Fair Value Measurement SFAS 157

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Fair Value Measurement (SFAS 157)

• Kaipo Doorley
• Amper Politziner and Mattia

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Agenda Topics Covered

• Fair Value Issues
• Fair Value Framework
• Fair Value Disclosure Requirements
• Alternative Investments
• Audit Considerations
• Recent Standard Setting Activity
• SEC Update

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FV Issues - The Fair Value Movement

• Moving toward everything eventually being
  initially measured at fair value
• Less and less use of cost-based measures for
  financial instruments
• SFAS 115, 133, 155, 156, 159
• Held to maturity debt securities and APB 18 are
  exceptions
• Nonfinancial instruments generally still use
  historic cost with impairment testing

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FV Issues Problem and Possible Solution

• The Problem Reliability of measures
• Different parties could get inconsistent measures
• Possible for management to influence measures
• The (Partial) Solution SFAS 157
• Detailed definition of fair value for use in
  accounting
• Does not expand use of fair value
• Provides guidance to make fair value measures
  more consistent and understandable to investors
• Requires disclosures to help users understand
  reliability of inputs
• Financial statement users still prefer fair value
  while management and auditors do not believe the
  market is always the most accurate reflection
  of a transaction/account

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FV Issues The Good News

• The Good News
• For most securities, decrease in value are being
  reported as they occur
• Impairment of other assets are being recognized
• Despite difficulty, companies/auditors have been
  able to come up with values
• FV disclosures are helpful to users (Level 3
  assets, etc.)
• Fair Value has been around for a very long time
  and now there is one definition of fair value
• Valuation specialists and certain industries have
  dealt with fair value for years and have
  expertise and insight

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FV Issues The Bad News

• Impairment models are inconsistent
• Some tests are impossible (other-than temporary)
• Standard-setters being pressured to back off
• Many implementation issues/question on 157
• FASBs VRG and staff working
• Some FSPs raise more questions than answers
• Tendency to apply rules instead of principles
• Looking to transactions that arent
  representative
• Supporting pricing service estimates
• Hard to convince auditors that losses are
  temporary
• The timing of SFAS 157 and the economic crisis

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Fair Value Framework - Definition

• Definition of Fair Value Exit Price not Entry
  Price
• What could you sell for in an orderly transaction
• Assume exit in principal or most advantages
  market
• Marketplace participant assumptions, not entity
  specific
• Looking to the market should reduce management
  bias and promote consistency (in concept)
• Marketplace participants are knowledgeable,
  independent parties willing and able to transact
• Transaction costs are not part of fair value
• Always include credit risk if inherent in
  asset/liability

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Fair Value Framework - Measurement

• Step 1 Determine the unit of account (based on
  accounting/reporting rule driving measurement)
• Stand alone asset/liability or group of assets
• For example is the unit of account a reporting
  unit being tested for goodwill or a single
  equity security recorded as available for sale

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Fair Value Framework - Measurement

• Step 2 Highest and best use (market participant
  view)
• In-use (used with a group of assets/liabilities
  to maximize value)
• In-exchange (stand alone basis)
• For example a market participant is a real estate
  developer and purchases a construction company
  for
• In-use Integrate the companys PPE
• In-exchange Operate the company as a stand
  alone entity
• Must be physically possible, legally permissible
  and financially feasible to the market
  participant
• The reporting entitys current or intended use of
  the asset/liability does not matter

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Fair Value Framework - Measurement

• Step 3 Determine principal or most advantageous
  (based on highest and best use)
• Principal market has the greatest volume and
  activity
• In the absence of a principal market, the most
  advantageous market in which the reporting
  entity would sell the asset/transfer the
  liability with the price that maximizes amounts
  received and minimizes amounts paid
• Based on market principal/most advantageous
  market the reporting entity identifies (not
  specifically) market participants
• The market and market participants should be
  evaluated at recognition and re-evaluated at each
  measurement date
• Inactive market and disorderly transactions
  discussed later

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Fair Value Framework - Measurement

• Fair value hierarchy
• Prioritizes inputs to the valuation technique
  used to measure fair value
• Level 1 quoted prices (unadjusted) in active
  markets for identical assets and liabilities
• Level 2 inputs and other quoted prices included
  in Level 1 that are observable either directly or
  indirectly
• Level 3 unobservable inputs reflecting the
  reporting entitys own assumptions about market
  participant assumptions

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Fair Value Frame Work - Measurement

• Characteristics of Level 1 Inputs
• Transactions occur with sufficient frequency and
• volume to provide pricing information on an
  ongoing
• basis.
• Reporting entity has ability to access
• Alternative pricing methods (e.g. matrix pricing)
  may be used as a practical expedient
• Alternative pricing method results in a lower
  level measurement
• After-hours trading or news events
• Not required, but should be considered

