Fair value reporting

Based on excerpts from PwC 2010 Fair Value Guide and other sources cited

Why is Fair Value Reporting Important?

Different areas of fair value use Expanded role of fair value through Fair Value Option Fair Value in IFRS

ASC 820-10 (formerly FAS 157) Purpose

ASC 820: how to determine fair value.

ASC 820 does not address when to apply or measure assets or liabilities at fair value. When to use fair value is determined by specific standards

PwC

(adopted from Sean Goldfarbs presentation at GMU in October 2010)

Whos affected by ASC 820 (formerly SFAS 157)?

Some examples where fair value is used:
Derivatives and trading activities; Long lived assets Investments in trading and available-for-sale securities; Impairments of certain investments in debt and equity securities; Business combinations, goodwill, and intangibles; Asset retirement obligations; Impairments of long-lived assets; Exit and disposal activities; Pensions and other post retirement benefit plans; Guarantees; and Long-term debt disclosures.

Scope exceptions
Share-based payments Inventory, software revenue recognition Leases

Key Fair Value Concepts-Price

Fair Value is Based on the Price to Sell an Asset or Transfer a Liability determine the price that would be received to sell the asset or paid to transfer the liability at the measurement date (an exit price as opposed to entry or original transaction price

Price-continued
Most of the time transaction and exit price are the same. Sometimes, not: requires recognition of day one gain or loss

Price-liabilities
fair value is based on the amount that would be paid to transfer a liability to another entity with the same credit standing. The valuation of a liability must incorporate nonperformance risk, which represents the risk that a liability will not be paid.

Focus on market participants assumptions

It is irrelevant what the entity thinks the asset is worth. assumptions about factors known only to management are irrelevant. what matters is the highest and best use of an asset by market participants.

Determining the market

Principal market: highest volume If there is no principal market, fair value is based on the price in the most advantageous market

Incorporation of standard valuation techniques

Market Approach Income Approach Cost Approach Consider all applicable valuation techniques

Required Disclosures Under ASC 820

allocation of fair value measurements among the levels within the fair value hierarchy, Information measurements using significant unobservable inputs. valuation technique(s) used to measure fair value any changes in those technique(s) during the period.

Unit of account
The reporting entity must determine the unit of account (i.e., value of what unit is being measured). For example, the unit of account for the first step of a goodwill impairment analysis is the reporting unit.

Highest and best use

Assess the highest and best use for the asset, based on the perspective of a market participant. The fair value of an asset is based on the use of the asset by market participants that would maximize its value. Liabilities are valued based on the transfer of the liability to a market participant on the measurement date.

In-use
The highest and best use of an asset is in-use if the asset would provide maximum value to market participants principally through its use with other assets as a group. .

In-exchange
In-exchange: The highest and best use of an asset is in-exchange if the asset would provide maximum value to market participants principally on a stand-alone basis.

Valuation of Liabilities
In accordance with ASC 820, the fair value of a liability is based on the price to transfer the obligation to a market participant at the measurement date.

Market Approach to valuation

The market approach is defined in this Subtopic as a valuation technique that uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities (including a business).
Example: valuation using multiples (e.g. P/E based multiple or Market-to-Book based multiple).

Income approach to valuation

The income approach is defined as an approach that uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present amount (discounted).

Considerations under present value techniques

Estimate of future cash flows; Risk free rate and duration of cash flows A risk premium due to uncertainty and illiquidity; For a liability, the risk of nonperformance.

Cost approach to valuation

ASC 820-10-35-34 defines the cost approach as follows: The cost approach is defined as a valuation technique based on the amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost).

Which approach should be used?

ASC 820 does not prescribe which valuation technique(s) should be used when measuring fair value and does not prioritize among the techniques. Use all the valuation techniques that are appropriate in the circumstances and for which sufficient data are available.

Observable vs. non-observable inputs

Observable inputs are based on data observable from the outside. Unobservable inputs come from inside the entity, i.e. represent entitys own data or assumptions on valuation inputs.

Fair Value Hierarchydefines which fair value to pick.

We always want to try to use the best (lowest) possible level (i.e. Level 1 is better to use than Level 2, etc.) Level 1: Active Markets Valuations Level 2: Observable Inputs other than prices Level 3: Includes unobservable inputs (such as entitys own assumptions about cash flows, risk, etc.)

