Understanding FAS 157 and Fair Value Accounting
3/31/2009
When the financial markets began their descent into what is now universally considered a historic downturn, many fingers began to point to fair value accounting, and the possibility of modifying or suspending fair value rules became a hot topic. Fair value—which requires companies to value certain assets at their current market value—is here to stay, and, even with modifications, it impacts companies across all industries.
Q: What is FAS 157 and when does it affect me?
A: FAS 157 was issued by the Financial Accounting Standards Board (FASB) in September 2006. The goal of the standard was to clarify the definition of fair value, provide a measurement framework for various classes of assets and liabilities, and improve disclosure requirements. Since the Standard was effective for fiscal years beginning after November 15, 2007, most companies have adopted it or will be doing so as part of their 2008 year-end financial statement filings. FAS 157 was effective for financial instruments in 2008 (for calendar year-end companies) and non-financial items as of January 1, 2009. Many companies are just beginning to address the application of the Standard to non-financial assets and liabilities.
Q: What guidance does FAS 157 provide for fair value measurements and disclosures?
A: To facilitate disclosures, FAS 157 created a three-tiered hierarchy for inputs. Generally, Level 1 inputs are quoted prices for the identical assets in active markets. Level 2 inputs are quoted prices for similar assets in markets that are active or quoted prices for identical assets in inactive markets or are wholly derived from inputs that are observable. Level 3 inputs have no external market and rely on the reporting entity’s analysis of fair value and information that is not observable by outside parties. Level 2 and 3 assets require companies and their auditors to perform considerable work to understand and evaluate the fair value measurement process for instruments such as investments in private enterprises, hedge funds, interest rate swaps, and other derivatives.
Q: Why is FAS 157 often misunderstood?
A: A common misconception is that FAS 157 established standards for fair value accounting, but FAS 157 does not establish any new accounting requirements as it relates to recognizing fair value changes in financial statements. In fact, most investments marked-to-market are valued based upon observable inputs, such as actual market quotes.
Numerous other standards—such as those which establish accounting for investments and derivatives—have been around for years and establish the requirement for companies to follow mark-to-market accounting. FAS 157 deals strictly with the measurement of fair value and tries to establish a more uniform approach to the measurement process.
Q: Most of J.H. Cohn’s clients are public and private middle-market companies. What unique challenges does this market segment face as it relates to fair value accounting and disclosures?
A: Our clients are facing accounting standards overload. Clearly, FAS 157 raises the bar in terms of documenting how fair values are determined. If a company has any assets or liabilities in either the Level 2 or 3 categories, we strongly recommend that they work with a firm or individual that is qualified to perform FAS 157 valuations to assist them with their fair value measurements and disclosures. (Your J.H. Cohn professional can provide recommendations.)
Q: What additional steps should companies take when it comes to fair value?
A: By now, most companies have adopted FAS 157 for the financial instruments adoption element. For the non-financial items, adoption will occur in 2009 and now is the time for companies to discuss with their auditors how they will determine fair values and how they will be evaluated. Fair value also impacts impairment measurements and business combinations.
Q: Mark-to-market accounting and fair value measurements seem to be a primary target for criticism and some say at least partially responsible for the downturn in the financial markets this past year. Do you believe this is accurate?
A: No, fair value accounting has been around for a long time. When values are rising or flat, as they were for so long in the U.S. markets, stakeholders don't have a proper view of the role of mark-to-market or fair value. Now that the economy is struggling and values have dropped, focusing on fair value is a way to not to address those realities in their financial statements. Admittedly, recent market conditions are unprecedented and this has made determining fair value a difficult and complex process for many financial items.
Q: How do current fair value accounting and measurement principles in the U.S. match up with International Financial Reporting Standards (IFRS)?
A: IFRS and Generally Accepted Accounting Principles in the United States (GAAP) both apply fair value accounting but there are differences in the measurement process. Under IFRS, fair value is neither an exit or entry price but the amount that an asset could be sold, or liability settled, between willing parties. Disclosures regarding fair value measurements are currently more extensive under GAAP than IFRS, but I expect those differences to narrow as the IFRS initiative gains momentum.
Q: There’s been much discussion about modifying the fair value rules. Can we expect more changes?
A: In December 2008, the SEC issued a reportrecommending improving, not suspending FAS 157 or eliminating mark-to-market accounting. The SEC’s study recommended developing additional guidance for companies and auditors for determining fair value in inactive or illiquid markets. It also asked for the enhancement of disclosures and educational efforts. The SEC called on the FASB to reconsider certain existing guidance and evaluate the need for more disclosure. We can also expect further direction from the FASB related to fair value disclosures in interim financial statements before the end of the first quarter of 2009.
Wade McKnight, CPA, is office managing partner of J.H. Cohn's San Diego office and chair of the Firm's committee on fair value. He can be reached at wmcknight@jhcohn.com or 858-300-3423.