OCTOBER 21, 2005 WORKING DRAFT Financial Accounting Series · Statement of Financial Accounting...

OCTOBER 21, 2005 WORKING DRAFT

Financial Accounting Series

Statement of Financial Accounting

Standards No. 15X

Fair Value Measurements

Financial Accounting Standards Boardof the Financial Accounting Foundation

Summary

This Statement defines fair value, establishes a framework for measuring fair value

in generally accepted accounting principles (GAAP), and enhances disclosures about fair

value measurements. This Statement applies broadly under other accounting

pronouncements that require fair value measurements, the Board having previously

concluded in those accounting pronouncements that fair value is the relevant measurement

attribute. Accordingly, this Statement does not require any new fair value measurements.

Reason for Issuing This Statement

Prior to this Statement, there were different definitions of fair value and limited

guidance for applying those definitions within GAAP. Moreover, that guidance was

dispersed among the many pronouncements that require fair value measurements.

Differences in that guidance created inconsistencies that added to the complexity in

GAAP. The Board decided to address those issues in this Statement. In developing this

Statement, the Board considered the need for increased consistency and comparability in

estimates of fair value and enhanced disclosures about the estimates.

Differences between This Statement and Current Practice

The changes to current practice resulting from the application of this Statement

relate to the definition of fair value, the methods used to estimate fair value, and the

requirement for expanded disclosures about estimates of fair value.

This Statement clarifies that fair value is the price that would be received for an

asset or paid to transfer a liability in a current transaction between marketplace

participants in the reference market for the asset or liability. In the absence of a

transaction involving the entity, the estimate of fair value is determined by reference to a

hypothetical transaction for the asset or liability at the measurement date (the effective

valuation date).

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For a liability, the estimate of fair value should reflect the price that would be paid in

a current transaction between marketplace participants of comparable credit standing.

Therefore, an entity should consider the effect of changes in its credit standing on the

creditworthiness of the liability in all periods in which the liability is remeasured at fair

value under other accounting pronouncements, including FASB Statement No. 133,

Accounting for Derivative Instruments and Hedging Activities.

This Statement affirms the Board’s decision in other FASB Statements that the fair

value of a large position of an unrestricted security with a quoted price in an active market

(block) should be estimated as the product of the quoted price times the quantity held,

thereby precluding the use of a blockage factor. This Statement extends that guidance to

broker-dealers and investment companies within the scope of the AICPA Audit and

Accounting Guides for those industries.

This Statement defines a restricted security as a security for which sale is legally

restricted by governmental or contractual requirement for a specified period, whether the

restriction limits sale (for example, to qualifying investors) or prohibits sale. This

Statement establishes the general principle that the fair value of a restricted security

should be estimated based on the quoted price for an otherwise identical unrestricted

security of the same issuer, adjusted as appropriate for the effect of the restriction. That

general principle applies even if the restriction terminates within one year, as is the case

for restricted stock measured at fair value under FASB Statement No. 115, Accounting for

Certain Investments in Debt and Equity Securities.

This Statement expands disclosures about the use of fair value to remeasure assets

and liabilities recognized in the statement of financial position. The disclosures focus on

the inputs used to develop estimates of fair value and the effects of the estimates on

income (or changes in net assets) for the period. This Statement encourages entities to

combine the fair value information disclosed under this Statement with the fair value

information disclosed under other accounting pronouncements, including FASB Statement

No. 107, Disclosures about Fair Value of Financial Instruments, where practicable.

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How the Changes in This Statement Improve Financial Reporting

A single definition of fair value, together with a framework for measuring fair value,

should result in increased consistency and comparability in estimates of fair value.

The expanded disclosures about the use of fair value to remeasure assets and

liabilities should improve the quality of information provided to users of financial

statements.

The amendments made by this Statement advance the Board’s initiatives to simplify

and codify the accounting literature, eliminating differences that have added to the

complexity in GAAP.

How the Conclusions in This Statement Relate to the FASB’s Conceptual Framework

The fair value framework considers the concepts in FASB Concepts Statement

No. 2, Qualitative Characteristics of Accounting Information, which emphasizes that

providing comparable information enables users of financial statements to identify

similarities in and differences between two sets of economic events.

The definition of fair value considers the concepts relating to assets and liabilities in

FASB Concepts Statement No. 6, Elements of Financial Statements, which defines assets

in terms of future economic benefits (future inflows) and liabilities in terms of future

sacrifices of economic benefits (future outflows).

The guidance for applying the definition of fair value incorporates the related

concepts in FASB Concepts Statement No. 7, Using Cash Flow Information and Present

Value in Accounting Measurements. In particular, Concepts Statement 7 establishes that

the most relevant measure of a liability always reflects the credit standing of the entity

obligated to pay. In addition, this Statement incorporates and clarifies the guidance in

Concepts Statement 7 for using present value techniques to estimate fair value. The

clarifications do not change the substantive guidance in Concepts Statement 7 or the

application of that guidance under existing accounting pronouncements. Therefore, this

Statement does not revise Concepts Statement 7. The Board expects to consider the need

to revise Concepts Statement 7 in its conceptual framework project.

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The expanded disclosures consider the need to provide information about the use of

fair value to remeasure assets and liabilities that is useful to users of financial statements

(present and potential investors, creditors, and others in making rational investment,

credit, and similar decisions)—the first objective of financial reporting in FASB Concepts

Statement No. 1, Objectives of Financial Reporting by Business Enterprises.

Costs and Benefits of Applying This Statement

Although the guidance in this Statement builds on current practice and requirements,

some entities will need to make changes to comply with the requirements of this

Statement, thereby incurring one-time costs. However, the benefits from increased

consistency and comparability in estimates of fair value and expanded disclosures about

those estimates should be ongoing.

The Effective Date of This Statement

This Statement is effective for financial statements issued for fiscal years

beginning after December 15, 2006, and interim periods within those fiscal years, except

as follows. The disclosure requirements of this Statement are effective for financial

statements issued for fiscal years ending after December 15, 2006. Earlier application is

encouraged. The provisions of this Statement are to be applied prospectively (similar to a

change in accounting estimate), except as follows. The change in method for estimating

the fair value of a block is to be applied retrospectively to all prior periods (similar to a

change in accounting principle).

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Statement of Financial Accounting Standards No. 15X

Fair Value Measurements October 21, 2005 Working Draft

CONTENTS Paragraph Numbers

Objective ...........................................................................................................................1 Standards of Financial Accounting and Reporting: Scope.......................................................................................................................2–4 Measurement.........................................................................................................5–34 Definition of Fair Value..................................................................................5–14 Current Transaction ........................................................................................6 Marketplace Participants.................................................................................7 Reference Market........................................................................................8–9 Application to Assets ..............................................................................10–12 Application to Liabilities ..............................................................................13 Transaction Costs..........................................................................................14 Fair Value Estimates at Initial Recognition and in Subsequent Periods.......15–16 Valuation Techniques ...................................................................................17–19 Market Inputs ................................................................................................20–22 Fair Value Hierarchy.....................................................................................23–34 Level 1 Inputs .........................................................................................25–29 Bid and Asked Prices ..............................................................................27 Blocks .....................................................................................................28 Alternative Pricing Methods ...................................................................29 Level 2 Inputs .........................................................................................30–31 Restricted Securities................................................................................31 Level 3 Inputs ...............................................................................................32 Level 4 Inputs ...............................................................................................33 Level 5 Inputs ...............................................................................................34 Disclosures..........................................................................................................35–38 Effective Date and Transition .............................................................................39–40 Appendix A: Present Value Techniques ......................................................................A1− Appendix B: Implementation Guidance ......................................................................B1− Appendix C: Background Information and Basis for Conclusions .............................C1− Appendix D: Amendments to Existing Pronouncements ............................................D1− Appendix E: References to Existing APB and FASB Pronouncements......................E1−

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Statement of Financial Accounting Standards No. 15X

Fair Value Measurements

October 21, 2005 Working Draft

OBJECTIVE

1. This Statement defines fair value, establishes a framework for measuring fair value

under accounting pronouncements that require fair value measurements, and enhances

disclosures about fair value measurements. Where applicable, this Statement simplifies

and codifies related guidance within generally accepted accounting principles (GAAP).

STANDARDS OF FINANCIAL ACCOUNTING AND REPORTING

Scope

2. This Statement applies under accounting pronouncements that require fair value

measurements, except as follows:

a. This Statement does not apply under accounting pronouncements that address share-based payment transactions: FASB Statement No. 123 (revised 2004), Share-Based Payment, and its related interpretive pronouncements and FASB Technical Bulletin No. 97-1, Accounting under Statement 123 for Certain Employee Stock Purchase Plans with a Look-Back Option.

b. This Statement does not eliminate the practicability exceptions to fair value measurements in accounting pronouncements within the scope of this Statement.1

1Accounting pronouncements that permit practicability exceptions to fair value measurements in specified circumstances include APB Opinion No. 29, Accounting for Nonmonetary Transactions, FASB Statements No. 87, Employers’ Accounting for Pensions, No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions, No. 107, Disclosures about Fair Value of Financial Instruments, No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and No. 153, Exchanges of Nonmonetary Assets, and FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. Also included among those pronouncements are EITF Issues No. 85-40, “Comprehensive Review of Sales of Marketable Securities with Put Arrangements,” and No. 99-17, “Accounting for Advertising Barter Transactions.”

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3. This Statement does not apply under accounting pronouncements that require

measurements that are similar to fair value but that are not intended to measure fair value,

including the following:

a. Accounting pronouncements that address revenue transactions measured using vendor-specific objective evidence (VSOE) of fair value2

b. ARB No. 43, Chapter 4, “Inventory Pricing.”

4. Appendix E lists pronouncements of the Accounting Principles Board (APB) and

FASB existing at the date of this Statement that are within the scope of this Statement.

Appendix D lists APB and FASB pronouncements that are amended by this Statement.

Measurement

Definition of Fair Value

5. Fair value is the price that would be received for an asset or paid to transfer a

liability in a current transaction between marketplace participants in the reference market

for the asset or liability.

Current Transaction

6. A fair value measurement presumes the absence of compulsion (duress).

Therefore, a current transaction is not a forced transaction (for example, a forced

liquidation or distress sale). Rather, a current transaction is an orderly transaction that

assumes adequate exposure to the market prior to the measurement date and reflects

market conditions existing at that date. In the absence of a transaction involving the

entity,3 the price that forms the basis for the measurement is an estimate, determined by

2Accounting pronouncements that require measurements using VSOE of fair value are AICPA Statement of Position 97-2, Software Revenue Recognition, as modified by AICPA Statement of Position 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions, and EITF Issues No. 00-3, “Application of AICPA Statement of Position 97-2 to Arrangements That Include the Right to Use Software Stored on Another Entity’s Hardware,” and No. 00-21, “Revenue Arrangements with Multiple Deliverables.” 3 All references to entity refer to the reporting entity.

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reference to a hypothetical transaction for the asset or liability at the measurement date.4

In developing the estimate, the emphasis is on the assumptions that marketplace

participants in the reference market for the asset or liability would use in their estimate of

fair value.

Marketplace Participants

7. In broad terms, marketplace participants are buyers and sellers in the reference

market for the asset or liability that are:

a. Independent of the entity, that is, they are not related parties5 b. Knowledgeable, having a reasonable level of understanding about factors relevant to

the asset or liability and the transaction, based on all available information, including information obtained through due diligence efforts

c. Able to transact for the asset or liability, having the legal and financial ability to do so d. Willing to transact for the asset or liability, that is, they are motivated but not forced or

otherwise compelled to do so.

Reference Market

8. The reference market is the most advantageous market in which the entity would

transact for the asset or liability. Because different entities with different business

activities transact in different markets, the reference market for the asset or liability will

differ depending on the following:

a. The business activities of the entity. For example, a broker-dealer that sells securities generally would transact in different markets than its customers.

b. The unit of account for the asset or liability in the most advantageous market in which the entity would transact for the asset or liability. The unit of account describes the asset or liability by reference to the level at which it is aggregated (or disaggregated). The unit of account establishes what is being measured at fair value, that is, whether the estimate is for an individual asset or liability or a group of assets and/or liabilities, including a business.6

4The measurement date is the effective valuation date. 5This Statement uses the term related parties consistent with its use in FASB Statement No. 57, Related Party Disclosures. 6The unit of account should be determined in accordance with the provisions of other applicable accounting pronouncements.

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9. If there are multiple markets for the asset or liability with different prices, the

principal market for the asset or liability is presumed to represent the most advantageous

market and, therefore, the reference market for the asset or liability.

Application to Assets

10. For an asset, the reference market is the market with the price that maximizes the

amount that would be received for the asset, assuming the highest and best use of the asset

from the perspective of marketplace participants. Therefore, the estimate of fair value

reflects the market’s estimate of the future inflows associated with the asset (discounted).

11. The highest and best use of an asset establishes the valuation premise used to

estimate the fair value of the asset. Specifically:

a. If the highest and best use of an asset is in-use, the estimate of fair value shall be determined using an in-use valuation premise (fair value in-use). The highest and best use of an asset is in-use if marketplace participants would continue to use the asset as it is currently installed or otherwise configured for use by the entity (the hypothetical transaction involves an asset group). That generally will be the case when the asset is an operating asset that provides value principally through its use in combination with other assets as part of an asset group, including a business (for example, certain intangible assets).

b. If the highest and best use of an asset is in-exchange, the estimate of fair value shall be determined using an in-exchange valuation premise (fair value in-exchange). The highest and best use of an asset is in-exchange if marketplace participants would not continue to use the asset as it is currently installed or otherwise configured for use by the entity or if the asset provides value principally on a stand-alone basis (the hypothetical transaction involves a standalone asset). In that case, the asset is separable or substitutable with other equivalent assets (for example, a financial asset).

12. Because the highest and best use of an asset is considered from the perspective of

marketplace participants, the estimate of fair value is based on the assumptions that

marketplace participants would use in their estimate of fair value, whether using an in-use

or an in-exchange valuation premise.

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Application to Liabilities

13. For a liability, the reference market is the market with the price that minimizes the

amount that would be paid to transfer the liability to a marketplace participant that would

similarly perform or similarly bear the consequences of not performing. The estimate of

fair value shall consider the effect of the entity’s credit standing on the creditworthiness of

the liability in all periods in which the liability is measured at fair value so that the

estimate reflects the price that would be paid to transfer the liability in a transaction

between marketplace participants of comparable credit standing.7 Therefore, the estimate

of fair value reflects the market’s estimate of the future outflows associated with the

liability (discounted).

