Fair Value Accounting - Professional Education Services | CPE

Course #6205A/QAS6205A

Course Material

Fair Value Accounting

Introduction

Introduction Numerous FASB Standards have been issued requiring certain items to be measured and reported at “fair value” on the Balance Sheet. Prior to the release of ASC 820 Fair Value Measurements and Disclosures (formerly known as SFAS 157), the concept of “fair value” had never been formally defined in U.S. accounting literature. Since its issuance in September 2006, ASC 820 has become one the most controversial accounting standards ever released. This course provides a conceptual review of fair value accounting, as outlined in ASC 820 and other U.S. accounting standards. This review includes discussions on the ongoing controversy surrounding its impact on the global economy, as well as the current FASB and IASB proposals that will potentially require fair value accounting for all financial instruments. Finally, this course will provide an overview of the authoritative guidance for auditing fair value measurements and disclosures, SAS No. 101.

Author’s Bio Michael J. Walker is a New England-based Certified Public Accountant with over fourteen years of accounting experience in the financial services, information technology services, and construction industries. He is currently a vice president at one of the largest financial institutions in the world. He has an extensive technical accounting background that includes hands-on experience with U.S. GAAP, Canadian GAAP, and International Financial Reporting Standards (IFRS). His expertise includes the accounting for derivatives, fixed income investments, and securitizations. He graduated from Bentley University with a B.S. in Finance (1995) and a M.S. in Accountancy (2000).

Table of Contents 1

Fair Value Accounting (Course #6205A/QAS6205A)

Table of Contents

Page Chapter 1: The Evolution of Fair Value

1.1 Historical Cost 1-1 1.2 The Rising Tide of Fair Value: The S&L Crisis 1-3

Review Questions & Solutions 1.1 1-6 1.3 A New Sense of Urgency: The Enron Crisis 1-11 1.4 ASC 820: Fair Value Measurements and Disclosures 1-12

Review Questions & Solutions 1.2 1-14 Chapter 1 Summary 1-16 Chapter 2: Measurement

2.1 Definition of Fair Value 2-1 Review Questions & Solutions 2.1 2-2

2.2 Fair Value Framework 2-5 2.2.1 The Price 2-5 2.2.2 The Principal (or Most Advantageous) Market 2-6 2.2.3 Market Participants 2-7 2.2.4 Attributes of the Asset or Liability 2-7 2.2.5 “Highest and Best Use” 2-8 2.2.6 Unit of Account 2-9

2.3 Fair Value at Initial Recognition 2-9 Review Questions & Solutions 2.2 2-11 Chapter 2 Summary 2-16 Chapter 3: Valuation Techniques and Inputs

3.1 Valuation Techniques 3-1 3.2 Valuation Inputs 3-5

Review Questions & Solutions 3.1 3-6 3.3 Fair Value Hierarchy 3-10

3.3.1 Level 1 Inputs 3-10 3.3.2 Level 2 Inputs 3-11 3.3.3 Level 3 Inputs 3-11

3.4 Pricing Services and Broker Quotes 3-12 3.5 Bid-Ask Prices 3-13

Review Questions & Solutions 3.2 3-14 Chapter 3 Summary 3-18

Table of Contents 2

Table of Contents (cont.)

Page Chapter 4: Auditing Fair Value Measurements and Disclosures

4.1 ASC 820 Disclosures 4-1 4.1.1 Assets and Liabilities Measured at Fair Value on a Recurring Basis 4-1 4.1.2 Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis 4-3

Review Questions & Solutions 4.1 4-6 4.2 SAS No. 101, Auditing Fair Value Measurements and Disclosures 4-8

4.2.1 Understanding the Entity’s Process for Determining Fair Value Measurements, Disclosures, the Relevant Controls, and Assessing Risk 4-8 4.2.2 Evaluating Conformity of Fair Value Measurements and Disclosures with GAAP 4-9 4.2.3 Testing the Entity’s Fair Value Measurements and Disclosures 4-10 4.2.4 Testing Management’s Significant Assumptions, the Valuation Model, and the Underlying Data 4-11 4.2.5 Auditing Disclosures about Fair Values 4-14

Review Questions & Solutions 4.2 4-15 Chapter 4 Summary 4-21 Chapter 5: The Fair Value Option

5.1 The Fair Value Option 5-1 5.2 ASC 825-10 Financial Instruments: The Fair Value Option 5-2

5.2.1 Scope 5-2 5.2.2 Excluded Items 5-2

Review Questions & Solutions 5.1 5-4 5.2.3 Accounting Election 5-7 5.2.4 Timing 5-7 5.2.5 Accounting Impact 5-8 5.2.6 Disclosure Requirements 5-9

Review Questions & Solutions 5.2 5-10 Chapter 5 Summary 5-14

Table of Contents 3

Table of Contents (cont.)

Page Chapter 6: The Future of Fair Value

6.1 Fair Value Accounting under IFRS 6-1 Review Questions & Solutions 6.1 6-3

6.2 The Credit Crisis 6-5 6.3 The Critical Backlash at “Fair Value” 6-6

Review Questions & Solutions 6.2 6-11 Chapter 6 Summary 6-15 Glossary Index

The Evolution of Fair Value 1-1

Chapter 1: The Evolution of Fair Value Learning Objectives: After studying this chapter, participants should be able to:

• Define the ‘historical cost’ method of accounting and calculate the current ‘amortized cost’ of assets and liabilities accounted for under this method.

• Define the ‘fair value’ method of accounting for assets and liabilities and recognize accounting practices consistent with this method.

• Recognize the differences between the ‘historical cost’ and ‘fair value’ methods of accounting.

“It is axiomatic that it is better to know what something is worth now than what it was worth at some moment in the past . . . Historic cost itself is in reality historic market value, the amount of a past transaction engaged in by the firm. . . . Historic cost data are never comparable on a firm-to-firm basis because the costs were incurred at different dates by different firms (or even within a single firm). There is no financial analyst who would not want to know the market value of individual assets and liabilities.” - CFA Institute, 1993 The above quote highlights a point that has been rigorously debated in the financial and accounting communities for decades. This debate centers on the proper measurement basis for a company’s assets and liabilities – “historical cost” or “fair value.” Depending on whom you ask, the answer to this question can vary. 1.1 Historical Cost Historical cost accounting is a method that presents an asset/liability on the balance sheet at the price paid/received at the time of its acquisition. Historical cost accounting includes recording revenue, expenditure and asset acquisition, and disposal at historical cost: that is, the actual amounts of money, or money's worth, received or paid to complete the transaction. The historical costs of physical assets (e.g., Property, Plant and Equipment) generally include:

• Purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates;

• Any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating. These can include site preparation, delivery and handling costs, installation, assembly, testing, professional fees and the costs of employees directly involved in these activities.

The Balance Sheet carrying value of the historical cost of an asset is generally reduced to reflect depreciation, which represents the systematic reduction in the value of the asset due to usage, passage of time, wear and tear, etc.


The concept of historical cost also applies to financial assets and liabilities (a.k.a. financial instruments). Examples of “financial” (i.e. non-physical) assets and liabilities include loans, deposits, securities, derivatives, and many other instruments.

- The historical cost basis of a financial asset generally includes the amount of consideration (e.g., cash) given up in exchange for the instrument and the costs incurred to acquire the asset.

- The historical cost basis of a financial liability generally includes the amount of consideration received as part of a financing agreement with a third party and the costs incurred to issue the liability.

Similar to depreciation, the concept of amortization generally applies to financial assets, financial liabilities and intangible assets. Amortization refers to the allocation of an asset’s acquisition cost (or liability’s issuance cost) in a systematic manner over the estimated useful economic life so as to reflect its consumption, expiration, obsolescence or other decline in value as a result of use or the passage of time. Examples of amounts associated with financial assets and liabilities that are amortized include:

• Purchase/issuance premiums and discounts1 • Nonrefundable fees and costs associated with lending activities and loan

purchases (e.g., origination fees) Methodologies for allocating amortization to each accounting period vary depending on the asset/liability. The term “amortized cost” refers to a bond’s historical cost less the cumulative amortization (or plus the cumulative accretion) recorded on the instrument. The historical cost method has been subject to many criticisms, mainly because it only considers the acquisition cost of an asset while ignoring the asset’s current market value. The historical cost method focuses primarily on allocating the cost of an asset over its useful life on the Income Statement, rather than presenting that asset on the Balance Sheet at its current market value. While this method informs the financial statements’ user of the asset’s acquisition cost and the associated depreciation/amortization in the following years, it ignores the possibility that the current market value of that asset may be higher or lower than it suggests.

1 The term ‘accretion’ is generally used when referring to the systematic recognition of income associated with a purchase discount received. The term ‘amortization’ generally is used when referring to the systematic allocation of a financial asset/liability’s acquisition cost (e.g. purchase premium/discount, origination cost, etc.).


The historical cost method also ignores a fundamental economic principle that affects the true value of any asset: inflation. An asset purchased at a point in time may be more expensive in the future. The traditional accounting principles record all assets at an original cost and continue to use these historic figures throughout the asset's life, thus ignoring the impact of the time value of money. Furthermore, the theory of historic accounting assumes that the currency in which transactions are recorded remains stable, i.e. its purchasing power remains the same over a period of time. This most certainly isn’t the case in many situations, as currency valuations can fluctuate frequently and materially. Despite its limitations, there are many benefits to the historical cost method of accounting. Historical cost is based on definitive records of the actual transactions, thus making the Balance Sheet carrying values of the items reliable. The historical cost method also provides managers with a significant range of alternatives in recognizing, reporting and measuring economic information. One other advantage is that it helps managers forecast future operational costs based on past data. The basic function of historical accounting is to tell a user "the cost of a thing." Without knowing the original costs, future income and expenses become very difficult to project. Historical costs can play an important role in providing this necessary information. 1.2 The Rising Tide of Fair Value: The S&L Crisis Although not formally defined in accounting literature until 2006, the concept of fair value has always been synonymous with the terms “current value” and “market value.” Fair value has historically referred to the value for which the asset could be sold for in the current market (i.e. the “exit” price).

Historical Cost – Example Q: A 10 year fixed income security with a par value of $100 million is purchased at a premium on 1/1/2010 for $105 million. There was $1 million of acquisition costs associated with acquiring the security. The total premium (including the acquisition costs) is amortized on a monthly basis at $50,000/month. The market price of the bond on 3/31/2010 is $107 million.

1. What was the original cost basis of the security? 2. What is the amortized cost of the security as of 3/31/2010?

A:

1. The original cost basis of the security was $106 million. This includes the $100 par value of the security, the $5 million purchase premium and the $1 million acquisition costs.

2. The amortized cost of the security as of 3/31/10 is $105,850,000. This equals the original cost basis ($106 million) minus the cumulative amortization recorded ($3 months @ $50,000/month).


The movement towards fair value accounting (a.k.a. mark-to-market accounting) began in the mid-to-late 1980’s with the advent of the savings and loan (S&L) crisis. This crisis resulted in the failure of 747 savings and loan associations in the United States. The root cause of the savings and loan crisis is generally considered to be the deregulation and evolution of the financial services industry, as the regulated thrift industry struggled to compete against its unregulated competition. However, many fair value accounting advocates believe the savings and loan crisis and its estimated $500 billion price tag could have been prevented if thrifts had used fair value accounting. More specifically, they believe that the use of historical cost accounting, rather than fair value accounting, failed to expose the industry's true financial condition. If thrifts had used fair value accounting, regulators and investors would have known about the precarious nature of the industry, acted to minimize future losses, and prevented the massive government bailout by the Resolution Trust Corporation. With the increasing concern in the public and private sectors about the adequacy of financial statement reporting by financial institutions, fair value accounting concepts began receiving considerable attention from Congress, the Financial Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC), and others as a possible means to improve financial reporting. Concern began to grow that the use of historical cost accounting by banking institutions had been a contributing factor in masking the true value of their assets, and thus misrepresenting the need for further intervention by regulators. The FASB initiated a project to consider comprehensive disclosures about risk, liquidity, interest rates, and market values of financial instruments. This project resulted in a new FASB Standard that expanded market value disclosure requirements to many types of financial instruments. The final FASB standard, Statement No. 107, Disclosures about Fair Value of Financial Instruments, was issued in December 1991. (Note – SFAS 107 is now a portion of ASC 825 Financial Instruments as a result of the accounting standards codification that occurred in 2009.) This standard requires entities to supplement their historical cost financial statements with disclosures about the fair values of financial instruments reported in those statements. The fair value vs. historical cost debate has raged on ever since the release of ASC 825. It is widely believed that the FASB themselves are proponents of fair value, as indicated by the numerous Standards that have been released over the past two decades that include the concept. The following is a sample of these standards that permit (or in some cases require) recognition and measurement at fair value:


Exhibit 1.1 – FASB Standards with References to Fair Value FASB Codification Reference Original Standard Number and Title Issue

Date ASC 825-10 Financial Instruments: The Fair Value Option

SFAS 159 – The Fair Value Option for Financial Assets and Financial Liabilities

Feb-07

ASC 715-20 Compensation: Defined Benefit Plans

SFAS 158 – Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106 and 132(R)

Sep-06

ASC 718 Stock Compensation SFAS 123 (revised 2004) – Share-Based Payments

Dec-04

ASC 480 Distinguishing Liabilities from Equity

SFAS No. 150 – Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity

May-03

ASC 420 Exit or Disposal Cost Obligations

SFAS 146 – Accounting for Costs Associated with Exit or Disposal Activities

Jun-02

ASC 360 Property, Plant and Equipment

SFAS 144 – Accounting for the Impairment or Disposal of Long-lived Assets

Aug-01

ASC 410-20 Asset Retirement and Environmental Obligations: Asset Retirement Obligations

SFAS 143 – Accounting for Asset Retirement Obligations

Jun-01

ASC 350 Intangibles: Goodwill and Other

SFAS 142 – Goodwill and Other Intangible Assets

Jun-01

ASC 860 Transfers and Servicing

SFAS 140 – Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities

Sep-00

ASC 815 Derivatives and Hedging

SFAS 133 – Accounting for Derivatives & Hedging Activities

Jun-98

ASC 320 Investments: Debt & Equity Securities

SFAS 115 – Accounting for Certain Investments in Debt and Equity Securities

May-93

ASC 825-50 Financial Instruments: Disclosure

SFAS 107 – Disclosures about Fair Value of Financial Instruments

Dec-91


REVIEW QUESTIONS 1.1

The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter.

1. Francona Financial owns a portfolio of mortgage-backed securities that it accounts

for under the historical cost accounting method. In accordance with U.S. GAAP, these financial assets should be presented on the Balance Sheet at: a) the value for which the asset could be sold in the current market b) the price paid for the security at the time of acquisition (less cumulative

amortization, if any) c) the cost to replace them if the assets were sold today d) their intrinsic value

2. Which of the following accounting practices is the most consistent with the concept of historical cost accounting under U.S. GAAP: a) Company A excludes installation costs and delivery fees from its historical cost

calculations b) Company B periodically adjusts the historical cost of its assets to reflect changes

in market conditions c) Company C immediately expenses purchase premiums paid for their financial

assets d) Company D systematically reduces the balance sheet value of its construction

equipment to reflect wear and tear

3. A ten year fixed income security with a par value of $100 million is purchased at a discount on January 31, 2010 for $97 million. There was no acquisition costs associated with the security. The same security can be purchased in the market for $99 million on July 31, 2010. What is the amortized cost of this security as of July 31, 2010: a) $97,150,000 b) $99,000,000 c) $100,000,000 d) $99,850,000


4. A research analyst is preparing a report on the pros and cons of historical cost accounting. Which of the following statements would most likely appear in the analyst’s report to describe the impact that this method had on the savings and loan scandal in the mid-to-late 1980’s: a) the use of historical cost accounting assisted in hiding the S&L industry’s true

financial condition at the time b) the use of historical cost accounting would have prevented the S&L crisis from

occurring c) the historical cost method would have properly reflected the S&L industry’s

assets and liabilities at their current values d) the fraudulent application of the historical cost method of accounting is what

ultimately caused the crisis

5. Which of the following accounting practices is the most consistent with the concept of fair value accounting under U.S. GAAP: a) Company A reports derivative instruments on the balance sheet at their

amortized cost b) Company B amortizes purchase premiums paid for their securities over the

estimated lives of the assets c) Company C reports loans held-for-sale on the balance sheet at their current

value d) Company D deducts the salvage value from the original cost of its auto fleet

when performing their depreciation calculations

6. A 20 year fixed income security with a par value of $100 million is purchased at a premium on January 31, 2010 for $102 million. There were no acquisition costs associated with the security. The same security can be purchased in the market for $103 million on July 31, 2010. What is the fair value of this security as of July 31, 2010: a) $100,000,000 b) $101,950,000 c) $102,000,000 d) $103,000,000

7. Which of the following accounting practices is the most consistent with the fair value accounting requirements of ASC 825-50 (formerly SFAS 107): a) Company A records all of their derivative instruments on the balance sheet at fair

value b) Company B records the changes in fair value associated with its security portfolio

in other comprehensive income c) Company C supplements their historical cost financial statements with

disclosures about the fair values of financial instruments d) Company D uses the retrospective method when amortizing the purchase

premiums associated with their bond positions


SOLUTIONS AND SUGGESTED RESPONSES 1.1

1. A: Incorrect. A security accounted for under the fair value accounting method (not historical cost) would be presented at its market value.

B: Correct. The portfolio would be presented at the price paid for the asset at the time of acquisition (less cumulative amortization, if any).

C: Incorrect. This describes the concept of ‘replacement cost’ which generally does not apply to financial instruments.

D: Incorrect. Intrinsic value is a concept that generally applies only to derivatives. It does not apply in this case. (See page 1-1+ of the course material.)

2. A: Incorrect. Installation costs and delivery fees should be included (not excluded) from the calculation of an asset’s historical cost.

B: Incorrect. The historical cost of an asset would not be adjusted in such a manner.

C: Incorrect. Purchase premiums must be amortized over the lives of financial assets under historical cost accounting.

D: Correct. This correctly describes the accounting practice of depreciation, which is a key component of historical cost accounting. (See page 1-1 of the course material.)

3. A: Correct. The amortized cost as of July 31, 2010 is $97,150,000. This amount

equals the original cost ($97,000,000) plus six months worth of discount accretion ($150,000).

