Fair value reporting short slides.pptx

8/14/2019 Fair value reporting short slides.pptx

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Fair value reporting

Based on excerpts from PwC 2010

Fair Value Guide and other sourcescited


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Why is Fair Value Reporting

Important?

Different areas of fair value use

Expanded role of fair value through Fair Value

Option

Fair Value in IFRS


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PwC

ASC 820-10 (formerly FAS 157) Purpose

ASC 820: how to determine fair value.

ASC 820 does not address when to apply or measure

assets or liabilities at fair value.

When to use fair value is determined by specificstandards

(adopted from Sean Goldfarbs

presentation at GMU in October

2010


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Scope exceptions

Share-based payments

Inventory, software revenue recognition

Leases


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Key Fair Value Concepts-Price

Fair Value is Based on the Price to Sell an Asset or

Transfer a Liability

determine the price that would be received to sellthe asset or paid to transfer

the liability at the measurement date (an exit priceas opposed to entry or original transaction price


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Price-continued

Most of the time transaction and exit price are

the same.

Sometimes, not:

requires recognition of day one gain or loss


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Price-liabilities

fair value is based on the amount that would be

paid to transfer a liability to another entity

with the same credit standing.

The valuation of a liability must incorporate

nonperformance risk, which represents the

risk that a liability will not be paid.


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Focus on market participants

assumptions

It is irrelevant what the entity thinks the asset

is worth.

assumptions about factors known only to

management are irrelevant.

what matters is the highest and best use of an

asset by market participants.


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Determining the market

Principal market: highest volume

If there is no principal market, fair value is

based on the price in the most advantageous

market


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Incorporation of standard valuation

techniques

Market Approach

Income Approach

Cost Approach Consider all applicable valuation techniques


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Required Disclosures Under ASC 820

allocation of fair value measurements among

the levels within the fair value hierarchy,

Information measurements using significant

unobservable inputs.

valuation technique(s)used to measure fair

value

any changes in those technique(s) during the

period.


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Unit of account

The reporting entity must determine the unit

of account (i.e., value of what unit is being

measured).

For example, the unit of account for the first

step of a goodwill impairment analysis is the

reporting unit.


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Highest and best use

Assess the highest and best use for the asset,based on the perspective of a market

participant.

The fair value of an asset is based on the useof the asset by market participants that wouldmaximize its value.

Liabilities are valued based on the transfer ofthe liability to a market participant on themeasurement date.


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In-use

The highest and best use of an asset is in-use if

the asset wouldprovide maximum value to

market participants principally through its

use with other assets as a group.

.


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In-exchange

In-exchange: The highest and best use of an

asset is in-exchangeif the asset would provide

maximum value to market participants

principally on a stand-alone basis.


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Valuation of Liabilities

In accordance with ASC 820, the fair value of a

liability is based on theprice to transfer the

obligation to a market participant at the

measurement date.


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Market Approach to valuation

The market approach is defined in this Subtopicas a valuation

technique that uses prices and other relevant

information generated by markettransactions involving identical orcomparable assets or liabilities (including abusiness).

Example: valuation using multiples (e.g. P/E basedmultiple or Market-to-Book based multiple).


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Cost approach to valuation

ASC 820-10-35-34 defines the cost approach as

follows:

The cost approach is defined as a valuation

technique based on the amount that currently

would be required to replace the service

capacity of an asset (often referred to as

current replacement cost).


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Which approach should be used?

ASC 820 does not prescribe which valuation

technique(s) should be used when measuring

fair value and does not prioritize among the

techniques.

Use all the valuation techniques that are

appropriate in the circumstances and for

which sufficient data are available.


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Observable vs. non-observable inputs

Observable inputs are based on data

observable from the outside.

Unobservable inputs come from inside the

entity, i.e. represent entitys own data or

assumptions on valuation inputs.


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Fair Value Hierarchydefines which

fair value to pick.

We always want to try to use the best (lowest)

possible level (i.e. Level 1 is better to use than

Level 2, etc.)

Level 1: Active Markets Valuations

Level 2: Observable Inputs other than prices

Level 3: Includes unobservable inputs (such as

entitys own assumptions about cash flows,

risk, etc.)


