Case Study- Real value corporation

What you need to know • Common requirements now exist for determining fair value and the related

disclosures under US GAAP and IFRS.

• While many principles under US GAAP remain the same, the amendments’

effects will likely vary by company and they could be significant.

• The new disclosure requirements could present operational challenges for

many companies.

• The amendments to US GAAP become effective in 2012.

Overview With ASU 2011-04 and IFRS 131, the Financial Accounting Standards Board (FASB)

and International Accounting Standards Board (IASB) (collectively, the Boards)

have generally created a uniform framework for applying fair value measurement

principles for companies around the world. These standards represent converged

guidance that the Boards believe will reduce complexity in applying the principles of

fair value and improve consistency in financial reporting across jurisdictions.

From a US GAAP perspective, the FASB’s primary reason for issuing the ASU was

convergence. As a result, many of the amendments to ASC 8202 clarify existing

concepts and are generally not expected to result in significant changes to how

many companies currently apply the fair value principles. Many of the amendments

eliminate wording differences or try to make the converged guidance more

understandable for companies applying it under IFRS for the first time.

In certain instances, however, the FASB changed a principle to achieve

convergence. While limited, these amendments have the potential to significantly

change practice for some companies. For example, the amendment to prohibit the

No. 2011-13

16 June 2011

Technical Line FASB — final guidance

In this issue:

Overview ........................................... 1

Background ....................................... 2

Summary of the amendments ............ 2

Changes to existing principles ........... 2

Other clarifications ............................ 7

Disclosures ...................................... 11

Effective date and transition ........... 15

Remaining differences between US GAAP and IFRS ...................... 15

Appendix A: Summary of significant amendments to ASC 820 ............. 18

Appendix B: Questions and interpretive responses ................. 19

Fair value measurement A closer look at the converged guidance

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use of block discounts in all fair value measurements will likely affect a number of

companies (particularly financial institutions).

This publication is written from a US GAAP perspective and provides our thoughts

on the key amendments and clarifications made to ASC 820, including the new

disclosure requirements. It does not address potential changes in practice under

IFRS that could result from the adoption of IFRS 13. Practice continues to evolve

and readers should continue to monitor developments in this area.

Appendix A summarizes the amendments to ASC 820. Appendix B includes

questions and interpretive responses on several implementation issues related to

the ASU.

Background The FASB issued comprehensive guidance3 in 2006 on how to measure fair value

when required or permitted by other standards. Guidance on how to measure fair

value in IFRS has been limited to provisions in multiple standards that sometimes

presented conflicting concepts. In 2009, the IASB issued an Exposure Draft, Fair

Value Measurement (the IASB ED), with the aim of creating a fair value framework

to be used consistently in IFRS.

The IASB ED was largely consistent with ASC 820, but certain elements differed

from US GAAP. When commenting on the IASB ED, many constituents stressed the

importance of converged guidance. In response, the Boards agreed to deliberate

jointly, with the objective of eliminating all substantive differences between the

IASB ED and ASC 820. This objective was effectively met, although certain limited

differences remain. Those differences are discussed later in this publication.

There are also differences between US GAAP and IFRS about what is measured at

fair value, but those differences are outside the scope of the joint project, which

focused on how to measure fair value.

Summary of the amendments The amendments to ASC 820 generally fall into the following three categories:

• Changes to a principle or requirement for measuring fair value

• Clarifications of the FASB’s intent regarding the application of existing

requirements

• Additional disclosure requirements

Key amendments in each of these categories are discussed in detail below.

Changes to existing principles

Measurement of financial instruments

During their deliberations, the Boards noted that financial instruments do not have

alternative uses and that their fair values usually do not depend on their use within

a group of other assets or liabilities. The ASU therefore specifies that the concepts

of “highest and best use” and “valuation premise” are relevant only when

measuring the fair value of nonfinancial assets.

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The result is that fair value for financial instruments should be largely based on the

unit of account prescribed by the Topic that requires (or permits) the fair value

measurement. This is often deemed to be the individual financial instrument. For

example, the unit of account in ASC 8154 for derivative instruments is generally

deemed to be the individual contract because that is the level at which hedge

effectiveness is assessed.

The fair value framework, as modified by the ASU, would therefore have required all

derivative contracts to be measured on an individual basis, consistent with their unit

of account. That would have caused a significant change from current practice, as

valuation adjustments related to over-the-counter (OTC) derivative contracts are

typically determined on a portfolio basis. Constituents argued that calculating

valuation adjustments for market and credit risk on a gross basis would be

inconsistent with their risk management practices and that the sum of the fair values

of the individual instruments is not equal to the fair value of their net risk exposure.

To maintain current practice, the ASU provides an exception that allows a company

to measure the fair value of a group of financial assets and liabilities with offsetting

risks based on the sale or transfer of its net exposure to a particular risk (or risks), if

certain criteria are met. The Boards acknowledge that this measurement approach

is an exception to the principles of fair value because it represents an entity-specific

measure (i.e., a company’s net risk exposure is a function of the other financial

instruments specifically held by that company and its unique risk preferences).

How we see it In general, we believe the measurement exception will allow companies to

continue current practice when determining derivative valuation adjustments for

bid-ask spreads and credit risk on a net basis. However, companies should

ensure they comply with the specified criteria discussed next.

