The Financial Accounting Standards Board has issued a proposed statement, Fair Value Measurements, which would provide guidance for how to measure fair value. The proposed statement seeks to establish a framework that would improve the consistency, comparability and reliability of fair value measurements and would apply broadly to financial and nonfinancial assets and liabilities that are measured at fair value under other authoritative accounting pronouncements. The FASB expects that the guidance provided by the proposed statement will be applied together with applicable valuation standards and generally accepted valuation practices, where appropriate. The changes to current practice resulting from the application of this proposed statement relate principally to the methods for measuring fair value and expanded disclosure requirements. In particular, the proposed statement would require:
oThe fair value of financial instruments traded in active dealer markets where bid and asked prices are more readily and regularly available than closing prices be estimated using bid prices for long positions and asked prices for short positions, except as otherwise specified for offsetting positions.
oThe fair value of restricted securities be estimated using the quoted price of an otherwise identical unrestricted security, adjusted for the effect of the restriction.
oIn the absence of quoted prices for identical or similar assets or liabilities, fair value be estimated using multiple valuation techniques consistent with the market approach, income approach and cost approach whenever the information necessary to apply those techniques is available without undue cost and effort.
oClarify and incorporate the guidance in FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, for using present value techniques to estimate fair value, thereby elevating that guidance to Level A GAAP.
oExpanded disclosures about the use of fair value to remeasure assets and liabilities recognized in the statement of financial position, including information about the fair value amounts, how those fair value amounts were determined and the effect of the remeasurements on earnings (including unrealized gains and losses).
The proposed statement would be effective for financial statements issued for fiscal years beginning after June 15, 2005, and interim periods within those fiscal years. Earlier application would be encouraged. Initial application of the statement should be as of the beginning of an entity’s fiscal year. The provisions of this proposed statement are to be applied prospectively, except for the change in accounting principle relating to bid-asked spread measurements. For that change, this proposed statement would require a retroactive transition approach applied by reporting a cumulative-effect adjustment.
Definition of Fair Value
The proposed statement defines fair value as “the price at which an asset or liability could be exchanged in a current transaction between knowledgeable, unrelated willing parties.” The objective of the measurement is to estimate the price for an asset or liability in the absence of an actual exchange transaction for that asset or liability. Thus, the estimate is determined by reference to a current hypothetical transaction between willing parties. Willing parties are presumed to be marketplace participants representing unrelated buyers and sellers that are (a) knowledgeable, having a common level of understanding about factors relevant to the asset or liability and the transaction and (b) willing and able to transact in the same market, having the legal and financial ability to do so.
Valuation techniques consistent with the market approach, income approach and cost approach should be considered for all estimates of fair value. In the absence of quoted prices for identical or similar assets or liabilities in active markets, fair value should be estimated based on the results of multiple valuation techniques whenever the information necessary to apply those techniques is available without undue cost and effort. Key aspects of these approaches are as follows:
a.The market approach requires observable prices and other information generated by actual transactions involving identical, similar or otherwise comparable assets or liabilities. The estimate of fair value is based on the value indicated by those transactions.
b. The income approach uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present amount. The estimate of fair value is based on the value indicated by marketplace expectations about those amounts. Those valuation techniques include present value techniques and option-pricing models, such as Black-Scholes-Merton.
c. For an asset, the cost approach considers the amount that currently would be required to replace its service capacity (that is, current replacement cost). The estimate of fair value considers the cost to acquire a substitute asset of comparable utility, adjusted for obsolescence.
Valuation techniques used to estimate fair value should be consistently applied. A change in the valuation technique used is appropriate only if the change results in a more reliable estimate of fair value, for example, as new markets develop or as new and improved valuation techniques become available.
Market inputs are the assumptions and data that marketplace participants would use in their estimates of fair value. Valuation techniques used to estimate fair value should emphasize market inputs, including those derived from active markets, whether using the market approach, income approach or cost approach. In an active market, such as the New York Stock Exchange, quoted prices that represent actual transactions are readily and regularly available; readily available means that pricing information is currently accessible and regularly available means that transactions occur with sufficient frequency to provide information on an ongoing basis. In determining whether a market is active, the emphasis is on the level of activity for a particular asset or liability.
Market inputs should be determined based on information that is timely, originated from sources independent of the entity and used by marketplace participants in making pricing decisions. Examples of market inputs that may be used, directly or indirectly as a basis for deriving other relevant inputs, include the following:
a.Quoted prices (completed transactions, bid/asked or rates), adjusted as appropriate. The fair value hierarchy specifies whether adjustments to those prices are appropriate, and if so, when.