OCTOBER 21, 2005 WORKING DRAFT Financial Accounting Series · Statement of Financial Accounting...
Transcript of OCTOBER 21, 2005 WORKING DRAFT Financial Accounting Series · Statement of Financial Accounting...
OCTOBER 21, 2005 WORKING DRAFT
Financial Accounting Series
Statement of Financial Accounting
Standards No. 15X
Fair Value Measurements
Financial Accounting Standards Boardof the Financial Accounting Foundation
Summary
This Statement defines fair value, establishes a framework for measuring fair value
in generally accepted accounting principles (GAAP), and enhances disclosures about fair
value measurements. This Statement applies broadly under other accounting
pronouncements that require fair value measurements, the Board having previously
concluded in those accounting pronouncements that fair value is the relevant measurement
attribute. Accordingly, this Statement does not require any new fair value measurements.
Reason for Issuing This Statement
Prior to this Statement, there were different definitions of fair value and limited
guidance for applying those definitions within GAAP. Moreover, that guidance was
dispersed among the many pronouncements that require fair value measurements.
Differences in that guidance created inconsistencies that added to the complexity in
GAAP. The Board decided to address those issues in this Statement. In developing this
Statement, the Board considered the need for increased consistency and comparability in
estimates of fair value and enhanced disclosures about the estimates.
Differences between This Statement and Current Practice
The changes to current practice resulting from the application of this Statement
relate to the definition of fair value, the methods used to estimate fair value, and the
requirement for expanded disclosures about estimates of fair value.
This Statement clarifies that fair value is the price that would be received for an
asset or paid to transfer a liability in a current transaction between marketplace
participants in the reference market for the asset or liability. In the absence of a
transaction involving the entity, the estimate of fair value is determined by reference to a
hypothetical transaction for the asset or liability at the measurement date (the effective
valuation date).
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For a liability, the estimate of fair value should reflect the price that would be paid in
a current transaction between marketplace participants of comparable credit standing.
Therefore, an entity should consider the effect of changes in its credit standing on the
creditworthiness of the liability in all periods in which the liability is remeasured at fair
value under other accounting pronouncements, including FASB Statement No. 133,
Accounting for Derivative Instruments and Hedging Activities.
This Statement affirms the Board’s decision in other FASB Statements that the fair
value of a large position of an unrestricted security with a quoted price in an active market
(block) should be estimated as the product of the quoted price times the quantity held,
thereby precluding the use of a blockage factor. This Statement extends that guidance to
broker-dealers and investment companies within the scope of the AICPA Audit and
Accounting Guides for those industries.
This Statement defines a restricted security as a security for which sale is legally
restricted by governmental or contractual requirement for a specified period, whether the
restriction limits sale (for example, to qualifying investors) or prohibits sale. This
Statement establishes the general principle that the fair value of a restricted security
should be estimated based on the quoted price for an otherwise identical unrestricted
security of the same issuer, adjusted as appropriate for the effect of the restriction. That
general principle applies even if the restriction terminates within one year, as is the case
for restricted stock measured at fair value under FASB Statement No. 115, Accounting for
Certain Investments in Debt and Equity Securities.
This Statement expands disclosures about the use of fair value to remeasure assets
and liabilities recognized in the statement of financial position. The disclosures focus on
the inputs used to develop estimates of fair value and the effects of the estimates on
income (or changes in net assets) for the period. This Statement encourages entities to
combine the fair value information disclosed under this Statement with the fair value
information disclosed under other accounting pronouncements, including FASB Statement
No. 107, Disclosures about Fair Value of Financial Instruments, where practicable.
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How the Changes in This Statement Improve Financial Reporting
A single definition of fair value, together with a framework for measuring fair value,
should result in increased consistency and comparability in estimates of fair value.
The expanded disclosures about the use of fair value to remeasure assets and
liabilities should improve the quality of information provided to users of financial
statements.
The amendments made by this Statement advance the Board’s initiatives to simplify
and codify the accounting literature, eliminating differences that have added to the
complexity in GAAP.
How the Conclusions in This Statement Relate to the FASB’s Conceptual Framework
The fair value framework considers the concepts in FASB Concepts Statement
No. 2, Qualitative Characteristics of Accounting Information, which emphasizes that
providing comparable information enables users of financial statements to identify
similarities in and differences between two sets of economic events.
The definition of fair value considers the concepts relating to assets and liabilities in
FASB Concepts Statement No. 6, Elements of Financial Statements, which defines assets
in terms of future economic benefits (future inflows) and liabilities in terms of future
sacrifices of economic benefits (future outflows).
The guidance for applying the definition of fair value incorporates the related
concepts in FASB Concepts Statement No. 7, Using Cash Flow Information and Present
Value in Accounting Measurements. In particular, Concepts Statement 7 establishes that
the most relevant measure of a liability always reflects the credit standing of the entity
obligated to pay. In addition, this Statement incorporates and clarifies the guidance in
Concepts Statement 7 for using present value techniques to estimate fair value. The
clarifications do not change the substantive guidance in Concepts Statement 7 or the
application of that guidance under existing accounting pronouncements. Therefore, this
Statement does not revise Concepts Statement 7. The Board expects to consider the need
to revise Concepts Statement 7 in its conceptual framework project.
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The expanded disclosures consider the need to provide information about the use of
fair value to remeasure assets and liabilities that is useful to users of financial statements
(present and potential investors, creditors, and others in making rational investment,
credit, and similar decisions)—the first objective of financial reporting in FASB Concepts
Statement No. 1, Objectives of Financial Reporting by Business Enterprises.
Costs and Benefits of Applying This Statement
Although the guidance in this Statement builds on current practice and requirements,
some entities will need to make changes to comply with the requirements of this
Statement, thereby incurring one-time costs. However, the benefits from increased
consistency and comparability in estimates of fair value and expanded disclosures about
those estimates should be ongoing.
The Effective Date of This Statement
This Statement is effective for financial statements issued for fiscal years
beginning after December 15, 2006, and interim periods within those fiscal years, except
as follows. The disclosure requirements of this Statement are effective for financial
statements issued for fiscal years ending after December 15, 2006. Earlier application is
encouraged. The provisions of this Statement are to be applied prospectively (similar to a
change in accounting estimate), except as follows. The change in method for estimating
the fair value of a block is to be applied retrospectively to all prior periods (similar to a
change in accounting principle).
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Statement of Financial Accounting Standards No. 15X
Fair Value Measurements October 21, 2005 Working Draft
CONTENTS Paragraph Numbers
Objective ...........................................................................................................................1 Standards of Financial Accounting and Reporting: Scope.......................................................................................................................2–4 Measurement.........................................................................................................5–34 Definition of Fair Value..................................................................................5–14 Current Transaction ........................................................................................6 Marketplace Participants.................................................................................7 Reference Market........................................................................................8–9 Application to Assets ..............................................................................10–12 Application to Liabilities ..............................................................................13 Transaction Costs..........................................................................................14 Fair Value Estimates at Initial Recognition and in Subsequent Periods.......15–16 Valuation Techniques ...................................................................................17–19 Market Inputs ................................................................................................20–22 Fair Value Hierarchy.....................................................................................23–34 Level 1 Inputs .........................................................................................25–29 Bid and Asked Prices ..............................................................................27 Blocks .....................................................................................................28 Alternative Pricing Methods ...................................................................29 Level 2 Inputs .........................................................................................30–31 Restricted Securities................................................................................31 Level 3 Inputs ...............................................................................................32 Level 4 Inputs ...............................................................................................33 Level 5 Inputs ...............................................................................................34 Disclosures..........................................................................................................35–38 Effective Date and Transition .............................................................................39–40 Appendix A: Present Value Techniques ......................................................................A1− Appendix B: Implementation Guidance ......................................................................B1− Appendix C: Background Information and Basis for Conclusions .............................C1− Appendix D: Amendments to Existing Pronouncements ............................................D1− Appendix E: References to Existing APB and FASB Pronouncements......................E1−
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Statement of Financial Accounting Standards No. 15X
Fair Value Measurements
October 21, 2005 Working Draft
OBJECTIVE
1. This Statement defines fair value, establishes a framework for measuring fair value
under accounting pronouncements that require fair value measurements, and enhances
disclosures about fair value measurements. Where applicable, this Statement simplifies
and codifies related guidance within generally accepted accounting principles (GAAP).
STANDARDS OF FINANCIAL ACCOUNTING AND REPORTING
Scope
2. This Statement applies under accounting pronouncements that require fair value
measurements, except as follows:
a. This Statement does not apply under accounting pronouncements that address share-based payment transactions: FASB Statement No. 123 (revised 2004), Share-Based Payment, and its related interpretive pronouncements and FASB Technical Bulletin No. 97-1, Accounting under Statement 123 for Certain Employee Stock Purchase Plans with a Look-Back Option.
b. This Statement does not eliminate the practicability exceptions to fair value measurements in accounting pronouncements within the scope of this Statement.1
1Accounting pronouncements that permit practicability exceptions to fair value measurements in specified circumstances include APB Opinion No. 29, Accounting for Nonmonetary Transactions, FASB Statements No. 87, Employers’ Accounting for Pensions, No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions, No. 107, Disclosures about Fair Value of Financial Instruments, No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and No. 153, Exchanges of Nonmonetary Assets, and FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. Also included among those pronouncements are EITF Issues No. 85-40, “Comprehensive Review of Sales of Marketable Securities with Put Arrangements,” and No. 99-17, “Accounting for Advertising Barter Transactions.”
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3. This Statement does not apply under accounting pronouncements that require
measurements that are similar to fair value but that are not intended to measure fair value,
including the following:
a. Accounting pronouncements that address revenue transactions measured using vendor-specific objective evidence (VSOE) of fair value2
b. ARB No. 43, Chapter 4, “Inventory Pricing.”
4. Appendix E lists pronouncements of the Accounting Principles Board (APB) and
FASB existing at the date of this Statement that are within the scope of this Statement.
Appendix D lists APB and FASB pronouncements that are amended by this Statement.
Measurement
Definition of Fair Value
5. Fair value is the price that would be received for an asset or paid to transfer a
liability in a current transaction between marketplace participants in the reference market
for the asset or liability.
Current Transaction
6. A fair value measurement presumes the absence of compulsion (duress).
Therefore, a current transaction is not a forced transaction (for example, a forced
liquidation or distress sale). Rather, a current transaction is an orderly transaction that
assumes adequate exposure to the market prior to the measurement date and reflects
market conditions existing at that date. In the absence of a transaction involving the
entity,3 the price that forms the basis for the measurement is an estimate, determined by
2Accounting pronouncements that require measurements using VSOE of fair value are AICPA Statement of Position 97-2, Software Revenue Recognition, as modified by AICPA Statement of Position 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions, and EITF Issues No. 00-3, “Application of AICPA Statement of Position 97-2 to Arrangements That Include the Right to Use Software Stored on Another Entity’s Hardware,” and No. 00-21, “Revenue Arrangements with Multiple Deliverables.” 3 All references to entity refer to the reporting entity.
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reference to a hypothetical transaction for the asset or liability at the measurement date.4
In developing the estimate, the emphasis is on the assumptions that marketplace
participants in the reference market for the asset or liability would use in their estimate of
fair value.
Marketplace Participants
7. In broad terms, marketplace participants are buyers and sellers in the reference
market for the asset or liability that are:
a. Independent of the entity, that is, they are not related parties5 b. Knowledgeable, having a reasonable level of understanding about factors relevant to
the asset or liability and the transaction, based on all available information, including information obtained through due diligence efforts
c. Able to transact for the asset or liability, having the legal and financial ability to do so d. Willing to transact for the asset or liability, that is, they are motivated but not forced or
otherwise compelled to do so.
Reference Market
8. The reference market is the most advantageous market in which the entity would
transact for the asset or liability. Because different entities with different business
activities transact in different markets, the reference market for the asset or liability will
differ depending on the following:
a. The business activities of the entity. For example, a broker-dealer that sells securities generally would transact in different markets than its customers.
b. The unit of account for the asset or liability in the most advantageous market in which the entity would transact for the asset or liability. The unit of account describes the asset or liability by reference to the level at which it is aggregated (or disaggregated). The unit of account establishes what is being measured at fair value, that is, whether the estimate is for an individual asset or liability or a group of assets and/or liabilities, including a business.6
4The measurement date is the effective valuation date. 5This Statement uses the term related parties consistent with its use in FASB Statement No. 57, Related Party Disclosures. 6The unit of account should be determined in accordance with the provisions of other applicable accounting pronouncements.
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9. If there are multiple markets for the asset or liability with different prices, the
principal market for the asset or liability is presumed to represent the most advantageous
market and, therefore, the reference market for the asset or liability.
Application to Assets
10. For an asset, the reference market is the market with the price that maximizes the
amount that would be received for the asset, assuming the highest and best use of the asset
from the perspective of marketplace participants. Therefore, the estimate of fair value
reflects the market’s estimate of the future inflows associated with the asset (discounted).
11. The highest and best use of an asset establishes the valuation premise used to
estimate the fair value of the asset. Specifically:
a. If the highest and best use of an asset is in-use, the estimate of fair value shall be determined using an in-use valuation premise (fair value in-use). The highest and best use of an asset is in-use if marketplace participants would continue to use the asset as it is currently installed or otherwise configured for use by the entity (the hypothetical transaction involves an asset group). That generally will be the case when the asset is an operating asset that provides value principally through its use in combination with other assets as part of an asset group, including a business (for example, certain intangible assets).
b. If the highest and best use of an asset is in-exchange, the estimate of fair value shall be determined using an in-exchange valuation premise (fair value in-exchange). The highest and best use of an asset is in-exchange if marketplace participants would not continue to use the asset as it is currently installed or otherwise configured for use by the entity or if the asset provides value principally on a stand-alone basis (the hypothetical transaction involves a standalone asset). In that case, the asset is separable or substitutable with other equivalent assets (for example, a financial asset).
12. Because the highest and best use of an asset is considered from the perspective of
marketplace participants, the estimate of fair value is based on the assumptions that
marketplace participants would use in their estimate of fair value, whether using an in-use
or an in-exchange valuation premise.
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Application to Liabilities
13. For a liability, the reference market is the market with the price that minimizes the
amount that would be paid to transfer the liability to a marketplace participant that would
similarly perform or similarly bear the consequences of not performing. The estimate of
fair value shall consider the effect of the entity’s credit standing on the creditworthiness of
the liability in all periods in which the liability is measured at fair value so that the
estimate reflects the price that would be paid to transfer the liability in a transaction
between marketplace participants of comparable credit standing.7 Therefore, the estimate
of fair value reflects the market’s estimate of the future outflows associated with the
liability (discounted).
