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Financial Reporting: FAS 157 Fair Value of financial securities and illiquid instruments

FAS 157 – FAIR VALUE OF ILLIQUID SECURITIES

Overview of FAS 157

Released by the Financial Accounting Standards Board (FASB) in September2006, the Financial Accounting Standards No. 157, Fair Value Measurements (FAS 157) became effective for fiscal years beginning 15th November 2007.

The standard defines fair value for financial reporting, establishes a framework to measure fair value under GAAP and expands disclosures on fair value measurements.

Definition of Fair Value

The purpose of FAS157 was to define a standard definition of fair value. This improves the transparency of corporate accounting practices and provides a standard framework for valuation, eliminating the inconsistencies, complexity and need for comparability present in the various definitions of fair value that existed prior to the standard.

FAS157 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.

 

The following must be kept in mind when assessing the fair value:

  • The price that is being considered is the price received to exit an existing position (sell asset or transfer liability)
  • The motivation for selling an asset or transferring the liability is an orderly transaction not a forced sale.
  • The perspective is that of a market participant that holds the asset. Fair value is intended to be a market-based measurement as opposed to an entity specific measurement.

 

Clarification of certain concepts

Market Participant

FAS157 places a great deal of importance on the market participant. The determination of the fair values of assets is based on assumptions that these participants would use in pricing the asset.

Market participants are defined as buyers or seller in the principal (i.e. the best volume) or most advantageous (i.e. the highest price) market who are:

  • Independent of the reporting entity
  • Knowledgeable about the asset and the transaction
  • Able to transact
  • Willing to transact

Orderly Transaction

An orderly transaction between market participants is one which occurs in the principal or most advantageous market for the asset or liability. It presumes that the asset/liability’s is exposed to the market for a certain period to allow for the usual and customary market activities and that the transaction is not a forced transaction.

Assets

The fair value measurement for a non financial asset assumes the “highest and best use” of an asset that is

  1. Legally possible
  2. Legally permissible
  3. Financially feasible

The valuation of the asset is based on an “in use/ in exchange” principal whereby the value of the asset is maximized based on how the asset will be used by market participants even if this use is different from the intended use by the reporting entity. The focus is on market participant use rather than on buyer-specific use.

Liabilities

The valuation of a liability is on the basis of the transfer of their associated non-performance risk to the market participant and not the elimination or settlement of this risk with the counterparty.

Establishes a framework to measure fair value

Valuation Techniques

FAS157 requires using valuation techniques that are consistent with three traditional approaches, namely:

  • Market Approach
    • Quoted prices in active markets for identical or comparable assets or liabilities.
    • Can include matrix pricing
  • Income Approach
    • Techniques to convert future amounts to a single present amount.
    • Can include present value, option-pricing, and multi-period excess earnings
  • Cost Approach
    • Replacement cost – does not apply to financial assets and liabilities

Such techniques should be consistently applied; a change is appropriate (for example, to the weighing of the various methods) only if it is a better representation of fair value.

In general the valuation techniques used would maximize the use of observable inputs and minimize the use of unobservable inputs.

 

Valuation inputs

FAS157 tends to focus on inputs rather than techniques. It defines a “fair value hierarchy” that distinguishes among three levels of value based on inputs:

Level One: Observable inputs are based on market data obtained from sources independent of the reporting entity. These are directly quoted unadjusted prices of in active markets for identical assets or liabilities at the measurement date.

Level Two: The inputs are observable inputs other than quoted prices for the asset or liability. These include:

  • Quoted prices for similar assets or liabilities in active markets.
  • Quoted prices for identical or similar assets or liabilities in inactive markets
  • Observable inputs other than quoted prices for the asset or liability, such as interest rates and yield curve observable at commonly quoted intervals, volatilities, prepayment speeds, loss severities, credit risks and default rates.
  • Inputs derived from or corroborate by market data such as by correlation

Level Three: These inputs are unobservable. There is very little if any market activity for the asset or liability at the measurement date. The inputs that the reporting entity will developed are to be based on its assumptions of what the market participants pricing assumptions would be and reflect the best information available to the entity, without undue cost or effort, of these assumptions.

