Definition of Financial Accounting Standard 157 (FAS 157)


What is Financial Accounting Standard 157 (FAS 157)?

Financial Accounting Standard 157 (FAS 157) is the controversial Financial Accounting Standards Board (FASB) fair value accounting standard, which was introduced in 2006, on the eve of the global financial crisis, and is now known as of the Accounting Standards Code. Subject 820.

Key points to remember

  • In 2006, the United States Financial Accounting Standards Board (FASB) audited how companies were required to mark their assets to market through the accounting standard known as FASB 157 (No. 157, Fair Value measurements).
  • Now named Accounting Standards Code Topic 820, FASB 157 introduced a classification system that aims to clarify the assets of companies’ balance sheets.
  • The FASB 157 categories for valuing assets have been coded Level 1, Level 2, and Level 3. Each level is distinguished by how easily assets can be accurately valued, with Level 1 assets being the easiest.

Understanding Financial Accounting Standard 157

Financial Accounting Standard 157 (FAS 157) has established a single, consistent framework for estimating fair value in the absence of quoted prices, based on the notion of “exit price” and a 3-level hierarchy to reflect the level of judgment involved in estimating fair value. values, ranging from market-based prices to Illiquid Level 3 assets where no observable market exists and valuations should be based on proprietary inside information, such as the most recent funding cycle.

Shortly after the introduction of the FAS 157, the subprime mortgage crisis tested its subjective measures of fair value. Equity market volatility and illiquid markets upended fair value accounting models and forced private equity firms to write down the value of assets on their balance sheets, triggering a destructive feedback loop of asset write-downs that threatened the solvency of the banking system. Because volatile markets and fair value accounting can give a misleading picture of the true state of a company’s finances, the FASB has since given companies more leeway when valuing illiquid assets.

other considerations

Prior to 2008, valuations were based on historical cost accounting rather than free-flowing estimates of market value, as it was widely considered more conservative and reliable. But the private equity industry lobbied for change because using historical cost doesn’t allow for easy comparison between companies, and they wanted to standardize the fair valuation of illiquid assets.

However, the limits of fantastic valuation calculations emerged in 2016, when venture capital-backed “unicorn” startup Dropbox was cut 50% overnight by mutual fund T. Rowe Price. , at $8 a share, because she thought $10 billion in valuations was irrational. When Dropbox went public in March 2018, its shares opened at $29 per share and its market valuation soared to $13 billion the day after the IPO.

FASB Asset Levels

The FASB 157 categories for valuing assets have been coded Level 1, Level 2, and Level 3. Each level is distinguished by how easily assets can be accurately valued, with Level 1 assets being the easiest.

Level 1

Level 1 assets are those that are valued at readily observable market prices. These assets can be marked to market and include treasury bills, marketable securities, foreign currency and gold bullion.

Level 2

These assets and liabilities do not have regular market prices, but may receive a fair value based on quoted prices in inactive markets or on models that have observable inputs, such as interest rates, default and yield curves. An interest rate swap is an example of a Level 2 asset.

Level 3

Level 3 is the least marked to market of the categories, with asset values ​​based on models and unobservable data — market participants’ assumptions are used to price the asset or liability, since there is no readily available market information about them. Level 3 assets are not actively traded and their value can only be estimated using a combination of complex market prices, mathematical models and subjective assumptions.

Examples of Tier 3 assets include mortgage-backed securities (MBS), private equity stocks, complex derivatives, foreign stocks, and distressed debt. The process of estimating the value of Level 3 assets is known as mark to management.

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