Financial Accounting Board issued a statement permitting the use of fair value measurement for business as a measuring attribute but some entities such as the banking industry suspended the application on the basis that FABS 157 contributes to the current credit crisis. The application of this measurement would change the current accounting principles and provide new measuring techniques that will be transparent and consistent. Reasons for issuing fair value measurement is that businesses were using measurement techniques that did not comply with GAAP. The Financial Accounting Standards Board (FABS) therefore designed fair value measurement that was inconsistent with GAAP.
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The project reviews Financial Accounting Standards Board Statement (FASB) Number 157 and describes fair value measurement techniques. The paper will begin by reviewing the fair value measurement techniques (present value and valuation techniques).
The paper will then give an overview of statement number 157. It will cover the reasoning for issuing the statement. In order to completely understand the reasoning for the statement, the paper will discern how fair value was measured prior to the issuing of statement number 157.
Once the rationale and the current situation have been discussed, the paper will review the anticipated improvement from the issuing of the statement, as well as, review the cost and benefit analysis of the implementation of the statement.
The original statement was issued in September 2006 with an effective date of November 15, 2007 and beyond. Since the issuance of the statement, companies have commented on the possible impact that the statement will have own their financial reporting. This paper will review the views of a few companies and industry experts.
The paper will also discuss how this statement could have affected/contributed to the current credit crisis. It is important to highlight the importance of how the standards that are issued by the FASB could affect the economy in a positive and/or negative way
Fair value is the price at which an asset is agreed to be sold or a liability transferred between willing participants to the market in which the reporting entity would transact for the asset or liability, known as the principle. The whole concept of fair value measurement focuses on the price that the item would be sold at or price paid to transfer the liability but not the price paid to acquire the assets or the liability entry price.
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Fair value is therefore market based measurement determined by perspective of market participants but not an entry specific measurement. Market participants determines fair market value by obtaining market data from reliable independent reporting sources and entities own assumption of what is considered to be fair market value. It draws its assumption basing on unobservable inputs of the market activity at that date at which the asset or liability will be measured (Financial Accounting Standards Boards 2009).
In a case where the fair value market is determined by participants, the reporting entity should employ maximum efforts in obtaining information about market participant’s assumptions before setting out prices. The assumption should be calculated in terms of foreseen risks such as those of pricing models used to measure valuation techniques. It is important for market participants to include assumption about risk such as risk inherent in valuation and reflect its effect the on the sale or use of the asset. If the asset is subjected to certain restriction on the sale or use, fair value measurement should consider effect of the laid down restriction on determining the price of that particular asset (Financial Accounting Standards Boards 2009).
Aims and objectives
The aim of this research is establish whether FASB No. 157 application to entities will improves effectiveness and consistency of measuring techniques. The research also intends to determine whether statement contributes to the current credit crisis.
FABS 157 fair value measurement ensures entities provide reliable information regarding their transactions thereby enabling users of financial statements compare similarities and differences between two sets of economic events that will be used to determine fair market values measurements. In price determination, assets and liabilities should comply with FASB statement no. 2 of “Qualitative Characteristics of Accounting Information” that emphasizes on provision of comparative information. FABS No. 157 fair value measurement uses participants’ assumption of current market situations to reflect the future inflows. Future inflows are the economical benefits attributed from sale of an asset and outflows of liability. It is this prediction that benefits the future economy (Financial Accounting Standards Boards 2009).
Fair value improves financial reporting by integrating fair value measurement into the current accounting system resulting to increased consistency and comparison in the measurement of fair values. The use of fair value measurement has provided users with reliable financial statements with better information about what fair values are used to measure assets and liabilities, effects on measurements used in calculating value of assets at a given period and what the system uses to develop the measurement (FASB 5).
