Fair Value Measurements

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Fair Value Measurements

• Application of Statement 157

Presenters Mitch Fane Ernst and Young
LLP Deborah Sobczak Ernst and Young LLP
2
SFAS 157 Landscape

• Key SFAS 157 Objectives
• Increase consistency and comparability in fair
  value measurements
• Improve transparency in financial reporting by
  expanding disclosures about fair value
  measurements
• Allow users to assess the relative reliability of
  FV measurements and the impact on earnings of
  Level 3 (i.e. unobservable) measurements
• Broad Impact on Industry Practices
• Principles based Statement - differences may
  exist in how entities interpret and implement
• Singular definition of fair value across all
  in-scope assets/liabilities has lead to
  difficulties in application (e.g. same
  definition for assets acquired in a business
  combination and for derivative assets/liabilities)
  
• Expanded disclosures requires significant
  operational changes

3
Fair value of liabilities
Nonperformance risk refers to the risk that the
obligation will not be fulfilled and affects the
value at which the liability is transferred.
Therefore the fair value of the liability shall
reflect the nonperformance risk relating to that
liability (Statement 157 paragraph 15).

• Although FAS 157 explicitly addresses only
  nonperformance risk consideration of
  counterparty credit risk is implicit in the fair
  value framework.
• Concept is not limited to changes in credit
  ratings fair values are affected by movements in
  credit spreads
• Many entities have struggled with the calculation
  of both counterparty credit and own credit
• Most recognize the US GAAP requirement but may
  challenge the materiality to the extent their
  company only trades with highly rated
  counterparties.
• What do the markets say

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Dealer credit default spreads 30 September 2004
5
Dealer credit default spreads 31 March 2008
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Dealer credit default spreads 30 June 2008
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Dealer credit default swap spreads (one year
spot) 30 April 2007 to 30 June 2008
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Fair value of liabilities

• The concept of nonperformance risk will primarily
  affect derivative transactions liabilities
  measured under the fair value option and FAS 107
  disclosures.
• Diversity in methods and approaches to
  quantifying credit risk exists particularly as
  it pertains to derivatives.
• Exposures vs. cash flows
• Current exposure vs. expected future exposure
• Gross cash flows vs. net cash flows
• Bilateral exposure vs. unilateral exposure
• Term structure of credit vs. constant credit
  spreads
• Market-implied inputs vs. historical-based inputs

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Assessment of nonperformance risk

• Expectations about credit valuation adjustments
  are based on several factors
• Credit enhancements
• Collateral-posting thresholds
• Master netting agreements
• Guarantees
• Market indications about credit risk
• Availability of information about market-implied
  credit spreads
• Credit derivatives bond trading or recently
  issued debt
• Exposure analysis by counterparty
• Consideration of the liability profile
• Type of instrument (such as debt derivative or
  warrant)
• Instrument terms (such as maturity date or
  notional)
• Attributes of the obligation (such as recourse
  priority of claim secured or unsecured)

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SFAS 157 Fair Value Hierarchy and Disclosures

• To the extent inputs are obtained from third
  parties (e.g. pricing services consensus
  pricing broker quotes etc.) management must
  understand and evaluate assumptions used to
  derive marks
• Evaluate if mark is an exit price compliant with
  SFAS 157
• Evaluate observability in light of the fair value
  hierarchy (e.g. consideration of NYMEX Clearport
  swaps ICE trades broker quotes etc.)
• Obtaining information regarding valuation
  methodologies has been a challenge for entities
  but continues to evolve

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SFAS 157 Fair Value Hierarchy and Disclosures

• Tagging of inputs into fair value hierarchy
  levels is a dynamic process
• Classification needs to be monitored on an
  ongoing basis as assets and liabilities move
  within the hierarchy
• Ex A long-dated derivative contract may move
  from Level 3 to Level 2 as the time to maturity
  shortens
• Ex A RMBS may move from Level 2 to Level 3 with
  a change in market liquidity
• Many entities have found they need to make
  simplifying assumptions in aggregating disclosure
  data due to system and reporting limitations
• Ex Assumptions about transfers in/out of Level 3
• Ex Assumptions about realized/unrealized Level 3
  PL
• Ex Considerations between quarter-to-date vs.
  year-to-date reconciliations (i.e. which
  reconciliations to include sum of the quarters
  vs. year-to-date)

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Observations from disclosures to date

• Few fair value option disclosures
• Accounting policy elections not robust
• E.g. transfers in/out of Level 3 unrealized
  gains and losses
• Discussion of valuation techniques for Level 3
  assets and liabilities limited
• Diversity in practice
• Classification in fair value hierarchy for
  similar instruments
• Level of detail provided on asset classes
• Similar items appear to be in different levels of
  the fair value hierarchy
• Inclusion and discussion of nonperformance risk
• Discussion in MDA or critical accounting
  policies
• See Appendix for a sample of Energy industry
  disclosures

13
SFAS 157 Market Perceptions

• Market understanding of Level 3 continues to
  evolve some still perceive Level 3 as
  mark-to-magic or mark-to-make-believe
• Recent popular press articles have partly blamed
  fair value measurements and SFAS 157 for current
  market illiquidity
• SEC Letter recommends additional disclosures
  around unobservable assets/liabilities

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Where are we now

• Effective for two quarters but processes
  continue to evolve
• Many are still in the process of designing and
  finalizing SOX controls
• Controls to ensure that accounting policies over
  determination of exit price are appropriately
  implemented
• Reconciliations between source systems and
  systems used to generate FAS 157 disclosures
• Controls around analyses/due diligence over
  levels of assets and liabilities
• Reviews for potential changes in liquidity (i.e.
  assigning levels is a dynamic process that
  requires controls)
• Controls over the generation of the Level 3
  rollforward
• Information technology general controls (i.e.
  logical security and change management) over FAS
  157 systems
• Some entities may have used a manual process for
  Q1 and Q2 but are exploring ways to automate and
  create a living process
• Companies who elected the FSP 157-2 deferral for
  non-recurring and non-financial assets and
  liabilities are preparing for January 1 2008
  adoption

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Recent standard-setter activities

• Pending guidance
• FSP 132(R)-a disclosures related to
  postretirement plan assets
• FSP 157-c measuring liabilities
• EITF 08-5 unit of account for guaranteed debt
• EITF 08-7 defensive intangibles
• SEC activities
• SEC roundtable
• Critical accounting policies
• Sensitivity analysis
• SEC staffs Dear CFO letter
• Comment letter activities
• Potential FR-61 revisions
• Professional Accounting Fellow focused on
  valuation matters at FASB and SEC
• Valuation resource group

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Appendix
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Q2 Industry Trends
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Q2 Industry Trends
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Q2 Industry Trends
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Q2 Industry Trends
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Q2 Industry Trends
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Percentage of assets and liabilities by Level -
Q1 vs. Q2
Q1 Q2 Q1 Q2
Assets Liabilities
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Fair value hierarchy classification for assets
Q2
Derivative assets
Compensation benefits investments
Investments
Other assets
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Fair value hierarchy classification for
liabilities Q2
Derivative liabilities
Compensation benefits obligations

Other liabilities
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Fair value hierarchy classification for net
derivatives Q2 2008
Some entities disclose net derivative assets
(liabilities) while others separately present
derivative assets and liabilities. This graph
presents the positions on a net basis for all
entities for all types of instruments.