Transaction Costs

14. The price in the reference market for the asset or liability shall not be adjusted for

transaction costs, that is, the incremental direct costs to transact in that market.8

Transaction costs are characteristics of the transaction, not the particular asset or liability

involved in the transaction. Transaction costs shall be accounted for in accordance with

the provisions of other applicable accounting pronouncements. However, the price in the

reference market for the asset or liability shall be adjusted for transportation costs, that is,

the costs to access that market, if the location of the asset or liability is a characteristic of

the particular asset or liability, for example, a physical commodity whose quoted price

reflects its current location.

7The effect of changes in the credit standing of the entity on the creditworthiness of the liability may differ, depending on facts and circumstances specific to the liability, for example, whether the liability is an obligation to deliver cash or otherwise perform, and the terms of any credit enhancements included in the contract for the liability. 8Incremental direct costs refer to costs that result directly from and are essential to a transaction involving an asset (or liability) and that would not have been incurred by the entity had the decision to exchange the asset (or liability) not been made, similar to cost to sell, as defined in paragraph 35 of FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets.

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Fair Value Estimates at Initial Recognition and in Subsequent Periods

15. In a transaction in which the entity acquires an asset or assumes a liability, the

transaction price (the price paid for the asset or received to assume the liability) is

presumed to represent the fair value of the asset or liability (the price that would be

received for the asset or paid to transfer the liability) at initial recognition, absent

persuasive evidence to the contrary. Examples of situations in which the transaction price

presumption might be rebutted include the following:

a. The transaction is between related parties or occurs under duress where the seller is experiencing severe financial difficulties, such as bankruptcy or other financial pressures, or is forced to accept the price in the transaction because of urgency.

b. The market in which the transaction occurs is not the reference market for the asset or liability (the entity would transact in a more advantageous market for the asset or liability).9 In that case, the fair value of the asset or liability to the entity would be based on the price in the reference market for the asset or liability. (If the counterparty would not transact in a more advantageous market, the fair value of the asset or liability to the counterparty would be based on the price in the market in which the transaction occurs, that is, the transaction price.)

16. In periods subsequent to initial recognition in which an asset or liability is

remeasured at fair value, the estimate of fair value shall be updated so that it represents the

price at which marketplace participants would currently transact. In developing that

updated estimate, an entity shall consider the frequency of other similar transactions,

changes in the market, and other relevant factors (for example, a change in the condition

or location of an asset) since the previous estimate.

Valuation Techniques

17. Valuation techniques used to estimate fair value shall be consistent with the

market approach, income approach, and cost (or asset-based) approach. Key aspects of

those approaches are summarized below:

9The transaction price represents the fair value of the consideration paid or received in the transaction and, therefore, is presumed to represent the fair value of the transaction. However, the transaction price might not similarly represent the fair value of the asset or liability if the market in which the transaction occurs is not the reference market for the asset or liability. Whether the transaction price also can be presumed to represent the fair value of the asset or liability will depend on facts and circumstances specific to the asset or liability and the reference market for the asset or liability.

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a. The market approach uses observable prices and other relevant information generated by market transactions involving comparable assets or liabilities (including a business). The estimate of fair value is based on the value indicated by those comparable transactions.

b. The income approach uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present amount (discounted). The estimate of fair value is based on the value indicated by marketplace expectations about those future amounts. Those valuation techniques include present value techniques; option-pricing models, such as the Black-Scholes-Merton formula and lattice models, which incorporate present value techniques; and the multi-period excess earnings method, a discounted cash flow method used to estimate the fair value of certain intangible assets.

c. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost). The estimate of fair value considers the cost to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence. Obsolescence encompasses physical deterioration, functional (technical) obsolescence, and economic (external) obsolescence and is broader than depreciation for financial reporting purposes (an allocation of historical cost) or tax purposes (based on specified service lives). For a business, an asset-based approach provides an estimate of fair value based on the fair values of each of the individual assets and liabilities.

18. Valuation techniques that are appropriate in the circumstances and for which

sufficient data are available shall be used to estimate fair value. In all cases, the objective

is to use the valuation technique (or combination of valuation techniques) that is

appropriate in the circumstances. In some cases, a single valuation technique will be

appropriate. In other cases, multiple valuation techniques will be appropriate. When

multiple valuation techniques are used to estimate fair value, the results (respective

indications of fair value) shall be evaluated and weighted, as appropriate, in determining

the single estimate of fair value.

19. Valuation techniques used to estimate fair value shall be consistently applied.

However, a change in a valuation technique or its application (for example, a change in its

weighting when multiple valuation techniques are used) is appropriate if the change

results in an estimate that is more representative of fair value in the circumstances. That

might be the case as new markets develop, new information becomes available, or

valuation techniques improve. Revisions resulting from a change in the valuation

technique or its application shall be accounted for prospectively, as changes in accounting

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estimates (in accordance with the provisions of FASB Statement No. 154, Accounting

Changes and Error Corrections, paragraph 19).10

Market Inputs

20. Valuation techniques used to estimate fair value shall maximize the use of market

inputs and minimize the use of entity inputs, whether using the market approach, income

approach, or cost (or asset-based) approach. Market inputs refer to the assumptions that

marketplace participants would use in making pricing decisions, based on market data

obtained from sources independent of the entity. In contrast, entity inputs refer to the

entity’s internally developed assumptions of market inputs, based on the entity’s own

data.

21. Markets in which assets and liabilities are exchanged vary in structure and level of

activity. For example, in an active market, transactions for the asset or liability occur with

sufficient frequency to provide pricing information on an ongoing basis. Therefore, a

quoted price in that market will be both readily available and representative of fair value.

In a market that is not active, for example, a market in which there are few transactions for

the asset or liability or price quotations vary substantially either over time or among

market makers, a quoted price might not be readily available or representative of fair

value.

22. Examples of markets in which assets and liabilities (in particular, financial

instruments) are exchanged include the following:

10The disclosure requirements of Statement 154 for a change in estimate do not apply for revisions resulting from a change in a valuation technique or its application.

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a. Exchange market. An exchange market provides high visibility and order to the trading of financial instruments. Typically, closing prices are both readily available and representative of fair value. In an exchange market, multiple identical exchange units are traded. An example of such a market is the New York Stock Exchange.

b. Dealer market. In a dealer market, dealers stand ready to trade (either buy or sell for their own account), thereby providing liquidity by using their capital to hold an inventory of the items for which they make a market. Typically, bid and asked prices are more readily available than closing prices. In a dealer market, multiple identical exchange units are traded. Over-the-counter (OTC) markets (where prices are publicly reported by the National Association of Securities Dealers Automated Quotations systems or by the National Quotation Bureau) are dealer markets. For example, the market for U.S. Treasury securities is a dealer market. Dealer markets also exist for other assets and liabilities, such as financial instruments, commodities, and physical assets (for example, certain used equipment).

c. Brokered market. In a brokered market, brokers attempt to match buyers with sellers but do not stand ready to trade for their own account. In other words, brokers do not use their own capital to hold an inventory of the items for which they make a market. The broker knows the prices bid and asked by the respective parties, but each party is typically unaware of another party’s price requirements. Prices of completed transactions are sometimes available. Brokered markets include electronic communication networks, in which buy and sell orders are matched, and commercial and residential real estate markets.

d. Principal-to-principal market. Principal-to-principal transactions, both originations and resales, are negotiated independently with no intermediary. Little information about those transactions may be released publicly.

Fair Value Hierarchy

23. The fair value hierarchy distinguishes between the inputs to valuation techniques

used to estimate fair value, considering the relative reliability of the inputs. The

availability of inputs relevant to the asset or liability and the relative reliability of the

inputs may affect the selection of appropriate valuation techniques. However, the fair

value hierarchy focuses on the inputs to valuation techniques, not the valuation techniques

themselves.

24. The fair value hierarchy gives the highest priority to market inputs that reflect

quoted prices for identical assets or liabilities in active markets (Level 1) and the lowest

priority to entity inputs (Level 5). In some cases, inputs to valuation techniques used to

estimate fair value might fall within different levels of the fair value hierarchy. Where

within the fair value hierarchy the estimate of fair value falls depends on where within the

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fair value hierarchy the inputs that have a significant effect on the estimate fall. The

inputs used to estimate fair value shall be evaluated and weighted, as appropriate, in

assessing the effect of those inputs on the estimate.11

Level 1 Inputs

25. Level 1 inputs are market inputs that reflect quoted prices for identical assets or

liabilities in active markets. A quoted price for an identical asset or liability in an active

market provides the most reliable estimate of fair value and shall be used to estimate fair

value whenever available, provided that the entity has the ability to access that market for

the asset or liability at the measurement date.

26. In some situations, significant events (principal-to-principal transactions, brokered

trades, or announcements) might occur after the close of a market but before the

measurement date. In those situations, a quoted price in that market might not be

representative of fair value at the measurement date. An entity should establish and

consistently apply a policy for determining how those events affect estimates of fair value.

Bid and asked prices

27. If a price in an active market is quoted in terms of bid and asked prices (for

example, in an active dealer market where the bid price represents the price the dealer is

willing to pay and the asked price represents the price at which the dealer is willing to

sell), the estimate of fair value shall represent the price within the bid-asked spread at

which marketplace participants would currently transact. For offsetting positions in the

same instrument, the same price shall be used to estimate the fair value of both the long

and short positions.

Blocks

28. If an entity holds a large position of a financial instrument with a quoted price in

an active market (block), the fair value of the position shall be estimated within Level 1 as

the product of the quoted price for an individual trading unit times the quantity held. The

11This Statement does not require a formulaic sensitivity analysis of the inputs used to estimate fair value as a basis for assessing the effect of those inputs on the estimate.

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quoted price shall not be adjusted by a blockage factor, that is, a discount (or premium)

based on the size of the position relative to trading volume, even if a market’s normal

trading volume for one day is not sufficient to absorb the quantity held and placing orders

to sell the position in a single transaction might affect the quoted price.12

Alternative pricing methods

29. If an entity holds a large number of similar assets and liabilities that are required to

be measured at fair value, a quoted price in an active market might not be readily

accessible for each of those assets and liabilities (for example, from pricing services or

individual broker-dealers). In that case, fair value may be estimated within Level 1 using

an alternative pricing method (for example, matrix pricing) as a practical expedient,

provided that the method is demonstrated to replicate actual prices. The practical

expedient within Level 1 is limited to situations in which individual price quotes could be

obtained but, for practical reasons, are not.

Level 2 Inputs

30. Level 2 inputs are market inputs that reflect quoted prices not encompassed within

Level 1, that is, (a) quoted prices for identical assets or liabilities in markets that are not

active and (b) quoted prices for similar assets or liabilities in all markets, regardless of the

level of activity. A quoted price within Level 2 shall be adjusted, as appropriate,

considering factors specific to the asset or liability. An adjustment having a significant

effect on the estimate might render the estimate a lower level estimate.

Restricted securities

31. If an entity holds a restricted security, the fair value of the security shall be

estimated based on a quoted price for an otherwise identical unrestricted security of the

same issuer, adjusted as appropriate to reflect the effect of the restriction, that is, the

amount a marketplace participant would demand to assume the risk arising from the

inability to access a public market for the security for the specified period. That general

12The guidance in this Statement applies for blocks held by broker-dealers and investment companies within the scope of the AICPA Audit and Accounting Guides for those industries.

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principle applies regardless of when the restriction terminates. A restricted security is a

security for which sale is legally restricted by governmental or contractual requirement for

a specified period, whether the restriction limits sale (for example, to qualifying investors)

or prohibits sale.13

Level 3 Inputs

32. Level 3 inputs are market inputs other than quoted prices that are directly

observable for the asset or liability. If the asset or liability is a financial instrument, a

Level 3 input must be observable over the full term of the instrument. Examples include

interest rates, yield curves, volatilities, and default rates.

Level 4 Inputs

33. Level 4 inputs are market inputs that are not directly observable for the asset or

liability but that are corroborated by other market data through correlation or by other

means, thereby incorporating market data that are observable (market-corroborated

inputs). If the asset or liability is a financial instrument, a Level 4 input must be

corroborated by other market data over the full term of the instrument. Examples include

inputs that are derived through extrapolation or interpolation.

Level 5 Inputs

34. Level 5 inputs are entity inputs. Examples include inputs that are derived through

extrapolation or interpolation but that are not corroborated by other market data. Entity

inputs may be used to estimate fair value as a practical expedient in the absence of market

inputs. When using entity inputs, the fair value objective remains the same. Therefore,

entity inputs shall be developed within market parameters, eliminating factors specific to

the entity whenever possible.

13The guidance in this Statement applies for equity securities with restrictions that terminate within one year that are measured at fair value under FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities.

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Disclosures

35. An entity shall disclose information that enables users of its financial statements to

evaluate the extent to which fair value is used to remeasure assets and liabilities

recognized in the statement of financial position and the inputs used to develop the

estimates. To meet that objective, an entity shall disclose the following information for

each interim and annual period for which a statement of financial position is presented,

separately for each major category of assets and liabilities (except as otherwise specified):

a. For assets and liabilities that are remeasured at fair value on a recurring basis (for example, trading securities), the fair value estimates at the reporting date, in total and as a percentage of total assets and liabilities

b. For assets and liabilities that are remeasured at fair value on a nonrecurring basis (for example, impaired assets), the fair value estimates and the reason(s) for the remeasurements

c. Where within the fair value hierarchy the fair value estimates in (a) and (b) above in their entirety fall, segregating those estimates that fall within Level 1, Levels 2–4, and Level 5

d. For annual periods only, the valuation technique(s) used for the fair value estimates in (a) and (b) above.

36. An entity shall disclose information that enables users of its financial statements to

evaluate the effects of fair value remeasurements on income (or changes in net assets) for

the period. To meet that objective, an entity shall disclose the following information for

each interim and annual period for which a statement of financial performance is

presented:

a. Total gains or losses for the period relating to each major category of assets and liabilities remeasured at fair value during the period, even if those assets and liabilities are not still held at the reporting date. Total gains or losses shall be presented separately if the related assets or liabilities are reported separately in the statement of financial performance, segregating those gains or losses included in other comprehensive income.

b. The change in unrealized gains or losses during the period relating to assets and liabilities remeasured at fair value during the period that are still held at the reporting date if the estimates fall within Level 5.

37. The quantitative disclosures required by this Statement shall be presented using a

tabular format. (See Appendix B.)

