FAS 157 Fair Value Measurement Issued Sept 2006

FAS 157 Fair Value Measurement Issued Sept 2006
Val Mulcahy May 2007 FAS 157_V1_May_07

Who wants Fair Value Accounting {FV}
Relatively new concept 1959 Tax rules Rapid growth in popularity in profession Financial engineering >> presumes it Regulatory agencies >> base rules on it Analysts >> request it Shareholder's >> seem to grasp it

FV Lexicon Adjustments Model risk Level 1 &2 Discount rate
Bid – Ask spread of prices Blocks of securities Costs Transaction Transportation Fair Value Hierarchy Level 1 Level 2 Level 3 Inputs Observable Non –observable Significantly un-observable Liability Non Performance risk Credit standing Market Participants Markets Principal market Most advantageous market Measurement dates Event date driven Reporting date driven Net Value Price Initial recognition price Entry price Exit price Restricted usage Risks Specific risks (aka unsystematic / diversifiable) General risks ( aka systematic / non-diversifiable) Term of asset or liability Transaction Initial Hypothetical Orderly transaction Unit of account Use Highest & best use In-use ( with other items) In –exchange use ( stand alone use)

Affirms FV is market based NOT entity specific
Introduction FAS 157 Affirms FV is market based NOT entity specific Validates FV measurement Provides financial techniques for FV calculation Establishes a framework for measuring FV Eliminates current diversity surrounding FV Eliminates inconsistencies Expands disclosure for FV This Statement is not intended to: Create any new accounting GAAP principles Validate or impose any single method of FV

Establishes a method for measuring FV Expands disclosures
Overview FAS 157 Defines fair value Establishes a method for measuring FV Expands disclosures Simplifies & Codifies guidance Applies to all pronouncements (79 effected) that invoke FV Does not require any new FV measurements.

Exchange notion is based on
Overview FAS 157 Exchange notion is based on an orderly transaction between market participants to sell an asset or transfer a liability in the principal or most advantageous market. The transaction is a hypothetical transaction at the measurement date focuses on the price that would be received an exit price not at entry price the price that would be paid.

FV is a market- based measurement Not entity- specific
Overview FAS 157 FV is a market- based measurement Not entity- specific It’s what market participants would use Under certain circumstances FV permits the reporting entitie’s own assumptions about market assumptions developed based on the best information available in the circumstances. .

Requires assumptions about risk
Overview FAS 157 Requires assumptions about risk What would market participants include? Adjustment maybe difficult to determine. Include the effect of restrictions on the sale or use of an asset if market participants would consider the effect Disclosures required as to both interim reports annual periods subsequent to initial recognition.

Liability FV reflects entity’s non-performance risk.
Overview FAS 157 Liability FV reflects entity’s non-performance risk. Hence FV looks to entity’s credit risk In all periods in which FV of liability is used No “Blockage Factor” FV is measured as the product of quoted price x times the quantity = FV Price is not adjusted for the size of the position held even if transaction would exceed daily volume i.e., a blockage factor

Scope FAS 157 Statements prepared in accordance with U.S. GAAP
Including not-for-profit entities. FAS 157 applies to other accounting pronouncements that require FV Exceptions {very minor} FASB Statement No. 123, Shared Based Payment, Does not eliminate the practicality exceptions Does not apply to “valuations similar” to FV Vendor specific Inventory Pricing

Applied prospectively
Effective Date FAS 157 November 15, 2007 Applied prospectively Beginning of the fiscal year in which is initially used Except Applied Retrospectively where A blockage factor was used previously “Initial recognition” under Statement 133 was used A hybrid financial instrument under FAS 155 that was a t” initial recognition” under Statements 133 and 155 prior to initial application of this Statement. Difference recognized in opening balance of retained earnings Disclosure applied in the first interim period of the fiscal year in which this Statement is initially applied.

FV Defined FV Price that would be Orderly Transaction
received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Orderly Transaction Assumes exposure to the market for a period. A hypothetical transaction Considered from the perspective of a market participant

FV Defined Objective is to determine
(cont’d) Objective is to determine Price that would be received to sell the asset or paid to transfer the liability Referred to as an exit price. After allowing reasonable marketing period Measurement date(s) either Event determined >> is the case of a specific transaction; a business combination, for example Time determined >> is primarily by reference to the issue date of financial statements.