Transaction Costs
14. The price in the reference market for the asset or liability shall not be adjusted for
transaction costs, that is, the incremental direct costs to transact in that market.8
Transaction costs are characteristics of the transaction, not the particular asset or liability
involved in the transaction. Transaction costs shall be accounted for in accordance with
the provisions of other applicable accounting pronouncements. However, the price in the
reference market for the asset or liability shall be adjusted for transportation costs, that is,
the costs to access that market, if the location of the asset or liability is a characteristic of
the particular asset or liability, for example, a physical commodity whose quoted price
reflects its current location.
7The effect of changes in the credit standing of the entity on the creditworthiness of the liability may differ, depending on facts and circumstances specific to the liability, for example, whether the liability is an obligation to deliver cash or otherwise perform, and the terms of any credit enhancements included in the contract for the liability. 8Incremental direct costs refer to costs that result directly from and are essential to a transaction involving an asset (or liability) and that would not have been incurred by the entity had the decision to exchange the asset (or liability) not been made, similar to cost to sell, as defined in paragraph 35 of FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets.
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Fair Value Estimates at Initial Recognition and in Subsequent Periods
15. In a transaction in which the entity acquires an asset or assumes a liability, the
transaction price (the price paid for the asset or received to assume the liability) is
presumed to represent the fair value of the asset or liability (the price that would be
received for the asset or paid to transfer the liability) at initial recognition, absent
persuasive evidence to the contrary. Examples of situations in which the transaction price
presumption might be rebutted include the following:
a. The transaction is between related parties or occurs under duress where the seller is experiencing severe financial difficulties, such as bankruptcy or other financial pressures, or is forced to accept the price in the transaction because of urgency.
b. The market in which the transaction occurs is not the reference market for the asset or liability (the entity would transact in a more advantageous market for the asset or liability).9 In that case, the fair value of the asset or liability to the entity would be based on the price in the reference market for the asset or liability. (If the counterparty would not transact in a more advantageous market, the fair value of the asset or liability to the counterparty would be based on the price in the market in which the transaction occurs, that is, the transaction price.)
16. In periods subsequent to initial recognition in which an asset or liability is
remeasured at fair value, the estimate of fair value shall be updated so that it represents the
price at which marketplace participants would currently transact. In developing that
updated estimate, an entity shall consider the frequency of other similar transactions,
changes in the market, and other relevant factors (for example, a change in the condition
or location of an asset) since the previous estimate.
Valuation Techniques
17. Valuation techniques used to estimate fair value shall be consistent with the
market approach, income approach, and cost (or asset-based) approach. Key aspects of
those approaches are summarized below:
9The transaction price represents the fair value of the consideration paid or received in the transaction and, therefore, is presumed to represent the fair value of the transaction. However, the transaction price might not similarly represent the fair value of the asset or liability if the market in which the transaction occurs is not the reference market for the asset or liability. Whether the transaction price also can be presumed to represent the fair value of the asset or liability will depend on facts and circumstances specific to the asset or liability and the reference market for the asset or liability.
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a. The market approach uses observable prices and other relevant information generated by market transactions involving comparable assets or liabilities (including a business). The estimate of fair value is based on the value indicated by those comparable transactions.
b. The income approach uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present amount (discounted). The estimate of fair value is based on the value indicated by marketplace expectations about those future amounts. Those valuation techniques include present value techniques; option-pricing models, such as the Black-Scholes-Merton formula and lattice models, which incorporate present value techniques; and the multi-period excess earnings method, a discounted cash flow method used to estimate the fair value of certain intangible assets.
c. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost). The estimate of fair value considers the cost to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence. Obsolescence encompasses physical deterioration, functional (technical) obsolescence, and economic (external) obsolescence and is broader than depreciation for financial reporting purposes (an allocation of historical cost) or tax purposes (based on specified service lives). For a business, an asset-based approach provides an estimate of fair value based on the fair values of each of the individual assets and liabilities.
18. Valuation techniques that are appropriate in the circumstances and for which
sufficient data are available shall be used to estimate fair value. In all cases, the objective
is to use the valuation technique (or combination of valuation techniques) that is
appropriate in the circumstances. In some cases, a single valuation technique will be
appropriate. In other cases, multiple valuation techniques will be appropriate. When
multiple valuation techniques are used to estimate fair value, the results (respective
indications of fair value) shall be evaluated and weighted, as appropriate, in determining
the single estimate of fair value.
19. Valuation techniques used to estimate fair value shall be consistently applied.
However, a change in a valuation technique or its application (for example, a change in its
weighting when multiple valuation techniques are used) is appropriate if the change
results in an estimate that is more representative of fair value in the circumstances. That
might be the case as new markets develop, new information becomes available, or
valuation techniques improve. Revisions resulting from a change in the valuation
technique or its application shall be accounted for prospectively, as changes in accounting
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estimates (in accordance with the provisions of FASB Statement No. 154, Accounting
Changes and Error Corrections, paragraph 19).10
Market Inputs
20. Valuation techniques used to estimate fair value shall maximize the use of market
inputs and minimize the use of entity inputs, whether using the market approach, income
approach, or cost (or asset-based) approach. Market inputs refer to the assumptions that
marketplace participants would use in making pricing decisions, based on market data
obtained from sources independent of the entity. In contrast, entity inputs refer to the
entity’s internally developed assumptions of market inputs, based on the entity’s own
data.
21. Markets in which assets and liabilities are exchanged vary in structure and level of
activity. For example, in an active market, transactions for the asset or liability occur with
sufficient frequency to provide pricing information on an ongoing basis. Therefore, a
quoted price in that market will be both readily available and representative of fair value.
In a market that is not active, for example, a market in which there are few transactions for
the asset or liability or price quotations vary substantially either over time or among
market makers, a quoted price might not be readily available or representative of fair
value.
22. Examples of markets in which assets and liabilities (in particular, financial
instruments) are exchanged include the following:
10The disclosure requirements of Statement 154 for a change in estimate do not apply for revisions resulting from a change in a valuation technique or its application.
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a. Exchange market. An exchange market provides high visibility and order to the trading of financial instruments. Typically, closing prices are both readily available and representative of fair value. In an exchange market, multiple identical exchange units are traded. An example of such a market is the New York Stock Exchange.
b. Dealer market. In a dealer market, dealers stand ready to trade (either buy or sell for their own account), thereby providing liquidity by using their capital to hold an inventory of the items for which they make a market. Typically, bid and asked prices are more readily available than closing prices. In a dealer market, multiple identical exchange units are traded. Over-the-counter (OTC) markets (where prices are publicly reported by the National Association of Securities Dealers Automated Quotations systems or by the National Quotation Bureau) are dealer markets. For example, the market for U.S. Treasury securities is a dealer market. Dealer markets also exist for other assets and liabilities, such as financial instruments, commodities, and physical assets (for example, certain used equipment).
c. Brokered market. In a brokered market, brokers attempt to match buyers with sellers but do not stand ready to trade for their own account. In other words, brokers do not use their own capital to hold an inventory of the items for which they make a market. The broker knows the prices bid and asked by the respective parties, but each party is typically unaware of another party’s price requirements. Prices of completed transactions are sometimes available. Brokered markets include electronic communication networks, in which buy and sell orders are matched, and commercial and residential real estate markets.
d. Principal-to-principal market. Principal-to-principal transactions, both originations and resales, are negotiated independently with no intermediary. Little information about those transactions may be released publicly.
Fair Value Hierarchy
23. The fair value hierarchy distinguishes between the inputs to valuation techniques
used to estimate fair value, considering the relative reliability of the inputs. The
availability of inputs relevant to the asset or liability and the relative reliability of the
inputs may affect the selection of appropriate valuation techniques. However, the fair
value hierarchy focuses on the inputs to valuation techniques, not the valuation techniques
themselves.
24. The fair value hierarchy gives the highest priority to market inputs that reflect
quoted prices for identical assets or liabilities in active markets (Level 1) and the lowest
priority to entity inputs (Level 5). In some cases, inputs to valuation techniques used to
estimate fair value might fall within different levels of the fair value hierarchy. Where
within the fair value hierarchy the estimate of fair value falls depends on where within the
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fair value hierarchy the inputs that have a significant effect on the estimate fall. The
inputs used to estimate fair value shall be evaluated and weighted, as appropriate, in
assessing the effect of those inputs on the estimate.11
Level 1 Inputs
25. Level 1 inputs are market inputs that reflect quoted prices for identical assets or
liabilities in active markets. A quoted price for an identical asset or liability in an active
market provides the most reliable estimate of fair value and shall be used to estimate fair
value whenever available, provided that the entity has the ability to access that market for
the asset or liability at the measurement date.
26. In some situations, significant events (principal-to-principal transactions, brokered
trades, or announcements) might occur after the close of a market but before the
measurement date. In those situations, a quoted price in that market might not be
representative of fair value at the measurement date. An entity should establish and
consistently apply a policy for determining how those events affect estimates of fair value.
Bid and asked prices
27. If a price in an active market is quoted in terms of bid and asked prices (for
example, in an active dealer market where the bid price represents the price the dealer is
willing to pay and the asked price represents the price at which the dealer is willing to
sell), the estimate of fair value shall represent the price within the bid-asked spread at
which marketplace participants would currently transact. For offsetting positions in the
same instrument, the same price shall be used to estimate the fair value of both the long
and short positions.
Blocks
28. If an entity holds a large position of a financial instrument with a quoted price in
an active market (block), the fair value of the position shall be estimated within Level 1 as
the product of the quoted price for an individual trading unit times the quantity held. The
11This Statement does not require a formulaic sensitivity analysis of the inputs used to estimate fair value as a basis for assessing the effect of those inputs on the estimate.
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quoted price shall not be adjusted by a blockage factor, that is, a discount (or premium)
based on the size of the position relative to trading volume, even if a market’s normal
trading volume for one day is not sufficient to absorb the quantity held and placing orders
to sell the position in a single transaction might affect the quoted price.12
Alternative pricing methods
29. If an entity holds a large number of similar assets and liabilities that are required to
be measured at fair value, a quoted price in an active market might not be readily
accessible for each of those assets and liabilities (for example, from pricing services or
individual broker-dealers). In that case, fair value may be estimated within Level 1 using
an alternative pricing method (for example, matrix pricing) as a practical expedient,
provided that the method is demonstrated to replicate actual prices. The practical
expedient within Level 1 is limited to situations in which individual price quotes could be
obtained but, for practical reasons, are not.
Level 2 Inputs
30. Level 2 inputs are market inputs that reflect quoted prices not encompassed within
Level 1, that is, (a) quoted prices for identical assets or liabilities in markets that are not
active and (b) quoted prices for similar assets or liabilities in all markets, regardless of the
level of activity. A quoted price within Level 2 shall be adjusted, as appropriate,
considering factors specific to the asset or liability. An adjustment having a significant
effect on the estimate might render the estimate a lower level estimate.
Restricted securities
31. If an entity holds a restricted security, the fair value of the security shall be
estimated based on a quoted price for an otherwise identical unrestricted security of the
same issuer, adjusted as appropriate to reflect the effect of the restriction, that is, the
amount a marketplace participant would demand to assume the risk arising from the
inability to access a public market for the security for the specified period. That general
12The guidance in this Statement applies for blocks held by broker-dealers and investment companies within the scope of the AICPA Audit and Accounting Guides for those industries.
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principle applies regardless of when the restriction terminates. A restricted security is a
security for which sale is legally restricted by governmental or contractual requirement for
a specified period, whether the restriction limits sale (for example, to qualifying investors)
or prohibits sale.13
Level 3 Inputs
32. Level 3 inputs are market inputs other than quoted prices that are directly
observable for the asset or liability. If the asset or liability is a financial instrument, a
Level 3 input must be observable over the full term of the instrument. Examples include
interest rates, yield curves, volatilities, and default rates.
Level 4 Inputs
33. Level 4 inputs are market inputs that are not directly observable for the asset or
liability but that are corroborated by other market data through correlation or by other
means, thereby incorporating market data that are observable (market-corroborated
inputs). If the asset or liability is a financial instrument, a Level 4 input must be
corroborated by other market data over the full term of the instrument. Examples include
inputs that are derived through extrapolation or interpolation.
Level 5 Inputs
34. Level 5 inputs are entity inputs. Examples include inputs that are derived through
extrapolation or interpolation but that are not corroborated by other market data. Entity
inputs may be used to estimate fair value as a practical expedient in the absence of market
inputs. When using entity inputs, the fair value objective remains the same. Therefore,
entity inputs shall be developed within market parameters, eliminating factors specific to
the entity whenever possible.
13The guidance in this Statement applies for equity securities with restrictions that terminate within one year that are measured at fair value under FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities.
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Disclosures
35. An entity shall disclose information that enables users of its financial statements to
evaluate the extent to which fair value is used to remeasure assets and liabilities
recognized in the statement of financial position and the inputs used to develop the
estimates. To meet that objective, an entity shall disclose the following information for
each interim and annual period for which a statement of financial position is presented,
separately for each major category of assets and liabilities (except as otherwise specified):
a. For assets and liabilities that are remeasured at fair value on a recurring basis (for example, trading securities), the fair value estimates at the reporting date, in total and as a percentage of total assets and liabilities
b. For assets and liabilities that are remeasured at fair value on a nonrecurring basis (for example, impaired assets), the fair value estimates and the reason(s) for the remeasurements
c. Where within the fair value hierarchy the fair value estimates in (a) and (b) above in their entirety fall, segregating those estimates that fall within Level 1, Levels 2–4, and Level 5
d. For annual periods only, the valuation technique(s) used for the fair value estimates in (a) and (b) above.
36. An entity shall disclose information that enables users of its financial statements to
evaluate the effects of fair value remeasurements on income (or changes in net assets) for
the period. To meet that objective, an entity shall disclose the following information for
each interim and annual period for which a statement of financial performance is
presented:
a. Total gains or losses for the period relating to each major category of assets and liabilities remeasured at fair value during the period, even if those assets and liabilities are not still held at the reporting date. Total gains or losses shall be presented separately if the related assets or liabilities are reported separately in the statement of financial performance, segregating those gains or losses included in other comprehensive income.
b. The change in unrealized gains or losses during the period relating to assets and liabilities remeasured at fair value during the period that are still held at the reporting date if the estimates fall within Level 5.