13

38. The fair value information disclosed under this Statement shall be combined and

disclosed together with the fair value information disclosed under other accounting

pronouncements (for example, FASB Statement No. 107, Disclosures about Fair Value of

Financial Instruments) in the periods in which those disclosures are required, if

practicable. Disclosures about other similar remeasurements (for example, inventories

remeasured at “market value” under ARB 43, Chapter 4) are encouraged but not required.

Effective Date and Transition

39. This Statement shall be effective for financial statements issued for fiscal years

beginning after December 15, 2006, and interim periods within those fiscal years, except

as follows. The disclosure requirements of this Statement (paragraphs 35–38) shall be

effective for financial statements issued for fiscal years ending after December 15, 2006.

Earlier application is encouraged.

40. This Statement shall be applied prospectively as of the first interim period for the

fiscal year in which this Statement is initially applied, except as follows. Paragraph 28 of

this Statement (blocks) shall be applied retrospectively to all prior periods. The

cumulative effect of the change in accounting principle on periods prior to those presented

shall be reflected as of the beginning of the first period presented. An offsetting

adjustment shall be made to the opening balance of retained earnings for that period. In

the fiscal year in which this Statement is initially applied, and in all interim periods within

that fiscal year, an entity shall disclose the effect of the change in accounting principle on

income before extraordinary items and any affected per-share amounts, if applicable

(Statement 154, paragraphs 17(b)(2) and 18).

The provisions of this Statement need not be applied to immaterial items.

14

10/21/05 WORKING DRAFT

Appendix C

BACKGROUND INFORMATION AND BASIS FOR CONCLUSIONS

CONTENTS Paragraph Numbers

Introduction....................................................................................................................C1 Background Information......................................................................................... C2–C6 Scope..................................................................................................................... C7–C18 Share-Based Payment Transactions.........................................................................C8 Leasing Transactions ...............................................................................................C9 Statement 114.........................................................................................................C10 Opinion 21 .................................................................................................... C11–C12 EITF Issue 02-3............................................................................................. C13–C15 Practicability Exceptions .............................................................................. C16–C17 Other Similar Measurements .................................................................................C18 Definition of Fair Value...................................................................................... C19–C44 Current Transaction ...................................................................................... C20–C21 Marketplace Participants............................................................................... C22–C23 Reference Market.......................................................................................... C24–C27 Principal Markets .............................................................................................C26 Hypothetical Markets.......................................................................................C27

Application to Assets .................................................................................... C28–C32 Highest and Best Use .............................................................................. C29–C32

Application to Liabilities .............................................................................. C33–C43 The Transfer............................................................................................ C34–C35 Credit Standing ....................................................................................... C36–C43 Transaction Costs...................................................................................................C44 Interaction between Fair Value and Fair Market Value...............................................C45 Fair Value Estimates at Initial Recognition ........................................................ C46–C48 Valuation Techniques ......................................................................................... C49–C59 Single versus Multiple Valuation Techniques .............................................. C50–C51 Undue Cost and Effort ...........................................................................................C52 Consistency Constraint ..........................................................................................C53 Present Value Techniques............................................................................. C54–C58 Multi-Period Excess Earnings Method ..................................................................C59

1


Paragraph Numbers Fair Value Hierarchy........................................................................................... C60–C99 Level Inputs .................................................................................................. C64–C84 Adjustments to Quoted Prices in Active Markets................................... C66–C67 Bid and Asked Prices .............................................................................. C68–C73 Blocks ..................................................................................................... C74–C83 Alternative Pricing Methods ............................................................................C84 Level 2 Inputs ............................................................................................... C85–C92 Restricted Securities................................................................................ C88–C92 Level 3 Inputs ............................................................................................... C93–C94 Level 4 Inputs ........................................................................................................C95 Level 5 Inputs ............................................................................................... C96–C99 Disclosures...................................................................................................... C100–C114 Fair Value Remeasurements ..................................................................... C104–C105 Unrealized Gains or Losses ...................................................................... C106–C108 Total Gains or Losses...........................................................................................C109 Other Disclosures...................................................................................... C110–C113 Amendment to Opinion 28...................................................................................C114 Effective Date and Transition ......................................................................... C115–C118 Benefits and Costs........................................................................................... C119–C123 International Financial Reporting Standards .............................................................C124

2


Appendix C

BACKGROUND INFORMATION AND BASIS FOR CONCLUSIONS

Introduction

C1. This appendix summarizes considerations that Board members deemed significant

in reaching the conclusions in this Statement. It includes the reasons for accepting certain

views and rejecting others. Individual Board members gave greater weight to some

factors than to others.

Background Information

C2. In many accounting pronouncements, the Board has concluded that fair value

information is relevant and users of financial statements generally have agreed. Paragraph

47 of FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting

Information, states, “To be relevant to investors, creditors, and others for investment,

credit, and similar decisions, accounting information must be capable of making a

difference in a decision by helping users to form predictions about the outcomes of past,

present, and future events or to confirm or correct expectations.”

C3. Others, however, have expressed concerns about the ability to apply the fair value

measurement objective in generally accepted accounting principles (GAAP), more

recently, in response to the FASB Proposal, Principles-Based Approach to U.S. Standard

Setting, issued in October 2002.1 In large part, those concerns focus on the reliability of

the measurements in the absence of quoted market prices, including concerns about the

ability to verify the measurements. Paragraph 59 of Concepts Statement 2 states, “The

reliability of a measure rests on the faithfulness with which it represents what it purports

to represent, coupled with an assurance for the user, which comes through verification,

that it has that representational quality.”

1In July 2003, the Securities and Exchange Commission (SEC) published, “Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System,” which encouraged a move to more “objectives-oriented” accounting standards.

3


C4. The Board believes that, in part, those concerns result because there is limited

guidance for applying the fair value measurement objective in GAAP. The guidance that

currently exists has evolved piecemeal over time. That guidance is dispersed among the

accounting pronouncements that require fair value measurements, and differences in that

guidance have created inconsistencies that have added to the complexity in GAAP. There

also is limited conceptual guidance for addressing measurement issues in the Board’s

conceptual framework.

C5. In June 2003, the Board added the fair value measurement project to its agenda to

address fair value measurement issues broadly.2 At that time, the Board agreed that

conceptually, the definition of fair value and its application in GAAP should be the same

for all assets and liabilities. This Statement is the result of that project. This Statement

defines fair value, establishes a framework for measuring fair value in GAAP that builds

on current practice and requirements, and enhances disclosures about fair value. Where

appropriate, this Statement also simplifies and codifies the related guidance that currently

exists for developing the measurements, eliminating differences that have added to the

complexity in GAAP. This Statement applies under other accounting pronouncements

that require fair value measurements, the Board having previously concluded in those

pronouncements that fair value is the relevant measurement attribute. This Statement does

not require any new fair value measurements.

C6. In June 2004, the Board issued an Exposure Draft, Fair Value Measurements, and

received comment letters from nearly 100 respondents. In September 2004, the Board

held public roundtable meetings with some of those respondents to discuss significant

issues raised in the comment letters. In its redeliberations, the Board considered those

comments, as well as input from the Valuation Resource Group, the Financial Accounting

Standards Advisory Council, the User Advisory Council (UAC), and other interested

parties. The Board reconsidered certain aspects of the proposals in the Exposure Draft

and clarified other aspects.

2The Board has a separate project on its agenda to improve its conceptual framework.

4


Scope

C7. In developing this Statement, the Board agreed that in a Statement that applies

broadly, there should be few, if any, scope exceptions. Therefore, to more clearly convey

the fair value measurement objective in GAAP, the Board focused on accounting

pronouncements that (a) specify a fair value measurement objective that differs from the

fair value measurement objective in this Statement or (b) otherwise provide guidance for

applying the fair value measurement objective that raises issues specific to the assets and

liabilities covered under those pronouncements.

Share-Based Payment Transactions

C8. Accounting pronouncements that require fair value measurements but that are

excluded from the scope of this Statement are limited to FASB Statement No. 123

(revised 2004), Share-Based Payment, and other accounting pronouncements that address

share-based payment transactions. Statement 123(R) specifies a fair value measurement

objective that is generally consistent with the fair value measurement objective in this

Statement. However, its application to certain share-based payment transactions with

employees results in a measurement at the grant date that is a fair-value-based

measurement, not a fair value measurement. In other cases under Statement 123(R),

application of its fair value measurement objective results in a measurement that is a fair

value measurement. However, because the principal focus of Statement 123(R) is on

share-based payment transactions with employees, the Board decided for practical reasons

to exclude Statement 123(R) in its entirety from the scope of this Statement.

Leasing Transactions

C9. In the Exposure Draft, the Board decided to exclude from the scope of this

Statement FASB Statement No. 13, Accounting for Leases, and other accounting

pronouncements that address leasing transactions. At that time, the Board was concerned

that applying the fair value measurement objective in this Statement to leasing

transactions could have unintended consequences when considered together with

longstanding valuation practices common within the leasing industry. The Board decided

5


to defer consideration of fair value measurement issues specific to those transactions.

However, respondents indicated that the fair value measurement objective for leasing

transactions is generally consistent with the fair value measurement objective in this

Statement and that the guidance in this Statement should apply for the fair value

measurements required for those transactions. Others in the leasing industry subsequently

affirmed that view. Therefore, the Board decided to include those pronouncements in the

scope of this Statement. Because this Statement does not require any new fair value

measurements, it does not apply under accounting pronouncements that address leasing

transactions and do not require fair value measurements for those transactions.

Statement 114

C10. In the Exposure Draft, the Board observed that the measurement for impaired

loans in FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan,

determined using a present value technique, is not a fair value measurement. At that time,

the Board decided to exclude Statement 114 from the scope of this Statement to

distinguish its measurement from other measurements determined using present value

techniques that are fair value measurements. Respondents agreed that the measurement

for impaired loans is not a fair value measurement. However, they noted that the practical

expedient in Statement 114 (fair value of collateral) is a fair value measurement. They

said that when that practical expedient is used, the guidance in this Statement should

apply. The Board agreed and decided to include Statement 114 in the scope of this

Statement as it relates to the practical expedient.

Opinion 21

C11. In this Statement, the Board affirmed that the measurement for receivables and

payables (notes) in APB Opinion No. 21, Interest on Receivables and Payables,

determined using a present value technique, is a fair value measurement. The discount

rate for contractual (promised) cash flows described in that Opinion (rate commensurate

with the risk) embodies the same notion as the discount rate used in the traditional or

discount rate adjustment (DRA) approach described in FASB Concepts Statement No. 7,

6


Using Cash Flow Information and Present Value in Accounting Measurements, and

clarified in this Statement (Appendix A). Paragraph 13 of Opinion 21 explains:

The objective is to approximate the rate which would have resulted if an independent borrower and an independent lender had negotiated a similar transaction under comparable terms and conditions with the option to pay the cash price upon purchase or to give a note for the amount of the purchase which bears the prevailing rate of interest to maturity.

C12. Accordingly, the guidance for using present value techniques to measure fair value

in this Statement applies for the measurements required under Opinion 21. It also applies

for the similar measurements required under other pronouncements, including FASB

Statements No. 15, Accounting by Debtors and Creditors for Troubled Debt

Restructurings, No. 35, Accounting and Reporting by Defined Benefit Pension Plans,

No. 63, Financial Reporting by Broadcasters, No. 87, Employers’ Accounting for

Pensions, and No. 106, Employers’ Accounting for Postretirement Benefits Other Than

Pensions.

EITF Issue 02-3

C13. In the Exposure Draft, the Board decided to exclude from the scope of this

Statement EITF Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts

Held for Trading Purposes and Contracts Involved in Energy Trading and Risk

Management Activities.” Issue 02-3 applies to certain derivative instruments that are

measured at fair value under FASB Statement No. 133, Accounting for Derivative

Instruments and Hedging Activities. In particular, Issue 02-3 focuses on transactions that

involve any long-dated, over-the-counter derivative instrument in an illiquid market.

C14. An issue addressed in Issue 02-3 is how to estimate the fair value of the derivative

instrument at initial recognition. The FASB staff guidance in footnote 3 to Issue 02-3

specifies that the estimate should be based on the transaction price unless an estimate

determined by the entity (generally, a model value) is based on market inputs that are

observable. A related issue is when an unrealized gain (loss), measured as the difference

between the transaction price and the estimate of the fair value of the derivative

instrument at initial recognition, should be recognized if it is not recognized at initial

7


recognition of the derivative instrument. Issue 02-3 does not address that issue. As a

result, practice is diverse with regard to both the method and timing of recognition. In the

Exposure Draft, the Board acknowledged that practice issue. However, the Board

concluded that, in addition to fair value measurement issues, Issue 02-3 raises revenue

recognition issues that are beyond the scope of this Statement and decided not to address

those issues in this Statement.

C15. Respondents said that for many entities, in particular, financial institutions,

Issue 02-3 is significant and that the Board should address related issues in this Statement,

focusing on the interaction of the FASB staff guidance in Issue 02-3 and the fair value

hierarchy in this Statement. In response, the Board subsequently decided to address the

revenue recognition issues in Issue 02-3 separately from the fair value measurement

issues. In June 2005, the Board added a separate project to its agenda to address those

revenue recognition issues. In October 2005, the Board issued a proposed FASB Staff

Position (FSP) FAS 133-a, “Accounting for Unrealized Gains (Losses) Relating to

Derivative Instruments Measured at Fair Value under Statement 133.” The proposed FSP,

which will nullify the FASB staff guidance in footnote 3 to Issue 02-3, will be included in

the scope of this Statement.

Practicability Exceptions

C16. The Board observed that some accounting pronouncements within the scope of this

Statement permit practicability exceptions to fair value measurements in specified

circumstances. For example, for financial instruments, FASB Statement No. 107,

Disclosures about Fair Value of Financial Instruments, permits a practicability exception

in certain specified circumstances; Statement 133 does not. The Board acknowledged the

inconsistencies created by those practicability exceptions. However, the Board concluded

that, in large part, they raise issues about the application of the fair value measurement

attribute that are beyond the scope of this Statement. Therefore, this Statement does not

eliminate those practicability exceptions.

C17. The Board considered a related issue in FASB Interpretation No. 45, Guarantor’s

Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees

8


of Indebtedness of Others. For a guarantee, Interpretation 45 emphasizes that the

measurement objective at initial recognition is fair value. However, Interpretation 45

specifies that the measurement at initial recognition should be the premium received (or

receivable), in effect, a transaction price. The Board observed that the transaction price

might not result in a fair value measurement. At the same time, however, the Board

observed that a conforming change to Interpretation 45 to apply the fair value

measurement objective in this Statement could result in a significant change to practice

under that Interpretation. In particular, it could raise revenue recognition issues for

guarantees that are not accounted for as derivatives similar to those addressed in proposed

FSP FAS 133-a, (which would apply for guarantees that are accounted for as derivatives).

