New fair value standards stress how, not just what: Financial Executives Research Foundation got opinions from users and preparers of financial statements on whether measuring assets and liabilities at fair value--rather than historical cost--provides users with more relevant information for decision-making.

• Author: Sinnett, William M.
• Position: Accounting standards

FAS 157--Statement of Financial Accounting Standards No. 157, Fair Value Measurements--defines fair value and establishes a framework for measuring fair value in generally accepted accounting principles (GAAP). While previous pronouncements involving valuation focused on what to measure at fair value, FAS 157--issued by the Financial Accounting Standards Board (FASB) on Sept. 15,2006--focuses on how to measure fair value.

FAS 157 provides this new definition of fair value: "Fair value is 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 definition abandons a longstanding practice of using the transaction price for an asset or liability as its initial fair value. In other words, fair value will no longer be based on what you pay for something; it will now be based on what you can sell it for, also known as its "exit price."

Just as important, this definition emphasizes that fair value is market-based--requiring the consideration of what other market participants might pay for something--and is no longer entity-specific. Valuation will now be determined by a skeptical, rather than optimistic, buyer.

In turn, the level of data available to measure fair value will determine how the valuation of an asset or liability is determined. Common valuation techniques identified by FAS 157 are the market approach, income approach and/or cost approach. These models require inputs that reflect assumptions that market participants would use in pricing an asset or liability. Observable inputs would be based on market data obtained from independent sources, such as stock exchange prices.

Meanwhile, in the absence of an active market for an asset or liability, unobservable inputs reflect the reporting entity's own assumptions. The standard provides a fair value hierarchy that gives highest priority to quoted prices in active markets (defined as Level 1) and lowest priority to unobservable inputs (Level 3).

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"Fair value is already a familiar concept and currently used in the financial services industry," says Mary Kay Scucci, CFO of Bear Stearns Asset Management. She adds that fair value is very valuable for financial assets, and that FAS 157 provides an additional benefit for financial services firms, as it eliminates the existing deferral of unrealized day one gains (EITF 02-3) "The enhanced disclosure requirements in FAS...