What Financial Officers Need to Know

What Financial Officers Need to Know

Establishing fair value for assets and liabilities under Topic 820 reporting requirements

Determining the fair value of assets and liabilities on a university's financial statement has become increasingly stringent, particularly under the Financial Accounting Standards Board (FASB) Accounting Standards Codification Fair Value Measurements and Disclosures (Topic 820), formerly FAS 157. Since compliance with accounting regulations is an undeniable part of a CFO's responsibility, it is important that accounting professionals in higher education are aware of the new standards under Topic 820.

Any university or college that is neither a land grant nor publicly financed institution is considered a FASB reporting entity. FASB Topic 820, which took effect in 2007 (previously known as FAS 157), provides guidelines for how entities such as colleges and universities determine fair value for assets and liabilities on financial statements. Prior to Topic 820, there were several different definitions of fair value and limited guidance for applying those definitions in the Generally Accepted Accounting Principles (GAAP). This made it difficult for higher education institutions to have consistent reporting in financial statements. FASB issued Topic 820 in an effort to increase consistency and comparability in fair value measurements and to expand disclosures about fair value measurements in financial statements.

Definition of Fair Value: At its center, Topic 820 standardizes the definition of fair value to mean the exit price of a transaction not the entry price. Specifically, "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." This definition replaces all previous definitions of fair value under Generally Acceptable Accounting Principles (GAAP).

Fair Value Hierarchy: In an effort to ensure that fair value measurements are market based or based upon assumptions that market participants would actually use when pricing an asset or liability, Topic 820 establishes a three—level, fair value hierarchy. This hierarchy encourages maximizing the use of observable inputs and minimizing the use of unobservable inputs for pricing when determining fair value.

  • Level 1 pricing inputs are observable inputs such as quoted prices, available in active markets, for identical assets or liabilities on the date of measurement.
  • Level 2 pricing inputs are either directly or indirectly observable inputs available in active markets as of the measurement date. They can be quoted prices for similar assets or liabilities in active markets or they can be quoted prices for similar or identical instruments in markets that are not active. Additionally, they can be observable inputs (not quoted prices) such as yield curves, interest rates, or default rates, among others, which are observable at commonly quoted intervals, or they can be market corroborated inputs.
  • Level 3 pricing inputs are unobservable inputs used in cases where financial instruments are considered illiquid, with no significant market activity and little or no pricing information on the date of measurement.

Disclosure Requirements: Disclosure requirements under Topic 820 vary depending upon how a security is classified under the fair value hierarchy. Securities classified as Level 1 require the least amount of disclosure, while disclosure requirements for securities classified as Level 3 were actually expanded under Topic 820. The impact of earnings on Level 3 investments must be disclosed and changes in Level 3 investments must be reconciled between periods under Topic 820.

Valuation Techniques: Topic 820 promotes using valuation techniques to measure fair value that are consistent with conventional approaches.

Market Approach: The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. An example of the market approach is matrix pricing.

Income Approach: The income approach uses valuation techniques to convert future cash flows to a single present amount using discounting. Values are measured by using current market expectations about future amounts. Examples of income approach are interest rate swaps and option valuations.

Cost Approach: The cost approach is based on the amount that would be required to replace the service capacity of an asset in today's market. The price that would be received for the asset is based on the cost to acquire or construct a substitute asset.

The preparer of a financial statement is allowed to use a combination of techniques to value assets and liabilities.

Additional Clarifications: Topic 820 clarifies that if market participants would use an assumption about risk in pricing the relevant security, then the fair value measurement should include assumptions about risk. If market participants would use an assumption about lack of liquidity in the market when pricing the relevant security, then the fair value measurement should include assumptions about restrictions on the sale or use of a security. Topic 820 clarifies that nonperformance risk, such as the impact of an entity's credit standing or any posted collateral, should also be taken into consideration in the fair value measurement.

Topic 820 was effective for fiscal years beginning after November 15, 2007. In December 2009, Topic 820 was amended with the following additional reporting requirements:

  • Disclose the amounts of significant transfers in and/or out of Level 1 and Level 2 fair value measurements and the reasons forthe transfers.
  • In the reconciliation for fair value measurements using significant unobservable inputs (Level 3), a reporting entity should present information about purchases, sales, issuances, and settlements on a gross basis rather than as one net number.
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  • Provide fair value measurement disclosures for each class of assets and liabilities. A class is often a subset of assets or liabilities within a line item in the statement of financial position. A reporting entity should apply judgment in determining the appropriate classes of assets and liabilities.
  • Provide disclosures about the input and valuation techniques used to measure fair value for both recurring and nonrecurring fair value measurements. Those disclosures are required for fair value measurements that fall in either Level 2 or Level 3.

Final amendments to Topic 820 will be effective for reporting periods starting after December 15, 2009, except for the requirement to provide the Level 3 activity for sales, purchases, issuances, and settlements on a gross basis, which will be effective for reporting periods beginning after December 15, 2010.

It's important that college and university establish a process for determining fair value as defined by Topic 820 and prepare their financial statements accordingly. Fair value must be established for all investments in an institution's portfolio. The more exotic the instrument, then the more difficult it is to value and the higher the level of disclosure required. Moving away from using bank statements and dealer prepared values represents a big step toward assuring university trustees that management is doing everything it can as a fiduciary to prepare and report financial information accurately.

Since auditors are only responsible for reviewing and signing off on the methodology and process used to ensure that the reported valuations represent fair value, more of them are recommending that an independent, third-party valuation firm be used to provide fair value measurements for Topic 820 reporting. Professional independent experts can provide dependable valuations for complex financial products, especially Level 2 and Level 3 assets/liabilities. Impartial values that come from an independent party ensure transparency and eliminate potential or actual conflicts of interest.

Bruce Stasch is an officer at DerivActiv, LLC (www.derivactiv.com), a provider of valuation services for Topic 815 (FAS 133), Topic 820 (FAS 157), FAS 133, 161, and GASB 53 compliance in financial statements, board and finance committee reports, and as an internal risk management tool.


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