The Financial Accounting Standards Board (FASB) made changes for measuring and disclosing fair value and for recognizing and presenting other-than-temporary impairment (OTTI) charges with the issuance on April 9 of three FASB Staff Positions (FSPs). The first FSP amends FASB Statement of Financial Accounting Standards No. 157, "Fair Value Measurements," (FAS 157 or Statement 157) to provide additional guidance for estimating fair value when there has been a significant decrease in volume and level of activity when compared with normal market activity for the financial instrument or similar instruments. The second FSP amends the OTTI guidance for debt securities. The third FSP requires more frequent disclosures of fair value information for public companies.
While some financial institutions have chosen to early adopt the first and second FSPs, the majority are waiting to adopt the FSPs in the second quarter of the calendar year.
FSP to Change FAS 157: Determining Fair Value
The Final FSP
FSP FAS 157-4, "Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly," provides guidance on determining when the volume and level of activity for an asset or liability have significantly decreased as well as when a transaction is not considered orderly. Both are key points because those decisions will affect whether a price quotation or observed transaction price should be adjusted.
The FASB emphasizes that FSP FAS 157-4 does not change the objective of a fair value measurement, even when market activity for the asset has decreased significantly. Fair value is the price that would be received for an asset sold in an orderly transaction – not a forced liquidation or distressed sale – between market participants at the measurement date under current market conditions. In other words, it does not change the fair value definition to be fair value in an active market. Paragraph 15 of FSP 157-4 reiterates Statement 157's objective of fair value measurement: "Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions."
FSP FAS 157-4 stresses the use judgment when determining whether a formerly active market has become inactive and when determining fair values in such markets. When determining fair value, an entity's intention to hold the asset or liability is not relevant because under FAS 157, fair value is a market-based measurement, not an entity-specific measurement.
A fair value measurement should include a risk premium reflecting the amount market participants would demand because of uncertainty in cash flows; otherwise, the measurement would not faithfully represent fair value. The FASB acknowledges that determining the appropriate risk premium might be difficult. However, the degree of difficulty alone is not a sufficient reason to exclude a risk adjustment.
The Proposed FSP
The proposed FSP FAS 157-e, "Determining Whether a Market Is Not Active and a Transaction Is Not Distressed," included a two-step model. The first step determined whether factors exist that indicate that a market for an asset is not active. If step one resulted in the conclusion that there is not an active market, step two evaluated whether the quoted price (a recent transaction or broker quotation) is not associated with a distressed transaction.
The proposed FSP FAS 157-e also included a presumption that a quoted price from a market that is not active is a distressed transaction unless there is evidence otherwise. The FASB retained the two-step approach but removed from the final FSP the presumption that all transactions are distressed unless proved otherwise.
The final FSP FAS 157-4 provides the following two-step process:
Step One: Evaluate the Market
The first step is to determine whether there has been a significant decrease in the volume and level of activity for the asset or liability when compared with normal market activity. One change from the proposed FSP is the use of the term "inactive market." The final FSP does not use the term "inactive market" because that suggests there is no market activity rather than decreased market activity. Factors to consider when evaluating whether there has been a significant decrease in the volume and level of activity in relation to normal market activity include, but are not limited to:
- Few recent transactions;
- Price quotations not based on current information;
- Price quotations that vary substantially (either over time or between market makers);
- A demonstrable change in correlation, that was previously highly correlated, between indexes and recent indications of fair values;
- A significant increase in implied liquidity risk premiums;
- A wide or significant increase in the bid-ask spread;
- A significant decline for new issuances of the financial instrument or similar financial instruments; and
- A lack of publicly available information.
If the factors are present, then transactions or quoted prices may not be determinative of fair value. If the entity concludes there is a significant decrease in the volume and level of activity when compared with normal market activity, move to step two to evaluate the transactions.
If the above or other relevant factors are not present, then the prices obtained are indicative of fair value and should be used, without adjustment, to determine fair value.
Step Two: Evaluate the Transactions
Even if there has been a significant decrease in the volume and level of activity for the asset or liability, it is not appropriate to conclude that all transactions are not orderly (that is, distressed or forced). An orderly transaction is a transaction that is neither a forced liquidation nor a distressed sale. Some circumstances that might indicate that a transaction is not orderly:
- There was not adequate exposure to the market to allow for marketing activities that are usual and customary.
- There was a usual and customary marketing period, but the seller marketed to a single market participant.
- The seller is in or near bankruptcy or receivership (that is, distressed), or the seller was required to sell to meet regulatory or legal requirements (that is, forced).
- The transaction price is an outlier compared to other recent transactions.
An entity should conclude whether a transaction is orderly based on the weight of the evidence. Quoted prices that are not representative of an orderly transaction are not solely determinative of fair value. When estimating fair value, more weight should be placed on transactions that are orderly, and less weight should be placed on transactions for which there is insufficient information to conclude whether they are orderly.
An entity need not undertake all possible efforts to determine whether a transaction is orderly; but on the other hand, an entity should not ignore information that is available without undue cost and effort.
In the period of adoption, entities should disclose a change in valuation technique and related inputs resulting from the application of the FSP and quantify the total effect of the change in valuation technique and related inputs, if practicable, by major category.
This FSP requires additional disclosures, both on an interim and annual basis, of inputs and valuation techniques used to determine fair value as well as changes to inputs and techniques. It also amends the FAS 157 disclosures to require detail within the trading, available for sale (AFS), and held to maturity (HTM) categories. As amended, FAS 157 defines major security types to be consistent with FAS 115, "Accounting for Certain Investments in Debt and Equity Securities."
As noted in FSP FAS 157-4, paragraph 20b, to comply with this requirement, financial institutions should include in their disclosure the following major security types, though additional types might be necessary:
- Equity securities (segregated by industry type, company size, or investment objective);
- Debt securities issued by the U.S. Treasury and other U.S. government corporations and agencies;
- Debt securities issued by states of the United States and political subdivisions of the states;
- Debt securities issued by foreign governments;
- Corporate debt securities;
- Residential mortgage-backed securities;
- Commercial mortgage-backed securities;
- Collateralized debt obligations;
- Other debt obligations.
Revisions resulting from a change in the valuation technique or its application will be accounted for as a change in accounting estimate in accordance with paragraph 19 of Statement 154, "Accounting Changes and Error Corrections."
To read this article in its entirety please click here.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.