The debate over one of the most controversial accounting standards in recent memory is coming to a somewhat anticlimactic end. The rule once known as FAS 157, which tells companies how to measure the fair value of assets and liabilities, has been rewritten and rechristened Topic 820. Now in final draft form, Topic 820 is open to comment until September 7.
Since the onset of the financial crisis, banks and their lobbyists have gone head-to-head with the Financial Accounting Standards Board and the International Accounting Standards Board, arguing against any rule changes that would increase the volatility of asset values — or worse, depress the book value of financial assets while the market recovered. FAS 157, which went into effect in 2009, was caught up in the debate and frequently vilified as a major cause of bank liquidity problems.
Yet in retrospect, the controversy seems misplaced. FAS 157 did not change what companies measured at fair value, or when they needed to apply fair-value accounting. Indeed, those mandates are part of other accounting standards (most notably the reworked rule on financial instruments). Instead, FAS 157 laid out a common methodology for measuring the market value of assets and liabilities.
The revised rule will affect more than just banks and other financial institutions that routinely measure the fair value of financial instruments, says Greg Forsythe, a valuation specialist at Deloitte Financial Advisory Services. All companies with accounts required to be measured at their fair value are fair game for Topic 820 — although the depth of that impact is relative to how much of a company’s accounting is centered on fair value. Nonfinancial companies involved in acquisitions, for example, will have to rework some calculations and disclosures related to goodwill-impairment testing if the rule is issued in its current form, notes Forsythe.
Most experts agree that the measurement guidance contained in Topic 820 does little more than clarify existing rules. But the disclosure provisions will undergo one big change related to so-called Level 3 assets and liabilities, the most difficult kind to measure. (Unlike Level 1 holdings, which can be measured using quoted prices in active markets, and Level 2 holdings, which are valued based on “observable inputs” such as quoted prices in similar markets, Level 3 items are illiquid assets and liabilities that must be valued using internal models and “unobservable inputs.”)
Topic 820 requires more disclosures around the measurement of uncertainty with respect to Level 3 assets and liabilities, says David Larsen, a managing director at Duff & Phelps, a financial advisory firm. Specifically, if the fair value of an item changes significantly when a different — but just as “reasonable” — input is used in the calculation, then the alternative fair value and input must be disclosed in the financial statements. Such modeling is often used, for instance, when it makes sense to plug in different growth rates or discount rates in discounted cash-flow calculations. FASB recommends using a table format to display alternative inputs and changes in fair value.
As the economy improves, markets will revive and there will be fewer Level 3 assets and liabilities, predicts Forsythe. “To a large extent, this whole concept of Level 3 didn’t exist until the credit crisis hit, because there was always a market to mark to,” he says.
The Topic 820 draft also cleans up some language in FAS 157, but the tweaks should not have an impact on the actual measurement of assets, says Forsythe. For example, the draft now states more clearly that under certain circumstances, companies will be permitted to measure financial assets and liabilities that are managed together in a portfolio on a net basis, rather than measuring the fair value of each instrument on a gross basis. The net measurement tends to be common practice among banks, but its usage parameters are not spelled out in the current rule.
Similarly, the language referring to an asset’s “highest and best use” has been tidied up, making it clear that the phrase, which comes from the real estate industry, is “relevant only when measuring the fair value of nonfinancial assets.” In addition, this time around, FASB is definitive about banning the use of “blockage discounts” to calculate the fair value of big chunks of stock. Instead, the draft rule clearly instructs companies to use the stated price of the stock at the time of the trade, multiplied by the number of shares, to determine the fair value.
Meanwhile, the draft of a similar fair-value rule has been released by the IASB and is scheduled to be issued in its final form at about the same time FASB releases the definitive version of Topic 820 (no later than early 2011). The IASB is in the same boat FASB was in before it released FAS 157, since previously all references to fair-value calculations were contained in other international standards. Given that the U.S. and international proposed rules are so similar, they are particularly well suited for accounting convergence, notes Larsen.