Lunch & Learn Seminar: Accounting for Fair Value (Fair Value Measurements) December 15, 2009

Transcription

1 Lunch & Learn Seminar: Accounting for Fair Value (Fair Value Measurements) December 15,

2 Should you be concerned about fair value accounting? Why is it such a big deal? To whom does it apply? When will it become effective? What is fair value accounting? Where do you go for help? 2

3 Why is it such a big deal? ASC 820 (formerly FAS 157) Fair Value Measurements was adopted to increase transparency and comparability in financial reporting Alignment with International Financial Reporting Standards 3

4 To whom does it apply? Public companies Private companies All GAAP conforming entities 4

5 Financial Statement Impact Balance Sheet Parenthetical disclosure ( at fair value ) Income Statement Unrealized or MTM Gain/Loss Cash Flow Statement Adjustment to net income as a non-cash adjustment 5

6 When will it become effective? In September 2006, the Financial Accounting Standards Board issued FAS 157 Fair Value Measurements which was effective for fiscal years beginning after November 15, 2007 In February 2008, FSP deferred the effective date of fair value measurements to fiscal years beginning after November 15, 2008 (for nonfinancial assets and nonfinancial liabilities other than those disclosed at fair value on a recurring basis) 6

7 FASB ASC 820 (formerly SFAS No. 157) Fair Value Measurements and Disclosures Defines fair value Establishes a framework to measure fair value Requires certain disclosures related to fair value Applies to assets and liabilities (and instruments classified in stockholder s equity) that were already required to be valued at fair value Does not apply to leases, but does apply to acquired assets and liabilities in a business combination that are required to measure fair value, even if those items are related to leases 7

8 Definition of Fair Value FASB Definition: 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. Based on the EXIT price rather than the purchase price 8

9 Market and Market Participants Assumes principal market, if one exists; otherwise, most advantageous market Assumes market participants are independent, knowledgeable of the asset or liability, and willing and able to transact 9

10 Application to Assets and Liabilities Assets: Assumes highest and best use by market participants even if the use differs from what the company would use the asset for Can be In-Use or In-Exchange In-Use: Use in combination with other assets (can assume use with other assets as long as other assets are also available to the market participants) In-Exchange: Used on a standalone basis Liabilities: Assumes liability is transferred at the measurement date (the liability is not settled) Assumes non-performance risk is the same before and after the transaction 10

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12 Inputs Level One Inputs: Observable inputs vs Unobservable inputs Quoted prices in an active market for identical assets and liabilities Level Two Inputs: Directly or indirectly observable for the asset or liability (other than level one inputs) Level Three Inputs: Unobservable inputs 12

13 Level One Inputs Quoted prices in an active market for identical assets and liabilities Always consider the principal market first, but the market must be accessible to the entity At times, significant events occur after market close, but before measurement date - if quoted price is adjusted, it becomes a lower-level measurement Should not use block size (bulk rate) instead, take quoted market price of one instrument and multiply by the number of instruments held 13

14 Level Two Inputs Directly or indirectly observable for the asset or liability, other than level one inputs Quoted prices for similar assets or liabilities in active markets Quoted prices for identical or similar assets or liabilities Inactive markets Prices are not current Price quotes vary substantially over time or among markets Little information is publicly released, i.e. brokered markets Inputs other than quoted prices that are observable for the asset or liability, i.e. interest rates, yield curve, volatility, prepayment speeds, credit risks, default rates 14

15 Level Three Inputs Unobservable inputs Reflects reporting entity s assumptions it believes the market would make Developed based on best available information (information available without undue cost and effort) 15

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17 Valuation Techniques Market approach Income approach Cost approach 17

18 Market Approach Use prices and other relevant information generated from market transactions involving identical or similar assets or liabilities (including a business) 18

19 Income Approach Converts future cash flows, earnings, or other amounts to a single discounted amount The measurement represents the value revealed by current market expectations about those future amounts 19

20 Discount Future Cash Flows Estimating net cash flows Grouping the estimated cash flows into discounting periods Selecting a rate Present value calculations 20

21 Cost Approach Represents the current replacement cost of an asset The cost of acquiring or constructing a substitute asset with similar functionality, adjusted for obsolescence 21

