1 Fair Value Measurements Revisited Herschel Mann Texas Tech University

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Fair Value MeasurementsRevisited

Herschel MannTexas Tech University

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FASB Statement 157Fair Value Measurements

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FASB Statement 157

• Guidance on determining fair value evolved piecemeal and is inconsistent

• SFAS 157 Defines fair value

Establishes a framework for measuring fair value

Expands disclosure requirements about fair value

• SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements; it does not require any new fair value measurements.

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FASB Statement 157

• Selected scope exceptions

SFAS 123R share-based payment transactions

ARB 43, Chapter 4, “Inventory Pricing”

Does not eliminate the practicability exceptions to fair value measurements in accounting pronouncements within the scope of SFAS 157

APB 29

SFAS 87, 106, 107, 140, 141, 143, 146, 153

FIN 45, 47

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FASB Statement 157

• 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

• A fair value measurement is for a particular asset or liability

• A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market or, in the absence of a principal market, the most advantageous market

• A fair value measurement assumes the highest and best use of the asset by market participants

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FASB Statement 157

• Valuation techniques used to measure fair value should maximize the use of observable inputs and minimize the use of unobservable inputs

• Fair value hierarchy Level 1 inputs – quoted prices in active markets

for identical assets or liabilities

Level 2 inputs – those other than quoted prices that are observable for the asset or liability

Level 3 inputs – unobservable inputs

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FASB Statement 157

• SFAS 157 is effective for financial statements issued fiscal years beginning after November 15, 2007.

• SFAS 157 must be applied prospectively.

• FSP 157-2 delays the effective date of SFAS 157 to fiscal years beginning after November 15, 2008 for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually).

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FASB Statement 159The Fair Value Option for Financial

Assets and Financial Liabilities

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FASB Statement 159

• SFAS 159 allows entities to choose to measure eligible items at fair value (the “fair value option”)

• The entity must report unrealized gains and losses on these “opted” items in earnings

• The decision to elect the fair value option is Applied instrument by instrument

Irrevocable (unless a new election date occurs)

Applied only to an entire instrument and not to only specified risks, cash flows, or portions of that instrument

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FASB Statement 159

• Entities may elect the fair value option for the following items A recognized financial asset and financial liability

A firm commitment that would otherwise not be recognized at inception and that involves only financial instruments

A written loan commitment

The rights and obligations under an insurance contract that is not a financial instrument but whose terms permit the insurer to settle by paying a third party to provide those goods or services

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FASB Statement 159

The rights and obligations under a warranty that is not a financial instrument but whose terms permit the warrantor to settle by paying a third party to provide those goods or services

A host financial instrument resulting from the separation of an embedded nonfinancial derivative instrument from a nonfinancial hybrid instrument under paragraph 12 of SFAS 133 (example is an instrument in which the value of the bifurcated embedded derivative is payable in cash, services, or merchandise but the debt host is payable only in cash)

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FASB Statement 159The following recognized financial assets and financial liabilities are not eligible items: An investment in a subsidiary that the entity is required to consolidate

An interest in a variable interest entity that an entity is required to consolidate

Employers’ and plans’ obligations for pension benefits, other postretirement benefits, postemployment benefits, employee stock option and stock purchase plans and other forms of deferred compensation arrangements

Financial assets and financial liabilities recognized under leases

Deposit liabilities, withdrawable on demand, of banks, savings and loan associations, credit unions, and other similar depository institutions

Financial instruments that are, in whole or in part, classified by the issuer as a component of shareholders’ equity

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FASB Statement 159• The following recognized financial assets and financial

liabilities are not eligible items: An investment in a subsidiary that the entity is required to consolidate

An interest in a variable interest entity that an entity is required to consolidate

Employers’ and plans’ obligations for pension benefits, other postretirement benefits, postemployment benefits, employee stock option and stock purchase plans and other forms of deferred compensation arrangements

Financial assets and financial liabilities recognized under leases

Deposit liabilities, withdrawable on demand, of banks, savings and loan associations, credit unions, and other similar depository institutions

Financial instruments that are, in whole or in part, classified by the issuer as a component of shareholders’ equity

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FASB Statement 159An entity may decide whether to elect the fair value option for each eligible item on its election date, which is the date that one of the following occurs: The entity first recognizes the eligible item

The entity enters into an eligible firm commitment

Financial assets that have been reported at fair value with unrealized gains and losses included in earnings because of specialized principles cease to qualify for that specialized accounting

