1. FAIR VALUE ACCOUNTING Grace A. Mullings, CPA
Director, Accounting Policy
Toyota Financial Services

2. Fair Value Accounting Learning Objectives
Understand the evolution of the fair value option
Provide participants with an overview of important accounting developments, disclosures and issues pertaining to fair value accounting

3. Agenda
FASB Statement No. 155 – Accounting for Certain Hybrid Financial Instruments (“Statement 155”)
FASB Statement No. 157 – Fair Value Measurements (“Statement 157”)
FASB Statement No. 159 – The Fair Value Option for Financial Assets and Financial Liabilities (“Statement 159”)

4. Accounting for Certain Hybrid Financial Instruments
FASB Statement No. 155
Accounting for Certain Hybrid Financial Instruments

5. Overview of Statement 155
Permits fair value measurement for certain hybrid financial instruments that contain an embedded derivative that would otherwise require bifurcation under Statement 133.
Amends Statement 133 to require evaluation of all interests in securitized financial assets. thus eliminating the exemption in Statement 133 accounts for certain hybrid instruments. As a result, entities will have to determine if such interest may be:
Freestanding derivatives,
Hybrid financial instruments containing embedded derivatives requiring bifurcation, or
Hybrid financial instruments containing embedded derivatives that do not require bifurcation
Clarifies that only the simplest and most direct separation of interest and principal cash flows need not be evaluated for embedded derivatives

6. Overview of Statement 155 (cont’d)
Clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives.
Amends Statement 140 to allow a QSPE to hold passive derivative instruments that pertain to beneficial interest that are or contain a derivative financial instrument
Irrevocable election on an instrument by instrument basis with all changes in fair value recognized in earnings.
The fair value election should be made at the time the financial instrument is acquired, issued or there is a new basis in a previously recognized financial instrument.
Upon adoption, applies to existing hybrid financial instruments that had been bifurcated under the requirements of Statement 133.
Effective for fiscal years beginning after September 15, 2006.

7. Hybrid Financial Instruments
The combination of a “Host contract” and an “Embedded derivative” = Hybrid Financial Instrument
Any embedded feature that meets the bifurcation criteria must be bifurcated from the host and accounted for separately.
Host
Hybrid
Derivative
Apply other applicable GAAP: historical cost accounting
Apply Statement 133:
mark-to-fair value through earnings;
may qualify as a hedging instrument

8. Hybrid Financial Instruments (cont’d)
The Bifurcation Model
Paragraph 12 of Statement 133:
1. Is the hybrid
carried at fair
value through
earnings?
(Par 12b)
Bifurcate
3. Is it clearly
and closely
related to the
Host contract?
(Par 12a) No
Yes
2. Would the
embedded
feature be a
derivative if it
was freestanding?
(Par 12c)
Do Not Bifurcate

9. Hybrid Financial Instruments (cont’d)
Bifurcate when interest rate indices not clearly and closely related
Paragraph 13 of Statement 133 OR
2. Double then-current market return for a contract with the same terms as the host and same credit quality at inception
And
any possible scenario
(even if unlikely)
1. Double the investor’s initial rate of return on the host
Double-Double Test (13b)
Investor may not recover
substantially all of
its initial investment
Substantially All (13a)

10. Hybrid Financial Instruments (cont’d)
Statement 133 Implementation Issue B39, “Embedded Derivatives: Application of Paragraph 13(b) to Call Options That Are Exercisable Only by the Debtor.”
Simple issuer call option is clearly and closely related
“When applying paragraph 13, the Board believes that certain embedded prepayment options in debt instruments would be unnecessarily bifurcated.”
If issuer controls when it pays a prepayment penalty, then investor cannot double its return.

11. Impact of Statement 155 on Beneficial Interests
Nullified Issue D1 Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.
Impact of Issue D1 was to defer the bifurcation requirements of Statement 133
Holders of beneficial financial interests must analyze arrangements that govern the payoff structure and the subordination status of the financial instrument
Prepayment risks in such structures could result in meeting the 13(b) requirements of Statement 133
Analyze the contractual terms of the interest in the securitized financial assets
Understand the nature and amount of assets and liabilities and other financial instruments comprising the securitization transaction.
Additionally, Statement 155 amended the comment section of example 6 in Statement 133 Implementation Issue No. B39, “Application of Paragraph 13(b) to Call Options That Are Exercisable by the Debtor.”