37. The quantitative disclosures required by this Statement shall be presented using a
tabular format. (See Appendix B.)
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38. The fair value information disclosed under this Statement shall be combined and
disclosed together with the fair value information disclosed under other accounting
pronouncements (for example, FASB Statement No. 107, Disclosures about Fair Value of
Financial Instruments) in the periods in which those disclosures are required, if
practicable. Disclosures about other similar remeasurements (for example, inventories
remeasured at “market value” under ARB 43, Chapter 4) are encouraged but not required.
Effective Date and Transition
39. This Statement shall be effective for financial statements issued for fiscal years
beginning after December 15, 2006, and interim periods within those fiscal years, except
as follows. The disclosure requirements of this Statement (paragraphs 35–38) shall be
effective for financial statements issued for fiscal years ending after December 15, 2006.
Earlier application is encouraged.
40. This Statement shall be applied prospectively as of the first interim period for the
fiscal year in which this Statement is initially applied, except as follows. Paragraph 28 of
this Statement (blocks) shall be applied retrospectively to all prior periods. The
cumulative effect of the change in accounting principle on periods prior to those presented
shall be reflected as of the beginning of the first period presented. An offsetting
adjustment shall be made to the opening balance of retained earnings for that period. In
the fiscal year in which this Statement is initially applied, and in all interim periods within
that fiscal year, an entity shall disclose the effect of the change in accounting principle on
income before extraordinary items and any affected per-share amounts, if applicable
(Statement 154, paragraphs 17(b)(2) and 18).
The provisions of this Statement need not be applied to immaterial items.
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Appendix C
BACKGROUND INFORMATION AND BASIS FOR CONCLUSIONS
CONTENTS Paragraph Numbers
Introduction....................................................................................................................C1 Background Information......................................................................................... C2–C6 Scope..................................................................................................................... C7–C18 Share-Based Payment Transactions.........................................................................C8 Leasing Transactions ...............................................................................................C9 Statement 114.........................................................................................................C10 Opinion 21 .................................................................................................... C11–C12 EITF Issue 02-3............................................................................................. C13–C15 Practicability Exceptions .............................................................................. C16–C17 Other Similar Measurements .................................................................................C18 Definition of Fair Value...................................................................................... C19–C44 Current Transaction ...................................................................................... C20–C21 Marketplace Participants............................................................................... C22–C23 Reference Market.......................................................................................... C24–C27 Principal Markets .............................................................................................C26 Hypothetical Markets.......................................................................................C27
Application to Assets .................................................................................... C28–C32 Highest and Best Use .............................................................................. C29–C32
Application to Liabilities .............................................................................. C33–C43 The Transfer............................................................................................ C34–C35 Credit Standing ....................................................................................... C36–C43 Transaction Costs...................................................................................................C44 Interaction between Fair Value and Fair Market Value...............................................C45 Fair Value Estimates at Initial Recognition ........................................................ C46–C48 Valuation Techniques ......................................................................................... C49–C59 Single versus Multiple Valuation Techniques .............................................. C50–C51 Undue Cost and Effort ...........................................................................................C52 Consistency Constraint ..........................................................................................C53 Present Value Techniques............................................................................. C54–C58 Multi-Period Excess Earnings Method ..................................................................C59
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Paragraph Numbers Fair Value Hierarchy........................................................................................... C60–C99 Level Inputs .................................................................................................. C64–C84 Adjustments to Quoted Prices in Active Markets................................... C66–C67 Bid and Asked Prices .............................................................................. C68–C73 Blocks ..................................................................................................... C74–C83 Alternative Pricing Methods ............................................................................C84 Level 2 Inputs ............................................................................................... C85–C92 Restricted Securities................................................................................ C88–C92 Level 3 Inputs ............................................................................................... C93–C94 Level 4 Inputs ........................................................................................................C95 Level 5 Inputs ............................................................................................... C96–C99 Disclosures...................................................................................................... C100–C114 Fair Value Remeasurements ..................................................................... C104–C105 Unrealized Gains or Losses ...................................................................... C106–C108 Total Gains or Losses...........................................................................................C109 Other Disclosures...................................................................................... C110–C113 Amendment to Opinion 28...................................................................................C114 Effective Date and Transition ......................................................................... C115–C118 Benefits and Costs........................................................................................... C119–C123 International Financial Reporting Standards .............................................................C124
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Appendix C
BACKGROUND INFORMATION AND BASIS FOR CONCLUSIONS
Introduction
C1. This appendix summarizes considerations that Board members deemed significant
in reaching the conclusions in this Statement. It includes the reasons for accepting certain
views and rejecting others. Individual Board members gave greater weight to some
factors than to others.
Background Information
C2. In many accounting pronouncements, the Board has concluded that fair value
information is relevant and users of financial statements generally have agreed. Paragraph
47 of FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting
Information, states, “To be relevant to investors, creditors, and others for investment,
credit, and similar decisions, accounting information must be capable of making a
difference in a decision by helping users to form predictions about the outcomes of past,
present, and future events or to confirm or correct expectations.”
C3. Others, however, have expressed concerns about the ability to apply the fair value
measurement objective in generally accepted accounting principles (GAAP), more
recently, in response to the FASB Proposal, Principles-Based Approach to U.S. Standard
Setting, issued in October 2002.1 In large part, those concerns focus on the reliability of
the measurements in the absence of quoted market prices, including concerns about the
ability to verify the measurements. Paragraph 59 of Concepts Statement 2 states, “The
reliability of a measure rests on the faithfulness with which it represents what it purports
to represent, coupled with an assurance for the user, which comes through verification,
that it has that representational quality.”
1In July 2003, the Securities and Exchange Commission (SEC) published, “Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System,” which encouraged a move to more “objectives-oriented” accounting standards.
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C4. The Board believes that, in part, those concerns result because there is limited
guidance for applying the fair value measurement objective in GAAP. The guidance that
currently exists has evolved piecemeal over time. That guidance is dispersed among the
accounting pronouncements that require fair value measurements, and differences in that
guidance have created inconsistencies that have added to the complexity in GAAP. There
also is limited conceptual guidance for addressing measurement issues in the Board’s
conceptual framework.
C5. In June 2003, the Board added the fair value measurement project to its agenda to
address fair value measurement issues broadly.2 At that time, the Board agreed that
conceptually, the definition of fair value and its application in GAAP should be the same
for all assets and liabilities. This Statement is the result of that project. This Statement
defines fair value, establishes a framework for measuring fair value in GAAP that builds
on current practice and requirements, and enhances disclosures about fair value. Where
appropriate, this Statement also simplifies and codifies the related guidance that currently
exists for developing the measurements, eliminating differences that have added to the
complexity in GAAP. This Statement applies under other accounting pronouncements
that require fair value measurements, the Board having previously concluded in those
pronouncements that fair value is the relevant measurement attribute. This Statement does
not require any new fair value measurements.
C6. In June 2004, the Board issued an Exposure Draft, Fair Value Measurements, and
received comment letters from nearly 100 respondents. In September 2004, the Board
held public roundtable meetings with some of those respondents to discuss significant
issues raised in the comment letters. In its redeliberations, the Board considered those
comments, as well as input from the Valuation Resource Group, the Financial Accounting
Standards Advisory Council, the User Advisory Council (UAC), and other interested
parties. The Board reconsidered certain aspects of the proposals in the Exposure Draft
and clarified other aspects.
2The Board has a separate project on its agenda to improve its conceptual framework.
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Scope
C7. In developing this Statement, the Board agreed that in a Statement that applies
broadly, there should be few, if any, scope exceptions. Therefore, to more clearly convey
the fair value measurement objective in GAAP, the Board focused on accounting
pronouncements that (a) specify a fair value measurement objective that differs from the
fair value measurement objective in this Statement or (b) otherwise provide guidance for
applying the fair value measurement objective that raises issues specific to the assets and
liabilities covered under those pronouncements.
Share-Based Payment Transactions
C8. Accounting pronouncements that require fair value measurements but that are
excluded from the scope of this Statement are limited to FASB Statement No. 123
(revised 2004), Share-Based Payment, and other accounting pronouncements that address
share-based payment transactions. Statement 123(R) specifies a fair value measurement
objective that is generally consistent with the fair value measurement objective in this
Statement. However, its application to certain share-based payment transactions with
employees results in a measurement at the grant date that is a fair-value-based
measurement, not a fair value measurement. In other cases under Statement 123(R),
application of its fair value measurement objective results in a measurement that is a fair
value measurement. However, because the principal focus of Statement 123(R) is on
share-based payment transactions with employees, the Board decided for practical reasons
to exclude Statement 123(R) in its entirety from the scope of this Statement.
Leasing Transactions
C9. In the Exposure Draft, the Board decided to exclude from the scope of this
Statement FASB Statement No. 13, Accounting for Leases, and other accounting
pronouncements that address leasing transactions. At that time, the Board was concerned
that applying the fair value measurement objective in this Statement to leasing
transactions could have unintended consequences when considered together with
longstanding valuation practices common within the leasing industry. The Board decided
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to defer consideration of fair value measurement issues specific to those transactions.
However, respondents indicated that the fair value measurement objective for leasing
transactions is generally consistent with the fair value measurement objective in this
Statement and that the guidance in this Statement should apply for the fair value
measurements required for those transactions. Others in the leasing industry subsequently
affirmed that view. Therefore, the Board decided to include those pronouncements in the
scope of this Statement. Because this Statement does not require any new fair value
measurements, it does not apply under accounting pronouncements that address leasing
transactions and do not require fair value measurements for those transactions.
Statement 114
C10. In the Exposure Draft, the Board observed that the measurement for impaired
loans in FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan,
determined using a present value technique, is not a fair value measurement. At that time,
the Board decided to exclude Statement 114 from the scope of this Statement to
distinguish its measurement from other measurements determined using present value
techniques that are fair value measurements. Respondents agreed that the measurement
for impaired loans is not a fair value measurement. However, they noted that the practical
expedient in Statement 114 (fair value of collateral) is a fair value measurement. They
said that when that practical expedient is used, the guidance in this Statement should
apply. The Board agreed and decided to include Statement 114 in the scope of this
Statement as it relates to the practical expedient.
Opinion 21
C11. In this Statement, the Board affirmed that the measurement for receivables and
payables (notes) in APB Opinion No. 21, Interest on Receivables and Payables,
determined using a present value technique, is a fair value measurement. The discount
rate for contractual (promised) cash flows described in that Opinion (rate commensurate
with the risk) embodies the same notion as the discount rate used in the traditional or
discount rate adjustment (DRA) approach described in FASB Concepts Statement No. 7,
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Using Cash Flow Information and Present Value in Accounting Measurements, and
clarified in this Statement (Appendix A). Paragraph 13 of Opinion 21 explains:
The objective is to approximate the rate which would have resulted if an independent borrower and an independent lender had negotiated a similar transaction under comparable terms and conditions with the option to pay the cash price upon purchase or to give a note for the amount of the purchase which bears the prevailing rate of interest to maturity.
C12. Accordingly, the guidance for using present value techniques to measure fair value
in this Statement applies for the measurements required under Opinion 21. It also applies
for the similar measurements required under other pronouncements, including FASB
Statements No. 15, Accounting by Debtors and Creditors for Troubled Debt
Restructurings, No. 35, Accounting and Reporting by Defined Benefit Pension Plans,
No. 63, Financial Reporting by Broadcasters, No. 87, Employers’ Accounting for
Pensions, and No. 106, Employers’ Accounting for Postretirement Benefits Other Than
Pensions.
EITF Issue 02-3
C13. In the Exposure Draft, the Board decided to exclude from the scope of this
Statement EITF Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts
Held for Trading Purposes and Contracts Involved in Energy Trading and Risk
Management Activities.” Issue 02-3 applies to certain derivative instruments that are
measured at fair value under FASB Statement No. 133, Accounting for Derivative
Instruments and Hedging Activities. In particular, Issue 02-3 focuses on transactions that
involve any long-dated, over-the-counter derivative instrument in an illiquid market.
C14. An issue addressed in Issue 02-3 is how to estimate the fair value of the derivative
instrument at initial recognition. The FASB staff guidance in footnote 3 to Issue 02-3
specifies that the estimate should be based on the transaction price unless an estimate
determined by the entity (generally, a model value) is based on market inputs that are
observable. A related issue is when an unrealized gain (loss), measured as the difference
between the transaction price and the estimate of the fair value of the derivative
instrument at initial recognition, should be recognized if it is not recognized at initial
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recognition of the derivative instrument. Issue 02-3 does not address that issue. As a
result, practice is diverse with regard to both the method and timing of recognition. In the
Exposure Draft, the Board acknowledged that practice issue. However, the Board
concluded that, in addition to fair value measurement issues, Issue 02-3 raises revenue
recognition issues that are beyond the scope of this Statement and decided not to address
those issues in this Statement.
C15. Respondents said that for many entities, in particular, financial institutions,
Issue 02-3 is significant and that the Board should address related issues in this Statement,
focusing on the interaction of the FASB staff guidance in Issue 02-3 and the fair value
hierarchy in this Statement. In response, the Board subsequently decided to address the
revenue recognition issues in Issue 02-3 separately from the fair value measurement
issues. In June 2005, the Board added a separate project to its agenda to address those
revenue recognition issues. In October 2005, the Board issued a proposed FASB Staff
Position (FSP) FAS 133-a, “Accounting for Unrealized Gains (Losses) Relating to
Derivative Instruments Measured at Fair Value under Statement 133.” The proposed FSP,
which will nullify the FASB staff guidance in footnote 3 to Issue 02-3, will be included in
the scope of this Statement.
Practicability Exceptions
C16. The Board observed that some accounting pronouncements within the scope of this
Statement permit practicability exceptions to fair value measurements in specified
circumstances. For example, for financial instruments, FASB Statement No. 107,
Disclosures about Fair Value of Financial Instruments, permits a practicability exception
in certain specified circumstances; Statement 133 does not. The Board acknowledged the
inconsistencies created by those practicability exceptions. However, the Board concluded
that, in large part, they raise issues about the application of the fair value measurement
attribute that are beyond the scope of this Statement. Therefore, this Statement does not
eliminate those practicability exceptions.
C17. The Board considered a related issue in FASB Interpretation No. 45, Guarantor’s
Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees
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of Indebtedness of Others. For a guarantee, Interpretation 45 emphasizes that the
measurement objective at initial recognition is fair value. However, Interpretation 45
specifies that the measurement at initial recognition should be the premium received (or
receivable), in effect, a transaction price. The Board observed that the transaction price
might not result in a fair value measurement. At the same time, however, the Board
observed that a conforming change to Interpretation 45 to apply the fair value
measurement objective in this Statement could result in a significant change to practice
under that Interpretation. In particular, it could raise revenue recognition issues for
guarantees that are not accounted for as derivatives similar to those addressed in proposed
FSP FAS 133-a, (which would apply for guarantees that are accounted for as derivatives).
