Statement of Financial Accounting Standards No. 157 - Paper Audit ...

liability being measured, it may be possible to derive a discount rate using data for
several comparable assets or liabilities in conjunction with the risk-free yield curve (a
“build-up” approach).
B9. To illustrate a build-up approach, assume that Asset A is a contractual right to
receive $800 in 1 year (no timing uncertainty). There is an established market for
comparable assets, and information about those assets, including price information, is
available. Of those comparable assets:
a. Asset B is a contractual right to receive $1,200 in 1 year and has a market price
of $1,083. Thus, the implied annual rate of return (1-year market rate of return)
is 10.8 percent [($1,200/$1,083) – 1].
b. Asset C is a contractual right to receive $700 in 2 years and has a market price
of $566. Thus, the implied annual rate of return (2-year market rate of return) is
11.2 percent [($700/$566)^0.5 – 1].
c. All three assets are comparable with respect to risk (dispersion of possible
payoffs and credit).
B10. Based on the timing of the contractual payments to be received relative to Asset A
(one year for Asset B versus two years for Asset C), Asset B is deemed more
comparable to Asset A. Using the contractual payment to be received for Asset A
($800) and the 1-year market rate derived from Asset B (10.8 percent), the fair value
of Asset A is $722 ($800/1.108). Alternatively, in the absence of available market
information for Asset B, the one-year market rate could be derived from Asset C using
the build-up approach. In that case, the 2-year market rate indicated by Asset C
(11.2 percent) would be adjusted to a 1-year market rate based on the term structure of
the risk-free yield curve. Additional information and analysis also might be required to
determine if the risk premium for one-year and two-year assets is the same. If it is
determined that the risk premium for one-year and two-year assets is not the same, the
two-year market rate of return would be further adjusted for that effect.
B11. In applying the discount rate adjustment technique to fixed claims, the adjustment
for risk inherent in the cash flows of the asset or liability being measured is included
in the discount rate. In some applications of the discount rate adjustment technique to
cash flows that are other than fixed claims, an adjustment to the cash flows also may
be necessary to achieve comparability with the observed asset or liability from which
the discount rate is derived.
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