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April 17, 2009 |
Schiff Hardin Corporate and Securities Client Alert Fair Value Reporting: FASB's Recent Actions Fair value reporting standards have achieved celebrity status among their fellow accounting principles. As celebrities are wont to do, they have recently undergone their most recent cosmetic surgery in an effort to appeal to a wider audience. On April 2, 2009, following a short fifteen day comment period that itself followed threats of congressional action, the Financial Accounting Standards Board (FASB) approved the issuance of three pronouncements effecting changes in certain aspects of fair value accounting. Despite the short comment period, FASB received and reviewed over 600 comment letters in addition to holding meetings and interviews with various constituents. Formally issued on April 9, 2009, the resulting pronouncements are: Recognition and Presentation of Other-Than-Temporary Impairments (FSP FAS 115-2 and FAS 124-2), Interim Disclosures about Fair Value of Financial Interests (FSP FAS 107-1 and APB 28-1), and the more verbose Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Indentifying Transactions That Are Not Orderly (FSP FAS 157-4). FSP FAS 157-4. FASB originally issued Statement No. 157, Fair Value Measurements, in September 2006. That Statement did not impose fair value requirements, but rather provided a methodology for measuring fair value where generally accepted accounting principles otherwise required fair value measurements. Statement 157 categorized the inputs used in determining value into three levels: Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities; Level 2 inputs are inputs other than Level 1 inputs that are observable for the relevant asset or liability, including quoted prices for similar assets or liabilities in inactive markets; and Level 3 inputs (sometimes referred to as "mark to model" or worse) are unobservable inputs for the relevant asset or liability that reflect the reporting entity's own assumptions about the assumptions that market participants would use in pricing the asset or liability. FASB issued FSP FAS 157-4 to deal with concerns as to when a preparer could significantly adjust a transaction price or a quoted price in an inactive market. In other words, if one had Level 2 inputs from an inactive market, when could judgment be used to override those inputs. FSP FAS 157-4 does not apply to Level 1 inputs because, by definition, those inputs derive from an active market. The new pronouncement provides for two steps. First, one must determine whether there has been a significant decrease in the volume and level of activity for the asset or liability being valued. In order to do that, the reporting entity should consider various factors, including those listed in FSP FAS 157-4 such as the existence of only a few recent transactions or price quotations not being based on current information. Second, assuming there has been the requisite significant decrease in activity, then the reporting entity must further analyze the transactions or quoted prices to determine if a significant adjustment to the inputs derived from them may be necessary. While not all such transactions or prices are necessarily the result of distressed or forced transactions, circumstances may indicate they are. FASB points to a seller's bankruptcy, a seller's marketing of the asset to a single market participant, or an outlier transaction price as examples of such circumstances. FSP FAS 157-4 directs the reporting entity to place more weight on the results of orderly transactions (as opposed to distressed or forced transactions) and less weight on those transactions that the entity does not have sufficient information to conclude are orderly. FSP FAS 157-4 makes it clear that, in the case of an inactive market, the intent of the exercise is to arrive at a price that would be received in an orderly transaction in that market on the date of the financial statements. At the same time, the pronouncement does not prescribe a methodology for arriving at fair value, but notes that a change in valuation technique or the use of multiple valuation techniques may be appropriate. FSP FAS 157-4 also provides for more disclosures. A reporting entity must provide more information regarding the inputs and valuation techniques used in Level 3 valuations and provide information as to values by major securities types based on the nature and risks of the securities, e.g., equity securities, U.S. government debt securities, foreign government securities, and corporate debt securities. Additionally, a reporting entity must disclose in both interim and annual periods the inputs and techniques used to measure fair value, discuss any changes in valuation techniques and related inputs during the reporting period, and quantify the total effect of any such changes in valuation technique and related inputs, if practicable, by major category. FSP FAS 157-4 will be effective for reporting periods ending after June 15, 2009 on a prospective basis with early adoption permitted for periods ending after March 15, 2009. FSP FAS 115-2 and FAS 124-2 (the OTTI Pronouncements). FASB issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, in 1993. That Statement required a reporting to classify its investments into one of three buckets: (1) trading assets — securities that are bought and held principally for the purpose of selling them in the near term; (2) held-to-maturity assets — securities that would be held to maturity (therefore, only debt instruments qualified); and (3) available-for-sale assets — all other securities. Placement of a security in the latter two categories permitted a reporting entity to avoid recognizing in earnings any unrealized (by disposition) impairment of the security (where the security's value declined below amortized cost) if the impairment was other-than-temporary. An entity did have to record an impairment of an available-for-sale asset in other comprehensive income, but this is a balance sheet item so any earnings impact was avoided. The OTTI Pronouncements, applicable only to debt securities, maintain the same tests as previously existed for determining whether an impairment is other-than-temporary. Previously, in order for a security to qualify as held-to-maturity under Statement 115, its holder had to have both the intent and the ability to hold the security for a period of time sufficient for the security to gain enough value to eliminate the impairment so that its value was again equal to or greater than its amortized cost. The OTTI Pronouncements change the test and its application. While retaining the intent condition, the OTTI Pronouncements substitute for the ability to hold condition a condition that it be more likely than not that the holder will not have to sell the security before it has sufficiently recovered its value. Under the OTTI Pronouncements, if the intent and more likely than not conditions are not satisfied for either a held-to-maturity debt or an available-for-sale debt, then an entity must take a charge against earnings for any other-than-temporary impairment. The amount recognized would be the difference between the investment's amortized cost basis and its fair value at the balance sheet date. Moreover, even if the intent and more likely than not conditions are satisfied, then further reporting is required. The security holder must take a charge against earnings for the credit loss portion of the impairment and report the remainder of the impairment on the balance sheet in other comprehensive income. From a presentation standpoint, the entity must report the full amount of the impairment in earnings subject to an offset for the amount reported in comprehensive income. For held-to-maturity debt, the entity must further amortize the non-credit loss portion over the remaining life of the debt unless the security is later sold or there are additional credit losses. The OTTI Pronouncements indicate that credit losses should be measured based on the difference between the reporting entity's estimate of the present value of cash flows the entity expects to collect from the debt security and its amortized cost. The OTTI Pronouncements also provide examples of factors to be considered in determining whether a credit loss exists and the period over which the debt security is expected to recover. In addition, the OTTI Pronouncements require significant additional disclosures that will be required for annual and interim periods, including the amortized cost basis of available-for-sale and held-to-maturity debt securities by major security type, information about the methodology and key inputs used to measure the reported credit loss portion of impairments, and more. The OTTI Pronouncements will be effective for reporting periods after June 15, 2009 with earlier adoption permitted for periods ending after March 15, 2009. FSP FAS 107-1 and APB 28-1. In 1991 FASB issued Statement 107 that required entities to make certain fair value disclosures on an annual basis about all of their financial instruments, subject to certain exceptions, whether or not recognized in the statement of financial position. Under these new pronouncements all publicly held companies must include those disclosures whenever they issue summarized financial information for interim reporting periods. FASB believes increasing the frequency of disclosures will improve the transparency and quality of the information being provided. The new FSP will be effective for reporting periods after June 15, 2009 with earlier adoption permitted for periods ending after March 15, 2009. Future. Both FASB and the International Accounting Standards Board (the entity that promulgates International Financial Reporting Standards) are engaged in a joint project related to financial instruments and expect to issue more pronouncements by the end of 2009. In addition, between now and then, there will undoubtedly be more concerns raised about existing fair value standards. The surgery is not yet complete. Caution: We urge anyone who reads this alert to contact their independent accounting firm if they have any specific questions regarding fair value accounting. 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