Conditions, location, sale restrictions and use of the asset or liability should be considered at measurable dates before their prices are determined. Assets or liabilities should be measured alone or as a group depending on the measurement used. Examples of standalone assets or liabilities are financial instrument and operating asset. Group assets or liabilities include reporting unit and businesses. Whichever way an asset or liability chooses to be measured, unit of account should be the determining factor. The measurement should also be based on the level at which an asset or liability is “aggregated or disaggregated” in order to apply other accounting principles. Accounting provisions requires that the unit of account of any asset or liability be determined in accordance to its pronouncements (FASB 8).
In determining asset measurement, fair value assumes the highest price as perceived by market participants. The asset to be transacted should be in good condition and financially feasible at the measurement date. Valuation premise method includes in-use and asset in-exchange methods. In-use method is where participants anticipate the asset will provide maximum value if used as a group, for example if the asset is installed.
Therefore when the asset achieves the highest and best value when in use, then fair value will be measured using “an in-use valuation premise”. In In-use valuation premise technique, fare value of the asset is determined by the price that will be received in a current transaction when the asset is sold on the assumption that the other combined assets i.e. used as a group will be available to market participants at that time b). Asset in-exchange, the highest and best value of an asset is calculated on stand alone basis. For instance, financial assets are measured using in-exchange valuating premise based on the price that will be received when that particular asset standalone is sold (FASB 9).
The fair value of a liability reflects nonperformance risks at a measurable date. The non reporting risk considers the effect of its credit when measuring the liability at fair value in all periods and the effect of the risks depends on each liability measured. For example, if the liability requires cash delivery (financial liability), delivery of goods and credit enhancement, they should all be considered (FASB 10).
Valuation techniques are methods used to measure assets and liabilities depending on the assumption of market participants. The techniques used to determine the prices are market, cost and income approaches.
Market approach uses pricing technique and gathered information involving market transactions of similar or comparable assets or liabilities. Market approach system incorporates a wide range of multiples to be used on each comparable. Markets participants therefore select prices within a range of appropriate multiples and also consider factors that apply to the chosen measurement such as qualitative and quantitative measurements. One of the multiple used is Matrix pricing technique that values debt securities without considering quoted prices for specific securities but rather on the underlying security relationship to other ruled out quoted securities (FASB 10).
Value measurement is determined by current market expectations of what it anticipates the future prices to be. Income approach therefore converts future amounts to present values such as discount rates. Option-pricing models as used by Black-Scholes-Menton formula and binomial model is employed in calculating income approach whereas multi-period excess earnings technique is used for measuring fair values of intangible assets (FASB 10).
In cost approach, the buyer determines the price of an asset by measuring the cost that will be required of him to acquire or construct a substitute asset or cost adjustments in case the asset deteriorates physically, technologically or economically (FASB 10).
In using valuation techniques the entities must provide sufficient data that will be used in measuring fair value of an asset or a liability. As we have seen earlier, some cases of value measurement may require application of single value technique when valuing assets and liabilities or multiple techniques in valuation of reporting units. Single valuation technique measures fare value using quoted prices of the current market for assets or liabilities that are identical while multiple evaluation technique measures its fair values basing on attained results from respective indicators and weighed as per the provided results by reasonable indicators.
Depending on each valuation technique employed, fair value measurement therefore indicates the point within which entities determine the range to represent their fair values at given measurable dates (FASB 11).
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Valuation techniques applied in fair value measurement should be consistence but its application may change in measurement especially when multiple valuation techniques are used. Changes in valuation techniques arise when new markets develop, technology changes, availability of new information and changes in valuation techniques. FASB No. 154 considers any change in valuation technique or application to be change in accounting estimates (FASB 11).
Input valuation techniques as used in fair value measurement is the assumption market participants’ uses to determining the price of an asset or a liability basing on the risks they anticipate to undergo such as risk inherent as used in pricing model to measure fair values.
