These steps are based on Paragraph A2 of FAS 157.
1. What assets and/or liabilities are recorded or reported at fair value?
Analyze your 2006 10K to determine which assets and/or liabilities were recorded or reported at fair value. Determine the FASB guidance for each item and then determine which were recorded at fair value (i.e. financial instruments, pension assets, trusts). The footnotes also need to be analyzed to see if any assets/liabilities were reported in the footnotes at fair value even though they were recorded on a different cost basis in the financial statements (i.e. long-term debt).
2. What is the unit of account or other attributes for each of the assets/liabilities?
Paragraph 6 of FAS 157 states that the attributes of the asset/liability should be considered when determining fair value. These attributes include the condition and/or location of the asset and any restrictions on the sale or use of the asset.
The unit of account would be either a group of assets or each individual asset. For example a dining room set consisting of a table and chairs or each chair sold individually. For commodity contracts the location of the asset must also be included in the fair value calculation. If there is significant transportation cost to move the asset from its current location to a market with willing buyers, these costs are included in the fair value. Restrictions on assets/liabilities are also taken into consideration for Level 2 and Level 3 measurements. These could include possible offsets in Master Netting Agreements or credit risk.
3. What is the valuation premise for each of these assets and/or liabilities?
Per paragraph 13 of FAS 157, the highest and best use establishes the valuation premise. The highest and best use refers to whether a market participant would place more value on an asset if it was used with other assets or if it would be used by itself. The highest and best use is not necessarily the same as how the reporting entity intends to use the asset.
A valuation premise of in-use would be for an asset that is used in combination with another asset such as a parcel of land with an office building. An in-exchange valuation premise would be for an asset that is to be used by itself such as just the parcel of land. The reporting entity must determine how a market participant would use the asset, regardless of how the entity is planning on using the asset.
Paragraph 10 of FAS 157 defines a market participant as being independent of the reporting entity, knowledgeable of the asset, and able and willing to transact for the asset, i.e. they are motivated but not forced.
4. What is the principal or most advantageous market for each of these assets and/or liabilities?
Paragraph 8 of FAS 157 states that the price of an asset or liability is to be determined in the principal or most advantageous market.
The principal market is the market where the entity generally purchases or sells the asset/liability with the greatest volume or level of activity. If a principal market can not be identified (i.e. if the entity does not normally purchase or sell the asset), then the most advantageous market must be identified. The most advantageous market is the market that a market participant could sell the asset to maximize the amount received. An entity may have to determine the fair value of an asset/liability in several markets to be able to determine the most advantageous market.
5. What valuation techniques are appropriate for each of these assets and/or liabilities?
Paragraph 19 of FAS 157 states that in calculating fair value, a valuation technique that is appropriate in the circumstances and for which sufficient data is available should be used. If multiple valuation techniques can be used the results should be evaluated or weighted and a point within the range that is most representative of the fair value should be used. The valuation technique is to be consistently applied and changes to the valuation technique are to be accounted for as a change in accounting estimate. Valuation techniques used to measure fair value shall maximize the use of observable inputs and minimize the use of unobservable inputs.
Per paragraph 18 of FAS 157, a valuation technique consistent with the market, income and/or cost approach should be used in determining the fair value of an asset/liability.
The market approach involves using prices and other relevant information generated by market transactions involving identical or comparable assets. An example would be a matrix pricing model or a direct quote from an established exchange.
The income approach uses valuation techniques to convert future amounts to a single present value and involves techniques such as Black-Scholes-Merton or binomial models, present value techniques and multi-period excess earnings method (for intangibles).
The cost approach is based on the amount that currently would be required to replace the service capacity of an asset and uses current replacement cost or is based on the cost to a market participant to acquire or construct a substitute asset of comparable utility adjusted for obsolescence (not depreciation).
6. What are the assumptions to be considered when determining the price of the asset/liability?
Paragraph 7 of FAS 157 states that the price of an asset/liability should be determined as the price that would be received to sell the asset at the measurement date.