B: Incorrect. This amount represents the fair value of the security.

C: Incorrect. This amount represents the par value of the security.

D: Incorrect. This amount equals the par value of the security ($100,000,000) minus six months of discount accretion, which is incorrect. (See page 1-2+ of the course material.)


4. A: Correct. Many critics believed that the use of historical cost accounting failed to expose the industry's true financial condition.

B: Incorrect. Historical cost accounting was considered a cause of the S&L crisis.

C: Incorrect. Fair value accounting (not historical cost accounting) recognizes assets and liabilities on the balance sheet at their current values.

D: Incorrect. The S&L’s were not criticized for fraudulently applying historical cost accounting. Rather, the historical cost basis itself was criticized as inherently flawed. (See page 1-3+ of the course material.)

5. A: Incorrect. The concepts of historical cost and amortized cost pertain to the

presentation of assets and liabilities on the balance sheet at their original cost. They are not synonymous with (or related to) the concept of fair value, which pertains to the presentation of assets and liabilities on the balance sheet at their current value.

B: Incorrect. The concepts of depreciation and amortization are related to the concept of historical cost (not fair value).

C: Correct. The concept of ‘fair value’ is synonymous with ‘current value.’ Therefore, this accounting practice is the most consistent with the concept of fair value accounting.

D: Incorrect. The concepts of depreciated value and salvage value are related to the concept of historical cost (not fair value). (See page 1-3 of the course material.)

6. A: Incorrect. This amount represents the par value of the security.

B: Incorrect. This amount represents the amortized cost of the security as of July 31, 2010. This amount equals the original cost ($102,000,000) minus six months worth of premium amortization ($50,000).

C: Incorrect. This amount represents the original cost (purchase price) of the security.

D: Correct. The fair value of the security equals the market price as of July 31, 2010, which is $103,000,000. (See page 1-3 of the course material.)


7. A: Incorrect. ASC 815 (formerly SFAS 133) pertains to the accounting for derivatives and hedging activities.

B: Incorrect. ASC 320 (formerly SFAS 115) pertains to the accounting for securities.

C: Correct. ASC 825-50 (formerly SFAS 107) requires entities to supplement their historical cost financial statements with disclosures about the fair values of financial instruments reported in those statements.

D: Incorrect. ASC 310-20 (formerly SFAS 91) pertains to the amortization of fees (including premiums and discounts on securities). (See page 1-4 of the course material.)


1.3 A New Sense of Urgency: The Enron Crisis As mentioned previously, the concept of “fair value” had existed for many years in Generally Accepted Accounting Principles without ever being formally defined by the FASB. The reason for this lack of guidance is uncertain, but its impact would be widely felt early in the new millennium. The Enron Corporation, an energy company based in Houston, TX, stunned the financial world by declaring bankruptcy in late 2001. The earliest revelations about Enron indicated that the company’s financial statements were seriously misleading. When the company announced massive write-offs and restatements in October and November 2001, it seemed that fraud must have been involved. As the Enron story unfolded, it was revealed that the company had pursued so many accounting loopholes in its financial reporting that “its financial statements bore little resemblance to its actual financial condition or performance.”2 It could even be argued that Enron resembled an organized crime syndicate, as efforts to mislead investors required the coordinated efforts of many people. As a result of their combined efforts, equity losses to Enron shareholders were $65 billion and losses to creditors were $51 billion. The most frequently criticized accounting issue at Enron was the company’s use of off-balance-sheet financing. The principal contention of the prosecution was that Enron hid losses through improper and misleading use of special-purpose entities (SPE) and outside partnerships. Enron also made extensive (and questionable) use of fair value accounting. Despite its likely overstatement of fair value assets, Enron’s use of fair value accounting was never an issue in the criminal case against former CEOs Kenneth Lay and Jeffrey Skilling. However several financial journalists questioned the Company’s use of fair value accounting and criticized the FASB for unknowingly enabling the massive fraud through its loose definition of “fair value.” The extent of Enron’s faulty fair value accounting was realized during the Company’s bankruptcy court proceedings. According to The CPA Journal (November 2006), Enron should have had almost $70 billion in total assets to satisfy the $63 billion in creditor claims. However, their bankruptcy plan revealed that only $12 billion was expected from the sale of Enron’s power-generating and gas-transmission utility businesses. What happened to the other $58 billion in assets? The most obvious explanation was that the balance sheet contained “assets” that had little or no real value. Enron’s balance sheet included current and non-current accounts described as “price risk management assets” (PRMA). Enron persuaded the SEC in January 1992 to allow them to use fair value accounting to value these long-term gas contracts and derivatives. However, no market existed for these “assets,” and thus Enron was free to value them as they saw fit. As a result, the SEC handed Enron the tools to abandon traditional principles and introduce the bookkeeping analogue of financial engineering into non-financial companies. Enron eagerly applied the tools and soon began discounting to present value as much as 29 years of income from customer contracts. The result, after considerable manipulation, was instantaneous increases in

2 Third Interim Report of Neal Batson, Court-Appointed Examiner,” U.S. Bankruptcy Court, S.D.N.Y., In re: Enron Corp., et al., Debtors, Chapter 11, Case No. 01-16034 (AJG), Jointly Administered, June 20, 2003


assets and offsetting equity and, of course, income. It soon became apparent that there was nothing “fair” about Enron’s use of fair value, and that the mark-to-market accounting of their price risk management assets was very likely used to obscure the depth of their problems. Once these issues came to light in the fall of 2001, Enron collapsed like the proverbial house of cards. The political fallout of the Enron debacle was tremendous:

• The Company’s auditing firm, Arthur Andersen LLP, shared the blame for the accounting scandal. On June 15, 2002, Andersen was convicted of obstruction of justice for shredding documents related to its audit of Enron. This conviction subsequently led to the firm surrendering its CPA licenses and its right to practice before the U.S. Securities and Exchange Commission on August 31, 2002 - effectively putting them out of business.

• The Sarbanes-Oxley Act of 2002 was passed by the U.S. Government in

response to a number of major corporate and accounting scandals, including those affecting Enron, Tyco International, Adelphia, Peregrine Systems and WorldCom. This legislation established new or enhanced standards for all U.S. public company boards, management, and public accounting firms. The Act also established a new quasi-public agency, the Public Company Accounting Oversight Board, or PCAOB, which is charged with overseeing, regulating, inspecting, and disciplining accounting firms in their roles as auditors of public companies. The Act covers issues such as auditor independence, corporate governance, internal control assessment, and enhanced financial disclosure. Upon signing the Act into law, President George W. Bush referred to it as "the most far-reaching reform of American business practices since the time of Franklin D. Roosevelt.”

1.4 ASC 820: Fair Value Measurements and Disclosures In June 2003, the Financial Accounting Standards Board added a fair value measurement project to its agenda to address fair value measurement issues broadly. The project had never been formally linked to the accounting scandals of the new millennium; however it was clear that new accounting guidance was necessary to prevent future irregularities resulting from the fraudulent use of fair value accounting. In 2003, the Board agreed that, conceptually, the definition of fair value and its application in GAAP should be the same for all assets and liabilities. The result of this project was the Statement of Financial Accounting Standards No. 157, Fair Value Measurements, issued in exposure draft form in June 2004. This new Statement was issued in order to:

- Define fair value - Establish a framework for measuring fair value - Expand disclosures about fair value measurements - Simplify and codify the related guidance that currently exists for developing fair

value measurements - Eliminate differences that have added to the complexity in GAAP.


The final version of SFAS 157 became effective for fiscal years beginning after November 15, 2007 (that is, January 1, 2008 for calendar year entities). SFAS 157 became known as ASC 820 Fair Value Measurements and Disclosures in 2009 as part of the FASB’s Accounting Standards Codification project. The Statement applies under other accounting pronouncements that require or permit fair value measurements, with the exception of ASC 718 Stock Compensation. The Statement does not require any new fair value measurements.




1. A research analyst is preparing a report on the Enron scandal of the early 2000’s.

Which of the following GAAP-related issues would the analyst most likely cite as enabling the fraud perpetrated by The Enron Corporation: a) the vague definition of ‘historical cost’ b) the permitted use of the cash method of accounting c) the inconsistent guidance on the accrual method of accounting d) the lack of specific guidance on the concept of fair value

2. Ellsbury Corp. is planning to apply the U.S. GAAP concepts of fair value to their year-end financial statements. Under the guidance of ASC 820, the definition of fair value and its application should be: a) unique for each individual class of assets and liabilities b) the same for all assets and liabilities c) the same for all assets, but unique for each individual liability class d) the same for all liabilities, but unique for each individual asset class

3. Which of the following statements accurately summarizes the FASB’s reasoning for issuing ASC 820 Fair Value Measurements and Disclosures: a) this FASB wished to prohibit the use of historical cost accounting b) the FASB wanted to reduce the required disclosures about fair value

measurements c) the FASB wanted to require several new fair value measurements that were

previously not included in existing FASB literature d) this FASB wished to define fair value and establish a framework for measuring

fair value



1. A: Incorrect. The lack of formal accounting guidance on the definition of “fair value” (not historical cost) has been blamed (in part) for enabling the Enron accounting scandal in 2001. B: Incorrect. The cash method of accounting was not considered a primary factor in the Enron fraud.

C: Incorrect. The accrual method of accounting was not considered a primary factor in the Enron fraud.

D: Correct. Many critics believed that fair value cost accounting enabled Enron to commit fraud on a massive scale in the early 2000’s. (See page 1-10+ of the course material.)

2. A: Incorrect. The FASB did not determine that the definition of fair value and its

application in GAAP should be unique to various classes of assets and liabilities.

B: Correct. The FASB determined that the definition of fair value and its application in GAAP should be the same for all assets and liabilities.

C: Incorrect. The FASB determined that the definition of fair value should be the same for all assets and liabilities. The FASB did not determine that the definition should be unique to various classes of liabilities.

D: Incorrect. The FASB determined that the definition of fair value should be the same for all assets and liabilities. The FASB did not determine that the definition should be unique to various classes of assets. (See page 1-11 of the course material.)

3. A: Incorrect. ASC 820 does not prohibit the use of historical cost accounting.

B: Incorrect. ASC 820 expands (not reduces) disclosures about fair value measurements.

C: Incorrect. ASC 820 does not require several new fair value measurements that were previously not included in existing FASB literature.

D: Correct. The Financial Accounting Standards Board (FASB) issued ASC 820 Fair Value Measurements and Disclosures in order to define fair value, establish a framework for measuring fair value, expand disclosures about fair value measurements, simplify and codify the related guidance that currently exists for developing fair value measurements, and eliminate differences that have added to the complexity in GAAP. (See page 1-11+ of the course material.)


CHAPTER 1 SUMMARY

• There is an ongoing debate regarding the proper measurement basis for a company’s assets and liabilities – “historical cost” or “fair value”.

• Historical cost accounting values an asset (liability) on the balance sheet at the

price paid (received) for the asset (liability) at the time of its acquisition (issuance).

• Fair value accounting values assets and liabilities on the balance sheet at their

“current” (or “market” values). The concept of “fair value” was not formally defined in accounting literature until 2006.

• The historical cost method has been subject to many criticisms, mainly because

it fails to consider several factors that impact the true value of an asset or liability, such as exchange rates and inflation rates.

• The use of historical cost accounting has been blamed for enabling the Savings

and Loan (S&L) crisis of the 1980’s by failing to expose the industry's true financial condition at the time.

• The lack of formal accounting guidance on the definition of “fair value” has been

blamed (in part) for enabling the Enron accounting scandal in 2001.

• The Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements, in exposure draft form in June 2004. This new Statement (now referred to as ASC 820 Fair Value Measurements and Disclosures) was issued in order to:

- Define fair value - Establish a framework for measuring fair value - Expand disclosures about fair value measurements - Simplify and codify the related guidance that currently exists for

developing fair value measurements - Eliminate differences that have added to the complexity in GAAP.

Measurement 2-1

Chapter 2: Measurement Learning Objectives: After studying this chapter, participants should be able to:

• Define ‘fair value’ as outlined in ASC 820 Fair Value Measurements and Disclosures.

• Recognize accounting practices that are consistent with the fair value framework established in ASC 820.

2.1 Definition of Fair Value ASC 820 defines fair value as “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.” While the definition in ASC 820 maintains the exchange price notion that existed in previous definitions of fair value, the revised definition (and its application in the fair value framework) provides clarity on a number of key points, including:

• Fair value is the price to sell an asset or transfer a liability and, therefore, represents an exit price, not an entry price.

• The exit price for an asset or liability is conceptually different from its transaction

price (and entry price). While exit and entry price may be identical in many situations, the transaction price is no longer presumed to represent the fair value of an asset or liability on its initial recognition.

• Fair value is the exit price in the principal market in which the reporting entity

would transact (or, if lacking a principal market, the most advantageous market). The price in the exit market should not be adjusted for transaction costs.

• Fair value is a market-based measurement, not an entity-specific measurement,

and as such, is determined based on the assumptions that market participants would use in pricing the asset or liability.

• The exit price objective of a fair value measurement applies regardless of the

reporting entity’s intent and/or ability to sell the asset or transfer the liability at the measurement.

• A fair value measurement contemplates the sale of an asset or transfer of a

liability, not a transaction to offset the risks associated with an asset or liability.

• The transaction to sell the asset or transfer the liability is a hypothetical transaction as of the measurement date and assumes an appropriate period of exposure to the market, such that the transaction is considered orderly.

Measurement 2-2



1. Which of the following accounting policies is compliant with ASC 820’s definition of

‘fair value’: a) Company A values its fair value assets at the historical price paid for each asset b) Company B values its fair value assets at the price paid for the asset in an

orderly transaction between market participants at the measurement date c) Company C does not apply the ASC 820 definition of fair value to its derivative

instruments d) Company D applies the ASC 820 definition of fair value only to stand-alone

assets

2. Which of the following prices would most likely be consistent with the definition of fair value under ASC 820:

a) a market-based price to purchase equipment b) a market-based price to sell an investment c) an entity-specific price to purchase equipment d) an entity-specific price to sell an investment

3. Which of the following scenarios depicts the appropriate application of the concept of ‘exit price’ as it is defined in ASC 820: a) Company A values its machinery at its acquisition cost b) Company B adjusts the fair value of its investments for trading costs c) Company C uses hypothetical transactions to estimate the value that its assets

would sell for in its principal market d) Company D bases its fair value calculations on its intent to hold or sell the asset

4. Which of the following would most likely be considered an ‘orderly transaction’ under the guidance provided in ASC 820: a) a machinery sale made as part of bankruptcy proceedings b) the distressed sale of an auto fleet c) a hypothetical equipment sale that assumes exposure to the market for a

customary period d) an investment sale that occurs in an illiquid market

Measurement 2-3

SOLUTIONS AND SUGGESTED RESPONSES 2.1 1. A: Incorrect. This is the definition of historical cost, not fair value.

B: Correct. ASC 820 defines fair value as the price paid for an asset or liability in an orderly transaction between market participants at the measurement date.

C: Incorrect. ASC 820 is applicable to most assets and liabilities accounted for at fair value, including derivative instruments.

D: Incorrect. ASC 820 is applicable to most assets and liabilities accounted for at fair value; it is not limited to stand-alone assets. (See page 2-1 of the course material.)

2. A: Incorrect. This description is consistent with the concept of an “entry price;” fair

value represents an exit price, not an entry price.

B: Correct. A market-based “exit” price to sell an investment would be consistent with the ASC 820 definition of fair value.

C: Incorrect. ASC 820 states that fair value is a market-based measurement, not an entity-specific measurement. Also, this description is consistent with the concept of an “entry price;” fair value represents an exit price, not an entry price.

D: Incorrect. ASC 820 states that fair value is a market-based measurement, not an entity-specific measurement. (See page 2-1 of the course material.)

3. A: Incorrect. The cost to acquire an asset is consistent with the concept of entry

price, not exit price.

B: Incorrect. The exit price should not be adjusted for transaction costs.

C: Correct. An exit price generally represents a hypothetical transaction price to sell an asset or transfer a liability in the item’s principal market.

D: Incorrect. The exit price objective of a fair value measurement applies regardless of the reporting entity’s intent and/or ability to sell the asset or transfer the liability at the measurement. (See page 2-1 of the course material.)

Measurement 2-4

4. A: Incorrect. A sale made as part of bankruptcy proceedings would generally be considered a ‘forced transaction’ under ASC 820.

B: Incorrect. A distressed sale would not generally be considered an ‘orderly transaction’ under ASC 820.

C: Correct. 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 and liabilities.

D: Incorrect. A transaction to buy or sell a financial instrument that takes place in an illiquid (or inactive) market is not generally considered an ‘orderly transaction’ under ASC 820. (See page 2-1 of the course material.)

Measurement 2-5

2.2 Fair Value Framework In addition to providing a revised definition of fair value, ASC 820 also establishes a framework (or approach) for applying this definition in financial reporting. Many of the key concepts used in the fair value framework are connected, and their interaction should be considered in the context of the entire approach. The following diagram summarizes the interdependence of the various components of the fair value approach prescribed in ASC 820. Exhibit 2.1 – ASC 820 Fair Value Approach

2.2.1 THE PRICE A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date. 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 and liabilities; it is not a forced transaction (for example a forced liquidation or distress sale). The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the assets or owes the liability. Therefore, the objective of a fair value measurement is to determine the price that would be received to sell the asset or paid to transfer the liability at the measurement date (an exit price). The concept of a hypothetical transaction clarifies that the transaction between market participants does not consider management’s intent to actually sell the asset or transfer the liability at the measurement date, nor does it consider the reporting entity’s ability to enter into the transaction on the measurement date. To illustrate, consider a hypothetical transaction to sell a security that is restricted from sale as of the measurement date. While the restriction may affect the determination of fair value for the asset, it does not preclude the consideration of a hypothetical transaction to sell the restricted security.

