Fair Value Measurement

1. Fair Value Measurement

2. Why focus on fair value? • Increasing relevance to financial statements and financial statement users • Increased complexity in financial instruments measured at fair value • Variety of fair value measurements and disclosures • Variety of prescribed methods for determining fair value • Different definitions of fair value or its determination in practice • Heightened regulatory interest in fair value measurements in the financial statements • SEC & PCAOB • Disruptions in credit markets have highlighted additional considerations when determining fair value

3. FAS 157: Effective Date • Originally effective for fiscal years beginning after 11/15/2007 (i.e., 1/1/2008 for calendar year entities). • FSP 157-2 delayed the effective date for non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually) • Effective date for these items is deferred to fiscal years beginning after 11/15/2008 • Examples of items eligible for deferral: • Reporting units measured at fair value in the first step of a goodwill impairment test under FAS 142 • Asset retirement obligations initially measured at fair value under FAS 143 • Non-financial long-lived assets (asset groups) measured at fair value for an impairment assessment under FAS 144

4. FAS 157: Recent Developments • FASB Staff Position No. 157-1 issued 2/14/2008 • Scoped out leasing transactions • Fair Value measurements for purposes of lease classification or measurement under Statement 13 are excluded from the scope of Statement 157 • Proposed FASB Staff Position No. 157-c, Measuring Liabilities under FASB Statement No. 157 • Intended to clarify the application of the principles in SFAS 157 to the measurement of liabilities: • A quoted price for the identical liability (unadjusted) in an active market (Level 1 input) • In the absence of a quoted price for the identical liability in an active market, the reporting entity may measure the fair value of its liability at the amount that it would receive as proceeds if it were to issue that liability at the measurement date.

5. FAS 157: Fair value measurements • What does it do? • Establishes a singular definition of fair value • Provides a conceptual framework for measuring fair value • Expands disclosures about the use of fair value • What doesn’t it do? • Require additional fair value measurements under GAAP • Provide detailed “how to” guidance with respect to valuation • Address which items are to be measured at fair value or when this measurement should be recognized • Eliminate the practicability exceptions to fair value measurements that exist in other accounting pronouncements

6. FAS 157: Fair value measurements • Valuation Resource Group • Broad constituency from valuation, accounting, preparers, users, regulators • Discussions are non-authoritative and meetings are not public • Purpose is to educate the FASB staff on: • Valuation issues • Diversity in practice • Alternative views • Board to decide which issues to add to agenda (and presumably issue proposed FSP) during open Board meetings

7. Scoped IN: Applies to all other accounting pronouncements that require FV measurements (with limited exceptions) See Appendix D to FAS 157 Covers items measured at FV On a recurring basis Only on initial recognition Non-recurring subsequent measurement Accounting pronouncements where FV used as part of a required analysis Scoped OUT: Share-based payments accounted for under FAS 123(R) Lease transactions accounted for under FAS 13 (FSP 157-1) and other accounting pronouncements that address FV measurements for the purposes of lease classification or measurement under FAS 13 Items that require/permit measurements similar to FV, but are not intended to measure FV Inventory pricing at LOCOM Vendor-specific objective evidence (VSOE) FAS 157: Examples of items IN versus OUT of FAS 157’s scope

8. FAS 157: Fair value framework The Asset or Liability Unit of Account 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

9. FAS 157 Framework: The asset or liability • Attributes of the asset or liability • Consider attributes that are specific to the asset or liability being valued • Restrictions, collateral, guarantees, etc. • Determine the fair value of the asset as it exists • May require adjustment to determine the price a market participant would pay for the asset in its current condition and location • Costs that are an attribute of an asset / liability • Transformation costs - Costs to recondition the asset • Transportation costs - Costs to move the asset • Costs not considered an attribute of an asset / liability • Transaction costs - Incremental direct costs to sell the asset or transfer the liability

10. FAS 157 Framework: Unit of account • Unit of account defines what is being measured for financial statement purposes • Generally identified in accordance with other accounting pronouncements • Primarily drives the level of aggregation (or disaggregation) for presentation and disclosure purposes • Unit of account vs. Unit of valuation • Unit of account may be the same as the unit of valuation • Classification in fair value hierarchy driven by unit of account

11. FAS 157 Framework: Valuation premise • Fair value measurement assumes the highest and best use of the asset • In certain circumstances this concept can be applied to liabilities • Highest and Best Use establishes valuation premise to maximize value from market participant’s perspective: • In-use. Provides maximum value to market participants through its use in combination with other assets • In-exchange. Provides maximum value on a stand-alone basis • Highest and best use is not an entity specific notion, but rather a market participant notion • Entity specific synergies excluded but would consider synergies of market participants

12. FAS 157 Framework: Highest and best use - example • A reporting entity acquires land in a business combination • The land is currently developed for industrial use as a site for a manufacturing facility • Nearby sites were recently developed for use as residential high-rise condominiums • Reporting entity determines that the land currently used as a site for a manufacturing facility could be developed as a site for residential use • In this instance, the highest and best use of the land would be determined by comparing: • (a) the fair value of the land used in the manufacturing operation, which presumes that the land would continue to be used as currently developed for industrial use (in-use) and • (b) the value of the land as a vacant site for residential use, considering the demolition and other costs necessary to convert the land to a vacant site (in-exchange) • Highest and best use of the land would be determined based on the higher of those values

