Fair Value Measurements 4/1/2017 Fair Value Measurements ASC 820 (FAS 157) Fair Value Disclosures Acct 414

ASC 820 (FAS 157): Definition of Fair Value 4/1/2017 ASC 820 (FAS 157): Definition of Fair Value 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 An exit price notion for a hypothetical transaction; may or may not equal actual entry price Not adjusted for transaction costs Not based on value to current owner or company-specific assumptions

Entry price vs. Exit price 4/1/2017 Materials & Labor Markets Manu-facturer Wholesale Market Dealer Retail Market Consumer 2nd Hand Market Based on From: Refining Fair Value Measurement, Miller, Paul B. W.; Bahnson, Paul R.. Journal of Accountancy, Nov2007, Vol. 204 Issue 5, p30-36, FASB’s Solution: “highest and best use”

Statement 157: Approach to Measuring Fair Value 4/1/2017 Statement 157: Approach to Measuring Fair Value Unit of Valuation Unit of Account THE ASSET OR LIABILITY Valuation Premise Highest and Best Use Exit Market Market Participant Assumptions Inputs to Valuation Techniques Attribute Value to Asset or Liability at Unit of Account Level Fair Value Measurement Indicated Value Unit of Valuation F/S Presentation and Disclosure

4/1/2017 FAS 157 - Exit Market The market in which the ENTITY would sell the asset or transfer the liability First Choice: Principal market is the market with the greatest volume and level of activity for asset or liability If there is no principal market : Most advantageous market maximizes the amount that would be received for the asset or minimizes the amount that would be paid to transfer the liability, considering transaction costs Valuation Premise Highest and Best Use Exit Market Step 2 – Determine the exit market Market Participant Assumptions

FAS 157 - Market Participant Assumptions 4/1/2017 FAS 157 - Market Participant Assumptions A fair value measurement should be determined based on the assumptions market participants would use in pricing the asset or liability, including assumptions about (measurement) risk, highest and best use (if asset), and nonperformance risk (if liability) Valuation Premise Highest and Best Use Step 3 – determine the market participants Market participants are buyers and sellers in the exit market (other entities with whom the entity would transact) Exit Market Market Participant Assumptions

4/1/2017 Unit of Valuation The unit of valuation depends on the highest and best use of the asset, which establishes the valuation premise used to measure the fair value of the asset In-use or in-exchange Valuation Premise Highest and Best Use Use by market participants that maximizes value of asset (or asset group) Step 4a – determine highest and best use Step 4b – determine valuation premise (in use or in exchange) Step 4c – determine unit of valuation (group of assets, stand-alone asset, etc.) Exit Market Market Participant Assumptions

Statement 157: Approach to Measuring Fair Value 4/1/2017 Statement 157: Approach to Measuring Fair Value Unit of Valuation Unit of Account THE ASSET OR LIABILITY Valuation Premise Highest and Best Use Exit Market Market Participant Assumptions Inputs to Valuation Techniques Attribute Value to Asset or Liability at Unit of Account Level Fair Value Measurement Indicated Value Unit of Valuation F/S Presentation and Disclosure

FAS 157 - Inputs to Valuation Techniques 4/1/2017 FAS 157 - Inputs to Valuation Techniques Market participant assumptions are incorporated in the fair value measurement through the inputs to valuation techniques Observable inputs Developed based on market data obtained from sources independent of the reporting entity Unobservable inputs Developed based on the best information available in the circumstances, subject to cost-benefit constraint We are to use observable inputs in preference to unobservable inputs. The next slide is a FLOWCHART on deciding which inputs to use – there isn’t always an observable input available.

