FSP Addresses Inactive Markets and Distressed Transactions

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April 29, 2009

The Board recently issued FASB Staff Position (FSP) FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.” The purpose of this FSP is to provide additional guidance on

  • Estimating fair value when the volume and level of activity for an asset or liability have significantly decreased
  • Determining when a transaction is not orderly

The FSP applies to all assets and liabilities within the scope of pronouncements that require or permit fair value measurements under FASB Statement 157, Fair Value Measurements, except as discussed in paragraphs 2 and 3 of Statement 157. The FSP does not apply to Level 1 inputs, regardless of changes in the volume and level of activity for an asset or liability. Level 1 inputs are defined in Statement 157 as quoted prices for an identical asset or liability in an active market.

The FSP emphasizes that, regardless of whether the volume and level of activity for an asset or liability have decreased significantly and regardless of which valuation technique was used, the objective of a fair value measurement under Statement 157 remains the same—to estimate the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions.

The FSP specifically addresses the market participant aspect of the objective of a fair value measurement under Statement 157 by stating that an entity’s intention to hold an asset or liability is irrelevant for purposes of a fair value measurement.

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Identifying a significant decrease in volume and level of activity

The FSP lists factors that indicate there has been a significant decrease in the volume and level of activity for an asset or liability in relation to normal market activity for the same or similar assets or liabilities. These indicators, which are not all inclusive, include those originally listed in paragraph 28(b) of Statement 157 and some new items. The listed factors include the following:

  • Few recent transactions (an indicator previously in paragraph 28(b) of Statement 157 was that there had been few transactions, recent or otherwise)
  • Indexes previously highly correlated with the fair values of the asset or liability that are now demonstrably uncorrelated with those fair values
  • Significant increase in implied liquidity risk premiums, yields, or performance indicators (for example, delinquency rates) for observed transactions or quoted prices compared to the entity’s estimate of expected cash flows, which must consider available market data about credit or other nonperformance risk for the asset or liability
  • A wide bid-ask spread, or a significant increase in the bid-ask spread
  • A significant decline in, or the absence of new issuances for, the asset or liability or for similar assets or liabilities

An entity must apply judgment in evaluating these factors, considering their significance and relevance, to determine whether the weight of the evidence indicates that there has been a significant decrease in the volume and level of activity in the market for an asset or liability.

If an entity determines that the volume or level of activity for the same or a similar asset or liability has significantly decreased, then transactions or quoted prices may not be determinative of fair value, as it may be more likely that transactions in such a market are not orderly. Transactions and quoted prices may therefore require significant adjustment to estimate fair value under Statement 157, and an entity must perform further analysis to determine whether significant adjustment is necessary.

Although Statement 157 does not prescribe a methodology for making significant adjustments to quoted prices, it does discuss the use of valuation techniques in estimating fair value. If an entity determines that there has been a significant decrease in the volume or level of activity, it may be appropriate for that entity to change the valuation technique used in prior periods, or to use multiple valuation techniques, to estimate the fair value of an asset or liability. When there are multiple indications of fair value, an entity must consider the range of those indications to determine the point within that range that is most representative of fair value under current market conditions. A wide range may indicate that further analysis is required.

Determining whether transactions are not orderly

If an entity determines that the volume and level of activity for an asset or liability have decreased significantly, it must consider whether observable transactions were orderly. The FSP lists several indicators that a transaction is not orderly:

  • There was inadequate exposure of the asset or liability to the market before the measurement date to allow for usual and customary marketing activities under current market conditions.
  • The asset or liability was marketed to a single market participant, although for a period considered usual and customary.
  • The seller was near or in bankruptcy or receivership, or was required to sell to meet regulatory requirements.
  • The transaction price is an outlier in relation to other recent transaction prices for the same or a similar asset or liability.

Incorporating evidence into fair value measurements

An entity must consider the weight of the evidence in determining whether a transaction was not orderly. The weight given to a transaction in a fair value measurement for an asset or liability that has experienced a significant decline in volume or level of activity depends on the evidence that the transaction was not orderly, as shown below:

  • If the weight of evidence indicates that a transaction was not orderly, then an entity must place little or no weight on that transaction price in its fair value measurement.
  • If the weight of evidence indicates that a transaction was orderly, then an entity must consider the transaction price when estimating fair value or market risk premiums, and the weight placed on the transaction price would depend on the facts and circumstances associated with the transaction.
  • If there is insufficient information to conclude whether the transaction was orderly or not, then an entity must consider the transaction price when estimating fair value or market risk premiums, but the price would not be determinative of fair value, and it would receive less weight than a price associated with an orderly transaction. If an entity was a party to a transaction, there is a presumption that it would have sufficient information to determine whether that transaction was orderly.

An entity must consider all relevant information that is available without undue cost and effort, but does not need to undertake all possible efforts to gather information to determine whether a transaction was orderly.

The FSP includes language from appendix B of Statement 157, reiterating that an entity must make appropriate adjustments to fair value measurements to reflect risk premiums that market participants would demand as compensation for the risk associated with the future cash flows of an asset, regardless of the difficulty associated with estimating those risk premiums. The FSP notes that risk premiums must be consistent with the fair value measurement objective of Statement 157.

The FSP addresses the use of broker quotes and pricing services in estimating fair value. It states that an entity should undertake an evaluation of quoted prices, when it has determined that the volume and level of activity for an asset or liability has decreased significantly from normal levels, to determine whether the quote is based on current information that reflects orderly transaction prices or a valuation technique that reflects market participant assumptions. An entity should place less weight on quotes that are not associated with actual transactions versus those that are, and less weight on nonbinding versus binding quotes.

Disclosures

The FSP requires the following disclosures:

  • In interim and annual periods, the valuation technique(s) and inputs used and changes in valuation techniques and related inputs for all fair value measurements
  • For the disclosures required under paragraphs 32 and 33 of Statement 157, the term “major category” is now defined to have the same meaning as “major security types” in paragraph 19 of Statement 115, Accounting for Certain Investments in Debt and Equity Securities. This definition applies to all debt and equity securities measured at fair value, regardless of whether they are required to be accounted for under Statement 115.

Paragraph 19 of Statement 115 states that major security types are based on the nature and risks of securities and include, but are not limited to, the following:

  • Equity securities (segregated by industry type, company size, or investment objective)
  • Debt securities (segregated by type of issuer, such as U.S. Treasury or corporations)
  • Mortgage-backed securities (segregated by type, such as residential or commercial)
  • Collateralized debt obligations
  • Other debt obligations

Effective date and transition

The FSP is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009, and must be applied prospectively. If an entity adopts either FSP FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments,” or FSP FAS 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments,” for periods ending after March 15, 2009, then it must adopt this FSP at the same time. Further, if an entity early adopts this FSP, it must adopt FSP FAS 115-2 and FAS 124-2 concurrently. At initial adoption, prior-period disclosures for comparative purposes are not required. Comparative disclosures are required only for periods ending after the initial adoption of this FSP.

Any revisions that result from a change in valuation technique(s) associated with adoption of this FSP must be accounted for as a change in accounting estimate in accordance with FASB Statement 154, Accounting Changes and Error Corrections. Changes in valuation techniques and related inputs resulting from adoption of this FSP must be disclosed in the period of adoption, and the total effect, by major category, must also be quantified and disclosed.

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