Measurement 2-6

2.2.2 THE PRINCIPAL (OR MOST ADVANTAGEOUS) MARKET A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The principal market is the market in which the reporting entity would sell the asset or transfer the liability with the greatest volume and level of activity for the asset or liability. The most advantageous market is the market in which the reporting entity would sell the asset or transfer the liability with the price that maximizes the amount that would be received for the asset or minimizes the amount that would be paid to transfer the liability, considering transaction costs in the respective market(s). ASC 820 specifies that if there is a principal market for the asset or liability being measured, the fair value for that asset or liability should represent the price in that market, even if the price in a different market is more advantageous at the measurement date. In other words, the most advantageous market concept is applied only in situations where the reporting entity determines there is no principal market for the asset or liability being measured. The determination of the principal (or most advantageous) market is made from the perspective of the reporting entity. This is an important clarification because it acknowledges that different reporting entities may sell assets or transfer liabilities in different markets depending on their activities. For example, a securities dealer may exit a financial instrument by selling it in the inter-dealer market, while a manufacturing company would sell a financial instrument in the retail market. The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs. Transaction costs represent the incremental direct costs to sell the asset or transfer the liability in the principal (or most advantageous) market for the asset or liability. Transaction costs are not considered an attribute of the asset or liability; rather, they are specific to the transaction and will differ depending on how the reporting entity transacts. However, transaction costs do not include the costs that would be incurred to transport the asset or liability to (or from) its principal (or most advantageous) market. If location is an attribute of the asset or liability (as might be the case for a commodity), the price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall be adjusted for the costs, if any, that would be incurred to transport the asset or liability to (or from) its principal (or most advantageous) market.

Measurement 2-7

2.2.3 MARKET PARTICIPANTS Market participants are buyers and sellers in the principal (or most advantageous) market for the asset or liability that are:

• Independent of the reporting entity (i.e., they are not related parties) • Knowledgeable, having a reasonable understanding about the asset or liability

and the transaction based on all available information, including information that might be obtained through due diligence efforts that are usual and customary

• Able to transact for the asset or liability

• Willing to transact for the asset or liability (i.e., they are motivated but not forced

or otherwise compelled to do so).

Determining the characteristics of market participants within the principal (or most advantageous) market of the reporting entity requires significant judgment. ASC 820 specifies that fair value is not the value specific to one entity, but rather is meant to be a market-based measurement. If market participants would consider adjustments for the inherent risk of the asset or liability, or consider the risk in the valuation technique used to measure fair value, then such risk adjustments should be considered in the fair value assumptions. In developing those assumptions, the reporting entity need not identify specific market participants. Rather, the reporting entity should identify characteristics that distinguish market participants generally, considering factors specific to:

a. The asset or liability, b. The principal (or most advantageous) market for the asset or liability, and c. Market participants with whom the reporting entity would transact in that market.

2.2.4 ATTRIBUTES OF THE ASSET OR LIABILITY A fair value measurement is for a particular asset or liability. The fair value measurement should therefore consider attributes specific to the asset or liability, including the condition and/or location of the asset or liability and restrictions on the sale or use of the asset (if any). For example, age and miles flown are attributes to be considered in determining a fair value measure for an aircraft. An important attribute of a financial asset or liability is the nonperformance risk (a.k.a. credit risk) associated with the instrument. Nonperformance risk is naturally associated with financial instruments with fair values equal to anything other than zero. The nonperformance risk associated with financial assets is generally known as counterparty credit risk. This risk (which is assumed by the purchasing entity) represents the probability that the counterparty becomes insolvent and/or is unable to meet the terms of the agreement. Counterparty credit risk is generally present in most financial assets; one exception includes U.S. Treasury bonds, which are backed by the U.S. Government and, therefore, considered credit risk-free. The nonperformance risk associated with financial liabilities is generally referred to as the entity’s own credit risk. This risk (which is generally assumed by a reporting entity’s counterparty) is the risk that the reporting entity becomes insolvent and/or is unable to meet the terms of the agreement.

Measurement 2-8

ASC 820 addresses the issue of nonperformance risk both explicitly and implicitly. With respect to the consideration of an entity’s own credit risk, the guidance in the Statement is explicit. ASC 820-35 states that the fair value of the liability shall reflect the nonperformance risk relating to the liability. Nonperformance risk includes but may not be limited to the reporting entity’s own credit risk. The reporting entity shall consider the effect of its credit risk (credit standing) on the fair value of the liability in all periods in which the liability is measured at fair value. With respect to the consideration of counterparty credit risk, the guidance in the Statement is more implicit. ASC 820 requires the fair value of an asset or liability to be determined based on the assumptions that market participants would use in pricing the asset or liability. Therefore, if market participants would consider counterparty credit risk in pricing the asset or liability, then an entity’s valuation methodology should incorporate the effect of this risk on fair value. 2.2.5 “HIGHEST AND BEST USE” A fair value measurement assumes the “highest and best use” of an asset by market participants. This term refers to the use of an asset by market participants that would maximize the value of that asset or group of assets. 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. The fair value measure assumes the highest and best use of the non-financial asset, in view of its characteristics, legal considerations, and cost factors. ASC 820-35 states that because the highest and best use is determined based on its use by market participants, the fair value measurement considers the assumptions that market participants would use in pricing the assets, whether using an in-use or an in-exchange valuation premise. Thus, the “highest and best use” of an asset determines whether the valuation should be “in-use” or “in-exchange”:

• The highest and best use is in-exchange if the asset would provide maximum value to market participants principally on a stand-alone basis. For example, if the highest and best use of a financial asset is on a stand-alone basis, then the fair value is measured using an in-exchange premise, such as the price that would be received in a current sale.

• 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). Example of such an asset might be land with a manufacturing plant. If the land offers the maximum value to market participants when combined with the manufacturing plant, then the fair value would be measured with an in-use premise – the price from selling the land assuming it would be used with the building and that the building would also be available for sale. If the highest and best use of the land would be for residential or condominium purposes, then the fair value would be measured with an in-exchange premise, on a stand-alone basis, net of demolition and other costs. Because the highest and best use of the land depends on the higher value, either in-use or in-exchange, market participants determine the fair value of the land.

Measurement 2-9

In another example of assigning the fair value to a non-financial asset, assume an entity acquires an in-process R&D project during a merger. The project competes with one of its own projects, so the entity intends to discontinue the acquired project. If the highest and best use is its in-use value, which is the price that a buyer with complementary assets available would pay, then that price would be the fair value. If the highest and best price is its in-exchange value, which is the price a buyer would pay as a stand-alone and then discontinue the project, then that price would be the fair value. Note. The highest and best use criteria generally apply only to non-financial asset (not liability) fair values. 2.2.6 UNIT OF ACCOUNT The asset or liability being valued might be a stand-alone asset or liability (e.g., a financial instrument) or a group of assets and/or liabilities (e.g., a reporting group or business). Whether the asset/liability is considered a standalone item or a group of items, depends on its unit of account. The unit of account defines what is being measured for financial reporting purposes. It is an accounting concept that determines the level at which an asset or liability is aggregated or disaggregated for purposes of applying ASC 820, as well as other accounting pronouncements. The identification of exactly what asset or liability is being measured, while basic, is fundamental to determining its fair value. 2.3 Fair Value at Initial Recognition When an asset is acquired or a liability is assumed in an exchange transaction for that asset or liability, the transaction price represents the price paid to acquire the asset or received to assume the liability (an entry price). In contrast, the fair value of the asset or liability represents the price that would be received to sell the asset or paid to transfer the liability (an exit price). Conceptually, entry prices and exit prices are different. Entities do not necessarily sell assets at the prices paid to acquire them. Similarly, entities do not necessarily transfer liabilities at the prices received to assume them. In many cases, the transaction price will equal the exit price and, therefore, represent the fair value of the asset or liability at initial recognition. In determining whether a transaction price represents the fair value of the asset or liability at initial recognition, the reporting entity shall consider factors specific to the transaction and the asset or liability. For example, a transaction price might not represent the fair value of an asset or liability at initial recognition if:

a. The transaction is between related parties. b. The transaction occurs under duress or the seller is forced to accept the price in

the transaction. For example, that might be the case if the seller is experiencing financial difficulty.

Measurement 2-10

c. The unit of account represented by the transaction price is different from the unit of account for the asset or liability measured at fair value. For example, that might be the case if the asset or liability measured at fair value is only one of the elements in the transaction, the transaction includes unstated rights and privileges that should be separately measured, or the transaction price includes transaction costs.

d. The market in which the transaction occurs is different from the market in which

the reporting entity would sell the asset or transfer the liability, that is, the principal or most advantageous market. For example, those markets might be different if the reporting entity is a securities dealer that transacts in different markets, depending on whether the counterparty is a retail customer (retail market) or another securities dealer (inter-dealer market).

The varying definitions of entry and exit price included in ASC 820 introduce the concept of “Day 1 Gains and Losses.” Such gains and losses if they exist, can impact the prospective accounting for the asset or liability. This is particularly the case with derivative instruments.

Measurement 2-11


The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. Use the following for questions 1 through 4: Brady Corp. is an investment bank that frequently purchases and sells all types of financial products (including derivative instruments) in many different markets. Brady accounts for these products at fair value. 1. Under ASC 820, the principal market of Brady’s financial products is:

a) the market in which Brady would purchase or sell each product with the greatest

volume and level of activity b) not considered if more advantageous prices are available in other markets c) always considered to be the retail market for each product, regardless of the

actual market from which the entity transacts d) the same for all identical assets, regardless of an entity’s access to other markets

2. Which of the following entities would Brady most likely consider a ‘market participant’

for their derivative products under the guidance of ASC 820: a) Company A, a wholly-owned subsidiary of Brady Corp b) Company B, a hedge fund who has recently sold their open positions as a result

of bankruptcy c) Company C, a commercial bank that is independent of Brady Corp d) Company D, a credit union that is prohibited from purchasing Brady’s financial

products

3. The risk that Brady’s derivative customers may default on the terms of their open derivative contracts is known as: a) interest rate risk b) an entity’s own credit risk c) prepayment risk d) counterparty credit risk

4. The risk that Brady Corp may default on the terms of their open derivative contracts

is known as: a) interest rate risk b) an entity’s own credit risk c) prepayment risk d) counterparty credit risk

Measurement 2-12

Use the following for questions 5 and 6: Kraft Auto, Inc. is attempting to value its car dealership (the building and land) and its car inventory in accordance with ASC 820. 5. Based on preliminary market research, Kraft determines that the land provides

maximum benefit when used in combination with the dealership building. Under ASC 820, the ______ valuation premise would likely be required in this circumstance. a) in-combination b) in-use c) in-exchange d) in-benefit

6. The basis at which Kraft accounts for its car inventory (i.e., a car-by-car basis vs. an aggregated basis) under other U.S. GAAP standards: a) will likely determine the level at which the assets are valued under ASC 820 b) is pre-determined for all asset and liability types within the scope of ASC 820 c) is not a fundamental component in the determination of fair value d) is a valuation concept that determines how the asset or liability is measured

7. Which of the following transactions has most likely been executed at a transaction

price that equals the asset’s fair value at the time of purchase: a) Company A purchases several equity investments on the NYSE b) Company B purchases equipment from its subsidiary c) Company C purchases machinery from a company that has filed bankruptcy d) Company D purchases a securities portfolio at a price that includes transaction

fees

8. An analyst is researching an income statement line item labeled “Day 1 Gains and Losses.” Within the scope of ASC 820, these gains and losses most likely are a result of the dissimilar definitions of ______ in the Standard. a) transaction price and entry price b) entry price and exit price c) market price and current price d) amortized cost and market price

Measurement 2-13

SOLUTIONS AND SUGGESTED RESPONSES 2.2 1. A: Correct. The principal market is the market in which the reporting entity would sell

the asset or transfer the liability with the greatest volume and level of activity for the asset or liability.

B: Incorrect. ASC 820 specifies that if there is a principal market for the asset or liability being measured, the fair value for that asset or liability should represent the price in that market, even if the price in a different market is more advantageous at the measurement date.

C: Incorrect. The determination of the principal (or most advantageous) market is made from the perspective of the reporting entity. Different reporting entities may sell assets or transfer liabilities in different markets depending on their activities.

D: Incorrect. The determination of the principal (or most advantageous) market is made from the perspective of the reporting entity. Different reporting entities may sell assets or transfer liabilities in different markets depending on their activities. (See page 2-6 of the course material.)

2. A: Incorrect. A ‘market participant’ should not be a related party to the reporting entity

under ASC 820 guidelines.

B: Incorrect. A ‘market participant’ should not be forced into the transaction.

C: Correct. Market participants must be independent of the reporting entity.

D: Incorrect. A ‘market participant’ must be able to transact for the asset or liability. (See page 2-7 of the course material.)

3. A: Incorrect. Interest rate risk is the risk that an investment's value will change due to

a change in the absolute level of interest rates. Interest rate derivatives are generally transacted to hedge interest rate risk.

B: Incorrect. An entity’s own credit risk (which is generally assumed by a reporting entity’s counterparty) is the risk that the reporting entity becomes insolvent and/or is unable to meet the terms of the agreement.

C: Incorrect. Prepayment risk is the risk associated with the early unscheduled return of principal on a fixed-income security.

D: Correct. This describes the concept referred to as counterparty credit risk (a form of nonperformance risk). (See page 2-7 of the course material.)

Measurement 2-14

4. A: Incorrect. Interest rate risk is the risk that an investment's value will change due to a change in the absolute level of interest rates. Interest rate derivatives are generally transacted to hedge interest rate risk.

B: Correct. This describes the concept referred to as an entity’s own credit risk. This is a form of nonperformance risk that is generally assumed by a reporting entity’s counterparty.

C: Incorrect. Prepayment risk is the risk associated with the early unscheduled return of principal on a fixed-income security.

D: Incorrect. Counterparty credit risk (which is generally assumed by the reporting entity) is the risk that the counterparty becomes insolvent and/or is unable to meet the terms of the agreement. (See page 2-7 of the course material.)

5. A: Incorrect. “In-combination” is not a valid valuation premise under ASC 820.

B: Correct. 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. This valuation premise would be required under this circumstance.

C: Incorrect. The highest and best use is in-exchange if the asset would provide maximum value to market participants principally on a stand-alone basis. It is not applicable in this case.

D: Incorrect. “In-benefit” is not a valid valuation premise under ASC 820. (See page 2-8 of the course material.)

6. A: Correct. The unit of account is an accounting concept that determines the level at

which an asset or liability is aggregated or disaggregated for purposes of applying ASC 820, as well as other accounting pronouncements.

B: Incorrect. ASC 820 does not prescribe the unit of account to be used for assets and liabilities required (or permitted) to be measured at fair value.

C: Incorrect. The unit of account represents exactly what asset or liability is being measured, which is fundamental in determining its fair value.

D: Incorrect. The valuation premise determines how the asset or liability is measured (not the unit of account). (See page 2-9 of the course material.)

Measurement 2-15

7. A: Correct. An asset’s transaction price (or ‘entry price’) generally equals its fair value (or ‘exit price’) if the transaction takes place in an active market for that asset and does not involve related parties or forced sales.

B: Incorrect. A transaction price might not represent the fair value of an asset or liability if the transaction is between related parties.

C: Incorrect. A transaction price might not represent the fair value of an asset or liability if the transaction occurs under duress (due to bankruptcy or other circumstances).

D: Incorrect. An exit price should not include transaction fees; therefore, in this case, the transaction price would not equal fair value. (See page 2-9 of the course material.)

8. A: Incorrect. The concepts of transaction and entry price are identical and do not

result in the potential recognition of Day 1 Gains and Losses.

B: Correct. Under ASC 820, ‘day one gains and losses’ often result from differences in the ‘entry price’ and ‘exit price’ of a transaction when it is executed.

C: Incorrect. The concepts of market and current price are identical and do not result in the potential recognition of Day 1 Gains and Losses.

D: Incorrect. Although the concepts of amortized cost and market price are different, they do not result in the potential recognition of Day 1 Gains and Losses as described in ASC 820. (See page 2-10 of the course material.)

Measurement 2-16

CHAPTER 2 SUMMARY

• ASC 820 defines fair value as “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.”

• Fair value is the price to sell an asset or transfer a liability and, therefore,

represents an exit price, not an entry price.

• Fair value is a market-based measurement, not an entity-specific measurement, and as such, is determined based on the assumptions that market participants would use in pricing the asset or liability.

• ASC 820 establishes a framework (or approach) for applying this definition in

financial reporting. Many of the key concepts used in the fair value framework are connected, and their interaction should be considered in the context of the entire approach. These concepts include:

- The price that would be received to sell the asset or paid to transfer the

liability at the measurement date - The principal (or most advantageous) market for the asset or liability

- The buyers and sellers in the principal (or most advantageous) market for

the asset or liability (a.k.a. the “market participants”)

- Attributes specific to the asset or liability, including nonperformance risk associated with financial assets and liabilities

- The “highest and best” use of an asset

- The unit of account

• In many cases, the entry (transaction) price of an asset or liability will equal the

exit price and, therefore, represent the fair value at initial recognition. However this is not always the case.

Valuation Techniques and Inputs 3-1

Chapter 3: Valuation Techniques and Inputs Learning Objectives: After studying this chapter, participants should be able to:

• Recognize valuation techniques that are consistent with the guidance of ASC 820.

• Recognize the proper classification of valuation inputs into the levels of the fair value hierarchy.

3.1 Valuation Techniques ASC 820 recognizes three valuation techniques to measure fair value:

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-Sholes-Merton formula (a closed-form model) and a binomial model (a lattice model), which incorporate present value techniques; and the multi-period 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).


It should be noted that ASC 820 does not prioritize the valuation techniques to be applied, as all three approaches may not be applicable to all assets or liabilities. The reporting entity should measure the fair value of an asset or liability using one or more valuation techniques where appropriate and for which adequate data is available. The selection of the valuation method(s) to apply should consider the exit market for the asset or liability and the nature of the asset or liability being valued. The determination of the appropriate technique to be applied requires significant judgment, sufficient knowledge of the asset or liability, and a level of expertise regarding the valuation techniques. As indicated by the Statement, the use of only one valuation technique may be appropriate in measuring the fair value of an asset or liability (in certain cases). This is especially true when the asset or liability is valued using an unadjusted quoted market price from an active market. However, in many situations more than one valuation technique may be deemed appropriate and multiple approaches should be applied. Most importantly, the FASB has emphasized that the application of valuation techniques be applied on a consistent basis, among similar assets, as well as across reporting periods. If a change in valuation technique results in a more representative fair value measurement, such changes should be implemented. Some circumstances that may trigger a change in valuation technique include changes in:

• The available or observable market data • The exit market for the asset or liability

• The market participants for the assets or liability

• The highest and best use of the asset

A change in valuation technique should be accounted for as a change in an accounting estimate. However, in situations where there was an error in the application of a valuation technique, the change to the correct application of the technique would be accounted for as the correction of an error in accordance with ASC 250 Accounting Changes and Error Corrections. The examples in Exhibit 3.1 (taken from ASC 820) illustrate the valuation technique concepts discussed thus far.


