment for non-financial assets and non-financial liabilities since those fair value measurements frequently rely on unobservable inputs. Accordingly, a partial deferral of the effective date of Statement 157 will allow for more time to resolve these issues without eliminating many of the Statement’s improvements to financial reporting.
As of February 28, 2008, the FASB has been considering a project the objective of which is to defer the effective date of FASB Statement No. 157. At the February 6, 2008 Board meeting the Board authorized the staff to prepare a final ballot of the proposed FSP.
In February 2008, the Board issued FASB Staff Position (FSP) FAS 157-2, Partial Deferral of the Effective Date of Statement 157. With the issuance of the FSP, the Board completed this project.
Initial Fair Value Measurements Used to Determine Whether a Lease Meets the Criteria for a Direct Financing Lease
Paragraph E4 of FAS 157 amended the Statement 13’s definition of fair value in paragraph 5(c) thusly:
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. (See definition of related parties in leasing transactions in paragraph 5(a).)
FAS 157 did not amend the rest of Statement 13, subparagraph 5(c) that says:
i. When the lessor is a manufacturer or dealer, the fair value of the property at the inception of the lease...will ordinarily be its normal selling price, reflecting any volume or trade discounts that may be applicable...
ii. When the lessor is not a manufacturer or dealer, the fair value of the property at the inception of the lease will ordinarily be its cost, reflecting any volume or trade discounts that may be applicable...
For purposes of lease classification, the initial fair value of the leased asset determined under Statement 157 might not be its cost because paragraph 17 of Statement 157 excludes transaction costs from a fair value measurement.
Fair Value Measurement Objective for Estimated Residual Values
In a direct financing lease and a sales-type lease, the lessor’s gross investment is equal to the minimum lease payments plus the unguaranteed residual value accruing to the lessor.
For additional information on FAS 157 and leases, FASB provides the following: http://fasb.org/pdf/fsp_fas157-1.pdf.
For general additional information on FAS 157, FASB provided the following: http://www.fasb.org/project/fas157_partial_deferral_effective_date.shtml.
Contacts:
Michael Tully, Valuation
Fellow, mwtully@fasb.org
John Drum, Postgraduate Technical Assistant, jcdrum@fasb.org
| FAS 157, Fair Value Measurements | September 2006 | Effective for fiscal years beginning after November 15, 2007, and all interim periods within those fiscal years. Earlier application is permitted if the entity has not yet issued interim or annual financial statements for that fiscal year. Click here to read more. |
| New — FSP FAS 157-1, "Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13" | February 2008 | Effective upon the initial adoption of Statement 157. Click here to read more. |
| New — FSP FAS 157-2, "Effective Date of FASB Statement No. 157” | February 2008 | Effective upon issuance. Click here to read more. |
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