The standard emphasizes the need to elevate the three-level hierarchy as high as possible to maximize the use of observable inputs. For example, if the entity has market prices from an exchange or dealer market, then an internal model (e.g., discounted cash flow model) cannot be used and readily available market prices cannot be ignored. The more illiquid the security, the greater there is need to use multiple valuation techniques to arrive at fair value.

When inputs used to measure the fair value of an asset or a liability are categorized within different levels of the fair value hierarchy, the fair value measurement will be categorized in its entirety in the same level of the fair value hierarchy as the lowest level input that is significant to the entire measurement.

Common Level 3 inputs

  • Cash flow forecasts for private companies
  • Default probabilities and loss severities for private placement debt or asset-backed securities
  • Growth expectations (revenue, earnings, etc.)
  • Required returns on illiquid investments
  • Anticipated holding periods for illiquid investments

Common Level 3 assets

  • Mortgage and asset-backed securities
  • Private placement corporate debt
  • Equity investments in private companies
  • Forward contracts, commitments, and guarantees
  • Other derivative contracts

New disclosure requirements

Under FAS157 the reporting entity has to disclose for all assets

  • the level of hierarchy under which the fair value measurement falls
  • the valuation technique used to measure the fair value

 

Additionally for assets using significant unobservable, i.e. Level 3 inputs:

  • for non-recurring assets and liabilities (e.g. impaired assets) a description of the inputs used and the information used to develop those inputs
  • for recurring measurements, a reconciliation of beginning and ending balances, total gains and losses (both realized and unrealized), purchases and sales of assets and transfers in and/or out of Level 3

Valuation of securities using Level 3 inputs

These inputs are used to value those securities having very little or no market activity, i.e. illiquid securities.

The reporting entity can use its only inputs but these inputs must be reflective of the assumptions that market participants would apply if they were to price the securities, even if the market participant assumptions are different than the reporting entity’s own expectations.

All reasonable information that is available without due cost and effort, on these market participant assumptions, must be taken into account when considering inputs. If this information reveals that the Level 3 inputs used by the reporting entity are different from the market participant assumptions, adjustments must be made to the inputs to reflect this.

The Centre of Audit Quality (CAQ) white paper and the illiquid security valuation debate

The question is whether the prices of these illiquid securities in the market indicate an imbalance between supply or demand or whether they are considered as forced or distressed transactions; whether the quoted prices will be used in the calculation of the prices or whether the valuation should be based of model prices.

The paper highlights a case where the SEC objected to an entity’s practice of ignoring current prices quoted by external pricing sources using instead a valuation based on a longer, return-to-equilibrium view of the market.

Under FAS157 if orderly transactions are occurring between market participants in a manner that are usual and customary for transactions involving such assets, then those transactions are not “forced” sales. The fact that transaction volume in a market is significantly lower than in previous periods does not necessarily mean that these are forced or distressed sales. Moreover, decreased volumes in a market do not necessarily mean the market has become inactive. Persuasive evidence is required to establish that an observable transaction is a forced or distressed transaction. It is not appropriate to assume that all transactions in a relatively illiquid market are forced or distressed transactions. Because the objective of a fair value measurement is to determine the price that would be received to sell the asset at the measurement date (an exit price) – such a measurement, by definition, requires consideration of current market conditions, including the relative liquidity of the market. It would not be appropriate to disregard observable prices, even if that market is relatively thinner as compared to previous market volume. Even if the volume of observable transactions is not sufficient to conclude that the market is “active,” such observable transactions would still constitute Level 2 inputs that must be considered in the measurement of fair value.

Under FAS 157 the role of the market is never disregarded or ignored when measuring fair value, even if markets are very thin and market prices fluctuate widely, i.e. there is a very significant bias towards empirical market data.

Use of valuation models

When quoted market prices in an active market do not exist, entities often employ valuation techniques, typically discounted cash flow models that utilize Level 2 and Level 3 inputs. If a valuation model is used, the objective of the measurement is to obtain the exit price at the current measurement date from the perspective of the seller. If market data exists about the assumptions that marketplace participants would use in pricing the asset, including observable market prices for similar assets (whether or not in active markets), as well as other Level 2 inputs, that information must be incorporated into the entity’s assumptions.

