Presentation on theme: "Fair Value Accounting & The Current Economic Crisis Michael D. Barrett Energy Risk Advisory May 4, 2008."— Presentation transcript:
Fair Value Accounting & The Current Economic Crisis Michael D. Barrett Energy Risk Advisory May 4, 2008
Page 2 Disclaimer Internal and External sources were used in the preparation of this presentation. The views expressed herein are not necessarily the official views of Ernst & Young and are presented for discussion purposes only.
Page 3 Agenda ► Market Opinions ► Overview of Fair Value Accounting ► Market Impacts ► FAS 71
Page 5 ► William Isaac, FDIC chairman from 1978 to 1985 and now the chairman of a consulting firm that advises banks, told the SEC that mark-to- market accounting rules caused the current financial meltdown: ► "I gotta tell you that I can't come up with any other answer than that the accounting system is destroying too much capital, and therefore diminishing bank lending capacity by some $5 trillion." ► “The devastation that followed stemmed largely from the tendency of accounting standards-setters and regulators to force banks, by means of their litigation-shy auditors, to mark their illiquid assets down to ‘unrealistic fire-sale prices’." ► “A survey conducted by Grant Thornton LLP and Bank Director magazine found that underwriting and a ‘political emphasis on increasing home ownership,’ as well as a ‘lack of oversight of the mortgage industry’ were cited as the top three causes for the current credit crisis… Notably, only 15 percent of bankers selected the much- maligned fair value accounting standard as one of their three top choices as the main cause of the credit crisis.” Market’s Opinions
Page 6 ► Lynn Turner, former SEC Chief Accountant: “Despite political pressure to do so, Congress might be best advised to stay away from mandating changes in accounting principles like FASB Statement No Arguably, had the banks been following this standard — or if investors had understood it and used it to their advantage — we would not be facing such a crisis today.” ► “Current application of the IFRS standards on fair value accounting was not in fact the cause of the current financial crisis and economic slowdown, but was a factor in its occurrence and intensified its impact, due in part to a lack of understanding by market participants. This is the basic message of a joint study conducted by Sal. Oppenheim Jr. & Cie. and Prof. Dr. Bernhard Pellens, chair of International Accounting at the Ruhr University in Bochum (and member of the Executive Board of the German Accounting Standards Committee - Deutsche Rechnungslegungs Standards Committee (DRSC)).” Market’s Opinions
Page 7 ► Mortgage Banker’s Association: “FASB should provide additional guidance that expands the list of “symptoms” of an inactive market to include 1) significant widening of “bid-ask” spreads, 2) significant reduction from the normal number of transactions in a market, and 3) trades occurring primarily by sellers who are financially troubled. In the longer term, FASB and the SEC should consider a strategic reevaluation of the entire fair value project.” ► SEC: “The SEC… notes that investors generally believe fair value accounting provides meaningful and transparent financial information, although certain improvements are desirable. The report recommends against the suspension of fair value accounting standards.” ► Beth Brooke, global vice chair at Ernst & Young LLP: “Suspending mark-to-market accounting, in essence, suspends reality” Market’s Opinions
Page 8 ► William Black, former deputy director of the Federal Home Loan Bank Board: The “…decision to relax the [Fair Value] rule is an attempt to ‘cover up’ the extent of the financial problems facing lenders.” ► “Good decision,” Citigroup Chairman Richard Parsons said of FASB’s move to relax the Fair Value rule for financial firms. “The market for mortgages and other assets was not working, so something had to change”. Citigroup as well as Wells Fargo representatives have said that Fair Value rules “…don’t work when markets are inactive.” ► Group of North American Insurance Enterprises (GNAIE): “The application of fair value accounting measurements to an inactive, illiquid, and disorderly market for structured credit products helped fuel the worldwide credit crisis, an organization of major insurers and reinsurers told the U.S. Financial Accounting Standards Board (FASB).” Market’s Opinions
Fair Value Accounting
Page 10 ► Fair value accounting, also called “mark-to-market,” is a way to measure assets and liabilities that appear on a company’s balance sheet and record changes in value of those asset and liabilities in the income statement ► FAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit value) ► Used for assets whose carrying value is based on mark-to-market valuations; for assets carried at historical cost, the fair value measurement is not used What is Fair Value Accounting?