Input valuation technique may be observable or un-observation depending on the measurable dates. Observable input is where participants determine the price of an asset or a liability per the market sources from independent reporting entities while unobservable input is the assumption reporting entities uses to predict the assumptions market participants would use in determining the price of assets or liability. They therefore use market participants’ assumptions in setting out prices. Valuation techniques should therefore maximize observable inputs and cut down on unobservable inputs (FASB 11).
Present Value Techniques
FASB Concepts Statement No.7 provides guidelines to entities that use Cash Flow Information and Present Value techniques for measuring fair values. The guidance provided bases on traditional or discounted rate adjustment to be used in cash flow and present value technique. There is no specific present value technique for measuring fair values as the method depends on facts and underlying situations in relation to the asset or liability to be measured in comparison to the market assumptions and availability of sufficient information (FASB 27)
Present value is a tool that links uncertainty of future amounts of cash flows and values to that of present amount using discounted rates. The technique used in value maximizing behavior and capital market equilibrium should be inconsistence with accounting standards. Therefore fair value of an asset or a liability should consider the following elements in measuring present value
- Draw expectations about possible variations in the amount of an asset or liability or timings of the cash flow that may create future uncertainties
- Allocate provisions for the prices in case of uncertainty inherent in the cash flows
- Consider case specific factors that will be used by market participants
- Consider the time value of money as represented by risk-free monetary asset rates such that maturity dates does not conflict with periods covered by cash flows also known as risk free interest rate.
When calculating present values for U.S, Treasury securities has established appropriate risk free interest rate to be used. U.S. Treasury securities are recommended to be used since they do not pose any uncertainty timing or risk to the holder e). Non-performance risks relating to liability including that of the obligator’s own credit risks (FASB 28).
Present value techniques must adhere to the following general principles in determining fair value measurement
- Cash flow and discount rates should reflect market assumptions for pricing the asset or liability
- Cash flow and discount rates should include factors attributed to asset or liability in measuring fair values
- Present value techniques should make sure that nothing is omitted or double counted in computing risk factors and discount rates.
Risk inherent used in cash flows should be calculated according to market participant’s assumptions d). Cash flows and discount rates assumptions should be determined internally.
This means that nominal cash flows should reflect the effect of inflation at that particular period and the discounted rates should include the effects of inflation. Nominal risk free interest rate as used by U.S. Treasury securities includes the effects of inflation and does not need further discounting. Real cash flows that do not include the effects of inflation should therefore be calculated at the rate that excludes the effect of inflation. Also after-tax cash flows discount rates should be computed using after-tax discount rate and pre-tax cash flows that comply with U.S. Treasury securities as quoted on pretax basis or on prevailing term loan rate e). Discount rates should reflect current economic factors such as credit crisis in the currency in which cash flow is denominated (FASB 28).
Risks and Uncertainty
Fair value measurement using present value technique requires observation of uncertain conditions since the method used in cash flows are based on estimates and therefore the amount and time used are unknown. The estimates become uncertain even if the amounts are fixed like loan payments. In risk-averse market, participants seek compensation for adopting uncertainty inherent in cash flows computation of assets or liabilities.
The compensation is known as the risk premium. Fair value measurement should therefore include risk premium depending on the amount market participants would request since risks inherent in cash flows are uncertain. Risk premiums should always be reflected in fair value measurements. Techniques used in present values differ from time to time in the way they adjust to risks and the type of cash flows used. For instance, discount rates adjustments use risk adjustment discounted rate technique and cash flows in the following methods;
- Present value technique uses a risk free rate and adjusts the risk in the cash flows and
- Present value technique method uses risk adjustment discount rate and expected cash flows for fair value measurements (FASB 28) (Brigham & Ehrhardt 2008).
Discount Rate Adjustment Technique
When computing discount rate adjustment techniques, single cash flows from a wide range of estimates are used. The estimated are based on contractual or promised amounts such as bonds or cash flows. Normally, cash flows estimates are conditional in their occurrence. As we have seen earlier, discounted rates are based on observed rates as used by comparable assets or liabilities, therefore when contractual, promised or cash flows are used, discounted rates should correspond to observed market rate per the assumption of market participants to reflect market rate returns. Before discount rate technique is applied, thorough market data analysis should be done for comparable assets or liabilities.
