1. ST Convergence with IASB
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ST Convergence with IASB
Prepared by Teresa Gordon

2. SFAS No. 151 – Inventory Costs
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SFAS No. 151 – Inventory Costs
Part of the “international convergence” project.
Clarifies that abnormal costs of idle facilities should not be capitalized as product costs.
Companies should use “normal capacity” for the allocation of overhead.
Any unallocated overhead is expensed during the period in which they are incurred.
Other abnormal handling costs or abnormal levels of spoilage might also need to be expensed.
Prepared by Teresa Gordon

3. Coming soon Short-term convergence with IASB
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Coming soon
Short-term convergence with IASB
EPS (ED expected 1st half 2007)
Income taxes (ED expected 1st half 2007)
Research and Development - ?
Prepared by Teresa Gordon

4. Fair Value Measurements
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Fair Value Measurements
SFAS No. 157
Signs of the Future!
Prepared by Teresa Gordon

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FAS157 Issued Sept. 2006
With a few exceptions, it does not change WHAT is currently measured using fair value
Sets out a framework for measuring fair value
Requires additional disclosures about fair value measurements
From summary: This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, the Board having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. However, for some entities, the application of this Statement will change current practice.
From Para 1 – OBJECTIVE
1. This Statement defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. Where applicable, this Statement simplifies and codifies related guidance within generally accepted accounting principles (GAAP).
Prepared by Teresa Gordon

6. FAS157 – Definition of Fair Value
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FAS157 – Definition of Fair Value
Paragraph 5 - Fair value is 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.
This is an exit-price definition of fair value (see paragraph 7)
Quote from KPMG Defining Issues
The Statement explains key concepts that are needed to apply the definition, including “market participants,” the markets in which the company would exchange the asset or liability, and the valuation premise that follows
from assumptions market participants would make about the use of an asset.
Prepared by Teresa Gordon

7. FAS157 – Related definitions
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FAS157 – Related definitions
Market Participants (4 criteria)
Independent of reporting entity
Have knowledge needed for reasonable understanding about transaction
Financial and legal ability to enter into the transaction
Be willing to enter into transaction without compulsion
Prepared by Teresa Gordon

8. FAS157 – Related definitions
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FAS157 – Related definitions
Principal Market
Has the greatest volume and level of activity.
If there is no principal market, use the most advantageous market
Most Advantageous Market
Most advantageous market has price that maximizes the net amount that would be received or minimizes the net amount paid
Transactions costs are included in determining which market to use but do NOT become part of the fair value measurement
Prepared by Teresa Gordon

9. Example of which market…
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Example of which market…
Market A
Market B
Selling price
$50
$48
Transaction cost $5 $2
Net proceeds
$45
$46
Fair value to use
From KPMG Defining Issues:
For example, assume an entity can sell an asset in two different markets and neither is the principal market. The asset can be sold for $50 in Market A with transaction costs of $5. The asset can be sold for $48 in Market B
with transaction costs of $2. Market B would be the most advantageous market because the entity would receive a net of $46 compared to the net of $45 available in Market A. However, because transaction costs are not included in the fair-value measurement, the fair value of the asset in this example would be $48.
$48
Prepared by Teresa Gordon

10. FAS157 – Related definitions
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FAS157 – Related definitions
Assumptions about the market
The asset or liability is exchanged in an orderly transaction between market participants
An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities;
it is not a forced transaction (for example, a forced liquidation or distress sale).
The price is for a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the item
Prepared by Teresa Gordon