Page 11 ► Huge losses reported by financial firms on subprime assets have led to a debate over the implementation of SFAS 157 in circumstances where markets collapse and price inputs aren’t readily available ► In the current crisis, banks and investment banks have had to reduce the value of the mortgages and mortgage-backed securities to reflect current prices. Those prices declined severely with the collapse of credit markets as mortgage defaults escalated Why is Fair Value Accounting important today?
Page 12 ► Establishes the definition of a derivative for financial reporting purposes as well as accounting and reporting standards for derivative instruments ► Requires companies to recognize all derivative assets and liabilities in the statement of financial position (Balance Sheet) ► Requires companies to recognize the change in the fair value of derivative position as unrealized gains and losses in the financial statements (Income Statement) ► Special accounting provided for derivatives that qualify as: ► Normal Purchases\Normal Sales ► Fair Value Hedges ► Cash Flow Hedges ► Net Investment Hedges FAS 133
Page 13 ► Normal Purchase/Normal Sale (“NPNS”) ► NPNS transactions are contracts that provide for the purchase of sale of something other than a financial instrument or a derivative instrument that will be delivered in quantities expected to be used or sold by the reporting entity over a reasonable period in the normal course of business ► Cannot net settle ► Elective, but once the election is made the contract cannot be designated by choice ► NPNS election allows companies to account for transactions on an “accrual basis”; impacting the financial statements only when the transaction settles or is realized. (i.e. opt out of fair value accounting) ► However, NPNS has significant limitations FAS 133
Page 14 ► Hedge Accounting ► Limits the impact that changes the fair value of derivatives have on the income statement, by either ► Reserving the change in fair value from unrealized gain/loss (I/S) against Other Compressive Income (B/S) for cash flow hedges ► Recognizing the offsetting change in fair value in unrealized gain/loss for fair value hedges ► Used when companies desire reduced earnings volatility ► Better reflects the economic characteristics of transactions that have “locked-in” margins (hedge accounting) ► Cash Flow Hedge ► A derivative instrument that hedges the exposure to variability in the expected future cash flows that is attributable to a particular risk ► Elective - can be designated by choice and for cause FAS 133
Page 15 ► Fair Value Hedge ► A derivative instrument that hedges the exposure to change in the fair value of an asset or a liability or an identified portion thereof ► Elective - can be designated by choice and for cause ► Net Investment Hedges ► Foreign currency derivative instruments or foreign currency dominated non-derivatives that hedge the foreign currency risk of a net investment in a foreign operations ► Elective - can be designated by choice and for cause FAS 133
Page 16 ► FAS 157 broadly applies to financial and nonfinancial assets and liabilities measured at fair value under other authoritative accounting pronouncements ► Absence of one single consistent framework for applying fair value measurements and developing a reliable estimate of a fair value in the absence of quoted prices has created inconsistencies and incomparability ► FAS 157 emphasizes the use of market inputs in valuing an asset or liability such as quoted prices, interest rates, yield curve, credit data, etc. ► Fair value is, by definition, derived from a current transaction which happens in an active market with knowledgeable and unrelated parties FAS 157
Page 17 ► When fair value is not available due to the lack of an actual transaction, it is logical to use information from an active market ► The basis of the framework centers on a fair value hierarchy which indicates reliability of inputs used to estimate fair value ► SFAS 157 provides a hierarchy of three levels of input data for determining the fair value of an asset or liability FAS 157
Page 18 ► Level 1 is quoted prices for identical items in active, liquid and visible markets such as stock exchanges ► Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date ► An active market for the asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis ► A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available FAS 157
Page 19 ► Level 2 is observable information for similar items in active or inactive markets, such as two similarly situated buildings in a downtown real estate market ► Inputs are other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly ► If the asset or liability has a specified (contractual) term, a Level 2 input must be observable for substantially the full term of the asset or liability FAS 157
Page 20 ► Level 3 are unobservable inputs to be used in situations where markets don’t exist or are illiquid such as the present credit crisis ► At this point fair market valuation becomes highly subjective ► Unobservable inputs should be used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date ► However, the fair value measurement objective should remain the same; that is, an exit price from the perspective of a market participant that holds the asset or owes the liability ► In developing unobservable inputs, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions ► The reporting entity's own data used to develop unobservable inputs should be adjusted if information is reasonably available without undue cost and effort that indicates that market participants would use different assumptions FAS 157
