Fair Value Accounting: SFAS 157 and IAS 39
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Fair Value Accounting: SFAS 157 and IAS 39
by Kevin Ow Yong
Executive Summary
• Fair value accounting is increasingly being adopted by many countries across the world.
• When financial instruments are not traded in active markets, fair value accounting involves subjective
estimations based on valuation models.
• There are many measurement considerations that managers need to be aware of when making
subjective valuation estimates of their firms’ financial instruments.
• Understanding these measurement issues aids managers in considering how best to manage their
firms’ assets and liabilities in a fair-value-driven accounting regime.
Introduction
Recent initiatives by both the International Accounting Standards Board (IASB) and the US Financial
Accounting Standards Board (FASB) have increased the use of fair value accounting for financial reporting
across many jurisdictions around the world. There are many issues surrounding fair value accounting. This
article outlines the main measurement issues contained in the fair value accounting standard used by the
FASB (SFAS 157), and that used by the IASB (IAS 39).
The Rationale for Fair Value Accounting
The increasing use of fair value accounting in financial reporting came about because accounting standard
setters have debated, and come to the conclusion that fair value appears to meet the conceptual framework
criteria better than other measurement bases (for example, historical cost, amortized cost, among others).
Notwithstanding this rationale, a major issue with fair value accounting is the difficulty of measurement
(“subjective estimates”) when financial instruments do not trade in active markets. Both SFAS 157 and IAS
39 provide measurement guidance as to how firms should compute fair value estimates in such a situation.
Fair Value Accounting Based on SFAS 157
SFAS 157 details the framework for measuring fair value for firms reporting their financial statements based
on US GAAP. Prior to this standard, there were different definitions of fair value, and limited guidance in the
applications of those definitions. SFAS 157 provides a consistent definition of fair value, outlines several
types of valuation techniques that can be used to measure fair value, and requires firms to disclose their
valuation inputs (the “fair value hierarchy”), in order to increase consistency and comparability in fair value
measurements.
The standard 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” (paragraph 5).
This definition focuses on the price that would be received to sell the asset or paid to transfer the liability
(“exit price”), not the price that would be paid to acquire the asset or received to assume the liability (“entry
price”). An orderly transaction assumes that the firm has sufficient time to market the asset. Hence, fair
value estimates should not be estimated as in a forced liquidation or distress sale, contrary to some
misconceptions about fair value accounting.
SFAS 157 states three valuation techniques which can be used for estimating fair values. They are the
market approach, income approach, and/or cost approach (paragraph 18). A market approach typically uses
quoted prices in active markets, but other valuation techniques consistent with the market approach include
the use of market multiples derived from a set of comparables, and matrix pricing that allows a firm to value
securities without relying exclusively on quoted prices.
Fair Value Accounting: SFAS 157 and IAS 39 1 of 6
www.qfinance.comThe second approach is the income approach. The income approach uses valuation techniques to convert
future amounts (cash flows or earnings) to a single present value amount. Examples of such valuation
techniques include present value discounted cash flows, option pricing models (for example, the Black–
Scholes–Merton formula, or a binomial model), and the multi-period excess earnings method. Finally, the
cost approach is based on the amount that would be required to replace the service capacity of an asset.
From the perspective of a seller, the price that would be received for the asset is determined based on the
cost to a buyer to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence
such as physical, functional (technological), and economic (external) obsolescence.
SFAS 157 establishes a fair value hierarchy that prioritizes the inputs to valuation techniques that are used
to measure fair value. Broadly speaking, inputs refer to the assumptions that market participants would use
in pricing the asset or liability, including assumptions about risk. The standard specifies the use of valuation
techniques that maximize the use of observable inputs (i.e., based on market data obtained from sources
independent of the firm), and minimize the use of unobservable inputs (i.e, inputs that reflect the firm’s own
assumptions as to how market participants would price an asset or liability) (paragraph 21).