Application of the measurement exception

Companies that hold a group of financial assets and liabilities are generally exposed

to market risks (e.g., interest rate risk, currency risk, etc.) and to the credit risk of

each of its counterparties. The ASU allows companies to make an accounting policy

election to measure the fair value of a group of financial assets and liabilities based

on the price that would be received to sell a net long position or transfer a net short

position for a particular risk exposure if all of the following criteria are met:

• The company manages the group of financial assets and liabilities on the basis

of its net exposure to a particular market risk or to the credit risk of a particular

counterparty in accordance with its documented risk management or

investment strategy.

• The company provides information about the group of financial instruments to

key management on this basis.

• The company measures all of the financial assets and liabilities in the group at

fair value in the statement of financial position each reporting period.

The ASU includes specific considerations for applying the measurement exception

to net exposures related to both market and credit risks.

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Additional considerations for offsetting market risks

When using the exception to measure a company’s net exposure to a particular

market risk, the ASU requires that the offsetting market risks be “substantially the

same.” For example, companies would not be able to offset the interest rate risk

associated with a financial asset with the currency price risk associated with a

financial liability because these two market risks are not substantially the same. The

combination of these financial instruments does not mitigate the market risk for

either the financial assets or liabilities.

We believe a company exposed to different forms of offsetting interest rate risk (for

example, a long exposure to USD LIBOR that is partially offset by a short exposure

to the USD prime rate) would generally meet the “substantially the same”

threshold. Although some basis risk exists between the positions, the combination

of these financial instruments mitigates the company’s overall interest rate risk.

While the measurement exception could be used in this instance, the fair value

measurement of the net long position should incorporate this basis risk.

Similarly, the ASU requires that the duration of a company’s exposure to a certain

market risk arising from a group of financial assets and liabilities be substantially

the same. For example, a company that holds a financial asset with a three-year

maturity and a financial liability (whose risk is substantially the same as the financial

asset) with a one-year maturity would measure the one-year exposure on a net

basis, but the remaining two-year exposure on a gross basis.

Additional considerations for offsetting credit risks

To measure its counterparty credit risk on a net basis, a company must have an

arrangement in place that mitigates credit risk upon default (such as a master

netting agreement or a collateral exchange agreement with the counterparty) that

market participants would take into account when pricing the exposure.

It is important to note that a company is not required to prove that such

agreements will be “legally enforceable” in all jurisdictions to use the measurement

exception. Instead, a company should consider market participant expectations

about the likelihood that such arrangements would be legally enforceable when

valuing the net credit exposure.

Other application issues

To use the measurement exception, companies are required to meet all the criteria

noted above both initially and on an ongoing basis. While the Boards indicated that

a company may change its election if its risk exposure preferences change, we

generally expect companies to use the exception consistently given that they

generally do not change their risk management policies from period to period.

As the general criteria above indicate, the measurement exception applies only to

financial instruments with offsetting risks. A group of financial instruments

comprised of only financial assets (such as a portfolio of loans) would not qualify for

the exception and would need to be valued in a manner consistent with its unit of

account. (Refer to the discussion of valuation inputs to be considered in the “Other

premiums and discounts” section later in this publication.) The ASU also indicates

that the measurement exception can be applied only to financial assets and

liabilities that are within the scope of ASC 815 or ASC 825.5

The measurement

exception applies only to

financial instruments with

offsetting risks.

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A company can elect the measurement exception on a portfolio-by-portfolio basis.

In addition, companies are not required to apply the exception to all of the risks

related to the financial assets and liabilities that make up a particular group. As

such, a company could choose to measure only the credit risk associated with a

group of financial instruments on a net basis, but not the group’s market risks.

A company also may apply the exception to only certain market risks related to the

group. For example, a company that is exposed to both interest rate and foreign

currency risk in a portfolio of financial assets and liabilities could choose to measure

only its interest rate risk exposure on a net basis.

The measurement exception also allows the current practice of offsetting credit and

market risks at different levels of aggregation to continue. In their respective Basis

for Conclusions, the Boards acknowledge that this approach may be required

because it is unlikely that all of the financial assets and liabilities giving rise to the

net exposure for a particular market risk will be with the same counterparty. The

example below illustrates this concept.

Illustration 1 — Calculating net exposure

Company XYZ holds a portfolio of long and short derivative positions (USD

interest rate swaps and USD/JPY foreign currency forwards) with various

counterparties as follows:

• Counterparties A, B and C: only interest rate swaps

• Counterparty D: interest rate swaps and foreign currency forwards

• Counterparties E, F and G: only foreign currency forwards

Company XYZ has executed master netting agreements with each of its

counterparties except counterparty G. In addition, the agreement in place with

counterparty D can be applied across products.

INTEREST RATE RISK FOREIGN CURRENCY RISK

COUNTERPARTY

C net short

credit exposure

(NET LONG IR EXPOSURE) (NET LONG FX EXPOSURE)

COUNTERPARTY

B net long

credit exposure

COUNTERPARTY

A net long

credit exposure

COUNTERPARTY

G short

positions

COUNTERPARTY

E net long

credit exposure

COUNTERPARTY

F net long

credit exposure

COUNTERPARTY

D net long

credit exposure

long positions

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Illustration 1 — Calculating net exposure (continued)

Using the measurement exception provided in the ASU, Company XYZ may

consider its credit risk exposure to each individual counterparty except

counterparty G on a net basis (i.e., net long credit exposure to Counterparty A,

net short credit exposure to Counterparty C, etc.).