Valuation Approach FAS proscribes No established valuation standards
Clarifies fair value in terms of the price in an orderly transaction Entity must determine: 1] The particular asset or liability that is the subject 2] Including a unit of account for the asset or group of assets 3] For an asset, the valuation premise appropriate for a measurement consistent with its highest and best use 4] The principal market for the asset or liability, and 5] The valuation technique appropriate, considering * availability of data for inputs * level in the fair value hierarchy within which the inputs fall.

“in-use” value Valuation Premise
The valuation objective for an asset’s FV is to assume a use which produces highest value and best use by market participants. The choice is either “in-use” value used in combination with other assets “in-exchange” value used on stand alone basis

Valuation Premise Valuation Premises may vary. Examples…
Valuation Premises may vary. Examples… A] Both may result in same value If asset is whole business, it is both stand alone & “in use” B] Refinements to stand alone value can modify it to an “in use” basis C] “In use” value may be based on individual “stand alone” components

Exit Price Conceptually, Entry Prices and Exit Prices are different.
Transaction price (Entry Price) represents the price paid to acquire the asset or received to assume the liability In contrast, FV price ( Exit Price) that would be received to sell the asset or paid to transfer the liability

Exit Price / ( & Initial Recognition)
Occasionally Transaction price (TP) = Entry Price = Exit price = FV Hence at initial recognition TP = FV Determination conditions A] Is the transaction between related parties? B] Does the transaction occur under duress? C] Is the unit of account represented by the TP same as FV unit of account? e.g if the asset or liability is only one of the elements of the multi –component transaction D] Are both the ‘Principal’ and ‘Most Advantageous markets’ the same? e.g. securities traded in retail v’s inter bank market

Market Participants Market participants are buyers and sellers in the ‘principal market’ for the asset or liability that are: Independent of the reporting entity. They are not related parties. Knowledgeable about the asset or liability and the transaction Able to transact. Willing to transact / motivated but not otherwise compelled to do so. Entity Must use FV assumptions that market participants would use Need not identify specific market participants. Should identify characteristics that distinguish market participants Be parties entity would deal with

Assets FV assumes the highest and best use of the asset by market participants At the measurement date Highest and Best use must be physically possible legally permissible financially feasible is determined by market participants (reflect on this) Highest and best use is That which maximizes the value of the asset. Based on the use of the asset by market participants, Even if entity plans are different (above) Established by the valuation premises. Specifically: In- use. in combination with other assets as a group. In-exchange.on a standalone basis.

The liability to the counterparty continues. Nonperformance risk
Liabilities FV assumes that the liability is transferred to a market participant at the measurement date. The liability to the counterparty continues. Nonperformance risk is risk obligation will not be fulfilled it affects the FV of the liability Is the same before and after the hypo’ transaction Nonperformance risk includes but may not be limited to the reporting entity’s own credit risk.

FV may vary if obligation is to deliver
Liabilities The entity must assess Its credit standing for the duration of the liability Terms of any credit enhancements FV may vary if obligation is to deliver cash (a financial liability) or goods or services (a performance liability)

(i) Principal & (ii) Most Advantageous Markets
The principal market the greatest volume and level of activity The most advantageous market yields greatest value to transaction considering transaction costs (bit of a twist) FV assumes that the transaction occurs in the principal market or, in absence of such the most advantageous market. Selection is considered from entity’s viewpoint Different entities? = maybe different markets If there is a clear principal market Entity must reference it for FV Even if the price in a different market is more advantageous On measurement date

The FV price shall not be adjusted for transaction costs. Reason: Transaction costs are not an attribute of the asset or liability; rather, they are specific to the transaction and will be different depending on how the reporting entity transacts. But: Price is adjusted for Transport costs If location is an attribute, the price shall be adjusted .

Class Exercise >>> Read details in manual Recommendation Strategic buyer acquires a group of assets (A, B, and C) Determine maximum value to a market participant would be ‘use in’ combination As a group 3 assets FV = $650 As stand alone assets FV = $600 Asset C is worth $70 more stand alone But assets A & B both have lower values, $120 lower in stand alone aggregate Entity cannot cherry–pick. It must be consistent On balance ‘In-use’ route is Higher & Better value .