22 Valuation Techniques Use the technique appropriate for the situation May be situations where multiple valuation techniques are appropriate; in these cases, select the fair value within the range that best represents the circumstances Be consistent Change in valuation technique should be accounted for as a change in accounting estimate 22

23 Disclosures (measured on a recurring basis) Fair value measurements at the reporting date The input level used to measure fair value GAAP suggests segregating the assets or liabilities by level of input For level 3 measurements A reconciliation of beginning and ending balances Presenting separately changes due to realized and unrealized gains and losses Purchases, sales, issuance, and settlements Transfers in and out of level 3 The amount of total gains and losses that are caused by changes in unrealized gains or losses for those assets and liabilities held at the reporting date In addition, details of where those unrealized gains and losses are reported in the income statement must be disclosed The valuation techniques used to measure fair value and, if there were any changes in valuation techniques used in prior periods, details surrounding the changes 23

24 Sample Disclosure NOTE 6 FAIR VALUES OF ASSETS AND LIABILITIES Effective January 1, 20X8, we adopted Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157), which provides a framework for measuring fair value under GAAP. SFAS 157 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. SFAS 157 requires that valuation techniques maximize the use of observable inputs and minimize the use of unobservable inputs. SFAS 157 also establishes a fair value hierarchy, which prioritizes the valuation inputs into three broad levels. There are three general valuation techniques that may be used to measure fair value, as described below: A) Market approach Uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. Prices may be indicated by pricing guides, sale transactions, market trades, or other sources; B) Cost approach Based on the amount that currently would be required to replace the service capacity of an asset (replacement cost); and C) Income approach Uses valuation techniques to convert future amounts to a single present amount based on current market expectations about the future amounts (includes present value techniques, and option-pricing models). Net present value is an income approach where a stream of expected cash flows is discounted at an appropriate market interest rate. Assets and liabilities itemized below were measured at fair value during the year ended using the market and income approaches. The market approach was used for Level 2. The income approach was used for Level 3. 24

25 Sample Disclosure Fair Value Measurements Using Quoted Prices In Active Significant Markets for Other Significant Identical Observable Unobservable Assets/Liabilities Inputs Inputs Fair Value (Level 1) (Level 2) (Level 3) December 31, 20X8 Interest Rate Caps Purchased $ 36,590 $ $ 36,590 $ Investment in Money Market Fund 112, ,346 Total Assets $ 148,936 $ $ 36,590 $ 112,346 Interest Rate Swap Agreements 63,489 63,489 Interest Rate Caps Sold 36,542 36,542 Total Liabilities $ 100,031 $ _ $ 36,542 $ 63,489 25

26 Sample Disclosure The table below presents a reconciliation for assets and liabilities measured at fair value on a recurring basis: Fair Value Measurements Using Significant Unobservable Inputs (Level 3) Investment in Interest Rate Money Mkt Fund Swaps Balance at January 1, 20X8 $ 72,697 Transfers into Level 3 $ 115,821 Total realized and unrealized losses: Included in earnings (3,475) (1,343) Included in other comprehensive income (10,225) Purchases, issuance, and settlements 20,776 Balance at December 31, 20X8 $ 112,346 $ (63,489) 26

27 Sample Disclosure Financial instruments are considered Level 3 when their values are determined using pricing models, discounted cash flow methodologies similar techniques and at least one significant model assumption or input is unobservable. Level 3 financial instruments also include those for which the determination of fair value requires significant management judgment or estimation. A brief description of the valuation techniques used for our Level 3 assets and liabilities is provided below. We had an investment of $115,821 in the Reserve Fund, a money market fund, which has suspended redemptions and is in the process of liquidating the portfolio of investments. In mid-december, the net asset value of the Reserve Fund decreased below $1 per share as a result of the trustee of the Reserve Fund valuing their investments in LBHI debt securities held by the Reserve Fund at zero. Because redemptions of the fund have been suspended and our investment is not readily convertible to cash, we reclassified this investment on our balance sheet from cash and cash equivalents to other assets. We recognized an other than temporary impairment of $3,475, at December 31, 20X8, by valuing the asset at the estimated net asset value of $0.97 per share as published by the Reserve Fund. As each security in the portfolio matures or additional liquidity becomes available within the fund, the Reserve Fund has indicated that interim distributions will be made to the investors in the fund on a prorata basis. Changes in market conditions could result in further adjustments to the fair value of this investment. Subsequent to December 31, 20X8, we received $58,800 as a partial distribution from the Reserve Fund. Our derivatives are not exchange traded but instead traded in over-the-counter markets where quoted market prices are not readily available. The fair value of derivatives is derived using models that use primarily market observable inputs, such as interest rate yield curves and credit curves. Any derivative fair value measurements using significant assumptions that are unobservable are classified as Level 3, which include interest rate swaps whose remaining terms extend beyond market observable interest rate yield curves. The impacts of the derivative liabilities for our and the counterparties non-performance risk to the derivative trades is considered when measuring the fair value of derivative liabilities. 27

