SHARING THE VISION™
Fair Value Under SFAS 157
Presented by:
Daniel Chavez, CPA
Audit Manager
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Objectives
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3.
Understanding the logic and basics of SFAS 157
• Background
• Concepts
• Disclosure requirements
Examples of application
• Financial institutions
• Financial statements
Regulatory requirements
• Call report
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Reasons for Changes in the Focus of
Accounting Standards to Fair Value
• It’s a new world! Economic and regulatory
environments have changed
• Convergence! FASB and IASB Projects
• The FASB’s Conceptual Framework Project
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The Changing Economic Environment
• The Information Revolution
– Escalation and availability of information
– Impact on decision-making process
• Global competition
• Wall Street Demands
– More transparency in reporting (a timely telling of the how
and the why)
• Increasing Complexity of financial transactions
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The FASB and IASB Convergence
Project
• “One single set of high quality, understandable and enforceable
global accounting standards
• The Norwalk Agreement in 2002
– Best efforts to make existing financial reporting standards fully
compatible
• Projects:
– Identification of individual differences between IFRS and US GAAP
• Conceptual framework project to serve as a foundation
– Fair value is on the agenda
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Recent Standards Require Fair Value
Measurements
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SFAS No. 159 The Fair Value Option
SFAS No. 158 Employer Accounting for Defined Benefit Plans
SFAS No. 157 Fair Value Measurements
SFAS No. 156 Accounting for Servicing of Financial Assets
SFAS No. 153 Exchanges in Nonmonetary Assets
SFAS No. 150 Accounting for Certain Financial Instruments with Characteristics
of both Liabilities and Debt
SFAS No. 146 Accounting for Costs Associated with Exit or Disposal Activities
SFAS No. 144 Accounting for Impairment of Long-Lived Assets
SFAS No. 143 Accounting for Asset Retirement Obligations
SFAS No. 142 Goodwill and Other Intangible Assets
SFAS No. 141 Business Combinations
SFAS No. 133 Accounting for Derivative Instruments and Hedging Activities
SFAS No. 123 Share-Based Payments
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SFAS No. 157 Fair Value
Measurements
What does it do?
• Defines fair value for financial reporting purposes singular
definition
• Establishes a framework/approach for measuring fair
value
• Expands disclosures about the use of fair value – to allow
users to assess the relative reliability of FV measurements
and the impact on earnings of Level 3 measurements
• Effective for financial statements issued for fiscal year
beginning after November 15, 2007, with early adoption
encouraged.
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SFAS No. 157 Fair Value
Measurements
What doesn’t it do?
• Require additional fair value measurements
under GAAP
• Provide detailed “how to” guidance with
respect to valuation
• Eliminate the practicability exceptions to fair
value measurements that exist in other
accounting pronouncements
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SFAS No. 157 Fair Value
Measurements
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Understand the definition of Fair Value
Understand the market participants concept
Understand “highest and best use”
Be able to distinguish between valuation premises
– In use and exchange
• Be able to determine the Fair Value Hierarchy
• Understand the required disclosures under SFAS
No. 157
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Old Definition of Fair Value from
SFAS 141 and 142
“The amount at which an asset (or
liability) could be bought (or incurred) or
sold (or settled) in a current transaction
between willing parties, that is, other
than in a forced or liquidation sale.”
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Revised Definition of Fair Value from
SFAS No. 157
“The price that would be received to
sell an asset or paid to transfer a liability
in an orderly transaction between
market participants in the market in
which the reporting entity transacts.”
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Elements of the Definition of Fair
Value
• Price
• Principal Market
• Market Participants
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The Price
• The objective of the fair value measurement
is to determine the price that would be
received to sell the asset (or paid to
transfer the liability) at the measurement
date
• Price in a hypothetical transaction to sell an
asset or transfer a liability (exit price)
• Not the price in actual transaction to acquire
an asset or assume a liability (an entry price)
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Define the Principal Market
• The Principal Market – 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 no principal market exists, then choose
– The most advantageous market is the market in
which the price obtained maximizes the amount
received (not the price).
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Observation:
If a principal market exists, fair value
is the price in that market, even if the
price in a different market is potentially
more advantageous.
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Multiple Markets for the same
asset? Which is principal?