Exhibit 3.1 – ASC 820 Valuation Technique Examples

Example – Machines Held and Used The reporting entity tests for impairment an asset group that is held and used in operations. The asset group is impaired. The reporting entity measures the fair value of a machine that is used in the asset group as a basis for allocating the impairment loss to the assets of the group in accordance with ASC 360-10, Impairment or Disposal of Long-Lived Assets. The machine, initially purchased from an outside vendor, was subsequently customized by the reporting entity for use in its operations. However, the customization of the machine was not extensive. The reporting entity determines that the asset would provide maximum value to market participants through its use in combination with other assets as a group (as installed or otherwise configured for use). Therefore, the highest and best use of the machine is in-use. The reporting entity determines that sufficient data are available to apply the cost approach and, because the customization of the machine was not extensive, the market approach. The income approach is not used because the machine does not have a separately identifiable income stream from which to develop reliable estimates of future cash flows. Further, information about short-term and intermediate-term lease rates for similar used machinery that otherwise could be used to project an income stream (lease payments over remaining service lives) is not available. The market and cost approaches are applied as follows:

• Market approach. The market approach is applied using quoted prices for similar machines adjusted for differences between the machine (as customized) and the similar machines. The measurement reflects the price that would be received for the machine in its current condition (used) and location (installed and configured for use), thereby including installation and transportation costs. The fair value indicated by that approach ranges from $40,000 to $48,000.

• Cost approach. The cost approach is applied by estimating the amount that currently

would be required to construct a substitute (customized) machine of comparable utility. The estimate considers the condition of the machine (for example, physical deterioration, functional obsolescence, and economic obsolescence) and includes installation costs. The fair value indicated by that approach ranges from $40,000 to $52,000.

The reporting entity determines that the fair value indicated by the market approach is more representative of fair value than the fair value indicated by the cost approach and, therefore, ascribes more weight to the results of the market approach. That determination is based on the relative reliability of the inputs, considering the degree of comparability between the machine and the similar machines. In particular:

• The inputs used in the market approach (quoted prices for similar machines) require relatively fewer and less subjective adjustments than the inputs used in the cost approach.

• The range indicated by the market approach overlaps with, but is narrower than, the range indicated by the cost approach.

• There are no known unexplained differences (between the machine and the similar machines) within that range.


Example – Machines Held and Used (continued) The reporting entity further determines that the higher end of the range indicated by the market approach is most representative of fair value, largely because the majority of relevant data points in the market approach fall at or near the higher end of the range. Accordingly, the reporting entity determines that the fair value of the machine is $48,000. Example – Software Asset The reporting entity acquires a group of assets. The asset group includes an income-producing software asset internally developed for license to customers and its complementary assets (including a related database with which the software asset is used). For purposes of allocating the cost of the group to the individual assets acquired, the reporting entity measures the fair value of the software asset. The reporting entity determines that the software asset would provide maximum value to market participants through its use in combination with other assets (its complementary assets) as a group. Therefore, the highest and best use of the software asset is in-use. (In this instance, the licensing of the software asset, in and of itself, does not render the highest and best use of the software asset in-exchange.) The reporting entity determines that in addition to the income approach, sufficient data might be available to apply the cost approach but not the market approach. Information about market transactions for comparable software assets is not available. The income and cost approaches are applied as follows:

• Income approach. The income approach is applied using a present value technique. The cash flows used in that technique reflect the income stream expected to result from the software asset (license fees from customers) over its economic life. The fair value indicated by that approach is $15 million.

• Cost approach. The cost approach is applied by estimating the amount that currently would be required to construct a substitute software asset of comparable utility (considering functional, technological, and economic obsolescence). The fair value indicated by that approach is $10 million.

Through its application of the cost approach, the reporting entity determines that market participants would not be able to replicate a substitute software asset of comparable utility. Certain attributes of the software asset are unique, having been developed using proprietary information, and cannot be readily replicated. The reporting entity determines that the fair value of the software asset is $15 million, as indicated by the income approach.


3.2 Valuation Inputs In ASC 820, inputs refer broadly to the assumptions that market participants would use in pricing an asset or liability, including assumptions about risk, for example, the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and/or the risk inherent in the inputs to the valuation technique. Inputs may be observable or unobservable.

a. Observable inputs are inputs that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the reporting entity.

b. Unobservable inputs are inputs that reflect the reporting entity’s own

assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances.

Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. The inputs used in fair value measurements may be observable or unobservable, but they should always attempt to reflect the assumptions that market participants would use in pricing the asset or liability. As such, the term ‘unobservable input’ is not meant to imply entity-specific assumptions. Although unobservable inputs may be developed using the reporting entity’s own data, these inputs should reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability. For example, in valuing an intangible asset using unobservable inputs, the assumptions that would be considered by market participants (and therefore the inputs to the valuation technique) should take into account the intended use of the asset by market participants, which could differ from the intended use specific to the reporting entity. In instances where a reporting entity determines that market participant assumptions are consistent with its own assumptions, the entity’s own data would not need to be adjusted.




1. Company A uses a valuation model that incorporates present value techniques to

price its portfolio of fixed rate debt securities. Under ASC 820, this valuation technique would be considered consistent with the: a) market approach b) income approach c) cost approach d) fixed approach

2. Company B uses a pricing matrix to price its portfolio of floating rate mortgage-backed securities. Under ASC 820, this valuation technique would be considered consistent with the: a) market approach b) income approach c) cost approach d) floating approach

3. Company C values its machinery at its current replacement cost on the Balance Sheet. Under ASC 820, this valuation technique would be considered consistent with the: a) market approach b) income approach c) cost approach d) machine approach

4. Which of the following valuation policies would most likely be considered consistent with the guidance of ASC 820: a) Company A prohibits the use of only one valuation technique when valuing an

asset or liability b) Company B prohibits the use of more than one valuation technique when valuing

an asset or liability c) Company C requires consistent application of valuation techniques among

similar assets d) Company D requires the use of the market approach in all cases


5. Daisuke Corp. utilizes a valuation model to estimate the fair value of its fixed income securities. The model uses two primary inputs when calculating this value: the 3-month LIBOR yield curve published in independent financial journals and prepayment assumptions that have been developed internally by Daisuke management. Based on the guidance provided in ASC 820, the LIBOR yield curve would most likely be considered an ______ input and the internally developed prepayment assumptions would most likely be considered an ______ input. a) observable; observable b) unobservable; observable c) unobservable; unobservable d) observable; unobservable

6. Which of the following policies would most likely ensure compliance with the requirements for fair value techniques outlined in ASC 820: a) Company A maximizes the use of observable inputs and minimizes the use of

unobservable inputs b) Company B maximizes the use of unobservable inputs and minimizes the use of

observable inputs c) Company C makes equal use of observable and unobservable inputs d) Company D prohibits the changing of their valuation methodologies once they

have been approved by their board of directors



1. A: Incorrect. The focus of the market approach is on prices and other relevant information generated by actual market transactions, not values derived from cash flow models.

B: Correct. This type of valuation technique would fall under the income approach, as described in ASC 820.

C: Incorrect. The cost approach is based on the replacement cost of the asset being valued, not on cash flow projections.

D: Incorrect. The “fixed approach” is not a valid valuation technique within the scope of ASC 820. (See page 3-1 of the course material.)

2. A: Correct. This type of valuation technique would fall under the market approach,

as described in ASC 820.

B: Incorrect. The income approach generally applies to valuations derived from cash flow models rather than market price of identical or similar assets.

C: Incorrect. The cost approach is based on the replacement cost of the asset being valued, not on market prices of identical or similar assets.

D: Incorrect. The “floating approach” is not a valid valuation technique within the scope of ASC 820. (See page 3-1 of the course material.)

3. A: Incorrect. The focus of the market approach is on prices and other relevant

information generated by actual market transactions, not the replacement cost of the asset.

B: Incorrect. The income approach generally applies to valuations derived from cash flow models rather than the replacement cost of the asset.

C: Correct. This type of valuation technique would fall under the cost approach, as described in ASC 820.

D: Incorrect. The “machine approach” is not a valid valuation technique within the scope of ASC 820. (See page 3-1 of the course material.)


4. A: Incorrect. The use of only one valuation technique may be appropriate in measuring the fair value of an asset or liability (in certain cases).

B: Incorrect. The reporting entity should measure fair value using one or more valuation techniques where appropriate.

C: Correct. The FASB has emphasized that the application of valuation techniques be applied on a consistent basis, among similar assets, as well as across reporting periods.

D: Incorrect. ASC 820 does not prioritize the valuation techniques to be applied, as all three approaches may not be applicable to all assets or liabilities. (See page 3-2 of the course material.)

5. A: Incorrect. The internally developed prepayment assumptions would not be

considered an observable input in this example.

B: Incorrect. Unadjusted LIBOR values are generally considered to be observable inputs. The internally developed prepayment assumptions would not be considered an observable input in this example.

C: Incorrect. Unadjusted LIBOR values are generally considered to be observable inputs.

D: Correct. An interest rate or index value (such as LIBOR) would be considered an ‘observable input’ because it is independently determined and widely published. Prepayment assumptions that have been developed internally would be considered an unobservable input as it is not widely observable in the market. (See page 3-5 of the course material.)

6. A: Correct. Valuation techniques used to measure fair value must maximize the use

of observable inputs and minimize the use of unobservable inputs.

B: Incorrect. ASC 820 places a higher priority on observable inputs over unobservable inputs.

C: Incorrect. ASC 820 places a higher priority on observable inputs over unobservable inputs.

D: Incorrect. A change in valuation technique is permitted, and should be accounted for as a change in accounting estimate in most cases. (See page 3-5 of the course material.)


3.3 Fair Value Hierarchy To increase consistency and comparability in fair value measurements, ASC 820 establishes a fair value hierarchy to prioritize the inputs used in valuation techniques. There are three broad levels to the fair value hierarchy of inputs to fair value (Level 1 being the highest priority and Level 3 being the lowest priority):

Level 1: Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets;

Level 2: Inputs other than quoted prices included in Level 1 that are observable

for the asset or liability either directly or indirectly; and

Level 3: Unobservable inputs (e.g., a reporting entity’s own data). By distinguishing between inputs that are observable in the marketplace, and therefore more objective, and those that are unobservable and therefore more subjective, the hierarchy is designed to indicate the relative reliability of the fair value measurements. In some cases, a valuation technique used to measure fair value may include inputs from multiple levels of the fair value hierarchy. The lowest level of significant input determines the placement of the entire fair value measurement in the hierarchy. Assessing the significance of a particular input to the fair value measurement requires judgment, considering factors specific to the asset or liability. Determining whether a fair value measurement is based on Level 1, Level 2, or Level 3 inputs is important because certain disclosures required by ASC 820 are applicable only to those fair value measurements that use Level 3 inputs. The ASC 820 disclosure requirements are discussed in further detail in Chapter 4: Auditing Fair Value Measurements and Disclosures. 3.3.1 LEVEL 1 INPUTS Level 1 inputs are quoted prices (unadjusted) for identical assets or liabilities in active markets. A quoted price for an identical asset or liability in an active market (e.g., an equity security traded on the NYSE) provides the most reliable fair value measurement and, if available, should be used to measure fair value in that particular market. As a general principle, ASC 820 mandates the use of quoted prices in active markets for identical assets and liabilities whenever available (with limited exception). Quoted prices in active markets should not be adjusted when determining the fair value of assets and liabilities that are identical to those for which the quotes pertain, as the FASB believes these prices provide the most reliable evidence of fair value. Examples of Level 1 inputs may include:

• New York Stock exchange prices for securities • NYMEX futures contract prices • U.S. Treasury prices


3.3.2 LEVEL 2 INPUTS Level 2 inputs are inputs that are observable, either directly or indirectly, but do not qualify as Level 1. In accordance with ASC 820, Level 2 inputs include the following:

a. Quoted prices for similar assets or liabilities in active markets. b. Quoted prices for identical or similar assets or liabilities in markets that are not

active, that is, markets in which there are few transactions for the asset or liability, the prices are not current, or price quotations vary substantially either over time or among market makers (for example, some brokered markets), or in which little information is released publicly (for example, a principal-to-principal market).

c. Inputs other than quoted prices that are observable for the asset or liability (for

example, interest rates and yield curves observable at commonly quoted intervals, volatilities, prepayment speeds, loss severities, credit risks, and default rates).

d. Inputs that are derived principally from or corroborated by observable market

data through correlation or by other means (market-corroborated inputs).

Adjustments to Level 2 inputs should include factors such as the condition and/or location of the asset or the liability on the measurement date and the volume and level of activity in the markets within which the inputs are observed. An adjustment that is significant to the fair value measurement may place the measurement in Level 3 in the fair value hierarchy. Examples of Level 2 inputs may include:

• Posted or published clearing prices, if corroborated • A dealer quote for a non-liquid security, provided the dealer is standing ready

and able to transact 3.3.3 LEVEL 3 INPUTS ASC 820 defines Level 3 inputs as follows:

Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs shall be used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. However, the fair value measurement objective remains the same, that is, an exit price from the perspective of a market participant that holds the asset or owes the liability. Therefore, unobservable inputs shall reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability (including assumptions about risk). Unobservable inputs shall be developed based on the best information available in the circumstances, which might include the reporting entity’s own data.


Level 3 inputs may include information derived through extrapolation or interpolation that cannot be corroborated by observable market data. In developing Level 3 inputs, a reporting entity need not undertake all possible efforts to obtain information about market participant assumptions; however, it should not ignore information that is reasonably available without undue cost and effort. Therefore, if a reporting entity uses its own data to develop Level 3 inputs, that data should be adjusted if information is reasonably available that indicates that market participants would use different assumptions. Examples of Level 3 inputs may include:

• Inputs obtained from broker quotes that are indicative (i.e., not being transacted upon) or not corroborated

• Models that incorporate management assumptions that cannot be corroborated with observable market data

3.4 Pricing Services and Broker Quotes In some cases, reporting entities may rely on pricing services or published prices that represent a consensus reporting of multiple brokers. It may not be clear if the prices provided can be transacted upon. In order to support an assertion that a broker quote or information obtained from a consensus pricing service represents a Level 2 input, an entity should typically perform due diligence to understand how the price was developed, including understanding the nature and observability of the inputs used to determine that price. Additional corroboration could include:

• Discussions with pricing services, dealers, or other entities to collect additional prices of identical or similar assets to corroborate the price;

• Back-testing of prices to determine historical accuracy; and

• Comparisons to other external or internal valuation model outputs.

The level of due diligence performed is highly dependent on the facts and circumstances, such as the type and complexity of the asset or liability being measured, as well as its observability and liquidity in the marketplace. Generally, the more unique the asset or liability being measured and the less liquid it is, the more due diligence will be necessary to corroborate the price in order to support classification as a Level 2 input. Determining the amount and type of due diligence to be performed is a matter of judgment, and reporting entities should clearly document the assessment performed in arriving at their conclusions. Without additional supporting information, prices obtained from a single broker or pricing service are indicative values or proxy quotes, and such information generally represents Level 3 inputs. It is important to note that an entity must have some higher-level data to support classification of an input as Level 2. A broker quote for which the broker does not stand ready to transact cannot be corroborated with an internal model populated with Level 3 information to support a Level 2 classification. However, there may be other instances where pricing information can be corroborated by market evidence, resulting in a Level 2 input.


Ultimately, it is management’s responsibility to determine the appropriateness of its fair value measurements and their classification in the fair value hierarchy, including instances where pricing services are used. Therefore, reporting entities that use pricing services will need to understand how the pricing information has been developed and obtain sufficient information to be able to determine where instruments fall within the fair value hierarchy. 3.5 Bid-Ask Prices 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 should be used to measure fair value, regardless of where in the fair value hierarchy the input falls (Level 1, 2, or 3). ASC 820 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.




1. Quoted prices of identical assets available on the New York Stock Exchange would

generally be considered a ______ input under ASC 820. a) Level 1 b) Level 2 c) Level 3 d) Level 4

2. Quoted prices for similar assets or liabilities used in a pricing matrix would generally be considered a ______ input under ASC 820. a) Level 1 b) Level 2 c) Level 3 d) Level 4

3. Mortgage prepayment assumptions which cannot be corroborated with observable market data would generally be considered a ______ input under ASC 820. a) Level 1 b) Level 2 c) Level 3 d) Level 4

4. Youkilis Bank relies on a pricing service to provide the fair value of its investments

portfolio. Which of the following statements accurately reflect the fair value accounting requirements for broker quotes received from an outside pricing service: a) such inputs must be classified as a Level 3 input in all circumstances b) such inputs may be classified as a Level 2 input if it can be corroborated by

market evidence c) such inputs be classified as a Level 2 input even if it cannot be corroborated by

market evidence d) such inputs must be classified as a Level 2 input in all circumstances


5. Ortiz, Inc. is preparing its fair value disclosures for the year ending 20X9. Which of the following parties would most likely bear the responsibility of determining the appropriateness of Ortiz’s fair value measurements, as well as their classification within the fair value hierarchy: a) Ortiz’s external auditors b) Ortiz’s internal auditors c) Ortiz’s shareholders d) Ortiz’s management



1. A: Correct. This type of valuation input would be considered Level 1 according to the ASC 820 fair value hierarchy.

B: Incorrect. Quoted prices of similar assets generally fall within the Level 2 classification; quoted prices of identical assets fall within the Level 1 classification.

C: Incorrect. Quoted prices would generally not fall into the Level 3 category unless significant adjustments were made based on unobservable information.

D: Incorrect. Level 4 is not a valid classification under the ASC 820 fair value hierarchy. (See page 3-10 of the course material.)

2. A: Incorrect. The Level 1 classification generally applies only to prices of identical assets that are traded in active markets.

B: Correct. This type of valuation input would be considered Level 2 according to the ASC 820 fair value hierarchy.

