The requirement to fair value assets and liabilities is pervasive in US Generally Accepted Accounting Principles (GAAP), but there was little authoritative guidance on how one actually fair values (FV). Fair Value Measurements Standard FAS 157 fills this gap by proscribing a comprehensive methodology for fair valuing both financial and non-financial assets and liabilities. FAS 157 is a principles-based standard, so how it is interpreted is now an evolving dialogue between reporting entities and their auditors.
The most valid criticism of FAS 157 is that it can require making subtle distinctions involving mental gymnastics in parallel universes. The least valid criticism of FAS 157 is that one shouldn’t FV financial instruments at all, especially in disorderly markets. However, since all financial institution trading books are marked-to-market for bonus purposes, it is self-serving to hide those marks from the shareholders and bond-holders. Fair valuing has some real measurement issues, but they are symptoms of a problem, not the cause.
Fair Valuing Financial Instruments
In FAS 157, paragraph 5, it says: “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 general FV valuation principles stated in paras 8-10 are:
- Assumes orderly markets in an entity’s principal or most advantageous market.
- Uses assumption of the market participants in the most advantageous/principal market.
- Excludes transaction costs.
- Use unit, not block, prices (i.e. no large blockage discount adjustments).
- Valuations between buy-sell spreads, whether mid-points or otherwise, are acceptable.
- Acceptable valuation methods include market quotes, pricing models and present valuing of point estimates or probability-weighted estimates.
- Requires company’s credit risk to be reflected in valuation when its financial instruments are in a loss position.
The first major change from pre-FAS 157 FV practices is that the initial valuation on inception is an exit price, rather than the transaction price. Thus, depending upon the particular circumstances, all derivatives with an initial transaction price of zero could be construed to have a negative value equal to the buy/sell spread. However, for corporates transacting derivatives in a retail market, as opposed to the interbank market, para A27 provides a great deal of comfort that the FAS 157 inception price is the transaction price rather than the exit price, a seeming contradiction.
The second major change is the requirement to reduce the value of financial instrument liability positions to reflect the entity’s risk of non-performance (‘credit-adjust’). Often when this happens, there is a debit to the financial instrument and credit to income.
It initially seems counter-intuitive that a credit downgrade could result in an increase in income, but when one thinks about it, it really isn’t. Tax authorities view forgiveness of debt as a taxable income item. Private equity firms deliberately leverage up a company, causing credit downgrades, for what they expect to be their ultimate (shareholder) benefit.
FV Hierarchy – Three Levels of Reliability
FAS 157 requires that all FVs be classified into one of three possible categories based on the valuation’s reliability:
- Level 1 – Marking to market, which is based on quoted market prices and deemed to be the most reliable. Used to value stock positions and quoted bonds.
- Level 2 – Marking to model, which uses pricing models using observable market data as inputs. This is how most derivative positions are valued.
- Level 3 – Marking to guess … er… assumptions. Here price models are used but the inputs into the pricing models are based upon management assumptions, not observable market data. Many of the mortgage backed securities, CDO’s, etc., are now in Level 3 land.
The categorisation level then defines how these valuations are disclosed. First, para 32 requires that there is enough information on the pricing techniques used to allow the reader to form their own judgment. Then, at each quarter, the FVs by Level 1, 2 and 3 must be disclosed separately for assets and liabilities. At year-end, there must be reconciliation of all movements in and out of Level 3 valuations and their impact on profit and loss (P&L), including specific valuation techniques used and any changes in techniques over the year.
In other words, the intent is to give the user of the financial statements enough information to make their own judgment on the quality of earnings derived from fair valuing financial instruments. For example, one could have Level 2 losses on financial assets offset by Level 3 gains on the financial liabilities. It is no wonder that the Institute of Chartered Financial Analysts is so much in favour of FAS 157 and is protesting against those who would prefer to go back to the Alice-in-Wonderland of historic cost accounting.
Applying FAS 157 to FAS 133
How does FAS 157 affect FAS 133 hedging practices? In a post-157 world, does fair valuing derivative liabilities on the balance sheet have to be reduced to reflect the entity’s risk of non-performance risk (e.g. credit risk, credit-adjusted) per para 15? Do the effectiveness tests also need to be credit-adjusted when either the hedged item or the hedge instrument is in a liability position? Does FAS 157 make critical terms and shortcut treatment no longer applicable? For non-financial companies who are not dealers in derivatives (‘corporates’), we argue below that FAS 157 does not require any of these changes.
It is possible that your auditors will not agree with these interpretations and we welcome alternative views. However, the interpretation of FAS 157 is not settled, and we believe the following arguments are firmly grounded in the text of FAS 157.
Question 1: How does FAS 157 apply to the valuing corporate derivatives liabilities on the balance sheet?