• An entity-specific determination (entity
specific volume)? – the market where
the entity has sold with the greatest
frequency and volume, or
• A market-based determination? – the
available market with the greatest
frequency and volume
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Why not use the Most Advantageous
Market all the time?
• The higher level of transactions in the
principal market provides more reliable
pricing (relevance and reliability)
• Focus on the principal market avoids a
required continual assessment of process
across all possible markets to find the highest
• Generally, principal and most advantageous
markets
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Who Are the Market Participants?
• Market Participants are the buyers and
sellers in the principal market that are:
– Independent of the reporting entity
– Knowledgeable of the asset or liability and the
transaction (including the results of usual
diligence)
– Able to transact for the asset or liability (qualified)
– Willing and motivated to transact for the asset or
liability (but not forced or otherwise compelled
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Who Are the Market Participants?
• May be other entities in the same industry
and may not
• Example:
– A manufacturing company holds land whose
highest and best use is for residential
development. A residential real estate developer
may be a market participant.
• Specific individual market participants do not
have to be identified.
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Who Are the Market Participants?
• Reporting entity need not identify specific market
participants; instead, indentify characteristics that
distinguish market participants generally, considering
factors specific to:
– The asset or liability
– The principal or most advantageous market
– Market participants with whom the reporting entity would
transact in that market
• Fair Value is determined based on the assumptions
that market participants would use in pricing an asset
or liability
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Definition – Highest and Best
Use
Definition – The use of an asset by
market participants that would maximize
the value of the asset (or the group of
assets within which the specific asset
would be used).
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Highest and Best Use Criteria
• The use must be:
– Physically possible
– Legally permissible
– Financially feasible
• Highest and best use is that of the
market participants, even if that use
differs from that of the Company
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Valuation Premise Used
Highest and best use establishes the valuation
premise for the asset
• In-use – the asset would provide maximum value to the
market participants principally through its use in
combination with other assets as a group
• In-Exchange – the asset would provide maximum value to
the market participants principally on a stand alone basis
(example: a financial asset)
• Fair value measurements consider the assumptions that
the market participants would use in pricing the asset,
whether using an in-use or an in-exchange premise of
value
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Three Approaches to Measuring
Fair Value
• Market Approach
• Income Approach
• Cost Approach
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Valuation Principles
Economic Principle
Valuation Approach
Principle of substitution
A. Market Approach
Principle of future benefits
B. Asset-based (cost)
approach
C. Income approach
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Economic Principles
• Principle of Substitution – One would not pay
more for a particular asset than the cost to
construct or purchase one with equivalent
economic utility.
• Principle of Future Benefits – The value of an
asset is the present value of the stream of
future benefits available to the owner.
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Income Approach
• Converts expected (predicted) future
amounts to a current price
• Examples include:
– Option-pricing models (Black-Scholes;
Merton formula)
– Binomial model (Lattice models)
– Discounted future cash flows
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Cost Approach
• The cost approach determines the amount
that currently would be required to replace
the service capacity of an asset.
• The price that would be received for the asset
is determined based on the cost to a market
participant (the buyer) to acquire or construct
a substitute asset of comparable utility, as
adjusted for obsolescence.
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And the Answer IS??
• IT DEPENDS!!!
• In some cases, the fair value result will be from one
of the three approaches (only one will be
appropriate).
– Example: Unadjusted quoted price from an active market
can be used. (Quantitative conclusion)
• In other cases, multiple valuation approaches may be
selected with the final conclusion being a point within
the range that is most representative of fair value in
the circumstances (Qualitative conclusion)
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Which of the Three Approaches
to Choose?
• The availability of inputs relevant to the asset
or liability being measured at fair value and
the reliability of those inputs will affect the
selection of the appropriate valuation
techniques
– Availability
– Relevancy
– Reliability
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Valuation Inputs
• Inputs = Assumptions the market participants would use in
pricing the asset or liability
• They consist of:
– Observable inputs (market data obtained from sources
independent of the reporting entity – e.g. closing prices on
NYSE)
– Unobservable inputs (inputs reflecting the reporting entity’s
own assumptions about the assumptions used by market
participants – e.g. growth rates, rates of return)
• Valuation techniques used to measure fair value should
maximize the use of observable inputs and minimize the use of
unobservable inputs)
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Fair Value Hierarchy for Inputs
• Level 1 – Quoted prices in active
markets for identical assets or liabilities
• Level 2 – Inputs other than the quoted
prices that are observable, either
directly or indirectly.
