820 replaces 157, level 2 messed up May 24, 2010 at 9:01 pm

Even for me, I will admit that is a cryptic title. It gets worse. It’s about accounting.

Let me explain. The principal US accounting standard about fair value was Federal Accounting Standard 157, or FAS 157 to its (few but loyal) friends. As part of its update, 157 has acquired a new number, and it is now FASB ASC Topic 820, Fair Value Measurement and Disclosure. The FASB text is here.

Why should you care, dear reader? Well, there are two things in 820 that struck me as apposite; one good, one bad.

(At this point if you don’t know about the three levels of FAS 157 you might either like to read about them or skip to the next post.)

The good one first.

Financial statement users indicated that information about the effect(s) of reasonably possible alternative inputs [to level 3 valuation models] would be relevant in their analysis of the reporting entity’s performance.

So, with a reasonable amount of luck, 820 will require firms not just to state the value of their level 3 assets, but also to assess uncertainty in that value. This would be a major step forward in accounting disclosures for financial instruments, and I commend the standard setters for it.

Now the bad part. They have made this a lot less useful than it would otherwise be by extending (or at least clarifying the extent of) level 2.

I used to think that level 2 assets were things valued using a model, but where all the model inputs were current market observables. In other words, a swap valued using a discounted cashflow model calibrated to the quoted libor rates is level 2, but a quanto option valued using historic correlation isn’t, as correlation is not a current market observable (but rather an historic property). In fact anything valued using a model where one input is an historic property – historic vol, historic prepayment rates, etc. – should be level 3.

Unfortunately the text of 820 now includes the clarification that anything based on a market input is in level 2. And since historical volatility is based on a price history, an option priced using historic rather than implied might be in level 2. This is not good. There is a crucial difference between a current price used as an input (or equivalently a convention for quoting prices, like implied vol) and anything else. Level 2 should be kept for purely price based model inputs. That, of course, would also make the level 3 uncertainty disclosures much more useful.

Update. I looked for the corresponding point in IFRS 9 and didn’t find it, because it is in IFRS 7. Duh. Anyway. It’s no clearer there.

3 Responses to “820 replaces 157, level 2 messed up”

  1. […] we bring it up because Deux Ex Macchiato has a neat take on the […]

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  3. […] Deux Ex Macchiato (hat tip FT Alphaville) tells of the disconcerting changes to what was formerly called FAS Rule 157, which brought us Level 1, 2, and 3 accounting. A brief recap: […]