FASB and IASB Convergence on Fair Value Standards: Key Insights and Changes

1. FASB Update ST Convegence with IASB Fair value standards (FAS157 and FAS159)

2. ST Convergence with IASB

3. SFAS No. 151 – Inventory Costs • Part of the “international convergence” project. • Clarifies that abnormal costs of idle facilities should not be capitalized as product costs. • Companies should use “normal capacity” for the allocation of overhead. • Any unallocated overhead is expensed during the period in which they are incurred. • Other abnormal handling costs or abnormal levels of spoilage might also need to be expensed.

4. Coming soon • Short-term convergence with IASB • EPS (ED expected 1st half 2007) • Income taxes (ED expected 1st half 2007) • Research and Development- ?

5. Fair Value Measurements SFAS No. 157 Signs of the Future!

6. FAS157 Issued Sept. 2006 • With a few exceptions, it does not change WHAT is currently measured using fair value • Sets out a framework for measuring fair value • Requires additional disclosures about fair value measurements

7. FAS157 – Definition of Fair Value • Paragraph 5 - 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. • This is an exit-price definition of fair value (see paragraph 7)

8. FAS157 – Related definitions • Market Participants (4 criteria) • Independent of reporting entity • Have knowledge needed for reasonable understanding about transaction • Financial and legal ability to enter into the transaction • Be willing to enter into transaction without compulsion

9. FAS157 – Related definitions • Principal Market • Has the greatest volume and level of activity. • If there is no principal market, use the most advantageous market • Most Advantageous Market • Most advantageous market has price that maximizes the net amount that would be received or minimizes the net amount paid • Transactions costs are included in determining which market to use but do NOT become part of the fair value measurement

10. Example of which market… $48

11. FAS157 – Related definitions • Assumptions about the market • The asset or liability is exchanged in an orderly transaction between market participants • An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; • it is not a forced transaction (for example, a forced liquidation or distress sale). • The price is for a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the item

12. FAS157 – Related definitions • Valuation premise – the assumption about how market participants would use an asset • Choose the premise based on “highest and best use” • In-use premise • Provides maximum value through use in combination with other assets • In-exchange premise • Provides maximum value principally on a stand-alone basis

13. Valuation Techniques • Market approach • Uses observable prices from market transactions for comparable assets or liabilities • Income approach • Analysis of future cash flows using present values • Cost approach • Estimates cost to replace an asset’s service capacity A change in valuation technique is a change in accounting estimate, not a change in accounting principle

14. The “Fair Value Hierarchy”

15. Valuing Liabilities • The valuation technique must consider the reporting entity’s credit standing • A reporting entity could record a GAIN for derivatives at a measurement date because the fair value of the liability decreases in response to a credit downgrade if all other inputs remain unchanged

16. Restrictions on Assets • Restrictions are evaluated to determine whether they are an attribute of the asset or an attribute of the reporting entity • If sold, would the restriction transfer to another holder? • If yes, the impact of the restriction would be taken into consideration (adjust asset fair value downward) • If no, the restriction would not reduce the fair value

17. Other provisions of FAS157 • It is now possible to recognize a gain on the day recognized (previously prohibited under EITF 02-3) • Blockage adjustments are not permitted in pricing • Bid-ask spreads • Use the price within the bid-ask spread that is most representative of fair value in the circumstances

18. FAS 157 Disclosures • Will be extensive and reported in three sections (see paragraph A33-A36 for examples) • Assets and liabilities measured at fair value on a recurring basis • Tabular display reconciles beginning and ending amounts when significant Level 3 inputs are used • Assets and liabilities measured at fair value on a nonrecurring basis (impairment of assets, etc.) • For all fair value measurements, a table showing the reliance on Level 1, 2 or 3 inputs plus discussion of the valuation techniques used for the measurements

19. FAS 157 – effective date • Implementation is prospective • Required for financial statements issued for fiscal years beginning AFTER Nov. 15, 2007

20. FAS 159 – The Fair Value Option Optional use of fair value for certain assets and liabilities

21. Essentially a one-time election • On a contract by contract basis, company can designate specified financial instrument to be accounted for using fair value instead of the usual measurement technique • Companies may be able to reduce volatility in reported earnings caused by measuring assets and liabilities differently

22. Other “benefits” • Movement toward accounting for all financial instruments at fair value • Brings US GAAP into closer agreement with IASB 39 which already contains a fair value election

23. Eligible assets & liabilities • Most recognized investments including those currently accounted for using the equity method • But cannot be used to recognized investments that must be consolidated (VIEs, subsidiaries) • Many recognized liabilities • Excluding leases, demand deposits of banks, postretirement plans, etc.

24. Eligible assets & liabilities • Firm purchase commitments that would otherwise not be recognized at inception (but only for ones involving financial instruments) • Rights and obligations under warranties that meet certain requirements • Certain host financial instruments that result from separation of embedded nonfinancial hybrid instruments under FAS133

25. Irrevocable election • Must be applied to contracts as a whole and not to parts of contracts • Changes in fair value will be recognized in earnings during each reporting period

26. Election date • Transition – any eligible item as of the date that FAS159 is initially adopted • Thereafter: • The eligible item is first recognized (including entering into an eligible firm commitment) • Occurrence of a short list of other events

27. Disclosures • If fair value option is elected, company must disclose separately assets and liabilities measured at fair value from those not measured at fair value • Intended to help readers compare companies that choose the option to those that choose not to elect fair value accounting

28. Disclosures – specific (1) • Why fair value option was selected for each eligible item • Difference between fair value and aggregate unpaid principal amounts • Relation to other fair value measurements under FAS157 • Description of partial applications to groups of similar items and why company chose not to be consistent

29. Disclosures – specific (2) • Loans carried at assets at fair value that are past due by 90 days or more • APB18 disclosures about investments that would otherwise have been reported using equity method • Description of how interest and dividends are measured and reported for items with fair value election • Quantitative information (line by line) as to where gains and losses related to fair value option have been reported in the income statement

30. FIN 46R and 48 • Lecture notes are in doc file (not ppt) and this was covered as part of the deferred tax lectures • Note to self – need to verify • FIN46R notes were only in doc file, I think

31. What’s Next?

32. Forthcoming – first half 2007 • Conceptual Framework – Reporting Entity – preliminary views • Business Combinations – for-profit: • Applying the Acquisition Method (final) • Noncontrolling Interests (final) • Derivatives disclosures (final)

33. Forthcoming – first half 2007 • Implementation Projects • Statement 140—Transfers of Financial Assets (ED) • Insurance Risk Transfer (ED) • Financial Guarantee Insurance (ED and maybe final by mid year) • Definition of liability vs. equity (Prelim views expected first half of 2007)

34. Forthcoming – second half 2007 • Financial Statement Presentation (prelim views maybe by 3rd quarter) • Revenue recognition (PV by 3rd or 4th Quarters)

35. Longer term projects • Not-for-profit business combinations and intangible assets • In process of reviewing comments (nothing on calendar about when a final version is expected)