DEFINITION of ‘Financial Accounting Standard 157 (FAS 157)’
Financial Accounting Standard 157 (FAS 157) is the Financial Accounting Standards Board (FASB)’s controversial fair value accounting standard, which was introduced in 2006, in the run up to the global financial crisis, and is now known as Accounting Standards Code Topic 820.
BREAKING DOWN ‘Financial Accounting Standard 157 (FAS 157)’
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.
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.
However, the limits of fantasy valuation maths has been made apparent in 2016, when VC-backed “unicorn” startup Dropbox was marked down 50% overnight by mutual fund T. Rowe Price, to $8 a share, because it thought $10 billion valuation was irrational. When Dropbox floated in March 2018, its shares opened at $29 per share, and its market valuation climbed toward $13 billion the day after the IPO.