Fair Value Measurements

1. Fair Value Measurements FAS 157 And Fair Value Disclosures Acct 592

2. Statement 157:Definition of Fair Value • 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 • An exit price notion for a hypothetical transaction; may or may not equal actual entry price • Not adjusted for transaction costs • Not based on value to current owner or company-specific assumptions

3. Entry price vs. Exit price FASB’s Solution: “highest and best use”

4. Changes existing GAAP but does not create new uses of fair value accounting • Fair value of the leased property. The price for which the property could be sold in an arm’s length transaction between unrelated parties.The price that would be received to sell the property in an orderly transaction between market participants at the measurement date. Market participants are buyers and sellers that are independent of the reporting entity, that is, they are not related parties at the measurement date.

5. We are beginning to see it applied to existing standards • New definition has been inserted into many standards • Next slide shows the revised LEASE definition • Which was RESCINDED by FSP FAS157-1 in Feb. 2008 • Comment letters led FASB to believe that it would impact classification of leases • It may change “back” when FASB/IASB joint project on leases comes to a conclusion • FSP FAS 132(R)-1 now applies it to pension disclosures

6. Not everyone concurs! • Suppose there’s an auction of a Picasso painting at Sotheby’s. • Fair market value = ? • Fair value = ?

7. Statement 157:Approach to Measuring Fair Value Unit of Valuation THE ASSET OR LIABILITY Unit of Account Highest and Best Use Valuation Premise Exit Market Market Participant Assumptions Inputs to Valuation Techniques Attribute Value to Asset or Liability at Unit of Account Level Fair Value Measurement Indicated Value Unit of Valuation F/S Presentation and Disclosure

8. FAS 157 - Exit Market • The market in which the ENTITY would sell the asset or transfer the liability First Choice:Principal marketis the market with the greatest volume and level of activity for asset or liability If there is no principal market :Most advantageous marketmaximizes the amount that would be received for the asset or minimizes the amount that would be paid to transfer the liability, considering transaction costs Highest and Best Use Valuation Premise Exit Market Market Participant Assumptions

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 • 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

12. FAS 157 - Market Participant Assumptions • A fair value measurement should be determined based on the assumptions market participants would use in pricing the asset or liability, including assumptions about (measurement) risk, highest and best use (if asset), and nonperformance risk (if liability) Highest and Best Use Valuation Premise Market participants are buyers and sellers in the exit market (other entities with whom the entity would transact) Exit Market Market Participant Assumptions

13. Unit of Valuation • The unit of valuation depends on the highest and best use of the asset, which establishes the valuation premise used to measure the fair value of the asset In-use or in-exchange Valuation Premise Highest and Best Use Use by market participants that maximizes value of asset (or asset group) Exit Market Market Participant Assumptions

14. 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

15. Unit of Valuation • The unit of valuation depends on the highest and best use of the asset, which establishes the valuation premise used to measure the fair value of the asset In-use or in-exchange Valuation Premise Highest and Best Use Use by market participants that maximizes value of asset (or asset group) Exit Market Market Participant Assumptions

16. 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

17. FSP FAS157-3 (Oct. 2008) • Added an example about how to determine whether a market is inactive • 1. When markets are inactive, the goal is still to determine a price that represents something that is NOT a liquidation or distressed sale amount. • 2. Use of a reporting entity’s own assumption about future cash flows and appropriately risk-adjusted rates is acceptable when relevant observable inputs are not available • 3. Broker prices are not necessarily determinative if an active market does not exist

18. Statement 157:Approach to Measuring Fair Value Unit of Valuation THE ASSET OR LIABILITY Unit of Account Highest and Best Use Valuation Premise Exit Market Market Participant Assumptions Inputs to Valuation Techniques Attribute Value to Asset or Liability at Unit of Account Level Fair Value Measurement Indicated Value Unit of Valuation F/S Presentation and Disclosure

19. 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

20. 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

21. 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

22. 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

23. FAS 157 - Inputs to Valuation Techniques • Market participant assumptions are incorporated in the fair value measurement through the inputs to valuation techniques • Observable inputs • Developed based on market data obtained from sources independent of the reporting entity • Unobservable inputs • Developed based on the best information available in the circumstances, subject to cost-benefit constraint

24. A fair value measurement should maximize the use of observable inputs From:Refining Fair Value Measurement,Miller, Paul B. W.; Bahnson, Paul R.. Journal of Accountancy, Nov2007, Vol. 204 Issue 5, p30-36,

25. Statement 157 - Fair Value Hierarchy

26. Last Step - Disclosures Unit of Valuation THE ASSET OR LIABILITY Unit of Account Highest and Best Use Valuation Premise Exit Market Market Participant Assumptions Inputs to Valuation Techniques Attribute Value to Asset or Liability at Unit of Account Level Fair Value Measurement Indicated Value Unit of Valuation F/S Presentation and Disclosure

27. 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

28. FAS 157 - Disclosures • Extensive disclosures to indicate the “quality” of fair value measurements by the 3 categories of inputs • For regularly re-valued assets & liabilities:

29. FAS 157 - Disclosures • For regularly re-valued assets & liabilities that use a lot of Level 3 unobservable inputs – there is more:

30. FAS 157 - Disclosures • For assets & liabilities not regularly revalued:

31. Fair Value Accounting – FAS 157 & 159 according to Dilbert

32. The steps to FV measurement • 1. Identify asset or liability being measured (unit of account) • 2. Determine the exit market • 3. Identify the market participants in the exit market • 4a. Determine the highest and best use for an asset or nonperformance risk for a liability being valued • 4b. Determine the valuation premise (in-use vs. in-exchange) based on highest and best use for an asset group of assets, reporting unit, or business being valued. • 4c. Determine the unit of valuation based on the highest and best use and the valuation premise

33. The steps to FV measurement • 5. Determine a value for the unit of valuation based on market participant assumptions and other market-based inputs, and apply one or more appropriate valuation techniques • 5a. If applicable, impute value determined in Step 5 to the unit of account • 6. Classify inputs used in Step 5 as Level 1, 2, or 3 and then classify the fair value measurement in its entirety to prepare SFAS No. 157 disclosures

34. FAS 157 – effective date • Implementation is prospective • Required for financial statements issued for fiscal years beginning AFTER Nov. 15, 2007 • A FSP FAS157-2 has delayed the effective date for ‘HIERARCHY LEVEL 3’ measurements like asset retirement obligations -- Now for FS beginning after Nov 15. 2008