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.
The Purpose of Topic 820, Formerly FAS 157
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.
Topic 820 Overview
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.