The Board concluded that those revenue recognition issues are beyond the scope of this

Statement. Further, otherwise addressing those issues could require the Board to address

issues relating to measurements in periods subsequent to initial recognition that are

beyond the scope of Interpretation 45. Largely for those reasons, the Board decided that

the guidance in Interpretation 45 should remain unchanged until it resolves related issues

more broadly in its revenue recognition project.

Other Similar Measurements

C18. This Statement does not apply under accounting pronouncements that require

measurements that are similar to fair value but that are not intended to measure fair value,

in particular, accounting pronouncements that require measurements that are based on, or

otherwise use, vendor specific objective evidence (VSOE) of fair value. Those

accounting pronouncements include AICPA Statement of Position 97-2, Software

Revenue Recognition, as modified by AICPA Statement of Position 98-9, Modification of

SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions, and

EITF Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” In those

accounting pronouncements, VSOE of fair value is based on the price charged by the

entity for a deliverable when it is sold separately or, for a deliverable not yet being sold

separately, the price established by management having the relevant authority (an entity-

specific measurement), except as otherwise specified in Issue 00-21, which allows for

third party evidence of fair value as a practical expedient to VSOE of fair value.

9


Conceptually, a VSOE of fair value measurement is not a fair value measurement. The

price that forms the basis for a VSOE of fair value measurement (and its practical

expedient) is an entry price. The price that forms the basis for a fair value measurement is

an exit price.

Definition of Fair Value

C19. To clearly convey the fair value measurement objective in GAAP, the Board

revised earlier definitions of fair value. The definition of fair value in this Statement

retains the exchange price notion contained, either explicitly or implicitly, in earlier

definitions of fair value. However, it clarifies that the exchange price is the price that

would be received for an asset or paid to transfer a liability in a current transaction

between marketplace participants in the reference market for the asset or liability. In other

words, the price that forms the basis for a fair value measurement is the price in the

market in which an entity sells or otherwise disposes of assets or transfers liabilities (an

exit price), as distinguished from the price in the market in which an entity acquires assets

or assumes liabilities (an entry price). The Board agreed that an exit price provides a

direct measure of the market’s estimate of the future inflows associated with an asset and

the future outflows associated with a liability, consistent with the definitions of assets and

liabilities in FASB Concepts Statement No. 6, Elements of Financial Statements.

Specifically, paragraph 25 of Concepts Statement 6 defines assets in terms of future

economic benefits (future inflows). Paragraph 35 of Concepts Statement 6 defines

liabilities in terms of future sacrifices of economic benefits (future outflows). The

definition of fair value focuses on assets and liabilities because they are the primary

subject of accounting measurement. However, the definition also could be applied to an

entity’s own equity instruments.

Current Transaction

C20. In its redeliberations, the Board affirmed that a current transaction is not a forced

transaction (for example, a forced liquidation or distress sale). Rather, it is an orderly

transaction that reflects market conditions existing at the measurement date. The Board

clarified that the definition of fair value allows for adequate exposure to the market prior

10


to that date, as do other similar definitions used in many valuation situations. As noted by

some respondents, adequate exposure to the market allows for the information

dissemination and marketing necessary to transact in the most advantageous market for

the asset or liability.

C21. The Board affirmed that until the entity transacts for the asset or liability, the price

that forms the basis for the measurement is an estimate at the measurement date. That is

the case even if the estimate can be made with a high level of confidence that it represents

what the price would be in a transaction for the asset or liability at the measurement date.

In that regard, the Board observed that a transaction for the asset or liability could affect

the price in the market for the asset or liability at the measurement date. Therefore, the

price that forms the basis for the estimate is determined by reference to a hypothetical

transaction for the asset or liability at the measurement date. This Statement clarifies that

in developing the estimate, the emphasis is on the assumptions that marketplace

participants in the reference market for the asset or liability would use in their estimate of

fair value.

Marketplace Participants

C22. Conceptually, the price that forms the basis for a fair value estimate reflects the

consensus view of marketplace participants about the asset or liability. The general

concept of marketplace participants is discussed in paragraph 26 of Concepts Statement 7,

which states:

Among their many functions, markets are systems that transmit information in the form of prices. Marketplace participants attribute prices to assets and, in doing so, distinguish the risks and rewards of one asset from those of another. Stated differently, the market’s pricing mechanism ensures that unlike things do not appear alike and that like things do not appear to be different (a qualitative characteristic of accounting information). An observed market price encompasses the consensus view of all marketplace participants about an asset or liability’s utility, future cash flows, the uncertainty surrounding those cash flows, and the amount that marketplace participants demand for bearing those uncertainties.

C23. This Statement incorporates and clarifies that concept of marketplace participants

in the context of buyers and sellers in the reference market for the asset or liability that are

11


independent of the entity (unrelated), knowledgeable, and both able and willing to transact

for the asset or liability. Some respondents questioned the extent to which marketplace

participants would be expected to be knowledgeable, referring to markets that are not fully

efficient and situations in which there might be information asymmetry in those markets.

Such situations exist when some marketplace participants have information about an asset

or liability that is not available to other marketplace participants. In considering that

issue, the Board agreed that it would be reasonable to presume that a marketplace

participant that is both able and willing to transact for the asset or liability would

undertake efforts necessary to become sufficiently knowledgeable about the asset or

liability based on all available information, including information obtained through due

diligence efforts, and factor any related risk (for example, information uncertainty risk)

into the estimate of fair value.

Reference Market

C24. The Exposure Draft established a reference market principle within Level 1 of the

fair value hierarchy, emphasizing that the estimate should reflect the price in the most

advantageous market for the asset or liability. The Board concluded that a most

advantageous market approach is reasonable based on the assumption that the goal of

most entities is to maximize profits or net assets. The most advantageous market

approach embodies both the buying and the selling sides of rational economic behavior

and is consistent with normal profit motivations. Respondents generally agreed with that

reference market principle within Level 1 of the fair value hierarchy. However, they

indicated that to achieve consistency in applying the fair value measurement objective in

GAAP, that reference market principle should be expressed as a general principle.

C25. The Board agreed and, in response, expanded the reference market principle so

that it applies broadly. In that broadened context, the Board observed that because

different entities with different business activities transact in different markets, the

reference market (and, thus, marketplace participants) will differ depending on the

business activities of the entity and the unit of account for the asset or liability in the

market in which the entity would transact. To allow for those differences, this Statement

12


clarifies that the reference market should be considered from the perspective of the entity.

Therefore, the reference market is the most advantageous market in which the entity

would transact for the asset or liability.

Principal Markets

C26. Some respondents interpreted the reference market principle within Level 1 of the

Exposure Draft as requiring the use of prices in most advantageous markets over prices in

principal markets in all cases, referring to possible conflicts with ASR No. 118,

Accounting for Investment Securities by Registered Investment Companies, and its

principal market approach for registered funds. They stated that because the principal

market is the market in which the preponderance of transactions for the asset or liability

occur, it generally is the most liquid market for the asset or liability. Therefore, the price

in the principal market for the asset or liability generally will be more reliable than a price

in a market that is more advantageous at the measurement date. Further, in situations in

which an asset or liability is exchanged in multiple locations (for example, if a security is

listed for trading on exchanges located in several countries) a most advantageous market

approach would create operational difficulties and impose additional costs. The Board

agreed that because the principal market is the market in which the preponderance of

transactions for the asset or liability occur it would be reasonable to presume that the

principal market will represent the most advantageous market for the asset or liability.

Therefore, this Statement clarifies that if there are multiple markets for the asset or

liability with different prices, the principal market for the asset or liability is presumed to

represent the reference market for the asset or liability (whether that market is determined

under ASR 118 or otherwise, based on volume data).

Hypothetical Markets

C27. The Board acknowledged that in some cases there might not be a market for the

asset or liability at the measurement date. In those cases, the reference market is

hypothetical, constructed from inputs relevant to the asset or liability. Accordingly,

marketplace participants in that reference market also are hypothetical. The Board

understands that for some, a hypothetical reference market construct raises concerns about

13


the relevance and reliability of the estimate. In particular, some believe that a

hypothetical reference market construct is an artificial construct that does not faithfully

represent an actual economic phenomenon and, as such, would seem to be of questionable

relevance to users of financial statements. Some Board members share those concerns.

However, the Board agreed that concerns about fair value measurements that are

predicated on hypothetical transactions in hypothetical markets derive from a threshold

issue that relates principally to the selection of the appropriate measurement attribute, an

important area of focus in the Board’s conceptual framework project. The Board plans to

continue to address the issue of which measurement attribute should be required in

individual accounting pronouncements on a project-by-project basis.

Application to Assets

C28. For an asset, the reference market is the market with the price that maximizes the

amount that would be received for the asset, assuming the highest and best use of the asset

from the perspective of marketplace participants.

Highest and Best Use

C29. Highest and best use is a valuation concept used to value many assets (for

example, real estate assets). In general terms, the highest and best use of an asset refers to

the use of the asset that maximizes the future inflows associated with the asset, consistent

with the most advantageous reference market approach in this Statement.3 Concepts

Statement 7 refers to that highest and best use concept as a basis for explaining differences

between an entity’s expectations of future cash flows and those of the market. In

particular, paragraph 32(a) of Concepts Statement 7 states:

The entity’s managers might intend different use or settlement than that anticipated by others. For example, they might intend to operate a property as a bowling alley, even though others in the marketplace consider its highest and best use to be a parking lot.

3The term highest and best use is similarly referred to in the glossary of International Valuation Standards, seventh edition, as, “The most probable use of a property which is physically possible, appropriately justified, legally permissible, financially feasible, and which results in the highest value of the property being valued.”

14


C30. The Exposure Draft incorporated that highest and best use concept, but indirectly

in the context of the valuation premise used to estimate the fair value of an asset. The

related guidance distinguished between an in-use and an in-exchange valuation premise,

referring generally to marketplace participant expectations with respect to the asset. In

commenting on that guidance, some respondents indicated that it was ambiguous with

respect to when an in-use versus an in-exchange valuation premise should be used.

C31. In response, this Statement incorporates that highest and best use concept directly

as a basis for establishing the valuation premise that should be used to estimate the fair

value of an asset, as suggested by some respondents. This Statement clarifies that if the

highest and best use of an asset from the perspective of marketplace participants is in use,

the estimate of fair value should be determined using an in-use valuation premise (fair

value in-use). If the highest and best use of an asset from the perspective of marketplace

participants is in-exchange, the estimate of fair value should be determined using an in-

exchange valuation premise (fair value in-exchange).

C32. A few respondents also questioned the interaction between an in-use valuation

premise and the exchange notion encompassed within the definition of fair value. In

response, the Board clarified that in situations in which the highest and best use of an asset

is in-use, an in-use valuation premise focuses the estimate on an exchange that involves an

asset group (the asset is installed or otherwise configured for use). Because highest and

best use is considered from the perspective of marketplace participants, the estimate is a

market-based estimate that reflects the consensus view of marketplace participants with

respect to the asset. It is not an entity-specific estimate that reflects the entity’s own

expectations with respect to the asset.

Application to Liabilities

C33. For a liability, the reference market is the market with the price that minimizes the

amount that would be paid to transfer the liability to a marketplace participant of

comparable credit standing that would similarly perform or similarly bear the

consequences of not performing.

15


The Transfer

C34. The estimate assumes that the liability is transferred to a marketplace participant

that has the ability to similarly perform at the measurement date. Therefore, the liability

to the counterparty continues (it is not settled or otherwise extinguished). The Board

acknowledged that in some cases, the entity might have advantages (or disadvantages)

relative to the market that would make it more (or less) beneficial for the entity to perform

using its own internal resources. However, the Board affirmed that the fair value of a

liability is the same regardless of how an entity intends to settle the liability (assuming

entities of comparable credit standing) and that the relative efficiency of an entity in

settling the liability using its own internal resources should be reflected over the course of

its settlement, not before. In effect, a fair value measurement provides a market

benchmark by which the entity’s advantages (or disadvantages) in performance or

settlement relative to the market can be assessed.

C35. In the context of both assets and liabilities, paragraph 33 of Concepts Statement 7

explains:

If the entity measures an asset or liability at fair value, its comparative advantage or disadvantage will appear in earnings as it realizes assets or settles liabilities for amounts different than fair value. The effect on earnings appears when the advantage is employed to achieve cost savings or the disadvantage results in excess costs. In contrast, if the entity measures an asset or liability using a measurement other than fair value, its comparative advantage or disadvantage is embedded in the measurement of the asset or liability at initial recognition. If the offsetting entry is to revenue or expense, measurements other than fair value cause the future effects of this comparative advantage or disadvantage to be recognized in earnings at initial measurement.

Credit Standing

C36. The estimate further assumes that the liability is transferred to a marketplace

participant of comparable credit standing. In this Statement, the Board affirmed its

conclusion in Concepts Statement 7 that “the most relevant measure of a liability always

reflects the credit standing of the entity obligated to pay” (paragraph 78). This Statement

incorporates that credit standing concept in Concepts Statement 7, thereby elevating it to

16


Level A GAAP. Therefore, the entity should consider the effect of its credit standing on

the fair value of the liability in all periods in which the liability is measured at fair value

so that the estimate reflects the price that would be paid in a current transaction between

marketplace participants of comparable credit standing.

C37. The Exposure Draft similarly incorporated the credit standing concept in Concepts

Statement 7. Respondents agreed that, conceptually, the effect of an entity’s credit

standing should be considered in all liability measurements at fair value. However, they

expressed concerns about elevating that concept to Level A GAAP, thereby requiring that

the entity consider the effect of changes in its credit standing on the fair value of the

liability in all cases in which the liability is remeasured at fair value. In particular, they

referred to the counterintuitive and potentially confusing reporting that could result by

including the effect in liability remeasurements at fair value (“gains” for credit

downgrades and “losses” for credit upgrades). Respondents further referred to diversity in

practice with respect to credit standing and liability remeasurements at fair value, noting

that related issues are not clearly and consistently addressed in Level A GAAP, in

particular, Statements 107 and 133.