The accounting treatment for an investment in another entity changes because the investment becomes subject to the equity method or the investor ceases to consolidate a subsidiary or a variable interest entity but retains an interest

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FASB Statement 159

An event that requires an eligible item to be measured at fair value at the time of the event but does not require fair value measurement at each reporting date after that (excluding the recognition of impairment)

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FASB Statement 159

Examples of events that require remeasurement of eligible items at fair value, initial recognition of eligible items, or both, and thereby create an election date for the fair value option are: Business combinations

Consolidation or deconsolidation of a subsidiary or variable interest entity

Significant modifications of debt

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FASB Statement 159

The fair value option may be elected for a single eligible item without electing it for other identical items, with the following four exceptions If multiple advances are made to one borrower pursuant to

a single contract and the individual advances lose their identify and become part of a larger loan balance, the fair value option should be applied only to the larger balance and not to each advance individually

If the fair value option is applied to an investment that would otherwise be accounted for under the equity method, it must be applied to all of the investor’s financial interests in that entity

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FASB Statement 159 If the fair value option is applied to an eligible insurance or

reinsurance contract, it should be applied to all claims and obligations under that contract

If the fair value option is elected for an insurance contract for which integrated or nonintegrated contract features or coverages are issued, the fair value option must be applied to those other features or coverages

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FASB Statement 159

Assets and liabilities reported at fair value under SFAS 159 must be reported separately from the carrying amounts of similar assets and liabilities measured using another measurement attribute

Present the aggregate of fair value and non-fair-value amounts in the same line item in the balance sheet and parenthetically disclose the amount measured at fair value included in the aggregate amount

Present two separate line items to display the fair value and non-fair-value carrying amounts

Cash receipts and payments related to items measured at fair value should be classified according to their nature in statements of cash flows

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FASB Statement 159

SFAS 159 became effective as of the beginning of each reporting entity’s first fiscal year that begins after November 15, 2007.

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Emergency Economic Stabilization Act of 2008

• Emergency Economic Stabilization Act of 2008 (EESA) signed into law on October 3, 2008

• Section 133 mandated that the SEC conduct a study on mark-to-market accounting standards as provided by SFAS 157 (in consultation with the Federal Reserve and the Secretary of the Treasury)

• EESA mandated that six key issues be addressed

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Six Key Issues Addressed in Response to EESA

• Effects of fair value accounting standards on financial institutions’ balance sheets

• Impact of fair value accounting on bank failures in 2008

• Impact of fair value accounting on the quality of financial information to investors

• Process used by the FASB in developing accounting standards

• Alternatives to fair value accounting standards

• Advisability and feasibility of modifications to fair value accounting standards

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Recommendations in SEC Response

1. SFAS 157 should be improved, but not suspended

2. Existing fair value and mark-to-market requirements should not be suspended

3. Additional measures should be taken to improve the application and practice related to existing fair value requirements (particularly as they relate to both Level 2 and Level 3 estimates

4. The accounting for financial asset impairments should be addressed

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Recommendations in SEC Response

5. Implement further guidance to foster the use of sound judgment

6. Accounting standards should continue to be established to meet the needs of investors

7. Additional formal measures to address the operation of existing accounting standards in practice should be established

8. Address the need to simplify the accounting for investments in financial assets

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FASB Staff Position (FSP) FAS 157-1(Issued Before SEC Response)

• SFAS 157 does not apply under SFAS 13, Accounting for Leases, and other accounting pronouncements that address fair value measurements for purposes of lease classification or measurement under SFAS 13

• This scope exception does not apply to assets acquired and liabilities assumed in a business combination that are required to be measured at fair value under SFAS 141 or SFAS 141R, regardless of whether those assets and liabilities are related to leases

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• Defers the effective date of SFAS 157 to fiscal years beginning after November 15, 2008 for nonfinancial assets and nonfinancial liabilities

except for items that are recognized or disclosed at fair value in an entity’s financial statements on a recurring basis (at least annually)

• Nonfinancial assets and nonfinancial liabilities include all assets and liabilities other than financial assets and financial liabilities (per SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities)

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• Clarifies the application of SFAS 157 in a market that is not active

• Added an illustrative example to SFAS 157 Example relates to an entity that invested in a AA-rated

tranche of a collateralized debt obligation security, with the underlying collateral for the collateralized debt obligation security being unguaranteed nonconforming residential mortgage loans

• This FSP became effective upon its issuance

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FASB Staff Position (FSP) FAS 157-4(Issued After SEC Response)