Answer: Generally, it is a Level 2 valuation using pricing models without adjustment for the reporting entity’s non-performance risk. In paras 5-15, FAS 157 states how FV is calculated (italicised phrases represent our emphasis):
“5. 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.
6. A fair value measurement is for a particular asset or liability. Therefore, the measurement should consider attributes specific to the asset or liability, for example, the condition and/or location of the asset or liability and restrictions, if any, on the sale or use of the asset at the measurement dat…
7. …The transaction to sell the asset or transfer the liability is hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the objective of a fair value measurement is to determine the price that would be received to sell the asset or paid to transfer the liability at the measurement date (an exit price).
8. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability… If there is a principal market for the asset or liability, the fair value measurement shall represent the price in that market (whether the price is directly observable or otherwise determined using a valuating technique)…
10. Market participants are buyers and sellers in the principal (or most advantageous) market for the asset or liability that are:
a. Independent…
b. Knowledgeable…
c. Able to transact…
d. Willing to transact…
11. The fair value of the asset or liability shall be determined on the assumptions that market participants would use in pricing the asset or liability. In developing those assumptions, the reporting entity need not identify specific market participants. Rather, the reporting entity should identify characteristics that distinguish market participants generally, considering factors specific to (a) the asset or liability, (b) the principal (or most advantageous market for the asset or liability, and (c) market participants with whom the reporting entity would transact in that market.
14. …the fair value measurement considers the assumptions of the market participants would use in pricing the asset…
15. A fair value measure assume that the liability is transferred to a market participant at the measurement date (the liability to the counterparty continues; it is not settled) and the non-performance risk relating to that liability is the same before and after its transfer. Non-performance risk refers to the risk that the obligation will not be fulfilled and affects the value at which the liability is transferred… The reporting entity shall consider the effect of its credit risk (credit standing) on the fair value of the liability … That effect may differ depending upon the liability…“
In applying these requirements to corporate derivatives, we note the following facts:
- As stated in para A27, example 7: Interest rate swap at initial recognition – the principal market for corporates for transacting derivatives is the retail market in which the market participants are AA-rated financial institutions (of course, if the counterparty is not AA rated, think Bear Stearns, that counterparty’s credit risk must be incorporated in the derivative valuation).
- In regards to para A27, for corporates, if the transaction price of the derivative is zero, then that price represents the fair value of the swap at initial recognition. This would not only be true for para A27’s interest rate swap example, but for FX and commodity forwards that also have a transaction price of zero. Thus, normal forwards and swaps that would otherwise be eligible for critical terms (G9) and shortcut (para 68) remain eligible because the initial fair value of the hedge instrument remains zero. See also DIG Issue E23, which allows shortcut even if the initial fair value is negative due to the buy-sell spread.
- Nearly all corporates have restrictions on their ability to transfer financial derivatives. Typically, they have International Swaps and Derivatives Association (ISDA) agreements with their financial institution counterparties governing transfers, in which transferring a derivative requires the financial institution’s consent, and that consent is only given to other similarly rated financial institution counterparties.
- Due to the nature of derivative financial instruments, which can flip-flop between asset and liability positions, derivatives are substantially different financial instruments than corporate debt liabilities. It is simply not possible to transfer a derivative liability to a counterparty in which the non-performance credit risk of the derivative liability remains after the transfer is identical to what it was before. When a derivative is transferred, the performance obligation is transferred as well. As a result, market participants of the corporate reporting entity price the transfer of a derivative without adjustment for non-performance risk (i.e. no credit spread), consistent with the terms financial institutions generally offer in a settlement. The logic is clear: when the derivative liability is transferred to another financial institution, it becomes that financial institution’s liability and thus is valued at the AA curve.
- Therefore, corporate reporting entities cannot credit-adjust derivative liabilities as required by FAS 157 para 15 because doing so is not consistent with general requirements of paras 7-14 for FV. In fact, we note that para 15 anticipates that this credit adjustment may vary by liability and is not, therefore, a universal prescription: “The reporting entity shall consider the effect of its credit risk (credit standing) on the fair value of the liability … That effect may differ depending upon the liability…”
- There is no doubt that financial institutions price the terms of their derivatives, especially longer-term derivatives, to reflect the credit risk of the corporate counterparty. However, FAS 157 requires an exit price valuation, not a transaction price valuation, and it is an economic fact that cannot be denied that when a corporate transfers a derivative liability, it is always done at a settlement price that does not reflect the corporate’s non-performance risk. Arguably, there could be situations in which a weak corporate credit might settle a derivative with its financial institution counterparty with a less than full adjustment for the credit risk involved that essentially represents a forgiveness of debt or a desire by the counterparty to salvage what it can to avoid a technical bankruptcy condition. However, FAS 157 para 11 states: “In developing those assumptions, the reporting entity need not identify specific market participants. Rather, the reporting entity should identify characteristics that distinguish market participants generally…”
To insist that para 15 overrides the valuation methodologies required by para 7, 8, 10 and 11 of FAS 157 in the special case of derivative liabilities requires the corporate reporting entity to make valuations based upon hypothetical transactions that can never happen in the corporate reporting entity’s principal market. If one accounting principle in a standard leads to an absurdity, and the other accounting principles do not, then the accounting principle that leads to the absurdity cannot be governing, especially since para 15 anticipates that this credit adjustment may vary by liability and is not, therefore, a universal prescription. In addition, Financial Accounting Standards Board (FASB) statements are written such that primary principles are written first, with refinements of those principles added subsequently in the main text of the standard, as in para 15 or in the background material, as in para A27.