Page 22 ► Main difference between fair value accounting and accrual accounting under U.S. GAAP accounting lies in the treatment of cash gains and losses on transaction and unrealized gains an losses due to market movements (i.e. asset/liability mismatches) ► Fair value accounting would report all gains and losses on both assets and liabilities in the period in which they arise ► Accrual accounting, on the other hand, recognizes gains and losses over the life of the block of business (or at the time of a transaction) ► When net gains and losses on assets and liabilities are immaterial, the pattern of earnings under both systems can be quite similar ► However, if a company is generating significant gains or losses on its net book of business (such as in the case of an asset/liability mismatch), fair value accounting will reveal this much sooner than Accrual Accounting General Impacts
Page 23 ► The credit portfolio includes financial instruments held on the balance sheet that, while securitized, may be held until their maturity and which may likely generate yields over time as a result of the difference between the cost of financing and the amounts charged to customers ► In such cases the factor determining the return is whether or not payments are made and the historical cost method provides reliable information about whether these payments are being made as agreed or not ► Against this, the fair value method gets away from the process of generation of returns and cash flows, offering a result that has more to do with the opportunity cost than the essence of buy and hold strategy. ► Obviously, the fair value of assets fluctuates over their lifetime, but if they are not going to be sold or redeemed early, registering these variations in the profit and loss account distorts the profits and introduces a fictitious volatility Impact to Financial Markets Mortgage Back Securities – Buy and Hold View
Page 24 ► When the full impact of its actions (including gains and losses) is reported in the current period, management is in a better position to understand how the value of the company is changing and adjust its decisions accordingly ► This is one of the main reasons for moving to a fair value system and is expected to be a major benefit if fair value accounting is ultimately adopted ► FASB’s decision to ease what are known as mark-to-market requirements for financial firms has raised concerns among some financial experts who warn that it will become harder for banks and investors to agree on what the troubled assets are actually worth and thus discourage their sale Impact to Financial Markets Mortgage Back Securities – Trading View
Page 25 Impacts on Utilities ► Many of the transactions executed on a daily basis to acquire electricity, serve the retail load, and sell excess generation require evaluation for fair value treatment. ► Additional products used to manage operations and logistics, such as capacity and FTR’s, also required evaluation. ► Any speculative or asset optimization strategies often require fair value treatment, with the affects impacting the financial statement in the current period.
Page 26 Sample Energy Industry Application of FAS 133 Instrument TypeComplexity (H, M, L) Derivative Assessment Consideration NPNS ConsiderationsCash Flow/Fair Value Hedge Considerations Swaps, Forward and Simple Purchased Options LowTypically meet the definition of a derivative Not typically considered normal due to net settlement characteristics Often used as a hedging instrument subject to the effectiveness between the financial settlement and the physical underlying Written OptionsLowTypically meet the definition of a derivative Not typically considered normal due to net settlement characteristics FAS 133 generally excludes written options as a potential hedging instrument Complex Options (Spark Spread, ATO) MediumTypically meet the definition of a derivative. Not typically considered normal due to net settlement characteristics Often used as a hedging instrument subject to the effectiveness between the financial settlement and the physical underlying Physical Block PowerMediumTypically meet the definition of a derivative May often be designated normal purchase or normal sale May be used as a hedging instrument subject to the effectiveness Load FollowingHighDefinition of a derivative is contingent on the quantification of a notional volume May often be designated normal purchase or normal sale Typically seen as the underlying in a cash flow hedge Unit Contingent, Tolling Agreements HighRequire an evaluation for Fin 46R or Lease Accounting prior to derivative evaluation May often be designated normal purchase or normal sale Typically seen as the underlying in a cash flow hedge FTRs/CapacityHighCould meet the definition of a derivative given the company’s assessment of market liquidity Not typically considered normal due to net settlement characteristics. While generally used as an economic hedge companies are having difficulty performing an effectiveness assessment Power Portfolio – Sample Illustration of Energy Industry Application of FAS 133 to typical power portfolio Sample Power Portfolio