Specifically, a firm is to use Level 1 inputs (unadjusted quoted prices in active markets) on the assumption
that a quoted price in an active market provides the most reliable evidence of fair value. It shall be used
whenever available (paragraph 24), except when it is available but not readily accessible (paragraph 25), or
when it might not represent fair value at the measurement date (paragraph 26). If observable prices are not
available, the firm can value its assets based on Level 2 inputs (observable inputs other than quoted prices
included within Level 1). Level 2 inputs are inputs such as (i) quoted prices for similar (but not identical)
assets or liabilities in both active and inactive markets, and (ii) inputs other than quoted prices such as
interest rates and yield curves, credit risks, default risks, and other inputs that can be derived principally from
observable market data by correlation, or other means (market-corroborated inputs). A Level 2 input must be
substantially observable for the full term of the asset or liability.
Finally, to the extent that observable Level 2 inputs are not available (for example, situations in which there
is little market activity for the asset or liability at measurement date), Level 3 inputs can be applied. These
are the firm’s own assumptions about how other market participants would price the asset or liability. To
ensure that there is information that will enable financial statement users to assess the quality of inputs used
to estimate these fair value measurements, the standard requires firms to disclose information (separately
for each major category of assets and liabilities), both quantitative information that shows how the fair value
measurements are segregated based on the valuation inputs, and qualitative information that details the
valuation techniques used to measure fair value. The quantitative disclosures are to be presented in tabular
format. An example is given in the Case Study.
Fair Value Accounting Based on IAS 39
IAS 39 details the principles for recognizing and measuring financial instruments for firms that report their
financial statements under IFRS. IAS 39 defines fair value slightly differently from SFAS 157. Fair value is
defined as “the amount for which an asset could be exchanged, or a liability settled, between knowledgeable,
willing parties in an arm’s length transaction” (paragraph 9).
There are some subtle language differences between the fair value definition in SFAS 157 versus that in IAS
39. SFAS 157’s definition is explicitly based on the concept of an “exit price,” whereas IAS 39’s definition is
based neither on “exit price,” nor “entry price.” SFAS 157 uses the “market participants” view whereas IAS
39’s definition uses the concept of “willing buyer and seller.” SFAS 157 states that the fair value of a liability
is the price that will be paid to transfer a liability, whereas IAS 39 defines the fair value of a liability as the
amount for which it can be settled. The IASB has asked for respondents’ views on these differences.
As with SFAS 157, IAS 39 states that fair value estimation is not the amount that a firm would receive or pay
in a forced transaction, involuntary liquidation, or distress sale (paragraph A69). Also consistent with SFAS
157, IAS 39 regards the best evidence of fair value as quoted prices in an active market (paragraph 48).
Finally, while IAS 39 does not explicitly classify valuation inputs into Level 1, Level 2, and Level 3 categories
as specified in SFAS 157, it does specify that the chosen valuation technique should make maximum use of
market inputs and rely as little as possible on firm-specific inputs.
Fair Value Accounting: SFAS 157 and IAS 39 2 of 6
www.qfinance.comRegarding the measurement issues relating to fair value estimation, IAS 39 provides three classifications:
Active markets for which quoted prices are available, inactive markets for nonequity instruments, and
inactive markets for equity instruments. For financial instruments trading in active markets, the appropriate
quoted market of an asset held (or liability to be issued) is the current bid price, whereas for assets to be
acquired (or liability held), it is the current ask price. When current bid and ask prices are unavailable, the
price of the most recent transaction can be used provided that there has not been a significant change in
economic circumstances since the time of the transaction. Furthermore, quoted prices can be adjusted if the
firm can demonstrate it is not fair value (for example, distress sales).
In the absence of an active market for a nonequity financial instrument, IAS 39 specifies that the preferred
valuation technique to be used is the valuation technique that is shown to be commonly used by market
participants to price the instrument (for example, if the valuation technique has been demonstrated to be
able to provide reliable estimates of fair value obtained in actual market transactions). The chosen valuation
technique needs to be consistent with established economic methodologies for pricing financial instruments,
and the firm needs to calibrate the valuation technique periodically by testing it for validity using prices from
any observable current market transactions in the same instrument (or based on any available observable
market data).
Finally, for equity instruments (and any linked derivatives) that do not have a quoted market price in active
markets, IAS 39 specifies that these instruments are to be measured at fair values only if the range of
reasonable fair value estimates is not significant, and the probabilities of the various estimates can be
reasonably assessed. Otherwise, the firm is precluded from measuring these instruments at fair value.
