Market Participants – the FASB uses the concept of market participants, which are independent of the reporting entity and are knowledgeable about the assets or liabilities to be transferred. They must also have the ability to follow through with the purchase or sale.

Valuation Techniques – FAS 157 recognizes three methodologies to value assets and liabilities. The market approach or comparable sales approach looks at identical or similar transactions in the market to determine fair value. The income approach is used to value income producing property, with discounted cash flows as the most common method. The cost approach, or replacement cost, considers what a user would pay for the remaining utility of an asset. Simply put, the cost for the new asset is adjusted downward for physical deterioration and other obsolescence.

FAS 157 introduces the concept of using the Principal Market or Most Advantageous Market. The principal market is defined where the transaction is conducted with the greatest volume. The most advantageous market is where the highest price can be obtained. (For many items these would be one in the same.)

FAS 157 also introduces the concept of Highest and Best Use Assumptions for Assets. This concept implies that the stated use of the selling (or buying) entity might not be the “highest and best use” from a willing market participant. This concept may assume an “in-use” valuation (where the asset has maximum value through its use in combination with other assets, such as property) or an “in-exchange” value (where the maximum value is on a standalone basis, such as investment securities).

The most significant change required by FAS 157 is to provide a hierarchy of reporting status for these financial instruments. The hierarchy is defined as:

• Level 1: Quoted prices in active markets for identical assets and liabilities.
   
• Level 2: Other observable inputs, which include quoted prices for similar assets and liabilities, and market corroborated inputs. These inputs could include such items as interest rates, yield curves, auction prices for equipment or per square foot selling prices for real estate.
   
• Level 3: Unobservable inputs, which include the entity’s assumptions. These inputs would include those internally developed and estimates, such as estimated cash flows or estimated occupancy rates.

The challenge will be defining what level within the hierarchy should be used. Using Level 1 is obvious, as the fair value is based on quoted prices in active markets. The difficult part will be identifying Levels 2 and 3. Should an appraisal used for valuing an impaired loan be classified as Level 2 or Level 3? The real question is whether the appraisal is based on observable inputs or estimates and market assumptions.

The disclosure requirements relate primarily to providing information about the inputs used to measure fair value, especially any significant unobservable inputs. The Statement distinguishes between fair values that are measured on a recurring basis, such as investments, and those determined on a nonrecurring basis, such as impairments.

The following disclosures are required separately for each major category of assets and liabilities that are measured at fair value on a recurring basis:

1. Fair values at the reporting date (balance sheet date), broken down by the 3 levels of the fair value hierarchy.
    

2. For fair value measurements using significant unobservable inputs (Level 3), a “roll-forward reconciliation that separately shows:

·        Total realized and unrealized gains and losses for the period (separately) and where they are reported in the income statement

·        Purchases, sales issuances and settlements (net)

·        Transfers into and out of Level 3
 

3. Unrealized gains and losses affecting income that relate to assets or liabilities still held at the balance sheet date, including where such gains or losses are reported on the income statement
    

4. For annual periods only, the valuation techniques used to measure fair values and a description of any changes in valuation techniques

For assets and liabilities that are measured at fair value on a nonrecurring basis the disclosures must include the following information on the inputs used to develop the values:

1. Fair value measurements during the period and the reasons for them (e.g. impairment)
    

2. The level in the hierarchy applicable to the values
    

3. For level 3 measurements, a description of the inputs and the information used to develop them
    

4. For annual periods only, the valuation techniques used to measure fair values and a description of any changes from methods used for similar valuation in the past.

Note: For all quantitative disclosures, the Statement requires that they be presented in a tabular format.

The answer to the second question, “What do I have to do?” is fairly straight forward. Make the election and documentation. Let’s discuss the election under FAS 159 in more detail.

Remember that once the election has been made, whether on a specific asset/liability or on a group, the election can not be revoked. This means that management must evaluate and understand the ramifications of the election and its potential, long-term effects. For most entities this means that they will follow the requirements of FAS 159 (and FAS 157 as required) and initially elect to report the current financial assets and liabilities under the current standard requirements.

Once the election has been made, the entity is required to hold fast unless an eligible election date or event occurs. For initial election, the entity must determine which instruments held will be reported under fair value accounting. All changes and adjustments related to the initial election of reporting under FAS 157, as of the beginning of the reporting period, must be reported as a cumulative adjustment to retained earnings. After the initial election date, changes are not allowed for items held except for special circumstances, such as changes in reporting parameters for an item. These changes may include impairments, consolidations, deconsolidations, business combinations and other special changes. For newly held instruments, the entity must determine the reporting when it first recognizes the eligible item.

A quick note, there are several items an entity may not elect under the fair value option. These include:

• An investment in a subsidiary that the entity is required to consolidate
• A variable interest entity that is required to be consolidated
• Obligations under pension benefits, postretirement benefits, employee stock options and other deferred compensation plans
• Items recognized under leases (see exceptions for guarantees)
• Items classified as equity (such as convertible debt)
• Demand deposit liabilities for banks and other financial institutions

Conclusions and final comments

FAS 157: Fair Value Measurement is the new definition for fair value reporting and will affect all financial instruments you are currently reporting at fair value. This includes available-for-sale securities and FAS 107 disclosures. For items without a known or comparable market, this will require significant new financial disclosures and proper documentation to support this information.

FAS 159: The Fair Value Option now allows you to report almost any financial asset or liability using fair value measurement. However you must be consistent in the reporting over the life of the financial instrument.

Most items you are currently reporting and tracking will not change significantly, as there are active markets and known parameters to value these items.  For unusual items without a specific market or for new items you may elect to report under FAS 159: The Fair Value Option, you must now have documented support for the fair value estimate including the assumptions and parameters used.

Be sure to research and evaluate items that do not seem to fall under the normal parameters and contact your financial accountant for more information.