Fair Value Measurements

1. Fair Value Measurements ASC 820 (FAS 157) Fair Value Disclosures Acct 414

3. ASC 820 (FAS 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

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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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,

12. Statement 157 - Fair Value Hierarchy

13. 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

14. 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:

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

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

17. 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

18. 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

19. Let’s look at HW#3 • Problem 3 – using level 1 & 2 inputs to determine fair value of bonds • Let’s look at Bond 2: • Term = 6 years, rating = BBB • Note: this is probably “level 2” since we don’t have an EXACT quotation for a market price for the exact bonds the company is holding

20. Bond 2: Term = 6 years, rating = BBB $1,000 face value * .99844 (approximation) = $998.44 fair value

21. Let’s try another one, $1000 Bond: Term = 8 years, rating = A

22. HW #3 (small groups okay) • The first two problems are related to understanding the “fair value option” • You will also practice fair value disclosures • Problems 4 and 5 will let you try your hand at creating the disclosure tables required under ASC Topic 820 • Use the “handout” files to get examples from FASB or find them in the FASB codification • There are also examples are in Appendix 17C in textbook • To this assignment, you will attach the FAIR VALUE part of the HW#2 serial bond problem