Financial Accounting Standards Board

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Financial Accounting Standards Board
Fair Value Measurement Project
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Disclaimer

• The views expressed in this presentation are my
  own and do not represent positions of the FASB.
  Positions of the FASB are arrived at only after
  extensive due process and deliberations

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Project Objectives

• Define fair value used in GAAP
• Establish a framework for measuring fair value
• Enhance disclosures about fair value
• Codify and simplify existing GAAP

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Project Chronology

• Added project to agenda June 2003
• FVM Exposure Draft June 2004
• 100 comment letters
• Roundtable meeting September 2004
• Final Statement December 2005

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Scope
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Definition of Fair Value

• FASBFair value is the price that would be
  received for an asset or paid to transfer a
  liability in a current transaction between
  marketplace participants in the reference market
  for the asset or liability
• IASBFair value is the amount for which an asset
  could be exchanged, or a liability settled,
  between knowledgeable, willing parties in an
  arms length transaction (IAS 39)

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Fair ValueMeasurement Objective

• Exit price objective, consistent with the
  definitions of assets and liabilities in CON 6
• Assets are future inflows
• Liabilities are future outflows

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Current Transaction

• In the absence of a transaction involving the
  entity, fair value is an estimate determined by
  reference to a hypothetical transaction
• The estimate should be based on the assumptions
  that marketplace participants in the reference
  market for the asset or liability would use in
  their estimate of fair value

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Marketplace Participants

• Buyers and sellers in the reference market for
  the asset or liability that are
• Independent of the entity (unrelated)
• Knowledgeable
• Able to transact
• Willing to transact

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Reference Market

• The most advantageous market in which the entity
  would transact for the asset or liability
  (assumes rational economic behavior)
• The reference market will depend on
• The business activities of the entity
• The unit of account for the asset or liability in
  the most advantageous market in which the entity
  would transact for the asset or liability

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Assets

• The reference market is the market that maximizes
  the amount that would be received for an asset,
  assuming the highest and best use of the asset
  from the perspective of marketplace participants
• Highest and best use establishes the valuation
  premise

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In-UseValuation Premise

• If highest and best use is in-use, the estimate
  is determined using an in-use valuation premise
  (fair value in-use)
• Highest and best use is in-use if marketplace
  participants would continue to use the asset as
  it is currently installed or otherwise configured
  for use with other assets as a group (the
  hypothetical exchange involves an asset group)
• Fair value in-use is not value in-use (IAS 36)

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In-ExchangeValuation Premise

• If highest and best use is in-exchange, the
  estimate is determined using an in-exchange
  valuation premise (fair value in-exchange)
• Highest and best use is in-exchange if
  marketplace participants would not continue to
  use the asset as it is currently installed or
  otherwise configured for use with other assets as
  a group or if the asset provides value
  principally on a stand-alone basis (the
  hypothetical transaction involves a stand-alone
  asset)

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Liabilities

• The reference market is the market that minimizes
  the amount that would be paid to transfer the
  liability to a marketplace participant of
  comparable credit standing
• The estimate assumes that the liability is
  transferred to a marketplace participant that
  would similarly perform it is not settled with
  the counterparty (layoff notion)

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Transaction Costs

• The price that forms the basis for the estimate
  is not adjusted for transaction costs (the costs
  to transact in the reference market for the asset
  or liability)
• Transaction costs are characteristics of the
  transaction, not the asset or liability

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Transportation Costs

• If location is a characteristic of the asset or
  liability, the price that forms the basis for the
  estimate is adjusted for transportation costs
  (the costs to access the reference market for the
  asset or liability)

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Transaction PricePresumption

• Transaction price (price paid for an asset or
  price received to assume a liability) is an entry
  price (the proposed customer consideration
  amount in a revenue transaction)
• Fair value (price that would be received for an
  asset or paid to transfer a liability) is an exit
  price
• In the reference market for the asset or
  liability, entry and exit prices are presumed to
  be the same at initial recognition, absent
  persuasive evidence to the contrary (exchange
  price notion)

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Valuation Techniques

• Valuation techniques should be consistent with
• Market approach (observed prices, multiples)
• Income approach (present value techniques,
  option-pricing models)
• Cost (or asset-based) approach
• Use valuation technique (or combination of
  valuation techniques) appropriate in the
  circumstances for which sufficient data are
  available

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Valuation Inputs

• The fair value hierarchy distinguishes the inputs
  to valuation techniques
• Market inputsassumptions that marketplace
  participants would use in making pricing
  decisions, based on market data obtained from
  sources independent of the entity
• Entity inputsentitys internally developed
  assumptions of market inputs, based on the
  entitys own data

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Fair Value Hierarchy
Level 1
P x Q
Levels 2 4
Other Market Inputs
Level 5
Entity Inputs
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Level 1

• Quoted prices for identical assets or liabilities
  in active markets the entity has the ability to
  access (PxQ)
• Ability to access is a criterion only within
  Level 1 it limits discretion in pricing an asset
  or liability when using a single market input to
  estimate fair value (quoted price)