At the same time, the company may consider its net long exposure to USD

interest rate risk from its portfolio of interest rate swaps with counterparties A,

B, C and D. The company may also consider its net long exposure to foreign

currency risk (Japanese yen risk) from its portfolio of foreign currency

derivatives with counterparties D, E, F and G.

Presentation considerations

The exception in the ASU applies only to the measurement of financial instruments.

The guidance clarifies that this exception to measure financial instruments on a net

basis does not affect financial statement presentation. That is, companies are

required to comply with the financial statement presentation requirements

specified in other Topics. (In a separate project, the Boards are considering whether

companies should be able to offset financial assets and liabilities on their balance

sheets.)

Companies may need to allocate portfolio-level adjustments for disclosure purposes

when items in the group fall into different levels of the fair value hierarchy. (Refer

to FAQ 20-12 in EY’s Financial Reporting Developments publication on fair value for

additional discussion on portfolio-level adjustments.)

Block discounts

The ASU describes a block discount (or blockage factor) as an adjustment to the

quoted price of an asset or liability because the market’s normal trading volume for

the item is not sufficient to absorb the quantity of the instrument held by the

reporting entity. The ASU clarifies that a premium or discount that reflects size as a

characteristic of a company’s holding, such as a block discount, should not be

included in any fair value measurement. Put another way, the ASU extends ASC

820’s current prohibition on block discounts for Level 1 measurements to all fair

value measurements, regardless of hierarchy level.

The Boards decided to prohibit block discounts because they believe that such an

adjustment is specific to the size of a company’s holding and its decision to transact

in a block, not a characteristic of the asset or liability itself.

How we see it The prohibition on block discounts for all fair value measurements will result in a

change in practice for companies that apply valuation adjustments based on the

size of the position they hold in a Level 2 or Level 3 instrument.

Premiums or discounts

that reflect the size of

a company’s holding —

and not of the asset or

liability being measured —

are prohibited.

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Illustration 2 highlights how practice may change based on the prohibition of

block discounts.

Illustration 2 — Block discounts

• Bank X has a large holding in a bond issue that does not trade in an active

market and thus is not classified in Level 1.

• The fair value is based on quoted prices for similar bonds that trade more

frequently, with appropriate adjustments for differences between these bonds

and the item being measured.

• Under current guidance in ASC 820, the fair value of Bank X’s bond position is

estimated to be $100 million, which incorporates an $8 million valuation

adjustment for “liquidity.”

• This adjustment historically considered both the size of Bank X’s holding

relative to market activity as well as the marketability of the instrument itself

(as shown below).

All else being equal, upon the adoption of the ASU, the fair value of Bank X’s bond

position would be $107 million (instead of $100 million). Bank X would not be able

to recognize the $7 million block discount because this adjustment is deemed to

be a characteristic that is specific to Bank X (i.e., the size of Bank X’s holding).

However, a discount for lack of marketability would still be acceptable if this

adjustment reflected a characteristic of the bond itself (i.e., if market participants

would require a similar adjustment in a transaction for an individual bond).

Other clarifications

Other premiums and discounts

The ASU indicates that companies should select inputs that are consistent with the

characteristics of an asset or liability that market participants would consider in a

transaction for that asset or liability. In certain instances, these characteristics

could result in the application of an adjustment, such as a premium or discount.

The ASU did not amend the principle in ASC 820 that instruments that trade in

active markets should generally not be adjusted from a Level 1 value based on the

quoted price of the individual instrument multiplied by the number of shares held

(i.e., P x Q). However, the ASU is less prescriptive about when premiums and

discounts (other than block discounts) may be applied.

Block discount

$7 million

Discount for lack of

marketability

$1 million

Original

valuation adjustment $8 million

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Premiums and discounts (such as control premiums or discounts for lack of

marketability) may be incorporated into a non-Level 1 fair value measurement if all

of the following conditions are met:

• The application of a premium or discount reflects the characteristics of the

asset or liability being measured.

• Market participants, acting in their “economic best interest,” would consider

these premiums and discounts when pricing the asset or liability.

• The inclusion of a premium or discount is not inconsistent with the unit of

account in the Topic that requires or permits the fair value measurement.

Unlike block discounts, which are deemed to be entity-specific, adjustments

reflecting size as a characteristic of the asset or liability being measured may be

incorporated into a fair value measurement, depending on the facts and

circumstances. For example, a control premium in valuing a controlling equity

interest in a private company (see Illustration 3) or a marketability discount in

valuing an individual financial instrument that has a large notional amount when

compared to the market norm (see Illustration 4) may be considered in certain

cases when measuring fair value.

Illustration 3 — Control premiums

An investment company (e.g., a private equity fund) acquires a controlling

interest in a private company. When measuring the fair value of its equity

interest in this portfolio company, the investment company would generally not

be precluded from considering a control premium based on the following

considerations:

• The equity investment represents a controlling interest.

• The shares of the portfolio company are not traded on an active market (i.e.,

not a Level 1 measurement).

• Market participants acting in their economic best interest would likely consider

such a premium when valuing the controlling interest.

