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Home > Balance Sheets Best Practice > Fair Value Accounting: SFAS 157 and IAS 39

Balance Sheets Best Practice

Fair Value Accounting: SFAS 157 and IAS 39

by Kevin Ow Yong

Executive Summary

  • Fair value accounting is increasingly being adopted by many countries across the world.

  • When financial instruments are not traded in active markets, fair value accounting involves subjective estimations based on valuation models.

  • There are many measurement considerations that managers need to be aware of when making subjective valuation estimates of their firms’ financial instruments.

  • Understanding these measurement issues aids managers in considering how best to manage their firms’ assets and liabilities in a fair-value-driven accounting regime.

Introduction

Recent initiatives by both the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) have increased the use of fair value accounting for financial reporting across many jurisdictions around the world. There are many issues surrounding fair value accounting. This article outlines the main measurement issues contained in the fair value accounting standard used by the FASB (SFAS 157), and that used by the IASB (IAS 39).

The Rationale for Fair Value Accounting

The increasing use of fair value accounting in financial reporting came about because accounting standard setters have debated, and come to the conclusion that fair value appears to meet the conceptual framework criteria better than other measurement bases (for example, historical cost, amortized cost, among others). Notwithstanding this rationale, a major issue with fair value accounting is the difficulty of measurement (“subjective estimates”) when financial instruments do not trade in active markets. Both SFAS 157 and IAS 39 provide measurement guidance as to how firms should compute fair value estimates in such a situation.

Fair Value Accounting Based on SFAS 157

SFAS 157 details the framework for measuring fair value for firms reporting their financial statements based on US GAAP. Prior to this standard, there were different definitions of fair value, and limited guidance in the applications of those definitions. SFAS 157 provides a consistent definition of fair value, outlines several types of valuation techniques that can be used to measure fair value, and requires firms to disclose their valuation inputs (the “fair value hierarchy”), in order to increase consistency and comparability in fair value measurements.

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” (paragraph 5). This definition focuses on the price that would be received to sell the asset or paid to transfer the liability (“exit price”), not the price that would be paid to acquire the asset or received to assume the liability (“entry price”). An orderly transaction assumes that the firm has sufficient time to market the asset. Hence, fair value estimates should not be estimated as in a forced liquidation or distress sale, contrary to some misconceptions about fair value accounting.

SFAS 157 states three valuation techniques which can be used for estimating fair values. They are the market approach, income approach, and/or cost approach (paragraph 18). A market approach typically uses quoted prices in active markets, but other valuation techniques consistent with the market approach include the use of market multiples derived from a set of comparables, and matrix pricing that allows a firm to value securities without relying exclusively on quoted prices.

The second approach is the income approach. The income approach uses valuation techniques to convert future amounts (cash flows or earnings) to a single present value amount. Examples of such valuation techniques include present value discounted cash flows, option pricing models (for example, the Black–Scholes–Merton formula, or a binomial model), and the multi-period excess earnings method. Finally, the cost approach is based on the amount that would be required to replace the service capacity of an asset. From the perspective of a seller, the price that would be received for the asset is determined based on the cost to a buyer to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence such as physical, functional (technological), and economic (external) obsolescence.

SFAS 157 establishes a fair value hierarchy that prioritizes the inputs to valuation techniques that are used to measure fair value. Broadly speaking, inputs refer to the assumptions that market participants would use in pricing the asset or liability, including assumptions about risk. The standard specifies the use of valuation techniques that maximize the use of observable inputs (i.e., based on market data obtained from sources independent of the firm), and minimize the use of unobservable inputs (i.e, inputs that reflect the firm’s own assumptions as to how market participants would price an asset or liability) (paragraph 21).

Specifically, a firm is to use Level 1 inputs (unadjusted quoted prices in active markets) on the assumption that a quoted price in an active market provides the most reliable evidence of fair value. It shall be used whenever available (paragraph 24), except when it is available but not readily accessible (paragraph 25), or when it might not represent fair value at the measurement date (paragraph 26). If observable prices are not available, the firm can value its assets based on Level 2 inputs (observable inputs other than quoted prices included within Level 1). Level 2 inputs are inputs such as (i) quoted prices for similar (but not identical) assets or liabilities in both active and inactive markets, and (ii) inputs other than quoted prices such as interest rates and yield curves, credit risks, default risks, and other inputs that can be derived principally from observable market data by correlation, or other means (market-corroborated inputs). A Level 2 input must be substantially observable for the full term of the asset or liability.

Finally, to the extent that observable Level 2 inputs are not available (for example, situations in which there is little market activity for the asset or liability at measurement date), Level 3 inputs can be applied. These are the firm’s own assumptions about how other market participants would price the asset or liability. To ensure that there is information that will enable financial statement users to assess the quality of inputs used to estimate these fair value measurements, the standard requires firms to disclose information (separately for each major category of assets and liabilities), both quantitative information that shows how the fair value measurements are segregated based on the valuation inputs, and qualitative information that details the valuation techniques used to measure fair value. The quantitative disclosures are to be presented in tabular format. An example is given in the Case Study.

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Further reading

Reports:

Websites:

  • Financial Accounting Standards Board (FASB): www.fasb.org
  • International Accounting Standards Board (IASB): www.iasb.org

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