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PwC

Framework for Application of ASC 820

Determine Classification within the Fair Value Hierarchy

Adopted from Sean

Goldfarb

Level 1

Observable

Quoted prices for identical assets or

liabilities in active markets for full term

Level 2 Quoted; similar items in active markets

Quoted, identical/similar, not active

Must be observable for full term

Level 3

Unobservable inputs (e.g., a companys owndata)

Market perspective still required

Fair value = Price * Quantity

Should be used whenever available

No blockage factor or other valuation

adjustments

Valuation may include factors such as

transportation

Adjustments suggest Level 3 if

measurement may be affected by a

significant amount

Requires significant judgment and

disclosure


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Inactive markets

Further analysis is required because the

transactions or quoted prices may not be

determinative of fair value and

significant adjustments may be necessary

when using the information in estimating fair

value

Disclosures Recurring Measurements


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Disclosures-RecurringMeasurements The fair value measurementat the reporting date.

The levelthat a measurement falls within the fair value hierarchy,

segregated between Level 1, Level 2 and Level 3 measurements by class ofassets or liabilities.

The amounts of significant transfers between Level 1 and Level 2and the

reasons for the transfers. Significant transfers into each level shall be

disclosed separately from transfers out of each level.

For Level 3fair value measurements a reconciliation of the beginning and ending balances, separately

presenting changes during the period attributable to any of the

following:

Total gains or lossesfor the period (realized and unrealized), separately

presenting gains or losses included in earnings (or changes in netassets) and gains or losses recognized in other comprehensive income.

A description of where those gains or losses included in earnings (or

changes in net assets) are reported in the statement of income or in

other comprehensive income.

Purchases, sales, issuances, and settlements(each type disclosed


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Disclosures-recurring items

(continued)

For the disclosure of gains or losses for Level 3

measurements, the amount of the total gains

or losses for the period in included in

earnings.

For Level 2 and Level 3 fair value

measurements, a description of the valuation

technique and the inputs used in determiningthe fair values


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Fair Value Option (FVO)

ASC 825


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FVO definition (FVO)

All entities may elect the fair value option for any

of the following eligible items:

a. A recognized financial asset and financial liability,

except as further noted. b. A firm commitment that would otherwise not be

recognized at inception and that involves only

financial instruments

c. A written loan commitment.

d. The rights and obligations under an insurance

contract that has both of the following characteristics:


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Fair Value and Financial Crisis

Summary of selected academic papers:Ryan, S. (2008)Accounting and Subprime

Crisis, and Lauz and Leuz (2009) The Crisis ofFair Value Accounting


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Ryan (2008): Causes of the Crisis

As firms announced losses on subprimepositions, debt markets became more averseto holding positions and increasingly illiquid

causing the fair value of the positions todecline further and become more difficult tomeasure

The primary reason for these feedbackeffects is the opacity of many subprimepositions.


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Ryan (2008): Causes of opacity

Complex partitioning of risks of these

positions through (re)securitizations, credit

derivatives, and other financial transactions.

Many subprime positions are off-balance

sheet.

The subprime crisis was caused by firms,

investors and households making bad

decisions, not by accounting.


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Why wasnt FV accounting a problem?

Given the magnitude of the crisis, even if all of

the subprime positions would be carried at

cost, other than temporary impairment would

be triggered.

The issue is lack of information to support

unimpaired valuations. Given absence of

liquidity, auditors were uncomfortable toaccept valuations at amortized cost.


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Ryan (2008)s primary concern with FV

accounting

FV accounting models fails when there are no

orderly markets.

In particular, preparers find it difficult to

convince auditors and others of the

reasonableness of measurements based on

orderly transaction element of fair value

definition in presence of securities fire sales.(Ryan, 2008, page 1608).


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What to do if there has been a

significant decrease in activity

change valuation technique or to apply

multiple valuation techniques.

consider the reasonableness of the range of

fair value indications.

The objective is to determine the point within

that range that is most representative of fair

value under current market conditions.


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Financial crisis-revisiting Ryan (2008)

The biggest issue related to fair value

accounting related to fair values was related

to the opacity of valuation in credit

derivatives.

Opacity is just another term for high

information uncertainty.

Next few slides give a review of the origins ofthis uncertainty.


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Two major culprits: CDSs and CDOs.

Two major credit derivatives that played a role

in the financial crisis were Credit Default

Swaps (CDS) and Collaterized Debt Obligations

(CDO).


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Whats a CDS?

CDS is akin to mortgage insurance you may have to buywhen you get a house.

When a lender buys a CDS he pays an insurancepremium to the seller of CDS to buy protection in case

a borrower defaults.

If a borrower defaults, a seller of the CDS has to coverthe lenders losses.

The price of the CDS depends on the notional amountof the debt. Hence, CDS is a credit derivative (on aliability side of the balance sheet) and has to be carriedat fair value by the CDSs seller.


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Why are CDSs sold?