12. Impact of Statement 155 on Beneficial Interests (cont’d)
Resulted in numerous requests to the FASB to provide guidance on the application of paragraph 13(b) to securitized interests in prepayable financial assets.
FASB responded by issuing Statement 133 Implementation Issue B40, “Embedded Derivatives: Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets.”
Provides a narrow scope exception tied only to the prepayment risk of the underlying prepayable financial assets
If a securitized interest contains any other terms that affect some or all of the cash flows or the value of other exchanges required by the contract in a manner similar to a derivative instrument, those securitized interests would be subject to the requirements of paragraph 13(b) of Statement 133 (for example, an inverse floater).

13. Statement 155 Financial Statement Disclosures
For Each Period in Which The Indicated Financial Statement is Presented
Required Disclosure
Balance Sheet
Separately report the fair values of hybrid financial instruments for which the fair value option was elected. or
Parenthetically disclose on the face of the balance sheet for each caption the aggregate amounts for hybrid instruments for which the fair value option has been applied.
Income Statement
The impact on earnings of changes in the fair value of hybrid financial instruments

14. FASB Statement No. 157 Fair Value Measurements

15. Overview of Statement 157 Creates a singular definition of fair value
Allows increased consistency and comparability in fair value measurements
Clarifies that the exchange price is the price in an orderly transaction between market participants
Expectation that fair value reflects market-based conclusions
Prioritizes the information hierarchy that should be used in developing assumptions to establish fair value
Another step in international convergence
Effective for fiscal years beginning after September 15, 2007

16. Statement 157 – Scope
All accounting pronouncements that require or permit fair value measurement and include such items as:
Investment securities – Statement 115
Derivatives – Statement 133
“Short sales” of securities – AICPA Audit Guides for certain industries
Investments carried at fair value by investment companies
Certain assets and liabilities measured at fair value in a business combination – Statement 141:
Intangible assets
In process R&D
Assets measured at fair value for an impairment test – Statements 142 and 144:
Long-lived assets held for sale
Reporting units
Goodwill

17. Differences Between Statement 157 and Current Practice
Issue
Current Practice
Statement 157
Definition
Various definitions of fair value – Amount at which an asset or liability could be bought or sold in a current transaction between willing parties, that is, other than in a forced liquidation sale
Price that would be received for an asset or paid to transfer a liability between market participants at the measurement date.
Transaction Entry Price
Presumed equal to fair value
May not be representative of fair value; provides indicators of when the transaction price may not be fair value.
Highest and Best Use
Current practice is to value assets in continued use unless identified for disposition
Independent of the reporting entity’s intent: considered from market participant perspective
Use of Market Data in Valuations
Use of market data encouraged. In some circumstances entity intent permitted to be considered in valuations.
Valuation techniques must maximize use of market observable data and minimize use of unobservable data
Hierarchy
No current mandated hierarchy.
Three levels distinguished between observable and unobservable inputs.
SOURCE: DELOITTE

18. Differences Between Statement 157 and Current Practice
Issue
Current Practice
Statement 157
Defensive Value -
New concept
Principal/Most Advantageous Market
Newly defined concept
Market Participants
Current guidance on market participants is unclear. Buyer-specific intent may be considered
Buyer-specific intent should be dismissed if different from that of other multiple market participants
Block Discounts
Broker-dealers and investment companies permitted to apply block discounts
Eliminated for all companies in relation to actively traded securities
Restricted Securities
Restrictions on marketable securities not required to be considered in the valuation if the restriction terminated within one year.
Fair value measurement should include the effect of a restriction, if the restriction is an attribute of the security which would pass to market participants.
Model Risk
Assessed as a component of the fair value measurement
SOURCE: DELOITTE

19. Statement 157 – Valuation Problem
Statement 157 provides three main approaches to measuring fair value.
Fair Value
Hierarchy
Level 1
Market- based
Level 3
Model-based
Objective
Subjective

