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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.aspx8/14/2019 Fair value reporting short slides.pptx
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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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