Key Takeaways
- FAS 157, now called ASC Topic 820, is a fair value accounting standard introduced in 2006 by the FASB.
- It established a 3-level hierarchy for asset valuation, ranging from easily valued Level 1 assets to complex Level 3 assets.
- Level 1 assets are marked to market, while Level 3 assets require complex models and assumptions for valuation.
- The 2008 financial crisis highlighted challenges with fair value accounting, leading to adjustments in valuing illiquid assets.
- Historical cost accounting was replaced by fair value to standardize the valuation of illiquid assets.
What Is Financial Accounting Standard 157 (FAS 157)?
Financial Accounting Standard 157 (FAS 157), now known as Accounting Standards Code Topic 820, is the Financial Accounting Standards Board (FASB)’s framework for measuring fair value with greater clarity and consistency.
It introduced a three-level hierarchy for valuing assets and liabilities, which became especially challenging during the subprime crisis when market volatility made illiquid assets difficult to price. The standard’s emphasis on transparent valuation highlighted both the need for clearer guidance and the strain that fair value measurements can face in distressed markets.
The Framework of FAS 157 Explained
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.
Historical Context and Transition to Fair Value
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.
In 2016, T. Rowe Price felt a $10 billion valuation for Dropbox was irrational, marking it down 51% to $9.40 per share. 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.
Breakdown of Asset Valuation Levels in FAS 157
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
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.
Level 2
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
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.
The Bottom Line
FAS 157, now ASC Topic 820, established a fair value accounting framework built around three valuation levels that vary by how easily an asset can be priced. Introduced shortly before the financial crisis, it aimed to replace historical cost with more consistent fair value measures, but its principles were quickly tested as illiquid assets became harder to value.
The crisis led to added flexibility and ongoing debate about fair value accounting, yet the standard remains central to financial reporting in volatile markets.