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Bid and Asked Prices

• If a price is quoted in terms of bid and asked
  prices, the estimate should represent the price
  within the bid-asked spread at which marketplace
  participants would currently transact (SEC ASR
  118)
• IAS 39 indicates fair value is the bid prices for
  assets and ask prices for liabilities, but allows
  use of mid point for offsetting positions

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Blocks

• The fair value of a large position of an
  unrestricted security with a quoted price in an
  active market (block) should be estimated using
  PxQ, no blockage factors within Level 1
• This is consistent with the implementation
  guidance to IAS 39

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Levels 2-4

• Other market inputs
• Quoted prices not included within Level 1,
  adjusted as appropriate
• Market inputs that are directly observable for
  the asset or liability (interest rates, yield
  curves, volatilities, default rates)
• Market-corroborated inputs

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Level 5

• Entity inputs used in the absence of market
  inputs
• Fair value measurement objective remains the
  same therefore, entity inputs should be
  developed within market parameters, eliminating
  factors specific to the entity whenever possible

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Examples of Level 2

• Restricted security which cannot be sold for a
  specified period
• Fair value estimated using the quoted price for
  an unrestricted security of the issuer that is
  identical in all respects except for the
  restriction
• Quoted price is adjusted to reflect the effect of
  the restriction
• A machine that is installed and configured for
  use
• Quoted prices in active markets for similar
  machines are available.
• The quoted prices are adjusted to reflect the
  differences from the similar machines,
  considering the condition of the machine and the
  location of the machine.
• The adjustments are not significant to the
  estimate.
• Internally developed software for use by the
  entity
• Quoted prices in active markets for similar
  software are available.
• The quoted prices are adjusted to reflect
  differences from the similar software assets,
  considering the utility of the software asset and
  any required customization as well as the
  condition of the software asset.
• The adjustments are not significant to the
  estimate.

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Examples of Level 3

• Untraded option on exchange-traded stock with
  five-year term
• Valued using an option pricing model
• Many inputs are market observations (stock price,
  risk free interest rate)
• The implied volatility for the entity is
  observable for the full term of the option (five
  years). If volatility is significant to the
  calculation, then level 3 calculation.
• A machine that is installed and configured for
  use
• The entity estimates fair value based on the
  historical cost (including installation) updated
  using a published cost trend index. The entity
  concludes historical costs is relevant because
  their reference market is the same as the market
  the asset was acquired in and there is no
  evidence of differences in entry versus exit
  prices for this market.
• Using the published cost trend index, the entity
  indexes the historical cost (including
  installation costs) of the machine to current
  cost.
• The historical cost information can be
  corroborated by a manufacturers price list.

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Examples of Level 4

• Untraded option on exchange-traded stock with
  five-year term
• Valued using an option pricing model
• Many inputs are market observations (stock price,
  risk free interest rate)
• Implied volatility for the entity is observable
  for three years. Implied volatility information
  for comparable entities is available for the term
  of the option (five years) as well as for three
  years. The implied three-year volatility for the
  entity highly correlates with the implied
  three-year If volatility of the comparable
  entities. As such, implied volatility for the
  entity can be extrapolated from the comparable
  entities resulting in a level 4 calculation.
• Building
• The building is valued based on square meters
  multiplied by an estimated price per square
  meter.
• The estimated price per square meter is derived
  from prices in observed transactions involving
  similar buildings in similar locations,
  considering differences between the condition,
  location, and other characteristics of the
  building and the similar buildings.

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Examples of Level 5

• Asset retirement obligation at initial
  recognition
• The estimate is developed using an expected
  present value technique and probability-weighted
  (expected) cash flows and are significant to the
  estimate of fair value.
• While the discount rate applied to the expected
  cash-flows is observable, the cash-flows are
  developed using the entitys own data and cannot
  be corroborated by observable market data,
  resulting in a level 5 calculation.
• In-process research and development project
• The estimate of fair value is determined using
  financial projections (considering varying
  factors, including revenues and expenses,
  probability estimates, and charges for
  contributory assets).
• The financial projections are significant to the
  estimate of fair value and cannot be corroborated
  by observable market data, resulting in a level 5
  calculation.

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Disclosures

• Quantitative disclosures using a tabular format
  required in all periods (interim and annual) for
  ongoing and periodic fair value remeasurements
• Qualitative (narrative) disclosures about
  valuation techniques required in annual periods

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Ongoing Fair ValueRemeasurements
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Ongoing Fair Value Remeasurements
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Periodic Fair ValueRemeasurements
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Effective Date/Transition

• Effective for fiscal years beginning after
  December 15, 2006, except for disclosures
• Disclosures effective for fiscal years ending
  after December 15, 2006
• Prospective application, except for blocks
• Retrospective application for blocks
• Earlier application encouraged

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High-level Comparison to AcSB Staff Discussion
Paper

• Different objectives
• Fair Value Measurements Statement objective is
  to establish a framework for measuring fair value
  when fair value is required under other
  accounting pronouncements.
• AcSB Staff Discussion Paper objective is to
  develop a conceptual framework for measurement,
  focusing on the relevance and reliability of
  possible measurement bases (including but not
  limited to fair value) at initial recognition.

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High-level Comparison to AcSB Staff Discussion
Paper