• Level 3 – Utilizes unobservable inputs
based on the best information available
in the circumstances
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Fair Value Hierarchy for Inputs
• Level 1examples:
– Financial Assets
• Available for sale securities – publicly traded securities
(stocks and bonds)
• Principal market
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–
Exchange market
Dealer market (OTC)
Brokered market
Principal to principal market
– Level 1 is best way to go when the data is
available.
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Fair Value Hierarchy for Inputs
• Level 2 – Inputs other than the quoted prices that are
observable, either directly or indirectly.
– Quoted prices for similar assets or liabilities
– Quoted prices for identical or similar assets or liabilities in
markets that are not active
– Observable inputs other than quoted prices (interest rates,
yield curves, credit risks, default rates)
• Level 2 is the second best way to go (when data is
available)
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Fair Value Hierarchy for Inputs
• Level 2 examples:
– Interest rate swaps
• Receive-fixed, pay-variable interest rate swap on the LIBOR
swap rate
– Licensing arrangement
• Royalty rates at inception
– Finished goods at a retail outlet
• Price to customers in a retail market (adjusted downward)
• Wholesale price to retailers in a wholesale market (adjusted
upward)
– Building held and used
• Price per square foot from comps
– Reporting unit
• Earnings or revenue multiples from comparable businesses
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Fair Value Hierarchy for Inputs
• Level 2 more examples:
– Restricted stock (using quoted price from active
market)
– Corporate and municipal bonds that trade
infrequently (using quoted prices for identical or
similar assets or liabilities in non-active markets)
– Certain residential and commercial mortgage
related assets (using pricing models whose inputs
are derived principally from or corroborated by
market data)
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Fair Value Hierarchy for Inputs
• Level 3 – Utilizes unobservable inputs based
on the best information available in the
circumstances
– Example: A financial forecast (cash flow or
earnings) developed using the company’s own
data, if no information shows market participants
would make different assumptions.
• Level 3 is the third best way to go (when
nothing else will work)
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Fair Value Hierarchy for Inputs
• Level 3 examples:
– Financial forecast (cash flow of earnings)
developed using the company’s own data,
if no information shows market participants
would make different assumptions
– Venture capital investments
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Level Three Observations
• A Level 3 fair value measurement can include
inputs that are observable (Level 1 and Level
2) and unobservable (Level 3)
• The level within which the fair value
measurement falls for financial reporting
purposes is the LOWEST level input that is
significant to the fair value measurement in its
entirety
• Assets can move between categories
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Example
• OTC Option (long-dated) inputs on a traded
equity security (using Black-Scholes)
– Risk free rate of interest (level 2)
– Dividend yield (Level 2)
– Volatility (Level 3)
• Because the volatility is a significant input, the
entire measurement might fall within Level 3
for disclosure purposes
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Level Three Observations – 10Q Third
Quarter 2007 – Merrill Lynch
“During the third quarter of 2007, a significant
amount of assets and liabilities was
reclassified from Level 2 to Level 3. This
reclassification primarily relates to U.S. subprime residential mortgage related assets and
liabilities, including ABS CDOs, due to a
significant decrease in the observability of
market pricing for these assets and liabilities
in the third quarter.”
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Use of Third-Party Pricing Service
• Not necessarily Level 1 just because a
price is obtained from such a service
– Management will need to understand the
sources of information and inputs used in
the price quotes
– Management is responsible for the fair
value measurements and required
disclosures
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Disclosures – Assets and Liabilities
Measured on a Recurring Basis
• FMV at reporting date
• Level used within the FV hierarchy (segregated by
Level 1, 2, and 3)
• If Level 3 (unobservable) inputs were used, a
reconciliation is required between beginning and
ending balances.
– Amount of total gains and losses
– Purchases, sales, issuances and settlements
– Transfer in and out of Level 3 (transfers due to changes in
the observability of significant inputs)
• The valuation technique(s) used and changes in such
technique(s) qualitative discussion.