13. FAS 157 Framework: Exit market • Fair value measurement assumes the transaction occurs in the principal (or most advantageous) market for the asset or liability • The market the reporting entity would transact with the greatest volume and level of activity for the asset or liabilities (entity vs. market consideration) • If a principal market exists, the fair value measurement represents the price in that market even if the price in a different market is more advantageous • In the absence of a principal market the most advantageous market is to be used

14. FAS 157 Framework: Exit market (cont.) Entity Specific vs. Market Participant Volume of Transactions Principal Market • Since Market B has the greatest volume for the market as a whole (and the entity has access to it), Market B is deemed the principal market • Principal markets can change over time • Management intent does not determine principal market • Subsidiaries (or parent and subsidiary) may have access to different markets for similar assets

15. FAS 157 Framework: Application to liabilities • Non-performance Risk • Risk that an obligation will not be fulfilled • Includes a reporting entity’s credit risk and may also include other risks • Assumes non-performance risk is the same before and after transfer of the liability • Impact of Own Credit Risk on the Fair Value of a Liability • An entity that experiences a credit deterioration would recognize an accounting gain on a liability measured at fair value, assuming all other inputs to the valuation remain unchanged • Consideration of non-performance risk in the subsequent measurement of a liability at fair value will be a new concept for many of our clients • FV of a liability is affected not only by a change in the reporting entity’s credit rating (i.e., the entity experiences a downgrade), but also by changes in credit spreads over time

16. FAS 157 Framework: Market participants and assumptions • Market participants are buyers and sellers in the exit market that are: • Independent of the reporting entity (not related parties) • Knowledgeable, having a reasonable understanding about the asset or liability and the transaction based on all available information • Able to transact for the asset or liability • Willing to transact for the asset or liability • Market participant assumptions are those market participants would use in pricing the asset or liability • One market participant (e.g., outlier) does not make a market • Specific market participants do not need to be identified • Rather the characteristics of market participants in general and the factors they would consider in pricing the asset or liability should be assessed

17. FAS 157: Inputs to valuation techniques and the fair value hierarchy • Goal is to allow users to assess the relative reliability of fair value measures (quality of earnings) • Prioritizes inputs to valuation techniques used to measure fair value • Fair value measurement should maximize the use of observable inputs and minimize the use of unobservable inputs • Hierarchy drives disclosures • Level at which measurement is disclosed is based on lowest level input that is “significant” to the overall fair value measure

18. FAS 157: Fair value hierarchy (continued)

19. FAS 157: Disclosure objectives • Expanded disclosures designed to provide additional transparency regarding: • Extent to which fair value is used to measure assets and liabilities • Inputs and assumptions used in measuring fair value • Effect of fair value measurements on earnings • Disclosures only apply to fair value measurements subsequent to initial recognition

20. FAS 157: Disclosure requirements • Items measured at fair value on a recurring basis • Fair value estimates for each major category of assets and liabilities • Where within the FV Hierarchy the estimates fall (Level 1, 2, or 3) • Reconciliation of beginning and ending balances for Level 3 measurements (by major category of asset and liability) • Valuation techniques used to measure fair value • For Level 3 measurements, a description of the inputs used to develop FV measurements and information used to develop the inputs • Items measure at fair value on a non-recurring basis • Fair value estimates for each major category of assets and liabilities • Where within the FV Hierarchy the estimates fall (Level 1, 2, or 3) • Valuation technique used to measure fair value • For Level 3 measurements, a description of the inputs used to develop FV measurements and information used to develop the inputs • Reason for re-measurement (e.g., impairment)

21. FAS 157: Transition • Two different transition approaches: • Prospective transition for majority of impacts of adopting the standard • Limited retrospective application for: • Positions in active markets previously valued using block discounts • EITF 02-3 and SFAS 155 transactions: Financial instruments previously measured at fair value at initial recognition using the transaction price • Difference between the carrying value and fair value (as now defined in FAS 157) at transition is recognized as a cumulative effect adjustment to the opening balance of retained earnings – single step approach

22. Impacts on Existing Practice • Recognition of Day 1 Gains and Losses • SFAS nullifies guidance in footnote 3 of EITF 02-3, “Issued involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities” • Transaction price no longer presumed to represent fair value at initial recognition • Exit price may not equal entry price • Credit adjustment fro liabilities measured at fair value • Considerations of counterparty credit risk • Hedge effectiveness testing • Treatment of transactions costs

23. Implementation Considerations and Challenges • Concepts in SFAS 157 are theoretical – the real challenge is the practical implementation of these concepts to a wide variety of facts and circumstances • Uncertainty regarding interpretation of some elements • Transaction Costs (geography) • Unit of Account • Significant area of judgment • Hypothetical exits markets • Market participants assumptions • Hierarchy levels • Determination of Significance for situations where inputs are from various levels • Short timeframe for implementation • Significant changes to systems, reporting and disclosure • Documentation of policies and procedures • SOX Compliance

