Financial Accounting Standard No. 157 (FAS 157)

Financial Accounting Standard No. 157 (FAS 157) defines fair value, establishes a framework for measuring fair value in accordance with Generally Accepted Accounting Principles (GAAP). This standard allows for huge write-offs in a company’s balance sheet and is not looked with a positive perspective. A company has three types of assets on basis of fair value measurement:

Basis of Fair Value Measurement:

Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2: Quoted prices in markets that are not active or financial instruments for which all significant inputs are observable, either directly or indirectly.

Level 3: Prices or valuations that require inputs that are both significant to the fair value measurement, and unobservable.

The hierarchy gives the highest priority to level 1 measurements and the lowest priority to level 3 measurements.

Now, as to why is it being opposed by many.

FAS 157 causes highly leveraged balance sheets, which is one of the most significant reasons as to why banks, brokerages and other financial firms have encountered huge problems especially in the past year.  FAS 157 allows for major write offs that can cause unintended yet disastrous consequences. This rule permits banks to make up the value of assets they carry on their books. These are assets that nobody wants to buy. By letting banks put whatever value they choose on these assets, they will no longer need to tell investors just how badly those assets have deteriorated. The system introduced a 3-tier asset level hierarchy – levels 1, 2 and 3. Level 3 assets are the ones that seem to be a problem according to many. They are merely artificial financial instruments and are valued in reference to a bank’s own models as they do not have quoted prices in the active markets. Level 3 assets are valued based on an entity’s assumptions, and if the assumptions are in line with the other participants, it calls for no verification which further leads to a balance sheet that is leveraged and has numbers that are not backed up by any evidence.

A revised version of FAS 157, FAS 157 e has been put in place.

The main change that would occur under the proposed FSP 157-e would be the two step process which would determine when a market is not active. It is different from the initial proposal in that the original FAS 157 assumes that the fair value measurement occurs in an orderly transaction but the FSP 157-e determines whether a transaction is distressed and takes that into account. It proposes that a reporting entity will conduct the two step process to determine the fair value. The first step of the process is to determine whether the market is active. This is done by following specific factors that indicate the activity of the market. Some of these factors include, price changes that vary substantially, few recent transactions, and little information released publically. If the reporting entity determines that the market is inactive, it will then move on to step two.

In step two the reporting entity would assume that a quoted price for the transaction is distressed unless it meets two factors; “(i) there is sufficient time before the measurement date to allow for usual and customary marketing activities for the asset and (ii) there were multiple bidders for the asset” (“Minutes.”).  If the transaction meets these two factors than the transaction is not distressed and the quoted price will be used in the valuation of the fair value. If it does not meet the criteria and is found to be distressed, the fair value must be determined using a different method than the quoted price without “significant adjustment”. The FASB states that the reporting entity should use an income approach to determine fair value such as a discounted cash flow analysis. By doing this it will convert the transaction from a distressed one into an orderly one to ensure a fairer value.

Note: The above research is not just my effort. I would like to credit my classmates Steve Paul, Jason Eddy, Andrew Bookstein and Adam Isaacson as it was a group effort and part of research we did in our Intermediate Accounting Class.

We used the following sources:

Investopedia

FASB

SEC

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