Fas 157

What Is FAS 157?

FAS 157, officially Statement of Financial Accounting Standards No. 157, was an accounting standard issued by the Financial Accounting Standards Board (FASB) in September 2006. It established a common definition for fair value and set forth a framework for measuring it within Generally Accepted Accounting Principles (GAAP). This standard, now largely codified under Accounting Standards Codification (ASC) Topic 820, aimed to enhance consistency, comparability, and transparency in financial reporting regarding fair value measurements. FAS 157 did not introduce new requirements for when to measure items at fair value, but rather provided guidance on how to perform such measurements when other accounting pronouncements mandated or permitted them³², ³³.

History and Origin

Prior to the issuance of FAS 157, various definitions and limited guidance for applying fair value measurements existed across different FASB pronouncements. This created inconsistencies and complexity in financial reporting. The FASB introduced FAS 157 to address these issues by providing a single, comprehensive definition and a standardized framework³¹. The standard became effective for fiscal years beginning after November 15, 2007³⁰.

FAS 157 was designed to respond to investors' requests for more detailed information about the extent to which companies measure assets and liabilities at fair value, the information used for these measurements, and their effect on earnings²⁹. The core principle of FAS 157 was to define fair value as an "exit price"—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. ²⁷, ²⁸This perspective differs from an "entry price," which is the price paid to acquire an asset or incur a liability.
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Key Takeaways

• FAS 157, now largely integrated into ASC Topic 820, standardized the definition of fair value for financial reporting under GAAP.
• It established a fair value hierarchy (Level 1, Level 2, and Level 3) based on the observability of inputs used in valuation techniques.
• The standard aimed to improve the consistency, comparability, and transparency of fair value measurements in financial statements.
• FAS 157 emphasized that fair value is a market-based measurement, reflecting assumptions that market participants would use, rather than an entity-specific measurement.
• Its implementation coincided with the 2008 global financial crisis, leading to significant debate and criticism regarding its role in amplifying market volatility.

Formula and Calculation

While FAS 157 does not prescribe a specific mathematical formula, it establishes a framework for determining fair value, primarily through its "fair value hierarchy." This hierarchy categorizes the inputs used in valuation techniques into three levels, prioritizing observable market data:

• Level 1 Inputs: These are the highest priority and consist of unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity can access at the measurement date. ²⁴, ²⁵Examples include publicly traded stocks on major exchanges.
• Level 2 Inputs: These are observable inputs other than Level 1 quoted prices, either directly or indirectly. ²³They include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in inactive markets, inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates, yield curves), and market-corroborated inputs. ²²Examples might include certain corporate bonds or over-the-counter derivatives.
• Level 3 Inputs: These are the lowest priority and consist of unobservable inputs for the asset or liability. ²¹These inputs are used when observable inputs are unavailable and are developed based on the reporting entity's own assumptions about how market participants would price the asset or liability, including assumptions about risk. ¹⁹, ²⁰Examples often involve illiquid private equity investments or complex structured financial instruments.

The standard requires entities to maximize the use of observable inputs and minimize the use of unobservable inputs when determining fair value.
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Interpreting the FAS 157

FAS 157 mandates that when an asset or liability is measured at fair value, that measurement should reflect the assumptions that market participants would use when pricing the item. ¹⁷This "market-based" perspective means that the fair value is not determined by an entity's specific intentions for holding an asset or liability, but rather by how independent, knowledgeable, willing, and able buyers and sellers would transact for it in an orderly manner.
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For example, when valuing an asset, FAS 157 assumes its "highest and best use," which considers what is physically possible, legally permissible, and financially feasible for market participants, even if the reporting entity has a different intended use. ¹⁵For a liability, the fair value measurement must reflect its non-performance risk, including the reporting entity's own credit risk. ¹⁴This focus on market participants and exit prices is central to interpreting FAS 157's application in financial reporting.

Hypothetical Example

Consider "Company Alpha," a publicly traded company that owns a portfolio of financial instruments.

1. Level 1 Asset: Company Alpha holds 10,000 shares of Microsoft stock. On December 31, the closing price for Microsoft stock on the NASDAQ is $450 per share. Since Microsoft stock trades in an active market and its price is a readily available quoted price, Company Alpha would record this asset at (10,000 \times $450 = $4,500,000) as a Level 1 fair value measurement on its balance sheet.

