Why the Update & When is it Effective?
According to Topic 820--Fair Value Measurements and Disclosures, fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” The fair value measurement assumes that a liability is exchanged in an orderly transactionbetween market participants and that the risk of nonperformance does not change as a result of the exchange. Entities have expressed concern that there may be a lack of observable market information (e.g., quoted price for identical liability in an active market) to measure the fair value of a liability, often because of contractual or other legal restrictions on the liability being valued. Therefore, some entities have questioned how to measure the fair value of a liability in a hypothetical transaction when a restriction prevents such a transfer. Considering that some liabilities (e.g., bonds) are traded in the marketplace as assets, questions have been raised about whether prices of debt instruments traded as assets represent the fair value of that instrument for the issuer (obligor). Considering these issues, the FASB has issued updated guidance (Accounting Standards Update 2009-05) on the fair value measurement of liabilities in order to address these issues.
Summary of Revisions
The update to Topic 820 (Measuring Liabilities at Fair Value) indicates that when a quoted price for an identical liability is not available, a reporting unit shall measure fair value using a valuation technique that uses either (1) the quoted price of the identical liability when traded as an asset or (2) the quoted prices for similar liabilities traded as a liability or asset or a valuation technique consistent with the principles of Topic 820. Such techniques could include an income approach or a market approach. The revision also allows for certain adjustments to the quoted price of a liability traded as an asset or valuation technique used to value the liability; however, the guidance advises that adjustments (e.g., discounts) should not be made to the quoted price or the valuation technique for restrictions that prevent the transfer of the underlying liability since the affect of the restriction is implicitly or explicitly already included in the other inputs to the fair value measurement.
The amendments to Topic 820 are summarized below:
Measurement
In circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity shall measure fair value using one or more of the following techniques:
- Quoted price of an identical liability when traded as an asset or quoted prices for similar liabilities traded as a liability or asset. A reporting entity needs to determine whether the quoted price in an active market should be adjusted for factors specific to the liability and the asset. Any adjustment to the quoted price should render the fair value measurement of the liability a lower level measurement in the fair value hierarchy.
- Another valuation technique that is consistent with the principles of Topic 820. For example, an income approach using a present value technique or a market approach reflecting the amount an entity would pay to transfer the identical liability or would receive to enter into the identical liability. When applying a valuation technique, inputs shall reflect the assumptions that market participants would use in the principal or most advantageous market for the liability with the same contractual terms.
A reporting entity shall apply all applicable guidance in Topic 820 in determining fair value when the volume and level of activity for an asset or liability have significantly decreased and for transactions that are not orderly. That is, further analysis of the transactions or quoted prices is needed, and a significant adjustment to the transactions or quoted prices may be necessary to estimate fair value. Alternatively, a change in valuation technique or the use of multiple valuation techniques may be appropriate (e.g., use of both a market approach and a present value technique).
Adjustments Allowed in Measuring Fair Value
When measuring the fair value of a liability using the quoted price of the liability when traded as an asset or using a valuation technique to value the liability, the reporting entity should not adjust the quoted price of the asset or adjust inputs to the valuation technique model for the effect of a restriction preventing the liability’s sale. The effect of a restriction that prevents the transfer of a liability is assumed to be either implicitly or explicitly already included in the other inputs to the fair value measurement. However, the quoted price of the liability when traded as an asset shall be adjusted for the factors specific to the asset that are not applicable to the fair value measurement of the liability. For example, the quoted price for the asset includes the effect of a third-party credit enhancement or the inclusion of a restriction preventing the sale of the asset (not the underlying liability). Also, as discussed above, adjustments are allowed when the volume and level of activity for an asset have significantly decreased and for transactions that are not orderly.
Effective Date
The new guidance is effective for the first reporting period (including interim periods) beginning after the date of issuance of the update which is August 26, 2009. A change in a valuation technique or its application resulting from the new guidance must be accounted for as a change in estimate. In the period of adoption, a reporting entity must disclose any resulting change in valuation technique and related inputs and quantify the total effect, if practicable.