A recent Financial Accounting Standards Board (FASB) statement, No. 157, Fair Value Measurements, is likely to affect every company’s financial reporting. As this article discusses, the statement defines and establishes a framework for measuring fair value and becomes effective for financial statements for fiscal years beginning after Nov. 15, 2007. Among other things, FASB 157 retains the “exchange price” notion used in previous definitions of fair value, but clarifies the concept. It also clarifies the meaning of “market participant assumptions.”
A recent Financial Accounting Standards Board (FASB) statement is likely to affect every company’s financial reporting. Statement No. 157, Fair Value Measurements, defines and establishes a framework for measuring fair value. It becomes effective for financial statements for fiscal years beginning after Nov. 15, 2007, and will apply across other accounting pronouncements that incorporate fair value measurements.
Significance of FASB 157
Before FASB 157 was issued in September 2006, there were several different definitions of fair value and only limited guidance on how to apply them under Generally Accepted Accounting Principles (GAAP). The guidance was dispersed across the many accounting pronouncements that require fair value measurements, creating inconsistencies. FASB, therefore, developed the new standard to increase consistency and comparability in fair value measurements and to provide users of financial statements with improved information about the role of fair value.
FASB 157 retains the “exchange price” notion used in previous definitions of fair value but clarifies the concept. It describes exchange price, and thus fair value, as the price in an orderly transaction between market participants to sell the asset or transfer the liability in the best market for that asset or liability. The transaction is hypothetical at the measurement date and considered from the perspective of a market participant that holds the asset or owes the liability. Thus, the definition of fair value in FASB 157 focuses on the exit price (what would be received to sell the asset or paid to transfer the liability), rather than the entry price (what would be paid to acquire the asset or received to assume the liability).
One of FASB 157’s stated goals is to establish a framework for measuring fair value under GAAP. The standard emphasizes that fair value is a market-based, not an entity-specific, measurement. Fair value should, therefore, be determined based on the assumptions that market participants would use in pricing the asset or liability.
FASB 157 mandates that valuation techniques be consistent with the market, income and cost approaches. It states that the techniques applied “shall maximize the use of observable inputs and minimize the use of unobservable inputs.”
Observable inputs represent market participant assumptions based on market data obtained from sources independent of the reporting entity. Unobservable inputs, on the other hand, reflect the entity’s own assumptions about market participant assumptions and are based on the best information available in the circumstances.
In developing unobservable inputs, an entity isn’t required to undertake all possible efforts to obtain information about market participant assumptions. But it can’t ignore information about market participant assumptions that is reasonably available without undue cost and effort.
FASB 157 clarifies the meaning of “market participant assumptions,” as well. It explains that the assumptions include those about risk, such as the risk inherent in a particular valuation technique or the inputs for the technique. A fair value measurement should include an adjustment for risk if market participants would include one in pricing the asset or liability — even if the adjustment is difficult to determine.
Market participant assumptions also include those about the effect of a restriction on the sale or use of an asset. Fair value for a restricted asset should consider the effect of the restriction if market participants would consider the effect in pricing the asset. What’s more, the location and condition of the asset must be considered.
Similarly, the fair value measurement for a liability should reflect its nonperformance risk — the risk the obligation won’t be fulfilled. Nonperformance risk includes the entity’s credit risk. So one should consider the effect of the credit risk on the liability’s fair value in all periods in which the liability is measured at fair value under other accounting pronouncements.
A ripple effect
FASB 157 will have a substantial effect on fair value measurement and be felt in a variety of financial reporting and valuation matters. While the standard builds on current practice and requirements, some entities may need to make system and other changes to comply, resulting in incremental costs. Their attorneys must understand the new obligations and facilitate the entities’ compliance to preempt regulatory and shareholder liability, as well as other potential repercussions.
Sidebar: FASB 157 and intangibles
Financial Accounting Standards Board (FASB) Statement No. 157’s fair value standard intersects other accounting standards, including FASB 142, Goodwill and Other Intangible Assets. FASB 142 requires that entities test their goodwill and intangibles for impairment — or overstated value — at least annually.
To test for impairment, the entity’s fair value is compared with its book value. If the book value is less than the fair value, no impairment loss exists. Where the book value exceeds the fair value, a purchase price allocation analysis must be performed to determine the impairment loss that should be reported. With this method, the fair value is used as the hypothetical purchase price and allocated to the entity’s tangible and intangible assets.
FASB 157 requires that the allocation include all potential intangible assets, not just identified intangible assets, as under previous rules. With the purchase price allocated over a greater number of assets, a smaller amount will remain for attribution to the entity’s goodwill.