FAIR VALUE ACCOUNTING

Grace A. Mullings, CPA

Director, Accounting Policy

Toyota Financial Services

Fair Value Accounting

Learning Objectives

1. Understand the evolution of the fair value option

2. Provide participants with an overview of important accounting developments, disclosures and issues pertaining to fair value accounting

Agenda

1. FASB Statement No. 155 – Accounting for Certain Hybrid Financial Instruments (“Statement 155”)

2. FASB Statement No. 157 – Fair Value Measurements (“Statement 157”)

3. FASB Statement No. 159 – The Fair Value Option for Financial Assets and Financial Liabilities (“Statement 159”)

FASB Statement No. 155

Accounting for Certain Hybrid Financial Instruments

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:

1. Freestanding derivatives,2. Hybrid financial instruments containing embedded derivatives requiring

bifurcation, or 3. 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

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.

Hybrid Financial Instruments

Host

Hybrid

Derivative

1. The combination of a “Host contract” and an “Embedded derivative” = Hybrid Financial Instrument

2. Any embedded feature that meets the bifurcation criteria must be bifurcated from the host and accounted for separately.

Apply other applicable GAAP: historical cost accounting

Apply Statement 133: mark-to-fair value through earnings; may qualify as a hedging instrument

Hybrid Financial Instruments (cont’d)

1. Is the hybridcarried at fairvalue through

earnings?(Par 12b)

Bifu

rcate

3. Is it clearlyand closely

related to the Host contract?

(Par 12a)

No

Yes

YesNo

YesNo

2. Would the embedded

feature be a derivative if it

was freestanding?(Par 12c)

Do Not Bifurcate

The Bifurcation Model Paragraph 12 of Statement 133:

Hybrid Financial Instruments (cont’d)

Bifurcate when interest rate indices not clearly and closely relatedParagraph 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)

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.

Impact of Statement 155 on Beneficial Interests

1. 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

2. 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.

3. 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.”

Impact of Statement 155 on Beneficial Interests (cont’d)

1. Resulted in numerous requests to the FASB to provide guidance on the application of paragraph 13(b) to securitized interests in prepayable financial assets.

2. FASB responded by issuing Statement 133 Implementation Issue B40, “Embedded Derivatives: Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets.”a. Provides a narrow scope exception tied only to the prepayment risk of

the underlying prepayable financial assets b. 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).

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.orParenthetically 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

FASB Statement No. 157

Fair Value Measurements

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

Statement 157 – Scope

• 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

All accounting pronouncements that require or permit fair value measurement and include such items as:

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

Differences Between Statement 157 and Current PracticeIssue 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

Statement 157 – Valuation Problem

Level 2Hybrid

Fair ValueHierarchy

Level 1Market- based

Level 3Model-based

Statement 157 provides three main approaches to measuring fair value.

Objective Subjective

Statement 157 – Financial Statement Disclosures

1. Requires expanded disclosures about fair value measurements designed to provide users of financial statements with additional transparency regarding:a. Extent to which fair value is used to measure assets and

liabilities

b. The inputs and assumptions used in measuring fair value

c. The effect of fair value measurements on earnings

Statement 157 – Financial Statement Disclosures (Cont’d)

2. Nature and extent of disclosure requirements vary depending on whether the subsequent fair value measurements are made on a recurring or nonrecurring basis.a. Fair Value Measurement on a Recurring Basis:

i. Disclose the level within the fair value hierarchy in which the fair value measurement falls.

ii. Reconcile the beginning and ending balances for any recurring fair value measurements that utilize significant unobservable inputs (i.e. Level 3 inputs).

b. Fair Value Measurement on a Nonrecurring Basis:i. Disclose for assets and liabilities measured at fair value on a nonrecurring

basis the reason for the fair value measurement during the period.

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

FASB Statement No. 159

The Fair Value Option for Financial Assets and Financial Liabilities

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

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

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

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

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

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.

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

Questions and

Answers