Valuation Techniques Market Cost Income
Three approaches are permitted Market Cost Income Market. Prices generated by market transactions Involving identical or comparable assets or liabilities May use market multiples derived from a set of comparables Method calls for judgment Multiples might lie in the ranges with a different multiple for each comparable May include matrix pricing. (definition: see manual) ** Illustrate with Municipal Market .

Valuation Techniques Three approaches are permitted … Cost.
. Cost. $’s currently required to replace the service capacity of an asset What would it cost a market participant to acquire or construct substitute asset of comparable utility adjusted for obsolescence. Obsolescence encompasses physical deterioration functional obsolescence and/or economic obsolescence is broader than depreciation for financial reporting purposes. .

Valuation Techniques Three approaches are permitted Income. Converts future amounts to a single present amount. Based on current market expectations about those future amounts. Discounted by appropriate interest rate Those valuation techniques include present value techniques, option-pricing models, such as Black Sholes formula and a binomial model, which incorporate present value techniques multi-period excess earnings method, used to measure the fair value of certain intangible assets. .

Valuation Techniques Either may be appropriate:
Single valuation technique Multiple valuation techniques If multiple, the results will be evaluated and weighed considering the reasonableness of the range indicated. FV is the point where range is most representative Techniques shall be consistently applied. Change permitted if more more representative of FV Say change in weightings / arrival of new products Impact handled as “change in accounting estimates” No adjustment to opening P&L The disclosure provisions of Statement 154 are not required .

Valuation Techniques Class Exercise >>> Read details in manual Recommendation The entity assesses whether market value use in combination with other assets is highest value use. The cost approach may apply too, The income approach is not used because the machine does not have a separately income stream. a. Market approach. Using quoted prices / for similar machine. In its current condition and location, thereby including installation and transportation costs. Approach ranges from $40,000 to $48,000. b. Cost approach. The cost to construct a substitute machine of comparable utility/ includes installation costs. Approach ranges from $40,000 to $52,000. Market approach is deemed more representative That determination is based on the relative reliability of the inputs, a. The inputs used in the market approach require less subjective adjustments b. The range indicated overlaps with, but is narrower than, the range indicated by the cost approach. c. No other differences. Higher end of the range because the majority of relevant data points at high end FV= $48,000. .

Inputs to Valuation Techniques
Inputs are assumptions that market participants would use Including assumptions about risk. Observable inputs Inputs based on market data Obtained from sources independent of the reporting entity. Unobservable inputs Inputs that reflect the reporting entities own assumptions About the assumptions market participants would use In pricing the asset or liability developed Based on the best information available in the circumstance. Valuation techniques shall maximize the use of observable inputs and minimize the use of unobservable inputs .

Fair Value Hierarchy To increase consistency, Inputs are prioritized into three broad levels. Highest priority to quoted prices I in active markets for identical assets or liabilities Lowest priority to unobservable inputs. Inputs used might fall in different levels of the fair value hierarchy. The Entity’s Overall Hierarchy Ranking shall be determined based on the lowest level input that is significant. Assessing the significance requires judgment, considering factors specific to the asset or liability. The availability of inputs and the relative reliability of the inputs might affect the selection of appropriate valuation techniques. It is important to note, the fair value hierarchy prioritizes The inputs to valuation NOT the valuation techniques. .

Fair Value Hierarchy Level 1
Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date a Level 1 input maybe available in multiple active markets. .

Determination of selected market a. The principle market or, the most advantageous market, considered from the perspective of the reporting entity; and b. Whether the reporting entity has the ability to access the price An active market is a market in which transactions occur with sufficient frequency and volume to provide pricing information on an ongoing basis. quoted price in an active market provides the most reliable evidence of FV It shall be used to measure fair value whenever available. .

Exceptions - Matrix Pricing allows an array of similar securities to be valued via interpolation A number of grid points are inputs from valid quotes The blank cells are then interpolated via historic correlation Beware the resultant FV ranks lower on hierarchy level than pure Level 1 If significant events occur after the close of a market but before the measurement date The reporting entity should identify & evaluate impact of those events. Adjustment for new information, renders lower hierarchy level “ Blocks “ do NOT give rise to adjustments. Valued as” quoted price x quantity held = FV”. The use of a blockage factor is prohibited, even if market’s normal daily trading volume is not sufficient to absorb the quantity held placing orders to sell the position in a single transaction might affect the quoted price. .

