SFAS 157, Fair value measurements

SFAS 157, Fair value measurements

The Statement of Financial Accounting Standards (SFAS) 157, known as ASC 820 in the FASB Codification, is the other controversial and interesting standard I choose to talk about. Issued by FASB in September 2006, SFAS 157 defines fair value and provides guidance for fair value measurement and disclosures.  This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. According to SFAS 157, fair value is “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 definition is accompanied by a framework which categorizes different types of assets and liabilities into 3 levels, and their measurement varied accordingly. The hierarchy of fair value is:
(1)Assets or liabilities whose values could be observed on an active market of identical assets or liabilities
(2)Assets or liabilities whose value could be quoted from an inactive market, or based on internal-developed models, with input data from observable markets of similar items.
(3)Financial assets and liabilities whose values couldn't be quoted from an observable market but instead based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement.

Critics have blamed SFAS 157 for the subprime crisis, pointing out that SFAS 157 created difficulties measuring the value of subprime positions. They claim that this standard forced financial institutions to value assets at “fire-sale” prices, creating a much lower than necessary valuation of subprime assets, which engendered the tighten lending. But proponents argue that fair value accounting provides a clear measurement of the underlying value of assets. They state that the subprime crisis was not caused by accounting, but by bad operating of firms, investors and sometimes by fraud. It is ridiculous to blame the fair value accounting that is merely a reflection of the actual problem.

The SEC is in support of the SFAS 157, concluding that SFAS 157 was not the cause of the financial institution failure and that this standard should not be suspended but could be improved. 

To get a better understanding of Statement No. 157, you can go to FASB website:

http://www.fasb.org/summary/stsum157.shtml or refer to Accounting Standard Codification Topic 820.