• Provides guidance for estimating fair value in accordance with SFAS 157 when the volume and level of activity for the asset or liability have been significantly decreased

• Provides guidance on identifying circumstances that indicate a transaction is not orderly

• Applies to all assets and liabilities within the scope of accounting pronouncements that require or permit fair value measurements, except for the exemptions identified in SFAS 157 (e.g., share-based payments)

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FASB Staff Position (FSP) FAS 157-4(Selected Items)

• This FSP does not change the requirements in paragraphs 24-27 of SFAS 157, which provides guidance on the use of Level 1 inputs

Thus, it does not apply to quoted prices for an identical asset or liability in an active market (Level 1 input)

For example, although the volume and level of activity for an asset or liability may significantly decrease, transactions for the asset or liability may still occur with sufficient frequency and volume to provide pricing information on an ongoing basis

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FASB Staff Position (FSP) FAS 157-4 (Par. 12)

• An entity must evaluate the following factors to determine whether there has been a significant decrease in the volume and level of activity for the asset or liability when compared with normal market activity for the asset or liability (or similar assets or liabilities): There are few recent transactions

Price quotations are not based on current information

Price quotations vary substantially, either over time or among market makers

Indexes that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability

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FASB Staff Position (FSP) FAS 157-4 (Par 12)

There is a significant increase in implied liquidity risk premiums, yields, or performance indicators for observed transactions or quoted prices when compared with the entity’s estimate of expected future cash flows, considering all available market data about credit and other nonperformance risk for the asset or liability

There is a wide bid-ask spread or significant increase in the bid-ask spread

There is a significant decline or absence of a market for new issuances (that is, a primary market) for the asset or liability or similar assets or liabilities

Little information is released publicly (e.g., a principal to principal market)

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• If the entity concludes there has been a significant decrease in the volume and level of activity for the asset or liability in relation to normal market activity for the asset or liability (or similar assets or liabilities), transactions or quoted prices may not be determinative of fair value (for example, there may be increased instances of transactions that are not orderly).

• In that case, further analysis of the transactions or quoted prices is needed, and a significant adjustment to the transactions or quoted prices is needed, and a significant adjustment to the transactions or quoted prices may be necessary.

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• SFAS 157 does not prescribe a methodology for making significant adjustments to transactions or quoted prices when estimating fair value.

• If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate.

• When weighting indications of fair value resulting from the use of multiple valuation techniques, a reporting entity shall consider the reasonableness of the range of fair value estimates.

• The objective is to determine the point within that range that is most representative of fair value under current market conditions.

• A wide range of fair value estimates may be an indication that further analysis is needed.

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• Even in circumstances where there has been a significant decrease in the volume and level of activity for the asset or liability and regardless of the valuation technique(s) used, the objective of a fair value measurement remains the same. Fair value is the price that would be received to sell an asset or paid

to transfer a liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions.

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FASB Staff Position (FSP) FAS 157-4 (Par. 15-16)

• Determining the price at which willing market participants would transact at the measurement date under current market conditions if there has been a significant decrease in the volume and level of activity for the asset or liability depends on the facts and circumstances and requires the use of significant judgment. However, a reporting entity’s intention to hold the asset or liability is

not relevant in estimating fair value. Fair value is a market-based measurement, not an entity-specific

measurement.

• A reporting entity shall evaluate the circumstances to determine whether the transaction is orderly based on the weight of evidence.

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• The determination of whether a transaction is orderly (or not orderly) is more difficult if there has been a significant decrease in the volume and level of activity for the asset or liability.

• Accordingly, a reporting entity shall consider the following guidance:a. If the weight of the evidence indicates the transaction is not orderly, a

reporting entity shall place little, if any, weight (compared with other indications of fair value) on that transaction price when estimating fair value or market risk premiums.

b. If the weight of the evidence indicates the transaction is orderly, a reporting entity shall consider that transaction price when estimating fair value or market risk premiums. The amount of weight placed on that transaction price when compared with other indications of fair value will depend on the facts and circumstances such as the volume of the transaction, the comparability of the transaction to the asset or liability being measured at fair value, and the proximity of the transaction to the measurement date.