C: Incorrect. Quoted prices would generally not fall into the Level 3 category unless significant adjustments were made based on unobservable information.

D: Incorrect. Level 4 is not a valid classification under the ASC 820 fair value hierarchy. (See page 3-11 of the course material.)

3. A: Incorrect. The Level 1 classification generally applies only to prices of identical

assets that are traded in active markets.

B: Incorrect. Management assumptions may fall into the Level 2 category only if they can be corroborated by observable market data.

C: Correct. This type of valuation input would be considered Level 3 according to the ASC 820 fair value hierarchy.

D: Incorrect. Level 4 is not a valid classification under the ASC 820 fair value hierarchy. (See page 3-11+ of the course material.)


4. A: Incorrect. ASC 820 does not require broker quotes or valuations received from an outside pricing service to automatically be classified as Level 3 inputs.

B: Correct. A broker quote or valuation received from an outside pricing service may be classified as a Level 2 input if the entity performs the due diligence necessary to corroborate the valuation with market observable information.

C: Incorrect. A broker quote or valuation received from an outside pricing service may only be classified as a Level 2 input if the entity performs the due diligence necessary to corroborate the valuation with market observable information.

D: Incorrect. ASC 820 does not require broker quotes or valuations received from an outside pricing service to automatically be classified as Level 2 inputs. (See page 3-12 of the course material.)

5. A: Incorrect. External auditors are not primarily responsible for determining the appropriateness of an entity’s fair value measurements and their classification in the fair value hierarchy.

B: Incorrect. Internal auditors are not primarily responsible for determining the appropriateness of an entity’s fair value measurements and their classification in the fair value hierarchy.

C: Incorrect. Shareholders are not primarily responsible for determining the appropriateness of an entity’s fair value measurements and their classification in the fair value hierarchy.

D: Correct. Ultimately, it is management’s responsibility to determine the appropriateness of its fair value measurements and their classification in the fair value hierarchy. (See page 3-13 of the course material.)


CHAPTER 3 SUMMARY

• ASC 820 recognizes three valuation techniques to measure fair value:

1. The market approach, which uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities (including a business).

2. The income approach, which uses valuation techniques to convert future

amounts (for example, cash flows or earnings) to a single present amount (discounted).

3. The cost approach, which 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).

• Inputs refer broadly to the assumptions that market participants would use in

pricing an asset or liability. • Valuation techniques used to measure fair value must maximize the use of

observable inputs and minimize the use of unobservable inputs.

• ASC 820 establishes a fair value hierarchy to prioritize the inputs used in valuation techniques. There are three broad levels to the fair value hierarchy of inputs to fair value:

- Level 1: Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets;

- Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or indirectly; and

- Level 3: Unobservable inputs (e.g., a reporting entity’s own data).

• It is management’s responsibility to determine the appropriateness of its fair value measurements and their classification in the fair value hierarchy, including instances where pricing services are used.

Auditing Fair Value Measurements and 4-1 Disclosures

Chapter 4: Auditing Fair Value Measurements and Disclosures Learning Objectives: After studying this chapter, participants should be able to:

• Recognize accounting practices consistent with the fair value disclosure requirements outlined in ASC 820.

• Recognize auditing practices consistent with the standards of fieldwork related to auditing fair value measurements and disclosures included in SAS No. 101.

• Explain the roles that management and the auditor have in the fair value measurement process.

4.1 ASC 820 Disclosures ASC 820 requires expanded disclosures about fair value measurements that are designed to provide users of financial statements with additional transparency regarding:

• The extent to which a reporting entity measures assets and liabilities at fair value; • The valuation techniques used to measure fair value; and • The effect of fair value measurements on earnings.

ASC 820 requires use of a tabular format to present the required quantitative disclosures. In addition, qualitative disclosures about the valuation techniques used to measure fair value are required in all annual periods. ASC 820’s disclosure requirements vary depending on whether the asset or liability is measured on a recurring or nonrecurring basis and the classification of the fair value measurement in its entirety within the fair value hierarchy. In either case, the requirements are intended to provide financial statement users with additional insight into the relative reliability of the various fair value measures, thus enhancing their ability to broadly assess the quality of earnings. 4.1.1 ASSETS AND LIABILITIES MEASURED AT FAIR VALUE ON A RECURRING BASIS ASC 820 requires reporting entities to disclose information that enables users of its financial statements to assess both of the following:

a. For assets and liabilities that are measured at fair value on a recurring basis in periods subsequent to initial recognition (for example, trading securities), the valuation techniques and inputs used to develop those measurements.

b. For recurring fair value measurements using significant unobservable inputs

(Level 3), the effect of the measurements on earnings (or changes in net assets) for the period.


To meet the objectives described above, a reporting entity must disclose all of the information listed below:

• The fair value measurement at the reporting date. • The level within the fair value hierarchy in which the fair value measurement in its

entirety falls, segregating the fair value measurement using any of the following:

o Quoted prices in active markets for identical assets or liabilities (Level 1) o Significant other observable inputs (Level 2) o Significant unobservable inputs (Level 3).

• The amounts of transfers between Level 1 and Level 2 of the fair value hierarchy and the reasons for the transfers.

• For fair value measurements using significant unobservable inputs (Level 3), a

reconciliation of the beginning and ending balances, separately presenting changes during the period attributable to any of the following:

o Total gains or losses for the period (realized and unrealized), separately

presenting gains or losses included in earnings (or changes in net assets) and gains or losses recognized in other comprehensive income, and a description of where those gains or losses included in earnings (or changes in net assets) are reported in the statement of income (or activities) or in other comprehensive income;1

o Purchases, sales, issuances, and settlements (each type disclosed separately);2

o Transfers in and/or out of Level 3 and the reasons for those transfers. Significant transfers into Level 3 must be disclosed separately from significant transfers out of Level 3.

• For fair value measurements using significant other observable inputs (Level 2)

and significant unobservable inputs (Level 3), a description of the valuation technique (or multiple valuation techniques) used (such as the market approach, income approach, or the cost approach), and the inputs used in determining the fair values of each class of assets or liabilities. If there has been a change in the valuation technique(s) (for example, changing from a market approach to an income approach or the use of an additional valuation technique), the reporting entity must disclose that change and the reason for making it.

• For fair value measurements categorized in Level 3 of the fair value hierarchy:

o Descriptions of the valuation processes in place (e.g., how the entity decides its valuation policies and procedures, as well as its analyses of changes in the fair value measurements from period to period).

1 Separate disclosures are also required for the amount of these gains or losses that are attributable to the change in unrealized gains or losses relating to those assets and liabilities still held at the reporting date. 2 This specific requirement is effective for fiscal years beginning after December 15, 2010; please see ASC 820-10-65-7 for further details.


o A narrative description of the sensitivity of the fair value to changes in unobservable inputs and interrelationships between those inputs if a change in those inputs would result in a significantly different fair value measurement.

The preceding disclosure requirements apply to each asset and liability class measured at fair value on the financial statements. ASC 820 notes that judgment is needed to determine the appropriate classes of assets and liabilities for which disclosures about fair value measurements should be provided. Fair value measurement disclosures for each class of assets and liabilities often will require greater disaggregation than the reporting entity’s line items in the statement of financial position. A reporting entity must determine the appropriate classes for those disclosures on the basis of the nature and risks of the assets and liabilities and their classification in the fair value hierarchy (that is, Levels 1, 2, and 3). Finally, ASC 820 encourages reporting entities to combine the fair value measurement disclosures with the fair value disclosures required under other accounting standards (e.g., ASC 825-50), if practicable. 4.1.2 ASSETS AND LIABILITIES MEASURED AT FAIR VALUE ON A NONRECURRING BASIS For assets and liabilities that are measured at fair value on a nonrecurring basis in periods after initial recognition (for example, impaired assets), the reporting entity must disclose information that enables users of its financial statements to assess the valuation techniques and inputs used to develop those measurements. To meet that objective, the reporting entity must disclose all of the following information for each interim and annual period separately for each class of assets and liabilities:

• The fair value measurement recorded during the period and the reasons for the measurement;

• The level within the fair value hierarchy in which the fair value measurement in its

entirety falls, segregating the fair value measurement using any of the following:

o Quoted prices in active markets for identical assets or liabilities (Level 1) o Significant other observable inputs (Level 2) o Significant unobservable inputs (Level 3).

• For fair value measurements using significant other observable inputs (Level 2)

and significant unobservable inputs (Level 3), a description of the valuation technique (or multiple valuation techniques) used, such as the market approach, the income approach, or the cost approach, and the inputs used in determining the fair values of each class of assets or liabilities. If there has been a change in the valuation technique(s) (for example, changing from a market approach to an income approach or the use of an additional valuation technique), the reporting entity must disclose that change and the reason for making it.

As with recurring measurements, the preceding disclosure requirements apply to each asset and liability class measured at fair value on the financial statements.


Unlike with recurring measurements, a reconciliation of beginning and ending balances is not required for Level 3 assets or liabilities measured on a nonrecurring basis. Because of their nonrecurring nature, these measurements do not lend themselves to a reconciliation approach. The following examples from ASC 820 illustrate the disclosure requirements for assets measured at fair value on a recurring and non-recurring basis: Exhibit 4.1(a) – ASC 820 Disclosure (Assets and Liabilities Measured on a Recurring Basis)


Exhibit 4.1(b) – ASC 820 Disclosure (Assets and Liabilities Measured on a Recurring Basis)

Exhibit 4.1(c) – ASC 820 Disclosure (Assets and Liabilities Measured on a Nonrecurring Basis)




1. A financial reporting manager at ABC, Inc. is researching the disclosure

requirements included in ASC 820. Which of the following statements is most consistent with these requirements: a) all of ABC’s financial assets and liabilities should be presented at fair value on

the Balance Sheet b) fair value amounts reported in ABC’s financial statements should be reconciled to

the amounts reported on their corporate tax returns c) ABC’s financial instrument disclosures (under ASC 825-50) should be replaced

with their ASC 820 disclosures d) ABC, Inc. should provide financial statement users with additional insight into the

relative reliability of fair value measures

2. Which of the following ASC 820 disclosures is required for a Level 1 asset that is measured at fair value on a recurring basis: a) Company A disclosed the impact that economic conditions had on the asset’s fair

value b) Company B disclosed the inputs used in the asset’s fair value measurements c) Company C disclosed the valuation technique used to estimate the asset’s fair

value d) Company D disclosed the asset’s fair value amortization methodology

3. Which of the following disclosures for assets and liabilities that are measured at fair value on a recurring basis is required under the requirements of ASC 820: a) Company A disclosed the effect that Level 1 fair value measurements had on

equity for the period b) Company B provided a reconciliation of beginning and ending balances for Level

3 assets or liabilities c) Company C disclosed the impact that their Level 2 fair value gains and losses

had on their earnings-per-share for the period d) Company D provided a reconciliation of fair values used for U.S. GAAP and tax

reporting purposes



1. A: Incorrect. There is no such requirement.

B: Incorrect. This type of reconciliation is not part of the disclosure requirements of ASC 820.

C: Incorrect. The disclosures required by ASC 820 do not replace those required by ASC 825-50. Rather, ASC 820 encourages reporting entities to combine the fair value measurement disclosures with the fair value disclosures required under other accounting standards (including ASC 825-50), if practicable.

D: Correct. The disclosure requirements are intended to provide financial statement users with additional insight into the relative reliability of the various fair value measures, thus enhancing their ability to broadly assess the quality of earnings. (See page 4-1 of the course material.)

2. A: Incorrect. Such information may be useful in certain circumstances, but it is not

required by ASC 820.

B: Correct. The reporting entity would be required to disclose the inputs used to develop the asset’s fair value measurements.

C: Incorrect. Such a disclosure is required for Level 2 and Level 3 assets, but not Level 1 assets. This is because Level 1 assets are valued using unadjusted market prices (not financial models or other valuation techniques).

D: Incorrect. This is not a required disclosure. (See page 4-1 of the course material.)

3. A: Incorrect. The disclosures required for assets and liabilities that are measured at

fair value on a recurring basis do not include the effect that Level 1 fair value measurements had on equity for the period.

B: Correct. A reconciliation of beginning and ending balances is required for Level 3 assets or liabilities measured on a recurring basis.

C: Incorrect. The disclosures required for assets and liabilities that are measured at fair value on a recurring basis do not include the impact that fair value gains and loss on EPS.

D: Incorrect. The disclosures required for assets and liabilities that are measured at fair value on a recurring basis do not include such a reconciliation. (See page 4-1 of the course material.)


4.2 SAS No. 101, Auditing Fair Value Measurements and Disclosures SAS No. 101 became effective for audits of financial statements for periods beginning on or after June 15, 2003. The purpose of SAS No. 101 is to establish standards and provide guidance on auditing fair value measurements and disclosures contained in financial statements. In particular, it addresses audit considerations relating to the measurement and disclosure of assets, liabilities, and specific components of equity presented or disclosed at fair value in financial statements. The standards of fieldwork included in SAS No. 101 include the following. 4.2.1 UNDERSTANDING THE ENTITY’S PROCESS FOR DETERMINING FAIR VALUE MEASUREMENTS, DISCLOSURES, THE RELEVANT CONTROLS, AND ASSESSING RISK

• Management is responsible for establishing an accounting and financial reporting process for determining fair value measurements. The auditor should obtain an understanding of this process and the related disclosures, as well as the relevant controls sufficient to develop an effective audit approach.

• When obtaining an understanding of the entity's process for determining fair

value measurements and disclosures, the auditor should consider:

- Controls over the process used to determine fair value measurements - The expertise and experience of those persons determining the fair value

measurements. - The role that information technology has in the process.

- The types of accounts or transactions requiring fair value measurements

or disclosures.

- The extent to which the entity's process relies on a service organization to provide fair value measurements or the data that supports the measurement.

- The extent to which the entity engages or employs specialists in

determining fair value measurements and disclosures.

- The significant management assumptions used in determining fair value.

- The documentation supporting management's assumptions.

- The process used to develop and apply management assumptions, including whether management used available market information to develop the assumptions.

- The process used to monitor changes in management's assumptions.


- The integrity of change controls and security procedures for valuation models and relevant information systems, including approval processes.

- The controls over the consistency, timeliness, and reliability of the data

used in valuation models.

4.2.2 EVALUATING CONFORMITY OF FAIR VALUE MEASUREMENTS AND DISCLOSURES WITH GAAP

• Management is responsible for making the fair value measurements and disclosures included in the financial statements. As part of fulfilling its responsibility, management needs to establish an accounting and financial reporting process for determining the fair value measurements and disclosures, select appropriate valuation methods, identify and adequately support any significant assumptions used, prepare the valuation, and ensure that the presentation and disclosure of the fair value measurements are in accordance with GAAP.

• The auditor should obtain sufficient appropriate audit evidence to provide

reasonable assurance that fair value measurements and disclosures are in conformity with GAAP.

• The evaluation of the entity's fair value measurements and of the audit evidence

depends, in part, on the auditor's knowledge of the nature of the business.

• The auditor should evaluate management's intent to carry out specific courses of action where intent is relevant to the use of fair value measurements, the related requirements involving presentation and disclosures, and how changes in fair values are reported in financial statements. The auditor also should evaluate management's ability to carry out those courses of action. Management often documents plans and intentions relevant to specific assets or liabilities and GAAP may require it to do so. While the extent of evidence to be obtained about management's intent and ability is a matter of professional judgment, the auditor's procedures ordinarily include inquiries of management, with appropriate corroboration of responses, for example, by:

- Considering management's past history of carrying out its stated

intentions with respect to assets or liabilities.

- Reviewing written plans and other documentation, including, where applicable, budgets, minutes, and other such items.

- Considering management's stated reasons for choosing a particular

course of action. - Considering management's ability to carry out a particular course of

action given the entity's economic circumstances, including the implications of its contractual commitments.


• When there are no observable market prices and the entity estimates fair value using a valuation method, the auditor should evaluate whether the entity's method of measurement is appropriate in the circumstances. That evaluation requires the use of professional judgment. It also involves obtaining an understanding of management's rationale for selecting a particular method by discussing with management its reasons for selecting the valuation method. The auditor considers whether:

a. Management has sufficiently evaluated and appropriately applied the

criteria, if any, provided by GAAP to support the selected method.

b. The valuation method is appropriate in the circumstances given the nature of the item being valued.

c. The valuation method is appropriate in relation to the business, industry,

and environment in which the entity operates.

• The auditor should evaluate whether the entity's method for determining fair value measurements is applied consistently and if so, whether the consistency is appropriate considering possible changes in the environment or circumstances affecting the entity, or changes in accounting principles. If management has changed the method for determining fair value, the auditor considers whether management can adequately demonstrate that the method to which it has changed provides a more appropriate basis of measurement or whether the change is supported by a change in the GAAP requirements or a change in circumstances.

4.2.3 TESTING THE ENTITY’S FAIR VALUE MEASUREMENTS AND DISCLOSURES

• Substantive tests of the fair value measurements may involve (a) testing management's significant assumptions, the valuation model, and the underlying data, (b) developing independent fair value estimates for corroborative purposes or (c) reviewing subsequent events and transactions.

• The auditor uses both the understanding of management's process for

determining fair value measurements and his or her assessment of the risk of material misstatement to determine the nature, timing, and extent of the audit procedures. The following are examples of considerations in the development of audit procedures:

- The fair value measurement (for example, a valuation by an independent

appraiser) may be made at a date that does not coincide with the date at which the entity is required to measure and report that information in its financial statements. In such cases, the auditor obtains evidence that management has taken into account the effect of events, transactions, and changes in circumstances occurring between the date of the fair value measurement and the reporting date.


- Collateral often is assigned for certain types of investments in debt instruments that either are required to be measured at fair value or are evaluated for possible impairment. If the collateral is an important factor in measuring the fair value of the investment or evaluating its carrying amount, the auditor obtains sufficient appropriate audit evidence regarding the existence, value, rights, and access to or transferability of such collateral, including consideration of whether all appropriate liens have been filed, and considers whether appropriate disclosures about the collateral have been made.

- In some situations, additional procedures, such as the inspection of an

asset by the auditor, may be necessary to obtain sufficient appropriate audit evidence about the appropriateness of a fair value measurement. For example, inspection of the asset may be necessary to obtain information about the current physical condition of the asset relevant to its fair value, or inspection of a security may reveal a restriction on its marketability that may affect its value.

