ST Convergence with IASB

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ST Convergence with IASB
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SFAS No. 151 Inventory Costs

• Part of the international convergence project.
• Clarifies that abnormal costs of idle facilities
  should not be capitalized as product costs.
• Companies should use normal capacity for the
  allocation of overhead.
• Any unallocated overhead is expensed during the
  period in which they are incurred.
• Other abnormal handling costs or abnormal levels
  of spoilage might also need to be expensed.

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Coming soon

• Short-term convergence with IASB
• EPS (ED expected 1st half 2007)
• Income taxes (ED expected 1st half 2007)
• Research and Development - ?

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Fair Value Measurements

• SFAS No. 157
• Signs of the Future!

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FAS157 Issued Sept. 2006

• With a few exceptions, it does not change WHAT is
  currently measured using fair value
• Sets out a framework for measuring fair value
• Requires additional disclosures about fair value
  measurements

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FAS157 Definition of Fair Value

• Paragraph 5 - Fair value is the price that would
  be received to sell an asset or paid to transfer
  a liability in an orderly transaction between
  market participants at the measurement date.
• This is an exit-price definition of fair value
  (see paragraph 7)

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FAS157 Related definitions

• Market Participants (4 criteria)
• Independent of reporting entity
• Have knowledge needed for reasonable
  understanding about transaction
• Financial and legal ability to enter into the
  transaction
• Be willing to enter into transaction without
  compulsion

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FAS157 Related definitions

• Principal Market
• Has the greatest volume and level of activity.
• If there is no principal market, use the most
  advantageous market
• Most Advantageous Market
• Most advantageous market has price that maximizes
  the net amount that would be received or
  minimizes the net amount paid
• Transactions costs are included in determining
  which market to use but do NOT become part of the
  fair value measurement

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Example of which market
Market A Market B
Selling price 50 48
Transaction cost 5 2
Net proceeds 45 46
Fair value to use
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FAS157 Related definitions

• Assumptions about the market
• The asset or liability is exchanged in an orderly
  transaction between market participants
• An orderly transaction is a transaction that
  assumes exposure to the market for a period prior
  to the measurement date to allow for marketing
  activities that are usual and customary for
  transactions involving such assets or
  liabilities
• it is not a forced transaction (for example, a
  forced liquidation or distress sale).
• The price is for a hypothetical transaction at
  the measurement date, considered from the
  perspective of a market participant that holds
  the item

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FAS157 Related definitions

• Valuation premise the assumption about how
  market participants would use an asset
• Choose the premise based on highest and best
  use
• In-use premise
• Provides maximum value through use in combination
  with other assets
• In-exchange premise
• Provides maximum value principally on a
  stand-alone basis

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Valuation Techniques

• Market approach
• Uses observable prices from market transactions
  for comparable assets or liabilities
• Income approach
• Analysis of future cash flows using present
  values
• Cost approach
• Estimates cost to replace an assets service
  capacity

A change in valuation technique is a change in
accounting estimate, not a change in accounting
principle
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The Fair Value Hierarchy
Level Inputs to achieve reliability level
1 Quoted prices in active markets for identical assets or liabilities
2 Observable prices in active markets for similar assets or liabilities, or prices from markets that are not active. Market inputs for substantially full term of item (interest rates). Market inputs that are not directly observable but can be derived or corroborated by market data
3 Unobservable inputs based on the reporting entitys own assumptions about assumptions that market participants would use. Cannot be corroborated by observable market data
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Valuing Liabilities

• The valuation technique must consider the
  reporting entitys credit standing
• A reporting entity could record a GAIN for
  derivatives at a measurement date because the
  fair value of the liability decreases in response
  to a credit downgrade if all other inputs remain
  unchanged

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Restrictions on Assets

• Restrictions are evaluated to determine whether
  they are an attribute of the asset or an
  attribute of the reporting entity
• If sold, would the restriction transfer to
  another holder?
• If yes, the impact of the restriction would be
  taken into consideration (adjust asset fair value
  downward)
• If no, the restriction would not reduce the fair
  value

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Other provisions of FAS157

• It is now possible to recognize a gain on the day
  recognized (previously prohibited under EITF
  02-3)
• Blockage adjustments are not permitted in pricing
  
• Bid-ask spreads
• Use the price within the bid-ask spread that is
  most representative of fair value in the
  circumstances