Case Study
Two examples are given that show how financial assets and liabilities are disclosed, as reported by HSBC
Finance Corporation, which is incorporated in the US, and HSBC Bank plc, a UK entity. Evidently, HSBC
Finance Corporation categorized and reported the fair values of its assets and liabilities based on the nature
of valuation inputs (Note 15 to the accounts). For example, the firm reported US$3,136 million of available-
for-sale securities, of which US$354 million were fair value estimates from quoted prices in active markets
(Level 1), US$2,743 million were fair value estimates from Level 2 inputs and US$39 million originated from
Level 3 valuation inputs.
In contrast, HSBC Bank plc has traditionally reported its fair values by measurement basis (for example,
£427,329 million as trading assets) in its Notes on the Financial Statements (Note 15: Analysis of financial
assets and liabilities by measurement basis). To provide additional disclosures that are similar to SFAS 157’s
disclosure requirements, HSBC Bank plc disaggregated its £427,329 million of trading assets into fair value
estimates that were derived from quoted prices (£234,399 million), versus those fair value estimates that
were based on valuation methods using observable inputs (£185,369 million), and significant nonobservable
1
inputs (£7,561 million).
Further Considerations
Recent illiquidity in some financial markets due to the subprime crisis has highlighted to standard setters the
need to provide additional guidance in the measurement of fair value of financial instruments in markets that
are not active. The IASB formed an expert advisery panel in mid-2008 to discuss specific issues encountered
in the current adverse market environment. Likewise, the FASB issued FSP FAS 157-3, Determining the fair
value of a financial asset in a market that is not active, to clarify how management’s internal assumptions
and observable market information should be considered when measuring fair value in markets that are not
active, as well as how market quotes such as broker quotes should be considered in measuring fair value.
First, while broker quotes may be an appropriate input when measuring fair value, they are not necessarily
determinative if an active market does not exist for the financial market. Thus, the firm should not
automatically conclude that a particular transaction price is determinative of fair value. In markets that are not
active, managerial judgment is required to evaluate whether individual transactions are forced liquidations or
distressed sales.
Fair Value Accounting: SFAS 157 and IAS 39 3 of 6
www.qfinance.comHaving said that, it is also inappropriate to automatically conclude that an inactive market implies
the presence of forced transactions. The determination of whether a transaction is forced requires a
comprehensive understanding of the circumstances of the transaction. Examples of what may constitute a
forced transaction include a legal requirement to transact regardless of market conditions, or a necessity to
dispose an asset immediately, even if there is insufficient time to market that asset to be sold. Hence, the
presence of an inactive market may simply reflect an imbalance between supply and demand (i.e., more
sellers than buyers), and not represent evidence of forced transactions (or distress sales).
Finally, the standard setters also clarify that, regardless of the valuation technique used to estimate fair
values, a firm should always include appropriate risk adjustments that take into account credit and liquidity
risks. This is because a fair value estimate that does not take into account all factors that market participants
would consider in pricing the instrument does not represent a fair estimate of a current transaction price on
the measurement date.
Going Forward
The IASB is currently working on several long-term projects that will further clarify guidance on fair
value measurements. First, the IASB is working to establish a single source of guidance for all fair value
measurements required or permitted by existing IFRSs, so as to reduce complexity, and improve consistency
in their application. This project is similar in intent to SFAS 157, although it might differ in its requirements
and wording. Publication of the exposure draft is expected in the second quarter of 2009, and the effective
date to publish the standard is projected to be in 2010.
Second, the IASB is currently working to simplify and improve IAS 39. The board recognizes the need to
improve the reporting of financial instruments, and to reduce the complexity of that reporting. In March 2008,
the IASB published a discussion paper, Reducing Complexity in Reporting Financial Instruments. Going
forward, the IASB plans to issue an IFRS to simplify financial instrument reporting, although no specific
timeline has been set.
Third, the financial crisis has raised concerns that users need further information on how firms estimate the
fair value of their financial instruments when there are only limited market data to support those estimates.
In October 2008, the IASB published an exposure draft, Improving Disclosures about Financial Instruments,
that proposes amendments to IFRS 7 (Financial Instruments: Disclosures). The exposure draft proposes
disclosure requirements that are similar to the disclosure requirements in SFAS 157, such as having the
three-level, fair value hierarchy. Depending on the comments received, the board will deliberate whether to
proceed with amending IFRS 7.
