The Governmental Accounting Standards Board (GASB) has issued for public comment a proposed Statement addressing accounting and financial reporting issues related to fair value measurements. The Exposure Draft, Fair Value Measurement and Application, describes how fair value should be defined and measured, what assets and liabilities should be measured at fair value, and what information about fair value should be disclosed in the notes to the financial statements.
The GASB is proposing that fair value be defined as 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 is more specific than the one found in GASB Statement No. 31, Accounting and Financial Reporting for Certain Investments and for External Investment Pools: “The amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale.” The change in language to “an orderly transaction between market participants” is intended to emphasize the GASB’s view that fair value is market based, not specific to a particular government. In other words, fair value should be objectively based on market conditions and relevant factors. The market to which the proposed definition refers is a government’s principal market or, when there is not a principal market, the government’s most advantageous market.
Another notable change in the proposed definition is the focus on a price to sell an asset or transfer a liability, rather than on an exchange. The proposed definition emphasizes that fair value is an exit price, whereas the existing definition is unclear as to whether fair value is a seller’s price or a buyer’s price, which sometimes may be significantly different. The use of “measurement date” in the new definition also is more precise than “current” in the existing definition. The initial measurement date is the date of the transaction, and subsequent measurement dates are the dates of the financial statements in which the fair value is reported.
The Exposure Draft also proposes that investments would generally be measured at fair value. Investments would be defined as a security or other asset that a government holds primarily for the purpose of income or profit and the present service capacity of which is based solely on its ability to generate cash or to be sold to generate cash.
Certain investments would continue to be excluded from measurement at fair value, such as investments in money market instruments with remaining maturities at time of purchase of one year or less.
The GASB is proposing three acceptable “valuation approaches” to measuring fair value—market, cost, or income:
- Determining fair value with the “market approach” utilizes information resulting from market transactions for identical or similar assets or liabilities
- The “cost approach,” on the other hand, bases fair value on the amount necessary to replace an asset’s present capacity for providing service
- The “income approach” calculates fair value by converting future amounts to a single current amount. For instance, a government might project cash flows from an asset and discount them to their present value.
Depending on the asset or liability in question, a government could establish fair value by employing any of a variety of “valuation techniques” that are consistent with one or more of these approaches. If market information that qualifies as a Level 1 input is available for measuring fair value, a government would employ valuations techniques consistent with the market approach rather than the cost or income approaches. Any valuation technique should be based on “observable inputs” as much as possible.
Under current accounting standards, state and local governments are required to disclose how they arrived at their measures of fair value if they are not based on quoted market prices. In the Exposure Draft, the GASB is proposing to expand those disclosures to include the inputs a government uses to measure fair value and the judgments made to arrive at those inputs.
The GASB is proposing a three-level hierarchy of inputs into the measurement of fair value. Level 1 and Level 2 inputs are observable and Level 3 inputs are unobservable. (This hierarchy has been in use in the private sector since 2006 under the standards of the Financial Accounting Standards Board.)
- Level 1 inputs are quoted prices from markets with many transactions for identical assets and liabilities. Level 1 inputs are derived directly from the market and need not be adjusted in any way.
- Level 2 inputs are either (a) directly observable, like quoted market prices, but for similar assets and liabilities, or (b) correlated or corroborated from observable market information. Generally, Level 2 inputs should not be used unless Level 1 inputs are unavailable.
- Level 3 inputs are assumptions a government develops based on the best information available to it. Generally, Level 3 inputs should not be used unless Level 1 and Level 2 inputs are unavailable.
The distinction between the three levels speaks to the reliability of the measurement of an asset or liability’s fair value. Observable inputs are innately more reliable than unobservable inputs because observable inputs are easier to verify. Level 1 inputs generally are more reliable than Level 2 inputs because Level 1 inputs are drawn directly from active markets without adjustment. However, if Level 1 inputs are based on transactions that are not orderly, Level 2 inputs may be more reliable in those circumstances.
Under existing standards, several types of investments are not required to be reported at fair value. The GASB is proposing that the following exceptions to the requirement to measure investments at fair value should be continued:
- Investments with a maturity of one year or less at the time of purchase, such as money market investments
- Investments in 2a7-like external investment pools (a type of government-sponsored, short-term investment pool)
- Most investments in life insurance
- Investments in common stock that meet the criteria for applying the equity method of accounting (briefly, an investment in voting stock that gives a government the ability to exercise significant influence over the company’s operating and financial policies)
- Non-participating interest-earning investment contracts (those with redemption terms that are not affected by market rates, such as a typical certificate of deposit)
- Unallocated insurance contracts (a type of investment that pension plans enter into with insurance companies)
- Synthetic guaranteed investment contracts that are fully benefit responsive (an explanation of the meaning of “fully benefit responsive” can be found in paragraph 67 of GASB Statement No. 53, Accounting and Financial Reporting for Derivative Instruments).
The GASB is proposing that fair value disclosures should be organized by type or class of asset and liability. In other words, it would not be sufficient in general for a government to simply disclose its investments in the aggregate. The extent to which those types or classes are disaggregated, though, depends on a variety of factors, such as:
- The nature, characteristics, and risks of the assets or liabilities (for instance, investments in corporate stock would be disclosed separately from commercial paper)
- Which level of inputs are used to measure the fair value of the assets or liabilities (there would be greater disaggregation for assets and liabilities measured using Level 3 inputs)
- If standards specifically require separate disclosure of an asset or liability (such as derivatives)
- The value of the assets or liabilities measured at fair value relative to all assets and liabilities.
Under current accounting standards, governments are required to disclose how they arrived at their measures of fair value if they are not based on quoted market prices. The GASB is proposing a more detailed set of disclosures that take into account the levels of inputs a government uses to measure fair value and their inherent degrees of uncertainty and subjectivity. Governments would disclose the following:
- The fair value amounts as of the date of the financial statements, and the levels of inputs used to determine them
- The valuation techniques and inputs used
- Any changes in techniques and inputs that had a significant impact on the measurement of fair value and the reasons for the changes
- For fair value measurements categorized in Level 3 (other than alternative investments), the effect of those investments on investment income for the reporting period.
The additional disclosure when Level 3 inputs are used is important because they are unobservable and, consequently, more difficult for a user to objectively verify. The GASB is proposing additional disclosures for alternative investments. As described earlier, these investments do not have a readily determinable fair value and, therefore, the GASB believes governments should be able to use net asset value per share to value them. However, net asset value per share is often more uncertain and subjective than the fair value measurements of other assets and liabilities.
Governments with alternative investments would disclose the following for each type of alternative investment:
- Fair value amounts as of the date of the financial statements
- Significant investment strategies of the entities in which the government has invested
- When the entities are expected to liquidate the assets underlying the investment
- The amount of any related commitments the government has, for which it has not set aside resources (unfunded commitments)
- Terms and conditions under which the government may redeem the investments
- Restrictions preventing the government from redeeming an investment that otherwise is redeemable, and when the restriction is expected to end. (If the government does not know when the restriction will end, it should disclose that fact and state how long the restriction has been in effect.)
- Other significant restrictions on the government’s ability to sell the investments.