24. Implementation Considerations and Challenges • Other operational complexities • Pervasive effect across the entity – impacts all assets and liabilities measured at fair value • Diversity in valuation sources and methodologies • Number of pricing sources, number of measurement models • Understanding and participation at various levels of the organization is critical • Identification of restrictions and determining whether they are an attribute of the assets

25. FAS 157: Revised definition of fair value “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.” • Clarifies a number of key points: • Fair value is an exit price (conceptually different from a transaction price which is an entry price) • An exit price in the principal market (or most advantageous market) in which the reporting entity would transact • Fair value is a market-based measurement, not an entity-specific measurement • Hypothetical transaction • Orderly transaction

26. FAS 159: The Fair Value Option

27. FAS 159: The fair value option FAS 159, The Fair Value Option for Financial Assets and Financial Liabilities • Issued February 2007 • Effective for fiscal years beginning after November 15, 2007 • Allows entities to voluntarily choose, at specified election dates, to measure certain financial assets and liabilities at fair value (the “fair value option”) • While FAS 159 is applicable to all entities, its provisions apply only to those entities that voluntarily elect the fair value option under FAS 159 • Issued to improve financial reporting by enabling entities to mitigate some volatility in reported earnings that results from different measurement attributes • For example, an entity can achieve consistent accounting for related assets and liabilities without having to apply complex hedge accounting provisions

28. FAS 159: The fair value option Fair value election • Election is generally made on an instrument-by-instrument basis • Election is irrevocable and requires all changes in fair value to be recognized in earnings • Initial adoption • One time chance to elect fair value option for any existing assets and liabilities within scope (January 1, 2008 for calendar year entities) • Going forward • Initial recognition of the item • Entity first enters into an eligible firm commitment • Financial assets carried at FV (because of specialized accounting rules) ceases to qualify for this accounting treatment • Investment becomes subject to the equity method or is no longer consolidated • Event requiring eligible items to be measured at fair value (other than impairments) at the time of the event, but not subsequently (e.g., business combination, modified debt)

29. FAS 159: Scope Items eligible for the fair value option: • Recognized financial assets and financial liabilities (unless specifically scoped out) • Firm commitments otherwise not recognized that involve only financial instruments • Written loan commitments • Rights and obligations under certain insurance and warranty contracts • Host financial instruments resulting from the separation of an embedded non-financial derivative instrument

30. FAS 159: Scope (continued) Items not eligible for the Fair Value Option: • Investment in a consolidated subsidiary / VIE • Obligations for pensions, other postretirement obligations, deferred compensation arrangements, employee stock option and stock purchase plans • Financial assets and liabilities under leases • Demand deposit liabilities • Financial instruments that are, in whole, or part, classified by the issuer as a component of shareholder’s equity

31. FAS 159: Pro’s and Con’s • Pros and Cons • Ability to mark-to-market and eliminate asymmetrical accounting • Reduce complexity • Reduce reliability • Impairs comparability because of elective nature • Gains/Losses as a result of change in own creditworthiness • Acceleration of revenue recognition • Costly to implement

32. FAS 159: Implementation Issues • Irrevocable in nature of election • Valuation Issues • Increased Documentation • Income statement classification • Balance sheet parenthetical disclosure • MD&A • Additional disclosure items that need to be tracked

33. FASB 161: Disclosures Statement of Financial Accounting Standards No. 161, “Disclosures about Derivative Instruments and Hedging Activities.”

34. FASB 161: Disclosures • FAS 161, Disclosures about Derivative Instruments and Hedging Activities • Issued March 2008 • Effective for fiscal years beginning after November 15, 2008 • Enhanced understanding of: • How and why an entity uses derivative instruments • How derivative instruments and related hedged items are accounted for under Statement 133 and its related interpretations • How derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows

35. FASB 161: Disclosures • Information about instruments shall be disclosed in the context of the primary underlying risk: • Interest rate • Credit, • Foreign exchange rate • Commodity price risk • Volume of its derivative activity • Location and fair value amounts of derivative instruments • Fair value shall be presented on a gross basis • Distinction between derivatives that are designated as hedging instruments and those that are not

36. FASB 161: Disclosures • Location and amount of gains/losses on derivative instruments and related hedge items • Derivative instruments designated and qualifying as hedging instruments in fair values hedges and related hedged items designated • Effective portion of gains and losses qualifying as cash flow hedges and net investment hedges recognized in OCI and reclassified into earnings during the period • Hedge ineffectiveness and amount excluded from assessment

37. FASB 161: Disclosures • For derivative instruments that are not designated or qualify for hedge accounting and included in trading activities, can elect not to disclose gains and losses separately as long as certain disclosures are made • Credit-risk–related contingent features • Circumstances in which the feature could be triggered that are in a net liability position • Aggregate fair value amount of derivative instruments that contain credit-risk-related contingent features in net liability position • Aggregate fair value of assets that are already posted as collateral • Aggregate fair value of assets needed to settle the instruments if features were triggered.