A fair value measurement should maximize the use of observable inputs 4/1/2017 A fair value measurement should maximize the use of observable inputs From: Refining Fair Value Measurement, Miller, Paul B. W.; Bahnson, Paul R.. Journal of Accountancy, Nov2007, Vol. 204 Issue 5, p30-36, The next slide give the FASB definitions of the three levels of inputs

Statement 157 - Fair Value Hierarchy 4/1/2017 Statement 157 - Fair Value Hierarchy Level 1 Quoted prices in active markets for identical assets/ liabilities (unadjusted); no blockage factors (Price x Quantity) Level 2 Other observable inputs—include quoted prices for similar assets/ liabilities (adjusted) and market-corroborated inputs Level 3 Unobservable inputs—entity’s own assumptions about market participant assumptions, including assumptions about risk, developed based on the best information available in the circumstances (subject to cost-benefit constraint); might include the entity’s own data

Last Step - Disclosures 4/1/2017 Last Step - Disclosures F/S Presentation and Disclosure THE ASSET OR LIABILITY Indicated Value Unit of Valuation Market Participant Assumptions Inputs to Valuation Techniques Attribute Value to Asset or Liability at Unit of Account Level Highest and Best Use Exit Market Valuation Premise Unit of Account Fair Value Measurement

4/1/2017 FAS 157 - Disclosures Extensive disclosures to indicate the “quality” of fair value measurements by the 3 categories of inputs For regularly re-valued assets & liabilities:

4/1/2017 FAS 157 - Disclosures For regularly re-valued assets & liabilities that use a lot of Level 3 unobservable inputs – there is more:

FAS 157 - Disclosures For assets & liabilities not regularly revalued: 4/1/2017 FAS 157 - Disclosures For assets & liabilities not regularly revalued:

The steps to FV measurement 4/1/2017 The steps to FV measurement 1. Identify asset or liability being measured (unit of account) 2. Determine the exit market 3. Identify the market participants in the exit market 4a. Determine the highest and best use for an asset or nonperformance risk for a liability being valued 4b. Determine the valuation premise (in-use vs. in-exchange) based on highest and best use for an asset group of assets, reporting unit, or business being valued. 4c. Determine the unit of valuation based on the highest and best use and the valuation premise Remember that step 2 assumes that the PRINCIPAL market should be used unless there is no principal market. In that case, use the most advantageous market

The steps to FV measurement 4/1/2017 The steps to FV measurement 5. Determine a value for the unit of valuation based on market participant assumptions and other market-based inputs, and apply one or more appropriate valuation techniques 5a. If applicable, impute value determined in Step 5 to the unit of account 6. Classify inputs used in Step 5 as Level 1, 2, or 3 and then classify the fair value measurement in its entirety to prepare SFAS No. 157 disclosures

4/1/2017 Let’s look at HW#3 Problem 3 – using level 1 & 2 inputs to determine fair value of bonds Let’s look at Bond 2: Term = 6 years, rating = BBB Note: this is probably “level 2” since we don’t have an EXACT quotation for a market price for the exact bonds the company is holding

Bond 2: Term = 6 years, rating = BBB 4/1/2017 Bond 2: Term = 6 years, rating = BBB Bond 2 Look at the BBB bond rating column. Term of 6 is how far between years 5 & 10? (Diff = 5 years, therefore 1/5 or 20%) Based on the term of the bond, Bond 2 is 20% of the way from 100.17 to 98.54. Estimated price of Bond 2 = .99844 × $1,000 = $998.44. Difference between the two rates = 100.17 – 98.54 = 1.630 20% * 1.630 = .326 100.17 - .326 = 99.844 $1,000 face value * .99844 (approximation) = $998.44 fair value

Let’s try another one, $1000 Bond: Term = 8 years, rating = A 4/1/2017 Let’s try another one, $1000 Bond: Term = 8 years, rating = A

HW #3 (small groups okay) 4/1/2017 HW #3 (small groups okay) The first two problems are related to understanding the “fair value option” You will also practice fair value disclosures Problems 4 and 5 will let you try your hand at creating the disclosure tables required under ASC Topic 820 Use the “handout” files to get examples from FASB or find them in the FASB codification There are also examples are in Appendix 17C in textbook To this assignment, you will attach the FAIR VALUE part of the HW#2 serial bond problem