The Board concluded that those revenue recognition issues are beyond the scope of this
Statement. Further, otherwise addressing those issues could require the Board to address
issues relating to measurements in periods subsequent to initial recognition that are
beyond the scope of Interpretation 45. Largely for those reasons, the Board decided that
the guidance in Interpretation 45 should remain unchanged until it resolves related issues
more broadly in its revenue recognition project.
Other Similar Measurements
C18. This Statement does not apply under accounting pronouncements that require
measurements that are similar to fair value but that are not intended to measure fair value,
in particular, accounting pronouncements that require measurements that are based on, or
otherwise use, vendor specific objective evidence (VSOE) of fair value. Those
accounting pronouncements include AICPA Statement of Position 97-2, Software
Revenue Recognition, as modified by AICPA Statement of Position 98-9, Modification of
SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions, and
EITF Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” In those
accounting pronouncements, VSOE of fair value is based on the price charged by the
entity for a deliverable when it is sold separately or, for a deliverable not yet being sold
separately, the price established by management having the relevant authority (an entity-
specific measurement), except as otherwise specified in Issue 00-21, which allows for
third party evidence of fair value as a practical expedient to VSOE of fair value.
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Conceptually, a VSOE of fair value measurement is not a fair value measurement. The
price that forms the basis for a VSOE of fair value measurement (and its practical
expedient) is an entry price. The price that forms the basis for a fair value measurement is
an exit price.
Definition of Fair Value
C19. To clearly convey the fair value measurement objective in GAAP, the Board
revised earlier definitions of fair value. The definition of fair value in this Statement
retains the exchange price notion contained, either explicitly or implicitly, in earlier
definitions of fair value. However, it clarifies that the exchange price is the price that
would be received for an asset or paid to transfer a liability in a current transaction
between marketplace participants in the reference market for the asset or liability. In other
words, the price that forms the basis for a fair value measurement is the price in the
market in which an entity sells or otherwise disposes of assets or transfers liabilities (an
exit price), as distinguished from the price in the market in which an entity acquires assets
or assumes liabilities (an entry price). The Board agreed that an exit price provides a
direct measure of the market’s estimate of the future inflows associated with an asset and
the future outflows associated with a liability, consistent with the definitions of assets and
liabilities in FASB Concepts Statement No. 6, Elements of Financial Statements.
Specifically, paragraph 25 of Concepts Statement 6 defines assets in terms of future
economic benefits (future inflows). Paragraph 35 of Concepts Statement 6 defines
liabilities in terms of future sacrifices of economic benefits (future outflows). The
definition of fair value focuses on assets and liabilities because they are the primary
subject of accounting measurement. However, the definition also could be applied to an
entity’s own equity instruments.
Current Transaction
C20. In its redeliberations, the Board affirmed that a current transaction is not a forced
transaction (for example, a forced liquidation or distress sale). Rather, it is an orderly
transaction that reflects market conditions existing at the measurement date. The Board
clarified that the definition of fair value allows for adequate exposure to the market prior
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to that date, as do other similar definitions used in many valuation situations. As noted by
some respondents, adequate exposure to the market allows for the information
dissemination and marketing necessary to transact in the most advantageous market for
the asset or liability.
C21. The Board affirmed that until the entity transacts for the asset or liability, the price
that forms the basis for the measurement is an estimate at the measurement date. That is
the case even if the estimate can be made with a high level of confidence that it represents
what the price would be in a transaction for the asset or liability at the measurement date.
In that regard, the Board observed that a transaction for the asset or liability could affect
the price in the market for the asset or liability at the measurement date. Therefore, the
price that forms the basis for the estimate is determined by reference to a hypothetical
transaction for the asset or liability at the measurement date. This Statement clarifies that
in developing the estimate, the emphasis is on the assumptions that marketplace
participants in the reference market for the asset or liability would use in their estimate of
fair value.
Marketplace Participants
C22. Conceptually, the price that forms the basis for a fair value estimate reflects the
consensus view of marketplace participants about the asset or liability. The general
concept of marketplace participants is discussed in paragraph 26 of Concepts Statement 7,
which states:
Among their many functions, markets are systems that transmit information in the form of prices. Marketplace participants attribute prices to assets and, in doing so, distinguish the risks and rewards of one asset from those of another. Stated differently, the market’s pricing mechanism ensures that unlike things do not appear alike and that like things do not appear to be different (a qualitative characteristic of accounting information). An observed market price encompasses the consensus view of all marketplace participants about an asset or liability’s utility, future cash flows, the uncertainty surrounding those cash flows, and the amount that marketplace participants demand for bearing those uncertainties.
C23. This Statement incorporates and clarifies that concept of marketplace participants
in the context of buyers and sellers in the reference market for the asset or liability that are
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independent of the entity (unrelated), knowledgeable, and both able and willing to transact
for the asset or liability. Some respondents questioned the extent to which marketplace
participants would be expected to be knowledgeable, referring to markets that are not fully
efficient and situations in which there might be information asymmetry in those markets.
Such situations exist when some marketplace participants have information about an asset
or liability that is not available to other marketplace participants. In considering that
issue, the Board agreed that it would be reasonable to presume that a marketplace
participant that is both able and willing to transact for the asset or liability would
undertake efforts necessary to become sufficiently knowledgeable about the asset or
liability based on all available information, including information obtained through due
diligence efforts, and factor any related risk (for example, information uncertainty risk)
into the estimate of fair value.
Reference Market
C24. The Exposure Draft established a reference market principle within Level 1 of the
fair value hierarchy, emphasizing that the estimate should reflect the price in the most
advantageous market for the asset or liability. The Board concluded that a most
advantageous market approach is reasonable based on the assumption that the goal of
most entities is to maximize profits or net assets. The most advantageous market
approach embodies both the buying and the selling sides of rational economic behavior
and is consistent with normal profit motivations. Respondents generally agreed with that
reference market principle within Level 1 of the fair value hierarchy. However, they
indicated that to achieve consistency in applying the fair value measurement objective in
GAAP, that reference market principle should be expressed as a general principle.
C25. The Board agreed and, in response, expanded the reference market principle so
that it applies broadly. In that broadened context, the Board observed that because
different entities with different business activities transact in different markets, the
reference market (and, thus, marketplace participants) will differ depending on the
business activities of the entity and the unit of account for the asset or liability in the
market in which the entity would transact. To allow for those differences, this Statement
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clarifies that the reference market should be considered from the perspective of the entity.
Therefore, the reference market is the most advantageous market in which the entity
would transact for the asset or liability.
Principal Markets
C26. Some respondents interpreted the reference market principle within Level 1 of the
Exposure Draft as requiring the use of prices in most advantageous markets over prices in
principal markets in all cases, referring to possible conflicts with ASR No. 118,
Accounting for Investment Securities by Registered Investment Companies, and its
principal market approach for registered funds. They stated that because the principal
market is the market in which the preponderance of transactions for the asset or liability
occur, it generally is the most liquid market for the asset or liability. Therefore, the price
in the principal market for the asset or liability generally will be more reliable than a price
in a market that is more advantageous at the measurement date. Further, in situations in
which an asset or liability is exchanged in multiple locations (for example, if a security is
listed for trading on exchanges located in several countries) a most advantageous market
approach would create operational difficulties and impose additional costs. The Board
agreed that because the principal market is the market in which the preponderance of
transactions for the asset or liability occur it would be reasonable to presume that the
principal market will represent the most advantageous market for the asset or liability.
Therefore, this Statement clarifies that if there are multiple markets for the asset or
liability with different prices, the principal market for the asset or liability is presumed to
represent the reference market for the asset or liability (whether that market is determined
under ASR 118 or otherwise, based on volume data).
Hypothetical Markets
C27. The Board acknowledged that in some cases there might not be a market for the
asset or liability at the measurement date. In those cases, the reference market is
hypothetical, constructed from inputs relevant to the asset or liability. Accordingly,
marketplace participants in that reference market also are hypothetical. The Board
understands that for some, a hypothetical reference market construct raises concerns about
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the relevance and reliability of the estimate. In particular, some believe that a
hypothetical reference market construct is an artificial construct that does not faithfully
represent an actual economic phenomenon and, as such, would seem to be of questionable
relevance to users of financial statements. Some Board members share those concerns.
However, the Board agreed that concerns about fair value measurements that are
predicated on hypothetical transactions in hypothetical markets derive from a threshold
issue that relates principally to the selection of the appropriate measurement attribute, an
important area of focus in the Board’s conceptual framework project. The Board plans to
continue to address the issue of which measurement attribute should be required in
individual accounting pronouncements on a project-by-project basis.
Application to Assets
C28. For an asset, the reference market is the market with the price that maximizes the
amount that would be received for the asset, assuming the highest and best use of the asset
from the perspective of marketplace participants.
Highest and Best Use
C29. Highest and best use is a valuation concept used to value many assets (for
example, real estate assets). In general terms, the highest and best use of an asset refers to
the use of the asset that maximizes the future inflows associated with the asset, consistent
with the most advantageous reference market approach in this Statement.3 Concepts
Statement 7 refers to that highest and best use concept as a basis for explaining differences
between an entity’s expectations of future cash flows and those of the market. In
particular, paragraph 32(a) of Concepts Statement 7 states:
The entity’s managers might intend different use or settlement than that anticipated by others. For example, they might intend to operate a property as a bowling alley, even though others in the marketplace consider its highest and best use to be a parking lot.
3The term highest and best use is similarly referred to in the glossary of International Valuation Standards, seventh edition, as, “The most probable use of a property which is physically possible, appropriately justified, legally permissible, financially feasible, and which results in the highest value of the property being valued.”
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C30. The Exposure Draft incorporated that highest and best use concept, but indirectly
in the context of the valuation premise used to estimate the fair value of an asset. The
related guidance distinguished between an in-use and an in-exchange valuation premise,
referring generally to marketplace participant expectations with respect to the asset. In
commenting on that guidance, some respondents indicated that it was ambiguous with
respect to when an in-use versus an in-exchange valuation premise should be used.
C31. In response, this Statement incorporates that highest and best use concept directly
as a basis for establishing the valuation premise that should be used to estimate the fair
value of an asset, as suggested by some respondents. This Statement clarifies that if the
highest and best use of an asset from the perspective of marketplace participants is in use,
the estimate of fair value should be determined using an in-use valuation premise (fair
value in-use). If the highest and best use of an asset from the perspective of marketplace
participants is in-exchange, the estimate of fair value should be determined using an in-
exchange valuation premise (fair value in-exchange).
C32. A few respondents also questioned the interaction between an in-use valuation
premise and the exchange notion encompassed within the definition of fair value. In
response, the Board clarified that in situations in which the highest and best use of an asset
is in-use, an in-use valuation premise focuses the estimate on an exchange that involves an
asset group (the asset is installed or otherwise configured for use). Because highest and
best use is considered from the perspective of marketplace participants, the estimate is a
market-based estimate that reflects the consensus view of marketplace participants with
respect to the asset. It is not an entity-specific estimate that reflects the entity’s own
expectations with respect to the asset.
Application to Liabilities
C33. For a liability, the reference market is the market with the price that minimizes the
amount that would be paid to transfer the liability to a marketplace participant of
comparable credit standing that would similarly perform or similarly bear the
consequences of not performing.
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The Transfer
C34. The estimate assumes that the liability is transferred to a marketplace participant
that has the ability to similarly perform at the measurement date. Therefore, the liability
to the counterparty continues (it is not settled or otherwise extinguished). The Board
acknowledged that in some cases, the entity might have advantages (or disadvantages)
relative to the market that would make it more (or less) beneficial for the entity to perform
using its own internal resources. However, the Board affirmed that the fair value of a
liability is the same regardless of how an entity intends to settle the liability (assuming
entities of comparable credit standing) and that the relative efficiency of an entity in
settling the liability using its own internal resources should be reflected over the course of
its settlement, not before. In effect, a fair value measurement provides a market
benchmark by which the entity’s advantages (or disadvantages) in performance or
settlement relative to the market can be assessed.
C35. In the context of both assets and liabilities, paragraph 33 of Concepts Statement 7
explains:
If the entity measures an asset or liability at fair value, its comparative advantage or disadvantage will appear in earnings as it realizes assets or settles liabilities for amounts different than fair value. The effect on earnings appears when the advantage is employed to achieve cost savings or the disadvantage results in excess costs. In contrast, if the entity measures an asset or liability using a measurement other than fair value, its comparative advantage or disadvantage is embedded in the measurement of the asset or liability at initial recognition. If the offsetting entry is to revenue or expense, measurements other than fair value cause the future effects of this comparative advantage or disadvantage to be recognized in earnings at initial measurement.
Credit Standing
C36. The estimate further assumes that the liability is transferred to a marketplace
participant of comparable credit standing. In this Statement, the Board affirmed its
conclusion in Concepts Statement 7 that “the most relevant measure of a liability always
reflects the credit standing of the entity obligated to pay” (paragraph 78). This Statement
incorporates that credit standing concept in Concepts Statement 7, thereby elevating it to
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Level A GAAP. Therefore, the entity should consider the effect of its credit standing on
the fair value of the liability in all periods in which the liability is measured at fair value
so that the estimate reflects the price that would be paid in a current transaction between
marketplace participants of comparable credit standing.
C37. The Exposure Draft similarly incorporated the credit standing concept in Concepts
Statement 7. Respondents agreed that, conceptually, the effect of an entity’s credit
standing should be considered in all liability measurements at fair value. However, they
expressed concerns about elevating that concept to Level A GAAP, thereby requiring that
the entity consider the effect of changes in its credit standing on the fair value of the
liability in all cases in which the liability is remeasured at fair value. In particular, they
referred to the counterintuitive and potentially confusing reporting that could result by
including the effect in liability remeasurements at fair value (“gains” for credit
downgrades and “losses” for credit upgrades). Respondents further referred to diversity in
practice with respect to credit standing and liability remeasurements at fair value, noting
that related issues are not clearly and consistently addressed in Level A GAAP, in
particular, Statements 107 and 133.