Comparability for this instance is established by determining the nature of cash flows based on contractual or non contractual basis as they respond similarly to economic conditions and other factors such as liquidity, restrictive covenants, collateral and credit standing. If single or comparable assets or liabilities do not reflect risk inherent in cash flows of assets or liabilities measured, then discounting rating should use data from several comparable assets or liabilities incorporation with the risk free yield curve also known as build up approach (FASB 29).
Benefit and Costs of using fair market values
- Financial Accounting Standards Board (FASB) missions and goals is to establish improved standards of financial accounting reporting such that information provided (financial statements) is reliable and useful to users such as creditors, capital markets, donors and investors. Reliable financial statements will enable users make rational investment decisions and offer credit extensions. FASB therefore ensures that proposed standards fulfill significant needs and estimated costs meet the board’s standards. Costs attributed from implementing new standards vary from organization to organization, but users of financial statements benefit a lot from improved financial reporting therefore stimulating effectiveness of market functionality for capital and credit facilities and also allocation of resources to the economy
- Fair value used together with frame work for measuring fair value result to increased consistency and comparability. Providing comparable information to users also helps them compare similarities in and differences between two economic sects
- The statement expands fair value measurement knowledge therefore improving the quality of information provided. Transparent information enables users to make rational investment decisions and assessment on credit worthiness (FASB 54)
The FASB plays an important part in ensuring the statements develops disclosures by obtaining input data from users, interested parties and preparers to make sure that information provided is within a reasonable cost-benefit constrains. Also business are required to disclose fair value information disclosed under FASB statement and also under accounting pronouncements all in one place as it improves quality of information provided by users of financial statements about measurements used therefore making the whole process easy to understand.
The statement also demonstrates to users how fair value financial reporting is used. Amendments made in fair value statement simplify and codify the current fair value measurement, eliminating the previous complexities experienced in GAAP and making sure that the statements are inconsistence with FASB related codification initiatives. Framework for measuring fair values bases on current practices and requirements but the FASB allows some entities to use certain methods that do not comply with its statement resulting to changes in the current practice. Once an entity adopts fair value measurement, operational changes will be made as cost increment will be realized.
Despite the expenses, benefits attributed to it are tremendous. Entities experience increased consistency and comparability in fair values information provided as compared to other accounting standards. The system also improves communication of financial statements information therefore improving financial reporting (FASB 55).
FASB No. 157 in use
Since statement FASB requires highest and best use of all assets or liabilities, real property has been using the statement for measuring its assets fair values. The price of the property is therefore determined by assumption of market participants. Before the property is sold, examination is done to determine whether it will be used as it is in its current condition or will be improved. Different properties uses different fair value for measuring their real property assets therefore statement no. 157 provides provisions for such adjustments. The statement considers the highest and the best use of group assets as per the assumption of market participants.
When assets or liabilities are valued as a group, seller benefit since the buyer pays higher for the assets in combination than they would individually. Statement No. 157 is still evaluating the best techniques for allocating real property. Since real property price is based on the intended purpose, fair value should then base their measurement on the assumption of market participants at a measurable date. Real estate properties (assets) or liabilities are the most affected by this statement since assumptions of market participants are the determining factors on what price the asset should be sold (Gottlieb, Bohlin et al 1-3).
The research was carried out in energy industry that required managers, employees and economist perception to the implementation of FASB No. 157.
Energy companies for instance KPMG are planning to implement FASB statement No. 157 in fair value measurement for financial assets and liabilities. Before implementation, the companies are required to plan and consider the impact statement adoption in reporting their financial statements. Energy companies in the implementation of the statement will concentrates more on financial assets and liabilities as well as non financial ones. Before the company implements the statement, project leader and management should provide proper infrastructure govern project development. Also clear channels of communication and issue resolution should be established to ensure the project runs efficiently.