20. Statement 157 – Financial Statement Disclosures
Requires expanded disclosures about fair value measurements designed to provide users of financial statements with additional transparency regarding:
Extent to which fair value is used to measure assets and liabilities
The inputs and assumptions used in measuring fair value
The effect of fair value measurements on earnings

21. Statement 157 – Financial Statement Disclosures (Cont’d)
Nature and extent of disclosure requirements vary depending on whether the subsequent fair value measurements are made on a recurring or nonrecurring basis.
Fair Value Measurement on a Recurring Basis:
Disclose the level within the fair value hierarchy in which the fair value measurement falls.
Reconcile the beginning and ending balances for any recurring fair value measurements that utilize significant unobservable inputs (i.e. Level 3 inputs).
Fair Value Measurement on a Nonrecurring Basis:
Disclose for assets and liabilities measured at fair value on a nonrecurring basis the reason for the fair value measurement during the period.

22. Statement 157 – Major Issues for Consideration
Determining primary or most advantageous market
Assigning and Monitoring Statement 157 hierarchy levels
Transaction costs
Whole loans and other receivables
Credit risk in valuing liabilities

23. The Fair Value Option for Financial Assets and Financial Liabilities
FASB Statement No. 159
The Fair Value Option for Financial Assets and Financial Liabilities

24. Overview of Statement 159
Allows entities to voluntarily choose to measure eligible financial instruments at fair value (the “fair value option”)
Changes in fair value recognized in earnings.
Election made on an instrument-by-instrument basis
Irrevocable

25. Overview of Statement 159 (cont’d)
FASB issued the FVO to:
Provide an opportunity to mitigate volatility in earnings caused by a mixed attribute accounting model
Reduce the need for applying complex hedge accounting provisions
Expand the use of fair value measurements
International convergence

26. Statement 159 – Scope Recognized financial assets and liabilities
Firm commitments that would otherwise not be recognized at inception and that involve only financial instruments
Written loan commitments
Certain rights and obligations under insurance contracts or warranty obligations
A financial host contract in a nonfinancial hybrid instrument
Nonfinancial assets and liabilities

27. Statement 159 – Exclusions
Investments in consolidated entities
Financial obligations for items such as pension benefits and other deferred compensation arrangements
Income tax assets and liabilities
Financial assets and liabilities recognized under leases as defined in Statement 13
Deposit liabilities, withdrawals on demand, of depository institutions
Financial instruments that are, in whole or in part, a component of shareholder’s equity

28. Statement 159 – FVO Election
Election must be documented:
On election date or
Via a pre-existing policy
Eligible election dates:
The entity first recognizes the eligible item
The entity enters into an eligible firm commitment
Specialized accounting rules requiring fair value cease to apply to the financial asset
Investment in an entity ceases to be consolidated or becomes subject to equity method accounting
An event that requires item to be measured at fair value, excluding impairments

29. Statement 159 – Financial Statement Disclosures
Requires extensive disclosure requirements, objective is to allow for comparability:
Between entities with similar financial assets and liabilities
Between assets and liabilities of an entity that selects different measurement attributes
Desired Results
Key Disclosures to Achieve Results
Understand management’s reasons for electing the FVO.
Description of management’s reasons for electing the FVO, fully or partially.
Understand how changes in fair value affect earnings for the period.
For each line item in the balance sheet, the gains and losses from fair value changes included in earnings during the period and in which line in the income statement they are reported.
For liabilities, loans and other receivable, information about instrument-specific credit risk.
Same disclosures for certain items whether or not the FVO had been elected.
Information about nonperforming loans.
Information about investments otherwise accounted for under the equity method.
Understand the differences between fair values and contractual cash follows for certain items.
Difference between aggregate fair value and aggregate unpaid principal balance of loans and other receivables, and long-term debt.

30. Statement 159 – Major Issues for Consideration
Cost and fees – cannot be deferred under FVO
Premium and discount not considered cost and fee
Interest Income and Expense – no guidance on determining or presenting interest income or expense for items under the FVO
Statement 159 vs. Statement 133
Debt covenants that may be based on equity or debt ratios
No Statement 5 reserves for items carried under FVO

31. Questions and
Answers