Similarly, the FASB has also announced the addition of new FASB agenda projects intended to improve both
the application guidance used to determine fair values, and the disclosure of fair value estimates. These
projects were added partly in response to recommendations contained in the December 2008 Securities
and Exchange Commission’s (SEC) report on mark-to-market accounting. The SEC report recommended
against suspension of fair value accounting standards, and reaffirmed that investors generally believe
fair value accounting increases financial reporting transparency. The FASB anticipates that the project
on application guidance will be completed by the end of the second quarter of 2009, and the project on
improving disclosures in time for 2009 year-end financial reporting.
Conclusion
The trend toward fair value accounting appears to be irreversible. Fair value accounting requires recognition
of balance sheet amounts at fair value, and changes in fair values to have an impact on the income
statement, or via stockholder equity. Managers should be aware of the various measurement issues involved
in valuing the financial instruments in their companies, especially when subjective fair value estimates are
involved.
Figure 1. HSBC Finance Corporation 10-Q filing for period ended September 30, 2008. (Source: “Notes to
accounts—Fair value measurements,” www.hsbcusa.com/hsbc_finance/financial_reports.html)
Fair Value Accounting: SFAS 157 and IAS 39 4 of 6
www.qfinance.comFigure 2. Extract from “Notes on the financial statements: Analysis of financial assets and liabilities by
measurement basis.” (Source: HSBC Bank plc, Annual Report 2008, www.hsbc.com/1/2/financialresults)
Figure 3. Extract from “Report of the directors: Impact of market turmoil.” (Source: HSBC Bank plc, Annual
Report 2008, www.hsbc.com/1/2/financialresults)
Making It Happen
Managers need to consider some important considerations when implementing fair value accounting. For
example:
• The availability of observable market inputs, and how that would affect the estimation of fair values;
• The validity of valuation models used to estimate subjective fair values, given that valuation models
might overlook certain key assumptions;
• The possible impact of increased volatility in their firms’ earnings, and/or valuations as a result of fair
value accounting, and how best to mitigate the increased volatility;
• The potential of systemic risk (or contagion risk) during periods of rapidly falling markets.
More Info
Reports:
• FASB. “FASB staff position no. FAS 157-3. Determining the fair value of a financial asset when the
market for that asset is not active.” October 10, 2008. Online at: www.fasb.org/pdf/fsp_fas157-3.pdf
• FASB. “Summary of statement no.157: Fair value measurements.” Online at: www.fasb.org/st/
summary/stsum157.shtml
• IASC Foundation. “Technical summary. IAS 39 Financial Instruments: Recognition and Measurement.”
Online at: www.iasb.org/NR/rdonlyres/339C384D-045B-47D7-AA8E-8D26DFA726FB/0/IAS39.pdf
• IASB Expert Advisery Panel. “Measuring and disclosing the fair value of financial
instruments in markets that are no longer active.” October 2008. Online at:
www.iasb.org/NR/rdonlyres/0E37D59C-1C74-4D61-A984-8FAC61915010/0/
IASB_Expert_Advisery_Panel_October_2008.pdf
• US Securities and Exchange Commission. “Report and recommendations pursuant to Section 133 of
the Emergency Economic Stabilization Act of 2008: Study on mark-to-market accounting.” Online at:
www.sec.gov/news/studies/2008/marktomarket123008.pdf
Websites:
• Financial Accounting Standards Board (FASB): www.fasb.org
• International Accounting Standards Board (IASB): www.iasb.org
See Also
Best Practice
• Effective Financial Reporting and Auditing: Importance and Limitations
• Has Financial Reporting Impacted on Internal Auditing Negatively?
• The Rationale of International Financial Reporting Standards and Their Acceptance by Major Countries
• Understanding the Requirements for Preparing IFRS Financial Statements
Checklists
• Balancing Hedging Objectives with Accounting Rules (FAS 133)
• International Financial Reporting Standards (IFRS): The Basics
• Key Accounting Standards and Organizations
• The Ten Accounting Principles
• Understanding the Key Components of GAAP: The Continuing Concern Concept
Finance Library
Fair Value Accounting: SFAS 157 and IAS 39 5 of 6
www.qfinance.com• Financial Accounting and Reporting
Industry Profile
• Banking and Financial Services
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