What Is Financial Accounting Standard 157 (FAS 157)?
Financial Accounting Standard 157 (FAS 157) is the Financial Accounting Standards Board (FASB)’s controversial fair value accounting standard, which was introduced in 2006, in the run-up to the global financial crisis, and is now known as Accounting Standards Code Topic 820.
- In 2006, the U.S. Financial Accounting Standards Board (FASB) verified 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 which aims to bring clarity to the balance sheet assets of corporations.
- The FASB 157 categories for asset valuation were given the codes 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) established a single consistent framework for estimating fair value in the absence of quoted prices, based on the notion of an “exit price” and a 3-level hierarchy to reflect the level of judgment involved in estimating fair values, ranging from market-based prices to illiquid Level 3 assets where no observable market exists and valuations have to be based on proprietary internal information, like the most recent funding round.
Shortly after the FAS 157 was introduced, the subprime crisis put its subjective measures of fair value to the test. Equity market volatility and illiquid markets played havoc with fair value accounting models and forced private equity firms to mark down the value of assets on their balance sheets – causing 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.
Before 2008, valuations were based on historical cost accounting rather than fluid mark to market estimates, because it was widely considered to be more conservative and reliable. But the private equity industry lobbied for change, because using historical cost does not allow for easy comparability between companies, and they wanted to standardize the fair valuation of illiquid assets.
However, the limits of fantasy valuation maths has been made apparent in 2016, when VC-backed “unicorn” startup Dropbox was marked down 51% overnight by mutual fund T. Rowe Price, to $9.40 a share, because it thought $10 billion valuations was irrational. When Dropbox floated in March 2018, its shares opened at $29 per share, and it's market valuation climbed toward $13 billion the day after the IPO.
FASB Levels of Assets
The FASB 157 categories for asset valuation were given the codes 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 assets are those valued according to readily observable market prices. These assets can be marked to market and include Treasury Bills, marketable securities, foreign currencies, and gold bullion.
These assets and liabilities do not have regular market pricing, but can be given a fair value based on quoted prices in inactive markets, or models which have observable inputs, such as interest rates, default rates, and yield curves. An interest rate swap is an example of a Level 2 asset.
Level 3 is the least marked to market of the categories, with asset values based on models and unobservable inputs — assumptions from market participants are used when pricing the asset or liability, given there is no readily available market information on them. Level 3 assets are not actively traded, and their values can only be estimated using a combination of complex market prices, mathematical models and subjective assumptions.
Examples of Level 3 assets include mortgage-backed securities (MBS), private equity shares, complex derivatives, foreign stocks, and distressed debt. The process of estimating the value of Level 3 assets is known as mark to management.