C38. Paragraph 68 of Statement 107 states:
The Board acknowledges that, as for assets with no quoted prices, variations in the methods used to estimate the fair value of liabilities with no quoted prices might reduce the comparability of fair value information among entities. Some entities will estimate fair value by using an incremental rate of borrowing that considers changes in an entity’s own credit risk, while others will use a settlement rate that ignores at least part of those credit risk changes. However, the Board concluded that it should not, at this time, prescribe a single method to be used for all unquoted liabilities.
C39. Similarly, paragraph 316 of Statement 133 states:
Some respondents to the Exposure Draft noted that Statement 107 permits an entity to choose whether to consider changes in its own creditworthiness in determining the fair value of its debt and asked for further guidance on that issue. The definition of fair value in Statement 125 says that in measuring liabilities at fair value by discounting estimated future cash flows, an objective is to use discount rates at which those
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liabilities could be settled in an arm’s-length transaction. However, the FASB’s pronouncements to date have not broadly addressed whether changes in a debtor’s creditworthiness after incurrence of a liability should be reflected in measuring its fair value. Pending resolution of the broad issue of the effect of a debtor’s creditworthiness on the fair value of its liabilities, the Board decided to use the definition in Statement 125 but not to provide additional guidance on reflecting the effects of changes in creditworthiness.
C40. Respondents acknowledged that liabilities currently remeasured at fair value on a
regular basis are limited largely to derivative liabilities under Statement 133. However,
they emphasized that issues related to credit standing and liability remeasurements will
become more pervasive as more liabilities are remeasured at fair value on a regular basis,
referring to agenda projects in which the Board is broadly considering liability
remeasurements at fair value (for example, the fair value option project). Because of that
future expansion and current practice, they urged the Board to address related issues.
C41. In its redeliberations, the Board noted that in Concepts Statement 7, it considered
many of the issues related to credit standing and liability remeasurements referred to by
respondents. Paragraphs 78–88 of Concepts Statement 7 explain:
The most relevant measure of a liability always reflects the credit standing of the entity obligated to pay. Those who hold the entity’s obligations as assets incorporate the entity’s credit standing in determining the prices they are willing to pay. When an entity incurs a liability in exchange for cash, the role of its credit standing is easy to observe. An entity with a strong credit standing will receive more cash, relative to a fixed promise to pay, than an entity with a weak credit standing. For example, if 2 entities both promise to pay $500 in 5 years, the entity with a strong credit standing may receive about $374 in exchange for its promise (a 6 percent interest rate). The entity with a weak credit standing may receive about $284 in exchange for its promise (a 12 percent interest rate). Each entity initially records its respective liability at fair value, which is [presumptively] the amount of proceeds received—an amount that incorporates that entity’s credit standing.
The effect of an entity’s credit standing on the fair value of [its] liabilities depends on the ability of the entity to pay and on [other provisions of those liabilities] that protect holders. Liabilities that are guaranteed by governmental bodies (for example, many bank deposit liabilities in the United States) may pose little risk of default to the holder. Other liabilities may include sinking-fund requirements or significant
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collateral. . . . [such] aspects must be considered in estimating the extent to which the entity’s credit standing affects the fair value of its liabilities.
The role of the entity’s credit standing in a settlement transaction is less direct but equally important. A settlement transaction involves three parties—the entity, the parties to whom it is obligated, and a third party. The price of the transaction will reflect the competing interests of each party. For example, suppose Entity A [obligor] has an obligation to pay $500 to Entity B [obligee] 3 years hence. Entity A has a poor credit rating and therefore borrows at a 12 percent interest rate.
a. In a settlement transaction, Entity B would never consent to replace Entity A with an entity of lower credit standing. All other things being equal, Entity B might consent to replace Entity A with a borrower of similar credit standing and would probably consent to replace Entity A with a more creditworthy entity.
b. Entity C has a good credit rating and therefore borrows at a 6 percent interest rate. It might willingly assume Entity A’s obligation for $420 (the present value at 6 percent). Entity C has no incentive to assume the obligation for less (a higher interest rate) if it can borrow at 6 percent because it can receive $420 for an identical promise to pay $500.
c. However, if Entity A were to borrow the money to pay Entity C, it would have to promise $590 ($420 due in 3 years with accumulated interest at 12 percent).
Based on the admittedly simple [example] above, the fair value of Entity A’s liability should be approximately $356 (the present value of $500 in 3 years at 12 percent). The $420 price demanded by Entity C includes the fair value of Entity A’s liability ($356) plus the price of an upgrade in the credit quality of the liability. . . . [Like the purchase of a guarantee, the additional amount represents a separate element of a new arrangement rather than an element of the fair value of Entity A’s original liability.]
The effect of an entity’s credit standing on the measurement of its liabilities is usually captured in an adjustment to the interest rate, as illustrated above. . . . [However], an [expected present value technique, which considers possible cash flows in the measurement], may be more effective when measuring the effect of credit standing on other liabilities [other then debt]. For example, a liability may present the entity with a range of possible outflows, ranging from very low to very high amounts. There may be little chance of default if the amount is low, but a high chance of default if the amount is high. . . . [In those situations, the effect of possible cash flows on an entity’s credit standing may be effectively incorporated in the computation of those expected cash flows.]
The role of an entity’s credit standing in the accounting measurement of its liabilities has been a controversial question among accountants. The entity’s credit standing clearly affects the interest rate at which it borrows in the marketplace. The initial proceeds of a loan, therefore, always reflect
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the entity’s credit standing at that time. Similarly, the price at which others buy and sell the entity’s loan includes their assessment of the entity’s ability to repay. The example [above] demonstrates how the entity’s credit standing would affect the price it would be required to pay to have another entity assume its liability. However, some have questioned whether an entity’s financial statements should reflect the effect of its credit standing (or changes in credit standing).
Some suggest that the measurement objective for liabilities is fundamentally different from the measurement objective for assets. In their view, financial statement users are better served by liability measurements that focus on the entity’s obligation. They suggest a measurement approach in which financial statements would portray the present value of an obligation such that two entities with the same obligation but different credit standing would report the same carrying amount. Some existing accounting pronouncements take this approach, most notably FASB Statements No. 87, Employers’ Accounting for Pensions, and No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions.
However, there is no convincing rationale for why the initial measurement of some liabilities would necessarily include the effect of credit standing (as in a loan for cash) while others might not (as in a warranty liability or similar item). Similarly, there is no rationale for why, in initial or fresh-start measurement, the recorded amount of a liability should reflect something other than the price that would exist in the marketplace. Consistent with its conclusions on fair value (refer to paragraph 30), the Board found no rationale for taking a different view in subsequent fresh-start measurements of an existing asset or liability than would pertain to measurements at initial recognition.
Some argue that changes in an entity’s credit standing are not relevant to users of financial statements. In their view, a fresh-start measurement that reflects changes in credit standing produces accounting results that are confusing. If the measurement includes changes in credit standing, and an entity’s credit standing declines, the fresh-start measurement of its liabilities declines. That decline in liabilities is accompanied by an increase in owners’ equity, a result that they find counterintuitive. How, they ask, can a bad thing (declining credit standing) produce a good thing (increased owners’ equity)?
Like all measurements at fair value, fresh-start measurement of liabilities can produce unfamiliar results when compared with reporting the liabilities on an amortized basis. A change in credit standing represents a change in the relative positions of the two classes of claimants (shareholders and creditors) to an entity’s assets. If the credit standing diminishes, the fair value of creditors’ claims diminishes. The amount of shareholders’ residual claim to the entity’s assets may appear to increase, but that increase probably is offset by losses that may have occasioned the decline in credit standing. Because shareholders usually cannot be called on to pay a corporation’s liabilities, the amount of their residual claims
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approaches, and is limited by, zero. Thus, a change in the position of borrowers necessarily alters the position of shareholders, and vice versa.
The failure to include changes in credit standing in the measurement of a liability ignores economic differences between liabilities. Consider the case of an entity that has two classes of borrowing. Class One was transacted when the entity had a strong credit standing and a correspondingly low interest rate. Class Two is new and was transacted under the entity’s current lower credit standing. Both classes trade in the marketplace based on the entity’s current credit standing. If the two liabilities are subject to fresh-start measurement, failing to include changes in the entity’s credit standing makes the classes of borrowings seem different—even though the marketplace evaluates the quality of their respective cash flows as similar to one another.
C42. The Board further noted that in the IAS 39 amendment, The Fair Value Option,
the IASB considered similar issues. Paragraph BC89 of the IAS 39 amendment (as it
appears in that amendment) states:
. . . the Board noted that because financial statements are prepared on a going concern basis, credit risk affects the value at which liabilities could be repurchased or settled. Accordingly, the fair value of a financial liability reflects the credit risk relating to that liability. Therefore, it decided to include credit risk relating to a financial liability in the fair value measurement of that liability for the following reasons:
(a) entities realize changes in fair value, including fair value attributable to ownthe liability’s credit risk, for example, by renegotiating or repurchasing liabilities or by using derivatives;
(b) changes in credit risk affect the observed market price of a financial liability and hence its fair value;
(c) it is difficult from a practical standpoint to exclude changes in credit risk from an observed market price; and
(d) the fair value of a financial liability (ie the price of that liability in an exchange between a knowledgeable, willing buyer and a knowledgeable, willing seller) on initial recognition reflects theits credit risk relating to that liability. The Board believes that it is inappropriate to include credit risk in the initial fair value measurement of financial liabilities, but not subsequently.
C43. In reconsidering issues relating to credit standing and liability measurements at fair
value, the Board affirmed that conceptually, credit standing is an essential component of a
fair value measurement. A measurement that does not consider the effect of the entity’s
credit standing (and changes in the entity’s credit standing) is not a fair value
measurement. The Board acknowledged the practical concerns about credit standing and
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liability remeasurements expressed by respondents. Some Board members share those
concerns, especially considering situations in which an entity that is experiencing
financial difficulty reports gains resulting from credit downgrades that it does not have the
ability to immediately realize. However, the Board agreed that those concerns derive
from a threshold issue that relates principally to the selection of the appropriate
measurement attribute for liability remeasurements. The Board plans to continue to
address the issue of which measurement attribute should be required for liability
remeasurements in individual accounting pronouncements on a project-by-project basis.
Transaction Costs
C44. Transaction costs refer to costs that represent the incremental direct costs to
transact in the reference market for the asset or liability, similar to cost to sell as defined
in paragraph 35 of FASB Statement No. 144, Accounting for the Impairment or Disposal
of Long-Lived Assets. In this Statement, the Board affirmed its view in other accounting
pronouncements that the price that forms the basis for a fair value measurement (that is,
the price in the reference market for the asset or liability) should not be adjusted for
transaction costs. A few respondents disagreed with that view. They indicated that a
measurement approach that ignores transaction costs has earnings implications and is
conceptually flawed. In response, the Board clarified that transaction costs are
characteristics of the transaction; they are not characteristics of the particular asset or
liability and, therefore, should not be considered in determining the fair value of the
particular asset or liability. Further, transaction costs may differ, depending on how an
entity decides to structure the transaction.
Interaction between Fair Value and Fair Market Value
C45. The Board agreed that the measurement objective encompassed within the
definition of fair value used for financial reporting purposes is generally consistent with
similar definitions of fair market value used for valuation purposes. For example, the
definition of fair market value in Internal Revenue Service Revenue Ruling 59-60 (the
legal standard of value in many valuation situations) refers to “the price at which property
would change hands between a willing buyer and a willing seller when the former is not
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under any compulsion to buy and the latter is not under any compulsion to sell, both
parties having reasonable knowledge of relevant facts.” However, the Board observed
that the definition of fair market value has a significant body of interpretive case law,
developed in the context of tax regulation. Because such interpretive case law, in the
context of financial reporting, may not be relevant, the Board chose not to simply adopt
the definition of fair market value, and its interpretive case law, for financial reporting
purposes.
Fair Value Estimates at Initial Recognition
C46. Some respondents questioned whether the price in a transaction in which the entity
acquires an asset or assumes a liability should be used to estimate the fair value of the
asset or liability at initial recognition. They indicated that the guidance in the Exposure
Draft was ambiguous with respect to when a price in a transaction involving the entity
versus an observed price (a price in a transaction that does not involve the entity) within
the fair value hierarchy should be used to estimate the fair value of an asset or liability at
initial recognition.
C47. In its redeliberations, the Board considered that issue in the context of the related
guidance in paragraphs 7 and 27 of Concepts Statement 7, which state:
At initial recognition, the cash or equivalent amount paid or received (historical cost or proceeds) is usually assumed to approximate fair value, absent evidence to the contrary.
A transaction in the marketplace—an exchange for cash at or near to the date of the transaction—is the most common trigger for accounting recognition, and accountants typically accept actual exchange prices as fair value in measuring those transactions, absent persuasive evidence to the contrary. Indeed, the usual condition for using a measurement other than the exchange price is a conclusion that the stated price is not representative of fair value.
C48. In this Statement, the Board agreed that in a transaction in which the entity
acquires an asset or assumes a liability, the transaction price (the price paid for the asset or
received to assume the liability) is an entry price. In contrast, the price that forms the
basis for a fair value estimate (the price that would be received for the asset or paid to
transfer the liability) is an exit price. The Board agreed that, conceptually, entry and exit
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prices are different. However, those prices are presumed to be the same at initial
recognition, absent persuasive evidence to the contrary. In other words, the transaction
price represents the clearing (or equilibrium) price in the reference market for the asset or
liability. Therefore, this Statement incorporates the transaction price presumption in
Concepts Statement 7, referring generally to situations in which the transaction price
presumption might be rebutted from the perspective of the entity. This Statement does not
identify when the transaction price presumption would be rebutted in any specific
situations. The Board plans to separately consider those situations in individual
accounting pronouncements on a project-by-project basis.
Valuation Techniques
C49. This Statement emphasizes that valuation techniques used to estimate fair value
should be consistent with the market approach, income approach, and cost (or asset-based)
approach. The related guidance in the Exposure Draft contained references to the use of
multiple valuation techniques consistent with all three valuation approaches whenever the
information necessary to apply those techniques is available without undue cost and effort.
In its redeliberations, the Board reconsidered certain aspects of that guidance and clarified
other aspects.
Single versus Multiple Valuation Techniques
C50. Several respondents interpreted the related guidance in the Exposure Draft as
requiring the use of multiple valuation techniques in all cases (except as otherwise
indicated, for example, within Level 1). They emphasized that in many cases, multiple
valuation techniques would not be appropriate or cost beneficial. The Board affirmed that
it was not its intent to require the use of multiple valuation techniques. To more clearly
convey its intent, the Board clarified that consistent with existing valuation practice, for
example, valuation practice under the Appraisal Foundation’s Uniform Standards of
Professional Appraisal Practice, valuation techniques that are appropriate in the
circumstances and for which sufficient data are available should be used to estimate fair
value.
