Fair Value Measurement (SFAS 157)

Fair Value Measurement (SFAS 157) Kaipo Doorley Amper Politziner and Mattia

Agenda – Topics Covered • Fair Value Issues • Fair Value Framework • Fair Value Disclosure Requirements • Alternative Investments • Audit Considerations • Recent Standard Setting Activity • SEC Update

FV Issues - The Fair Value “Movement” • Moving toward everything eventually being “initially” measured at fair value • Less and less use of cost-based measures for financial instruments • SFAS 115, 133, 155, 156, 159 • Held to maturity debt securities and APB 18 are exceptions • Nonfinancial instruments generally still use historic cost with impairment testing

FV Issues – Problem and Possible Solution • The Problem – Reliability of measures • Different parties could get inconsistent measures • Possible for management to influence measures • The (Partial) Solution – SFAS 157 • Detailed definition of “fair value” for use in accounting • Does not expand use of fair value • Provides guidance to make fair value measures more consistent and understandable to investors • Requires disclosures to help users understand reliability of inputs • Financial statement users still prefer fair value while management and auditors do not believe the “market” is always the most accurate reflection of a transaction/account

FV Issues – The Good News • The Good News • For most securities, decrease in value are being reported as they occur • Impairment of other assets are being recognized • Despite difficulty, companies/auditors have been able to come up with values • FV disclosures are helpful to users (Level 3 assets, etc.) • Fair Value has been around for a very long time and now there is one definition of fair value • Valuation specialists and certain industries have dealt with fair value for years and have expertise and insight

FV Issues – The Bad News • Impairment models are inconsistent • Some tests are impossible (other-than temporary) • Standard-setters being pressured to back off • Many implementation issues/question on 157 • FASB’s VRG and staff working • Some FSPs raise more questions than answers • Tendency to apply “rules” instead of principles • Looking to transactions that aren’t representative • Supporting pricing service estimates • Hard to convince auditors that losses are temporary • The timing of SFAS 157 and the economic crisis

Fair Value Framework - Definition • Definition of Fair Value – Exit Price not Entry Price • What could you sell for in an orderly transaction • Assume exit in principal or most advantages market • Marketplace participant assumptions, not entity specific • Looking to the market should reduce management bias and promote consistency (in concept) • “Marketplace participants” are knowledgeable, independent parties willing and able to transact • Transaction costs are not part of fair value • Always include credit risk if inherent in asset/liability

Fair Value Framework - Measurement • Step 1: Determine the unit of account (based on accounting/reporting rule driving measurement) • Stand alone asset/liability or group of assets • For example is the unit of account a “reporting unit” being tested for goodwill or a single equity security recorded as available for sale

Fair Value Framework - Measurement • Step 2: Highest and best use (market participant view) • In-use (used with a group of assets/liabilities to maximize value) • In-exchange (stand alone basis) • For example a market participant is a real estate developer and purchases a construction company for: • In-use: Integrate the company’s PP&E • In-exchange: Operate the company as a stand alone entity • Must be physically possible, legally permissible and financially feasible to the market participant • The reporting entity’s current or intended use of the asset/liability does not matter

Fair Value Framework - Measurement • Step 3: Determine principal or most advantageous (based on highest and best use) • Principal market has the greatest volume and activity • In the absence of a principal market, the most advantageous market in which the “reporting entity” would sell the asset/transfer the liability with the price that maximizes amounts received and minimizes amounts paid • Based on market principal/most advantageous market the reporting entity identifies (not specifically) market participants • The market and market participants should be evaluated at recognition and re-evaluated at each measurement date • Inactive market and disorderly transactions discussed later

Fair Value Framework - Measurement • Fair value hierarchy • Prioritizes inputs to the valuation technique used to measure fair value • Level 1 – quoted prices (unadjusted) in active markets for identical assets and liabilities • Level 2 – inputs and other quoted prices included in Level 1 that are observable either directly or indirectly • Level 3 – unobservable inputs reflecting the reporting entity’s own assumptions about market participant assumptions