28 Disclosures (measured on a non-recurring basis) The fair value measurements recorded during the period and why the measurements were necessary The input levels used to measure fair value, segregating measurements into levels 1, 2, and 3 For level 3 measurements, a description of the inputs and sources of data used to develop the inputs The valuation techniques used and, if there were any changes in the techniques used to measure similar assets or liabilities in prior periods, details surrounding the change 28

29 Sample Disclosure Fair Value Measurements Using Quoted Prices In Active Significant Markets for Other Significant Identical Observable Unobservable Total Assets/Liabilities Inputs Inputs Gains Fair Value (Level 1) (Level 2) (Level 3) (Losses) Description Long-lived assets held and used $ 750,000 $ $ 750,000 $ $ (250,000) Goodwill 300, ,000 (350,000) Long-lived assets held for sale 260, ,000 (150,000) $ (750,000) In accordance with the provisions of SFAS No. 144, long-lived assets held and used with a carrying amount of $1,000,000 were written down to their fair value of $750,000, resulting in an impairment charge of $250,000, which was included in earnings for the year. In accordance with the provisions of SFAS No. 142, goodwill with a carrying amount of $650,000 was written down to its implied fair value of $300,000, resulting in an impairment charge of $350,000, which was included in earnings for the period. In accordance with the provisions of SFAS No. 144, long-lived assets held for sale with a carrying amount of $350,000 were writte down to their fair value of $260,000, less cost to sell of $60,000 (or $200,000), resulting in a loss of $150,000, which was include in earnings for the year. Long-lived assets have been valued using a market approach. The values were determined using market prices of similar long-lived assets. Goodwill was valued using the income approach and the multiperiod excess earnings method 29

30 Additional Clarification to ASC 820 (formerly FAS 157) Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active - FSP Effective upon issuance (October 10, 2008) Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Indentifying Transactions That Are Not Orderly - FSP Effective for periods ending after June 15, 2009 Accounting Standards Update (ASU) No Measuring Liabilities at Fair Value Issued August 2009, effective for year beginning after this date Accounting Standards Update (ASU) No Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent) Issued September 2009, effective for reporting periods ending after December 15,

31 Key Terms - Defined Financial Asset cash or evidence of an ownership interest in an entity, or a contract that requires the exchange of cash or other financial instruments that convey a right to the entity Financial Liability a contract that imposes an obligation on the entity Nonfinancial Asset an asset that is not a financial asset (i.e. equipment) Nonfinancial Liability liability that is not a financial liability (i.e. an obligation to deliver goods or services) Principal Market the market in which the reporting entity would sell the asset or transfer the liability with the greatest volume and level of activity for the asset or liability Most Advantageous Market the market in which the reporting entity would sell the asset or transfer the liability with the price that maximizes the amount that would be received for the asset or minimizes the amount that would be paid to transfer the liability, considering transaction costs in the respective market(s) Observable Inputs inputs that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the reporting entity Unobservable Inputs inputs that reflect the reporting entity's own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances Reporting Entity any organization, which reports its accounts to its stockholders 31

32 Dave Gaver, CPA, Senior Manager Watkins Meegan Government Contracting & Technology Group (703) Kristin Drozdowski, Supervisor Watkins Meegan Risk Services Group (703) Watkins Meegan offers a wide range of accounting, audit, tax, and business advisory services while placing a premium on personalized, accessible customer relationships. The firm serves a broad market of entrepreneurial and mid-market clients including corporations, closely held businesses, not-for-profits, partnerships, estates, trusts, and high-net-worth individuals. Bethesda, MD Vienna, VA Annapolis, MD 32