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C51. The Board expects that in some cases, a single valuation technique will be
appropriate, for example, for financial instruments that are valued using a pricing model
(whether that model is common in the industry or internally developed). In other cases,
multiple valuation techniques will be appropriate. The Board acknowledged that
valuation techniques will differ, depending on the asset or liability and the availability of
data. Therefore, selecting the appropriate valuation technique requires judgment.
However, in all cases, the objective is to use the valuation technique (or combination of
valuation techniques) that is appropriate in the circumstances.
Undue Cost and Effort
C52. Some respondents referred to the “undue cost and effort” criterion in the Exposure
Draft relating to the availability of information necessary to use valuation techniques.
They pointed out that the most appropriate valuation technique also might be the most
costly valuation technique and that undue cost and effort should not be a basis for
determining whether to use that valuation technique. Moreover, an undue cost and effort
criterion likely would not be consistently applied. The Board agreed and, in response,
removed that undue cost and effort criterion from this Statement. Valuation techniques
that are appropriate in the circumstances and for which sufficient data are available should
be used to estimate fair value, even if obtaining the data involves cost and effort.
Consistency Constraint
C53. The Exposure Draft emphasized the need for consistency in the valuation
technique(s) used to estimate fair value. Some respondents interpreted the related
guidance as allowing a change in the valuation technique used to estimate fair value or its
application (for example, a change in its weighting when multiple valuation techniques are
used) only in limited situations. They stated that consistency is important but that it
should not be the only consideration in selecting the appropriate valuation technique. The
Board agreed. This Statement does not preclude a change in the valuation technique used
to estimate fair value or its application if the change results in an estimate that is more
representative of fair value in the circumstances. The Board affirmed that revisions
resulting from a change in the valuation technique used should be accounted for
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prospectively, as changes in accounting estimates in accordance with the provisions of
FASB Statement No. 154, Accounting Changes and Error Corrections. However, the
Board concluded that in those situations, the disclosure requirements in Statement 154 for
a change in estimate could be unduly burdensome. Therefore, those disclosures do not
apply.
Present Value Techniques
C54. Valuation techniques consistent with the income approach include the present
value techniques discussed in Concepts Statement 7; specifically, the (a) traditional or
discount rate adjustment (DRA) technique and (b) expected cash flow approach or
expected present value (EPV) technique. In this Statement, the Board clarified aspects of
the guidance for applying those techniques in Concepts Statement 7 (Appendix A).
C55. The clarifications made through this Statement focus principally on the adjustment
for risk (systematic or nondiversifiable risk) when using an EPV technique. The Board
understands that because Concepts Statement 7 refers to the appropriate discount rate for
expected cash flows as the risk-free interest rate, the related guidance could be interpreted
as requiring that the adjustment for risk be reflected only in the expected cash flows,
which could result in a significant change to valuation practice. In many valuation
situations, the adjustment for risk is reflected in the discount rate, that is, as an adjustment
to the risk-free interest rate.
C56. The Board agreed that it was not its intent in Concepts Statement 7 to preclude that
alternative approach. To convey its intent more clearly, the Board expanded the guidance
in Concepts Statement 7 to clarify that when using an EPV technique, the adjustment for
risk may be reflected in either:
a. The expected cash flows, in which case the risk-adjusted expected cash flows should be discounted at a risk-free interest rate (Method 1); or
b. The discount rate, in which case the unadjusted expected cash flows should be discounted at a risk-adjusted discount rate, that is, the risk-free interest rate, adjusted for risk (Method 2).
C57. In its discussions, the Board acknowledged, as it did in paragraph 68 of Concepts
Statement 7, that “the appropriate risk premium consistent with fair value may be difficult
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to determine.” However, the Board agreed that the potential difficulty of determining the
appropriate risk premium is not, in and of itself, a sufficient basis for excluding that
adjustment (in effect, allowing a default of no risk adjustment). Risk is an essential
element of any present value technique. Therefore, an estimate of fair value, using present
value, should include an adjustment for risk if it is apparent that marketplace participants
include one, that is, if the amount is identifiable, measurable, and significant, as indicated
in paragraph 62 of Concepts Statement 7.
C58. This Statement incorporates the related guidance in Concepts Statement 7, as
clarified (Appendix A). However, the Board decided not to revise Concepts Statement 7
to reflect conforming changes to that guidance. Some respondents indicated that leaving
the conceptual guidance in Concepts Statement 7 unchanged would create conflicts
between the Concepts Statements and Level A GAAP that would be confusing. The
Board acknowledged those concerns, but concluded that because this Statement clarifies
and does not change the substantive guidance in Concepts Statement 7 or its application
under existing accounting pronouncements, it was not necessary to revise Concepts
Statement 7 in this project. The Board expects to separately consider the need to revise
Concepts Statement 7 in its conceptual framework project.
Multi-Period Excess Earnings Method
C59. In response to questions raised by some respondents, the Board clarified that
valuation techniques consistent with the income approach also include the multi-period
excess earnings method discussed in the AICPA Practice Aid, Assets Acquired in a
Business Combination to Be Used in Research and Development Activities: A Focus on
Software, Electronic Devices, and Pharmaceutical Industries (Practice Aid). The Board
understands that a multi-period excess earnings method is used to estimate the fair value
of certain intangible assets acquired in a business combination. The Board agreed that the
method should continue to be used under this Statement. However, the Board observed
that the related guidance in the Practice Aid could be interpreted to require an estimate
using an in-exchange valuation premise in situations in which marketplace participants
would continue to use an asset that the entity does not intend to use. For example, that
might be the case if an entity (acquirer) intends to abandon certain proprietary assets that
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marketplace participants would continue to use. The Board agreed that consistent with the
related guidance in this Statement, the estimate should be considered from the perspective
of marketplace participants and developed using an in-use valuation premise, where
appropriate.
Fair Value Hierarchy
C60. To increase consistency and comparability in estimates of fair value estimates and
related disclosures about the estimates, the Exposure Draft established a fair value
hierarchy that prioritized the inputs to valuation techniques used to estimate fair value.
Specifically, it grouped those inputs into three broad levels, considering the relative
reliability of the inputs. Those groupings distinguished between market inputs that reflect
quoted prices in active markets for identical or similar assets or liabilities (Levels 1 and 2)
and other inputs (Level 3).
C61. Many respondents generally agreed that prioritizing the inputs to valuation
techniques used to estimate fair value is important and that the fair value hierarchy
provides a useful construct for considering the relative reliability of the estimates. In that
regard, the American Accounting Association (AAA) referred to the body of research that
jointly examines the relevance and reliability of fair value estimates derived from various
sources. AAA noted that the research supports the emphasis in this Statement on market
inputs and disclosures of the extent to which estimates of fair value incorporate those
inputs.
C62. Some respondents urged the Board to revise and expand the fair value hierarchy in
the Exposure Draft so that it more clearly conveys a continuum of inputs. In particular,
they referred to the need to distinguish between estimates that are objectively determined
and estimates that are more subjectively determined. In its redeliberations, the Board
revised the fair value hierarchy so that it conveys a continuum of inputs, as suggested by
respondents.
C63. The fair value hierarchy gives the highest priority to market inputs that reflect
quoted prices for identical assets or liabilities in active markets (Level 1) and the lowest
priority to entity inputs (Level 5), clarifying the inputs that fall within that range (Levels
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2–4). The Board observed that in some cases, the inputs to valuation techniques used to
estimate fair value might fall within multiple levels of the fair value hierarchy. This
Statement clarifies that where within the fair value hierarchy the estimate falls depends on
where within the fair value hierarchy the inputs that have a significant effect on the
estimate fall. This Statement does not specify the method that should be used in assessing
the effect of those inputs on the estimate. Because those inputs will differ depending on
the asset or liability, the Board decided that this Statement should allow for judgment in
that regard.
Level 1 Inputs
C64. Level 1 inputs are market inputs that reflect quoted prices for identical assets or
liabilities in active markets. The Board affirmed that quoted prices for identical assets or
liabilities in active markets (such as the New York Stock Exchange) provide the most
reliable estimate of fair value and should be used to estimate fair value whenever
available. Similarly, paragraph 57 of Statement 107 states:
The Board concluded that quoted market prices provide the most reliable measure of fair value. Quoted market prices are easy to obtain and are reliable and verifiable. They are used and relied upon regularly and are well understood by investors, creditors, and other users of financial information. In recent years, new markets have developed and some existing markets have evolved from thin to active markets, thereby increasing the ready availability of reliable fair value information.
C65. Like the Exposure Draft, this Statement emphasizes that because a Level 1
estimate is based solely on a quoted price in an active market, an entity must have the
ability to access that market for the asset or liability at the measurement date. In
particular, it limits discretion in pricing the asset or liability.
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Adjustments to Quoted Prices in Active Markets
C66. The Exposure Draft emphasized that a quoted price for an identical asset or
liability in an active market should be used to estimate fair value whenever it is available,
without adjustment. Some respondents interpreted the related guidance as requiring the
use of a quoted price for an identical asset or liability in an active market whenever it is
observable, without regard to whether that price is readily available or representative of
fair value. Respondents referred to possible conflicts with ASR 118, which requires
adjustments to a quoted price in similar situations (“fair value pricing”). In its
redeliberations, the Board affirmed that it was not its intent to preclude adjustments to a
quoted price for an identical asset or liability in an active market if that price is not readily
available or representative of fair value, noting that in those situations, the market for the
particular asset or liability would not be active. To more clearly convey its intent, the
Board clarified that in those situations, a quoted price for an identical asset or liability in
an active market should be adjusted, as appropriate. However, the resulting estimate will
fall within a lower level of the fair value hierarchy.
C67. The Board further clarified that in some cases, significant events (for example,
principal-to-principal transactions or brokered trades or announcements) might occur after
the close of a market but before the measurement date. In those cases, a quoted price in
that market might not be representative of fair value at the measurement date. The Board
affirmed its view in the Exposure Draft that an entity need not undertake all possible
efforts to obtain information about after-hours trading. However, an awareness of
changes is particularly important for instruments traded in foreign markets that close
many hours before the normal end of the business day in the local area. Therefore, the
entity should not ignore information that is available at the reporting date (for example, a
large change in the price in another market after the close of the principal market in which
the asset or liability trades). The Board agreed that entities should establish and
consistently apply a policy for determining how those events affect estimates of fair value.
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Bid and Asked Prices
C68. In developing this Statement, the Board observed that in some situations, Level 1
inputs will include prices that are quoted in terms of bid and asked prices, for example, in
an active dealer market where the bid price represents the price the dealer is willing to pay
and the asked price represents the price at which the dealer is willing to sell.
C69. In the Exposure Draft, the Board decided to require the use of bid prices for long
positions (assets) and asked prices for short positions (liabilities) in all cases. At that time,
the Board concluded that a single bid-asked spread pricing method would maximize the
consistency and comparability of the estimates within Level 1. Also, the required bid-
asked spread pricing method would have been generally consistent with the related
guidance in paragraph BC99 of IAS 39 (revised), Financial Instruments: Recognition and
Measurement, which states:
The Board confirmed the proposal in the Exposure Draft that the appropriate quoted market price for an asset held or liability to be issued is usually the current bid price and, for an asset to be acquired or liability held, the asking price. It concluded that applying mid-market prices to an individual instrument is not appropriate because it would result in entities recognising up-front gains or losses for the difference between the bid-ask price and the mid-market price.
C70. Respondents agreed that a single bid-asked spread pricing method would
maximize the consistency and comparability of the estimates within Level 1. However,
they stated that because different marketplace participants transact at different prices
within a bid-asked spread, the resulting estimates would not be relevant in all cases.
Further, the required bid-asked spread pricing method in the Exposure Draft would
represent a significant change to practice under ASR 118. The related guidance in ASR
118 is used by investment companies and broker-dealers and provides those entities with
flexibility in selecting the bid-asked pricing method used to estimate fair value. Some
respondents emphasized that for entities that enter into derivative instruments to manage
risk, limiting that flexibility would create operational difficulties because many of those
instruments are traded in active dealer markets and currently valued using other pricing
methods (for example, mid-market prices or prices within a range of observable bid and
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asked prices). Respondents stated that this Statement should allow the flexibility in ASR
118 in applying the fair value concept.
C71. In its redeliberations, the Board reconsidered the required bid-asked spread pricing
method within Level 1. The Board decided to emphasize the fair value measurement
objective and allow a pricing method within the bid-asked spread that provides an
estimate of the price at which marketplace participants would currently transact,
consistently applied. Bid-asked spread pricing methods appropriate under ASR 118 are
appropriate under this Statement. Accordingly, the use of bid prices for long positions
(assets) and asked prices for short positions (liabilities) is permitted but not required.
C72. Because the Exposure Draft would have required the use of bid prices for long
positions (assets) and asked prices for short positions (liabilities) in all cases, the Board
initially decided to specify the pricing for offsetting positions to preclude recognition of
up-front gains or losses. Specifically, for offsetting positions, the Board decided to
require the use of mid-market prices for the matched portion and bid and asked prices for
the net open position, as appropriate, similar to the guidance in IAS 39 (revised).
Paragraph BC100 of IAS 39 (revised) states:
The Board discussed whether the bid-ask spread should be applied to the net open position of a portfolio containing offsetting market risk positions, or to each instrument in the portfolio. It noted the concerns raised by constituents that applying the bid-ask spread to the net open position better reflects the fair value of the risk retained in the portfolio. The Board concluded that for offsetting risk positions, entities could use mid-market prices to determine fair value, and hence may apply the bid or asking price to the net open position as appropriate. The Board believes that when an entity has offsetting risk positions, using the mid-market price is appropriate because the entity (a) has locked in its cash flows from the asset and liability and (b) potentially could sell the matched position without incurring the bid-ask spread.
C73. Because it decided not to require the use of bid prices for long positions (assets)
and asked prices for short positions (liabilities), the Board subsequently decided to revise
the related guidance for offsetting positions in the Exposure Draft. Specifically, the Board
decided that this Statement should provide general guidance clarifying that for offsetting
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positions in the same instrument, the same price should be used to value both the long and
short positions.
