© 1 Fair Value Measurements SFAS 157

2 What Does SFAS 157 Accomplish? Defines fair value Establishes a framework for measuring fair value in GAAP Expands disclosures about fair value measurements Though it does not specify when fair value must be used

3 Why Was SFAS 157 Issued? Raised the bar by specifying new factors to consider when measuring already-required GAAP fair values Deficiencies in previous GAAP that resulted in varying definitions of fair value Limited guidance for applying those definitions Existing guidance dispersed among many pronouncements Resulted in inconsistency and complexity Paved the way for SFAS 159, “Fair Value Option for Financial Assets and Financial Liabilities” Sets the stage for new Conceptual Framework project

4 How Does SFAS 157 Differ from Previous Practice? Definition of fair value – 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 Definition of fair value – 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 Retains the exchange price notion provided in earlier definitions of fair value Clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability

5 How Does SFAS 157 Differ from Previous Practice? (cont.) The transaction to sell the asset or transfer the liability is a hypothetical transaction at the market date It is considered from the perspective of a market participant that holds the asset or owes the liability The hypothetical transaction occurs in the principal or most advantageous market for the asset or liability

6 How Does SFAS 157 Differ from Current Practice? (cont.) The definition focuses on the price that would be received to sell the asset or paid to transfer the liability, not the price that would be paid to acquire the asset or received to assume the liability an exit price rather than an entry price

7 Long-Standing Fair Value Controversy: Exit Price vs. Entry Price? Exit PriceExit Price Amount owner would receive upon selling an asset Amount owner would receive upon selling an asset Outcome could be immediate loss to buyer Outcome could be immediate loss to buyer Entry PriceEntry Price Amount owner would pay to buy a new asset Amount owner would pay to buy a new asset Differences between the two are actually the sources of most income FASB resolved dilemma by requiring presumption of sale based on “highest and best use” by market participants

8 Determining Fair Value It is a market-based measurement - not an entity- specific measurement Fair value measurements should be based on the assumptions that market participants would use in pricing the asset or liability Creates a hierarchy that distinguishes between observable inputs and unobservable inputs Intended to allow for situations where there is little, if any, market activity

9 Determining Fair Value, cont. Statement requires that market participants’ assessment of risk be included Examples Risk inherent in valuation techniques used Risks inherent in inputs used in valuation models Required even if adjustment is difficult to determine Fair value measurements for liabilities must include risk of nonperformance Statement requires that restrictions on sale or use of an asset be included

10 The Price Use fair value – as defined – assuming that asset or liability is exchanged in an orderly transaction between market participants Not a forced transaction Assumes highest and best use of the asset by market participants, even if intended use by acquiring company is different Physically possible Legally permissible Financially feasible at the measurement date Maximizes the value of the asset or the group of assets within which the asset would be used

11 The Price, continued Two premises of value established by the highest and best use In-use The highest and best use of the asset is in-use if the asset would provide maximum value to market participants principally through its use in combination with other asset as a group (e.g., nonfinancial assets such as intangible assets) In-exchange The highest and best use of the asset is in- exchange if the asset would provide maximum value to market participants principally on a standalone basis (e.g., financial assets).

12 What is Market? Must assume that the transaction occurs in the principal market for the asset or liability The principal market is the market in which the reporting entity would sell the asset or transfer the liability with the greatest volume and level of activity for the asset or liability If there is a principal market for the asset or liability, the fair value measurement shall represent the price in that market even if the price in a different market is potentially more advantageous

13 The Market In the absence of a principal market, must assume that the transaction occurs in the most advantageous market for the asset or liability. The most advantageous market is the market in which the reporting entity would sell the asset or transfer the liability with the price that maximizes the amount that would be received for the asset or minimizes the amount that would be paid to transfer the liability

14 Who Are Market Participants? The concept of “market participants” is central to SFAS 157. Buyers and sellers in the principal (or most advantageous) market that are Independent of the reporting entity Have a reasonable understanding about the asset or liability and transaction Able to transact for asset or liability Willing to transact for asset or liability Motivated but not forced

