ATTACHMENT C Background FAIR VALUE MEASUREMENT Financial Accounting Standards Advisory Council March 2006 In June 2003, the Board added a project to its agenda to improve guidance for measuring fair value, in part, in response to respondents comments on the FASB Proposal, Principles-Based Approach to U.S. Standard Setting (discussed by Council members at the March 2003 FASAC meeting). The overall objective of the project is to develop a Statement that will define fair value and establish a framework for applying the fair value measurement objective in GAAP. Related objectives are to improve the consistency and comparability of the measurements, codify and simplify the guidance that currently exists for developing the measurements, and improve disclosures about the measurements. In June 2004, the Board issued an FASB Exposure Draft of a proposed Statement, Fair Value Measurements. The comment period ended in September 2004, at which time the Board held a public roundtable meeting with some respondents to discuss significant issues raised in comment letters (discussed by Council members at the March 2005 FASAC meeting). In October 2005, the Board posted a working draft of a final FASB Statement, Fair Value Measurements (FVM Statement), to the FASB website. Separately, the Board solicited input from selected external reviewers. Since that time, the Board has discussed, in education sessions with the staff and some external reviewers, issues raised on the FVM Statement and possible revisions to the related guidance. Note: These materials are provided to facilitate understanding of the issues to be addressed at the March 23, 2006 FASAC meeting. These materials are presented for discussion purposes only; they are not intended to reflect the views of the FASB or its staff. Official positions of the FASB are determined only after extensive due process and deliberations. 29 FASAC Fair Value Measurement 06/13/06
2 Key Provisions of FVM Statement Aspects of the guidance in the FVM Statement, as revised, will result in a change to practice for some entities in applying the fair value measurement objective under other accounting pronouncements. Those aspects are discussed below. Fair Value Definition The definition of fair value in the FVM Statement retains the exchange price notion in earlier definitions of fair value. However, it clarifies that the exchange price is the price that would be received for an asset or paid to transfer a liability in a transaction between market participants at the measurement date. In other words, the price used to measure fair value is an exit price considered from the perspective of a market participant (seller) that holds the asset or liability. Therefore, a fair value measurement should reflect the assumptions that market participants would use in pricing the asset or liability. The valuation technique that is used to measure fair value should take into account all of the assumptions that market participants would use in pricing the asset or liability, and exclude factors specific to the reporting entity if information is available that indicates that market participants would exclude those factors. In determining whether all market participant assumptions are included in the fair value measurement, the reporting entity should consider the extent to which the measurement is based on unobservable market inputs and any pricing adjustments a market participant (buyer) would demand to assume the related risk as well as other factors specific to the asset or liability. Transaction Prices and Initial Fair Value Measurements The FVM Statement clarifies that, in situations in which an asset is acquired or a liability is assumed in an exchange transaction, the transaction price represents the price paid for the asset or received to assume the liability (an entry price). In contrast, the fair value of the asset or liability represents the price that would be received for the asset or paid to transfer the liability (an exit price). Conceptually, those prices can be different. However, in many situations, the transaction price 2
3 will represent the fair value of the asset or liability at initial recognition (in other words, those prices will be the same). In determining whether the transaction price represents the fair value of the asset or liability at initial recognition, the reporting entity should consider factors specific to the transaction and the asset or liability, including the following: a. Whether the number of elements (unit of account) represented by the transaction price is different from the unit of account for the asset or liability measured at fair value, for example, if the transaction is a multiple-element transaction and the asset or liability being measured at fair value is only one of the elements in the transaction; the transaction includes unstated rights and privileges that should be separately measured; or the transaction price includes transaction costs b. Whether the transaction is between related parties c. Whether the transaction occurs under duress or the seller is forced to accept the price in the transaction because of urgency (for example, a forced liquidation or distress sale where a particular entity is experiencing financial difficulty) d. Whether the market in which the transaction occurs is different from the market in which the reporting entity would sell or otherwise dispose of the asset or transfer the liability. In FASB Staff Position (FSP) FAS 133-a, Accounting for Unrealized Gains (Losses) Relating to Derivative Instruments Measured at Fair Value under Statement 133, the Board is considering issues relating to the use of a transaction price to measure the fair value of a derivative instrument at initial recognition (discussed by Council Members at the September 2005 FASAC meeting). The principal issue is whether an unrealized gain (loss), measured as the difference between the transaction price and the fair value of the derivative instrument at initial recognition, should be recognized in income if the fair value of the derivative instrument is measured using unobservable market inputs. In that regard, the Board plans to discuss whether to establish a minimum reliability threshold that would require that fair value be measured using observable market inputs for purposes of determining whether to recognize unrealized gains (losses) in income and whether to amend FASB Statement No. 133, Accounting 3
4 for Derivative Instruments and Hedging Activities, to require a transaction price measurement at initial recognition. In either case, the Board also plans to discuss the need for expanded disclosures about fair value measurements using unobservable market inputs. Principal (Most Advantageous) Markets The FVM Statement establishes that a fair value measurement assumes an orderly transaction in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. In either case, selection of the appropriate market is considered from the perspective of the reporting entity, that is, the principal (most advantageous) market in which the reporting entity would sell or otherwise dispose of an asset or transfer a liability, allowing for differences between and among entities and the markets in which those entities transact (for example, retail versus wholesale markets). Application to Assets and Liabilities For an asset, the FVM Statement incorporates the highest and best use concept referred to in FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements. Highest and best refers broadly to the use of an asset by some (two or more) market participants that would maximize the fair value of the asset in a hypothetical transaction between market participants to sell or otherwise dispose of the asset at the measurement date. The highest and best use of an asset is determined without regard to the intended use of the asset by the reporting entity. For example, the highest and best use of certain intangible assets acquired in a business combination might be in use, even if the acquiring entity does not intend to use the assets. For a liability, the FVM Statement incorporates the credit standing concept discussed in Concepts Statement 7. Specifically, the FVM establishes that a fair value measurement assumes that a liability is transferred to a market participant of comparable credit standing that would similarly perform (or similarly bear the 4