11. FAS157 – Related definitions
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FAS157 – Related definitions
Valuation premise – the assumption about how market participants would use an asset
Choose the premise based on “highest and best use”
In-use premise
Provides maximum value through use in combination with other assets
In-exchange premise
Provides maximum value principally on a stand-alone basis
Application to Assets
12. A fair value measurement assumes the highest and best use of the asset by market participants, considering the use of the asset that is physically possible, legally permissible, and financially feasible at the measurement date. In broad terms, highest and best use refers to the use of an asset by market participants that would maximize the value of the asset or the group of assets within which the asset would be used. Highest and best use is determined based on the use of the asset by market participants, even if the intended use of the asset by the reporting entity is different.
13. The highest and best use of the asset establishes the valuation premise used to measure the fair value of the asset. Specifically:
a. In-use. The highest and best use of the asset is in-use if the asset would provide maximum value to market participants principally through its use in combination with other assets as a group (as installed or otherwise configured for use). For example, that might be the case for certain nonfinancial assets. If the highest and
best use of the asset is in-use, the fair value of the asset shall be measured using an in-use valuation premise. When using an in-use valuation premise, the fair value of the asset is determined based on the price that would be received in a current transaction to sell the asset assuming that the asset would be used with
other assets as a group and that those assets would be available to market participants. Generally, assumptions about the highest and best use of the asset should be consistent for all of the assets of the group within which it would be used.
b. In-exchange. The highest and best use of the asset is in-exchange if the asset would provide maximum value to market participants principally on a standalone basis. For example, that might be the case for a financial asset. If the highest and best use of the asset is in-exchange, the fair value of the asset shall be measured using an in-exchange valuation premise. When using an in-exchange valuation premise, the fair value of the asset is determined based on the price that would be received in a current transaction to sell the asset standalone.
Prepared by Teresa Gordon

12. Valuation Techniques Market approach Income approach Cost approach
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Valuation Techniques
Market approach
Uses observable prices from market transactions for comparable assets or liabilities
Income approach
Analysis of future cash flows using present values
Cost approach
Estimates cost to replace an asset’s service capacity
Valuation Techniques
18. Valuation techniques consistent with the market approach, income approach, and/or cost approach shall be used to measure fair value. Key aspects of those approaches are summarized below:
a. Market approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities (including a business). For example, valuation techniques consistent with the market approach often use market multiples derived from a set of
comparables. Multiples might lie in ranges with a different multiple for each comparable. The selection of where within the range the appropriate multiple falls requires judgment, considering factors specific to the measurement (qualitative and quantitative). Valuation techniques consistent with the market approach include matrix pricing. Matrix pricing is a mathematical technique used principally to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the securities’ relationship to other benchmark quoted securities.
b. Income approach. The income approach uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present amount (discounted). The measurement is based on the value indicated by current market expectations about those future amounts. Those valuation techniques include present value techniques; option-pricing models, such as the Black-Scholes-Merton formula (a closed-form model) and a binomial model (a lattice model), which incorporate present value techniques; and the multiperiod excess earnings method, which is used to measure the fair value of certain intangible assets.
c. Cost approach. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost). From the perspective of a market participant (seller), the price that would be received for the asset is determined based on the cost to a market participant (buyer) to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence. Obsolescence encompasses physical deterioration, functional (technological) obsolescence, and economic (external) obsolescence and is broader than depreciation for financial reporting purposes (an allocation of historical cost) or tax purposes (based on specified service lives).
A change in valuation technique is a change in accounting estimate, not a change in accounting principle
Prepared by Teresa Gordon

13. The “Fair Value Hierarchy”
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The “Fair Value Hierarchy”
Level
Inputs to achieve reliability level 1
Quoted prices in active markets for identical assets or liabilities 2
Observable prices in active markets for similar assets or liabilities, or prices from markets that are not active. Market inputs for substantially full term of item (interest rates). Market inputs that are not directly observable but can be derived or corroborated by market data 3
Unobservable inputs based on the reporting entity’s own assumptions about assumptions that market participants would use. Cannot be corroborated by observable market data
Fair Value Hierarchy
22. To increase consistency and comparability in fair value measurements and related disclosures, the fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). In some cases, the inputs used to measure fair value might fall in different levels of the fair value hierarchy. The level in the fair value hierarchy within which the fair value measurement in its entirety falls shall be determined based on the lowest level input that is significant to the fair value measurement in its entirety. Assessing the significance of a particular
input to the fair value measurement in its entirety requires judgment, considering factors specific to the asset or liability.
From KPMG DI
The lowest-level-significant-input assumption will mean that many fair-value measurements of nonfinancial assets and asset groups or reporting units will be Level 3 measurements because of their reliance on Level 3 inputs, such as forecasts of the reporting unit’s or asset group’s future cash flows. Fair-value measurements of financial instruments, however, may be based entirely on higher level inputs in some situations (e.g., measures of instruments that are traded in active markets or of instruments with contractual cash flows and interest rates that are observable as Level 2 inputs).
Prepared by Teresa Gordon