C38. Paragraph 68 of Statement 107 states:

The Board acknowledges that, as for assets with no quoted prices, variations in the methods used to estimate the fair value of liabilities with no quoted prices might reduce the comparability of fair value information among entities. Some entities will estimate fair value by using an incremental rate of borrowing that considers changes in an entity’s own credit risk, while others will use a settlement rate that ignores at least part of those credit risk changes. However, the Board concluded that it should not, at this time, prescribe a single method to be used for all unquoted liabilities.

C39. Similarly, paragraph 316 of Statement 133 states:

Some respondents to the Exposure Draft noted that Statement 107 permits an entity to choose whether to consider changes in its own creditworthiness in determining the fair value of its debt and asked for further guidance on that issue. The definition of fair value in Statement 125 says that in measuring liabilities at fair value by discounting estimated future cash flows, an objective is to use discount rates at which those

17


liabilities could be settled in an arm’s-length transaction. However, the FASB’s pronouncements to date have not broadly addressed whether changes in a debtor’s creditworthiness after incurrence of a liability should be reflected in measuring its fair value. Pending resolution of the broad issue of the effect of a debtor’s creditworthiness on the fair value of its liabilities, the Board decided to use the definition in Statement 125 but not to provide additional guidance on reflecting the effects of changes in creditworthiness.

C40. Respondents acknowledged that liabilities currently remeasured at fair value on a

regular basis are limited largely to derivative liabilities under Statement 133. However,

they emphasized that issues related to credit standing and liability remeasurements will

become more pervasive as more liabilities are remeasured at fair value on a regular basis,

referring to agenda projects in which the Board is broadly considering liability

remeasurements at fair value (for example, the fair value option project). Because of that

future expansion and current practice, they urged the Board to address related issues.

C41. In its redeliberations, the Board noted that in Concepts Statement 7, it considered

many of the issues related to credit standing and liability remeasurements referred to by

respondents. Paragraphs 78–88 of Concepts Statement 7 explain:

The most relevant measure of a liability always reflects the credit standing of the entity obligated to pay. Those who hold the entity’s obligations as assets incorporate the entity’s credit standing in determining the prices they are willing to pay. When an entity incurs a liability in exchange for cash, the role of its credit standing is easy to observe. An entity with a strong credit standing will receive more cash, relative to a fixed promise to pay, than an entity with a weak credit standing. For example, if 2 entities both promise to pay $500 in 5 years, the entity with a strong credit standing may receive about $374 in exchange for its promise (a 6 percent interest rate). The entity with a weak credit standing may receive about $284 in exchange for its promise (a 12 percent interest rate). Each entity initially records its respective liability at fair value, which is [presumptively] the amount of proceeds received—an amount that incorporates that entity’s credit standing.

The effect of an entity’s credit standing on the fair value of [its] liabilities depends on the ability of the entity to pay and on [other provisions of those liabilities] that protect holders. Liabilities that are guaranteed by governmental bodies (for example, many bank deposit liabilities in the United States) may pose little risk of default to the holder. Other liabilities may include sinking-fund requirements or significant

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collateral. . . . [such] aspects must be considered in estimating the extent to which the entity’s credit standing affects the fair value of its liabilities.

The role of the entity’s credit standing in a settlement transaction is less direct but equally important. A settlement transaction involves three parties—the entity, the parties to whom it is obligated, and a third party. The price of the transaction will reflect the competing interests of each party. For example, suppose Entity A [obligor] has an obligation to pay $500 to Entity B [obligee] 3 years hence. Entity A has a poor credit rating and therefore borrows at a 12 percent interest rate.

a. In a settlement transaction, Entity B would never consent to replace Entity A with an entity of lower credit standing. All other things being equal, Entity B might consent to replace Entity A with a borrower of similar credit standing and would probably consent to replace Entity A with a more creditworthy entity.

b. Entity C has a good credit rating and therefore borrows at a 6 percent interest rate. It might willingly assume Entity A’s obligation for $420 (the present value at 6 percent). Entity C has no incentive to assume the obligation for less (a higher interest rate) if it can borrow at 6 percent because it can receive $420 for an identical promise to pay $500.

c. However, if Entity A were to borrow the money to pay Entity C, it would have to promise $590 ($420 due in 3 years with accumulated interest at 12 percent).

Based on the admittedly simple [example] above, the fair value of Entity A’s liability should be approximately $356 (the present value of $500 in 3 years at 12 percent). The $420 price demanded by Entity C includes the fair value of Entity A’s liability ($356) plus the price of an upgrade in the credit quality of the liability. . . . [Like the purchase of a guarantee, the additional amount represents a separate element of a new arrangement rather than an element of the fair value of Entity A’s original liability.]

The effect of an entity’s credit standing on the measurement of its liabilities is usually captured in an adjustment to the interest rate, as illustrated above. . . . [However], an [expected present value technique, which considers possible cash flows in the measurement], may be more effective when measuring the effect of credit standing on other liabilities [other then debt]. For example, a liability may present the entity with a range of possible outflows, ranging from very low to very high amounts. There may be little chance of default if the amount is low, but a high chance of default if the amount is high. . . . [In those situations, the effect of possible cash flows on an entity’s credit standing may be effectively incorporated in the computation of those expected cash flows.]

The role of an entity’s credit standing in the accounting measurement of its liabilities has been a controversial question among accountants. The entity’s credit standing clearly affects the interest rate at which it borrows in the marketplace. The initial proceeds of a loan, therefore, always reflect

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the entity’s credit standing at that time. Similarly, the price at which others buy and sell the entity’s loan includes their assessment of the entity’s ability to repay. The example [above] demonstrates how the entity’s credit standing would affect the price it would be required to pay to have another entity assume its liability. However, some have questioned whether an entity’s financial statements should reflect the effect of its credit standing (or changes in credit standing).

Some suggest that the measurement objective for liabilities is fundamentally different from the measurement objective for assets. In their view, financial statement users are better served by liability measurements that focus on the entity’s obligation. They suggest a measurement approach in which financial statements would portray the present value of an obligation such that two entities with the same obligation but different credit standing would report the same carrying amount. Some existing accounting pronouncements take this approach, most notably FASB Statements No. 87, Employers’ Accounting for Pensions, and No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions.

However, there is no convincing rationale for why the initial measurement of some liabilities would necessarily include the effect of credit standing (as in a loan for cash) while others might not (as in a warranty liability or similar item). Similarly, there is no rationale for why, in initial or fresh-start measurement, the recorded amount of a liability should reflect something other than the price that would exist in the marketplace. Consistent with its conclusions on fair value (refer to paragraph 30), the Board found no rationale for taking a different view in subsequent fresh-start measurements of an existing asset or liability than would pertain to measurements at initial recognition.

Some argue that changes in an entity’s credit standing are not relevant to users of financial statements. In their view, a fresh-start measurement that reflects changes in credit standing produces accounting results that are confusing. If the measurement includes changes in credit standing, and an entity’s credit standing declines, the fresh-start measurement of its liabilities declines. That decline in liabilities is accompanied by an increase in owners’ equity, a result that they find counterintuitive. How, they ask, can a bad thing (declining credit standing) produce a good thing (increased owners’ equity)?

Like all measurements at fair value, fresh-start measurement of liabilities can produce unfamiliar results when compared with reporting the liabilities on an amortized basis. A change in credit standing represents a change in the relative positions of the two classes of claimants (shareholders and creditors) to an entity’s assets. If the credit standing diminishes, the fair value of creditors’ claims diminishes. The amount of shareholders’ residual claim to the entity’s assets may appear to increase, but that increase probably is offset by losses that may have occasioned the decline in credit standing. Because shareholders usually cannot be called on to pay a corporation’s liabilities, the amount of their residual claims

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approaches, and is limited by, zero. Thus, a change in the position of borrowers necessarily alters the position of shareholders, and vice versa.

The failure to include changes in credit standing in the measurement of a liability ignores economic differences between liabilities. Consider the case of an entity that has two classes of borrowing. Class One was transacted when the entity had a strong credit standing and a correspondingly low interest rate. Class Two is new and was transacted under the entity’s current lower credit standing. Both classes trade in the marketplace based on the entity’s current credit standing. If the two liabilities are subject to fresh-start measurement, failing to include changes in the entity’s credit standing makes the classes of borrowings seem different—even though the marketplace evaluates the quality of their respective cash flows as similar to one another.

C42. The Board further noted that in the IAS 39 amendment, The Fair Value Option,

the IASB considered similar issues. Paragraph BC89 of the IAS 39 amendment (as it

appears in that amendment) states:

. . . the Board noted that because financial statements are prepared on a going concern basis, credit risk affects the value at which liabilities could be repurchased or settled. Accordingly, the fair value of a financial liability reflects the credit risk relating to that liability. Therefore, it decided to include credit risk relating to a financial liability in the fair value measurement of that liability for the following reasons:

(a) entities realize changes in fair value, including fair value attributable to ownthe liability’s credit risk, for example, by renegotiating or repurchasing liabilities or by using derivatives;

(b) changes in credit risk affect the observed market price of a financial liability and hence its fair value;

(c) it is difficult from a practical standpoint to exclude changes in credit risk from an observed market price; and

(d) the fair value of a financial liability (ie the price of that liability in an exchange between a knowledgeable, willing buyer and a knowledgeable, willing seller) on initial recognition reflects theits credit risk relating to that liability. The Board believes that it is inappropriate to include credit risk in the initial fair value measurement of financial liabilities, but not subsequently.

C43. In reconsidering issues relating to credit standing and liability measurements at fair

value, the Board affirmed that conceptually, credit standing is an essential component of a

fair value measurement. A measurement that does not consider the effect of the entity’s

credit standing (and changes in the entity’s credit standing) is not a fair value

measurement. The Board acknowledged the practical concerns about credit standing and

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liability remeasurements expressed by respondents. Some Board members share those

concerns, especially considering situations in which an entity that is experiencing

financial difficulty reports gains resulting from credit downgrades that it does not have the

ability to immediately realize. However, the Board agreed that those concerns derive

from a threshold issue that relates principally to the selection of the appropriate

measurement attribute for liability remeasurements. The Board plans to continue to

address the issue of which measurement attribute should be required for liability

remeasurements in individual accounting pronouncements on a project-by-project basis.

Transaction Costs

C44. Transaction costs refer to costs that represent the incremental direct costs to

transact in the reference market for the asset or liability, similar to cost to sell as defined

in paragraph 35 of FASB Statement No. 144, Accounting for the Impairment or Disposal

of Long-Lived Assets. In this Statement, the Board affirmed its view in other accounting

pronouncements that the price that forms the basis for a fair value measurement (that is,

the price in the reference market for the asset or liability) should not be adjusted for

transaction costs. A few respondents disagreed with that view. They indicated that a

measurement approach that ignores transaction costs has earnings implications and is

conceptually flawed. In response, the Board clarified that transaction costs are

characteristics of the transaction; they are not characteristics of the particular asset or

liability and, therefore, should not be considered in determining the fair value of the

particular asset or liability. Further, transaction costs may differ, depending on how an

entity decides to structure the transaction.

Interaction between Fair Value and Fair Market Value

C45. The Board agreed that the measurement objective encompassed within the

definition of fair value used for financial reporting purposes is generally consistent with

similar definitions of fair market value used for valuation purposes. For example, the

definition of fair market value in Internal Revenue Service Revenue Ruling 59-60 (the

legal standard of value in many valuation situations) refers to “the price at which property

would change hands between a willing buyer and a willing seller when the former is not

22


under any compulsion to buy and the latter is not under any compulsion to sell, both

parties having reasonable knowledge of relevant facts.” However, the Board observed

that the definition of fair market value has a significant body of interpretive case law,

developed in the context of tax regulation. Because such interpretive case law, in the

context of financial reporting, may not be relevant, the Board chose not to simply adopt

the definition of fair market value, and its interpretive case law, for financial reporting

purposes.

Fair Value Estimates at Initial Recognition

C46. Some respondents questioned whether the price in a transaction in which the entity

acquires an asset or assumes a liability should be used to estimate the fair value of the

asset or liability at initial recognition. They indicated that the guidance in the Exposure

Draft was ambiguous with respect to when a price in a transaction involving the entity

versus an observed price (a price in a transaction that does not involve the entity) within

the fair value hierarchy should be used to estimate the fair value of an asset or liability at

initial recognition.

C47. In its redeliberations, the Board considered that issue in the context of the related

guidance in paragraphs 7 and 27 of Concepts Statement 7, which state:

At initial recognition, the cash or equivalent amount paid or received (historical cost or proceeds) is usually assumed to approximate fair value, absent evidence to the contrary.

A transaction in the marketplace—an exchange for cash at or near to the date of the transaction—is the most common trigger for accounting recognition, and accountants typically accept actual exchange prices as fair value in measuring those transactions, absent persuasive evidence to the contrary. Indeed, the usual condition for using a measurement other than the exchange price is a conclusion that the stated price is not representative of fair value.

C48. In this Statement, the Board agreed that in a transaction in which the entity

acquires an asset or assumes a liability, the transaction price (the price paid for the asset or

received to assume the liability) is an entry price. In contrast, the price that forms the

basis for a fair value estimate (the price that would be received for the asset or paid to

transfer the liability) is an exit price. The Board agreed that, conceptually, entry and exit

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prices are different. However, those prices are presumed to be the same at initial

recognition, absent persuasive evidence to the contrary. In other words, the transaction

price represents the clearing (or equilibrium) price in the reference market for the asset or

liability. Therefore, this Statement incorporates the transaction price presumption in

Concepts Statement 7, referring generally to situations in which the transaction price

presumption might be rebutted from the perspective of the entity. This Statement does not

identify when the transaction price presumption would be rebutted in any specific

situations. The Board plans to separately consider those situations in individual

accounting pronouncements on a project-by-project basis.

Valuation Techniques

C49. This Statement emphasizes that valuation techniques used to estimate fair value

should be consistent with the market approach, income approach, and cost (or asset-based)

approach. The related guidance in the Exposure Draft contained references to the use of

multiple valuation techniques consistent with all three valuation approaches whenever the

information necessary to apply those techniques is available without undue cost and effort.

In its redeliberations, the Board reconsidered certain aspects of that guidance and clarified

other aspects.

Single versus Multiple Valuation Techniques

C50. Several respondents interpreted the related guidance in the Exposure Draft as

requiring the use of multiple valuation techniques in all cases (except as otherwise

indicated, for example, within Level 1). They emphasized that in many cases, multiple

valuation techniques would not be appropriate or cost beneficial. The Board affirmed that

it was not its intent to require the use of multiple valuation techniques. To more clearly

convey its intent, the Board clarified that consistent with existing valuation practice, for

example, valuation practice under the Appraisal Foundation’s Uniform Standards of

Professional Appraisal Practice, valuation techniques that are appropriate in the

circumstances and for which sufficient data are available should be used to estimate fair

value.