• The inclusion of a control premium would not be inconsistent with the unit of

account guidance in ASC 946.6

Had the portfolio company’s shares been, and continued to be, publicly traded

(i.e., a Level 1 measurement), the investment company could not incorporate a

control premium in measuring fair value, consistent with existing practice.

Refer to Question 2 of Appendix B on how the ASU would apply when an

investment company holds both debt and a controlling equity interest in the

same portfolio company.

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Illustration 4 — Marketability discount

• Bank X has one outstanding OTC derivative contract with Dealer A.

• The notional amount of this contract is $1 billion, which is significantly larger

than the market norm for these types of contracts.

• Bank Y has 100 identical OTC derivative contracts outstanding with various

dealers (whose risks are not offsetting because all the contracts are assets).

• Each of the 100 contracts has a notional amount of $10 million, which is

consistent with the market norm for these types of contracts.

Although Bank X and Bank Y have virtually identical market exposures (ignoring

credit risk for simplicity), the ASU would allow Bank X to consider a discount for

lack of marketability but would preclude Bank Y from applying a similar discount.

For Bank X, the large notional amount ($1 billion) is a characteristic of the

instrument that would likely be considered by market participants when

transacting for the derivative based on its unit of account.

In contrast, the unit of account for Bank Y’s 100 derivative contracts is the

individual OTC contract (and not the block). As a result, a discount that is applied

by Bank Y based solely on the size of its holding (i.e., 100 contracts) would be

considered a block discount that cannot be considered in the fair value

measurement.

Measurement of liabilities and own equity instruments

Liabilities

The FASB originally addressed questions surrounding how to determine the fair

value of a liability in ASU 2009-05.7 That guidance indicated that using the quoted

price for an identical (or similar) liability when traded as an asset is an appropriate

way to estimate the fair value of a liability. Companies questioned whether this

approach should be applied when the corresponding asset held by another party

did not trade.

To eliminate diversity in practice, the ASU clarifies that when the quoted price for

the transfer of an identical (or similar) liability is not available and the identical item

is held by another party as an asset, a company should measure the fair value of

the liability from the perspective of a market participant that holds the instrument

as an asset. This amendment clarifies that the use of a corresponding asset to

measure a liability is not limited to instances when the corresponding asset trades.

(Refer to Question 3 in Appendix B for how the ASU applies when determining the

fair value of contingent consideration liabilities.)

OTC derivative with a notional of $1 billion

100 identical

OTC contracts each with a $10 million notional

With a few exceptions,

the requirements for

measuring the fair value

of own equity instruments

are identical to the

guidance for liabilities.

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The ASU also clarifies how to measure the fair value of a liability when the identical

instrument is not held by another party as an asset (e.g., an asset retirement

obligation). In these instances, it is likely that a present value technique will be

needed to estimate the future cash outflows that market participants would expect

to incur in fulfilling the obligation. These future outflows should capture market

participant expectations related to both the costs to fulfill the obligation and the

compensation required for taking on the obligation. The ASU indicates that the

compensation market participants would require consists of two components:

• Compensation for undertaking the activities required to fulfill the obligation

(i.e., for using resources that could have been allocated for other activities)

• A risk premium reflecting the risk that actual cash outflows may differ from the

expected cash outflows

Own equity instruments

Although ASC 820 currently applies to instruments classified in stockholders’

equity, it does not provide explicit guidance for measuring the fair value of these

types of instruments. The ASU clarifies that companies should measure the fair

value of their equity instruments consistent with the guidance for measuring

liabilities (i.e., from the perspective of a market participant who holds the identical

equity instrument as an asset, when applicable).

Principal market

The ASU reaffirms the requirement in ASC 820 that a fair value measurement

assumes the asset is sold or the liability is transferred in the principal market. The

Boards clarified that the principal market for an asset or liability should be

determined based on the market with the greatest volume and level of activity that

the company can access, not the company’s own level of activity in a specific

market. (Refer to Chapter 7 of EY’s Financial Reporting Developments publication

on fair value for additional discussion and examples illustrating this concept.)

However, the ASU also includes a rebuttable presumption that the market in which

a company normally transacts for the asset or liability is the principal market,

unless contrary evidence exists. The ASU indicates a company is not required to

undertake an exhaustive search of all possible exit markets for the asset or liability,

but cannot ignore information that is reasonably available in assessing which

market has the greatest volume and level of activity. A company would look to the

most advantageous market to measure an asset or liability only in the absence of a

principal market. (In practice, the principal and most advantageous markets are

often the same.)

Market participants

ASC 820 currently describes market participants as being independent of the

reporting entity. The ASU amends this guidance to indicate that market participants

are assumed to be independent of each other. This clarification emphasizes that a

fair value measurement assumes an orderly transaction between market

participants at the measurement date, not an orderly transaction between the

reporting entity and another market participant.

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Although this amendment makes clear that market participants are not related

parties, the ASU indicates that the price in a related party transaction may be used

as an input in a fair value measurement if a company has evidence that the

transaction was entered into at market terms.

