FAS 157 – Fair value accounting and Level 3 assets
Statements of Financial Accounting Standards No. 157, Fair Value Measurements, commonly known as “FAS 157”, is an accounting standard issued in September 2006 by the Financial Accounting Standards Board (FASB). FAS 157 became effective for entities with fiscal years beginning after November 15, 2007.
Objective of FAS 157
To define fair value, establish a framework for measuring fair value and expand disclosures about fair value.
What is FAS 157?
FAS 157 require that assets or liability should be measured at “fair value”, at “The price that would be received when an asset is sold or paid to transfer a liability in an orderly transaction between market participants at the measurement date”.
It sounds simple but begs the question, how should one calculate the fair value? FAS 157 classified assets and liabilities in three categories on the basis of measurement and disclosure.
- Securities and instruments that are traded and quoted on a daily basis
- Securities and instruments that are not quoted but have observable prices
- Unobservable prices (not directly or indirectly available but calculated based on assumptions)
Level 1: These are assets and liabilities which have quoted prices in active markets such as Treasury Bills, US Government Bond, liquid and marketable securities, foreign currencies, gold bullion, etc. These instruments and securities can be valued and marked-to-market. Mark-to-market is the price or value of a position (asset or liability) based on the current or most recent market price.
Level 2: Financial assets and liabilities whose values are based on quoted prices in inactive markets, or whose values are based on models – but the inputs (interest rates, yield curves, volatilities, prepayments, default rates etc) to those models are observable either directly or indirectly for substantially the full term of the life of the asset or liability. For example, an interest rate swap uses known, public data, such as interest rates and the contract terms can be used to calculate a value of the interest rate swap. The instrument can be valued indirectly using observable data. Level 2 prices are further categorized between prices based on trading in thin markets, prices based on similar assets or liabilities (like real estate properties in comparable locations and with comparable built up area and features) and finally prices based on limited observable data which is thin in coverage compared to the first two categories but still sufficient to estimate fair value.
Level 3: Unobservable prices based on assets and liabilities that are not actively traded, are illiquid and can only be estimated using assumptions about assumptions. The unobservable inputs reflect management’s own assumptions about the assumptions (hence the term “mark to management”) a market participant would use in pricing the asset or liability (examples include private equity investments, illiquid residential and commercial mortgage tranches (including loans, securities and derivatives), and long-dated or complex derivatives including foreign stock exchanges, foreign options and long dated options on gas, electricity and other commodities).
FAS 157 VALUATION GUIDELINES
- Comparable values in all markets
- Discounted Cash Flows
- Black-Scholes Option Pricing
- Multi-period Excess Earnings
- Cost to acquire a substitute asset with the same utility
Application of Valuation Approach on three levels
- Level 1 – Market
- Level 2 – Market & Income
- Level 3 – Income & Cost
When you apply FAS 157 your focus needs to be on the exit price (for an asset, the price at which it would be sold (bid price)) rather than an entry price (for an asset, the price at which it would be bought (ask price)), regardless of whether the entity plans to hold the asset for investment or resell it later.
Second, FAS 157 emphasizes that fair value is market-based rather than entity-specific. Thus, the optimism that often characterizes an asset acquirer must be replaced with the skepticism that typically characterizes a dispassionate, risk-averse buyer.