5 consequences of not performing). In other words, the liability to the counterparty remains outstanding; it is not settled (or otherwise extinguished). Therefore, the reporting entity should consider the effect of its credit standing on the fair value of the liability in all periods in which the liability is measured at fair value under other accounting pronouncements, including Statement 133 (or the proposed fair value option). Fair Value Hierarchy The FVM Statement emphasizes that a valuation technique used to measure the fair value of an asset or liability should maximize the use of observable market inputs and minimize the use of unobservable market inputs. Market inputs refer broadly to the assumptions that market participants would use in making pricing decisions. Observable market inputs refer to inputs developed based on market data obtained from sources independent of the reporting entity. Unobservable market inputs refer to inputs that reflect the reporting entity s assumptions of market inputs, developed based on its own data, adjusted to exclude factors specific to the reporting entity if information is available that indicates that market participants would use different assumptions. The fair value hierarchy prioritizes the market inputs to valuation techniques used to measure fair value into three broad levels (discussed below), providing a framework for related disclosures. Level 1 Level 1 inputs are observable market inputs that reflect quoted prices for identical assets or liabilities in active markets the reporting entity has the ability to access at the measurement date. The FVM Statement affirms the Board s conclusion in other accounting pronouncements that a quoted price in an active market provides the most reliable evidence of fair value and should be used to measure fair value whenever available. For a large position (block) of a financial instrument that trades in an active market, the FVM Statement affirms the requirement of other FASB Statements that the fair value of the block should be measured (within Level 1) as the product of the quoted price for an individual trading unit times the quantity held, 5
6 thereby precluding the use of a blockage factor. The FVM Statement extends that requirement to broker-dealers and investment companies within the scope of the AICPA Audit and Accounting Guides for those industries. Level 2 Level 2 inputs are observable market inputs other than quoted prices for identical assets or liabilities included within Level 1. The FVM Statement clarifies that observable market inputs include market inputs that are not directly observable for the asset or liability but that are derived principally from or corroborated by other observable market data through correlation or by other means (marketcorroborated inputs). Level 3 Level 3 inputs are unobservable market inputs (previously referred to in the context of entity inputs). Unobservable market inputs may be used to measure fair value, but only if observable market inputs are not available, allowing for situations in which there might be little, if any, market activity for the asset or liability. In those situations, the fair value measurement objective remains the same, that is, an exit price from the perspective of a market participant (seller). Therefore, the reporting entity s own data used to develop the inputs should be adjusted to exclude factors specific to the reporting entity if information is available that indicates that market participants would exclude those factors. Disclosures The FVM Statement establishes two broad disclosure objectives. The first disclosure objective is to provide information that enables users of financial statements to assess the extent to which fair value is used to remeasure assets and liabilities recognized in the statement of financial position and the inputs used to develop the measurements. To meet that objective, the related disclosures focus on the fair value measurements and where within the fair value hierarchy the measurements fall. 6
7 The second disclosure objective is to provide information that enables users of financial statements to assess the effects of fair value remeasurements on income (or changes in net assets) for the period. To meet that objective, the related disclosures previously discussed by the Board focus on the change in unrealized gains (losses) during the period relating to assets and liabilities that are remeasured at fair value on a recurring basis if the measurements are determined using unobservable market inputs (within Level 3). However, external reviewers and others raised significant concerns about the ability to provide those disclosures within reasonable cost-benefit constraints. In particular, they emphasized that that information, by itself, would not be meaningful. Moreover, it would necessitate systems changes, in some cases, significant (for example, for derivatives). In response, the Board and staff met with some external reviewers to discuss possible disclosures that would meet the broad disclosure objective within reasonable cost-benefit constraints. Those disclosures focus on changes in fair value measurements within Level 3 in the aggregate, that is, total gains (losses) versus unrealized gains (losses). The Board plans to discuss those disclosures further, after it receives additional input from representative users. Effective Date The Board plans to issue the FVM Statement by June 30, 2006. At this time, the Board does not plan to re-expose the FVM ED, having received input from constituents throughout the redeliberations process. Rather, the Board plans to solicit input on the FVM Statement, as recently revised, from selected external reviewers, including members of its valuation resource group. Currently, the FVM Statement would be effective for 2007 fiscal years. However, the Board plans to revisit the issue of effective date. Specifically, the Board plans to discuss whether to delay that effective date by one year, considering the need for related communications, education, and constituent outreach. 7
8 Discussion at the March Council Meeting At the March Council meeting, the Board seeks input from Council members on the following issues related to the FVM Statement: 1. Will the concepts in the FVM Statement be generally understood by preparers, auditors, and users? 2. Should the FVM Statement include expanded disclosures about the effect of changes in fair value measurements within Level 3 on income (or changes in net assets) for the period? 3. Do Council members have any concerns about the changes to practice that might result by applying the FVM Statement? 4. Should the effective date of the FVM Statement be delayed to allow for related communications, education, and constituent outreach? 5. What initiatives should the FASB undertake to facilitate related communications, education, and constituent outreach? 8