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Fair Value Frame Work - Measurement

• Characteristics of Level 2 Inputs
• Quoted prices for similar assets or liabilities
  in active markets
• Quoted prices for identical or similar assets or
  liabilities in markets that are not active
• Inputs other than quoted prices that are
  observable (e.g. yield curves)
• Market-corroborated inputs Derived principally
  from or corroborated by observable market data by
  correlation or other means
• Adjustments necessary to corroborate inputs may
  result in Level 3 measurement

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Fair Value Frame Work - Measurement

• Characteristics of Level 3 Inputs
• Unobservable inputs used to the extent that
  observable inputs are not available
• Includes assumptions about risk, developed based
  on best information available without undue cost
  and
• effort
• Data used to develop the inputs should be
  adjusted if there are contrary data indicating
  market participants would use different
  assumptions
• FV may be determined based on the best available
  information in the circumstances

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Fair Value Framework - Measurement

• Valuation techniques consistent with market,
  income and/or cost approaches shall be used to
  measure FV
• Market Approach Uses observable prices and
  other relevant information generated by market
  transactions involving identical or comparable
  assets or liabilities
• Income Approach Converts cash flow or earnings
  to a single present amount (discounted) . Value
  indicated by current market expectation about
  future amounts
• Cost Approach Amount that would currently be
  required to replace the service capacity of an
  asset (current replacement cost)
• Use valuation techniques that are appropriate in
  the circumstances and for which sufficient data
  are available
• Single or multiple techniques may be appropriate
  depending on the circumstances.

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Fair Value Disclosure Requirements

• Assets and liabilities measured at FV on a
  recurring basis
• Disclose the level of inputs used (tabular
  format)
• Level 3 inputs rolled forward
• Valuation techniques annually (see FSP updates)
• Assets and liabilities measured at FV on a
  nonrecurring basis
• Same as above AND
• The reasons for the measurement
• Note FASB fair value disclosure project discussed
  later

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Alternative Investments

• What is an alternative investment?
• AICPA Practice Aid
• AICPA Draft Issue Paper
• Specific Issues for Alternative Investments
• FASB FSP 157-g Estimating the Fair Value of
  Investments in Investment Companies That Have
  Calculated Net Asset Value per Share in
  Accordance with the AICPA Audit and Accounting
  Guide, Investment Companies Issued Monday June
  8,2009 and comment period ends July 8, 2009
• Will be effectiv3e immediately upon release

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Alternative Investments Specific Issues

• Defining markets/market participants
• Factors in deciding whether a market is active
• Evaluating transactions
• Transparency
• Relevance
• Distressed
• Determining fair value of interest in alternative
  investments
• Unique Elements of Private Equity
• Consideration of use of NAV as a practical
  expedient
• FASB issues FSP FAS 157-g

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Audit Considerations

• Auditing standards
• If market assumptions not available, an entity
  may use own assumptions as long as no contrary
  data that market participants would consider
• Auditor must understand the entitys process for
  determining fair value and relevant controls to
  develop an audit approach
• Use of specialists
• Auditor must find the assumptions reasonable and
  the valuation methods appropriate and properly
  applied
• Consideration of variances from period to period

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Audit Considerations (contd)

• Non-Authoritative Guidance
• AICPA Toolkit for Auditing Fair Value
  Measurements and Disclosures
• Auditor must understand the entitys process for
  determining fair value and relevant controls to
  develop an audit approach
• Use of specialists
• Auditor must find the assumptions reasonable and
  the valuation methods appropriate and properly
  applied
• Consideration of variances from period to period
• Practice Issues for Non-Issuers

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Recent Standard Setting Activity

• FSP FAS 157-4 (fair value measurement)
• FSP FAS 157-f (fair value of liabilities)
• FSP FAS 107-1 and APB 28-1 (fair value
  disclosures)
• FSP FAS 115-2 and FAS 124-2 (OTTI of debt
  securities)
• Ongoing FASB Projects
• Fair Value Disclosure Project
• Financial Instruments Project
• Recoveries of Other-Than-Temporary Impairment
  (Reversal) Project

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Recent Standard Setting Activity FSP 157-4

• FSP FAS 157-4, Determining Fair Value When the
  Volume and Level of Activity for the Asset or
  liability Have Significantly Decreased and
  Identifying Transactions That Are Not Orderly
• Superseded FSP FAS 157-3
• No longer just relates to financial assets
• Despite a significant decrease in market activity
  for an asset, the objective of fair value
  measurement remain
• Provides factors to consider for significant
  decrease in volume and level of activity
• When market activity significantly declines,
  further and more robust analysis required