2. Level 2 Asset: Company Alpha also holds a privately placed corporate bond issued by "Company Beta." While this specific bond doesn't trade on an active exchange, similar bonds from companies with comparable credit ratings and maturities are actively traded. Using observable inputs from these similar bonds, such as yield curves and interest rates, Company Alpha's valuation specialists apply appropriate valuation techniques to determine the fair value of the Company Beta bond. This would be a Level 2 measurement.

3. Level 3 Asset: Furthermore, Company Alpha has a significant investment in a private, early-stage biotechnology startup. There is no active market for the startup's equity, and there are no comparable public companies. To determine the fair value of this investment, Company Alpha's analysts develop their own assumptions about future cash flows and discount rates, considering the specific risks of the startup. These estimates, relying heavily on unobservable inputs and significant judgment, would result in a Level 3 fair value measurement.

Practical Applications

FAS 157, through its subsequent integration into ASC 820, is fundamental to how companies present the fair value of certain assets and liabilities on their financial statements. It applies broadly across various sectors where fair value measurement is required or permitted by other accounting standards.

Public companies, particularly financial institutions, routinely apply FAS 157 guidance when valuing complex financial instruments such as derivatives, certain investment securities, and securitized assets. The standard's framework helps determine the carrying amount of these items on the balance sheet and influences reported earnings. Beyond corporate financial reporting, the principles of FAS 157 are also relevant for auditors, valuation specialists, and regulators who rely on consistent and transparent fair value measurements. The Financial Accounting Foundation (FAF), which oversees the FASB, generally found that FAS 157 has provided investors with useful information, despite acknowledging difficulties some investors have in understanding it.
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Limitations and Criticisms

Despite its aim to enhance transparency, FAS 157 faced considerable scrutiny, especially during and after the 2008 global financial crisis. Critics argued that the "mark-to-market" aspect of fair value accounting, as guided by FAS 157, exacerbated the crisis by forcing companies, particularly banks, to write down the value of illiquid assets to distress-sale prices. ¹¹, ¹²This was believed to create a "downward spiral" where falling asset prices led to reduced regulatory capital, prompting further asset sales that depressed prices even more.
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The debate often centered on Level 3 assets, for which observable market data was scarce or non-existent. Determining fair value for these assets required significant management judgment and the use of unobservable inputs, which some argued could lead to subjective and unreliable valuations during periods of market stress. ⁶, ⁷, ⁸Proponents countered that fair value accounting merely acted as a messenger, revealing the true underlying problems within the financial system, rather than causing them. ⁵They also pointed out that fair value accounting, particularly FAS 157, requires consideration of factors like non-performance risk for liabilities and encourages the use of valuation models even in inactive markets, allowing for more nuanced application than simply "fire-sale" pricing.
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Research on the impact of fair value accounting during the crisis remains varied, with some studies suggesting it played a minor role compared to other systemic factors.
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FAS 157 vs. Historical Cost Accounting

FAS 157 fundamentally diverges from historical cost accounting, particularly in how assets and liabilities are measured on the balance sheet.

The primary point of confusion and debate stems from their differing philosophies: fair value emphasizes current market reality and investor decision-making relevance, while historical cost prioritizes reliability and verifiability based on past transactions. During periods of market stability, the differences may be less pronounced, but in volatile markets, FAS 157's requirements can lead to significant changes in reported financial position compared to a historical cost accounting approach.

FAQs

What is the main purpose of FAS 157?

The main purpose of FAS 157 was to define fair value, establish a consistent framework for measuring it within Generally Accepted Accounting Principles (GAAP), and expand disclosures about these measurements. It aimed to improve transparency and comparability in financial reporting.

Is FAS 157 still in effect?

FAS 157 itself has been superseded and is largely codified within ASC Topic 820, "Fair Value Measurement." This means the principles and framework originally laid out in FAS 157 are still active and foundational to fair value accounting in the U.S.

How does FAS 157 define fair value?

FAS 157 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." This is often referred to as an "exit price."

What are the three levels of the fair value hierarchy?

The three levels of the fair value hierarchy are: Level 1 (unadjusted quoted prices in active markets for identical items), Level 2 (observable inputs other than Level 1 quoted prices, like prices for similar items or observable interest rates), and Level 3 (unobservable inputs based on management's own assumptions). This hierarchy dictates the priority of inputs used in valuation techniques.