Example – Level ( See detail in manual) A financial asset is traded on two different exchanges with different prices. The entity transacts in both markets has the ability to access the price in both markets for the asset at the measurement date. In Market A, $26 -$3= $23 . In Market B, $25 -$1= $24 Easy case If Market A is the principal market FV = $26 If neither market is the principal market . An interesting twist occurs The FV price in the most advantageous market drives the decision. Most advantageous market is the one with best “NET” market value = B Notwithstanding “transaction costs” are not part of FV FV = $25 would be measured using the price in that market ($25). Transaction costs are considered in determining the most advantageous market, But FV is not adjusted for those costs. .

Level 2 Inputs Other than quoted prices included within Level 1 That are observable for the asset or liability Either directly or indirectly Must be observable for the term of the asset or liability. Level 2 inputs include the following: Quoted prices for similar assets or liabilities in active markets Non active market Quoted prices for same or similar items. Inputs other than quoted prices that are observable for items for example, interest rates and yield curves observable at commonly quoted intervals, volatilities, prepayment speeds, loss severities, credit risks, and default rates. .

(cont’d) · Inputs that are derived principally from or corroborated by observable market data by correlation or other means. Adjustments to Level 2 inputs Will vary depending on factors specific to the asset or liability. Those factors include the condition and/or location of the item the extent to which the inputs relate to items that are comparable to the item the volume and level of activity in the markets within which the inputs are observed. Significant adjustments might render the FV a Level 3 .

Examples – Types of Level 2 Inputs a. Receive-fixed, pay-variable interest rate swap based on the LIBOR swap rate. LIBOR swap rate if that rate is observable for the full term of the swap. b. Three-year option on exchange-traded shares. implied volatility for the shares derived through extrapolation to year 3 c. Licensing arrangement. recently negotiated / unrelated party by the acquired the royalty rate at inception. d. Finished goods inventory at retail outlet. price to customers in a retail market /or a wholesale price to retailers in a wholesale market, adjusted for /condition / location / requisite selling efforts e. Building held and used. the price per square foot for the building derived from observable/ multiples derived from prices in observed transactions / comparable buildings / similar locations. f. Reporting unit. multiple of earnings / revenue /or a similar performance measure / from observable market data /comparable businesses/ considering operational market, financial and nonfinancial factors. .

Level 3 inputs Unobservable inputs for FV of the asset or liability. Only if observable input are not available Reflect the reporting entity’s own assumptions Including risk that market participants would use in pricing the item Based on the best information available. Deriving market participants assumption; Entity:- Need not undertake all possible efforts to obtain information about market participant assumptions. Shall take reasonable steps to deduce market participant assumptions Need not incur undue cost in this research .

Examples - Level 3 Asset retirement obligation at initial recognition. Expected cash flows developed using the entity’s own data Appropriate risk weighted discount rate applied FV is the resulting PV FV of a Reporting unit. Level 3 input would include a financial forecast of cash flows or earnings developed using the entity’s own data .

Examples - Level 3 Inputs Based on Bid and Ask Prices Price within the bid-ask spread that is most representative of fair value Regardless of where in the fair value hierarchy the input falls (Level 1, 2, or 3) FAS 157 does not preclude the use of mid-market pricing other pricing conventions practical expedients for FV within a bid-ask spread. Note: Buy at the ask ( high side) and sell at the bid ( low side) is a well established convention. .

Restricted Assets Assessment by market participants in driving force in FV Example – Restriction on Sale of Security The entity holds a security of an issuer for which sale is legally restricted for a specified period; a “section144 a” security. The restriction would transfer to market participants. ‘Clean’ market quote would be reduced for restriction

Liabilities & Credit Risk
Nonperformance risk relating to a liability includes the entity’s credit risk. The entity should consider the effect of its credit standing on the fair value of the liability In all periods in which the liability is measured at fair value Assumers of the debt will examine entity’s credit standing in FV price

Liabilities & Credit Risk
(cont’d) For example, assume that Entity X and Entity Y each enter into a contractual obligation to pay cash ($500) to Entity Z in 5 years. Entity X has AA credit rating and can borrow at 6 percent Entity Y has BBB credit rating and can borrow at 12 percent. Entity X will receive about $374 in exchange for its promise (the percent value of $500 in 5 years at 6 percent). Entity Y will receive about $284 in exchange for its promise (the present value of $500 in 5 years at 12 percent). The fair value of the liability to each entity (the proceeds) incorporates that entity’s credit standing.