Just like with any insurance, as long as the

number of defaults is low, the sellers of CDS

make profit between the premiums they

collect and the costs of defaults they have tocover.

As long as the defaults are not massive, selling

CDSs is a potentially very profitableproposition.

h h l i j


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What was the CDSs role in major

defaults during the recent crisis?

AIG was one of the largest CDSs sellers. When

massive defaults on the subprime debt

started, AIG was obliged to cover those losses.

Because losses were so massive, AIG did not

have the ability to cover them, and hence had

to be bailed out by the government.


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What do we learn from this story?

AIG did not properly price their CDSs because

they did not have good information on the

likelihood of massive defaults. Hence, any

cash they collected from CDSs premiums wasnot sufficient to cover massive losses.


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CDOs

There could be two types of CDOs:

Cash CDO

Synthetic CDO


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Cash CDO

Lender sells her loans to a special purpose vehicle(SPV)

SPV then issues debt notes in various tranches:senior (highest rated, mezzanine and equity

(lowest rating)). SPV invests the proceeds fromthis sale into the low risk investments.

Original borrowers repay their loans to the SPV.Simultaneously SPV repays her obligations to the

holders of various tranches. SPV makes money onthe spread between subprime loans and interestit pays on her own notes.

A ti i i t d ith h


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Accounting issues associated with cash

CDO

Does the original lender have any recourseobligations to the SPV? Does it guaranteeanything? Does it have an obligation torepurchase the assets?

Do holders of various tranches have goodinformation about valuations of underlyingcollateral (original subprime debt)? Were

tranches correctly valued at issuance? The ability of SPV to repay the notes is driven by her

ability to collect on the subprime debt.


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Comments

If a bank maintains material recourse orrepurchase obligations on the assets ittransfers to SPV, it is not a sale, but rather a

borrowing transaction requiring a liability withfair value on the banks balance sheet.

If original subprime debt is not correctlyvalued by the holders of CDOs notes (i.e. risk

premium was too low), then CDOs notes aremajorly overvalued.


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Comments (continued)

Plenty of evidence suggests that bad informationplayed a role in massive original over-valuation ofCDOs.

Contributors to this originalover-valuation:

No docs loans

Manipulation of FICO scores to gain more favorable creditrating on CDOs debt.

Assumption of indefinite price increases in housing market

Low required collateral on houses. Credit rating agencies gave highly optimistic ratings to

CDOs debt.


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Summary: is fair value the evil culprit?

No. Bad information is the culprit. People bought stuffthey did not understand and did not apply fair valuecorrectly from the start.

If fair value was correctly applied, subprime debt

would have been much cheaper, and resulting investorlosses much lower.

Complex transaction structure (like in a CDO) withmultiple layers of investors and unclear accounting ledto massive price protection ex-post. Hence, we had a

mortgage meltdown. The best recipe against future meltdowns is correct

ex-ante application of fair value.


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Implications of Fair Value to auditors

Auditing Standards pertaining to Fair Value: SAS

101 (AU 328,also adopted into PCAOB standards)

http://pcaobus.org/Standards/Auditing/Pages/A

U328.aspx. As more assets and liabilities are measured at

fair value, auditorsmust understand not only

the valuation modelsbut managements

potential biases and likely errors when applying

the models(Martin et al. 2006, page 288).
http://pcaobus.org/Standards/Auditing/Pages/AU328.aspxhttp://pcaobus.org/Standards/Auditing/Pages/AU328.aspxhttp://pcaobus.org/Standards/Auditing/Pages/AU328.aspxhttp://pcaobus.org/Standards/Auditing/Pages/AU328.aspx


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FV Challenges to auditors

(1) to obtain a sufficient understanding of theentitys processes and relevant controls fordetermining FV to develop an effective audit

approach (2) to evaluate whether entitys methods of

measurement and significant assumptions areappropriate and are likely to provide a

reasonable basis for the FVs and relateddisclosures (Martin et al. 2006)


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Fair Value-goodwill impairment rules

Old test: two-step test approach:

(1) compare fair value of the reporting unit (FVRU)

to its carrying value (CVRU)

(2) if FVRU


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Goodwill impairment: new rules

(based on PwC dataline)

ASU 2011-08, effective beginning after Dec 15

2011.

Qualitative assessment (more likely than not

test)

Can choose to bypass qualitative assessment

and use the old rule


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Goodwill impairment-cont.

Triggers of impairment test under qualitative

assessment: deterioration in general

economic conditions, entity-specific events

such as declining financial performance, andother events such as an expectation that a

reporting unit will be sold.


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