Preparing for Changes in Standards Overview and Fair Value Measurement

Preparing for Changes in Standards Overview and Fair Value Measurement

Module 1: Introduction

Agenda Preparing for Changes in Standards material to be covered today: Fair value measurement Revenue recognition Leasing Financial instruments 2011 Deloitte Global Services Limited 3

Objectives Discuss key decisions and principles that have been agreed or that are planned by the FASB and IASB. Describe key provisions of the projects and identify potential changes to current accounting standards. Anticipate and prepare for initial conversations with entities regarding information to gather and actions to take in anticipation of the upcoming new standards. Identify areas that may require increased use of professional judgment related to the upcoming new standards. Discuss audit, documentation, crucial conversations, and industry implications, as applicable, that may result due to the upcoming new standards. 2011 Deloitte Global Services Limited 4

Overview

Why is the current guidance changing? FASB IASB Align U.S. and international accounting standards 2011 Deloitte Global Services Limited 6

Current timeline Effective date TBD (no earlier than 1/1/2015) Norwalk Agreement Memorandum of Understanding (MoU) Updated MoU, identifying priority projects, including revenue recognition, leases, financial instruments, and others SEC issues a statement on its commitment to the development of globally accepted accounting standards Continued work on high-priority convergence projects 2002 2006 2008 2010 2011-2012 2011 Deloitte Global Services Limited 7

Module 2: Fair value measurement

What was the objective behind the joint project on fair value measurements? FASB IASB Develop common requirements for measuring fair value and for disclosing information about fair value measurements 2011 Deloitte Global Services Limited 9

Overview of FAS 157 (codified in ASC 820) Notion of an exit price is integrated into fair value definition. Exit price Hierarchy Other key provisions: 3-level fair value hierarchy Modifying the long-standing assumption that fair value equals transaction price Specific disclosure requirements Transaction price ASC 820 Disclosures 2011 Deloitte Global Services Limited 10

What are the significant amendments in ASU 2011-04 and who is affected? Own equity Premiums and discounts Highest and best use Expanded disclosures ASU 2011-04 amends ASC 820 and affects Offsetting positions All entities required or permitted to measure or disclose assets, liabilities, or own equity at fair value. 2011 Deloitte Global Services Limited 11

Effective date and transition December 15, 2011 December 15, 2012 January 1, 2013 U.S. GAAP public company First reporting period beginning after December 15, 2011 U.S. GAAP nonpublic company Annual periods ending on or after December 15, 2012 IFRS Annual periods beginning on or after January 1, 2013 Early adoption is not permitted Early adoption is permitted Early adoption is permitted Transition: Prospective (i.e., no recasting of prior periods or cumulative effect adjustment to retained earnings) 2011 Deloitte Global Services Limited 12

Discussion question #1 What is the effective date for the Fair Value Measurement Update for a U.S. GAAP public company? a)first reporting period beginning after December 15, 2011 b)first annual reporting period ending after December 15, 2012 c)first annual period beginning after January 1, 2013 d)at the same time as IFRS 13 2011 Deloitte Global Services Limited 13

Questions to think about Develop a list of audit implications as a result of this update. What additional procedures should be performed as a result of the update and what additional documentation will be needed from the entity? How will you communicate the additional procedures or requests, hours, and fees (if any)? Do you communicate these changes only to the entity? What about Seniors and Staff? You have 5 minutes to complete this activity. 2011 Deloitte Global Services Limited 14

Expanded disclosures: level 3 New requirement Required to disclose quantitative information about inputs.* Required to provide a narrative description of the measures sensitivity to changes in unobservable inputs and describe interrelationships between those inputs. Required to disclose a description of the valuation process used by the entity. * Not required to create quantitative information to comply with this disclosure requirement (e.g., when the entity uses prices from prior transactions or third-party pricing information without adjustment). However, cannot ignore quantitative unobservable inputs that are reasonably available to the entity. Observations The FASB decided to consider whether to have a quantitative sensitivity analysis for level 3 fair value measurements as part of a separate project. These new disclosure requirements are anticipated to impact preparers and auditors more significantly compared to the other provisions in ASU 2011-04. 2011 Deloitte Global Services Limited 15

