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Fair Value Measurements

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Title: Fair Value Measurements


1
Fair Value Measurements
  • Application of Statement 157

Presenters Mitch Fane, Ernst and Young,
LLP Deborah Sobczak, Ernst and Young, LLP
2
SFAS 157 Landscape
  • Key SFAS 157 Objectives
  • Increase consistency and comparability in fair
    value measurements
  • Improve transparency in financial reporting by
    expanding disclosures about fair value
    measurements
  • Allow users to assess the relative reliability of
    FV measurements and the impact on earnings of
    Level 3 (i.e., unobservable) measurements
  • Broad Impact on Industry Practices
  • Principles based Statement - differences may
    exist in how entities interpret and implement
  • Singular definition of fair value across all
    in-scope assets/liabilities has lead to
    difficulties in application (e.g., same
    definition for assets acquired in a business
    combination and for derivative assets/liabilities)
  • Expanded disclosures requires significant
    operational changes

3
Fair value of liabilities
Nonperformance risk refers to the risk that the
obligation will not be fulfilled and affects the
value at which the liability is transferred.
Therefore, the fair value of the liability shall
reflect the nonperformance risk relating to that
liability (Statement 157, paragraph 15).
  • Although FAS 157 explicitly addresses only
    nonperformance risk, consideration of
    counterparty credit risk is implicit in the fair
    value framework.
  • Concept is not limited to changes in credit
    ratings fair values are affected by movements in
    credit spreads
  • Many entities have struggled with the calculation
    of both counterparty credit and own credit
  • Most recognize the US GAAP requirement, but may
    challenge the materiality to the extent their
    company only trades with highly rated
    counterparties.
  • What do the markets say?

4
Dealer credit default spreads 30 September 2004
5
Dealer credit default spreads 31 March 2008
6
Dealer credit default spreads 30 June 2008
7
Dealer credit default swap spreads (one year
spot) 30 April 2007 to 30 June 2008
8
Fair value of liabilities
  • The concept of nonperformance risk will primarily
    affect derivative transactions, liabilities
    measured under the fair value option and FAS 107
    disclosures.
  • Diversity in methods and approaches to
    quantifying credit risk exists, particularly as
    it pertains to derivatives.
  • Exposures vs. cash flows
  • Current exposure vs. expected future exposure
  • Gross cash flows vs. net cash flows
  • Bilateral exposure vs. unilateral exposure
  • Term structure of credit vs. constant credit
    spreads
  • Market-implied inputs vs. historical-based inputs

9
Assessment of nonperformance risk
  • Expectations about credit valuation adjustments
    are based on several factors
  • Credit enhancements
  • Collateral-posting thresholds
  • Master netting agreements
  • Guarantees
  • Market indications about credit risk
  • Availability of information about market-implied
    credit spreads
  • Credit derivatives, bond trading or recently
    issued debt
  • Exposure analysis by counterparty
  • Consideration of the liability profile
  • Type of instrument (such as debt, derivative or
    warrant)
  • Instrument terms (such as maturity date or
    notional)
  • Attributes of the obligation (such as recourse,
    priority of claim, secured or unsecured)

10
SFAS 157 Fair Value Hierarchy and Disclosures
  • To the extent inputs are obtained from third
    parties (e.g., pricing services, consensus
    pricing, broker quotes, etc.) management must
    understand and evaluate assumptions used to
    derive marks
  • Evaluate if mark is an exit price compliant with
    SFAS 157
  • Evaluate observability in light of the fair value
    hierarchy (e.g., consideration of NYMEX Clearport
    swaps, ICE trades, broker quotes, etc.)
  • Obtaining information regarding valuation
    methodologies has been a challenge for entities
    but continues to evolve