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c. If a reporting entity does not have sufficient information to conclude that the transaction is orderly or that the transaction is not orderly, it shall consider that transaction price when estimating fair value or market risk premiums. However, that transaction price may not be determinative of fair value (that is, that transaction price may not be the sole or primary basis for estimating fair value or market risk premiums.) A reporting entity shall place less weight on transactions on which a reporting entity does not have sufficient information to conclude whether the transaction is orderly when compared with other transactions that are known to be orderly. In its determinations, a reporting entity need not undertake all

possible efforts, but shall not ignore information that is available without undue cost and effort.

A reporting entity would be expected to have sufficient information to conclude whether a transaction is orderly when it is party to the transaction.

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FASB Staff Position (FSP) FAS 157-4

Effective Date and Transition

• FSP FAS157-4 is effective for interim and annual reporting periods ending after June 15, 2009, and must be applied prospectively.

• Early adoption is permitted for periods ending after March 15, 2009. If an entity elects to adopt early either FSP FAS

115-2 and FAS 124-2 or FSP FAS 107-1 and APB 28-1, it also is required to adopt early this FSP.

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FSP FAS 115-1and FAS 124-1

• This FSP addresses the determination as to when an investment

is considered impaired whether that impairment is other than temporary the measurement of an impairment loss

• Issued November 3, 2005

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FSP FAS 115-1and FAS 124-1Step 1 – Determine Whether an Investment is Impaired

• Impairment must be assessed at the individual security level Individual security level means the level and method of

aggregation used by the reporting entity to measure realized and unrealized gains and losses on its debt and equity securities.

• An investment is impaired if its fair value is less than its cost Cost includes adjustments made to the cost basis of an investment

for accretion, amortization, previous other-than-temporary impairments, and hedging.

• Except as otherwise provided in this FSP, an investor must assess whether an investment is impaired in each reporting period.

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• An investor may not combine separate contracts (a debt security and a guarantee or other credit enhancement) for purposes of determining whether a debt security is impaired or can contractually be prepaid or otherwise settled in such a way that the investor would not recover substantially all of its cost.

• For investments other than cost-method investments, if the fair value of the investment is less than its cost, proceed to Step 2 (i.e., evaluate whether an impairment is other than temporary)

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• Since the fair value of cost-method investments is not readily determinable, the evaluation of whether an investment is impaired should be determined as follows: If an investor has estimated the fair value of a cost-method

investment, that estimate should be used to determine if the investment is impaired for the reporting periods in which the investor estimates fair value.

If the investor has not estimated the fair value of a cost-method investment, the investor must evaluate whether an event or change in circumstances has occurred in that period that may have a significant adverse effect on the fair value of the investment (an “impairment indicator”).

If an impairment indicator is present, the investor must estimate the fair value of the investment.

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• Examples of “impairment indicators” A significant deterioration in the earnings performance, credit rating,

asset quality, or business prospects of the investee A significant adverse change in the regulatory, econo9mic, or

technological environment of the investee A significant adverse change in the general market condition of

either the geographic area or the industry in which the investee operates

A bona fide offer to purchase (whether solicited or unsolicited), an offer by the investee to sell, or a completed auction process for the same or similar security for an amount less than the cost of the investment

Factors that raise significant concerns about the investee’s ability to continue as a going concern, such as negative cash flows from operations, working capital deficiencies, or noncompliance with statutory capital requirements of debt covenants.

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FSP FAS 115-1and FAS 124-1Step 2 – Evaluate Whether an Impairment Loss

is Other Than Temporary

• If in Step 1, when the fair value of the investment is less than its cost at the balance sheet date for which impairment is assessed, the impairment is either temporary or other than temporary.

• An investor should apply other guidance that is pertinent to the determination of whether an impairment is other than temporary (such as paragraph 16 of SFAS 115).

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FSP FAS 115-1and FAS 124-1Step 3 – If the Impairment is Other Than Temporary, Recognize an Impairment Loss Equal to the Difference between the Investment’s

Cost and Its Fair Value

• If the impairment loss is other than temporary, an impairment loss should be recognized in earnings equal to the entire difference between the investor’s cost and its fair value at the balance sheet date of the reporting period in which the assessment is made.

• The fair value of the investment would then become the new cost basis of the investment and should not be adjusted for subsequent recoveries in fair value.

• In periods subsequent to the recognition of an other-than-temporary loss for debt securities, an investor should account for the other-than-temporarily impaired debt security as if the debt security had been purchased at the measurement date of the other-than-temporary impairment.

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FSP FAS 115-1and FAS 124-1

• Effective Date and Transition The guidance in this FSP must be applied to

reporting periods beginning after December 15, 2005.