4.2.4 TESTING MANAGEMENT’S SIGNIFICANT ASSUMPTIONS, THE VALUATION MODEL, AND THE UNDERLYING DATA

• The auditor's understanding of the reliability of the process used by management to determine fair value is an important element in support of the resulting amounts and therefore affects the nature, timing, and extent of audit procedures. When testing the entity's fair value measurements and disclosures, the auditor evaluates whether:

a. Management's assumptions are reasonable and reflect, or are not

inconsistent with, market information.

b. The fair value measurement was determined using an appropriate model, if applicable.

c. Management used relevant information that was reasonably available at

the time.

• Where applicable, the auditor should evaluate whether the significant assumptions used by management in measuring fair value, taken individually and as a whole, provide a reasonable basis for the fair value measurements and disclosures in the entity's financial statements.

• Assumptions are integral components of more complex valuation methods, for

example, valuation methods that employ a combination of estimates of expected future cash flows together with estimates of the values of assets or liabilities in the future, discounted to the present. Auditors pay particular attention to the significant assumptions underlying a valuation method and evaluate whether such assumptions are reasonable and reflect, or are not inconsistent with, market information.


• Specific assumptions will vary with the characteristics of the item being valued and the valuation approach used (for example, cost, market, or income). For example, where the discounted cash flows method (a method under the income approach) is used, there will be assumptions about the level of cash flows, the period of time used in the analysis, and the discount rate.

• Assumptions ordinarily are supported by differing types of evidence from internal

and external sources that provide objective support for the assumptions used. The auditor evaluates the source and reliability of evidence supporting management's assumptions, including consideration of the assumptions in light of historical and market information.

• Audit procedures dealing with management's assumptions are performed in the

context of the audit of the entity's financial statements. The objective of the audit procedures is therefore not intended to obtain sufficient appropriate audit evidence to provide an opinion on the assumptions themselves. Rather, the auditor performs procedures to evaluate whether the assumptions provide a reasonable basis for measuring fair values in the context of an audit of the financial statements taken as a whole.

• Identifying those assumptions that appear to be significant to the fair value

measurement requires the exercise of judgment by management. The auditor focuses attention on the significant assumptions that management has identified. Generally, significant assumptions cover matters that materially affect the fair value measurement and may include those that are:

a. Sensitive to variation or uncertainty in amount or nature. For example,

assumptions about short-term interest rates may be less susceptible to significant variation compared to assumptions about long-term interest rates.

b. Susceptible to misapplication or bias.

• The auditor considers the sensitivity of the valuation to changes in significant

assumptions, including market conditions that may affect the value. Where applicable, the auditor encourages management to use techniques such as sensitivity analysis to help identify particularly sensitive assumptions. If management has not identified particularly sensitive assumptions, the auditor considers whether to employ techniques to identify those assumptions.

• To be reasonable, the assumptions on which the fair value measurements are

based (for example, the discount rate used in calculating the present value of future cash flows), individually and taken as a whole, need to be realistic and consistent with:

a. The general economic environment, the economic environment of the

specific industry, and the entity's economic circumstances; b. Existing market information;


c. The plans of the entity, including what management expects will be the outcome of specific objectives and strategies;

d. Assumptions made in prior periods, if appropriate; e. Past experience of, or previous conditions experienced by, the entity to

the extent currently applicable; f. Other matters relating to the financial statements, for example,

assumptions used by management in accounting estimates for financial statement accounts other than those relating to fair value measurements and disclosures; and

g. The risk associated with cash flows, if applicable, including the potential

variability in the amount and timing of the cash flows and the related effect on the discount rate.

• Where assumptions are reflective of management's intent and ability to carry out

specific courses of action, the auditor considers whether they are consistent with the entity's plans and past experience.

• If management relies on historical financial information in the development of

assumptions, the auditor considers the extent to which such reliance is justified. However, historical information might not be representative of future conditions or events, for example, if management intends to engage in new activities or circumstances change.

• For items valued by the entity using a valuation model, the auditor does not

function as an appraiser and is not expected to substitute his or her judgment for that of the entity's management. Rather, the auditor reviews the model and evaluates whether the assumptions used are reasonable and the model is appropriate considering the entity's circumstances.

• The auditor should test the data used to develop the fair value measurements

and disclosures and evaluate whether the fair value measurements have been properly determined from such data and management's assumptions. Specifically, the auditor evaluates whether the data on which the fair value measurements are based, including the data used in the work of a specialist, is accurate, complete, and relevant; and whether fair value measurements have been properly determined using such data and management's assumptions. The auditor's tests also may include, for example, procedures such as verifying the source of the data, mathematical re-computation of inputs, and reviewing of information for internal consistency, including whether such information is consistent with management's intent and ability to carry out specific courses of action.


4.2.5 AUDITING DISCLOSURES ABOUT FAIR VALUES

• The auditor should evaluate whether the disclosures about fair values made by the entity are in conformity with GAAP.

• When auditing fair value measurements and related disclosures included in the

notes to the financial statements, whether required by GAAP or disclosed voluntarily, the auditor ordinarily performs essentially the same types of audit procedures as those employed in auditing a fair value measurement recognized in the financial statements. The auditor obtains sufficient appropriate audit evidence that the valuation principles are appropriate under GAAP and are being consistently applied, and that the method of estimation and significant assumptions used are adequately disclosed in accordance with GAAP.

• The auditor evaluates whether the entity has made adequate disclosures about

fair value information. If an item contains a high degree of measurement uncertainty, the auditor assesses whether the disclosures are sufficient to inform users of such uncertainty.

• When disclosure of fair value information under GAAP is omitted because it is

not practicable to determine fair value with sufficient reliability, the auditor evaluates the adequacy of disclosures required in these circumstances. If the entity has not appropriately disclosed fair value information required by GAAP, the auditor evaluates whether the financial statements are materially misstated.




1. Which of the following processes would normally be considered appropriate for an

auditor to perform under the standards of fieldwork included in SAS No. 101: a) Auditor A establishes an accounting and financial reporting process for

determining fair value measurements b) Auditor B disregards the role that information technology has in the fair value

process c) Auditor C obtains an understanding of the client’s process for determining fair

value measurements and the related disclosures d) Auditor D does not consider the expertise and experience of those persons

determining the fair value measurements

2. Which of the following processes would normally fall within the scope of responsibility for management to perform under the standards of fieldwork included in SAS No. 101: a) Company A’s management evaluates their intent and ability to carry out specific

courses of action where they are relevant to the use of fair value measurements b) Company B’s management prepares fair value measurements and the related

disclosures included in the financial statements c) Company C’s management evaluates whether the entity’s method for

determining fair value measurements is applied consistently d) Company D’s management obtains sufficient appropriate audit evidence to

provide reasonable assurance that fair value measurements and disclosures are in conformity with GAAP

3. An auditor is preparing to perform substantive tests of his client’s fair value

measurements. Such tests would generally involve: a) developing independent fair value estimates for corroborative purposes b) requiring the entity to measure its assets or liabilities using valuation models

under all circumstances c) preparing the fair value measurements and related disclosures included in the

financial statements d) ignoring subsequent events and transactions due to engagement time

constraints


Use the following for questions 4 through 7: A partner at Timlin & Foulke, LLC is reviewing the work papers of the audit team assigned to Wakefield Bank. The audit papers show that Wakefield owns several investments for which there are no observable market prices. Wakefield used a valuation model to provide the fair values of those investments. 4. Which of the following actions should be taken by the audit firm regarding their

client’s failure to use observable market prices when estimating the fair values of these assets: a) issue a qualified opinion b) withdraw from the engagement c) accept the fair value measurement as provided, without further corroboration d) evaluate whether the entity’s method of measurement is appropriate in the

circumstances

5. When testing Wakefield’s fair value measurements and disclosures, the T&F auditors should: a) obtain sufficient appropriate audit evidence to provide an opinion on specific fair

value assumptions b) evaluate whether or not management’s assumptions are reasonable and reflect

market information c) prepare the fair value disclosures for Wakefield in accordance with GAAP d) disregard the sensitivity of the valuation to changes in significant assumptions

that may affect the value

6. Which of the following procedures would the auditors at Timlin & Foulke LLC most likely perform for assets valued using a valuation model: a) function as an appraiser and re-value the items using his or her own judgment b) discourage management from using techniques such as sensitivity analysis to

help identify particularly sensitive assumptions c) review the model and evaluate whether the assumptions used are reasonable

and appropriate d) obtain sufficient appropriate audit evidence to provide an opinion on specific fair

value assumptions included in the model

7. When auditing Wakefield’s disclosures about fair values included in the notes to the financial statements, the T&F auditors: a) should generally perform essentially the same types of audit procedures as those

employed in auditing a fair value measurement recognized in the financial statements

b) are required to perform separate audit procedures to confirm that the disclosures are in conformity with GAAP

c) must always issue a qualified opinion if the disclosures are not in conformity with GAAP

d) should disregard sections related to the methods of estimation and significant assumptions made by management



1. A: Incorrect. Management is responsible for establishing an accounting and financial reporting process for determining fair value measurements. The auditor should obtain an understanding of this process and the related disclosures, as well as the relevant controls sufficient to develop an effective audit approach.

B: Incorrect. An auditor should consider the role that information technology has in the process.

C: Correct. An auditor should obtain an understanding of the client’s process for determining fair value measurements and the related disclosures.

D: Incorrect. An auditor should consider this. (See page 4-8 of the course material.)

2. A: Incorrect. Under SAS 101, an auditor is responsible for evaluating management’s

intent and ability to carry out specific courses of action where they are relevant to the use of fair value measurements.

B: Correct. Management is responsible for making the fair value measurements and disclosures included in the financial statements. As part of fulfilling its responsibility, management needs to establish an accounting and financial reporting process for determining the fair value measurements and disclosures, select appropriate valuation methods, identify and adequately support any significant assumptions used, prepare the valuation, and ensure that the presentation and disclosure of the fair value measurements are in accordance with GAAP.

C: Incorrect. Under SAS 101, an auditor is responsible for evaluating whether an entity’s method for determining fair value measurements is applied consistently.

D: Incorrect. Under SAS 101, an auditor is responsible for obtaining sufficient appropriate audit evidence to provide reasonable assurance that fair value measurements and disclosures are in conformity with GAAP. (See page 4-9 of the course material.)


3. A: Correct. Substantive tests of the fair value measurements may involve: (a) testing management's significant assumptions, the valuation model, and the underlying data, (b) developing independent fair value estimates for corroborative purposes, or (c) reviewing subsequent events and transactions.

B: Incorrect. Such a requirement would not be considered appropriate.

C: Incorrect. Management is responsible for preparing the fair value measurements and related disclosures.

D: Incorrect. An auditor should review subsequent events and transactions as part of the substantive tests. (See page 4-10 of the course material.)

4. A: Incorrect. ASC 820 permits the use of valuation models, and their use alone is

normally not cause for an auditor to issue a qualified opinion.

B: Incorrect. ASC 820 permits the use of valuation models, and their use alone is normally not cause for an auditor to withdraw from an engagement.

C: Incorrect. An auditor should apply procedures to evaluate whether the assumptions included in a valuation model provide a reasonable basis for measuring fair values in the context of an audit of the financial statements taken as a whole.

D: Correct. When there are no observable market prices, and the entity estimates fair value using a valuation method, the auditor should evaluate whether the entity's method of measurement is appropriate in the circumstances. That evaluation requires the use of professional judgment. It also involves obtaining an understanding of management's rationale for selecting a particular method by discussing with management its reasons for selecting the valuation method. (See page 4-10 of the course material.)


5. A: Incorrect. Audit procedures dealing with management's assumptions are performed in the context of the audit of the entity's financial statements. The objective of the audit procedures is therefore not intended to obtain sufficient appropriate audit evidence to provide an opinion on the assumptions themselves. Rather, the auditor performs procedures to evaluate whether the assumptions provide a reasonable basis for measuring fair values in the context of an audit of the financial statements taken as a whole.

B: Correct. The auditors should perform procedures to evaluate whether the assumptions provide a reasonable basis for measuring fair values in the context of an audit of the financial statements taken as a whole.

C: Incorrect. Management is responsible for preparing fair value disclosures in accordance with GAAP.

D: Incorrect. When testing an entity’s fair value measurements and disclosures, an auditor should consider the sensitivity of the valuation to changes in significant assumptions that may affect the value. (See page 4-12 of the course material.)

6. A: Incorrect. The auditor is not expected to substitute his or her judgment for that of the entity’s management.

B: Incorrect. An auditor should encourage management to use techniques such as sensitivity analysis to help identify particularly sensitive assumptions.

C: Correct. For items valued by the entity using a valuation model, the auditor does not function as an appraiser and is not expected to substitute his or her judgment for that of the entity's management. Rather, the auditor reviews the model and evaluates whether the assumptions used are reasonable and the model is appropriate considering the entity's circumstances.

D: Incorrect. Audit procedures dealing with management's assumptions are performed in the context of the audit of the entity's financial statements. The objective of the audit procedures is therefore not intended to obtain sufficient appropriate audit evidence to provide an opinion on the assumptions themselves. (See page 4-13 of the course material.)


7. A: Correct. When auditing fair value measurements and related disclosures included in the notes to the financial statements, whether required by GAAP or disclosed voluntarily, the auditor ordinarily performs essentially the same types of audit procedures as those employed in auditing a fair value measurement recognized in the financial statements. The auditor obtains sufficient appropriate audit evidence that the valuation principles are appropriate under GAAP and are being consistently applied, and that the method of estimation and significant assumptions used are adequately disclosed in accordance with GAAP.

B: Incorrect. Separate audit procedures are not required.

C: Incorrect. If the entity has not appropriately disclosed fair value information required by GAAP, the auditor evaluates whether the financial statements are materially misstated.

D: Incorrect. An auditor should not disregard such information. (See page 4-14 of the course material.)


CHAPTER 4 SUMMARY

• ASC 820 requires expanded disclosures (quantitative and qualitative) about fair value measurements that are designed to provide users of financial statements with additional transparency regarding:

- The extent to which a reporting entity measures assets and liabilities at fair value;

- The valuation techniques used to measure fair value; and - The effect of fair value measurements on earnings.

• ASC 820’s disclosure requirements vary depending on whether the asset or

liability is measured on a recurring or nonrecurring basis and the classification of the fair value measurement in its entirety within the fair value hierarchy.

• SAS No. 101, Auditing Fair Value Measurements and Disclosures, establishes

standards and provides guidance on auditing fair value measurements and disclosures contained in financial statements.

• Management is responsible for establishing an accounting and financial reporting

process for determining fair value measurements. An auditor should obtain an understanding of this process and the related disclosures, as well as the relevant controls sufficient to develop an effective audit approach.

• Management is responsible for making the fair value measurements and

disclosures included in the financial statements. An auditor should obtain sufficient appropriate audit evidence to provide reasonable assurance that fair value measurements and disclosures are in conformity with GAAP.

• An auditor’s substantive tests of the fair value measurements may involve (a)

testing management's significant assumptions, the valuation model, and the underlying data, (b) developing independent fair value estimates for corroborative purposes, or (c) reviewing subsequent events and transactions.

• Where applicable, an auditor should evaluate whether the significant

assumptions used by management in measuring fair value, taken individually and as a whole, provide a reasonable basis for the fair value measurements and disclosures in the entity's financial statements.

• An auditor should evaluate whether the disclosures about fair values made by

the entity are in conformity with GAAP.

The Fair Value Option 5-1

Chapter 5: The Fair Value Option Learning Objectives: After studying this chapter, participants should be able to:

• Recognize the proper application of the fair value option under ASC 825-10. • Identify assets and liabilities that are eligible for the fair value option.

5.1 The Fair Value Option Recent FASB pronouncements provide reporting entities with an option to measure many financial instruments, selected hybrid financial instruments, and separately recognized servicing assets and servicing liabilities at fair value. The fair value options (FVO) provided by these standards considerably expands the ability of a reporting entity to select the basis of measurement for certain assets and liabilities. The key implications of the FVO standards include the following:

• ASC 815-15-25 Fair Value Election for Hybrid Financial Instruments provides the FVO for certain hybrid financial instruments that contain an embedded derivative that would otherwise require bifurcation under the requirements of ASC 815 (formerly SFAS 133).

• ASC 860-50 Servicing Assets and Liabilities permits a reporting entity to choose

between the amortization method and the fair value measurement method for each class of separately recognized servicing assets and servicing liabilities.

• ASC 825-10 Financial Instruments: The Fair Value Option provides a

measurement basis election for most financial instruments (i.e., either historical cost or fair value), allowing reporting entities to mitigate potential mismatches that arise under the current mixed measurement attribute model. For example, potential differences may arise because certain financial assets are required to be measured at fair value but the related financial liabilities are required to be measured at amortized historical cost.

In addition, both ASC 815-15-25 and ASC 825-10 allow entities to offset changes in the fair values of a derivative instrument and the related hedged item by selecting the FVO for the hedged item. This means entities can avoid application of the complex hedge accounting provisions of ASC 815 Derivatives & Hedging. In accordance with the requirements of the Standards discussed above, once the FVO election is made, it is irrevocable. Because the FVO is not a requirement, adoption of the option may result in reduced comparability of financial reporting, both among similar reporting entities and within a single entity, because similar assets or liabilities could be reported under different measurement attributes (i.e., some at historical cost and some at fair value). However, the disclosure provisions of the standards are intended to mitigate this issue by requiring: (1) identification of instruments for which the option is elected, and (2) extensive information about the effects on the financial statements.


5.2 ASC 825-10 Financial Instruments: The Fair Value Option 5.2.1 SCOPE Under ASC 825-10, reporting entities may elect the fair value option for the following eligible items:

• A recognized financial asset and financial liability, except those that are identified

as “excluded items” (see section 5.2.2).

• A firm commitment that would otherwise not be recognized at inception and that involves only financial instruments. (An example is a forward purchase contract for a loan that is not readily convertible to cash. That commitment involves only financial instruments – a loan and cash – and would not otherwise be recognized because it is not a derivative instrument.)

• A written loan commitment.