15 Initial Fair Value Recognition In many cases, the transaction price represents fair value. Possible exceptions: The transaction is between related parties The transaction occurs under duress (e.g.,seller is experiencing financial difficulty) Market where transaction occurs isn’t the most advantageous market

16 Valuation Techniques Market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities (including a business). Income approach uses valuation techniques to convert future amounts to a present value Discounted cash flow method Option-pricing models Multi-period excess earnings method

17 Valuation Techniques, cont. Cost approach based on the amount that currently would be required to replace the service capacity of an asset From perspective of a market participant, it is based on cost to acquire or construct a substitute asset of comparable utility adjusted for obsolescence (physical deterioration, function or technological, and economic)

18 Inputs to Valuation Techniques Assumptions that market participants would use in pricing the asset or liability including assumptions about risk. Observable inputs reflect assumptions by market participants based on market data obtained from sources independent of the reporting entity Use of these should be maximized Unobservable inputs reflect the reporting entity’s own assumptions about the assumptions that market participants would use based on the best information available in the circumstances. Use of these should be minimized

19 Fair Value Hierarchy Prioritizes the inputs to valuation techniques Level 1 – Quoted prices (unadjusted) in active markets for identical assets or liabilities Very few items, especially physical assets, trade in active markets Level 2 – Inputs other than quoted prices that are observable for the asset or liability 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 (e.g., few transactions, prices are not current, little information is available) Inputs other than quoted prices that are observable for the asset or liability Inputs that are derived principally from or corroborated by observable market data

20 Fair Value Hierarchy, cont. Level 3 – Unobservable inputs Based on entity’s own assumptions about the assumptions market participants would use Not independent sources To be used to the extent that observable inputs are not available Situations where there is little, if any, market activity Measurement objective is still the same – exit price for market participant

21 Implementation Concerns Recent financial crisis raised the question of what constituted an inactive market, and the impact on market values Concern raised that the required accounting may have contributed to a “downward spiral” FASB issued FSP 157-3, which provides the following guidance: in an inactive market, companies may determine that observable (Level 2) inputs require significant adjustment, and thus it would be more appropriate to use unobservable (Level 3) inputs in determining fair value Means that when a market is inactive and market inputs are distressed, reporting entities have the discretion to override observable inputs with unobservable inputs and assumptions

22 Implementation Concerns, continued FSP Issued to help accountants determine if a market is inactive, if transactions are not orderly, and how to measure fair value in those situations Provides factors to consider, though also states that the lists are not exhaustive Thus companies still have discretion in determining whether a market is inactive and transactions are not orderly Still focuses on market-based measurements, not entity-specific measurements

23 Disclosure Requirements For assets and liabilities that are measured at fair value on a recurring basis in periods subsequent to initial recognition (example – trading securities), companies must disclose information to help users assess inputs used to develop the measures the impact of those measurements on earnings Specific disclosures required: The fair value measurements at the reporting date The level within the fair value hierarchy in which the fair value measurements fall segregated by level For fair value measurements using significant unobservable inputs (Level 3), a reconciliation of the beginning and ending balances The amount of the total gains or losses for the period included earnings or changes in net assets that are attributable to the change in unrealized gains or losses relating to those assets and liabilities still held at the reporting date In annual periods only, the valuation techniques used to measure fair value and a discussion of changes in valuation techniques, if any, during the period

24 Disclosure Requirements, cont. For assets and liabilities that are measured at fair value on a nonrecurring basis in periods subsequent to initial recognition (for example, impaired assets), companies must disclose information that enables users to assess inputs used to develop those measures Specific requirements: The fair value measurements recorded during the period and the reasons for the measurements The level within the fair value hierarchy in which the fair value measurements fall segregated by level For fair value measurements using significant unobservable inputs (Level 3), a description of the inputs and the information used to develop the inputs In annual periods only, the valuation techniques used to measure fair value and a discussion of changes in valuation techniques, if any, in prior periods