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SFAS157 – Recurring Basis
Assets Measured at Fair Value on a Recurring Basis
($ in 000s)
Fair Value Measurements at Reporting Date Using:
Quoted Prices in Active
Markets for Identical
Assets (Level 1)
Significant Other
Observable Inputs
(Level 2)
$115
$105
$10
Available-for-sale securities
75
75
Derivatives
60
25
Venture capital investments
10
Description
Trading securities
Total
12/31/XX
$260
(Note: For Liabilities, a similar table should be presented)
15
Significant
Unobservable
Inputs (Level 3)
20
10
$205
$25
$30
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Selected JP Morgan Disclosures
Methodology
Level 2 - Securities Purchases Under
Resale Agreements
Market inputs in discounted cash flow
model
Loans expected to be securitized:
Level 2 – Commercial and residential
mortgages
Observable pricing of asset-based
securities with similar collateral,
adjusted for securitization uncertainties
Level 3 – Subprime loans
Consideration of liquidating proceeds
and property repossession/liquidation
information
Other Loans:
Level 3 – Purchased nonperforming
loans
No observable pricing so modeled factor
analysis
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Selected JP Morgan Disclosures
Methodology
Securities:
Level 1 – Highly Liquid government bonds
Quoted prices
Level 1 – Mortgage products for which there
are quoted prices
Quoted prices
Level 2 – Collateralized Mortgage Obligations,
High Yield debt securities
Pricing models, quoted prices
Level 3 – Collateralized Mortgage Obligations,
High Yield debt securities
Benchmarking, analyzing default
and recovery rates
Level 3 – Collateralized Debt Obligations
Market standard models
Level 3 – Asset backed securities
External prices and assumptions
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Selected JP Morgan Disclosures
Methodology
Derivatives:
Level 1 – Exchange traded derivatives
Quoted prices
Level 2 – Derivative contracts
Internal models, Black Sholes
Level 3 – Credit default swaps
Referenced to mortgage-backed securities,
benchmarked based on implied spreads
relevant observable market indices
Mortgage Service Rights:
Level 3 – Mortgage Service Rights
Option adjusted spread valuation model
Retained Interests in Securitization:
Level 3 – Interest only strips
Discounted cash flows
Private Equity investments:
Level 2 – Publicly held obtained thru IPO
Quoted price, less adjustments for sales
restrictions
Level 3 – Nonpublic private equity investments
Market comps, adjusted for company specific
issues
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SFAS 157 Added Disclosures for Level 3
Reconciliation
Assets Measured at Fair Value on a Recurring Basis
($ in 000s)
Fair Value Measurements at Reporting Date Using
Significant Unobservable Inputs (Level 3)
Description
Beginning Balance
Derivatives
$14
Venture Capital
Investments
$11
Total
$25
Total gains or losses
(realized/unrealized)
Included in earnings (or changes in net assets)
11
(3)
8
4
4
8
Purchases, issuances, and settlements
(7)
(2)
(9)
Transfers in and/or out of Level 3
(2)
-
(2)
Included in other comprehensive income
Total
(Note: For Liabilities, a similar table should be presented)
$20
$10
$30
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Disclosures – Assets and Liabilities
Measured on a Nonrecurring Basis
• Example: Impaired Assets
– FMV measurements recorded during the period
and the reasons for the measurements
– Level used within the FV hierarchy
– If Level 3 inputs were used, a description of the
inputs and the information used to develop the
inputs.
– For annual periods only, the valuation techniques
used and changes in techniques from prior
periods.
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SFAS 157 Assets Measured on a Nonrecurring
Basis
Assets Measured at Fair Value on a Nonrecurring Basis
($ in millions)
Fair Value Measurements Using:
Description
Long lived assets held and
used
12/31/XX
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
$75
Goodwill
30
Long lived assets held for sale
26
(Note: For Liabilities, a similar table should be presented)
Significant Other
Observable
Inputs (Level 2)
Significant
Unobservable
Inputs (Level 3)
$75
30
26
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Regulatory Issues
• Call report
– FFIEC 031 and 041 effective June 30, 2008, fair
value amounts to be disclosed.
– FFIEC 002 effective for September 30, 2008.
– To be completed by banks that have adopted FAS
157 and have elected to account for financial
instruments or servicing assets and liabilities at FV
option or are required to complete Schedule RC-D
– Trading Assets and Liabilities
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Questions