• The rights and obligations under an insurance contract that is not a financial

instrument (because it requires or permits the insurer to provide goods or services rather than a cash settlement), but whose terms permit the insurer to settle by paying a third party to provide those goods or services.

• The rights and obligations under a warranty that is not a financial instrument

(because it requires or permits the warrantor to provide goods or services rather than a cash settlement) but whose terms permit the warrantor to settle by paying a third party to provide those goods or services.

• A host financial instrument resulting from the separation of an embedded non-

financial derivative instrument from a non-financial hybrid instrument under ASC 815, Derivatives & Hedging, subject to certain scope exceptions. (An example of such a non-financial hybrid instrument is an instrument in which the value of the bifurcated embedded derivative is payable in cash, services, or merchandise but the debt host is payable only in cash.)

5.2.2 EXCLUDED ITEMS Under ASC 825-10, the following items are explicitly excluded from the scope of the fair value option:

• An investment in a subsidiary that the entity is required to consolidate • An interest in a variable interest entity that the entity is required to consolidate • Employers’ and plans’ obligations (or assets representing net over funded

positions) for pension benefits, other post retirement benefits (including health care and life insurance benefits), post employment benefits, employee stock options, stock purchase plans, and other forms of deferred compensation arrangements


• Financial assets and liabilities recognized as leases. (This exception does not apply to a guarantee of a third-party lease obligation or a contingent obligation arising from a cancelled lease)

• Deposit liabilities, withdrawable on demand, of banks, savings and loan

associations, credit unions, and other similar depository institutions.

In addition, ASC 470-20 Debt with Conversion and Other Options precludes reporting entities from electing the fair value option for financial instruments that are, in whole or in part, classified by the issuer as a component of shareholder’s equity (including “temporary equity”). An example is a convertible debt security with a non-contingent beneficial conversion feature.


REVIEW QUESTIONS 5.1 The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. Use the following for questions 1 through 4: Beantown Enterprises frequently issues debt to purchase trading securities as a means of generating spread income. The trading securities are accounted for at fair value, while the debt issued to fund the asset purchases are accounted for at amortized cost. The CFO of Beantown Enterprises is concerned about the resulting accounting mismatch that has been impacting Beantown’s earnings for the year. The CFO would like to apply the “fair value option” to eliminate this mismatch, as well as other similar mismatches that exist on Beantown Enterprise’s balance sheet. 1. The use of the fair value option in the case of Beantown Enterprises would:

a) provide them the option of measuring their trading securities at amortized cost on

the balance sheet b) require all of their financial instruments to be measured at fair value on the

balance sheet c) considerably expand their ability to select the basis of measurement for their debt d) considerably limit their ability to select the basis of measurement for their debt

2. One of the benefits of the fair value option is that it would allow Beantown to:

a) offset changes in the fair values of their derivative instruments and the related

hedged items while avoiding complex hedge accounting b) apply fair value accounting to investments in subsidiaries that Beantown is

required to consolidate c) revoke the election at any point in the future d) reduce the comparability of their financial statements, as similar assets or

liabilities could be reported under different measurement attributes

3. Once Beantown has elected the fair value option, the election is: a) revocable at any point in the future b) revocable in the current reporting period only c) revocable only when hedge accounting is subsequently applied d) irrevocable

4. Items currently on Beantown’s balance sheet that are eligible for the fair value option include: a) investment in Yawkey Corp., a wholly owned subsidiary (consolidation required) b) fixed rate demand deposits c) loan commitments (underwritten by Beantown) d) interests in a variable interest entity (consolidation required)


SOLUTIONS AND SUGGESTED RESPONSES 5.1 1. A: Incorrect. The fair value option does not provide for the ability to measure trading

securities at amortized cost.

B: Incorrect. There is no such requirement (yet).

C: Correct. The fair value options provided by U.S. GAAP considerably expands the ability of a reporting entity to select the basis of measurement for certain assets and liabilities.

D: Incorrect. The fair value option expands (not limits) the ability of a reporting entity to select the basis of measurement for certain assets and liabilities. (See page 5-1 of the course material.)

2. A: Correct. Both ASC 815-15-25 and ASC 825-10 allow entities to offset changes in

the fair values of a derivative instrument and the related hedged item by selecting the FVO for the hedged item. This means entities can avoid application of complex hedge accounting provisions.

B: Incorrect. Such investments are excluded from the scope of ASC 825-10.

C: Incorrect. The election of the fair value option is irrevocable.

D: Incorrect. The fair value option can reduce the comparability of financial statements, however, this is not considered to be a benefit. (See page 5-1 of the course material.)

3. A: Incorrect. The fair value option is not revocable at any point in the future.

B: Incorrect. The fair value option is not revocable in the current reporting period.

C: Incorrect. Once this fair value option is elected, it is irrevocable.

D: Correct. In accordance with the requirements of U.S. GAAP, once the FVO election is made, it is irrevocable. (See page 5-1 of the course material.)


4. A: Incorrect. The fair value option may not be applied to investments in subsidiaries that the entity is required to consolidate.

B: Incorrect. The fair value option may not be applied to demand deposit liabilities.

C: Correct. ASC 825-10 allows entities to elect the fair value option for written loan commitments. D: Incorrect. The fair value option may not be applied to interests in VIEs that the reporting entity is required to consolidate. (See page 5-2 of the course material.)


5.2.3 ACCOUNTING ELECTION ASC 825-10 permits reporting entities to apply the FVO on an instrument-by-instrument basis. Therefore, a reporting entity can elect the FVO for certain instruments but not others within a group of similar items (e.g., for some available-for-sale securities but not for others). However, if the FVO is not elected for all eligible instruments within a group of similar instruments, the reporting entity is required to disclose the reasons for its partial election. In addition, the reporting entity must disclose the amounts to which it applied the FVO and the amounts to which it did not apply the FVO within that group. ASC 825-10 provides exceptions to the instrument-by-instrument election as follows:

a. If multiple advances are made to one borrower pursuant to a single contract (such as a line of credit or construction loan) and the individual advances lose their identity and become part of a larger loan balance, the fair value option shall be applied only to the larger balance and not to each advance individually.

b. If the fair value option is applied to an investment that would otherwise be

accounted for under the equity method of accounting, it shall be applied to all of the investor’s financial interests in the same entity (equity and debt, including guarantees) that are eligible items.

c. If the fair value option is applied to an eligible insurance or reinsurance contract,

it shall be applied to all claims and obligations under the contract.

d. If the fair value option is elected for an insurance contract (base contract) for which integrated or non-integrated contract features or coverages (some of which are called riders) are issued either concurrently or subsequently, the fair value option also must be applied to those features or coverages. The fair value option cannot be elected for only the nonintegrated contract features or coverages, even though those features and coverages are accounted for separately under ASC 944-30 Insurance: Acquisition Costs.

A financial instrument that represents a single contract may not be further separated into parts for purposes of electing the FVO. However, a loan syndication arrangement may result in multiple loans issued to the same borrower. Under ASC 825-10, each of those loans is a separate instrument, and the FVO may be elected for some loans but not others. 5.2.4 TIMING Subsequent to initial adoption, in accordance with ASC 825-10-25-4, an entity can choose to apply the FVO on the date when any one of the following occurs:

a. The entity first recognizes the eligible item. b. The entity enters into an eligible firm commitment.

c. Financial assets that have been reported at fair value with unrealized gains and

losses included in earnings because of specialized accounting principles cease to qualify for that specialized accounting.


d. The accounting treatment for an investment in an entity changes.

e. An event that requires an eligible item to be measured at fair value at the time of the event but does not require fair value measurement at each reporting date after that, excluding the recognition of impairment under lower-of-cost-or-market accounting or other-than-temporary impairment.

Re-measurement events, as discussed in item (e) above, are described in ASC 825-10-25-5. Re-measurement events include: (1) business combinations as defined in ASC 805; (2) the initial consolidation or deconsolidation of a subsidiary or a variable interest entity (or the reconsolidation of a deconsolidated variable interest entity); and (3) significant modifications of debt, as defined in ASC 470-50 Debt: Modifications and Extinguishments. 5.2.5 ACCOUNTING IMPACT ASC 825-10 requires immediate recognition of upfront costs and fees related to items for which the FVO is elected. For example, if the FVO is elected for an insurance contract, a company should not recognize any deferred acquisition costs related to that contract. Similarly, if the FVO is elected for a loan receivable, the entity should not recognize any deferred loan-origination fees or costs related to that loan. Immediate recognition of previously deferred income and expense items will significantly change both the recognition pattern and the presentation of income or expense in the income statement. For example, for originated loans that are not measured using the FVO, deferred fees and costs are capitalized as a net basis adjustment and either amortized to interest income or recognized as part of the gain/loss on sale of the loan. However, if an originated loan is measured using the FVO, the costs and fees are recognized in current earnings in the applicable expense or revenue accounts (e.g., salaries, legal fees, fee revenue). Interest Income and Expense ASC 825-10 specifies that amortization of premiums and discounts does not apply to items for which the FVO has been elected. Furthermore, ASC 825-10 states that it does not establish requirements for recognizing and measuring dividend income, interest income, or interest expense but that the reporting entity’s policy for such recognition should be disclosed. ASC 825-10 allows for significant policy discretion in how to report interest income and expense for items under the FVO. This may include the application of one (or some variation) of the following models for reporting interest income and expense:

• Present the entire change in fair value of the FVO item – including the component related to accrued interest, in a single line item in the income statement.


• Separate the interest income or expense from the full change in fair value of the FVO item and present that amount in interest income/expense with the remainder of the change in fair value presented in a separate line item in the income statement. The allocation to interest income/expense should be an appropriate and acceptable method under GAAP.

Each presentation covers the same net change in fair value of the FVO item but can result in significant differences in individual line items in the income statement. Reporting entities should select a policy for income statement presentation that is appropriate for their individual facts and circumstances, disclose the policy in the notes to financial statements, and follow it consistently. Any upfront costs and fees related to items measured at fair value upon the adoption of ASC 825-10 should be removed from the statement of financial position and included in the cumulative-effect of adoption adjustment. Other Income Statement Impact The SEC staff recently updated its position related to the presentation in the income statement of instruments measured at fair value. The SEC staff currently believes that changes in the fair value of an instrument recognized at fair value each reporting period should be presented on a single line on the income statement, with certain exceptions (i.e., different components of the change in fair value should not be presented separately). The only exceptions to this single line item presentation are when other specific GAAP permits a different (i.e., separated) presentation. Examples of exceptions include derivatives that have been designated in qualifying hedging relationships; certain investments in debt and equity securities; certain originated or acquired loans; and certain indebtedness. The change in fair value of these instruments may be presented in other than a single line presentation pursuant to the GAAP applicable to the instruments. 5.2.6 DISCLOSURE REQUIREMENTS Due to the potential for reduced comparability of financial reporting, one of the FASB’s objectives in prescribing the required disclosures is to ensure that the reader of a reporting entity’s financial statements will understand the extent to which the FVO is being used and how changes in fair values affect earnings for the period. ASC 825-10 permits entities to apply the FVO on an instrument-by-instrument basis; however, it requires additional disclosures if the FVO is elected for only some of the eligible items within a group of similar eligible items (e.g., a description of those similar items and reasons for partial election). ASC 825-10-55-6 includes an example of a disclosure that integrates the Standard’s disclosure requirements with the requirements in both ASC 820 (formerly SFAS 157) and ASC 825-50 (formerly SFAS 107). The example is for illustrative purposes only and does not present the only method to comply with the disclosure requirements.




1. Which of the following accounting practices represents an application of the fair

value option that is consistent with the requirements of ASC 825-10: a) Company A elected the option in 2009 for a group of assets and subsequently

revoked the option in 2010 b) Company B elects the option on an instrument-by-instrument basis c) Company C elects the option at any point during the life cycle of a financial asset

or liability d) Company D elected the option for its interests in variable interest entities that the

company is required to consolidate

Use the following for questions 2 through 5: Lowe Bank elected the fair value option to account for financial assets held in one of their portfolios. Lowe chose to elect the option only for certain instruments held in that portfolio; the remaining instruments continued to be recognized at amortized cost. Lowe generally pays upfront fees whenever purchasing these assets. 2. Subsequent to the fair value option election, the changes in fair value associated

with Lowe’s FVO assets should be reflected: a) in other comprehensive income b) as a direct adjustment to retained earnings c) in earnings d) on the balance sheet as a contra-asset or contra-liability

3. The upfront fees paid by Lowe to purchase their assets accounted for using the fair value option should be ______; the upfront fees paid by Lowe to purchase their assets accounted for at amortized cost should be ______. a) deferred; expensed b) deferred; deferred c) expensed; expensed d) expensed; deferred


4. Which of the following statements correctly summarizes the ASC 825-10 presentation requirements for the interest income earned on Lowe’s FVO assets: a) Lowe is prohibited from presenting any items associated with its FVO assets in

interest income b) Lowe may use considerable judgment when determining how to report the

interest income associated with its FVO assets c) Lowe must present all fair value changes in non-interest income d) Lowe must present the amortization of the upfront fees paid on their FVO assets

in interest income

5. Which of the following statements correctly summarizes Lowe’s ability to elect the fair value option on an instrument-by-instrument basis: a) such election is strictly prohibited b) such election is permitted, but only for “hybrid” financial instruments c) such election would require additional disclosures in this case d) such election requires no additional disclosures



1. A: Incorrect. The election of the fair value option is irrevocable.

B: Correct. ASC 825-10 permits reporting entities to apply the FVO on an instrument-by-instrument basis. Therefore, a reporting entity can elect the FVO for certain instruments but not others within a group of similar items (e.g., for some available-for-sale securities but not for others).

C: Incorrect. The company generally must elect the fair value option when the asset or liability is first recognized (with limited exceptions).

D: Incorrect. These items are specifically excluded from the scope of ASC 825-10. (See page 5-7 of the course material.)

2. A: Incorrect. The changes in fair value must be reflected in earnings (not in other

comprehensive income).

B: Incorrect. The changes in fair value must be reflected in earnings (not as a direct adjustment to retained earnings).

C: Correct. Once the fair value option is elected for a financial asset or liability, the changes in fair value for that item going forward are reflected in earnings.

D: Incorrect. The changes in fair value must be reflected in earnings (not on the balance sheet as a contra-asset or contra-liability). (See page 5-8 of the course material.)

3. A: Incorrect. Upfront fees associated with assets that are accounted for under the fair

value option should not be deferred; upfront fees associated with assets that are accounted for at amortized cost should not be expensed immediately.

B: Incorrect. Upfront fees associated with assets that are accounted for under the fair value option should not be deferred.

C: Incorrect. Upfront fees associated with assets that are accounted for at amortized cost should not be expensed immediately.

D: Correct. Upfront fees associated with assets that are accounted for under the fair value option should be expensed as incurred; upfront fees associated with assets that are accounted for at amortized cost should be deferred and amortized. (See page 5-8 of the course material.)


4. A: Incorrect. Lowe is not prohibited from presenting items (such as interest accruals, fair value gains and losses) in interest income.

B: Correct. ASC 825-10 allows for significant policy discretion in how to report interest income and expense for items under the FVO. The Standard does not include specific presentation requirements.

C: Incorrect. Lowe is not specifically required to present fair value changes in non-interest income by ASC 825-10.

D: Incorrect. Upfront fees associated with assets that are accounted for under the fair value option should not be deferred and amortized. (See page 5-8 of the course material.)

5. A: Incorrect. ASC 825-10 permits entities to apply the FVO on an instrument-by-instrument basis.

B: Incorrect. The instrument-by-instrument basis allowance is not limited to hybrid instruments.

C: Correct. ASC 825-10 permits entities to apply the FVO on an instrument-by-instrument basis; however, it requires additional disclosures if the FVO is elected for only some of the eligible items within a group of similar eligible items (e.g., a description of those similar items and reasons for partial election).

D: Incorrect. Additional disclosures are required. (See page 5-9 of the course material.)


CHAPTER 5 SUMMARY

• U.S. GAAP provides reporting entities with an option to measure many financial instruments, selected hybrid financial instruments, and separately recognized servicing assets and servicing liabilities at fair value. The most commonly referenced Standard related to this area is ASC 825-10 Financial Instruments: The Fair Value Option.

• Election of the fair value option is irrevocable.

• Items eligible for the fair value option include most recognized financial assets,

financial liabilities, firm commitments, and written loan commitments.

• Items explicitly excluded from the scope of ASC 825-10 include investments in subsidiaries and variable interest entities that require consolidation, financial assets and liabilities recognized under leases, and deposit liabilities.

• ASC 825-10 permits reporting entities to apply the FVO on an instrument-by-

instrument basis. However, if the FVO is not elected for all eligible instruments within a group of similar instruments, the reporting entity is required to disclose the reasons for its partial election.

• In general, the fair value option is only available when the entity first recognizes

the eligible item. However certain “re-measurement events” permit subsequent election in some cases.

• ASC 825-10 requires immediate recognition of upfront costs and fees related to

items for which the FVO is elected.

The Future of Fair Value 6-1

Chapter 6: The Future of Fair Value Learning Objectives: After studying this chapter, participants should be able to:

• Describe the ongoing FASB/IASB “convergence” project and its impact on fair value accounting.

• Describe the principal arguments against fair value accounting. • Explain the limitations of applying the ASC 820 definition of fair value when

markets are illiquid or inactive. For more than 20 years, FASB and the International Accounting Standards Board (IASB) have been on a steady march to radically overhaul the foundations of corporate accounting in Europe and the United States. ASC 825-10, Financial Instruments: The Fair Value Option, enacted in February 2007, represented a watershed event in FASB’s drive toward a full fair-value basis for financial accounting. It also represented a significant move towards convergence with International Financial Reporting Standards (IFRS).