Page 27 Sample Energy Industry Application of FAS 133 Instrument TypeComplexity (H, M, L) Derivative Assessment ConsiderationNPNS ConsiderationsCash Flow/Fair Value Hedge Considerations Swaps, Forward and Simple Purchased Options LowTypically meet the definition of a derivative Not typically considered normal due to net settlement characteristics Often used as a hedging instrument subject to the effectiveness between the financial settlement and the physical underlying Written OptionsLowTypically meet the definition of a derivative Not typically considered normal due to net settlement characteristics FAS 133 often excludes written options as a potential hedging instrument Physical PurchasesMediumTypically meet the definition of a derivative May often be designated normal purchase or normal sale Could be designated as a cash flow hedge, however, ineffectiveness due to index risk has under recent scrutiny Storage InventoryHighNot a derivativeN/ACould be the underlying in a cash flow or fair value hedge relationship Park-n-ride or Park- n-loans HighCould meet the definition of a derivative Not typically considered normal due to net settlement characteristics Typically not used as in cash flow/fair value hedge relationship Transportation Capacity HighNot a derivativeN/ATypically not used as in cash flow/fair value hedge due to the uncertainty of occurrence Illiquid Markets Physical Transactions HighIlliquidity could, on an exception basis, exclude physical transactions from designation as a derivative N/A Gas Portfolio – Sample Illustration of Energy Industry Application of FAS 133 to typical gas portfolio Sample Gas Portfolio
Page 28 Sample Energy Industry Application of FAS 133 Instrument TypeComplexity (H, M, L) Derivative Assessment Consideration NPNS ConsiderationsCash Flow/Fair Value Hedge Considerations Physical CoalMediumMine mouth coal could meet the definition of a derivative, other physical deliveries could have transportation limitations May often be designated normal purchase or normal sale Typically not used as in cash flow/fair value hedge relationship EmissionsHighInitial allocations often recorded as an intangible asset, secondary market transactions could meet the definition Physical transactions often settle too quickly for normal treatment. Forward sales and vintage year swaps could hedge future requirements WeatherHighContracts with a climatic variable as an underlying must be exchange traded to meet the definition Not typically considered normal due to net settlement characteristics. Effectiveness maybe difficult to prove in a cash flow hedge Commodities Portfolio – Sample Illustration of Energy Industry Application of FAS 133 to typical other related commodities portfolio Sample Commodities Portfolio
Page 29 ► Utility companies are allocated emission rights (typically NOx and SOx, but now CO2 and REC’s in some markets). These rights come with a target level and companies are allowed to trade the rights attached. Some of the key issues are: ► What value should be ascribed to the asset? ► The asset should initially be recognized at cost where there was a cost or at fair value where there was no initial cost. ► Should the asset be revalued? (No US GAAP Guidance) ► Initially the IASB’s thinking was that the asset should not be subsequently re-measured at fair value; however they noted the staff’s concerns around potential mismatches between recording the asset at cost and re- measuring to fair value at each reporting date any emission liabilities recognized under IAS 37; in early 2004 the IASB’s IFRIC committee decided that emission rights and liabilities should be measured at fair value, with changes in value recognized in profit and loss. Impact on Utility Markets – Environmental
Page 30 Utilities vs. Financial Institutions ► Generally, a significant portion of a Utilities contracts are physical ► Any financial transactions are often “plain vanilla” type contracts ► Utilities do not often hold on to highly complex financial transactions that are difficult to value ► Some complexities arise in physical contracts, such as requirements and full requirements, but they are less complex and in more liquid markets than complex banking items, such as mortgage backed securities ► The average tenor of a Utilities portfolio is less than the average tenor of a Financial Institutions portfolio
FAS 71 Briefly
Page 32 FAS 71 ► FAS 71 allows regulated companies to defer costs and create regulatory assets provided the regulatory agency grants authority for such a deferral ► Regulators sometimes include costs in allowable costs in a period other than the period in which the costs would be charged to expense by an unregulated enterprise. ► That procedure can create assets (future cash inflows that will result from the rate- making process), reduce assets (reductions of future cash inflows that will result from the rate-making process), or create liabilities (future cash outflows that will result from the rate-making process) for the regulated enterprise. ► For general-purpose financial reporting, an incurred cost for which a regulator permits recovery in a future period is accounted for like an incurred cost that is reimbursable under a cost-reimbursement-type contract.
Page 33 FAS 71 ► Rate actions of a regulator can provide reasonable assurance of the existence of an asset. An enterprise shall capitalize all or part of an incurred cost that would otherwise be charged to expense if both of the following criteria are met: ► It is probable that future revenue in an amount at least equal to the capitalized cost will result from inclusion of that cost in allowable costs for rate-making purposes. ► Based on available evidence, the future revenue will be provided to permit recovery of the previously incurred costs rather than to provide for expected levels of similar future costs. If the revenue will be provided through an automatic rate-adjustment clause, this criterion requires that the regulator's intent clearly be to permit recovery of the previously incurred costs.