Expanded disclosures: level 3 Example: quantitative information about level 3 fair value measurements Item Fair value at 12/31/XX Valuation technique Unobservable input Range (weighted average) Residential mortgage-backed securities $125 Discounted cash flow Constant prepayment rate Probability of default Loss severity 3.5% to 5.5% (4.5%) 5% to 50% (10%) 40% to 100% (60%) Direct venture capital investments: energy $32 Market comparable companies EBITDA multiple Revenue multiple Discount for lack of marketability 6.5 to12 (9.5%) 1.0 to 3.0 (2.0%) 5% to 20% (10%) Control premium Source: The table above is an excerpt from ASC 820-10-55-103. 2011 Deloitte Global Services Limited 16

Expanded disclosures: level 3 Example: narrative description of sensitivity The significant unobservable inputs used in the fair value measurement of the reporting entity s residential mortgage-backed securities are prepayment rates, probability of default, and loss severity in the event of default. Significant increases (decreases) in any of those inputs in isolation would result in a significantly lower (higher) fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption used for prepayment rates. (Reprinted from ASC 820-10-55-106) 2011 Deloitte Global Services Limited 17

Expanded disclosures: transfers between Level 1 and 2 Before Disclosure of significant transfers were required. After All transfers should be disclosed. Nonpublic entities are not required to make this disclosure. Other requirements The reasons for those transfers The entity s policy for determining when transfers between levels are deemed to have occurred Separate disclosures of transfers into and out of each level Observation Entities may find it an added burden to disclose all transfers if they previously only captured and reported significant transfers between level 1 and level 2. 2011 Deloitte Global Services Limited 18

Expanded disclosures: when highest and best use (HBU) is not the current use Before There was no requirement to make disclosures about situations when an entity s current use of an asset differs from its highest and best use. After Disclosure is now required. New requirement For recurring and nonrecurring fair value measurements, if the highest and best use of a nonfinancial asset differs from its current use, an entity shall disclose that fact and why the nonfinancial asset is being used in a manner that differs from its highest and best use. Observation This disclosure is not expected to occur frequently. 2011 Deloitte Global Services Limited 19

Expanded disclosures: when fair value is only disclosed * Before No requirement to provide the level in the fair value hierarchy or other additional disclosures After Must disclose the level in the fair value hierarchy Valuation techniques and inputs used HBU disclosure Observation The Board believes that the category will help investors better understand the relative reliability of the fair value measurements that are only disclosed in the footnotes. * That is, assets and liabilities not measured at fair value in the statement of financial position but for which the fair value is disclosed. 2011 Deloitte Global Services Limited 20

Discussion question #2 Which one of the following best defines blockage factor? a) The fee charged to audit a fair value measurement that is not based on quoted prices b) A control premium or an adjustment to an asset s fair value measurement applicable when an investor holds a controlling interest c) An adjustment made to the fair value measurement of nonfinancial assets to account for a holder s defensive use of an asset. That is, an entity may block others from using a nonfinancial asset in order to protect its competitive position (i.e., defensive use) d) An adjustment to the quoted price of an asset or a liability made because the market s normal daily trading volume is not sufficient to absorb the quantity held by the entity 2011 Deloitte Global Services Limited 21

Premiums and discounts Before Blockage factor prohibited for level 1 items After Establishes principles for considering when premiums and discounts are appropriate New requirement Establishes the following principles: A fair value measurement shall not incorporate a premium or discount that is inconsistent with the unit of account. Look to other topics in the ASC for guidance on unit of account. Premiums or discounts that reflect size as a characteristic of the entity s holding rather than as a characteristic of the asset or liability (i.e., blockage factor) are not permitted, regardless of the level within the hierarchy. If there is a quoted price in an active market (i.e., a level 1 input) for an asset or a liability, an entity shall use that price without adjustment when measuring fair value. Observation Entities that have historically applied a blockage factor to a level 2 or level 3 measurement would not be permitted to continue such practices. Other adjustments that are a characteristic of the item are not precluded (for example, market illiquidity or restrictions). Adjustments for noncontrolling interests and control premiums may still be appropriate. 2011 Deloitte Global Services Limited 22

Discussion question #3 Is it appropriate to consider blockage factors in fair value measurements? a) Yes b) No 2011 Deloitte Global Services Limited 23