The model must be calibrated to initial transaction prices (if these are fair value) or the model may be tested against similar securities for which price data is available. A model reflects current market data appropriately if the model’s prices adequately approximate the market prices of these similar securities. Alternatively the entity may back test the realized transactions by comparing the realized fair value with the fair value reported in the most recent financial reporting period

Finally, any significant unobservable assumptions, including significant adjustments to Level 2 inputs, likely render the entire measurement a Level 3 measurement.

Illiquid Securities and Illiquidity Discounts

For illiquid securities where a market may not exist, the entity must develop a fair value approach based upon a hypothetical market which incorporates assumptions potential market participants would use in purchasing the security.

Illiquid securities are usually worth less than liquid securities however the impact of illiquidity is usually difficult to model because most theoretical models make the simplifying assumption of full liquidity. The illiquidity in these securities are usually priced using an illiquidity discount, i.e. the difference between as-if-fully liquid price and the fair value of the illiquid security. These discounts are a function of the length or severity of the liquidity restrictions and the risk of illiquid securities. Given the scarcity of trade data another issue here is what would be an appropriate measure for this illiquidity risk- would it be volatility or would it be beta?

Indications of exit prices that have been used to determine illiquidity discounts for these securities have been:

  • transaction data from secondary market sales of restricted securities (i.e. securities having restriction on resale)
  • transaction data from private placements.

FASB Staff Position (FSP) FAS157-4

This statement provides additional guidance in determining the fair value of a security when the volume and level of activity of that security has significantly decreased and identifies transactions that are not orderly.

The key definition for fair value is the same. However further analysis and significant judgement may be necessary in estimating the fair value in such circumstances. Usually it would require the application of multiple valuation techniques in order to estimate a reasonable range of fair value estimates and then determine a point within that range that is most representative of the fair value under current market conditions. The wider the range is the greater the level of additional analysis that will be need.

Significant Decrease in Volume and Level of Activity

The change in the level of activity will be evaluated using the following eight factors:

  • Few recent transactions
  • Price quotations are not based on current information
  • Price quotations vary substantially over time or among market makers
  • Indexes that previously were highly correlated with fair values are demonstrably uncorrelated with recent indications of fair value
  • There is a significant increase in implied liquidity risk premiums, yields, or performance indicators (for example delinquency rates) for observed transactions or quoted prices when compared with estimated expected cash flows, considering all available market data about credit and other nonperformance risks
  • There is a wide bid-ask spread or a significant increase in the bid-ask spread
  • There is a significant decline or absence of a market for new issuances
  • Little information is released publicly

If the is evidence of a significant decrease, then the quoted prices may not be determinative of fair value and further analysis/ adjustments would be required to estimate the fair value.

Orderly vs. Not Orderly Transactions

The following are some of the characteristics of a not orderly transaction:

  • There was not adequate exposure to the market to allow for usual and customary marketing activities for transactions involving such assets under current market conditions.
  • There was a usual and customary marketing period, but the seller marketed to only one buyer.
  • The seller is in or near bankruptcy or receivership (distressed) or the seller was required to sell to meet regulatory or legal requirements (forced).
  • The transaction price is an outlier compared to other recent transaction prices for the same or similar assets.

However, even if there has been a significant decrease in the volume and level of activity, it should not be concluded that all observable transactions are not orderly (that is, distressed or forced).

Estimating Fair Value When Volume and Level of Activity Have Significantly Decreased

Determining if an observable transaction is orderly or not orderly is more difficult when there has been a significant decrease in the volume and level of activity for the asset. Therefore the following decision tree can be used:

  • If the weight of the evidence indicates that an observable transaction is not orderly, then little weight should be placed on that transaction price when estimating fair value (or market risk premiums).
  • If the weight of the evidence indicates that an observable transaction is orderly, then the observable transaction price should be considered when estimating fair value (or market risk premiums). The weight placed on the observable transaction price compared with the weight placed on other indications of fair value is based on the facts and circumstances such as volume, comparability, and proximity.
  • If sufficient information is not available to conclude an observable transaction price is orderly or not orderly, then the observable transaction price may not be determinative of fair value and may not be used as the sole or primary basis for estimating fair value (or market risk premiums) and should receive less weight than other inputs.

     

Comparison with Staff Draft of IFRS on fair value measurement released on August 2010

There is very little difference between the staff draft of IFRS and the principles outlined in the FAS157 standard. These differences would be further reduced once the revised FASB exposure draft and IASB drafts are finalized.

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