by Rick Wittgren,

While Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157) does not necessarily require any new fair value measurements, this pronouncement may significantly change how organizations apply fair value measurements.

SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. It applies to an organization’s financial statements for years beginning after November 15, 2007, and interim periods within those fiscal years.

SFAS 157 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” This also is referred to as an exit price and conceptually it may differ from the price paid to acquire an asset or the price received to assume a liability (an entry price). The definition of fair value assumes the transaction to sell the asset or transfer the liability will occur in the principal market, or if there is no principal market, the most advantageous market to the seller. Transaction costs are excluded from fair value measurements; however, such costs are included in determining the net amount to be received or paid for purposes of identifying the most advantageous market.

One of the most notable provisions of SFAS 157 is this standard establishes a fair value hierarchy that prioritizes the inputs used in various valuation techniques into three broad levels, considering the relative reliability of the inputs. The three levels of the fair value hierarchy are as follows:

• Level 1 (highest priority) – Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities. An example of a financial instrument likely to be categorized within Level 1 is an investment in the stock of a company that is actively traded on a national exchange, such as the New York Stock Exchange.
• Level 2 – Inputs other than quoted prices included in Level 1 that are observable, either directly or indirectly. This may include quoted prices for similar (vs. identical) assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active or inputs other than quoted prices that are observable, e.g., interest rates such as London Interbank Offered Rate (LIBOR) observable at commonly quoted intervals. An example of a financial instrument that may be categorized within Level 2 is a receive fixed/pay variable interest rate swap agreement based on LIBOR for which fair value was estimated using a mathematical model with observable inputs.
• Level 3 (lowest priority) – Unob- servable inputs such as a reporting entity’s own assumptions. An example of a financial instrument that would likely be categorized within Level 3 is an alternative investment for which there are no quoted market prices available and no active market for the organization’s interest in such an investment.

Finally, SFAS 157 expands the current disclosure requirements related to fair value. For assets and liabilities that are measured at fair value on a recurring basis, organizations are required to disclose fair value measurements at the reporting date; the level within the fair value hierarchy (Level 1, 2, or 3) that each fair value measurement falls and the valuation technique(s) used to measure fair value and a discussion of changes in valuation techniques, if any, during the period. The disclosure requirements for fair value measurements categorized as Level 3 are further expanded to include a reconciliation of the beginning and ending balances, including purchases, sales, issuances and settlements (net) and transfers in and/or out of Level 3. Other disclosures specific to Level 3 measurements include the amount of the total gains or losses (realized or unrealized) included in the change in net assets, as well as a description of where those gains and losses are reported in the statement of activities, including separate disclosure of the portion that is attributable to those assets and liabilities still held at the reporting date.

For assets and liabilities that are measured at fair value on a nonrecurring basis in periods subsequent to initial recognition, organizations are required to disclose fair value measurements recorded during the period and the reasons for the measurements; the level within the fair value hierarchy (Level 1, 2, or 3) each fair value measurement falls and the valuation techniques used to measure fair value and a discussion of changes in valuation techniques, if any, used to measure similar assets and/or liabilities in prior periods. For fair value measurements using significant unobservable inputs (Level 3), a description of the inputs and the information used to develop the inputs should also be disclosed.

It is important to address these complex provisions of FAS 157 early. Contact your BKD advisor to assist you in understanding FAS 157 and how it applies to your organization, so you can begin the implementation process early. Organizations should pay special attention to financial instruments that are not actively traded on a stock exchange—alternative investments, interest rate swaps, etc. The fair value of such instruments may be estimated using matrix pricing, a proprietary model, dealer estimates or other methods, which will result in either a Level 2 or Level 3 measurement. Financial instruments that have liquidity restrictions, restraints, obligations or other restrictive covenants on an organization’s ability to withdraw or transfer funds could result in the need to discount the fair value measurement in question. An example of such a situation would be an investment in a private equity fund that prohibits distributions for a predetermined number of years. Such a situation may result in an organization determining a discount to the fair value measurement is appropriate to reflect the risk relating to the inability of market participants to unconditionally liquidate such an investment.