If your auditor continues to insist that the exit price of a derivative must reflect your credit risk of non-performance, ask him to consider the following example in which the AA curve valuation of a derivative is a US$1,000,000 loss and if we apply some sort of credit spread to the AA curve, the credit-adjusted price would be a US$900,000 loss and your auditor, therefore, must be willing to claim that that there are market participants in the retail market who would be willing to accept US$900,000 for accepting the derivative transfer/assignment.
Then ask your auditor what would be consequences on the market participant’s books? It cannot be booked at a US$900,000 loss because para A27 clearly states that the market participant must value the newly acquired derivative in the market participant’s principal market, the interbank derivative market, and mark it to be a US$1,000,000 liability. Thus, the bank accepting the derivative would immediately take a US$100,000 loss. What bank in the world would be willing, as required by FAS 157 para 10.d, do this?
However, it must be stated that some auditors follow a very literal reading of para 15 and do require credit-adjusting credit liabilities, even if the credit liability is offset by asset positions with the same counterparty. Some companies will not credit-adjust their derivative liabilities but perform tests to show the effect of credit-adjusting is immaterial.
Question 2: Does FAS 157 apply to cash flow effectiveness tests of forecast exposures?
Answer: No, for two reasons. First, FAS 133’s cash flow requirements in para 28 involve showing how the hedging instrument is effective in “… hedging the exposure to variability in expected future cash flows that is attributable to a particular risk.” Therefore, cash flow effectiveness tests do not involve fair valuing and thus FAS 157 does not apply.
Second, FAS 157 applies only to assets, liabilities and equity instruments as FAS 157 states in para 5 and 6: “5. 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.
6. A fair value measurement is for a particular asset or liability.”
Footnote 4 of FAS 157 states: “The definition of fair value focuses on assets and liabilities because they are a primary subject of accounting measurement. However, the definition of fair value should be applied to instruments measured at fair value that are classified in stockholders’ equity.”
Most corporate cash flow hedges are hedges of forecasts, and since forecasts by their very definition are not assets and liabilities, they are not in the scope of FAS 157. If FASB wanted forecasts to be fair valued, they would have said so in para 5-6 and in footnote 4.
For the most part, the Big Four seem to agree that exposures should not be credit adjusted in effectiveness testing. However, if they require derivative credit liabilities to be credit-adjusted, they will generally want the effectiveness tests to reflect credit-adjusting when the derivative valuation is negative.
Question 3: Does FAS 157 apply to FV and cash flow effectiveness tests involving hedges of the benchmark interest rate risk?
Answer: No. FAS 133 allows hedging of bifurcated risks, one of which is the benchmark interest rate as described in FAS 133 para 21.f.(2): “The risk of changes in its fair value attributable to changes in the designated benchmark interest rate (referred to an interest rate risk”; and para 29.h.(2): “The risk of changes in its cash flows attributable to changes in the designated benchmark interest rate (referred to as interest rate risk).”
To apply FAS 157 to the benchmark interest rate, and require that it be credit-adjusted, would mean that the benchmark interest rate is no longer the benchmark interest rate, and is in fact the all-in, overall interest rate. Thus, in effectiveness tests involving hedging the benchmark interest rate risk, there should be no adjustment for non-performance credit risk of the reporting entity on the hedged exposure. Similarly, since we have shown in question one that fair valuing liability derivatives should not be credit-adjusted, there should be no credit-adjusting for the changes in the FV of the derivative in any FV effectiveness testing.
However, FAS 157 valuation methodologies, including para 15’s adjustment for non-performance risk, do apply for FV hedges of the risk of overall changes in FV of the hedged item, as described in FAS 133 para 21.f.(1). Whether it would apply to overall changes in cash flow changes of the hedged all-in interest rate risk, as described in para 29.h.(1), is a delicate question. This latter issue will become quite relevant in 2009 if the announced revisions to FAS 133 occur, disallowing hedging the benchmark interest rate risk.