FSP FAS 157-3 – Determining the Fair Value of a Financial Asset when the Market for that Asset is Not Active

FSP FAS 157-3 – Determining the Fair Value of a Financial Asset when the Market for that Asset is Not Active

This FSP was issued in October, 2008 and was effective upon issuance. Revisions resulting from a change in the valuation technique or its application shall be accounted for as a change in accounting estimate, but the disclosure requirements of FAS 154 are not required.

FSP FAS 157-3 was issued to clarify the application of FAS 157 in a market that is not active and provides an example to illustrate key considerations. This FSP follows the guidance that given in the letter issued by the SEC and the FASB in September 2008.

There are three key principles of FAS 157 that this FSP emphasizes:

1. A fair value measurement represents the price that would be received by the holder of the financial asset in an orderly transaction that is not a forced liquidation or distressed sale. Generally a market price is considered the best estimate of the fair value and an indicator that the sale is not a forced liquidation. When a market is in turmoil, it is not appropriate to conclude that all market activity represents forced liquidations, nor is it appropriate to assume that a market price is the fair value of the asset. An entity must use judgment to determine if the market price is representative of fair value, especially when the market is in turmoil.

2. The use of a reporting entity’s own assumptions about future cash flows and appropriately risk-adjusted discount rates is acceptable when relevant observable inputs are not available (such as when a market is in turmoil). Occasionally observable inputs must be adjusted to be relevant to an entity’s particular asset. This would cause the input to be lowered to a Level 3 input, but it may be a better indicator of the actual fair value and an appropriate disclosure would be used to explain this to investors.

3. Broker (or pricing services) quotes may be an acceptable input for fair value, but if the market is not active, the entity would need to determine how the quote was determined. If the broker is using an internal model to calculate the quote instead of information from actual market transactions, then the entity should place less reliance on the broker quote.

The purpose of FAS 157 was to provide information to investors about how an entity determines the fair value of its assets. Considering the crash of the credit market and the current financial situation, I would suggest very robust disclosures around the fair value of financial instruments, especially derivative instruments, in your 2008 10Ks.

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Linda is a CPA living in Southwestern Ohio, working as a research accountant for an investor-owned publicly traded utility company. She specializes in implementing new FASB and SEC requirements and FAS 133 derivative issues. In her role at the utility she has encountered many issues and written many memos, so send in your implementation and derivative issues and Linda will help figure out an answer.

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