Fair Value Frame Work - Measurement • Characteristics of Level 1 Inputs • Transactions occur with sufficient frequency and volume to provide pricing information on an ongoing basis. • Reporting entity has ability to access • Alternative pricing methods (e.g. matrix pricing) may be used as a practical expedient • Alternative pricing method results in a lower level measurement • After-hours trading or news events • Not required, but should be considered

Fair Value Frame Work - Measurement • Characteristics of Level 2 Inputs • 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 • Inputs other than quoted prices that are observable (e.g. yield curves) • Market-corroborated inputs: Derived principally from or corroborated by observable market data by correlation or other means • Adjustments necessary to corroborate inputs may result in Level 3 measurement

Fair Value Frame Work - Measurement • Characteristics of Level 3 Inputs • Unobservable inputs used to the extent that observable inputs are not available • Includes assumptions about risk, developed based on best information available without undue cost and effort • Data used to develop the inputs should be adjusted if there are contrary data indicating market participants would use different assumptions • FV may be determined based on the best available information in the circumstances

Fair Value Framework - Measurement • Valuation techniques consistent with market, income and/or cost approaches shall be used to measure FV • Market Approach – Uses observable prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities • Income Approach – Converts cash flow or earnings to a single present amount (discounted) . Value indicated by current market expectation about future amounts • Cost Approach – Amount that would currently be required to replace the service capacity of an asset (current replacement cost) • Use valuation techniques that are appropriate in the circumstances and for which sufficient data are available • Single or multiple techniques may be appropriate depending on the circumstances.

Fair Value Disclosure Requirements • Assets and liabilities measured at FV on a recurring basis • Disclose the level of inputs used (tabular format) • Level 3 inputs rolled forward • Valuation techniques – annually (see FSP updates) • Assets and liabilities measured at FV on a nonrecurring basis • Same as above AND • The reasons for the measurement • Note FASB fair value disclosure project discussed later

Alternative Investments • What is an alternative investment? • AICPA Practice Aid • AICPA Draft Issue Paper • Specific Issues for Alternative Investments • FASB FSP 157-g Estimating the Fair Value of Investments in Investment Companies That Have Calculated Net Asset Value per Share in Accordance with the AICPA Audit and Accounting Guide, Investment Companies – Issued Monday June 8,2009 and comment period ends July 8, 2009 • Will be effectiv3e immediately upon release

Alternative Investments – Specific Issues • Defining markets/market participants • Factors in deciding whether a market is active • Evaluating transactions • Transparency • Relevance • Distressed • Determining fair value of interest in alternative investments • Unique Elements of Private Equity • Consideration of use of NAV as a practical expedient • FASB issues FSP FAS 157-g

Audit Considerations • Auditing standards • If market assumptions not available, an entity may use own assumptions as long as no contrary data that market participants would consider • Auditor must understand the entity’s process for determining fair value and relevant controls to develop an audit approach • Use of specialists • Auditor must find the assumptions reasonable and the valuation methods appropriate and properly applied • Consideration of variances from period to period

Audit Considerations (cont’d) • Non-Authoritative Guidance • AICPA Toolkit for Auditing Fair Value Measurements and Disclosures • Auditor must understand the entity’s process for determining fair value and relevant controls to develop an audit approach • Use of specialists • Auditor must find the assumptions reasonable and the valuation methods appropriate and properly applied • Consideration of variances from period to period • Practice Issues for Non-Issuers

Recent Standard Setting Activity • FSP FAS 157-4 (fair value measurement) • FSP FAS 157-f (fair value of liabilities) • FSP FAS 107-1 and APB 28-1 (fair value disclosures) • FSP FAS 115-2 and FAS 124-2 (OTTI of debt securities) • Ongoing FASB Projects • Fair Value Disclosure Project • Financial Instruments Project • Recoveries of Other-Than-Temporary Impairment (Reversal) Project

