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Thursday, October 7, 2010

Measuring Liabilities at Fair Value


On Aug. 27, 2009, the FASB issued Accounting Standards Update No. 2009-05, Measuring Liabilities at Fair Value. The ASU reports on some important amendments such as guidance on measuring the fair value of liabilities under what previously was referred to as FAS 157 and now is ASC 820, Fair Value Measurements and Disclosures.

Background

ASC 820 defines fair value as “the price that would be received to sell an asset or pay to transfer a liability in an orderly transaction between market participants at the measurement date.” An “orderly” transaction is one that isn’t a forced liquidation or distressed sale.

The ASC establishes a three-tier valuation hierarchy. Highest priority is given to Level 1 inputs — quoted prices in active markets for identical assets or liabilities. Lower priority is given to Level 2 inputs — prices in active markets for similar assets or liabilities or other “observable” inputs. And lowest priority is given to “unobservable” inputs — such as the reporting entity’s own data.

Challenges in Valuing Liabilities

ASC 820 presents several challenges for entities required to measure the fair value of liabilities. For one thing, its definition of fair value presumes that a liability would be transferred in a hypothetical orderly transaction between market participants. But in practice, liabilities are rarely transferred in the marketplace, mainly because of contractual restrictions that prevent such transfers.

Also, the ASC requires that a liability’s fair value reflect nonperformance risk (including the reporting entity’s own credit risk) and that such risk be the same before and after a hypothetical transfer. But in the limited circumstances in which a liability is transferred to another party, it’s not unusual for the transferee’s nonperformance risk to be lower or higher than the transferor’s.

The New Guidance

ASU 2009-05 covers amendments that address these concerns. The amendments confirm that, for purposes of the ASC, it is assumed that a liability is transferred to a market participant rather than settled.

The amendments provide that an entity should first determine whether a quoted price in an active market for the identical liability is available (that is, a Level 1 measurement). If not, the entity should measure fair value with one or more valuation techniques that:

  • use the quoted price of the identical liability when traded as an asset,
  • use quoted prices for similar liabilities or similar liabilities when traded as assets, or
  • are consistent with ASC 820’s principles, such as certain income- or market-based techniques — for example, a present value technique.

Whichever techniques are used, the amendments call for maximizing the use of observable inputs and minimizing the use of unobservable inputs. The amendments also clarify that an unadjusted price quote for an identical liability traded as an asset in an active market is a Level 1 measurement.

But the amendments require reporting entities to determine whether adjustments are needed to reflect factors specific to the asset. This may be the case if, for example, a quoted price for the asset relates to a similar (but not identical) liability traded as an asset or if the price reflects a third-party credit enhancement (such as private mortgage insurance or a letter of credit from a bank). These types of adjustments will require the fair value measurement to be treated as a Level 2 or Level 3 measurement.

The amendments provide that an entity should not include a separate input or adjustment related to contractual restrictions on the transfer of a liability. The reason for this is that the impact of such a restriction “is either implicitly or explicitly already included in the other inputs to the fair value measurement.”

The amendments also include three “cases” that provide examples of measuring liabilities under ASU 820.

Get Ready

The amendments reported in ASU 2009-05 are effective for the first reporting period (including interim periods) beginning after Aug. 27, 2009. FASB is also considering additional amendments to ASC 820 that would provide further guidance on fair value disclosures. Please contact us for the latest information and to discuss the implications of the most recent amendments for your company. We’d be pleased to provide assistance in adapting your valuation procedures to meet the new requirements.

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