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FASB 157 clarified asset valuation practices for publicly traded companies in the US, requiring assets to be divided into three categories based on reliability of fair value estimates. The change led to significant writedowns and revealed the true value of many companies, but did not cause the financial crisis of 2007.
FASB 157 was a publication issued by the Financial Accounting Standards Board (FASB) in 2006 to clarify accounting practices for the valuation of assets in publicly traded companies in the United States. This publication was designed to create more precision when it comes to asset valuation statements by providing investors with an idea of the true fair value of assets listed in public disclosures. An immediate result of FASB 157 was significant writedowns at several major companies. Changes in accounting practices are dictated by the FASB in response to changing trends in the accounting and financial community.
Under FASB 157, when a company values assets, it must divide them into three different categories based on the reliability of its fair value estimates. Level one assets can be valued using market accounting and have the most accurate estimates of value because they are linked to identical assets priced on the open market. Bonds, for example, are easy to value because their fair market value is known.
Tier two assets are somewhat more difficult to value and must be valued using a pricing model. This is known as brand-to-model accounting. Equivalent assets are not sold on the open market, providing a price point, but sufficiently similar assets are traded or sold to make valuation possible, allowing companies to make a reasonable estimate of value. Finally, tier three assets, such as mortgage-backed securities, cannot be accurately valued and are, in most cases, highly illiquid in nature.
Companies with high value in level three assets were forced to report their full value after FASB 157, reflecting the uncertainty of their reported asset valuation. Since a number of companies had invested heavily in the 2000s in precisely these types of assets, the effective date of FASB 157 marked a dramatic change in the reported asset value of many companies. This could be used as evidence to suggest that the release was needed, to provide investors with a more accurate picture of the value of the companies they were interested in.
Shortly after FASB 157 went into effect in 2007, a global financial crisis occurred, and much of it revolved around level three assets. Several factors contributed to this crisis, and the tightening of accounting standards certainly cannot be blamed for the drop in value at many major companies; The change in accounting practices did not cause a material change in value, but only made the true value of many publicly traded companies more apparent.
SmartAsset.
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