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C51. The Board expects that in some cases, a single valuation technique will be

appropriate, for example, for financial instruments that are valued using a pricing model

(whether that model is common in the industry or internally developed). In other cases,

multiple valuation techniques will be appropriate. The Board acknowledged that

valuation techniques will differ, depending on the asset or liability and the availability of

data. Therefore, selecting the appropriate valuation technique requires judgment.

However, in all cases, the objective is to use the valuation technique (or combination of

valuation techniques) that is appropriate in the circumstances.

Undue Cost and Effort

C52. Some respondents referred to the “undue cost and effort” criterion in the Exposure

Draft relating to the availability of information necessary to use valuation techniques.

They pointed out that the most appropriate valuation technique also might be the most

costly valuation technique and that undue cost and effort should not be a basis for

determining whether to use that valuation technique. Moreover, an undue cost and effort

criterion likely would not be consistently applied. The Board agreed and, in response,

removed that undue cost and effort criterion from this Statement. Valuation techniques

that are appropriate in the circumstances and for which sufficient data are available should

be used to estimate fair value, even if obtaining the data involves cost and effort.

Consistency Constraint

C53. The Exposure Draft emphasized the need for consistency in the valuation

technique(s) used to estimate fair value. Some respondents interpreted the related

guidance as allowing a change in the valuation technique used to estimate fair value or its

application (for example, a change in its weighting when multiple valuation techniques are

used) only in limited situations. They stated that consistency is important but that it

should not be the only consideration in selecting the appropriate valuation technique. The

Board agreed. This Statement does not preclude a change in the valuation technique used

to estimate fair value or its application if the change results in an estimate that is more

representative of fair value in the circumstances. The Board affirmed that revisions

resulting from a change in the valuation technique used should be accounted for

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prospectively, as changes in accounting estimates in accordance with the provisions of

FASB Statement No. 154, Accounting Changes and Error Corrections. However, the

Board concluded that in those situations, the disclosure requirements in Statement 154 for

a change in estimate could be unduly burdensome. Therefore, those disclosures do not

apply.

Present Value Techniques

C54. Valuation techniques consistent with the income approach include the present

value techniques discussed in Concepts Statement 7; specifically, the (a) traditional or

discount rate adjustment (DRA) technique and (b) expected cash flow approach or

expected present value (EPV) technique. In this Statement, the Board clarified aspects of

the guidance for applying those techniques in Concepts Statement 7 (Appendix A).

C55. The clarifications made through this Statement focus principally on the adjustment

for risk (systematic or nondiversifiable risk) when using an EPV technique. The Board

understands that because Concepts Statement 7 refers to the appropriate discount rate for

expected cash flows as the risk-free interest rate, the related guidance could be interpreted

as requiring that the adjustment for risk be reflected only in the expected cash flows,

which could result in a significant change to valuation practice. In many valuation

situations, the adjustment for risk is reflected in the discount rate, that is, as an adjustment

to the risk-free interest rate.

C56. The Board agreed that it was not its intent in Concepts Statement 7 to preclude that

alternative approach. To convey its intent more clearly, the Board expanded the guidance

in Concepts Statement 7 to clarify that when using an EPV technique, the adjustment for

risk may be reflected in either:

a. The expected cash flows, in which case the risk-adjusted expected cash flows should be discounted at a risk-free interest rate (Method 1); or

b. The discount rate, in which case the unadjusted expected cash flows should be discounted at a risk-adjusted discount rate, that is, the risk-free interest rate, adjusted for risk (Method 2).

C57. In its discussions, the Board acknowledged, as it did in paragraph 68 of Concepts

Statement 7, that “the appropriate risk premium consistent with fair value may be difficult

26


to determine.” However, the Board agreed that the potential difficulty of determining the

appropriate risk premium is not, in and of itself, a sufficient basis for excluding that

adjustment (in effect, allowing a default of no risk adjustment). Risk is an essential

element of any present value technique. Therefore, an estimate of fair value, using present

value, should include an adjustment for risk if it is apparent that marketplace participants

include one, that is, if the amount is identifiable, measurable, and significant, as indicated

in paragraph 62 of Concepts Statement 7.

C58. This Statement incorporates the related guidance in Concepts Statement 7, as

clarified (Appendix A). However, the Board decided not to revise Concepts Statement 7

to reflect conforming changes to that guidance. Some respondents indicated that leaving

the conceptual guidance in Concepts Statement 7 unchanged would create conflicts

between the Concepts Statements and Level A GAAP that would be confusing. The

Board acknowledged those concerns, but concluded that because this Statement clarifies

and does not change the substantive guidance in Concepts Statement 7 or its application

under existing accounting pronouncements, it was not necessary to revise Concepts

Statement 7 in this project. The Board expects to separately consider the need to revise

Concepts Statement 7 in its conceptual framework project.

Multi-Period Excess Earnings Method

C59. In response to questions raised by some respondents, the Board clarified that

valuation techniques consistent with the income approach also include the multi-period

excess earnings method discussed in the AICPA Practice Aid, Assets Acquired in a

Business Combination to Be Used in Research and Development Activities: A Focus on

Software, Electronic Devices, and Pharmaceutical Industries (Practice Aid). The Board

understands that a multi-period excess earnings method is used to estimate the fair value

of certain intangible assets acquired in a business combination. The Board agreed that the

method should continue to be used under this Statement. However, the Board observed

that the related guidance in the Practice Aid could be interpreted to require an estimate

using an in-exchange valuation premise in situations in which marketplace participants

would continue to use an asset that the entity does not intend to use. For example, that

might be the case if an entity (acquirer) intends to abandon certain proprietary assets that

27


marketplace participants would continue to use. The Board agreed that consistent with the

related guidance in this Statement, the estimate should be considered from the perspective

of marketplace participants and developed using an in-use valuation premise, where

appropriate.

Fair Value Hierarchy

C60. To increase consistency and comparability in estimates of fair value estimates and

related disclosures about the estimates, the Exposure Draft established a fair value

hierarchy that prioritized the inputs to valuation techniques used to estimate fair value.

Specifically, it grouped those inputs into three broad levels, considering the relative

reliability of the inputs. Those groupings distinguished between market inputs that reflect

quoted prices in active markets for identical or similar assets or liabilities (Levels 1 and 2)

and other inputs (Level 3).

C61. Many respondents generally agreed that prioritizing the inputs to valuation

techniques used to estimate fair value is important and that the fair value hierarchy

provides a useful construct for considering the relative reliability of the estimates. In that

regard, the American Accounting Association (AAA) referred to the body of research that

jointly examines the relevance and reliability of fair value estimates derived from various

sources. AAA noted that the research supports the emphasis in this Statement on market

inputs and disclosures of the extent to which estimates of fair value incorporate those

inputs.

C62. Some respondents urged the Board to revise and expand the fair value hierarchy in

the Exposure Draft so that it more clearly conveys a continuum of inputs. In particular,

they referred to the need to distinguish between estimates that are objectively determined

and estimates that are more subjectively determined. In its redeliberations, the Board

revised the fair value hierarchy so that it conveys a continuum of inputs, as suggested by

respondents.

C63. The fair value hierarchy gives the highest priority to market inputs that reflect

quoted prices for identical assets or liabilities in active markets (Level 1) and the lowest

priority to entity inputs (Level 5), clarifying the inputs that fall within that range (Levels

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2–4). The Board observed that in some cases, the inputs to valuation techniques used to

estimate fair value might fall within multiple levels of the fair value hierarchy. This

Statement clarifies that where within the fair value hierarchy the estimate falls depends on

where within the fair value hierarchy the inputs that have a significant effect on the

estimate fall. This Statement does not specify the method that should be used in assessing

the effect of those inputs on the estimate. Because those inputs will differ depending on

the asset or liability, the Board decided that this Statement should allow for judgment in

that regard.

Level 1 Inputs

C64. Level 1 inputs are market inputs that reflect quoted prices for identical assets or

liabilities in active markets. The Board affirmed that quoted prices for identical assets or

liabilities in active markets (such as the New York Stock Exchange) provide the most

reliable estimate of fair value and should be used to estimate fair value whenever

available. Similarly, paragraph 57 of Statement 107 states:

The Board concluded that quoted market prices provide the most reliable measure of fair value. Quoted market prices are easy to obtain and are reliable and verifiable. They are used and relied upon regularly and are well understood by investors, creditors, and other users of financial information. In recent years, new markets have developed and some existing markets have evolved from thin to active markets, thereby increasing the ready availability of reliable fair value information.

C65. Like the Exposure Draft, this Statement emphasizes that because a Level 1

estimate is based solely on a quoted price in an active market, an entity must have the

ability to access that market for the asset or liability at the measurement date. In

particular, it limits discretion in pricing the asset or liability.

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Adjustments to Quoted Prices in Active Markets

C66. The Exposure Draft emphasized that a quoted price for an identical asset or

liability in an active market should be used to estimate fair value whenever it is available,

without adjustment. Some respondents interpreted the related guidance as requiring the

use of a quoted price for an identical asset or liability in an active market whenever it is

observable, without regard to whether that price is readily available or representative of

fair value. Respondents referred to possible conflicts with ASR 118, which requires

adjustments to a quoted price in similar situations (“fair value pricing”). In its

redeliberations, the Board affirmed that it was not its intent to preclude adjustments to a

quoted price for an identical asset or liability in an active market if that price is not readily

available or representative of fair value, noting that in those situations, the market for the

particular asset or liability would not be active. To more clearly convey its intent, the

Board clarified that in those situations, a quoted price for an identical asset or liability in

an active market should be adjusted, as appropriate. However, the resulting estimate will

fall within a lower level of the fair value hierarchy.

C67. The Board further clarified that in some cases, significant events (for example,

principal-to-principal transactions or brokered trades or announcements) might occur after

the close of a market but before the measurement date. In those cases, a quoted price in

that market might not be representative of fair value at the measurement date. The Board

affirmed its view in the Exposure Draft that an entity need not undertake all possible

efforts to obtain information about after-hours trading. However, an awareness of

changes is particularly important for instruments traded in foreign markets that close

many hours before the normal end of the business day in the local area. Therefore, the

entity should not ignore information that is available at the reporting date (for example, a

large change in the price in another market after the close of the principal market in which

the asset or liability trades). The Board agreed that entities should establish and

consistently apply a policy for determining how those events affect estimates of fair value.

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Bid and Asked Prices

C68. In developing this Statement, the Board observed that in some situations, Level 1

inputs will include prices that are quoted in terms of bid and asked prices, for example, in

an active dealer market where the bid price represents the price the dealer is willing to pay

and the asked price represents the price at which the dealer is willing to sell.

C69. In the Exposure Draft, the Board decided to require the use of bid prices for long

positions (assets) and asked prices for short positions (liabilities) in all cases. At that time,

the Board concluded that a single bid-asked spread pricing method would maximize the

consistency and comparability of the estimates within Level 1. Also, the required bid-

asked spread pricing method would have been generally consistent with the related

guidance in paragraph BC99 of IAS 39 (revised), Financial Instruments: Recognition and

Measurement, which states:

The Board confirmed the proposal in the Exposure Draft that the appropriate quoted market price for an asset held or liability to be issued is usually the current bid price and, for an asset to be acquired or liability held, the asking price. It concluded that applying mid-market prices to an individual instrument is not appropriate because it would result in entities recognising up-front gains or losses for the difference between the bid-ask price and the mid-market price.

C70. Respondents agreed that a single bid-asked spread pricing method would

maximize the consistency and comparability of the estimates within Level 1. However,

they stated that because different marketplace participants transact at different prices

within a bid-asked spread, the resulting estimates would not be relevant in all cases.

Further, the required bid-asked spread pricing method in the Exposure Draft would

represent a significant change to practice under ASR 118. The related guidance in ASR

118 is used by investment companies and broker-dealers and provides those entities with

flexibility in selecting the bid-asked pricing method used to estimate fair value. Some

respondents emphasized that for entities that enter into derivative instruments to manage

risk, limiting that flexibility would create operational difficulties because many of those

instruments are traded in active dealer markets and currently valued using other pricing

methods (for example, mid-market prices or prices within a range of observable bid and

31


asked prices). Respondents stated that this Statement should allow the flexibility in ASR

118 in applying the fair value concept.

C71. In its redeliberations, the Board reconsidered the required bid-asked spread pricing

method within Level 1. The Board decided to emphasize the fair value measurement

objective and allow a pricing method within the bid-asked spread that provides an

estimate of the price at which marketplace participants would currently transact,

consistently applied. Bid-asked spread pricing methods appropriate under ASR 118 are

appropriate under this Statement. Accordingly, the use of bid prices for long positions

(assets) and asked prices for short positions (liabilities) is permitted but not required.

C72. Because the Exposure Draft would have required the use of bid prices for long

positions (assets) and asked prices for short positions (liabilities) in all cases, the Board

initially decided to specify the pricing for offsetting positions to preclude recognition of

up-front gains or losses. Specifically, for offsetting positions, the Board decided to

require the use of mid-market prices for the matched portion and bid and asked prices for

the net open position, as appropriate, similar to the guidance in IAS 39 (revised).

Paragraph BC100 of IAS 39 (revised) states:

The Board discussed whether the bid-ask spread should be applied to the net open position of a portfolio containing offsetting market risk positions, or to each instrument in the portfolio. It noted the concerns raised by constituents that applying the bid-ask spread to the net open position better reflects the fair value of the risk retained in the portfolio. The Board concluded that for offsetting risk positions, entities could use mid-market prices to determine fair value, and hence may apply the bid or asking price to the net open position as appropriate. The Board believes that when an entity has offsetting risk positions, using the mid-market price is appropriate because the entity (a) has locked in its cash flows from the asset and liability and (b) potentially could sell the matched position without incurring the bid-ask spread.

C73. Because it decided not to require the use of bid prices for long positions (assets)

and asked prices for short positions (liabilities), the Board subsequently decided to revise

the related guidance for offsetting positions in the Exposure Draft. Specifically, the Board

decided that this Statement should provide general guidance clarifying that for offsetting

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positions in the same instrument, the same price should be used to value both the long and

short positions.

