Financial Accounting Standard 157 (FAS 157) Explained: Framework, Asset Valuation, and Implications

Financial accounting standard 157 (FAS 157), later rebranded as accounting standards code topic 820, ushered in a paradigm shift in fair value accounting in 2006. This in-depth analysis navigates through the critical components of FAS 157, delving into the controversial level 1, level 2, and level 3 asset valuation categories and examining the ramifications on financial reporting during periods of economic uncertainty.

Financial accounting standard 157 (FAS 157) emerged as a pivotal framework for estimating fair value in situations where quoted prices were absent. This standard introduced the concept of an “exit price” and established a three-level hierarchy reflecting the degree of judgment required in fair value estimation. The levels ranged from market-based prices to the challenging task of valuing illiquid level 3 assets with no observable market, relying on proprietary internal information.

The FASB 157 classification system categorizes assets into level 1, level 2, and level 3, based on the ease of accurate valuation.

Level 1 assets, the most readily valued, hinge on observable market prices. This category includes easily marketable assets such as treasury bills, marketable securities, foreign currencies, and gold bullion.

Assets categorized under level 2 lack regular market pricing but can be fairly valued based on quoted prices in inactive markets or models with observable inputs like interest rates and yield curves. An example is an interest rate swap.

Level 3 assets present the least marked-to-market category, relying on models and unobservable inputs. Assets like mortgage-backed securities, private equity shares, and complex derivatives fall into this level, demanding a valuation process known as mark to management.

The subprime crisis of 2008 became a litmus test for FAS 157’s subjective fair value measures. Unprecedented market volatility compelled the financial accounting standards board (FASB) to grant companies greater flexibility in valuing illiquid assets to prevent the dissemination of misleading financial information.

Before 2008, historical cost accounting prevailed over fluid mark-to-market estimates. However, lobbying from the private equity industry led to the adoption of FAS 157, as it aimed to standardize the fair valuation of illiquid assets.

In 2016, the limitations of fantasy valuation became apparent when VC-backed startup Dropbox faced a 51% overnight markdown by T. Rowe Price. The discrepancy in valuation methods highlighted the challenges in assessing the true value of assets.

FAS 157, now topic 820, enhances transparency by establishing a consistent framework for fair value estimation, impacting how companies report their assets on balance sheets.

Yes, before FAS 157, historical cost accounting prevailed. FAS 157 introduced a shift towards mark-to-market estimates, particularly advocated by the private equity industry for fair valuation standardization.

FAS 157 was adopted to address the need for standardizing the fair valuation of illiquid assets, providing a more accurate representation of a company’s financial state.

The subprime crisis subjected FAS 157’s fair value measures to volatility and prompted the FASB to allow more flexibility in valuing illiquid assets to prevent misleading financial portrayals.