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Wednesday, January, 9, 2008

FAS 157: FASB Statement issued in September 2006 and newly in effect for fiscal years commencing after November 15, 2007 that defines fair value, establishes a framework for measuring it in GAAP and imposes expanded disclosure requirements on fair value measurements.

FAS 157 IN THE REAL WORLD: You'd think that Pocket MBA could start a new year with something completely new. But dealing with FAS 157 is more akin to tying up loose ends for this newsletter, and for those of you who were subscribers back on June 26, 2004, you're excused if you heave a sigh of "finally." On that date, Volume 2, No. 25 of this newsletter issued, and it was all about fair value and FASB's fair value project. But it was decidedly incomplete, closing with the following: "So think of this as Pocket MBA issue on fair value, Part 1. Part 2 to come." But Part 2 never came, and Pocket MBA kept wondering whether it had missed something, or whether FASB had simply thrown up its institutional hands and said "good riddance" to trying to define the vagaries of the "amount at which an asset (or liability) can be bought (or incurred) or sold (or settled) in a current voluntary transaction (i.e. outside of liquidation or other forced purchase or sale)." That was how the term was defined in FASB's Statement of Financial Accounting Concept 7. As Pocket MBA's father used to say when wee little Pocket MBA complained that something was unfair, "What's fair?"

So, back in 2004 Pocket MBA concluded that fair value was one of those "I know it when I see it" things. But in the accounting world, that works about as well as rounding to the nearest million. And in the interim, if the travails of financial institutions trying to assess the value of mortgage backed securities that have fallen from grace (or liquidity) have taught anything, it is that value is even more of a tough nut than anyone suspected. So kudos to FASB, both for FAS 157, which defines fair value, and for allowing Pocket MBA to make good on its June 2004 promise. (Although PMBA is pretty sure that FASB didn't care whether that promise was made good or not.) There may be some rough transition for your clients, but in the end, anything solid is better than "I know it when I see it."

First of all, if you want to read FAS 157 (or more accurately, Statement of Financial Accounting Standard 157) for yourself, take a trip here. Beware, it's long (158 pages). If you just want the definition of fair value, you can quit after the following few lines:

Fair value is 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.

You might look at that definition and the prior definition and say, "well that seems like the same thing." And in some respects, you'd be right, for as FASB notes in the summary of FAS 157, "the definition of fair value retains the exchange price notion in earlier definitions of fair value." But note the subtle difference in emphasis between the SFAC 7 definition up in the first paragraph and the FAS 157 definition. Now, fair value "focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price)."

And what's the point of all this? Well, to be blunt, fair value is important because purchasers and sellers of assets (and investors) need to know if they're getting ripped off. They need to have a sense of what makes an entity value an asset "X" at $Y. What FAS 157 does, in essence, is to create a guide by which an entity can value an asset and then report how it came to that valuation, thus allowing you or Pocket MBA to see how the valuation is "fair." That's all.

This process is not that difficult with regard to most assets. When there are ready markets for assets, it's easy to assess value. And fair value, as defined and put into practice in FAS 157 is a "market-based measurement." What about when markets are not so readily available? In a period in which we are reading headlines on a daily basis about the difficulty of valuing CDOs and SIVs other banking assets, it's a critical question, and FAS 157 has an answer in "unobservable inputs," which are the bases for valuation when there is no readily available market:

As a basis for considering market participant assumptions in fair value measurements, this Statement establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from sources independent of the reporting entity (observable inputs) and (2) the reporting entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The notion of unobservable inputs is intended to allow for situations in which there is little, if any, market activity for the asset or liability at the measurement date. In those situations, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. However, the reporting entity must not ignore information about market participant assumptions that is reasonably available without undue cost and effort.

FAS 157 establishes a three-level "input" valuation disclosure hierarchy—if an asset clearly falls into one of the levels, the entity should value the asset according to those inputs.

Level 1 is the easy to value asset because it is based on observable inputs: "Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date." Level 2 inputs are a little more complicated because there may not be an active market in the asset. Level 2 inputs are those "other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly." These can include:

a) Quoted prices for similar assets or liabilities in active markets

b) Quoted prices for identical or similar assets or liabilities in markets that are not active, that is, markets in which there are few transactions for the asset or liability, the prices are not current, or price quotations vary substantially either over time or among market makers (for example, some brokered markets), or in which little information is released publicly (for example, a principal-to-principal
market)

c) Inputs other than quoted prices that are observable for the asset or liability (for example, interest rates and yield curves observable at commonly quoted
intervals, volatilities, prepayment speeds, loss severities, credit risks, and default rates)

d) Inputs that are derived principally from or corroborated by observable market data by correlation or other means (market-corroborated inputs).

Level 3 inputs are where things get really murky, for they "are unobservable inputs for the asset or liability," and they "shall be used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date." Even so, the objective as to fair valuation is the same, "that is, an exit price from the perspective of a market participant that holds the asset or owes the liability." Level 3 is the closest FAS 157 comes to the "I know it when I see it" of the prior regime. Thus,

unobservable inputs shall reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability (including assumptions about risk). Unobservable inputs shall be developed based on the best information available in the circumstances, which might include the reporting entity’s own data. In developing unobservable inputs, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. However, the reporting entity shall not ignore information about market participant assumptions that is reasonably available without undue cost and effort. Therefore, the reporting entity’s own data used to develop unobservable inputs shall be adjusted if information is reasonably available without undue cost and effort that indicates that market participants would use different assumptions.

And the bottom line with all this is disclosure. So an entity has to disclose information that would allow you to discern which of the inputs it used to value a particular asset so that we can all agree the value is fair.

The Pocket MBA, lay-finance take away? From this year on, if you see an asset valuation based on Level 1 inputs, you'll know it is a market valuation, and you can trust it like you trust the price of a piece of furniture or a can of cola. But if it's based almost entirely on Level 3 (and we may begin to see this soon with the securitized assets on and off bank balance sheets), well, the value may well be fair, but caveat emptor and all that other great Latin stuff.

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