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Online Finance: Fair Value – FAS 157 – valuation of illiquid securities

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.

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