This is one of the main differences that FAS 157 introduces. The price to be used in determining fair value is the exit price and not the transaction price that the reporting entity paid for the asset/liability. The transaction price might very well be the same as the exit price, but is no longer presumed to be the same. The reporting entity must determine a hypothetical transaction at the measurement date using assumptions that would be held by a market participant, with the highest and best use in the principal or most advantageous market. Transportation costs are included in the price, but transaction costs are not.
Per Paragraph 17 of FAS 157, a transaction price might not represent fair value if:
a. the transaction is between related parties
b. the transaction occurs under duress
c. the unit of account represented by the transaction price is different from the unit of account represented by the exit price
d. the market in which the transaction occurs is different from the principal or most advantageous market.
Paragraph 15 of FAS 157 states that when determining the fair value of a liability, the risk of non-performance by one of the parties must be taken into consideration.
Non-performance risk needs to be determined for the counterparty and the reporting entity. Therefore, in valuing the debt instruments the company’s own credit risk must be taken into account.
In determining the inputs for the valuation technique, the assumptions that a market participant would use to price the asset/liability should be used. These assumptions include the exit price, the non-performance risk of both parties, the market and the valuation premise.
7. What level of the hierarchy do the inputs used to determine the fair value of the assets and/or liabilities fall under?
The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets and the lowest priority to unobservable inputs. The hierarchy is used to prioritize the inputs to the valuation technique not the valuation technique itself.
Level 1 Inputs
Per Paragraph 24 of FAS 157, Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets that the reporting entity has the ability to access at the measurement date.
Paragraphs 25 and 26 give exceptions to the definition in Paragraph 24. One exception is if a reporting entity holds a large number of similar assets or liabilities which have a quoted price in an active market but the quoted price is not readily accessible for each of the assets or liabilities individually. Also, if significant events occur after the close of a market but before the measurement date, then the quoted price may not represent fair value. If the quoted price is adjusted for any new information or if it is adjusted to accommodate different attributes of the assets or liabilities being measured, then the adjustment moves the fair value measurement to a lower level.
To be a Level 1 input, the asset/liability must be traded in an active market. An active market for the asset is a market in which transactions for the asset occurs with sufficient frequency and volume to provide pricing information on an ongoing basis. This definition is not further explained except for stating when market conditions do not allow a blockage factor. Paragraph 27 and C25 of FAS 157 state that a blockage discount is not to be taken even if the market’s normal daily trading volume is not able to absorb the quantity being held nor if placing orders to sell the position in a single transaction might affect the quoted price. Therefore, the volume held by the entity is not to be used in the determination of an active market.
Level 2 Inputs
Per Paragraph 28 of FAS 157, Level 2 inputs are inputs other than quoted prices that are observable for the asset either directly or indirectly and include quoted prices for similar assets in active markets, quoted prices for identical assets in markets that are not active, interest rates and yield curves and inputs derived principally from or corroborated by observable market data by correlation or other means.
Therefore, Level 2 inputs are Level 1 inputs that have been adjusted due to some particular attribute of the asset/liability being measured at fair value. Paragraph 29 of FAS 157 gives examples of some adjustments that might be made:
a. condition and/or location of asset
b. extent to which the inputs relate to items that are comparable to the asset
c. volume and level of activity in the markets within which the inputs are observed.
Level 3 Inputs
Paragraph 30 of FAS 157 defines Level 3 inputs as unobservable and that reflect the reporting entity’s own assumptions and are based on the best information available and does not preclude the use of mid-market pricing or other pricing conventions as a practical expedient for fair value measurements within a bid-ask spread.
Therefore, if an asset/liability should be measured at fair value and if quoted prices for an identical asset or quoted prices that can be adjusted for a similar asset are not obtainable, then a reporting entity is to use judgment in determining the assumptions of a market participant to determine the fair value of the asset/liability.
This is a lot to take in, so please send me a note if you have questions.