Present Value Techniques
Present value converts uncertain future cash flows to a present value using a discount rate. Comprises An estimate of future cash slows. Expectations about possible variations in the amount and/or timing of the cash flows. Risk-free interest rate. d U.S. Treasury securities determines the appropriate risk-free interest rate. e.g. Risk premium, the price for bearing the uncertainty inherent in the case flows . In the case of a liability the obligor’s own credit risk.

General Principles a. Cash flows and discount rates should reflect assumptions that market participants would use. b. Cash flows and discount rates should consider only factors attributed to the asset (or liability) being measured. c. Assumptions behind cash flows and discount rates should be internally consistent. For example consistently handle:- inflation after-tax v’s pre-tax cash flows underlying economic factors of the currency

Discount Rate Adjustment Technique (the “point estimate”) One stream of cash flows selected from all possibilities One discount rate that approximates observed rate for valued item Looks to comparable items Attention to variables outcomes is accommodated via “ Adjusting the Discount rate for the accumulated risks” It’s a direct technique sullied by obvious shortcomings

Expected Present Value Technique Seeks to ameliorate other methods shortcomings Uses an array of possible cash flows These are then weighted by their probability of This yields expected value outcomes. The resulted weighted cash flow is no longer event dependent Market participants want risk free investments ‘Specific risk’ aka unsystematic (diversifiable) risk. ‘General market’ risk, aka systematic (non-diversifiable) risk. Market participants will be compensated only for bearing the systematic or no diversifiable risk inherent in the cash flows.

Expected Present Value Technique Method 1 Method 1 adjusts the expected cash flows for the systematic risk It explicitly takes out a “risk premium” from the regulate business cash flows by subtracting a cash risk premium (risk-adjusted expected cash flows). Results in a certainty-equivalent cash flow Method 2 Takes turns the other lever in the equation Method 2 adjusts for systematic (market) risk by adding a risk premium to the risk-free interest rate. See manual for A] Worked example B] Probabilistic forecasting primer

Disclosures [A] Fair Value Measurements on a Recurring Basis
Information enabling users of financial statements to assess the inputs used to FV Effect on P&L from using FV unobservable inputs (Level 3) For each major category of assets or liabilities the following information For each interim and annual period separately A. The fair value measurements at the reporting date; B. The level within the hierarchy in which the measurements, in their entirety, fall, segregating quoted prices in active markets for identical assets or liabilities (Level 1), other observable inputs (Level 2), and unobservable inputs (Level 3);

Disclosures (cont’d) [A] Fair Value Measurements on a Recurring Basis
C For fair value measurements using unobservable inputs (Level 3), a reconciliation of the beginning and ending balances, separately presenting changes during the period attributable to the following; (1) Total gains or losses for the period (realized and unrealized) and where those gains or losses are reported in the statement of income (2) Purchases, sales, issuances, and settlement (net), and (3) Transfers in or out of Level 3 (for example, transfers due to changes in the observability of significant inputs); D The total gains or losses for the period in subparagraph (c)(1) above, that are attributable to the change in unrealized gains or losses relating to those assets and liabilities still held at the reporting date, and, where those unrealized gains or losses are in the statement of income; E In annual periods only, the valuation techniques(s) used to measure fair value and a discussion of changes in valuation techniques, if any, during the period. The information might be presented as shown in the manual

Disclosures [B] Fair Value Measurements on a Non Recurring Basis Enable users to assess the inputs used to develop FV items. Disclose the following information for each interim and annual period separately for each major category of assets and liabilities: a. The fair value measurements recorded during the period and the reasons for the measurements; b. The level within the fair value hierarchy in which the fair value measurements, in their entirety, fall; c. For fair value measurements using significant unobservable inputs, a description of the inputs and the information used to develop the inputs; and d. In annual periods only, the valuation technique(s) used to measure fair value and a discussion of changes, if any, in the valuation techniques used. See table in manual

FAS 157 Fair Value Measurement Issued Sept 2006

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FAS 157 Fair Value Measurement Issued Sept 2006

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