Measurement of nonfinancial assets

The ASU eliminates the terms “in-use” and “in-exchange” in ASC 820 when

describing the valuation premise for nonfinancial assets because the Boards

believed the terms were often misunderstood and confused with other accounting

concepts. While these terms are no longer used, the concept of considering the

appropriate valuation premise for nonfinancial assets remains the same. That is,

the fair value of a nonfinancial asset considers the perspective of market

participants on the asset’s highest and best use either in combination with other

assets and liabilities or on a standalone basis.

Under the current guidance in ASC 820, the concept of an “in-use” valuation

premise is limited primarily to assets used in combination with other assets. The

ASU clarifies that in certain circumstances one might consider the highest and best

use of a nonfinancial asset in combination with other assets and liabilities. The ASU

does not provide much guidance on the types of liabilities that could be considered

complementary to a nonfinancial asset, other than citing liabilities that fund

working capital.

How we see it While the ASU formally introduces the concept of complementary liabilities

when measuring the fair value of a nonfinancial asset, we believe this

clarification was generally intended to align the guidance in ASC 820 with

current practice for measuring the fair value of certain nonfinancial assets (such

as intangible assets) where a contributory charge is taken for working capital.

We generally do not expect this clarification to result in significant changes to

the valuation of most nonfinancial assets.

For example, we continue to believe that real estate should be valued

independently from any debt used to finance the property. As a result, the fair

value of real estate may be lower than the par value of any nonrecourse debt

used to fund the real estate.

Disclosures

New Level 3 disclosures

In response to user demands for additional transparency, the ASU requires

additional disclosures for Level 3 fair value measurements. Similar to the existing

disclosure requirements in ASC 820, the ASU’s new Level 3 disclosures described

below apply to items measured at fair value on the statement of financial position

after initial recognition.

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Quantitative information about significant unobservable inputs

The ASU requires public and nonpublic companies to disclose the unobservable

inputs that are significant to the fair value measurement. That is, companies are now

required to quantitatively disclose the unobservable inputs used in their Level 3

measurements. Importantly, this requirement applies to all Level 3 measurements

and not just those assets and liabilities measured at fair value on a recurring basis.

For example, a company with asset-backed securities classified in Level 3 would

generally disclose the inputs used in its valuation models related to prepayment

speed, probability of default and loss given default (assuming these inputs were all

unobservable and deemed to be significant to the valuation). Consistent with all of

the disclosures in ASC 820, companies are required to present this information

separately for each class of asset and or liability based on the nature,

characteristics and risks of their Level 3 measurements. As such, we expect that

companies will likely disclose both the range and weighted average of the

unobservable inputs used across a particular class of Level 3 assets or liabilities.

There is one exception to this disclosure requirement: investments in investment

companies whose fair value is estimated using unadjusted net asset value (NAV) as

a practical expedient. The FASB provided this exception because it agreed with

constituents who pointed out that the classification of these instruments in Level 3

is based on the ability of the reporting entity to redeem its investment, not on the

observability of the inputs used to determine NAV.

The ASU addresses situations when significant unobservable inputs are not

developed by the company in measuring fair value, such as when a company uses

third-party pricing information without adjustment. In these instances, the ASU

states that a company is not required to create quantitative information to comply

with this disclosure requirement. However, when making these disclosures,

companies cannot ignore information about significant unobservable inputs that is

“reasonably available.”

We would expect significant unobservable inputs to be reasonably available when a

third-party valuation expert is engaged to help a company determine the fair value

of its assets. In these instances, the company would likely receive a valuation report

that summarizes the techniques and assumptions the valuation specialist used. In

some cases, company management may actually provide the specialist with the key

assumptions to be used in the valuation.

In contrast, when a company receives price quotes or other valuation information

from a third-party pricing service or broker, the specific unobservable inputs

underlying this information may not be reasonably available to the company.

Companies should begin talking to their service providers about the types of

information these service providers can provide to meet this disclosure requirement.

In addition, any adjustments made by a company to the pricing data received from

a third-party should be disclosed if these adjustments are not based on observable

market data and are deemed to be significant to the overall measurement.

Companies with

significant Level 3

measurements may find

the new disclosure

requirements challenging.

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How we see it Companies with significant Level 3 measurements may find the new disclosure

requirements to be operationally challenging. Capturing and disclosing

information at a level of disaggregation that is both meaningful and practical will

require judgment and may be difficult.

Companies should make reasonable efforts to obtain the information needed to

meet this disclosure requirement. Determining whether information is

“reasonably available” will require judgment, and there may be some diversity in

practice stemming from differences in companies’ access to information and

information vendors may be willing or able to provide.

Valuation processes

Public and private companies will also be required to describe the valuation

processes they have in place for all Level 3 measurements. The new disclosure

requirement is consistent with disclosures recommended by the IASB’s Expert

Advisory Panel in its October 2008 report, Measuring and Disclosing the Fair Value

of Financial Instruments in Markets that are No Longer Active, except that the ASU’s

requirement applies to all Level 3 measurements (both recurring and nonrecurring).