Blocks
C74. Prior to this Statement, the FASB, the AICPA Accounting Standards Executive
Committee (AcSEC), the Securities and Exchange Commission (SEC), and others
considered issues relating to fair value estimates involving large positions of unrestricted
securities with quoted prices in active markets (blocks). The threshold issue focused on
whether the appropriate unit of account for the block is (a) the individual trading unit,
where the estimate would be determined as the product of the quoted price times the
quantity held (P × Q), or (b) the block, where the estimate would be determined using a
blockage factor, that is, a discount (or premium) to the quoted price based on the size of
the position relative to trading volume.
C75. In other FASB Statements (including Statements 107 and 133, and FASB
Statements No. 115, Accounting for Certain Investments in Debt and Equity Securities,
and No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations),
the Board decided that for a block, the estimate should be based on the individual trading
unit, determined using P × Q. Therefore, those Statements preclude the use of a blockage
factor, even if a market’s normal trading volume for one day is not sufficient to absorb the
quantity held and placing orders to sell the position in a single transaction might affect the
quoted price.
C76. Paragraph 58 of Statement 107 states:
Although many respondents to the 1990 and 1987 Exposure Drafts agreed with the usefulness of disclosing quoted market prices derived from active markets, some argued that quoted prices from thin markets do not provide relevant measures of fair value, particularly when an entity holds a large amount of a thinly traded financial instrument that could not be absorbed by the market in a single transaction. The Board considered this issue and reiterated its belief that quoted prices, even from thin markets, provide useful information because investors and creditors regularly rely on those prices to make their decisions. The Board noted that providing the liquidation value of a block of financial instruments is not the objective of this Statement. The Board also concluded that requiring the use of
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available quoted market prices would increase the comparability of the disclosures among entities.
C77. Similarly, paragraph 315 of Statement 133 states:
Consistent with Statement 107, the definition of fair value in this Statement precludes an entity from using a “blockage” factor (that is, a premium or discount based on the relative size of the position held, such as a large proportion of the total trading units of an instrument) in determining the fair value of a large block of financial instruments. The definition of fair value requires that fair value be determined as the product of the number of trading units of an asset times a quoted market price if available [as required by Statement 107]. . . . Some respondents to the Exposure Draft indicated that the guidance in Statement 107 (and implicitly the definition of fair value in this Statement) should be revised to require or permit consideration of a discount in valuing a large asset position. They asserted that an entity that holds a relatively large amount (compared with average trading volume) of a traded asset and liquidates the entire amount at one time likely would receive an amount less than the quoted market price. Although respondents generally focused on a discount, holding a relatively large amount of an asset might sometimes result in a premium over the market price for a single trading unit. The Board currently believes that the use of a blockage factor would lessen the reliability and comparability of reported estimates of fair value.
C78. However, for broker-dealers and certain investment companies (investment
companies other than registered funds subject to SEC reporting requirements that used
blockage factors in financial statements for fiscal years ending on or before May 31, 2000)
the AICPA Audit and Accounting Guides for those industries (the Guides) allowed an
exception to the requirement of other FASB pronouncements to use P × Q to estimate the
fair value of a block. Specifically, the Guides permitted an estimate using a blockage
factor, where appropriate.
C79. In developing this Statement, the Board decided to address that inconsistency
within GAAP. The Board considered the earlier work completed by AcSEC through its
Blockage Factor Task Force, which was formed in 2000 to address issues specific to the
use of blockage factors (discounts) by broker-dealers and investment companies. Based
on discussions with industry representatives (broker-dealers, mutual funds, and other
investment companies) and review of relevant academic research and market data, the task
force affirmed that discounts involving large blocks exist, generally increasing as the size
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of the block to be traded (expressed as a percentage of the daily trading volume) increases,
but that the methods for measuring the blockage factors (discounts) are largely subjective.
C80. In the Exposure Draft, the Board acknowledged the diversity in practice with
respect to the methods for measuring blockage factors (discounts). However, the Board
agreed that for entities that regularly buy and sell securities in blocks, the financial
reporting that would result when using P × Q to estimate the fair value of a block would
not be representationally faithful of the underlying business activities. In particular, if a
block is purchased at a discount to the quoted price, an estimate using P × Q would give
the appearance of an instant gain upon buying the block, followed by a reported loss on
subsequently selling the block (at a discount to the quoted price), resulting in misleading
reporting. At that time, the Board understood that for blocks held by broker-dealers,
industry practice was to sell the securities in blocks. In view of that selling practice (in
blocks), the Board decided that this Statement should allow the exception to P × Q in the
Guides to continue, thereby permitting the use of blockage factors by broker-dealers and
certain investment companies.
C81. Many respondents, in particular, broker-dealers, agreed with that decision.
However, during its redeliberations, the Board discussed issues relating to the
measurement of blocks with representative respondents and certain user groups, including
analysts that follow broker-dealers. Through those discussions, the Board learned that for
blocks held by broker-dealers, industry practice is to sell the securities in quantities that
are not necessarily blocks, thereby allowing for situations in which the securities could be
sold at the quoted price for an individual trading unit. Because of that selling practice (in
non-blocks), the Board determined that there is no compelling reason to allow the
exception to P × Q in the Guides to continue under this Statement. The Board decided
that the estimate of the fair value of a block should be determined using P × Q .
C82. In reaching that decision, the Board affirmed its conclusions relating to the
prohibition on the use of blockage factors in other FASB Statements. In particular, the
Board emphasized that when a quoted price for a security in an active market is available,
that price should be used to estimate fair value without regard to an entity’s intent to
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transact at that price. Basing the fair value on the quoted price results in comparable
reporting. Adjusting the price for the size of the position introduces management intent
(to trade in blocks) into the measurement, reducing comparability. Following the
reasoning used in Statement 107, the quoted price provides useful information because
investors regularly rely on quoted prices for decision making. Also, the decision to
exchange a large position in equity securities in a single transaction at a price lower than
the price that would be available if the position were to be exchanged in multiple
transactions (in smaller quantities) is a decision whose consequences should be reported
when that decision is executed. Until that transaction occurs, the entity that holds the
block has the ability to effect the transaction either in the block market or in another
market.
C83. Therefore, this Statement precludes the use of blockage factors within Level 1 and
eliminates the exception to P × Q in the Guides. IAS 39 (revised) includes similar
guidance in paragraph AG72, which states, “The fair value of a portfolio of financial
instruments is the product of the number of units of the instrument and its quoted price.”
Alternative Pricing Methods
C84. A few respondents referred to situations in which an entity holds a large number of
similar assets and liabilities that are required to be measured at fair value and a quoted
price in an active market is not readily obtainable for each of those assets and liabilities
(for example, from financial reporting services or individual broker-dealers). They
indicated that, in those situations, the fair value hierarchy should allow for practical
considerations and trade-offs in selecting the valuation technique used to estimate fair
value within Level 1, considering the number of assets and/or liabilities required to be
measured in a financial reporting period and the timing of that reporting. In its
redeliberations, the Board revised the guidance within Level 1 to allow for the use of an
alternative valuation method (for example, matrix pricing) as a practical expedient,
provided that the method has been demonstrated to replicate actual prices. This Statement
emphasizes that the practical expedient within Level 1 applies only in the limited
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situations in which a quoted price in an active market could be obtained but, for practical
reasons, is not.
Level 2 Inputs
C85. Level 2 inputs are market inputs that reflect quoted prices not encompassed within
Level 1, adjusted as appropriate.
C86. The Exposure Draft limited the inputs within Level 2 to quoted prices for similar
assets or liabilities in active markets, adjusted as appropriate, emphasizing that within
Level 2, such adjustments must be objectively determinable. The Exposure Draft referred
to situations in which different entities likely would develop similar estimates for the same
asset or liability. Many respondents indicated that because all adjustments involve at least
some degree of subjective judgment and estimation, Level 2 would be overly restrictive.
Moreover, the objectively determinable criterion within Level 2 likely would not be
consistently applied.
C87. In its redeliberations, the Board reconsidered the inputs within Level 2. The Board
decided that those inputs should include all quoted prices that are not encompassed within
Level 1, adjusted as appropriate. The Board observed that in cases in which a price is
quoted in a market that is not active, it might be necessary to also consider the results of
valuation techniques that use other inputs in a market that is active (within Levels 2–4 of
the fair value hierarchy). However, the Board agreed that combining those quoted price
inputs in a single level within the fair value hierarchy would provide an objective basis for
considering requisite adjustments and the reliability of the estimates using those inputs
(within Level 2) relative to estimates using other inputs (within Level 3 or Level 4). The
Board eliminated the objectively determinable criterion for adjustments to quoted prices.
Instead, the Board clarified that an adjustment having a significant effect on the estimate
might render the estimate a lower level estimate, considering where within the fair value
hierarchy the inputs used to determine the adjustment fall.
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Restricted Securities
C88. The Board observed that accounting pronouncements that require fair value
measurements for restricted securities do not consistently refer to restricted securities.
Therefore, the guidance for developing the requisite estimates differs. The Board decided
to address that issue in this Statement.
C89. This Statement defines a restricted security broadly, as a security for which sale is
legally restricted by governmental or contractual requirement for a specified period,
whether the restriction limits sales (for example, to qualifying investors, as may be the
case under Rule 144 or similar rules of the SEC) or otherwise prohibits sales. In either
case, an adjustment (discount) from the quoted price for an otherwise identical
unrestricted security of the same issuer that trades in a public market is required to reflect
the effect of the restriction (a Level 2 input). Therefore, this Statement establishes the
general principle that the adjustment (discount) should reflect the amount a marketplace
participant would demand to assume the risk arising from the inability to access a public
market for the security for the specified period. That general principle applies regardless
of when the restriction terminates.
C90. The Exposure Draft provided general guidance for developing the estimate that
carried forward related guidance in ASR No. 113, Statement Regarding “Restricted
Securities.” That guidance, considered in the context of investment companies,
emphasizes factors that should not be considered in determining the estimate. Largely for
that reason, respondents that commented on that aspect of the Exposure Draft stated that
the guidance in ASR 113 is not particularly useful. They indicated a need for additional
guidance emphasizing factors that should be considered in determining the estimate.
C91. In the Exposure Draft, the Board discussed factors that should be considered in
determining the estimate. However, the Board observed that those factors will vary,
depending on the nature and duration of the restriction and facts and circumstances
specific to the particular security and issuer (quantitative and qualitative). For that reason,
the Board concluded that it would not be possible to identify all factors that should be
considered in all cases. In its redeliberations, the Board affirmed that conclusion and
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decided to remove the guidance in ASR 113 from this Statement. The Board observed
that many fair value estimates will require adjustments and that this Statement does not
provide guidance specific to any of those adjustments. The Board determined that there is
no compelling reason to provide detailed guidance for adjustments involving restricted
securities. Instead, the Board decided to emphasize the fair value measurement objective
and allow judgment in applying that objective.
C92. Having defined restricted securities in this Statement, the Board decided that this
Statement should amend Statement 115 to eliminate its definition of restricted stock in
footnote 2 to paragraph 3(a). The guidance in this Statement applies when estimating the
fair value of restricted securities included in the scope of Statement 115 (that is, equity
securities with restrictions that terminate within one year), thereby precluding an estimate
using a quoted price for an otherwise identical unrestricted security of the same issuer,
unadjusted.
Level 3 Inputs
C93. Level 3 inputs are market inputs other than quoted prices that are directly
observable for the asset or liability. Those inputs include information about interest rates,
yield curves, volatilities, and default rates.
C94. In the Exposure Draft, Level 3 encompassed all inputs used in valuation
techniques to estimate fair value other than quoted prices in active markets. Nearly all
respondents indicated that Level 3 would be overly broad, encompassing estimates that
vary significantly with respect to the inputs used to derive the estimates and the relative
reliability of the estimates. The principal concern expressed by respondents focused on
the disclosure of the resulting estimates in the aggregate, as “Level 3 estimates.” To more
clearly convey a continuum of inputs previously encompassed within Level 3, the Board
included some Level 3 inputs within Level 2 (quoted prices in markets that are not active)
and expanded the fair value hierarchy to include other Level 3 inputs within different
levels (Levels 4 and 5).
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Level 4 Inputs
C95. Level 4 inputs are market inputs that are not directly observable for the asset or
liability but that are corroborated by other market data for the asset or liability through
correlation or by other means (market-corroborated). The concept of corroborated market
data is intended to incorporate market data that are observable, based on an assessment of
factors relevant to the asset or liability. Market-corroborated inputs include inputs that are
derived through extrapolation or interpolation. The Board concluded that market-
corroborated inputs are market inputs and that estimates that are derived principally from
market-corroborated inputs should be distinguished from estimates that are derived
principally from entity inputs (within Level 5).
Level 5 Inputs
C96. Level 5 inputs are entity inputs. Entity inputs may range from market inputs that
are derived through extrapolation or interpolation but that are not corroborated by other
market data to inputs that reflect an entity’s own cost estimates. In this Statement, the
Board affirmed its conclusion in other accounting pronouncements that in the absence of
market inputs, entity inputs may be used to estimate fair value as a practical expedient.
Paragraph 38 of Concepts Statement 7 explains:
. . . an entity that uses cash flows in accounting measurements often has little or no information about some or all of the assumptions that marketplace participants would use in assessing the fair value of an asset or a liability. In those situations, the entity must necessarily use the information that is available without undue cost and effort in developing cash flow estimates. The use of an entity’s own assumptions about future cash flows is compatible with an estimate of fair value, as long as there are no contrary data indicating that marketplace participants would use different assumptions. If such data exist, the entity must adjust its assumptions to incorporate that market information.
C97. The Exposure Draft incorporated that guidance in Concepts Statement 7, referring
to the use of entity inputs as a practical expedient if market inputs are not available
without undue cost and effort. As noted by some respondents, in many cases, some form
of market inputs will be available. They stated that where such inputs are relevant, undue
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cost and effort should not be a basis for determining whether to use those inputs. The
Board agreed and, in response, clarified that market inputs should be used to estimate fair
value whenever those inputs are available, even if obtaining or otherwise deriving such
inputs involves cost and effort.
C98. The Board acknowledged that entity inputs will vary and require trade-offs,
considering the extent to which such inputs are both representationally faithful and
verifiable. Paragraphs 63 and 81 of Concepts Statement 2 explain:
Representational faithfulness is correspondence or agreement between a measure or description and the phenomenon it purports to represent. In accounting, the phenomena to be represented are economic resources and obligations and the transactions and events that change those resources and obligations. The quality of verifiability contributes to the usefulness of accounting information because the purpose of verification is to provide a significant degree of assurance that accounting measures represent what they purport to represent. Verification is more successful in minimizing measurer bias than measurement bias, and thus contributes in varying degrees toward assuring that particular measures represent faithfully the economic things or events that they purport to represent. Verification contributes little or nothing toward insuring that measures used are relevant to the decisions for which the information is intended to be useful. [Footnote reference omitted.]
