The following article is reprinted from the Quarter 1, 2008 issue
of On the Edge, the Interactive Data Fixed Income Analytics Quarterly newsletter.
FAS 157 - Fair Value Measurements
Teri Geske
Senior Vice President, Business and Product Development
FAS 157, the accounting standard that defines fair value reporting of financial assets and liabilities, became effective as of November 15, 2007. FAS 157 requires that companies disclose the methodology used to value their investments, so it is not surprising that we have fielded a number of inquiries recently about the source of prices in BondEdge. Also, given the crisis of confidence caused by plummeting sub-prime mortgage valuations and the market’s outright inability to price many ABS and CDOs of ABS, it is understandable that portfolio managers, their clients and their auditors are focusing on the issue of valuation. While BondEdge is not a pricing source and therefore cannot be relied upon to respond to FAS 157-related requirements, we thought it would be useful to provide some background about FAS 157.
FAS 157 Overview
In a nutshell, FAS 157 is designed to give investors and other stakeholders information about the source of information used to price investments as well as other assets and liabilities. One goal of FAS 157 is to indicate how objective or subjective are the valuations presented in financial statements. As explained below, FAS 157 establishes a hierarchy of inputs, recognizing that some prices can be obtained directly from exchanges, some are observable from actual, same-day trades, while in many cases only a “modeled” price is available.
FAS 1571 defines fair value, establishes a framework for measuring fair value, and requires statement preparers to disclose information about their fair value determinations in their financial statements. It establishes a fair value hierarchy based on the nature of data inputs used to determine fair value, and statement preparers are required to value assets using assumptions that market participants would employ to value that asset. When other assumptions are used to value an asset, FAS 157 requires that additional information about the assumptions be disclosed, along with the effects on earnings or changes in net assets for the period.
Inputs to Fair Value Determinations
FAS 157 states that "inputs refer broadly to the assumptions that market participants would use in pricing the asset or liability, including assumptions about risk…” It characterizes inputs as observable or unobservable, and requires that statement preparers “maximize the use of observable inputs and minimize the use of unobservable inputs.” 2
- "Observable inputs are inputs that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the reporting entity."
- "Unobservable inputs are inputs that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset of liability developed based on the best information available in the circumstances.” 3
Fair Value Hierarchy
FAS 157 sets forth a fair value measurement hierarchy for inputs. When a valuation utilizes inputs that are in different levels, the fair value hierarchy level is “determined based on the lowest level input that is significant to the fair value measurement in its entirety.” 4 The fair value hierarchy levels are summarized below.
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Level 1 inputs are “quoted prices (unadjusted) in active markets for identical assets” for the instrument or security to be valued. A commonly cited example is a New York Stock Exchange closing price.5
- Level 2 inputs are inputs that are “observable for the asset or liability, either directly or indirectly”. FAS 157 provides several examples of level 2 inputs, including: “quoted prices for similar assets and liabilities in active markets”; “quoted prices for identical or similar assets or liabilities in markets that are not active…”; “interest rates and yield curves observable at commonly quoted intervals, volatilities, prepayment speeds, loss severities, credit risks and default rates”; and “inputs that are derived principally from or corroborated by observable market data by correlation or other means (market-corroborated inputs).” 6
- Level 3 inputs are “unobservable” and contain the assumptions of the party fair valuing the asset or liability. FAS 157 states: “Unobservable inputs shall be used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any market activity for the asset or liability…” 7
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As noted above, BondEdge is not a pricing service. The prices in BondEdge are intended to be indicative of current market levels and are provided as a courtesy in support of our analytics but are not intended to be used as an official source for the purpose of reporting investment values. Therefore, we cannot offer any official pricing methodology papers for FAS 157 purposes. For questions regarding how the various security types in BondEdge are modeled, please refer to the document “A Quick Guide to Security Models in BondEdge” (updated October 2007, available via the BondEdge Private Client Website).
1 Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 157: Fair Value Measurements, (September 2006), effective for financial statements for fiscal years beginning after November 15, 2007.
2 Ibid., 9.
3 Ibid., 9.
4 Ibid., 9.
5 Ibid., 10.
6 Ibid., 11.
7 Ibid., 11-12.
If clients have FAS 157 designations in their accounting system, values can be imported via the Expand file into the Custom Report Writer for reporting, scanning, etc. Please contact your BondEdge Consultant for assistance.