Framework for Application of ASC 820

Determine Classification within the Fair Value Hierarchy

Level 1 Observable Quoted prices for identical assets or liabilities in active markets for full term Level 2 Quoted; similar items in active markets Quoted, identical/similar, not active Must be observable for full term Level 3 Unobservable inputs (e.g., a companys own data) Market perspective still required

Fair value = Price * Quantity Should be used whenever available No blockage factor or other valuation

adjustments
Valuation may include factors such as

transportation Adjustments suggest Level 3 if measurement may be affected by a significant amount

Requires significant judgment and

disclosure

PwC

Adopted from Sean Goldfarb

Fair Value Hierarchy The lowest level of significant input determines the placement of the entire fair value measurement in the hierarchy

Inactive markets
Further analysis is required because the transactions or quoted prices may not be determinative of fair value and significant adjustments may be necessary when using the information in estimating fair value

Disclosures-Recurring Measurements
The fair value measurement at the reporting date. The level that a measurement falls within the fair value hierarchy, segregated between Level 1, Level 2 and Level 3 measurements by class of assets or liabilities. The amounts of significant transfers between Level 1 and Level 2 and the reasons for the transfers. Significant transfers into each level shall be disclosed separately from transfers out of each level. For Level 3 fair value measurements a reconciliation of the beginning and ending balances, separately presenting changes during the period attributable to any of the following: Total gains or losses for the period (realized and unrealized), separately presenting gains or losses included in earnings (or changes in net assets) and gains or losses recognized in other comprehensive income. A description of where those gains or losses included in earnings (or changes in net assets) are reported in the statement of income or in other comprehensive income. Purchases, sales, issuances, and settlements (each type disclosed

Disclosures-recurring items (continued)

For the disclosure of gains or losses for Level 3 measurements, the amount of the total gains or losses for the period in included in earnings. For Level 2 and Level 3 fair value measurements, a description of the valuation technique and the inputs used in determining the fair values

Fair Value Option (FVO)

ASC 825

FVO definition (FVO)

All entities may elect the fair value option for any of the following eligible items:
a. A recognized financial asset and financial liability, except as further noted. b. A firm commitment that would otherwise not be recognized at inception and that involves only financial instruments c. A written loan commitment. d. The rights and obligations under an insurance contract that has both of the following characteristics:

Applying FVO-partial election

Can apply the FVO on an instrument-byinstrument basis. can elect the FVO for certain instruments but not others within a group of similar items the reporting entity is required to disclose the reasons for its partial election.

Fair Value and Financial Crisis

Summary of selected academic papers: Ryan, S. (2008) Accounting and Subprime Crisis, and Lauz and Leuz (2009) The Crisis of Fair Value Accounting

Ryan (2008): Causes of the Crisis

As firms announced losses on subprime positions, debt markets became more averse to holding positions and increasingly illiquid causing the fair value of the positions to decline further and become more difficult to measure The primary reason for these feedback effects is the opacity of many subprime positions.

Ryan (2008): Causes of opacity

Complex partitioning of risks of these positions through (re)securitizations, credit derivatives, and other financial transactions. Many subprime positions are off-balance sheet. The subprime crisis was caused by firms, investors and households making bad decisions, not by accounting.

Two key contributors to the subprime bust

(1) Implicit strong reliance in subprime refinancing on the refinancing option which presumed stable or increasing real estate prices. (2) Magnitude of losses given default rises with home depreciation. (Ryan, 2008, page 1607).

Why wasnt FV accounting a problem?

Given the magnitude of the crisis, even if all of the subprime positions would be carried at cost, other than temporary impairment would be triggered. The issue is lack of information to support unimpaired valuations. Given absence of liquidity, auditors were uncomfortable to accept valuations at amortized cost.

Ryan (2008)s primary concern with FV accounting

FV accounting models fails when there are no orderly markets. In particular, preparers find it difficult to convince auditors and others of the reasonableness of measurements based on orderly transaction element of fair value definition in presence of securities fire sales. (Ryan, 2008, page 1608).

What to do if there has been a significant decrease in activity

change valuation technique or to apply multiple valuation techniques. consider the reasonableness of the range of fair value indications. The objective is to determine the point within that range that is most representative of fair value under current market conditions.

Financial crisis-revisiting Ryan (2008)

The biggest issue related to fair value accounting related to fair values was related to the opacity of valuation in credit derivatives. Opacity is just another term for high information uncertainty. Next few slides give a review of the origins of this uncertainty.

Two major culprits: CDSs and CDOs.

Two major credit derivatives that played a role in the financial crisis were Credit Default Swaps (CDS) and Collaterized Debt Obligations (CDO).