C99. In particular, some entity inputs might be both representationally faithful and
verifiable. Other entity inputs might be representationally faithful but subject to
verification difficulties. Yet other entity inputs might be verifiable but lack
representational faithfulness. However, the Board affirmed its view in the Exposure Draft
that in all cases, the fair value measurement objective remains the same. Therefore, entity
inputs should be developed within market parameters, eliminating the effect of factors
specific to the entity whenever possible.
Disclosures
C100. The Board observed that few of the accounting pronouncements that require fair
value measurements included in the scope of this Statement also require disclosures about
those measurements. Further, the required disclosures vary. The Board decided that
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having established a framework for measuring fair value, this Statement should require
enhanced disclosures about those measurements. Because at initial recognition many
assets and liabilities are measured in the statement of financial position at amounts that
approximate fair value (for example, in a business combination), the Board decided to
limit the disclosures to fair value remeasurements in periods subsequent to initial
recognition, whether the remeasurements are made on a recurring or nonrecurring basis.
C101. Some respondents disagreed with the Board’s decision to include enhanced
disclosures about fair value in this Statement. In particular, they expressed concerns about
requiring those disclosures without first reconsidering all related disclosures currently
required under existing accounting pronouncements as part of a comprehensive disclosure
framework.
C102. Some respondents further indicated that the Board should reconsider those
disclosures in its project on financial performance reporting by business enterprises. In
the Exposure Draft, the Board considered the interaction between this project and its
project on financial performance reporting by business enterprises. Based on input
received from the UAC and others, the Board concluded that until such time as a final
Statement in that project is issued, the disclosures required by this Statement would
provide information about fair value remeasurements that is useful to users of financial
statements. The Board subsequently affirmed that conclusion.
C103. The Board agreed that issues raised by respondents indicated the need to
reconsider or otherwise clarify some of the disclosure requirements, but not eliminate
them from this Statement altogether. In that regard, the Board understands that some
entities (in particular, entities in the financial services industry) already are making similar
disclosures in SEC filings as part of disclosures about critical accounting estimates.
Fair Value Remeasurements
C104. In this Statement, the Board decided that an entity should disclose information that
enables users of its financial statements to evaluate the extent to which fair value is used
to remeasure assets and liabilities recognized in the statement of financial position and the
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inputs used to develop the estimates. The Board agreed that information about the inputs
used to develop the estimates would allow users of financial statements to assess the
relative reliability of the estimates.
C105. To achieve that disclosure objective, the related disclosures in the Exposure Draft
focused on the inputs used to estimate fair value within each major category of assets and
liabilities remeasured at fair value during the period. Many respondents generally agreed
with those disclosures, subject to clarifications to conform the disclosures to the fair value
hierarchy, as revised. In response, the Board established three broad disclosure levels
within the fair value hierarchy to distinguish estimates that fall within Level 1, Levels 2-4,
and Level 5.
Unrealized Gains or Losses
C106. In this Statement, the Board decided that an entity also should disclose information
that enables users of its financial statements to evaluate the effects of fair value
remeasurements on income (or changes in net assets) for the period.
C107. To achieve that disclosure objective, the related disclosures in the Exposure Draft
focused on the change in unrealized gains or losses during the period relating to estimates
within each major category of assets and liabilities remeasured at fair value, segregating
unrealized gains or losses included in other comprehensive income. In that regard, the
Board agreed that information about unrealized gains or losses is relevant to users of
financial statements. However, some respondents disagreed. In particular, they stated
that for assets and liabilities that are remeasured at fair value on a recurring basis
(principally, financial instruments), disclosures about unrealized gains or losses would not
provide useful information to users of financial statements. Further, that information
could be misleading; for example, users of financial statements might conclude that
unrealized gains or losses are of a “lesser quality” than realized gains or losses, which is
not the case. Also, those disclosures would not be cost-effective. Because entities do not
currently capture that information, incremental systems changes (in some cases
significant) would be required to comply with those disclosures. Those respondents stated
that the Board should remove those disclosures from this Statement.
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C108. The Board subsequently affirmed its view in the Exposure Draft that information
about unrealized gains or losses is relevant to users of financial statements. However, the
Board agreed that it did not intend to require entities to make significant incremental
systems changes to comply with the related disclosure requirements of this Statement. To
mitigate cost-benefit concerns, the Board decided to focus the disclosures on unrealized
gains or losses that relate to estimates that are subjectively determined using entity inputs
(within Level 5).
Total Gains or Losses
C109. In its redeliberations, the Board observed that subsequent changes in fair value
reflect changes in economic conditions without regard to whether an entity has transacted.
The Board observed that disclosure of total gains or losses (unrealized and realized) would
provide information about changes in the wealth of the entity due to changes in economic
conditions. The Board agreed that information would further enable users of financial
statements to evaluate the effects of fair value remeasurements during the period on
income (or changes in net assets) for the period. Therefore, the Board decided that this
Statement should require disclosure of total gains or losses relating to estimates within
each major category of assets and liabilities remeasured at fair value (even if those assets
and liabilities are not still held at the end of the period), segregating those gains or losses
included in other comprehensive income.
Other Disclosures
C110. A few respondents stated that this Statement should standardize disclosures of the
discount rate and other assumptions used in valuation techniques to estimate fair value.
The Board affirmed its view in the Exposure Draft that standardizing those disclosures for
all assets and liabilities remeasured at fair value (for example, requiring disclosure of
assumptions used in developing all estimates of fair value) would not be practical. By
way of example, the Board referred to other accounting pronouncements in which it
reached different decisions on whether to require disclosures about significant
assumptions. The Board noted that in many cases (in particular, for nonfinancial assets
and liabilities), an overwhelming volume of information would need to be disclosed for
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that information to be meaningful. Instead, this Statement establishes broad disclosure
objectives, which the Board expects to use as a basis for considering more specific
disclosures in individual accounting pronouncements that require fair value measurements
on a project-by-project basis.
C111. A few respondents also referred to the disclosures about the fair value of financial
instruments required by Statement 107. They suggested that the Board consolidate those
disclosures with the disclosures in this Statement. The Board disagreed. The disclosures
required by Statement 107 are specific to financial instruments, as defined in that
Statement, and extend beyond the measurements themselves. Further, those disclosures
apply regardless of whether a financial instrument is recognized in the statement of
financial position and measured at fair value. However, the Board agreed that the related
disclosures required by this Statement should be encouraged for financial instruments
disclosed at fair value for which the disclosures required by this Statement would not
otherwise apply, including financial instruments recognized in the statement of financial
position at amounts other than fair value (for example, loans carried at cost). Therefore,
this Statement amends Statement 107 to refer to the related disclosures in this Statement.
C112. A few respondents also referred to possible conflicts and overlap with SEC
disclosure requirements within management discussion and analysis, noting that to
varying degrees, the disclosures required by this Statement would duplicate those and
other industry-specific disclosures made outside the basic financial statements. The Board
affirmed its view in the Exposure Draft that the disclosures required by this Statement
supplement and do not change or otherwise conflict with the related disclosures required
by other accounting pronouncements. The disclosures required by this Statement apply
for all entities that hold assets and liabilities recognized in the statement of financial
position that are remeasured at fair value. Further, all entities should include those
disclosures within the basic financial statements.
C113. The Board emphasized that consistent with its related codification initiatives, the
fair value information disclosed under this Statement should be combined and disclosed
together with the fair value information disclosed under other pronouncements, including
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Statement 107 (for example, in a single fair value footnote), where practicable. The Board
concluded that having those disclosures available in one place would enhance users’
understanding about fair value and the use of fair value in financial reporting.
Amendment to Opinion 28
C114. In the Exposure Draft, the Board decided that the disclosures required by this
Statement should be made in all interim periods. Some respondents emphasized that those
disclosures, in all interim periods, would not be cost beneficial. The Board acknowledged
those concerns. However, the Board affirmed its conclusion in the Exposure Draft that
fair value disclosures, in interim periods, would provide timely information to users about
fair value estimates and factors affecting the estimates during the year. Moreover,
increased information about fair value on an ongoing basis would enhance users’
understanding about fair value and the use of fair value in financial reporting. Because of
respondents’ concerns, the Board decided to limit the disclosures that are required in
interim periods to quantitative disclosures. In reaching that decision the Board considered
related research, which indicates that presentation of financial information is an important
communications tool. To more clearly communicate the information conveyed by those
quantitative disclosures, the Board decided to require tabular presentation (in all periods).
This Statement amends APB Opinion No. 28, Interim Financial Reporting, accordingly.
Qualitative disclosures, for example, narrative disclosure about the valuation techniques
used to estimate fair value, need be made only in annual periods.
Effective Date and Transition
C115. The Board decided that this Statement should be effective for financial statements
issued for fiscal years beginning after December 15, 2006, and interim periods within
those fiscal years, except as discussed in paragraph C116. Because this Statement applies
under other accounting pronouncements that require fair value measurements and,
therefore, does not require any new fair value measurements, the Board believes that the
effective date of this Statement provides sufficient time for entities, their auditors, and
users of financial statements to analyze, interpret, and prepare for implementation of the
provisions of this Statement. The Board encourages earlier application.
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C116. The Board observed that, to a large extent, the disclosure requirements of this
Statement clarify and codify the fair value information reported under existing accounting
pronouncements. In considering the importance of the information conveyed by those
disclosures, the Board agreed that they should not be deferred until this Statement is
initially applied in its entirety. Therefore, the Board decided that the disclosure
requirements of this Statement should be effective earlier, for financial statements issued
for fiscal years ending after December 15, 2006.
C117. The Board agreed, as it did in the Exposure Draft, that because the substantive
guidance in this Statement focuses broadly on the methods used to estimate fair value,
application of that guidance would result in a change in the method of applying an
accounting principle, which is considered a change in accounting principle. However,
because the methods used to estimate fair value are referred to generally, for example, in
the context of inputs requiring both quantitative and qualitative assessments, the Board
concluded that a change in the methods used to estimate fair value would be inseparable
from a change in the estimates (that is, as new events occur or as new information is
obtained, for example, through better insight or improved judgment). Therefore, the
Board decided that the guidance in this Statement should be applied prospectively (similar
to a change in accounting estimate) as of the first interim period for the fiscal year in
which this Statement is initially applied, except as discussed in paragraph C118.
C118. For blocks held by broker-dealers and certain investment companies, this
Statement specifies the method that should be used to estimate fair value (paragraph 28).
The Board agreed that change in method is a change in accounting principle that would be
separable from the change in the estimate. Because the information necessary to apply
that change in accounting principle retrospectively to all prior periods presented should be
available, the Board decided that change in accounting principle should be applied
retrospectively to all prior periods (similar to a change in accounting principle). The
cumulative effect of the change in accounting principle on periods prior to those presented
should be reflected in the carrying amounts of assets and liabilities as of the beginning of
the first period presented. An offsetting adjustment should be made to the opening
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balance of retained earnings for that period. The disclosures for a change in accounting
principle in paragraphs 17(b)(2) and 18 of Statement 154 are required.
Benefits and Costs
C119. The mission of the FASB is to establish and improve standards of financial
accounting and reporting for the guidance and education of the public, including
preparers, auditors, and users of financial information. In fulfilling that mission, the
Board endeavors to determine that a proposed standard will fill a significant need and that
the costs imposed to meet that standard, as compared with other alternatives, are justified
in relation to the overall benefits of the resulting information. Although the costs to
implement a new standard may not be borne evenly, investors and creditors—both present
and potential—and other users of financial information benefit from improvements in
financial reporting, thereby facilitating the functioning of markets for capital and credit
and the efficient allocation of resources in the economy.
C120. The Board concluded that this Statement will result in improved financial
reporting. In particular, this Statement establishes a single definition of fair value within
GAAP and a framework for measuring fair value that applies broadly under other
accounting pronouncements. A single definition of fair value, together with a framework
for measuring fair value, should result in increased consistency in application and, with
respect to the resulting fair value estimates, increased comparability. Concepts Statement
2 emphasizes that providing comparable information enables users to identify similarities
in and differences between two sets of economic events.
C121. This Statement also enhances disclosures about the use of fair value to remeasure
assets and liabilities, providing information that is useful to present and potential
investors, creditors, and others in making rational investment, credit, and similar
decisions—the first objective of financial reporting in FASB Concepts Statement No. 1,
Objectives of Financial Reporting by Business Enterprises. This Statement encourages
entities to include the fair value information disclosed under this Statement together with
the fair value information disclosed under other accounting pronouncements in one place,
where practicable. The Board concluded that having that information available in one
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place would improve the quality of information provided to users of financial statements
about fair value measurements, thereby enhancing users’ understanding about fair value
and the use of fair value in financial reporting. The Board agreed that because the
disclosures required by this Statement relate to assets and liabilities that are remeasured at
fair value in the statement of financial position and rely largely on the information used
for the remeasurements, they should entail minimal incremental cost.
C122. In addition, the amendments made by this Statement simplify and, where
appropriate, codify the related guidance that currently exists for measuring fair value,
eliminating differences that have added to the complexity in GAAP, consistent with the
Board’s related codification initiatives.
C123. Although the framework for measuring fair value builds on current practice and
requirements, the Board acknowledges that certain methods required by this Statement
may result in a change to practice for some entities—in particular, entities that do not
currently consider the effect of changes in credit standing on the fair value of liabilities
remeasured at fair value (principally, derivative liabilities under Statement 133), broker-
dealers and certain investment companies that use blockage factors to estimate the fair
value of blocks, and entities within the scope of Statement 115 that estimate the fair value
of equity securities with restrictions that terminate within one year using the quoted price
for an identical unrestricted security of the issuer (unadjusted). In addition, some entities
might need to make systems and other changes to comply with the requirements of this
Statement, incurring one-time costs. However, the Board believes that the benefits
resulting from increased consistency and comparability of fair value information and
improved communication of that information to users of financial statements will be
ongoing.
International Financial Reporting Standards
C124. Many International Financial Reporting Standards (IFRS) require fair value
measurements. Like the FASB, the International Accounting Standards Board (IASB) has
addressed issues related to fair value largely in the context of financial instruments, more
recently, in IAS 39 (revised). In developing this Statement, the Board considered the
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comparable fair value measurement guidance in IAS 39 (revised). That guidance in IAS
39 (revised) is largely consistent with the guidance in this Statement, except as otherwise
noted.
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