FAS 157

In September 2006, the Financial Accounting Standards Board (FASB) of the United States issued Statement of Financial Accounting Standards 157: Fair Value Measurements), which “defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements.” This statement is effective for financial reporting fiscal periods commencing after November 15, 2007 and the interim periods applicable.

Paragraph 5 of SFAS No. 157 (now known as ASC 820 in the updated FASB Codification) defines fair value as “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.” Of note, this Statement requires consideration of the exit price paid (if liability) or received (if asset) in a hypothetical transaction in an orderly market (i.e., not a forced liquidation or sold under duress).

This Statement also introduces two more concepts to the definition of fair value – the Principal (or Most Advantageous) Market and Highest and Best Use.

Principal (or Most advantageous) Market – Fair Value Measurement assumes the hypothetical transaction occurs in a principal market, the “the market in which the reporting entity would sell the asset or transfer the liability with the greatest volume and level of activity for the asset or liability.” In the absence of a principal market, the asset or liability is assumed to be transferred in the most advantageous market, “the market in which the reporting entity would sell the asset or transfer the liability with the price that maximizes the amount that would be received for the asset or minimizes the amount that would be paid to transfer the liability, considering transaction costs in the respective market(s).”

Highest and Best Use – Fair Value Measurement assumes the asset is being utilized in a manner that will maximize its value. For example, where a company owns a factory, but the property would have a higher value as a residential lot, the asset should be fair valued as a residential lot.

The concept of the Fair Value Hierarchy there for is introduced in paragraphs 22 through 31 in SFAS No. 157. To provide the financial statement user with more insight into the valuation techniques and to create comparability among financial statements, SFAS No. 157 requires the fair value assets and liabilities to be allocated to based on the transparencies of the inputs to valuing the assets/liabilities.

Level 1, the highest on the hierarchy, indicates assets/liabilities with the most transparent and tangible valuation techniques. A Level 1 financial instrument typically has quoted prices and active markets – for example, an equity stock. This type of instrument has the most verifiable and reliable fair value measurement.

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