The company should identify key stake holders and participants in each department to take part in the implementation. First and fore most, key players need to be educated on the components and application of FASB no. 157 and identify accounting areas and specific amounts to be affected by the new requirement in fair value measurement (KPMG 2).
Inputs are categorized into three levels according to fair value measurement hierarchies. The levels include Levels 1, 2 and 3. In level 1, inputs from markets are given the highest priority while Level 3 gives the lowest priority to unobservable inputs. The company should therefore categorize each item on its list within fair value hierarchy. If most of the items are listed under Level 1, then the company may experience some challenges in implementation of the statement. If items fall in Level 3 of fair value measurement, then the company will be required to make changes in its current policies, systems and processes of reporting. The company should also make a list of challenges it anticipates to face in Level 3 measurement as well.
Apart from identifying accounting policies and line items that will be affected by FASB No. 157, the company should consolidate an imperative inventory system and reliable data sources that it will use for determining fair value measurements. The company should also analyze its business environment such as if its requires other stake holders in its operations such as IT that may need it to comply with other accounting principles for this case the Sarbanes-Oxely Act and analyze how the implementation can affect reporting environment. Energy companies will need to keep in mind complexities of some valuation techniques and make sure the one they choose is they most appropriate as defined under the statement. For instance if it chooses to use market valuation approach, it will be then be required to have maximum access to market pricing resources (KPMG 3).
Trade groups gave out mixed reactions to the implementation of fair value measurement in banking industry for reporting financial statements saying that the move will lead to income statement buoyancies (understatement and overstatements). Fair value measure as proposed by U.S and International Accounting Standards is the most desirable financial instrument for trading purposes according to ABA reports. He adds that assets or liabilities that are not based on short term trading or held to maturity, loans, deposits and receivable for instance may affect income statement fair value measurement that may eventually lead to overstatements and understatement.
Bankers are opting to using mixed attribute financial reporting model to that of fair value measurement as financial instruments. The reason for this option is that, loans are issued for the purpose of generating interest over time (maturity period. Therefore fair value calculation that requires periodic up to date information of the loan development would result to less predictive value therefore unable to use the statement. It is the absence of relevance and reliability that force bankers to use mixed attribute financial reporting model. Yingling emphasizes that financial conditions and value of assets and liabilities should be measured based on real life situations. He adds that accounting policies should focus on measuring the current economic crisis (Leone 1).
According to Herz, loans are financial instruments and should be subjected to fair value measurement contrary to bankers’ opinion. Also loans are not always held to maturity periods therefore qualifying for the rule. Bankers should incorporate fair value measurement in its accounting system to reflect the interest of investors as they rely on the financial statements in decision making. In a survey carried out on investors perspective on use of fair value measurement, 79 percent of 2,000 investment professions conclude that the statement improved transparency and enabled them better understand the risk profiles of the business.
They also said that fair value requirement would greatly improve market integrity. CFA institute argues that bankers should use fair value measurement in loan calculation as it helps them determine whether loans would be paid because the statement reflects the current market information. The problem encountered by mixed attribute model is that the method is not transparent therefore hard for investors to make their decisions basing on them (Leone 2).
Statement FASB 157 requires commercial banks to value securities and loans reflected in their balance sheet quarterly per the prices paid for the same instruments o the current market regardless of whether the bank planned to sell the asset or not. Martin Sullivan former chief executive of American International Group said the current accounting practices created huge losses for insurance firms. He says the losses experienced by insurance firms required $85 billion bail out that stressed the economy. He adds that the accounting practices resulted to transaction vacuum that made mortgage securities disappear to what is currently known as mortgage risks.