The ASU provides the following examples of information companies might provide

to comply with this disclosure requirement:

• A description of the group responsible for valuation policies and procedures, to

whom the group reports and the types of internal reporting procedures in place

(e.g., interaction between the group and risk management or the audit

committee to assess fair value measurements)

• A description of the frequency and methods for calibration, back testing and

other testing procedures used to evaluate pricing models

• A description of the process for analyzing changes in fair value measurements

from period to period

• A description of the methods used to evaluate pricing information provided by

third-party brokers or pricing services

• A description of the methods used to develop and substantiate the

unobservable inputs used in a fair value measurement

Sensitivity to changes in unobservable inputs

The ASU also requires public companies to provide narrative descriptions of the

sensitivity of their recurring Level 3 fair value measurements to changes in the

unobservable inputs used, if changing those inputs would significantly affect the fair

value measurement. Public companies should also describe any interrelationships

between these inputs and discuss how they might magnify or mitigate the effect of

changes to the unobservable inputs on the fair value measurement.

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14 16 June 2011 Technical Line Fair value measurement A closer look at the converged guidance

This disclosure, combined with the quantitative disclosure of significant unobservable

inputs, is designed to permit financial statement users to understand the directional

effect of certain inputs on an item’s fair value and to evaluate whether the company’s

views about individual unobservable inputs differ from their own. The Boards believe

these disclosures can provide meaningful information to users who are not familiar

with the pricing models and valuation techniques used to measure a particular class

of assets or liabilities (e.g., complex structured instruments).

How we see it The illustrative example of a narrative sensitivity analysis provided in the ASU is

fairly general in nature, particularly because no numbers relating to how the

unobservable inputs might be changed, or how such a change would affect fair

value, are required to be disclosed. However, companies should avoid over-

generalizations that may not hold true in all cases.

Proposed measurement uncertainty disclosures for Level 3 measurements

The Boards had proposed a “measurement uncertainty disclosure” that would have

required companies to quantify and present the range of Level 3 values that would

have resulted from using other reasonable unobservable inputs (if significantly

different from the determined fair value). While similar to the quantitative

sensitivity analysis required under IFRS 78 for Level 3 financial instruments, the

proposal would have added the complexity of requiring any interrelationships

between unobservable inputs to be considered in the analysis.

Based on constituent feedback, the Boards decided to defer a final decision on

whether to require these disclosures pending the outcome of additional field-testing

and outreach. It is currently unclear when the Boards will reconsider this proposal.

How we see it We agree with the Boards’ decision to conduct more field tests before deciding

whether to require the disclosure of the effect of using other reasonable

unobservable inputs on Level 3 measurements. This work will help the Boards

better understand the costs associated with making these disclosures.

Other new disclosures

In addition to expanding the disclosures for Level 3 measurements, the ASU

requires the following new disclosures:

• Any (not just significant) transfers between Level 1 and Level 2 of the fair value

hierarchy (only for public companies)

• The hierarchy classification for assets and liabilities whose fair value is

disclosed only in the footnotes, such as loans carried at amortized cost whose

fair values are required to be disclosed in accordance with ASC 825 (only for

public companies)

• The reason nonfinancial assets measured at fair value are being used in a

manner that differs from their highest and best use

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Private companies are exempt from the first two requirements above. Upon the

adoption of ASU 2011-04, they will no longer be required to disclose any

information on transfers between Level 1 and Level 2 of the fair value hierarchy.

Under current guidance, public and private companies are required to disclose

significant transfers between these levels.

How we see it The requirement to disclose all transfers between Level 1 and Level 2 may pose

data-capture issues for some public companies. This amendment will be more

challenging to implement for public companies that do not have systems

designed to capture all transfers, but instead manually identify only those

transfers deemed to be significant.

Effective date and transition

Effective date

The ASU is effective for public companies in interim and annual periods beginning

after 15 December 2011. For example, public companies with fiscal years ending

on 31 December 2011 would apply the amendments as of 1 January 2012.

However, a public company whose fiscal year ends on 31 October 2011 would

apply the amendments during the second quarter of its fiscal year (i.e., the quarter

ending 30 April 2012) since this is the first interim period beginning after

15 December 2011.

For nonpublic companies, the ASU is effective for annual periods beginning after 15

December 2011 (i.e., year-end 2012 for calendar-year nonpublic companies).

Unlike public companies, nonpublic companies may elect to early adopt the ASU.

Transition

All of the amendments in the ASU are applied prospectively. That is, any fair value

measurement difference resulting from the adoption of the ASU will be recognized

in income in the period of adoption. The new disclosures in the ASU are required

only for periods beginning after the effective date. Companies are not required to

provide comparative disclosures for periods prior to the effective date.

In addition, in the period of adoption, companies are required to disclose changes in

valuation techniques and inputs resulting from applying the ASU and quantify the

total effect of these changes, if practicable.

Remaining differences between US GAAP and IFRS While the amendments converge most of the fair value measurement requirements,

certain key differences remain between US GAAP and IFRS.

Practical expedient for alternative investments

ASC 820 provides a practical expedient to measure the fair value of certain

investments in investment companies (e.g., investments in hedge funds or

private equity funds that do not have readily determinable fair values) using NAV

or its equivalent.

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The IASB decided not to provide a similar practical expedient in IFRS 13. IFRS does

not currently have accounting requirements that are specific to investment

companies and therefore the IASB believed it would be difficult to identify when

such a practical expedient would be applied, given the different practices

companies across the world use to calculate NAV.

This difference may be addressed as part of the IASB’s project on Investment

Entities.