Own equity Before Fair value definition should be applied to an instrument measured at fair value in equity, but no explicit guidance exists. After Explicit guidance is provided. Fair value measurements of own equity items follow the principles used to estimate the fair value of liabilities. New requirement Assume that the equity-classified instrument is not canceled but instead transferred to a market participant who would take on the rights and obligations associated with the instrument on the measurement date. Estimate an exit price from the perspective of a market participant who holds the identical item as an asset, if a quoted price for a transfer is not available and the identical item is held as an asset by another party. Observation The update is generally not expected to have a significant impact on current practice. The guidance applicable to liabilities and own equity is complex, providing a hierarchy or decision tree, prescribing the preferred valuation techniques and assumptions depending on certain factors. 2011 Deloitte Global Services Limited 24

Highest and best use Before Did not prohibit in combination valuation premise for financial assets Used terms in-use and in exchange After HBU concept and valuation premise only applicable to nonfinancial assets (for example, fixed assets and intangibles) and certain liabilities (for example, working capital). New guidance on offsetting risk positions for financial assets and financial liabilities has been provided. Uses terms in combination and standalone. Observation The update is generally not expected to have a significant effect on current practice. 2011 Deloitte Global Services Limited 25

Offsetting positions Before No explicit guidance on measuring the fair value of assets and liabilities with offsetting positions in a given market risk or credit risk. After Explicit guidance is now provided. New requirement Fair value measurement on a the basis of a net position is permitted when financial assets and financial liabilities that have offsetting positions in market risks and counterparty credit risk are: 1.Managed on the basis of the net exposure to either of those risks. 2.Information is provided to the entity s key management personnel on that basis. 3.Measures those financial assets and financial liabilities at fair value in the statement of financial position at each reporting date. Observation Not expected to have a significant effect on current practice; entities should consider how best to document and support their policy 2011 Deloitte Global Services Limited 26

U.S. GAAP versus IFRS Disclosure requirements U.S. GAAP Narrative description of the sensitivity in level 3 fair value measurements to changes in significant unobservable inputs. Nonpublic entity disclosure exemptions: Disclosures required for public companies relating to fair value measures disclosed but not recognized Narrative sensitivity analysis Transfers between level 1 and 2 IFRS Qualitative and quantitative sensitivity analysis. No exemptions for nonpublic entities Amounts disclosed may differ, because offsetting requirements for financial instruments differ, pending the outcome of a current joint project. 2011 Deloitte Global Services Limited 27

U.S. GAAP versus IFRS (continued) Net asset value Day-one gains or losses U.S. GAAP Reporting entity may use net asset value per share ( NAV ) to determine fair value of investments in certain entities that apply investment-company accounting on the basis of NAV. There is no prohibition against day-one recognition of differences between fair value and transaction price. IFRS NAV is not available as a practical expedient when determining fair value of investments in investment companies, because IFRSs do not currently have equivalent investment-company accounting. These are prohibited under IFRS 9 and IAS 39, unless based on observable inputs. Deposit liability Deposit liability value must be equal to the amount payable on demand as of the reporting date. Deposit liability value cannot be less than the present value of the amount payable on demand. 2011 Deloitte Global Services Limited 28

Discussion question #4 What are the criteria that the entity must meet to use the exception to fair value measurements for financial assets grouped with other assets or other assets and liabilities? (Hint: More than one may be correct.) a) Manage the group on the basis of the reporting entity s net exposure to a particular market risk or counterparty credit risk in accordance with a documented risk management strategy b) Provide information to management on the basis of net exposure to a particular market risk or counterparty credit risk c) Measure each financial asset and financial liability in the group at fair value in the statement of financial position at the end of each reporting period d) Determine the net position fair value is higher than the combination of stand-alone fair values 2011 Deloitte Global Services Limited 29

Questions to think about debrief What additional procedures should be performed as a result of the update and what additional documentation will be needed from the entity? How will you communicate the additional procedures or requests, hours, and fees (if any)? Do you communicate these changes only to the entity? What about Seniors and Staff? You have 5 minutes to complete this activity. 2011 Deloitte Global Services Limited 30

Questions? 2011 Deloitte Global Services Limited 31

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