SFAS 157: What You Need to Know About FASB’s Fair Value Measurements
Business Valuation Advisor, Summer 2007

The Financial Accounting Standards Board’s (FASB) Statement of Financial Accounting Standards (SFAS) 157, Fair Value Measurements, is the latest evidence that the FASB is indeed moving from rules-based to principle-based standards. Effective for fiscal years ending November 2007, SFAS 157 is now a fixture on the fair value landscape, and business appraisers as well as attorneys need to understand its implications and applications.

Parsing the new Statement

The best way to understand the new FASB pronouncement is to parse its elements. SFAS 157 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.

• Price. The Statement does not contemplate a strict entry or exit price; rather, it seeks to include assumptions concerning market participants (see below) to realize the price they would pay on the measurement date.
• Orderly transaction. Although SFAS 157 specifies a valuation date, it assumes the asset’s exposure to the market for a prior period to allow for customary marketing activities.
• Market participants. Closely aligned with the hypothetical willing buyer and seller, market participants in a fair value assessment are:
• Unrelated parties: Independent of any specific entity, including the reporting entity
• Knowledgeable: Having a reasonable understanding of the transaction, asset, or liability based on all available information, including due diligence
• Willing and able: Under no compulsion to transact for the asset or liability

The reporting entity need not identify specific market participants, only the characteristics that distinguish them generally, considering the specific asset or liability, its principal market, and the market participants with whom the entity would transact.

• Application to assets. Fair value measurement assumes the highest and best use of the asset that is: (1) physically possible; (2) legally permissible; and (3) financially feasible. The valuation premise is in use/in exchange, which seeks to maximize the value of the asset or group of assets in which the asset will be used. This bases value on the use by market participants—even if the reporting entity intends a different use. In this case, even if an acquiring company has a clear strategy for the deployment of an asset, conformity with SFAS 157 may require eliminating buyer-specific strategies.
• Application to liabilities. The Statement assumes that the liability is transferred to a market participant and that the non-performance risk is the same before the transfer as after. The liability continues; in other words, it is not settled.
• Valuation approaches. The Statement requires “techniques that are appropriate in the circumstances and for which sufficient data are available.” They should be consistently applied; a change is appropriate only if it is “a better representation of fair value.”

Fair value hierarchy

SFAS 157 prioritizes the valuation inputs according to whether they are observable (reflecting market assumptions based on independent data) or unobservable (reflecting reporting entity assumptions from its own data). This hierarchy allows the user of financial statements to assess the relative reliability of fair value measurements, ranked as follows:

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities, which the reporting entity can access at the measurement date.

Level 2 inputs are those other than Level 1 quoted prices, directly or indirectly observable, such as:

• Quoted prices for similar assets or liabilities in active markets;
• Quoted prices for identical or similar assets or liabilities in inactive markets; or in which there are few participants; or in which prices are not current or vary substantially among market makers (brokered markets); or in which little information is released publicly (principal-to-principal market);
• Observable inputs, other than quoted prices, such as interest rates, yield curves, volatilities, prepayment speeds, loss severities, credit risks, and default rates; and
• Inputs that are derived principally from or can be corroborated by market data.

Level 3 inputs are unobservable inputs; i.e., inputs that reflect the reporting entity’s own assumptions about what market participants would use to price the asset or liability (including risk), developed using the best information available without undue cost and effort. There is no verification requirement if the assumptions are in line with those of market participants.

Blockage discounts

SFAS 157 affirms the fair value of actively traded positions in a financial instrument (including a block) as the product of its quoted price times the quantity held (p x q), without adjustment for a blockage factor and extends this requirement to broker-dealers and investment companies. But as for broader discounts, such as control premiums, swing votes, and non-financial assets (real estate), FASB will most likely examine these in future statements.