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FAS 157 Disclosures

• Will be extensive and reported in three sections
  (see paragraph A33-A36 for examples)
• Assets and liabilities measured at fair value on
  a recurring basis
• Tabular display reconciles beginning and ending
  amounts when significant Level 3 inputs are used
• Assets and liabilities measured at fair value on
  a nonrecurring basis (impairment of assets, etc.)
• For all fair value measurements, a table showing
  the reliance on Level 1, 2 or 3 inputs plus
  discussion of the valuation techniques used for
  the measurements

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FAS 157 effective date

• Implementation is prospective
• Required for financial statements issued for
  fiscal years beginning AFTER Nov. 15, 2007

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FAS 159 The Fair Value Option

• Optional use of fair value for certain assets and
  liabilities

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Essentially a one-time election

• On a contract by contract basis, company can
  designate specified financial instrument to be
  accounted for using fair value instead of the
  usual measurement technique
• Companies may be able to reduce volatility in
  reported earnings caused by measuring assets and
  liabilities differently

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Other benefits

• Movement toward accounting for all financial
  instruments at fair value
• Brings US GAAP into closer agreement with IASB 39
  which already contains a fair value election

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Eligible assets liabilities

• Most recognized investments including those
  currently accounted for using the equity method
• But cannot be used to recognized investments that
  must be consolidated (VIEs, subsidiaries)
• Many recognized liabilities
• Excluding leases, demand deposits of banks,
  postretirement plans, etc.

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Eligible assets liabilities

• Firm purchase commitments that would otherwise
  not be recognized at inception (but only for ones
  involving financial instruments)
• Rights and obligations under warranties that meet
  certain requirements
• Certain host financial instruments that result
  from separation of embedded nonfinancial hybrid
  instruments under FAS133

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Irrevocable election

• Must be applied to contracts as a whole and not
  to parts of contracts
• Changes in fair value will be recognized in
  earnings during each reporting period

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Election date

• Transition any eligible item as of the date
  that FAS159 is initially adopted
• Thereafter
• The eligible item is first recognized (including
  entering into an eligible firm commitment)
• Occurrence of a short list of other events

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Disclosures

• If fair value option is elected, company must
  disclose separately assets and liabilities
  measured at fair value from those not measured at
  fair value
• Intended to help readers compare companies that
  choose the option to those that choose not to
  elect fair value accounting

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Disclosures specific (1)

• Why fair value option was selected for each
  eligible item
• Difference between fair value and aggregate
  unpaid principal amounts
• Relation to other fair value measurements under
  FAS157
• Description of partial applications to groups of
  similar items and why company chose not to be
  consistent

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Disclosures specific (2)

• Loans carried at assets at fair value that are
  past due by 90 days or more
• APB18 disclosures about investments that would
  otherwise have been reported using equity method
• Description of how interest and dividends are
  measured and reported for items with fair value
  election
• Quantitative information (line by line) as to
  where gains and losses related to fair value
  option have been reported in the income statement

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FIN 46R and 48

• Lecture notes are in doc file (not ppt) and this
  was covered as part of the deferred tax lectures
• Note to self need to verify
• FIN46R notes were only in doc file, I think

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FSP of interest

• Note that FSP158-1 (Feb 21, 2007) contains Update
  of Illustrations, Application Guidance
• Dont hit print 257 pages!
• Fixes examples in FAS87, FAS88 FAS106 as
  related to issuance of FAS158. FAS132R was
  fixed in FAS158 so is not included in this FSP

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Whats Next?
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Forthcoming first half 2007

• Conceptual Framework Reporting Entity
  preliminary views
• Business Combinations for-profit
• Applying the Acquisition Method (final)
• Noncontrolling Interests (final)
• Derivatives disclosures (final)

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Forthcoming first half 2007

• Implementation Projects
• Statement 140Transfers of Financial Assets (ED)
• Insurance Risk Transfer (ED)
• Financial Guarantee Insurance (ED and maybe final
  by mid year)
• Definition of liability vs. equity (Prelim views
  expected first half of 2007)

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Forthcoming second half 2007

• Financial Statement Presentation (prelim views
  maybe by 3rd quarter)
• Revenue recognition (PV by 3rd or 4th Quarters)

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Longer term projects

• Not-for-profit business combinations and
  intangible assets
• In process of reviewing comments (nothing on
  calendar about when a final version is expected)