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Valuing Liabilities
The valuation technique must consider the reporting entity’s credit standing
A reporting entity could record a GAIN for derivatives at a measurement date because the fair value of the liability decreases in response to a credit downgrade if all other inputs remain unchanged
Prepared by Teresa Gordon

15. Restrictions on Assets
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Restrictions on Assets
Restrictions are evaluated to determine whether they are an attribute of the asset or an attribute of the reporting entity
If sold, would the restriction transfer to another holder?
If yes, the impact of the restriction would be taken into consideration (adjust asset fair value downward)
If no, the restriction would not reduce the fair value
Prepared by Teresa Gordon

16. Other provisions of FAS157
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Other provisions of FAS157
It is now possible to recognize a gain on the day recognized (previously prohibited under EITF 02-3)
Blockage adjustments are not permitted in pricing
Bid-ask spreads
Use the price within the bid-ask spread that is most representative of fair value in the circumstances
Blockage factor adjustment prohibited
27. If the reporting entity holds a position in a single financial instrument (including a block) and the instrument is traded in an active market, the fair value of the position shall be measured within Level 1 as the product of the quoted price for the individual instrument times the quantity held. The quoted price shall not be adjusted because of the size of the position relative to trading volume (blockage factor). The use of a blockage factor is prohibited, even if a market’s normal daily trading volume is not sufficient to absorb the quantity held and placing orders to sell the position in a single transaction might affect the quoted price.
Inputs Based on Bid and Ask Prices
31. If an input used to measure fair value is based on bid and ask prices (for example, in a dealer market), the price within the bid-ask spread that is most representative of fair value in the circumstances shall be used to measure fair value, regardless of where in the fair value hierarchy the input falls (Level 1, 2, or 3). This Statement does not preclude the use of mid-market pricing or other pricing conventions as a practical expedient for fair value measurements within a bid-ask spread.
Prepared by Teresa Gordon

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FAS 157 Disclosures
Will be extensive and reported in three sections (see paragraph A33-A36 for examples)
Assets and liabilities measured at fair value on a recurring basis
Tabular display reconciles beginning and ending amounts when significant Level 3 inputs are used
Assets and liabilities measured at fair value on a nonrecurring basis (impairment of assets, etc.)
For all fair value measurements, a table showing the reliance on Level 1, 2 or 3 inputs plus discussion of the valuation techniques used for the measurements
Prepared by Teresa Gordon

18. FAS 157 – effective date Implementation is prospective
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FAS 157 – effective date
Implementation is prospective
Required for financial statements issued for fiscal years beginning AFTER Nov. 15, 2007
Prepared by Teresa Gordon

19. FAS 159 – The Fair Value Option
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FAS 159 – The Fair Value Option
Optional use of fair value for certain assets and liabilities
Prepared by Teresa Gordon

20. Essentially a one-time election
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Essentially a one-time election
On a contract by contract basis, company can designate specified financial instrument to be accounted for using fair value instead of the usual measurement technique
Companies may be able to reduce volatility in reported earnings caused by measuring assets and liabilities differently
There are guidelines as to what “contract by contract” basis means.
For example, if you choose to account for an equity method investment at fair value, you must use fair value to account for liabilities and receivables related to the same entity
Prepared by Teresa Gordon

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Other “benefits”
Movement toward accounting for all financial instruments at fair value
Brings US GAAP into closer agreement with IASB 39 which already contains a fair value election
Prepared by Teresa Gordon

22. Eligible assets & liabilities
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Eligible assets & liabilities
Most recognized investments including those currently accounted for using the equity method
But cannot be used to recognized investments that must be consolidated (VIEs, subsidiaries)
Many recognized liabilities
Excluding leases, demand deposits of banks, postretirement plans, etc.
Prepared by Teresa Gordon