Whats a CDS?
CDS is akin to mortgage insurance you may have to buy when you get a house. When a lender buys a CDS he pays an insurance premium to the seller of CDS to buy protection in case a borrower defaults. If a borrower defaults, a seller of the CDS has to cover the lenders losses. The price of the CDS depends on the notional amount of the debt. Hence, CDS is a credit derivative (on a liability side of the balance sheet) and has to be carried at fair value by the CDSs seller.

Why are CDSs sold?

Just like with any insurance, as long as the number of defaults is low, the sellers of CDS make profit between the premiums they collect and the costs of defaults they have to cover. As long as the defaults are not massive, selling CDSs is a potentially very profitable proposition.

What was the CDSs role in major defaults during the recent crisis?
AIG was one of the largest CDSs sellers. When massive defaults on the subprime debt started, AIG was obliged to cover those losses. Because losses were so massive, AIG did not have the ability to cover them, and hence had to be bailed out by the government.

What do we learn from this story?

AIG did not properly price their CDSs because they did not have good information on the likelihood of massive defaults. Hence, any cash they collected from CDSs premiums was not sufficient to cover massive losses.

CDOs
There could be two types of CDOs:
Cash CDO Synthetic CDO

Cash CDO
Lender sells her loans to a special purpose vehicle (SPV) SPV then issues debt notes in various tranches: senior (highest rated, mezzanine and equity (lowest rating)). SPV invests the proceeds from this sale into the low risk investments. Original borrowers repay their loans to the SPV. Simultaneously SPV repays her obligations to the holders of various tranches. SPV makes money on the spread between subprime loans and interest it pays on her own notes.

Accounting issues associated with cash CDO

Does the original lender have any recourse obligations to the SPV? Does it guarantee anything? Does it have an obligation to repurchase the assets? Do holders of various tranches have good information about valuations of underlying collateral (original subprime debt)? Were tranches correctly valued at issuance?
The ability of SPV to repay the notes is driven by her ability to collect on the subprime debt.

Comments
If a bank maintains material recourse or repurchase obligations on the assets it transfers to SPV, it is not a sale, but rather a borrowing transaction requiring a liability with fair value on the banks balance sheet. If original subprime debt is not correctly valued by the holders of CDOs notes (i.e. risk premium was too low), then CDOs notes are majorly overvalued.

Comments (continued)
Plenty of evidence suggests that bad information played a role in massive original over-valuation of CDOs. Contributors to this original over-valuation:
No docs loans Manipulation of FICO scores to gain more favorable credit rating on CDOs debt. Assumption of indefinite price increases in housing market Low required collateral on houses. Credit rating agencies gave highly optimistic ratings to CDOs debt.

Summary: is fair value the evil culprit?

No. Bad information is the culprit. People bought stuff they did not understand and did not apply fair value correctly from the start. If fair value was correctly applied, subprime debt would have been much cheaper, and resulting investor losses much lower. Complex transaction structure (like in a CDO) with multiple layers of investors and unclear accounting led to massive price protection ex-post. Hence, we had a mortgage meltdown. The best recipe against future meltdowns is correct ex-ante application of fair value.

Implications of Fair Value to auditors

Auditing Standards pertaining to Fair Value: SAS 101 (AU 328,also adopted into PCAOB standards) http://pcaobus.org/Standards/Auditing/Pages/A U328.aspx. As more assets and liabilities are measured at fair value, auditorsmust understand not only the valuation modelsbut managements potential biases and likely errors when applying the models(Martin et al. 2006, page 288).

FV Challenges to auditors
(1) to obtain a sufficient understanding of the entitys processes and relevant controls for determining FV to develop an effective audit approach (2) to evaluate whether entitys methods of measurement and significant assumptions are appropriate and are likely to provide a reasonable basis for the FVs and related disclosures (Martin et al. 2006)

Fair Value-goodwill impairment rules

Old test: two-step test approach:
(1) compare fair value of the reporting unit (FVRU) to its carrying value (CVRU) (2) if FVRU<CVRU, then write down goodwill balance to its implied fair value This test had to be done at least once a year.

Goodwill impairment: new rules (based on PwC dataline)

ASU 2011-08, effective beginning after Dec 15 2011. Qualitative assessment (more likely than not test) Can choose to bypass qualitative assessment and use the old rule

Goodwill impairment-cont.
Triggers of impairment test under qualitative assessment: deterioration in general economic conditions, entity-specific events such as declining financial performance, and other events such as an expectation that a reporting unit will be sold.