The amount of U.S. commercial mortgage-backed securities (CMBS) issued July 2008 to September was zero as compared to $60 million CMBS issued the previous year. Taking mortgages to the market when there is less demand results to vindictive pricing since few bonds available will be lucky to be traded. Since the markets are not liquidated, agitated sellers undermine the value of the transactions resulting to undervaluation of bank’s balance sheet (Hudgins 2008).
Sullivant laments that if financial institutions used fair value accounting, financial crisis would not have sunken that deep. Trade leaders of Commercial Mortgage Securities Association and bank industry were authorized by law makers to put on hold FASB 157 use as a bail out measure for some period until when market stabilizes.
Change in accounting system should help financial institutions improve their efficiency and at this time of economic depression, the banks should use it as a bail out in helping them regain liquidity either than shifting complains. Dan Smith, managing director of Real Estate Mortgage Company argues that securities should be valued in relation to current sales otherwise problems will be created by price distortions sinking the economy further. It’s to this reason that policy makers were unable to avoid current crisis regardless of fair value suspension.
The only effect of applying fair value measurement to banks at this time of credit crisis is that the statement will overstate the balance sheet but this does not mean that it would have contributed to the crisis. Credit crisis is too big to be fixed by suspending fair value measurement since it’s not the central part of the problem. Jim Smith, an economist argues that the main problem of credit crisis is that financial institutions lack of transparency in disclosing information on how assets were valuated on balance sheets.
Therefore, if the system would have been transparent, the fear of further crisis development affecting credit market would reduce. Leamer points out that the FASB No. 157 application would subject banks to insolvency as they would have already established fear that the statement would drive market valuation. The fear is based on lack of trust and transparency in the current accounting systems (Hudgins 2008).
Lack of trust and transparency in the banking system should be the main reason for credit crisis rather than FASB N0. 157 statement application. According to Leamer, the key to restoring liquidity would be increasing transparency in the system by banks disclosing all their assets in balance sheets and forcing these institutions to acknowledge their losses and establish measures to prevent them in future. The president and chief operating officer of capital markets, Kenneth Rudy agrees the idea of suspending FASB 157 as the statement will enable banks quickly resume to lending then later realize losses as they will be quickly disposing off securities and loans.
Once the government starts buying securities that are piled up on lenders balance sheets, then suspension of fair value measurement will allow banks to make more money as they will selling more securities enabling them to offer loans. Law makers should lift fair value measurement suspension once credit markets regain stability as the statement maintains transparency as compared to other accounting applications (Hudgins 2008).
Statement No. 157 established disclosure of valuation technique it uses enabling users understand how fair value estimates were produced, a system that banking industries are not willing to undertake. What contributes to the current credit crisis is the fact that the existing accounting methods do not require financial institutions to disclose all their assets and liabilities therefore enabling them mask balance statements.
In order to get out economic depression, managers must disclose all assets and liabilities to provide transparency on techniques in valuation thereby gaining users’ confidence. The statement has been able to bring accounting standards into the 21century by creating environment of fair value estimations. Fair value measurement has not created new accounting standards but designed the existing ones to suit the current economic situation. This statement has enhanced guidance on how to measure assets and liabilities in many economical sectors and integrated the measurements into one accounting standards.
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Financial Accounting Standards Board. 2009. Summary of Statement No. 157. Web.
FASB.“Original Pronouncements As Amended”. Statement of Financial Accounting Standards No. 157(2008):1-86.
Gottllieb, S., Meulmeester, R., & Bohlin, M.”Financial reporting for real estate: will FASB 157 achieve a higher and better use? Journal of accountancy, (2009):1-13.
Hudgins, Matt. “FASB 157: Warning Light or Smoking Gun?” National Real Estate Investor, (2008).
KPMG. Implementing SFAS 157. KPMG’s Global Energy Institute, (2008):1-3.
Leone, Marie. “Bankers: Fair Value is Like Throwing Gasoline on a Fire”. CFO. (2009):1-2.