23. Eligible assets & liabilities
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Eligible assets & liabilities
Firm purchase commitments that would otherwise not be recognized at inception (but only for ones involving financial instruments)
Rights and obligations under warranties that meet certain requirements
Certain host financial instruments that result from separation of embedded nonfinancial hybrid instruments under FAS133
Prepared by Teresa Gordon

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Irrevocable election
Must be applied to contracts as a whole and not to parts of contracts
Changes in fair value will be recognized in earnings during each reporting period
The rules explain what is meant by a contract by contract basis.
For example, accounting for equity method investment at fair value would mean also accounting for loans to that entity using fair value.
Prepared by Teresa Gordon

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Election date
Transition – any eligible item as of the date that FAS159 is initially adopted
Thereafter:
The eligible item is first recognized (including entering into an eligible firm commitment)
Occurrence of a short list of other events
Prepared by Teresa Gordon

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Disclosures
If fair value option is elected, company must disclose separately assets and liabilities measured at fair value from those not measured at fair value
Intended to help readers compare companies that choose the option to those that choose not to elect fair value accounting
Prepared by Teresa Gordon

27. Disclosures – specific (1)
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Disclosures – specific (1)
Why fair value option was selected for each eligible item
Difference between fair value and aggregate unpaid principal amounts
Relation to other fair value measurements under FAS157
Description of partial applications to groups of similar items and why company chose not to be consistent
Prepared by Teresa Gordon

28. Disclosures – specific (2)
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Disclosures – specific (2)
Loans carried at assets at fair value that are past due by 90 days or more
APB18 disclosures about investments that would otherwise have been reported using equity method
Description of how interest and dividends are measured and reported for items with fair value election
Quantitative information (line by line) as to where gains and losses related to fair value option have been reported in the income statement
Prepared by Teresa Gordon

29. Acct 592
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FIN 46R and 48
Lecture notes are in doc file (not ppt) and this was covered as part of the deferred tax lectures
Note to self – need to verify
FIN46R notes were only in doc file, I think
Prepared by Teresa Gordon

30. Acct 592
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FSP of interest
Note that FSP158-1 (Feb 21, 2007) contains Update of Illustrations, Application Guidance
Don’t hit ‘print’ – 257 pages!
Fixes examples in FAS87, FAS88 & FAS106 as related to issuance of FAS158. FAS132R was “fixed” in FAS158 so is not included in this FSP
Prepared by Teresa Gordon

31. Acct 592
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What’s Next?
Prepared by Teresa Gordon

32. Forthcoming – first half 2007
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Forthcoming – first half 2007
Conceptual Framework – Reporting Entity – preliminary views
Business Combinations – for-profit:
Applying the Acquisition Method (final)
Noncontrolling Interests (final)
Derivatives disclosures (final)
Part of the “international convergence” project.
Seems to be a minor point to me – fairly technical
Was expected 2nd Qtr 2005 but now expected 1st Qtr 2006
Prepared by Teresa Gordon

33. Forthcoming – first half 2007
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Forthcoming – first half 2007
Implementation Projects
Statement 140—Transfers of Financial Assets (ED)
Insurance Risk Transfer (ED)
Financial Guarantee Insurance (ED and maybe final by mid year)
Definition of liability vs. equity (Prelim views expected first half of 2007)
Part of the “international convergence” project.
Seems to be a minor point to me – fairly technical
Was expected 2nd Qtr 2005 but now expected 1st Qtr 2006
Prepared by Teresa Gordon

34. Forthcoming – second half 2007
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Forthcoming – second half 2007
Financial Statement Presentation (prelim views maybe by 3rd quarter)
Revenue recognition (PV by 3rd or 4th Quarters)
Prepared by Teresa Gordon

35. Acct 592
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Longer term projects
Not-for-profit business combinations and intangible assets
In process of reviewing comments (nothing on calendar about when a final version is expected)
Prepared by Teresa Gordon