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Recent Standard Setting Activity FSP 157-4

• FSP FAS 157-4 (contd)
• Requires additional disclosures of fair value
  measurements
• For interim and annual periods the inputs and
  valuation technique(s) used to measure fair value
  and a discussion of changes in valuation
  techniques and related inputs, if any, during the
  period
• Major security types shall be based on the nature
  and risks of the security. Disaggregation of
  financial instruments are much greater and a
  listing is included in the FSP
• Effective for periods ending after 6/15/09

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Recent Standard Setting Activity FSP 157-4

• FSP FAS 157-4 (contd)
• Provides circumstances that may indicate a
  transaction is NOT orderly
• If not orderly, place little if any weight
• If orderly, consider transaction price and weight
  depends on facts and circumstances
• If not sufficient information available to
  determine whether orderly or not, the transaction
  price may not be determinative of fair value
• Use of broker quotes and pricing services not
  precluded, but a reporting entity must evaluate
  the quote

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Recent Standard Setting Activity FSP 157-f

• FSP FAS 157-f, Measuring Liabilities Under SFAS
  157
• FASB is redeliberating a proposed FSP to provide
  additional guidance on determining the fair value
  of liabilities
• A proposed FSP was issued in May for comment
• Generally estimate fair value of liabilities as
  you would estimate fair value of an asset
• However, should not make any adjustments due to
  restrictions on the transfer of a liability

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Recent Standard Setting Activity FSP 157-f

• FSP FAS 157-f, Measuring Liabilities Under SFAS
  157
• FASB is redeliberating a proposed FSP to provide
  additional guidance on determining the fair value
  of liabilities
• A proposed FSP was issued in May for comment
• Generally estimate fair value of liabilities as
  you would estimate fair value of an asset
• However, should not make any adjustments due to
  restrictions on the transfer of a liability

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Recent Standard Setting Activity FSP 107-1

• FSP FAS 107-1 and APB 28-1, Interim Disclosures
  about Fair Value of Financial Instruments
• Applies to all public companies
• Applies to fair value disclosures for any
  financial instruments that are not currently
  reflected on the balance sheet at fair value
• Requires disclosures on a quarterly basis,
  providing qualitative and quantitative
  information about fair value estimates for
  financial instruments not measured on the balance
  sheet at fair value
• Effective for periods ending after 6/15/09

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Recent Standard Setting Activity (contd)

• FSP FAS 115-2 and FAS 124-2, Recognition and
  Presentation of Other-Than-Temporary Impairments
• Applies debt securities scope in to SFAS 115
• If FV lt CV (amortized cost), instrument is
  impaired
• If an entity intends to sell or more likely than
  not will be required to sell before recovery, all
  OTTI recognized through earnings
• If entity does not intend to sell and it is not
  more likely than not, OTTI is separated into (a)
  credit loss and (b) amounts related to other
  factors
• Credit loss through earnings and the rest through
  OCI
• Note covered in greater detail

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Recent Standard Setting Activity (contd)

• Fair Value Disclosure Project
• FASB recently added a project to its agenda to
  improve disclosures of fair value measurements
• Project will consider additional disclosures,
  such as
• Sensitivities of measurement to key inputs
• Transfers of items between the fair value
  hierarchy levels
• Levels of aggregation
• Expected timing for this project is year end 2009

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Recent Standard Setting Activity (contd)

• Financial Instruments Project
• Financial Instruments Improvements to
  Recognition and Measurement Joint project of
  the IASB and FASB
• Project objectives
• Simplify reporting to improve decision usefulness
  and understandability
• Determine which financial instruments should be
  recognized at fair value and which financial
  instruments would be recognized at a different
  measurement attribute
• Address impairment, hedging, fair value option,
  and financial statement presentation issues
• Expected timing for this project is by year end
  2009

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Recent Standard Setting Activity (contd)

• Recoveries of Other-Than-Temporary Impairment
  (Reversal) Project
• Objective of this project is to consider allowing
  an entity to recover, through earnings, a
  previously recognized OTTI loss when evidence
  exists that an impairment loss has reversed
• Another objective of this project is to converge
  with IFRS with regard to the accounting for
  recoveries of OTTI
• Expected timing for this project is by year end
  2009

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SEC Update

• SEC Staff Views of Fair Value Measurements
• SEC Staff Letters Financial Asset Impairments
• Hot Topics Related to Fair Value Measurements
• Control premiums
• Discount rates/WACC
• Valuation of restricted stock
• Use of valuation Specialists
• Limited scope engagements

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Questions?