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Fair Value — What's New?

During 2006, two standards were issued by FASB addressing the topic of fair value; both standards are effective January 1, 2008 for calendar year-end companies. The first pronouncement, FAS 157 – Fair Value Measurements, provides guidance on how to measure fair value. The second, FAS 159 – The Fair Value Option for Financial Assets and Financial Liabilities, provides the guidance on what to measure. FAS 157 is required to be adopted as it addresses disclosure issues, while FAS 159 only applies to those entities who chose to adopt the fair value option for measuring financial assets and liabilities. Here is a summary of what the two standards require and the potential impact to your institution. 

Fair Value Measurements


Nearly every bank has assets or liabilities carried at fair value. The AFS investment portfolio, for example, includes widely traded securities; these securities have readily determinable fair values based on quoted market prices. Additionally, banks typically issue stock options to key employees and directors. Expense is recorded for the fair value of the stock options, which is determined through a complex computation comprised of observable market data and other estimates from management. These two examples employ two very different methods, yet both are recorded in the financial statements based on the fair value of the instruments.

FAS 157 addresses the issue of differing fair values by creating (1) a single definition of fair value and (2) a hierarchy of fair value. FAS 157 amends 28 existing accounting standards which individually addressed fair value. The hierarchy of fair value that has been created is based on a spectrum of how observable the valuations are; the hierarchy is defined as Level 1, Level 2, and Level 3. Observable items, such as U.S. Treasury Securities, are considered Level 1. Level 3 valuations include unobservable data used in certain models, such as stock option valuation models. FAS 157 also requires enhanced disclosures for financial instruments regularly carried at fair value (for example, investments) and financial instruments periodically reviewed for impairment (for example, mortgage servicing rights). 

The Fair Value Option


FAS 159, referred to as the Fair Value Option (FVO) standard, was perhaps the most debated and discussed new standard in 2007 due to an early adoption period with unique expiration dates.

FAS 159 creates an option that allows entities to carry individual financial instruments (loans, borrowings, etc.) at fair value with changes in fair value accounted for through the income statement. This election can be made on an instrument-by-instrument basis.

The FASB had a number of objectives in mind when issuing FAS 159. The first was to give entities the opportunity to eliminate artificial volatility in reported earnings that occur when financial assets and liabilities are measured and reported differently in the financial statements (some financial instruments are carried at cost, others at fair value). The FVO allows entities to measure virtually all financial assets and liabilities at fair value and eliminates many accounting mismatches and the complex accounting issues associated with derivative instruments. 

What needs to be done now?


We recommend you become familiar with the new disclosure requirements of FAS 157 so that you are prepared for the disclosures in 2008, including disclosures in SEC Form 10-Q for public companies. Regarding FAS 159, consideration should be given as to whether adoption would be beneficial for your bank. If you need assistance in evaluating the impact of these statements, or if you would like to further discuss the attributes of these new standards, please contact your P&M advisor.

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Chris Ritter

312-602-3601