Recent Standard Setting Activity – FSP 157-4 • FSP FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly • Superseded FSP FAS 157-3 • No longer just relates to financial assets • Despite a significant decrease in market activity for an asset, the objective of fair value measurement remain • Provides factors to consider for significant decrease in volume and level of activity • When market activity significantly declines, further and more robust analysis required

Recent Standard Setting Activity – FSP 157-4 • FSP FAS 157-4 (cont’d) • Requires additional disclosures of fair value measurements • For interim and annual periods the inputs and valuation technique(s) used to measure fair value and a discussion of changes in valuation techniques and related inputs, if any, during the period • Major security types shall be based on the nature and risks of the security. Disaggregation of financial instruments are much greater and a listing is included in the FSP • Effective for periods ending after 6/15/09

Recent Standard Setting Activity – FSP 157-4 • FSP FAS 157-4 (cont’d) • Provides circumstances that may indicate a transaction is “NOT” orderly • If not orderly, place little if any weight • If orderly, consider transaction price and weight depends on facts and circumstances • If not sufficient information available to determine whether orderly or not, the transaction price may not be determinative of fair value • Use of broker quotes and pricing services not precluded, but a reporting entity must evaluate the quote

Recent Standard Setting Activity – FSP 157-f • FSP FAS 157-f, Measuring Liabilities Under SFAS 157 • FASB is redeliberating a proposed FSP to provide additional guidance on determining the fair value of liabilities • A proposed FSP was issued in May for comment • Generally estimate fair value of liabilities as you would estimate fair value of an asset • However, should not make any adjustments due to restrictions on the transfer of a liability

Recent Standard Setting Activity – FSP 107-1 • FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments • Applies to all public companies • Applies to fair value disclosures for any financial instruments that are not currently reflected on the balance sheet at fair value • Requires disclosures on a quarterly basis, providing qualitative and quantitative information about fair value estimates for financial instruments not measured on the balance sheet at fair value • Effective for periods ending after 6/15/09

Recent Standard Setting Activity (cont’d) • FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments • Applies debt securities scope in to SFAS 115 • If FV < CV (amortized cost), instrument is impaired • If an entity intends to sell or more likely than not will be required to sell before recovery, all OTTI recognized through earnings • If entity does not intend to sell and it is not more likely than not, OTTI is separated into (a) credit loss and (b) amounts related to other factors • Credit loss through earnings and the rest through OCI • Note covered in greater detail

Recent Standard Setting Activity (cont’d) • Fair Value Disclosure Project • FASB recently added a project to its agenda to improve disclosures of fair value measurements • Project will consider additional disclosures, such as: • Sensitivities of measurement to key inputs • Transfers of items between the fair value hierarchy levels • Levels of aggregation • Expected timing for this project is year end 2009

Recent Standard Setting Activity (cont’d) • Financial Instruments Project • Financial Instruments: Improvements to Recognition and Measurement – Joint project of the IASB and FASB • Project objectives: • Simplify reporting to improve decision usefulness and understandability • Determine which financial instruments should be recognized at fair value and which financial instruments would be recognized at a different measurement attribute • Address impairment, hedging, fair value option, and financial statement presentation issues • Expected timing for this project is by year end 2009

Recent Standard Setting Activity (cont’d) • Recoveries of Other-Than-Temporary Impairment (Reversal) Project • Objective of this project is to consider allowing an entity to recover, through earnings, a previously recognized OTTI loss when evidence exists that an impairment loss has reversed • Another objective of this project is to converge with IFRS with regard to the accounting for recoveries of OTTI • Expected timing for this project is by year end 2009

SEC Update • SEC Staff Views of Fair Value Measurements • SEC Staff Letters – Financial Asset Impairments • Hot Topics Related to Fair Value Measurements • Control premiums • Discount rates/WACC • Valuation of restricted stock • Use of valuation Specialists • Limited scope engagements

Questions? “The material contained in this presentation is for general information and should not be acted upon without prior professional consultation.”

Fair Value Measurement (SFAS 157)