Fair Value Financial Statements

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Fair Value Financial Statements

• The Panic of 2008

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The Panic of 2008

• Press coverage of losses ostensibly caused by
  fair value accounting.
• "The only thing fair-value accounting did is
  force you to tell investors you made a bunch of
  very bad loans."
• Lynn E. Turner, Former SEC Chief
  Accountant.
• The concept of fair value, which was intended to
  help bring transparency, was scored by some as a
  villain, exacerbating the turmoil, and heralded
  by others as a savior in revealing the problems
  on a timely basis.
• Robert Hertz, chair of the FASB,
  9/18

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of Assets at Fair Value
(as of FYE 2007)
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Financial Markets Turmoil

• Breakdown in underwriting standards
• Erosion of market discipline in securitizations
• Flaw in credit rating agencies assessment of
  structured products
• Weakness in risk management practices
• Regulatory policies and disclosure practices that
  failed to mitigate these weaknesses
• Contagion

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Home Prices (Case-Schiller Index)
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Agenda

• What is fair value accounting?
• What are Level 1, Level 2, and Level 3 assets and
  liabilities?
• What do the new FAS 157 disclosures tell
  investors that they did not know before?
• A few words about IFRS
• What should you look for in your clients
  financial statements?

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Background to FAS 157
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Main Principles of FAS 157
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What is fair value?

• Fair value is the 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.
• Orderly transaction No fire sale
• Selling price, not the buying price, in the
  principal market
• Must consider price in the principal market even
  if the price is temporarily higher in some other
  market
• Excludes transactions costs (which are treated
  separately)
• Fair value is adjusted downwards for
  transportation costs

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Market Participants

• Independent and knowledgeable parties
• Able and willing, not forced to transact
• Price based on assumptions that market
  participants would use
• Value in highest and best use of the asset

• Example
• As part of a business combination, a buyer
  acquires certain assets it has no intensions of
  using post-acquisition.
• However, the assets would be worth 100,000 to
  other market participants.
• For competitive reasons, the buyer has no
  intentions of selling the assets.
• Under FAS 157, the buyer should record these
  assets at 100,000 (market participant view) and
  assess for impairment on Day 2 and thereafter.

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Exit vs. Entry Prices

• The price that would be received for selling an
  asset.
• The price that would be paid to transfer a
  liability.

• Example
• As part of a business combination, a buyer
  acquires a car.
• Could acquire the car from a dealership for
  3,500.
• The car could be sold in the same market for
  3,200.
• Under FAS 157, the buyer should value the car at
  3,200 the exit price.

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What if Market Prices do not Reflect Economic
Reality?

• In-active or illiquid markets
• Unusually high risk premiums
• Market quote is indicative pricing vs. binding
  offer
• Highest and best use

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When transaction price can differ from fair value?

• Related-party transactions
• Seller is desperate to sell the asset
• Asset or liability is bundled with other items,
  which are not being separately measured
• Transaction price includes transaction costs
• When the entity buys in one market (wholesale
  market) and sells in another (retail market)

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Valuation Inputs
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Disclosure Requirements
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Level 3 Asset Exposure
( of equity, as of FYE 2007)
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Fair Value Problems/Risks

• Consistent/appropriate valuation methods
• Using values which do not reflect market when
  they are available to avoid recognizing losses
• Using values derived from inaccurate or flawed
  models
• Using internal pricing when external pricing is
  available
• use of happy value instead of market-based
  values
• Auditor/examiner bias

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How should risks of fair value accounting be
managed?

• Strong controls over use of valuation
  methods/models and fair value reporting, and
  periodic in-depth internal assessments of those
  controls
• Deep and comprehensive disclosures about
• Fair value methodologies
• Assets and liabilities reported at fair value
• How valuation changes have affected financial
  reports
• How management expects valuation changes to
  affect future financial reports
• Clear and unambiguous discussion about the impact
  of fair value accounting

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Fair-value-related controls

• Controls over recording the results of pricing
• Controls over the accuracy of model inputs
• Controls over the models used/inputs used to
  price assets and liabilities
• Controls over model design and prospective and
  retrospective (back-) testing
• Oversight over the above controls

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International Financial Reporting Standards (IFRS)

• Allowing filing in IFRS for U.S. issuers is
  something we want to accomplish this year.
• SEC Chairman Cox, 2/5/08
• Steps have been made toward the use of IFRS in
  the U.S.
• Elimination of U.S. GAAP reconciliation for
  foreign private issuers who use IFRS as adopted
  by the IASB
• Concept Release allowing U.S. issuers to file
  under IFRS
• Canada is adopting IFRS in 2011

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Managing Complexity

• Complete understanding of transaction, including
  terms, economics, rights, obligations, risks and
  rewards
• Adequate accounting resources knowledgeable,
  experienced and unbiased
• Management and Audit Committee involvement
• Potentially more than one correct answer
• Financial statement transparency

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Questions?
Calvetti, Ferguson Wagner, P.C.13105 Northwest
Fwy, Suite 1250Houston, TX 77040 Phone
832.782.5936Email kchesser_at_cfw-cpa.com