Recognition of day-one gains and losses

IFRS continues to restrict the recognition of day-one gains and losses when fair

value is determined using unobservable inputs. Although fair value is defined as an

exit price (which can differ from an entry price), IFRS 13 defers to other IFRSs (such

as IAS 399) on whether to recognize any difference between fair value and

transaction price at initial recognition.

US GAAP contains no specific requirements regarding the observability of fair value

inputs, thereby allowing for the recognition of day-one gains or losses even when

the fair value measurement is based on significant unobservable inputs (i.e., a Level

3 measurement).

Fair value of liabilities with a demand feature

The guidance in IFRS on the fair value measurement of a financial liability with a

demand feature differs slightly from US GAAP. IFRS 13 states that the fair value of a

liability with a demand feature cannot be less than the present value of the amount

payable on demand. Under US GAAP, the fair value of a liability with a demand

feature is described as the amount payable on demand at the reporting date.

Disclosures

Quantitative sensitivity analysis disclosures for Level 3 financial instruments

IFRS currently requires a quantitative sensitivity analysis disclosure for Level 3

financial instruments. That is, if different inputs could have reasonably been used in

place of one or more of the unobservable inputs used to estimate fair value (and

those inputs would have significantly changed the fair value measurement), IFRS 7

requires companies to state that fact, disclose the effect on their fair value

measurements and describe how they calculated those effects.

No similar disclosure is currently required under US GAAP. However, as described

previously, the Boards will revisit whether to require a measurement uncertainty

disclosure, which includes a quantitative sensitivity analysis (similar to those

currently required under IFRS 7) that considers the interrelationships between the

unobservable inputs.

Other Level 3 disclosures

IFRS generally does not allow for derivative assets and liabilities to be presented on

a net basis. As such, amounts disclosed for fair value measurements categorized in

Level 3 might differ between US GAAP and IFRS (e.g., Level 3 rollforward).

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Nonpublic company disclosures

IFRS does not provide disclosure exemptions for nonpublic companies similar to

those included in ASU 2011-04. However, certain nonpublic companies reporting

under IFRS for Small and Medium-sized Entities are subject to less-stringent

presentation and disclosure requirements. As a result, nonpublic companies may be

subject to different disclosure requirements under US GAAP and IFRS.

Endnotes: __________________________

1 Accounting Standards Update 2011-04, Amendments to Achieve Common Fair Value Measurement

and Disclosure Requirements in U.S. GAAP and IFRSs (the ASU), and International Financial Reporting Standard (IFRS) 13, Fair Value Measurement

2 Accounting Standards Codification (ASC) Topic 820, Fair Value Measurement 3 FASB Statement No. 157, Fair Value Measurements 4 ASC Topic 815, Derivatives and Hedging 5 ASC Topic 825, Financial Instruments 6 ASC Topic 946, Financial Services — Investment Companies 7 Accounting Standards Update 2009-05, Measuring Liabilities at Fair Value

8 IFRS 7, Financial Instruments: Disclosures 9 International Accounting Standard 39, Financial Instruments: Recognition and Measurement

Ernst & Young

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All Rights Reserved.

SCORE No. BB2147

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18 16 June 2011 Technical Line Fair value measurement A closer look at the converged guidance

Appendix A: Summary of significant amendments to ASC 820

Current US GAAP ASU 2011-04

Measurement of

financial instruments

Concepts of "highest and best use" and

valuation premise may be applied to

financial instruments

"Highest and best use" and valuation

premise concepts no longer apply, but

financial instruments with offsetting risks

may be valued using a measurement

exception if certain criteria are met

Block discounts Prohibited for Level 1 fair value

measurements

Prohibited for all fair value measurements,

regardless of hierarchy level

Other premiums and

discounts No explicit guidance in ASC 820

Generally applicable when market

participants would consider them when

transacting for the asset or liability and

when not inconsistent with unit of account

Measurement of

liabilities

Use the quoted price of an identical (or

similar) liability when traded as an asset

Use inputs consistent with the valuation of

an identical liability when held by another

party as an asset

Measurement of own

equity instruments No explicit guidance in ASC 820

Use inputs consistent with the valuation of

an identical instrument when held by

another party as an asset

Principal market Unclear whether market-based or entity-

specific volume drove determination

Market with the greatest volume and level

of activity for the asset or liability that the

company can access (presumed to be

where the company normally transacts)

Market participants Described as being independent of the

reporting entity

Described as being independent of

each other

Valuation premise for

nonfinancial assets

"In-use" and "in-exchange" are used to

describe valuation premise

"In combination with other assets and (or)

liabilties" and "on a standalone basis" are

used to describe valuation premise

Level 3

measurements

Description of valuation techniques and

inputs used

Quantitative disclosure of significant

unobservable inputs used and other

additional disclosures (e.g., qualitative

sensitivity analysis, valuation processes)

Transfers between

Level 1 and Level 2

Significant transfers between Level 1 and

Level 2 of the fair value hierarchy

Public companies: All transfers between

Levels 1 and 2 of the fair value hierarchy

Nonpublic companies: Transfers between

Level 1 and Level 2 no longer required

Nonfinancial asset

used differently from

highest and best use

Not required

Disclose reasons why the current use of a

nonfinancial asset differs from its highest

and best use

Hierarchy

classification for

items not presented

on the balance sheet

Not required

Hierarchy classification is required for

assets and liabilities whose fair value is

disclosed only in the footnotes (only public

companies)

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19 16 June 2011 Technical Line Fair value measurement A closer look at the converged guidance

Appendix B: Questions and interpretive responses This section provides questions and interpretive responses to issues companies may encounter when

applying or considering the effects of the new fair value guidance.

