Title: Fair Value Measurements
1Fair Value Measurements
- Application of Statement 157
Presenters Mitch Fane, Ernst and Young,
LLP Deborah Sobczak, Ernst and Young, LLP
2SFAS 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
3Fair 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?
-
4Dealer credit default spreads 30 September 2004
5Dealer credit default spreads 31 March 2008
6Dealer credit default spreads 30 June 2008
7Dealer credit default swap spreads (one year
spot) 30 April 2007 to 30 June 2008
8Fair 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
9Assessment 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)
10SFAS 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
11SFAS 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)
12Observations 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
13SFAS 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
14Where 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
15Recent 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
16Appendix
17Q2 Industry Trends
18Q2 Industry Trends
19Q2 Industry Trends
20Q2 Industry Trends
21Q2 Industry Trends
22Percentage of assets and liabilities by Level -
Q1 vs. Q2
Q1 Q2 Q1 Q2
Assets Liabilities
23Fair value hierarchy classification for assets
Q2
Derivative assets
Compensation benefits investments
Investments
Other assets
24Fair value hierarchy classification for
liabilities Q2
Derivative liabilities
Compensation benefits obligations
Other liabilities
25Fair 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.