October 13, 2008
The SEC and FASB staffs have recently issued additional guidance on the application of FASB No. 157 ("Fair Value Measurements") when determining the fair value of illiquid financial instruments. First, the SEC and FASB staffs issued a joint press release on September 30, 2008, which included a series of Q&As on this topic. Then, on October 10, 2008, the FASB staff issued FASB Staff Position No. FAS 157-3 ("FSP FAS 157-3"). Each of these releases focuses on fair market valuation of assets in non-active markets. The guidance in FSP FAS 157-3 is effective immediately, including for prior periods for which financial statements have not been issued.
Separately, the SEC’s Division of Corporation Finance staff also recently posted a sample letter that highlights disclosure issues related to fair value measurements for issuers to consider in preparing Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A"). This guidance follows a similar letter on the subject issued in March 2008.
This collective guidance from the SEC and FASB staffs bears close scrutiny in preparing upcoming periodic reports filed with the SEC.
Additional SEC and FASB Staff Guidance on Application of FAS 157
FAS 157 was issued in September 2006 in response to confusion resulting from the widely differing methodologies used by preparers in determining fair values. FAS 157 does not itself establish an accounting principle that fair value accounting must be used to value certain assets. Rather, it creates a framework for applying fair value accounting where such accounting is required. Specifically, FAS 157 creates a fair value hierarchy for inputs used in the valuation process: There are three tiers of inputs:
1. Level 1. Level 1 inputs are quoted prices (unadjusted for blockage or similar items) in active markets for identical assets that the preparer has access to on the measurement date.
2. Level 2. Level 2 inputs are inputs other than quoted prices that are observable either directly or indirectly. These inputs can include quoted prices in active and less active markets for similar assets, observable inputs like interest rates, yield curves, credit risks and default rates or inputs derived principally from market data by methods such as correlation.
3. Level 3. Level 3 inputs are unobservable and are used where observable inputs are not available. They can include the preparer’s own assumptions about the assumptions market participants would use in pricing the asset or even the preparer’s own data such as models. The preparer must not ignore information about market participants’ assumptions if it is available without undue effort and expense.
The guidance from the SEC and FASB staffs is intended to clarify the application of FAS 157 in a market that is inactive. In particular, the guidance includes several important observations that collectively appear to give some additional flexibility in using unobservable inputs when modeling fair value. First, the guidance provides that, in some circumstances, it is permissible to use Level 3 (unobservable) inputs rather than Level 2 (observable) inputs. Specifically, the guidance notes that this approach is acceptable when the Level 2 inputs would require significant adjustments due to market disruptions. FSP FAS 157-3 characterizes this clarification as a recognition that the "significant adjustments" are themselves generated from unobservable data, rendering the adjusted Level 2 input a Level 3 measurement overall.
Second, the SEC and FASB staffs’ guidance explains that broker quotes based on models rather than actual transactions deserve less weight. Further, a broker quote deserves less weight if it is nonbinding.
Third, the guidance from the SEC and FASB staffs provides that distressed asset sales are not necessarily determinative of fair value. Both documents note that determining whether an observed sale was distressed is a matter of judgment. FSP FAS 157-3 emphasizes, however, that even in distressed markets not all sales are forced or distressed and should not be assumed to be so. The joint press release also emphasized that even if a market is inactive, some transactions in the market may be orderly, and that orderly transactions even in inactive markets should be considered, subject to appropriate adjustments.
Fourth, the guidance from the SEC and FASB staffs provides insight on how to recognize an inactive market. The relevant factors for this determination include: (a) a significant increase in bid–ask spread and (b) a significant decrease in trading volume. The guidance also leaves open the possibility that there may be other factors. FSP FAS 157-3 also includes an illustrative example that provides more detail on this topic.
The example in FSP FAS 157-3 also shows how an entity could properly transition from using a market valuation approach for a collateralized debt obligation security to using a discounted cash flow approach. The example uses both qualitative and quantitative data to show how the entity could decide the income approach is more appropriate and then how the entity could select the appropriate discount rate for its cash flows.
MD&A Disclosure Guidance Related To Fair Value Measurements
The SEC’s Division of Corporation Finance staff issued a letter in March 2008 with extensive guidance on disclosure issues related to fair value measurements. In September 2008, the SEC staff supplemented this guidance by highlighting, among other things, the following additional MD&A disclosure issues for consideration:
 Available at http://www.fasb.org/pdf/fsp_fas157-3.pdf.
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