Financial instruments

Question 1 May Level 1 instruments be included in a portfolio of financial instruments with

offsetting risks when calculating the net exposure to a particular market risk?

We believe Level 1 instruments may be included when using the exception to value

financial instruments with offsetting risks. As noted in the example provided in ASC

820-10-35-18K, a reporting entity is allowed to consider the effect of holding

futures contracts when evaluating its net exposure to a particular market risk, such

as interest rate risk. While Level 1 instruments such as futures contracts may be

considered when calculating a company’s net exposure to a particular market risk,

we believe the quoted price (unadjusted) for these Level 1 instruments should be

used when allocating the fair value to the individual units of account for

presentation and disclosure purposes, in order to comply with the requirement in

ASC 820 that Level 1 instruments be measured at P x Q.

For example, consider a company that is long a forward to sell 100,000 bushels of

corn for $250,000 in one year. To hedge its position, the company “sells” 20 corn

futures contracts with a one-year maturity at $2.30 per 5,000 bushels on the

Chicago Mercantile Exchange (CME). (This example assumes that the forward and

futures contracts are deemed to be derivative instruments in accordance with ASC

815 and meet the ASU’s measurement exception criteria.)

In this example, the company may calculate a bid-ask adjustment based on its

$20,000 net long position. The futures contracts would be recorded using the

quoted price on the exchange.

Premiums and discounts

Question 2 May investment companies (such as private equity and hedge funds) value debt

and a controlling equity interest in a portfolio company held in the same fund

based on enterprise value?

In some cases, an investment company holds debt (with a provision that requires

the debt to be repaid at par upon a change in control) and a controlling equity

investment in the same portfolio company. Consider the following example:

Enterprise value = $ 1,600 (controlling basis)

Par value of debt = $ 400 (with a change in control provision)

Fair value of debt = $ 300

Forward (long): $250,000

Futures (short): $2.30 x 5,000 x 20 contracts = ($230,000)

Net position (long): $20,000

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Under current practice, both the debt and controlling equity interest are assumed

to be sold to the same market participant in the mergers and acquisitions (M&A)

market. This hypothetical sale in the M&A market would generally result in the fair

value of the debt and controlling equity investment to be equivalent to enterprise

value as illustrated below.

We believe the ASU would not change current practice as this approach reflects the

characteristics of the items being measured. In addition, market participants would

transact in this manner, consistent with their economic best interest.

Contingent consideration

Question 3 Will the ASU affect the way acquirers value contingent consideration that is

recognized as a liability in a business combination?

Prior to ASU 2011-04, constituents held different views as to whether ASC 820

allowed an entity to value a contingent consideration liability based on the fair value

of the contingent consideration as an asset, because this asset is generally not

traded. (ASC 805, Business Combinations, requires contingent consideration to be

recognized and measured at fair value as part of the purchase consideration for the

acquired business.)

Some constituents believed that the fair value of a contingent consideration liability

should not be considered from the perspective of another party holding the

corresponding asset. These constituents argued that risk-averse market

participants would require a risk premium to assume this obligation, similar to an

asset retirement obligation (ARO), given the uncertainty associated with the future

payout on the liability. Due to the absence of a “market” for the asset, they argued

that another party who assumes the liability cannot hedge the uncertainty risk and

would therefore demand additional compensation (i.e., risk premium) that would

cause the fair value of the liability to exceed the fair value of the corresponding

asset. As a result, these constituents believed that the fair value of contingent

consideration would be different between the liability holder and the asset holder.

In contrast, other constituents believed that the fair value of a contingent

consideration liability should equal its fair value when held as an asset. These

constituents pointed to existing guidance in ASC 820 that allows an entity to

consider a corresponding asset when valuing a liability whose price is not

observable. They noted that the other view is inconsistent with the exit price

concept in ASC 820, which they believe assumes an efficient and competitive

market where the fundamental principle of “no arbitrage” holds. Further, these

constituents argued that the hypothetical market construct in ASC 820 applies to

contingent consideration and would provide symmetry between the fair value of

contingent consideration as a liability or as an asset.

The Valuation Resource Group (VRG) discussed this issue at its November 2010

meeting and concurred with the second view. The VRG, however, clarified that such

an approach would not apply to liabilities that do not have a corresponding asset

Fair value of debt = $ 400 (par value due to change in control)

Fair value of controlling equity = enterprise value — par value of debt

= $ 1,200 ($1,600 — $400)

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such as AROs. For these liabilities, a risk premium should be incorporated,

increasing the fair value of the obligation.

The amended guidance in ASU 2011-04 reaffirms the VRG’s view by clarifying that,

absent a quoted price, the fair value of a liability should be considered from the

perspective of another party holding the identical instrument as an asset, even

when the asset is not traded. Consistent with the “no arbitrage” premise of the

second view, the Boards further explain in their respective Basis for Conclusions

that “the fair value of a liability equals the fair value of a properly defined

corresponding asset (that is, an asset whose features mirror those of the liability),

assuming an exit from both positions in the same market.”