11
SFAS 157 Fair Value Hierarchy and Disclosures
  • Tagging of inputs into fair value hierarchy
    levels is a dynamic process
  • Classification needs to be monitored on an
    ongoing basis as assets and liabilities move
    within the hierarchy
  • Ex A long-dated derivative contract may move
    from Level 3 to Level 2 as the time to maturity
    shortens
  • Ex A RMBS may move from Level 2 to Level 3 with
    a change in market liquidity
  • Many entities have found they need to make
    simplifying assumptions in aggregating disclosure
    data due to system and reporting limitations
  • Ex Assumptions about transfers in/out of Level 3
  • Ex Assumptions about realized/unrealized Level 3
    PL
  • Ex Considerations between quarter-to-date vs.
    year-to-date reconciliations (i.e. which
    reconciliations to include sum of the quarters
    vs. year-to-date)

12
Observations from disclosures to date
  • Few fair value option disclosures
  • Accounting policy elections not robust
  • E.g., transfers in/out of Level 3, unrealized
    gains and losses
  • Discussion of valuation techniques for Level 3
    assets and liabilities limited
  • Diversity in practice
  • Classification in fair value hierarchy for
    similar instruments
  • Level of detail provided on asset classes
  • Similar items appear to be in different levels of
    the fair value hierarchy
  • Inclusion and discussion of nonperformance risk
  • Discussion in MDA or critical accounting
    policies
  • See Appendix for a sample of Energy industry
    disclosures

13
SFAS 157 Market Perceptions
  • Market understanding of Level 3 continues to
    evolve some still perceive Level 3 as
    mark-to-magic or mark-to-make-believe
  • Recent popular press articles have partly blamed
    fair value measurements and SFAS 157 for current
    market illiquidity
  • SEC Letter recommends additional disclosures
    around unobservable assets/liabilities

14
Where are we now?
  • Effective for two quarters, but processes
    continue to evolve
  • Many are still in the process of designing and
    finalizing SOX controls
  • Controls to ensure that accounting policies over
    determination of exit price are appropriately
    implemented
  • Reconciliations between source systems and
    systems used to generate FAS 157 disclosures
  • Controls around analyses/due diligence over
    levels of assets and liabilities
  • Reviews for potential changes in liquidity (i.e.,
    assigning levels is a dynamic process that
    requires controls)
  • Controls over the generation of the Level 3
    rollforward
  • Information technology general controls (i.e.,
    logical security and change management) over FAS
    157 systems
  • Some entities may have used a manual process for
    Q1 and Q2, but are exploring ways to automate and
    create a living process
  • Companies who elected the FSP 157-2 deferral for
    non-recurring and non-financial assets and
    liabilities are preparing for January 1, 2008
    adoption

15
Recent standard-setter activities
  • Pending guidance
  • FSP 132(R)-a disclosures related to
    postretirement plan assets
  • FSP 157-c measuring liabilities
  • EITF 08-5 unit of account for guaranteed debt
  • EITF 08-7 defensive intangibles
  • SEC activities
  • SEC roundtable
  • Critical accounting policies
  • Sensitivity analysis
  • SEC staffs Dear CFO letter
  • Comment letter activities
  • Potential FR-61 revisions
  • Professional Accounting Fellow focused on
    valuation matters at FASB and SEC
  • Valuation resource group

16
Appendix
17
Q2 Industry Trends
18
Q2 Industry Trends
19
Q2 Industry Trends
20
Q2 Industry Trends
21
Q2 Industry Trends
22
Percentage of assets and liabilities by Level -
Q1 vs. Q2
Q1 Q2 Q1 Q2
Assets Liabilities
23
Fair value hierarchy classification for assets
Q2
Derivative assets
Compensation benefits investments
Investments
Other assets
24
Fair value hierarchy classification for
liabilities Q2
Derivative liabilities
Compensation benefits obligations

Other liabilities
25
Fair value hierarchy classification for net
derivatives Q2 2008
Some entities disclose net derivative assets
(liabilities), while others separately present
derivative assets and liabilities. This graph
presents the positions on a net basis for all
entities for all types of instruments.
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