FAS 157 Establishes a framework to measure fair value
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.
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.