Fair Value Accounting by the FASB

Fair Value Accounting by the FASB

Introduction

Recent initiatives by both the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) have increased the use of fair value accounting for financial reporting across many jurisdictions around the world. There are many issues surrounding fair value accounting. This article outlines the main measurement issues contained in the fair value accounting standard used by the FASB (SFAS 157), and that used by the IASB (IAS 39).

The Rationale for Fair Value Accounting

The increasing use of fair value accounting in financial reporting came about because accounting standard setters have debated, and come to the conclusion that fair value appears to meet the conceptual framework criteria better than other measurement bases (for example, historical cost, amortized cost, among others). Notwithstanding this rationale, a major issue with fair value accounting is the difficulty of measurement (“subjective estimates”) when financial instruments do not trade in active markets. Both SFAS 157 and IAS 39 provide measurement guidance as to how firms should compute fair value estimates in such a situation.

SFAS 157 details the framework for measuring fair value for firms reporting their financial statements based on US GAAP. Prior to this standard, there were different definitions of fair value, and limited guidance in the applications of those definitions. SFAS 157 provides a consistent definition of fair value, outlines several types of valuation techniques that can be used to measure fair value, and requires firms to disclose their valuation inputs (the “fair value hierarchy”), in order to increase consistency and comparability in fair value measurements. The standard 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” (paragraph 5).

This definition focuses on the price that would be received to sell the asset or paid to transfer the liability (“exit price”), not the price that would be paid to acquire the asset or received to assume the liability (“entry price”). An orderly transaction assumes that the firm has sufficient time to market the asset. Hence, fair value estimates should not be estimated as in a forced liquidation or distress sale, contrary to some misconceptions about fair value accounting. SFAS 157 states three valuation techniques which can be used for estimating fair values. They are the market approach, income approach, and/or cost approach (paragraph 18). A market approach typically uses quoted prices in active markets, but other valuation techniques consistent with the market approach include the use of market multiples derived from a set of comparables, and matrix pricing that allows a firm to value securities without relying exclusively on quoted prices.

The second approach is the income approach. The income approach uses valuation techniques to convert future amounts (cash flows or earnings) to a single present value amount. Examples of such valuation techniques include present value discounted cash flows, option pricing models (for example, the Black- Scholes-Merton formula, or a binomial model), ...