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FSP FAS 115-2 and FAS 124-2

• Issued April 9, 2009• The recognition guidance in this FSP applies to

debt securities classified as available-for-sale and held-to-maturity that are subject to other –than-temporary impairment guidance within: SFAS 115 FSP FAS 115-1 and FAS 124-1 EITF Issue 99-20, as amended by FSP EITF 99-20-1 AICPA Statement of Position 03-3

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FSP FAS 115-2 and FAS 124-2Evaluating Whether an Impairment of a Debt Security Is

Other Than Temporary

• If the fair value of a debt security is less than its amortized cost basis at the balance sheet date, an entity shall assess whether the impairment is other than temporary.

• If an entity has decided to sell the debt security, an other-than-temporary impairment shall be considered to have occurred.

• If an entity does not intend to sell the debt security, the entity should consider available evidence to assess whether it more likely than not will be required to sell the security before the recovery of the amortized cost basis. If so, an other-than-temporary impairment shall be considered to have occurred.

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FSP FAS 115-2 and FAS 124-2Evaluating Whether an Impairment of a Debt Security Is

Other Than Temporary

• If the entity does not expect to recover the entire amortized cost basis, the entity would be unable to assert that it will recover its amortized cost basis even if it does not intend to sell the security. Therefore, an other-than-temporary impairment shall be considered to have occurred. In assessing whether the entire cost basis of the security will be

recovered, an entity must compare the present value of cash flows expected to be collected from the security with the amortized cost basis of the security.

If present value of cash flows expected to be collected is less than the amortized cost basis of the security, the entire amortized cost basis of the security will not be recovered (that is, a credit loss exists), and an other-than-temporary impairment shall be considered to have occurred.

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FSP FAS 115-2 and FAS 124-2Determination of the Amount of an Other-Than Temporary

Impairment Recognized in Earnings and OCI

• When an other-than-temporary impairment loss has occurred, the amount that should be recognized in earnings depends on whether an entity intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss. If it intends to sell the security or more likely than not will be required to sell it

before recovery of its amortized cost basis less any current-period credit loss, the other-than-temporary impairment must be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date.

If an entity does not intend to sell the security and it is not more likely than not that the entity to be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the other-than-temporary shall be separated into (a) the amount representing the credit loss and (b) the amount related to all other factors.

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FSP FAS 115-2 and FAS 124-2Determination of the Amount of an Other-Than Temporary

Impairment Recognized in Earnings and OCI

The amount of the total other-than-temporary impairment related to the credit loss must be recognized in earnings. The amount of the total other-than-temporary impairment related to other factors must be recognized in OCI, net of applicable taxes.

The previous amortized cost less the other-than-temporary impairment recognized in earnings shall become the new amortized cost basis of the investment.

The new amortized cost basis shall not be adjusted for subsequent recoveries in fair value.

• However, the amortized cost basis should be adjusted for accretion and amortization as prescribed in this FSP.

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FSP FAS 115-2 and FAS 124-2Accounting for Debt Securities after an

Other-Than Temporary Impairment

An entity shall account for the other-than-temporarily-impaired debt security as if the debt security had been purchased on the measurement date of the other-than-temporary impairment at an amortized cost basis equal to the previous amortized cost basis less the other-than-temporary impairment recognized in earnings.

Debt securities classified as available-for-sale• Subsequent increases and decreases (if not an additional other-than-temporary

impairment) in the fair value of the available-for-sale securities shall be included in OCI.

Debt securities classified as held-to-maturity• The other-than-temporary impairment recognized in OCI shall be accreted from

OCI to the amortized cost of the debt security over the remaining life of the debt security in a prospective manner on the basis of the amount and timing of future estimated cash flows.

• That accretion shall increase the carrying value of the security and shall continue until the security is sold, the security matures, or there is an additional other-than-temporary impairment that is recognized in earnings.

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FSP FAS 115-2 and FAS 124-2Presentation

• In periods in which an entity has an other-than-temporary impairment, the entity must present the total other-than-temporary impairment in the statement of earnings with an offset for the amount that is recognized in OCI.

• An entity also must separately present, in the financial statement where the components of accumulated OCI are reported, amounts recognized therein related to held-to-maturity and available-for-sale debt securities for which a portion of an other-than-temporary impairment has been recognized in earnings.

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FSP FAS 115-2 and FAS 124-2Effective Date and Transition

• This FSP is effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. Earlier adoption is prohibited.

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Documents

1 Fair Value Measurements Revisited Herschel Mann Texas Tech University