Blocks

C74. Prior to this Statement, the FASB, the AICPA Accounting Standards Executive

Committee (AcSEC), the Securities and Exchange Commission (SEC), and others

considered issues relating to fair value estimates involving large positions of unrestricted

securities with quoted prices in active markets (blocks). The threshold issue focused on

whether the appropriate unit of account for the block is (a) the individual trading unit,

where the estimate would be determined as the product of the quoted price times the

quantity held (P × Q), or (b) the block, where the estimate would be determined using a

blockage factor, that is, a discount (or premium) to the quoted price based on the size of

the position relative to trading volume.

C75. In other FASB Statements (including Statements 107 and 133, and FASB

Statements No. 115, Accounting for Certain Investments in Debt and Equity Securities,

and No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations),

the Board decided that for a block, the estimate should be based on the individual trading

unit, determined using P × Q. Therefore, those Statements preclude the use of a blockage

factor, even if a market’s normal trading volume for one day is not sufficient to absorb the

quantity held and placing orders to sell the position in a single transaction might affect the

quoted price.

C76. Paragraph 58 of Statement 107 states:

Although many respondents to the 1990 and 1987 Exposure Drafts agreed with the usefulness of disclosing quoted market prices derived from active markets, some argued that quoted prices from thin markets do not provide relevant measures of fair value, particularly when an entity holds a large amount of a thinly traded financial instrument that could not be absorbed by the market in a single transaction. The Board considered this issue and reiterated its belief that quoted prices, even from thin markets, provide useful information because investors and creditors regularly rely on those prices to make their decisions. The Board noted that providing the liquidation value of a block of financial instruments is not the objective of this Statement. The Board also concluded that requiring the use of

33


available quoted market prices would increase the comparability of the disclosures among entities.

C77. Similarly, paragraph 315 of Statement 133 states:

Consistent with Statement 107, the definition of fair value in this Statement precludes an entity from using a “blockage” factor (that is, a premium or discount based on the relative size of the position held, such as a large proportion of the total trading units of an instrument) in determining the fair value of a large block of financial instruments. The definition of fair value requires that fair value be determined as the product of the number of trading units of an asset times a quoted market price if available [as required by Statement 107]. . . . Some respondents to the Exposure Draft indicated that the guidance in Statement 107 (and implicitly the definition of fair value in this Statement) should be revised to require or permit consideration of a discount in valuing a large asset position. They asserted that an entity that holds a relatively large amount (compared with average trading volume) of a traded asset and liquidates the entire amount at one time likely would receive an amount less than the quoted market price. Although respondents generally focused on a discount, holding a relatively large amount of an asset might sometimes result in a premium over the market price for a single trading unit. The Board currently believes that the use of a blockage factor would lessen the reliability and comparability of reported estimates of fair value.

C78. However, for broker-dealers and certain investment companies (investment

companies other than registered funds subject to SEC reporting requirements that used

blockage factors in financial statements for fiscal years ending on or before May 31, 2000)

the AICPA Audit and Accounting Guides for those industries (the Guides) allowed an

exception to the requirement of other FASB pronouncements to use P × Q to estimate the

fair value of a block. Specifically, the Guides permitted an estimate using a blockage

factor, where appropriate.

C79. In developing this Statement, the Board decided to address that inconsistency

within GAAP. The Board considered the earlier work completed by AcSEC through its

Blockage Factor Task Force, which was formed in 2000 to address issues specific to the

use of blockage factors (discounts) by broker-dealers and investment companies. Based

on discussions with industry representatives (broker-dealers, mutual funds, and other

investment companies) and review of relevant academic research and market data, the task

force affirmed that discounts involving large blocks exist, generally increasing as the size

34


of the block to be traded (expressed as a percentage of the daily trading volume) increases,

but that the methods for measuring the blockage factors (discounts) are largely subjective.

C80. In the Exposure Draft, the Board acknowledged the diversity in practice with

respect to the methods for measuring blockage factors (discounts). However, the Board

agreed that for entities that regularly buy and sell securities in blocks, the financial

reporting that would result when using P × Q to estimate the fair value of a block would

not be representationally faithful of the underlying business activities. In particular, if a

block is purchased at a discount to the quoted price, an estimate using P × Q would give

the appearance of an instant gain upon buying the block, followed by a reported loss on

subsequently selling the block (at a discount to the quoted price), resulting in misleading

reporting. At that time, the Board understood that for blocks held by broker-dealers,

industry practice was to sell the securities in blocks. In view of that selling practice (in

blocks), the Board decided that this Statement should allow the exception to P × Q in the

Guides to continue, thereby permitting the use of blockage factors by broker-dealers and

certain investment companies.

C81. Many respondents, in particular, broker-dealers, agreed with that decision.

However, during its redeliberations, the Board discussed issues relating to the

measurement of blocks with representative respondents and certain user groups, including

analysts that follow broker-dealers. Through those discussions, the Board learned that for

blocks held by broker-dealers, industry practice is to sell the securities in quantities that

are not necessarily blocks, thereby allowing for situations in which the securities could be

sold at the quoted price for an individual trading unit. Because of that selling practice (in

non-blocks), the Board determined that there is no compelling reason to allow the

exception to P × Q in the Guides to continue under this Statement. The Board decided

that the estimate of the fair value of a block should be determined using P × Q .

C82. In reaching that decision, the Board affirmed its conclusions relating to the

prohibition on the use of blockage factors in other FASB Statements. In particular, the

Board emphasized that when a quoted price for a security in an active market is available,

that price should be used to estimate fair value without regard to an entity’s intent to

35


transact at that price. Basing the fair value on the quoted price results in comparable

reporting. Adjusting the price for the size of the position introduces management intent

(to trade in blocks) into the measurement, reducing comparability. Following the

reasoning used in Statement 107, the quoted price provides useful information because

investors regularly rely on quoted prices for decision making. Also, the decision to

exchange a large position in equity securities in a single transaction at a price lower than

the price that would be available if the position were to be exchanged in multiple

transactions (in smaller quantities) is a decision whose consequences should be reported

when that decision is executed. Until that transaction occurs, the entity that holds the

block has the ability to effect the transaction either in the block market or in another

market.

C83. Therefore, this Statement precludes the use of blockage factors within Level 1 and

eliminates the exception to P × Q in the Guides. IAS 39 (revised) includes similar

guidance in paragraph AG72, which states, “The fair value of a portfolio of financial

instruments is the product of the number of units of the instrument and its quoted price.”

Alternative Pricing Methods

C84. A few respondents referred to situations in which an entity holds a large number of

similar assets and liabilities that are required to be measured at fair value and a quoted

price in an active market is not readily obtainable for each of those assets and liabilities

(for example, from financial reporting services or individual broker-dealers). They

indicated that, in those situations, the fair value hierarchy should allow for practical

considerations and trade-offs in selecting the valuation technique used to estimate fair

value within Level 1, considering the number of assets and/or liabilities required to be

measured in a financial reporting period and the timing of that reporting. In its

redeliberations, the Board revised the guidance within Level 1 to allow for the use of an

alternative valuation method (for example, matrix pricing) as a practical expedient,

provided that the method has been demonstrated to replicate actual prices. This Statement

emphasizes that the practical expedient within Level 1 applies only in the limited

36


situations in which a quoted price in an active market could be obtained but, for practical

reasons, is not.

Level 2 Inputs

C85. Level 2 inputs are market inputs that reflect quoted prices not encompassed within

Level 1, adjusted as appropriate.

C86. The Exposure Draft limited the inputs within Level 2 to quoted prices for similar

assets or liabilities in active markets, adjusted as appropriate, emphasizing that within

Level 2, such adjustments must be objectively determinable. The Exposure Draft referred

to situations in which different entities likely would develop similar estimates for the same

asset or liability. Many respondents indicated that because all adjustments involve at least

some degree of subjective judgment and estimation, Level 2 would be overly restrictive.

Moreover, the objectively determinable criterion within Level 2 likely would not be

consistently applied.

C87. In its redeliberations, the Board reconsidered the inputs within Level 2. The Board

decided that those inputs should include all quoted prices that are not encompassed within

Level 1, adjusted as appropriate. The Board observed that in cases in which a price is

quoted in a market that is not active, it might be necessary to also consider the results of

valuation techniques that use other inputs in a market that is active (within Levels 2–4 of

the fair value hierarchy). However, the Board agreed that combining those quoted price

inputs in a single level within the fair value hierarchy would provide an objective basis for

considering requisite adjustments and the reliability of the estimates using those inputs

(within Level 2) relative to estimates using other inputs (within Level 3 or Level 4). The

Board eliminated the objectively determinable criterion for adjustments to quoted prices.

Instead, the Board clarified that an adjustment having a significant effect on the estimate

might render the estimate a lower level estimate, considering where within the fair value

hierarchy the inputs used to determine the adjustment fall.

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Restricted Securities

C88. The Board observed that accounting pronouncements that require fair value

measurements for restricted securities do not consistently refer to restricted securities.

Therefore, the guidance for developing the requisite estimates differs. The Board decided

to address that issue in this Statement.

C89. This Statement defines a restricted security broadly, as a security for which sale is

legally restricted by governmental or contractual requirement for a specified period,

whether the restriction limits sales (for example, to qualifying investors, as may be the

case under Rule 144 or similar rules of the SEC) or otherwise prohibits sales. In either

case, an adjustment (discount) from the quoted price for an otherwise identical

unrestricted security of the same issuer that trades in a public market is required to reflect

the effect of the restriction (a Level 2 input). Therefore, this Statement establishes the

general principle that the adjustment (discount) should reflect the amount a marketplace

participant would demand to assume the risk arising from the inability to access a public

market for the security for the specified period. That general principle applies regardless

of when the restriction terminates.

C90. The Exposure Draft provided general guidance for developing the estimate that

carried forward related guidance in ASR No. 113, Statement Regarding “Restricted

Securities.” That guidance, considered in the context of investment companies,

emphasizes factors that should not be considered in determining the estimate. Largely for

that reason, respondents that commented on that aspect of the Exposure Draft stated that

the guidance in ASR 113 is not particularly useful. They indicated a need for additional

guidance emphasizing factors that should be considered in determining the estimate.

C91. In the Exposure Draft, the Board discussed factors that should be considered in

determining the estimate. However, the Board observed that those factors will vary,

depending on the nature and duration of the restriction and facts and circumstances

specific to the particular security and issuer (quantitative and qualitative). For that reason,

the Board concluded that it would not be possible to identify all factors that should be

considered in all cases. In its redeliberations, the Board affirmed that conclusion and

38


decided to remove the guidance in ASR 113 from this Statement. The Board observed

that many fair value estimates will require adjustments and that this Statement does not

provide guidance specific to any of those adjustments. The Board determined that there is

no compelling reason to provide detailed guidance for adjustments involving restricted

securities. Instead, the Board decided to emphasize the fair value measurement objective

and allow judgment in applying that objective.

C92. Having defined restricted securities in this Statement, the Board decided that this

Statement should amend Statement 115 to eliminate its definition of restricted stock in

footnote 2 to paragraph 3(a). The guidance in this Statement applies when estimating the

fair value of restricted securities included in the scope of Statement 115 (that is, equity

securities with restrictions that terminate within one year), thereby precluding an estimate

using a quoted price for an otherwise identical unrestricted security of the same issuer,

unadjusted.

Level 3 Inputs

C93. Level 3 inputs are market inputs other than quoted prices that are directly

observable for the asset or liability. Those inputs include information about interest rates,

yield curves, volatilities, and default rates.

C94. In the Exposure Draft, Level 3 encompassed all inputs used in valuation

techniques to estimate fair value other than quoted prices in active markets. Nearly all

respondents indicated that Level 3 would be overly broad, encompassing estimates that

vary significantly with respect to the inputs used to derive the estimates and the relative

reliability of the estimates. The principal concern expressed by respondents focused on

the disclosure of the resulting estimates in the aggregate, as “Level 3 estimates.” To more

clearly convey a continuum of inputs previously encompassed within Level 3, the Board

included some Level 3 inputs within Level 2 (quoted prices in markets that are not active)

and expanded the fair value hierarchy to include other Level 3 inputs within different

levels (Levels 4 and 5).

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Level 4 Inputs

C95. Level 4 inputs are market inputs that are not directly observable for the asset or

liability but that are corroborated by other market data for the asset or liability through

correlation or by other means (market-corroborated). The concept of corroborated market

data is intended to incorporate market data that are observable, based on an assessment of

factors relevant to the asset or liability. Market-corroborated inputs include inputs that are

derived through extrapolation or interpolation. The Board concluded that market-

corroborated inputs are market inputs and that estimates that are derived principally from

market-corroborated inputs should be distinguished from estimates that are derived

principally from entity inputs (within Level 5).

Level 5 Inputs

C96. Level 5 inputs are entity inputs. Entity inputs may range from market inputs that

are derived through extrapolation or interpolation but that are not corroborated by other

market data to inputs that reflect an entity’s own cost estimates. In this Statement, the

Board affirmed its conclusion in other accounting pronouncements that in the absence of

market inputs, entity inputs may be used to estimate fair value as a practical expedient.

Paragraph 38 of Concepts Statement 7 explains:

. . . an entity that uses cash flows in accounting measurements often has little or no information about some or all of the assumptions that marketplace participants would use in assessing the fair value of an asset or a liability. In those situations, the entity must necessarily use the information that is available without undue cost and effort in developing cash flow estimates. The use of an entity’s own assumptions about future cash flows is compatible with an estimate of fair value, as long as there are no contrary data indicating that marketplace participants would use different assumptions. If such data exist, the entity must adjust its assumptions to incorporate that market information.

C97. The Exposure Draft incorporated that guidance in Concepts Statement 7, referring

to the use of entity inputs as a practical expedient if market inputs are not available

without undue cost and effort. As noted by some respondents, in many cases, some form

of market inputs will be available. They stated that where such inputs are relevant, undue

40


cost and effort should not be a basis for determining whether to use those inputs. The

Board agreed and, in response, clarified that market inputs should be used to estimate fair

value whenever those inputs are available, even if obtaining or otherwise deriving such

inputs involves cost and effort.

C98. The Board acknowledged that entity inputs will vary and require trade-offs,

considering the extent to which such inputs are both representationally faithful and

verifiable. Paragraphs 63 and 81 of Concepts Statement 2 explain:

Representational faithfulness is correspondence or agreement between a measure or description and the phenomenon it purports to represent. In accounting, the phenomena to be represented are economic resources and obligations and the transactions and events that change those resources and obligations. The quality of verifiability contributes to the usefulness of accounting information because the purpose of verification is to provide a significant degree of assurance that accounting measures represent what they purport to represent. Verification is more successful in minimizing measurer bias than measurement bias, and thus contributes in varying degrees toward assuring that particular measures represent faithfully the economic things or events that they purport to represent. Verification contributes little or nothing toward insuring that measures used are relevant to the decisions for which the information is intended to be useful. [Footnote reference omitted.]

C99. In particular, some entity inputs might be both representationally faithful and

verifiable. Other entity inputs might be representationally faithful but subject to

verification difficulties. Yet other entity inputs might be verifiable but lack

representational faithfulness. However, the Board affirmed its view in the Exposure Draft

that in all cases, the fair value measurement objective remains the same. Therefore, entity

inputs should be developed within market parameters, eliminating the effect of factors

specific to the entity whenever possible.

Disclosures

C100. The Board observed that few of the accounting pronouncements that require fair

value measurements included in the scope of this Statement also require disclosures about

those measurements. Further, the required disclosures vary. The Board decided that

41


having established a framework for measuring fair value, this Statement should require

enhanced disclosures about those measurements. Because at initial recognition many

assets and liabilities are measured in the statement of financial position at amounts that

approximate fair value (for example, in a business combination), the Board decided to

limit the disclosures to fair value remeasurements in periods subsequent to initial

recognition, whether the remeasurements are made on a recurring or nonrecurring basis.

C101. Some respondents disagreed with the Board’s decision to include enhanced

disclosures about fair value in this Statement. In particular, they expressed concerns about

requiring those disclosures without first reconsidering all related disclosures currently

required under existing accounting pronouncements as part of a comprehensive disclosure

framework.

C102. Some respondents further indicated that the Board should reconsider those

disclosures in its project on financial performance reporting by business enterprises. In

the Exposure Draft, the Board considered the interaction between this project and its

project on financial performance reporting by business enterprises. Based on input

received from the UAC and others, the Board concluded that until such time as a final

Statement in that project is issued, the disclosures required by this Statement would

provide information about fair value remeasurements that is useful to users of financial

statements. The Board subsequently affirmed that conclusion.

C103. The Board agreed that issues raised by respondents indicated the need to

reconsider or otherwise clarify some of the disclosure requirements, but not eliminate

them from this Statement altogether. In that regard, the Board understands that some

entities (in particular, entities in the financial services industry) already are making similar

disclosures in SEC filings as part of disclosures about critical accounting estimates.

Fair Value Remeasurements

C104. In this Statement, the Board decided that an entity should disclose information that

enables users of its financial statements to evaluate the extent to which fair value is used

to remeasure assets and liabilities recognized in the statement of financial position and the

42


inputs used to develop the estimates. The Board agreed that information about the inputs

used to develop the estimates would allow users of financial statements to assess the

relative reliability of the estimates.

C105. To achieve that disclosure objective, the related disclosures in the Exposure Draft

focused on the inputs used to estimate fair value within each major category of assets and

liabilities remeasured at fair value during the period. Many respondents generally agreed

with those disclosures, subject to clarifications to conform the disclosures to the fair value

hierarchy, as revised. In response, the Board established three broad disclosure levels

within the fair value hierarchy to distinguish estimates that fall within Level 1, Levels 2-4,

and Level 5.

Unrealized Gains or Losses

C106. In this Statement, the Board decided that an entity also should disclose information

that enables users of its financial statements to evaluate the effects of fair value

remeasurements on income (or changes in net assets) for the period.

C107. To achieve that disclosure objective, the related disclosures in the Exposure Draft

focused on the change in unrealized gains or losses during the period relating to estimates

within each major category of assets and liabilities remeasured at fair value, segregating

unrealized gains or losses included in other comprehensive income. In that regard, the

Board agreed that information about unrealized gains or losses is relevant to users of

financial statements. However, some respondents disagreed. In particular, they stated

that for assets and liabilities that are remeasured at fair value on a recurring basis

(principally, financial instruments), disclosures about unrealized gains or losses would not

provide useful information to users of financial statements. Further, that information

could be misleading; for example, users of financial statements might conclude that

unrealized gains or losses are of a “lesser quality” than realized gains or losses, which is

not the case. Also, those disclosures would not be cost-effective. Because entities do not

currently capture that information, incremental systems changes (in some cases

significant) would be required to comply with those disclosures. Those respondents stated

that the Board should remove those disclosures from this Statement.

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C108. The Board subsequently affirmed its view in the Exposure Draft that information

about unrealized gains or losses is relevant to users of financial statements. However, the

Board agreed that it did not intend to require entities to make significant incremental

systems changes to comply with the related disclosure requirements of this Statement. To

mitigate cost-benefit concerns, the Board decided to focus the disclosures on unrealized

gains or losses that relate to estimates that are subjectively determined using entity inputs

(within Level 5).

Total Gains or Losses

C109. In its redeliberations, the Board observed that subsequent changes in fair value

reflect changes in economic conditions without regard to whether an entity has transacted.

The Board observed that disclosure of total gains or losses (unrealized and realized) would

provide information about changes in the wealth of the entity due to changes in economic

conditions. The Board agreed that information would further enable users of financial

statements to evaluate the effects of fair value remeasurements during the period on

income (or changes in net assets) for the period. Therefore, the Board decided that this

Statement should require disclosure of total gains or losses relating to estimates within

each major category of assets and liabilities remeasured at fair value (even if those assets

and liabilities are not still held at the end of the period), segregating those gains or losses

included in other comprehensive income.

Other Disclosures

C110. A few respondents stated that this Statement should standardize disclosures of the

discount rate and other assumptions used in valuation techniques to estimate fair value.

The Board affirmed its view in the Exposure Draft that standardizing those disclosures for

all assets and liabilities remeasured at fair value (for example, requiring disclosure of

assumptions used in developing all estimates of fair value) would not be practical. By

way of example, the Board referred to other accounting pronouncements in which it

reached different decisions on whether to require disclosures about significant

assumptions. The Board noted that in many cases (in particular, for nonfinancial assets

and liabilities), an overwhelming volume of information would need to be disclosed for

44


that information to be meaningful. Instead, this Statement establishes broad disclosure

objectives, which the Board expects to use as a basis for considering more specific

disclosures in individual accounting pronouncements that require fair value measurements

on a project-by-project basis.

C111. A few respondents also referred to the disclosures about the fair value of financial

instruments required by Statement 107. They suggested that the Board consolidate those

disclosures with the disclosures in this Statement. The Board disagreed. The disclosures

required by Statement 107 are specific to financial instruments, as defined in that

Statement, and extend beyond the measurements themselves. Further, those disclosures

apply regardless of whether a financial instrument is recognized in the statement of

financial position and measured at fair value. However, the Board agreed that the related

disclosures required by this Statement should be encouraged for financial instruments

disclosed at fair value for which the disclosures required by this Statement would not

otherwise apply, including financial instruments recognized in the statement of financial

position at amounts other than fair value (for example, loans carried at cost). Therefore,

this Statement amends Statement 107 to refer to the related disclosures in this Statement.

C112. A few respondents also referred to possible conflicts and overlap with SEC

disclosure requirements within management discussion and analysis, noting that to

varying degrees, the disclosures required by this Statement would duplicate those and

other industry-specific disclosures made outside the basic financial statements. The Board

affirmed its view in the Exposure Draft that the disclosures required by this Statement

supplement and do not change or otherwise conflict with the related disclosures required

by other accounting pronouncements. The disclosures required by this Statement apply

for all entities that hold assets and liabilities recognized in the statement of financial

position that are remeasured at fair value. Further, all entities should include those

disclosures within the basic financial statements.

C113. The Board emphasized that consistent with its related codification initiatives, the

fair value information disclosed under this Statement should be combined and disclosed

together with the fair value information disclosed under other pronouncements, including

45


Statement 107 (for example, in a single fair value footnote), where practicable. The Board

concluded that having those disclosures available in one place would enhance users’

understanding about fair value and the use of fair value in financial reporting.

Amendment to Opinion 28

C114. In the Exposure Draft, the Board decided that the disclosures required by this

Statement should be made in all interim periods. Some respondents emphasized that those

disclosures, in all interim periods, would not be cost beneficial. The Board acknowledged

those concerns. However, the Board affirmed its conclusion in the Exposure Draft that

fair value disclosures, in interim periods, would provide timely information to users about

fair value estimates and factors affecting the estimates during the year. Moreover,

increased information about fair value on an ongoing basis would enhance users’

understanding about fair value and the use of fair value in financial reporting. Because of

respondents’ concerns, the Board decided to limit the disclosures that are required in

interim periods to quantitative disclosures. In reaching that decision the Board considered

related research, which indicates that presentation of financial information is an important

communications tool. To more clearly communicate the information conveyed by those

quantitative disclosures, the Board decided to require tabular presentation (in all periods).

This Statement amends APB Opinion No. 28, Interim Financial Reporting, accordingly.

Qualitative disclosures, for example, narrative disclosure about the valuation techniques

used to estimate fair value, need be made only in annual periods.

Effective Date and Transition

C115. The Board decided that this Statement should be effective for financial statements

issued for fiscal years beginning after December 15, 2006, and interim periods within

those fiscal years, except as discussed in paragraph C116. Because this Statement applies

under other accounting pronouncements that require fair value measurements and,

therefore, does not require any new fair value measurements, the Board believes that the

effective date of this Statement provides sufficient time for entities, their auditors, and

users of financial statements to analyze, interpret, and prepare for implementation of the

provisions of this Statement. The Board encourages earlier application.

46


C116. The Board observed that, to a large extent, the disclosure requirements of this

Statement clarify and codify the fair value information reported under existing accounting

pronouncements. In considering the importance of the information conveyed by those

disclosures, the Board agreed that they should not be deferred until this Statement is

initially applied in its entirety. Therefore, the Board decided that the disclosure

requirements of this Statement should be effective earlier, for financial statements issued

for fiscal years ending after December 15, 2006.

C117. The Board agreed, as it did in the Exposure Draft, that because the substantive

guidance in this Statement focuses broadly on the methods used to estimate fair value,

application of that guidance would result in a change in the method of applying an

accounting principle, which is considered a change in accounting principle. However,

because the methods used to estimate fair value are referred to generally, for example, in

the context of inputs requiring both quantitative and qualitative assessments, the Board

concluded that a change in the methods used to estimate fair value would be inseparable

from a change in the estimates (that is, as new events occur or as new information is

obtained, for example, through better insight or improved judgment). Therefore, the

Board decided that the guidance in this Statement should be applied prospectively (similar

to a change in accounting estimate) as of the first interim period for the fiscal year in

which this Statement is initially applied, except as discussed in paragraph C118.

C118. For blocks held by broker-dealers and certain investment companies, this

Statement specifies the method that should be used to estimate fair value (paragraph 28).

The Board agreed that change in method is a change in accounting principle that would be

separable from the change in the estimate. Because the information necessary to apply

that change in accounting principle retrospectively to all prior periods presented should be

available, the Board decided that change in accounting principle should be applied

retrospectively to all prior periods (similar to a change in accounting principle). The

cumulative effect of the change in accounting principle on periods prior to those presented

should be reflected in the carrying amounts of assets and liabilities as of the beginning of

the first period presented. An offsetting adjustment should be made to the opening

47


balance of retained earnings for that period. The disclosures for a change in accounting

principle in paragraphs 17(b)(2) and 18 of Statement 154 are required.

Benefits and Costs

C119. The mission of the FASB is to establish and improve standards of financial

accounting and reporting for the guidance and education of the public, including

preparers, auditors, and users of financial information. In fulfilling that mission, the

Board endeavors to determine that a proposed standard will fill a significant need and that

the costs imposed to meet that standard, as compared with other alternatives, are justified

in relation to the overall benefits of the resulting information. Although the costs to

implement a new standard may not be borne evenly, investors and creditors—both present

and potential—and other users of financial information benefit from improvements in

financial reporting, thereby facilitating the functioning of markets for capital and credit

and the efficient allocation of resources in the economy.

C120. The Board concluded that this Statement will result in improved financial

reporting. In particular, this Statement establishes a single definition of fair value within

GAAP and a framework for measuring fair value that applies broadly under other

accounting pronouncements. A single definition of fair value, together with a framework

for measuring fair value, should result in increased consistency in application and, with

respect to the resulting fair value estimates, increased comparability. Concepts Statement

2 emphasizes that providing comparable information enables users to identify similarities

in and differences between two sets of economic events.

C121. This Statement also enhances disclosures about the use of fair value to remeasure

assets and liabilities, providing information that is useful to present and potential

investors, creditors, and others in making rational investment, credit, and similar

decisions—the first objective of financial reporting in FASB Concepts Statement No. 1,

Objectives of Financial Reporting by Business Enterprises. This Statement encourages

entities to include the fair value information disclosed under this Statement together with

the fair value information disclosed under other accounting pronouncements in one place,

where practicable. The Board concluded that having that information available in one

48


place would improve the quality of information provided to users of financial statements

about fair value measurements, thereby enhancing users’ understanding about fair value

and the use of fair value in financial reporting. The Board agreed that because the

disclosures required by this Statement relate to assets and liabilities that are remeasured at

fair value in the statement of financial position and rely largely on the information used

for the remeasurements, they should entail minimal incremental cost.

C122. In addition, the amendments made by this Statement simplify and, where

appropriate, codify the related guidance that currently exists for measuring fair value,

eliminating differences that have added to the complexity in GAAP, consistent with the

Board’s related codification initiatives.

C123. Although the framework for measuring fair value builds on current practice and

requirements, the Board acknowledges that certain methods required by this Statement

may result in a change to practice for some entities—in particular, entities that do not

currently consider the effect of changes in credit standing on the fair value of liabilities

remeasured at fair value (principally, derivative liabilities under Statement 133), broker-

dealers and certain investment companies that use blockage factors to estimate the fair

value of blocks, and entities within the scope of Statement 115 that estimate the fair value

of equity securities with restrictions that terminate within one year using the quoted price

for an identical unrestricted security of the issuer (unadjusted). In addition, some entities

might need to make systems and other changes to comply with the requirements of this

Statement, incurring one-time costs. However, the Board believes that the benefits

resulting from increased consistency and comparability of fair value information and

improved communication of that information to users of financial statements will be

ongoing.

International Financial Reporting Standards

C124. Many International Financial Reporting Standards (IFRS) require fair value

measurements. Like the FASB, the International Accounting Standards Board (IASB) has

addressed issues related to fair value largely in the context of financial instruments, more

recently, in IAS 39 (revised). In developing this Statement, the Board considered the

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comparable fair value measurement guidance in IAS 39 (revised). That guidance in IAS

39 (revised) is largely consistent with the guidance in this Statement, except as otherwise

noted.

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