6.1 Fair Value Accounting Under IFRS In 2002 at a meeting in Norwalk, Connecticut, the IASB and the FASB agreed to harmonize their agenda and work towards reducing differences between IFRS and U.S. GAAP (this subsequently became known as the ‘Norwalk Agreement’). In February 2006, FASB and IASB issued a “Memorandum of Understanding” which included a program of topics on which the two bodies will seek to achieve convergence. The ultimate goal of the convergence project is to create one single set of global accounting standards. This includes a single standard that defines fair value. The use of fair value accounting in IFRS has been gaining significant ground over the past 10 years. The following table includes a sample of IFRS that require the use of fair values for one or more classes of assets or liabilities:

Standard Number and Title Issue Date IAS 41: Agriculture Feb-01 IAS 40: Investment Property Apr-00 IAS 39 Financial Instruments: Recognition and Measurement Mar-99 IAS 38 Intangible Assets Sep-98 IAS 36 Impairment of Assets Jun-98 IAS 19 Employee Benefits Feb-98 IFRS 3 Business Combinations Oct-98 IFRS 2 Share-based Payment Feb-04 Prior to May 2011, an International Accounting Standard that formally defined the concept of “fair value” did not exist. The IASB had previously endorsed the FASB’s definition of “fair value” and recommended its use by the preparers of IFRS financial statements. The IASB finally released its own accounting standard that defined fair value


(IFRS 13 Fair Value Measurement) in May 2011. This new standard is largely consistent with the existing fair value measurement principles in U.S. GAAP, with a few exceptions, including the following:

• Certain style differences that are not expected to result in inconsistent application (e.g., differences in spelling and differences in references to other U.S. GAAP and IFRS).

• Differences in disclosure requirements, including the following: o Amounts disclosed in Level 3 of the fair value hierarchy under IFRS may

differ from those disclosed under U.S. GAAP because the offsetting requirements for financial instruments differ. Currently, the boards are working to converge their accounting standards on the offsetting of financial assets and liabilities to address these quantitative presentation differences.

o Quantitative measurement uncertainty analysis is required under IFRS for financial instruments measured at fair value and categorized in Level 3 of the fair value hierarchy.

o Nonpublic entities are exempt from certain fair value disclosure requirements under U.S. GAAP. Under IFRS, there is no similar exclusion.

• Differences in the recognition of day-one gains or losses that arise when the initial fair value of an asset or liability differs from the transaction price. For example, under IFRS 9 and IAS 39, gains and losses related to unobservable market data are precluded from immediate recognition. Under U.S. GAAP, there is no similar prohibition.

In addition to their new Fair Value Measurement standard, the IASB has been focusing heavily on an overhaul of the accounting Standards for financial instruments. This project began with the issuance of a discussion paper in March 2008 titled “Reducing Complexity in Reporting Financial Instruments.” This document, part of the Memorandum of Understanding between the IASB and FASB, sought to identify the main causes of complexity in reporting financial instruments. The discussion paper suggested intermediate and long term solutions to improve financial reporting for financial instruments, including the measurement of all financial instruments using a single measurement attribute – fair value. It is proposed that identical measurement of financial instruments would make reporting information easier to understand and increase comparability. The discussion paper supports the view that fair value is the only measure that is appropriate for all types of financial instruments and its use could reduce today’s measurement-related complexity. The discussion paper issued by the IASB represents yet another significant move towards what many have long considered to be the future of financial reporting – all fair value, all the time. However, the timing of the paper’s release proved to be unfortunate, as the global economy was in the midst of one of the worst recessions in recent memory. And unlike the post-S&L Crisis recession of the early 1990’s, fair value was not seen by all as the future of accounting. Rather, fair value accounting was looked upon by some as public enemy number one.



The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. 1. An auditor is researching the ongoing convergence efforts of the IASB and FASB.

The auditor learns that the primary goal of the convergence project is to: a) create one single set of global accounting standards b) give power to the IASB c) simplify auditing standards d) reduce accounting scandals

2. An analyst has been asked to review the IASB discussion paper titled, “Reducing Complexity in Reporting Financial Instruments” and provide a summary report to his manager. Which of the following statements summarizes the IASB’s opinions on the accounting financial assets and liabilities: a) historical cost is the only measure that is appropriate for all types of financial

instruments b) fair value is the only measure that is appropriate for all types of financial

instruments c) the current mixed measurement model should be used indefinitely d) the use of fair value as a measurement basis is appropriate only when markets

are active/liquid



1. A: Correct. The ultimate goal of the convergence project is to create one single set of global accounting standards.

B: Incorrect. The goal of the convergence project is not to give power to the IASB.

C: Incorrect. The goal of the convergence project is not to simplify auditing standards.

D: Incorrect. The goal of the convergence project is not to reduce accounting scandals. (See page 6-1 of the course material.)

2. A: Incorrect. The discussion paper supports fair value, not historical cost, as the

appropriate measurement basis for all types of financial instruments.

B: Correct. The discussion paper supports the view that fair value is the only measure that is appropriate for all types of financial instruments, and its use could reduce today’s measurement-related complexity.

C: Incorrect. The discussion paper does not argue that the current mixed measurement model should be used indefinitely.

D: Incorrect. This argument is not part of the discussion paper. (See page 6-2 of the course material.)


6.2 The Credit Crisis The global credit crisis as we know it today started in the subprime mortgage market in the United States. Bankers and others use the word “subprime” to refer to less than highly creditworthy assets (e.g., subprime mortgages) that yield higher interest rates than do prime assets with similar non-credit risks. The crisis began with the bursting of the United States housing bubble, thus leading to high default rates on subprime and adjustable rate mortgages (ARM). Government policies and competitive pressures that existed for several years prior to the crisis encouraged higher risk lending practices. In addition, an increase in loan incentives and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. However, interest rates began rising and housing prices began falling moderately in 2006-2007 in many parts of the U.S.; thus, refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to appreciate as anticipated, and ARM interest rates reset higher. Home foreclosures accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006.

Financial products known as mortgage-backed securities (MBS), which derive their value from mortgage payments and housing prices, had enabled financial institutions and investors around the world to invest in the U.S. housing market. Those institutions that had borrowed and invested heavily in MBS experienced billions of dollars worth of losses in 2008. The liquidity and solvency concerns regarding these key institutions drove central banks to take action to provide funds to: (1) encourage lending to worthy borrowers, and (2) restore faith in the commercial paper markets (which are integral to funding business operations). Governments around the world began assuming significant additional financial commitments by bailing out many of these key financial institutions. The risks to the broader economy created by the housing market downturn and subsequent financial market crisis were primary factors in several decisions by central banks around the world to cut interest rates and governments to implement economic stimulus packages. This included a $787 billion stimulus package implemented by the United States in 2009. These actions were designed to stimulate economic growth and inspire confidence in the financial markets. Effects on global stock markets due to the crisis have been dramatic in both 2009 and 2010. The proposed causes of this crisis have been varied and complex. The crisis has been attributed to a number of factors present in both housing and credit markets, including:

• The inability of homeowners to make their mortgage payments, due primarily to adjusted rate mortgages resetting

• Borrowers overextending

• Predatory lending


• Speculation overbuilding during the boom period

• Risky mortgage products

• High personal and corporate debt levels

• Financial products that distributed and perhaps concealed the risk of mortgage default

• Monetary policy • International trade imbalances • Government regulation (or the lack thereof)

6.3 The Critical Backlash at “Fair Value” One area that has received particular scrutiny during the Credit Crisis is fair value accounting. Many banks that accounted for their MBS portfolios at fair value saw their capital bases erode quickly as the values of these securities plummeted as homeowners continued to default on their mortgages. These losses caused the demand for MBS to be almost nonexistent, which in turn caused the markets to “seize up” and prices to drop even further. Banks responded to this trend by vehemently attacking fair value accounting, arguing that the definition of fair value outlined in ASC 820 was indeed not “fair”. Many others joined the campaign against fair value, including many prominent U.S. politicians and Wall Street executives. Their principal arguments included the following:

Fair value accounting standards create a downward bias on asset values during periods of illiquid (or less liquid) market conditions.

Issues associated with the measurement of fair value began surfacing in mid-2007, in the context of illiquid (or less liquid) market conditions that had emerged in many segments of the credit markets. This issue became significant enough for the American Institute of Certified Public Accountant (AICPA) to address in a Center for Audit Quality (CAQ) white paper titled “Measurements of Fair Value in Illiquid (or Less Liquid) Markets”. This paper emphasized that fair value is defined as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. It reminded readers that GAAP requires the use of quoted prices in active markets whenever they are available. The paper explored the “fair value hierarchy” (the relative reliability of inputs to a valuation technique used in arriving at a fair-value estimate), the concept of an active market, and the use of valuation models when quoted prices in active markets are not available. According to the white paper, the objective of a valuation is to estimate the price that would be received under existing market conditions. Therefore, the assumptions used in a valuation model must be consistent with assumptions that market participants would use to price an asset at the measurement date.


The guidance provided in the CAQ white paper was seen as a critical flaw in the logic of fair value accounting. Many believe that the fair value hierarchy within ASC 820 creates a bias towards the use of an observable market transaction even when that transaction may be “distressed” or the market for that transaction may not be active. Several FASB constituents (including banks) indicated that this emphasis on the use of the so-called “last transaction price” as the sole or primary basis of fair value, even when significant adjustments may be required to the transaction price or when other valuation techniques should be considered, can result in significant write downs in asset values that are not grounded in economic reality. As the Credit Crisis intensified, so did the critical backlash against fair value accounting. On October 3, 2008, the Emergency Economic Stabilization Act of 2008 was signed into law. Section 133 of the Act mandated that the SEC conduct a study on mark-to-market accounting standards. One of the recommendations in the study stated that “additional measures should be taken to improve the application and practice related to existing fair value requirements (particularly as they relate to both Level 2 and Level 3 estimates).” This recommendation further noted that “Fair value requirements should be improved through development of application and best practices guidance for determining fair value in illiquid or inactive markets.” The SEC Staff’s suggestions for additional guidance included: (1) How to determine when markets become inactive; and (2) How to determine if a transaction or group of transactions is forced or distressed. In response to this request from the SEC, the FASB issued FSP FAS 157-3 “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” on October 10, 2008. The primary intent of the FSP was to reinforce the existing fair value accounting principles and emphasize that those principles allow an entity to use its own assumptions when relevant observable inputs are not available. The critical response to this new guidance was mixed. Some constituents indicated that FSP FAS 157-3 provided useful application guidance, since it permits entities to exercise professional judgment and utilize an entity’s own assumptions when relevant observable inputs are not available. However many others (including banks) indicated that while judgment is permitted, the end result is no different than using the last transaction price, which may have been a distressed transaction. This is because the FSP indicates that market participant liquidity risk must be considered. They point out that many have interpreted that to mean that entities must use the liquidity risk implied in the last transaction price, since it is argued that there is no better indicator of market participant liquidity risk. The “illiquid market” debate reached critical mass on March 12, 2009, when members of the United States Congress vilified fair value accounting rules during a House Financial Services subcommittee meeting. Both Republicans and Democrats blamed fair value accounting for causing major write-downs at financial institutions and allowing the Credit Crisis to continue. The subcommittee demanded that FASB “fix” fair value immediately, or risk the intervention of Congress. The FASB quickly responded by issuing a FASB Staff Position (FSP FAS 157-4 Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly) to provide additional guidance on determining whether a market for a financial asset is not


active and a transaction is not distressed. This amendment provides factors that indicate that a market is not active. Those factors include:

a. Few recent transactions (based on volume and level of activity in the market). Thus, there is not sufficient frequency and volume to provide pricing information on an ongoing basis.

b. Price quotations are not based on current information.

c. Price quotations vary substantially either over time or among market makers (for

example, some brokered markets).

d. Indexes that previously were highly correlated with the fair values of the asset are demonstrably uncorrelated with recent fair values.

e. Abnormal (or significant increases in) liquidity risk premiums or implied yields for

quoted prices when compared with reasonable estimates (using realistic assumptions) of credit and other nonperformance risk for the asset class.

f. Abnormally wide bid-ask spread or significant increases in the bid-ask spread.

g. Little information is released publicly (for example, a principal-to-principal

market).

Under the FSP, a reporting entity must evaluate the significance and relevance of these factors to determine whether, based on the weight of the evidence, there has been a significant decrease in the volume and level of activity for the asset or liability. If the reporting entity concludes there has been a significant decrease in the volume and level of activity for the asset or liability in relation to normal market activity for the asset or liability (or similar assets or liabilities), transactions or quoted prices may not be determinative of fair value. The FSP concludes that “a significant adjustment to the transactions or quoted prices may be necessary to estimate fair value in accordance with ASC 820.” However, the amendment also re-emphasizes that the objective of a fair value measurement remains the same. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. Determining the price at which willing market participants would transact at the measurement date under current market conditions if there has been a significant decrease in the volume and level of activity for the asset or liability depends on the facts and circumstances and requires the use of significant judgment. Fair value accounting is “pro-cyclical” Fair value is believed by some to be very “pro-cyclical” (in economic terms). In other words, it tends to magnify current financial trends, whatever they are. Many critics believe that fair value accounting was, in substantial part, responsible for the residential real estate bubble that collapsed and led to the current global economic crisis. These


critics claim that the mark-to-market effect of fair value accounting caused a downward slide in asset values and this decline evolved into a dangerous downward spiral. For example, as losses mounted in subprime mortgage portfolios in mid-2007, lenders demanded more collateral. If the companies holding the assets did not have additional collateral to supply, they were compelled to sell the assets. These sales depressed the market for mortgage-backed securities (MBS) and also raised questions about the quality of the ratings these securities had previously received. Doubts about the quality of ratings for MBS raised questions about the quality of ratings for other asset-backed securities (ABS). As a result, trading in MBS and ABS came to a virtual halt. Meanwhile, continued withdrawal of financing sources compelled the holders of these securities to sell them at distressed or liquidation prices, even though the underlying cash flows of these portfolios had not necessarily been seriously diminished. As more and more distress or liquidation sales occurred, asset prices declined further, and these declines created more lender demands for additional collateral, resulting in more distress or liquidation sales and more declines in asset values as measured on a ASC 820 basis. A downward spiral had developed. Rising asset prices can have the opposite (and equally pro-cyclical) effect. As fair values rise for homes, stocks, commodities, or any item that has a readily available price, more and more credit becomes available to carry these assets. As more credit is available, the demand for these assets outweighs the supply and prices rise as a result. From the standpoint of institutions, a rise in the value of assets is recognized in earnings under fair value principles if the assets were “held for trading” and recognized in the institution’s capital or equity position if the assets were treated as “available for sale”. In both cases, the growing earnings and strengthening capital induces more borrowing and the acquisition of more assets, so the upward spiral (or, ‘bubble’) continues. Fair value accounting, when applied to liabilities, can lead to misleading amounts being reported as income. Another less-publicized criticism of fair value accounting involves its application to financial liabilities. As discussed in Chapter 5, ASC 825-10 permits an entity to elect the fair value option for financial assets and liabilities for which fair value accounting had previously not been required. The inclusion of liabilities within the framework of ASC 825-10 allows companies to apply fair value concepts to their own debt. ASC 820 states that the fair value of a company’s liability must reflect the risk that the company won’t pay it back (i.e. “an entity’s own credit risk”, as discussed in Chapter 2). Thus, as the risk that companies won’t pay back their debts rises, their reported liabilities actually decrease – and may even provide an earnings boost. The following example presents the fair value accounting of a liability and discusses the conceptual issues associated with such treatment:


The anti-fair value rhetoric that dominated the financial press in 2008-2009 has subsided somewhat in the wake of the ongoing U.S. economic recovery. However, it is clear that fair value accounting, and the accounting profession itself, is at a crossroads. The financial community is at a virtual stalemate regarding the use of fair value, with various CEO’s, politicians and other pundits arguing that it almost led the United States into a new economic depression, while standard setters, regulators and investors argue that fair value is the inevitable future of financial reporting.

Example – Fair Value Accounting Applied to a Company’s Own Liability Assume that ABC Corp. received a $1 million loan from their bank. They elected to account for this loan at fair value under ASC 825-10. At the inception of the loan agreement, ABC Corp. was considered a low credit risk customer to the bank and the loan was valued at $1 million. The entry to record this loan on the books of ABC Corp. at fair value was as follows: Cash $1,000,000 DR Bank Loan Liability $1,000,000 CR Now assume that ABC Corp. falls onto hard times. A ratings agency now considers them to be a higher credit risk, which results in the fair value of their loan to fall to $750,000. The resulting accounting adjustment made by ABC Corp. to record the loan on their books at the new fair value would be: Bank Loan Liability $250,000 DR MTM Gain on Bank Loan (P&L) $250,000 CR Therefore a decline in ABC Corp.’s own credit standing actually improves their net profitability under the requirements of fair value accounting. Such illogical treatment has only served to provide more fuel to the anti-fair value fire.




1. Which of the following asset valuation approaches is considered the most

appropriate according to the CAQ white paper “Measurements of Fair Value in Illiquid (or Less Liquid Markets)”: a) Company A estimates the price that would be received under optimal market

conditions b) Company B estimates the price that would be received under existing market

conditions c) Company C estimates the price that would be received under illiquid market

conditions d) Company D estimates the price that would be received under expected (future)

market conditions

2. Which of the following valuation methodologies has garnered significant criticism from FASB constituents for creating a “downward bias” on asset fair values: a) Company A uses a valuation model with significant unobservable inputs b) Company B adjusts the market price to remove the affect of abnormal liquidity

risk premiums c) Company C uses an unadjusted last transaction price d) Company D uses the income approach described in ASC 820

3. Williams Co. is attempting to estimate the fair value of a financial asset that is associated with a market that is currently inactive. According to the FASB amendment to ASC 820 issued in March 2009, factors that indicate that a market is inactive would include: a) many recent market transactions b) price quotations that are consistent among market makers c) normal liquidity risk premiums d) indexes that are not highly correlated with the fair values of the asset


4. An author is writing a book on the pros and cons of fair value accounting. Which of the following arguments is generally considered one of the principal criticisms of fair value: a) fair value accounting is pro-cyclical b) fair value accounting is counter-cyclical c) fair value accounting creates an upward bias on asset values during periods of

illiquid market conditions d) fair value accounting failed to expose the financial industry's ailing financial

condition during the global credit crisis

5. Bay Financial (a AAA-rated company) elects the fair value option to account for their financing liability. In 2009, they are downgraded to BBB by several ratings agencies due to credit concerns. The resulting impact of this downgrade on: (1) the fair value of their liability, and (2) their earnings for the period would be: a) decrease, increase b) increase, decrease c) increase, increase d) decrease, decrease

6. Which of the following scenarios accurately represents what is widely believed to be the future of accounting for financial instruments under U.S. GAAP and IFRS: a) Company A recognizes all financial instruments at amortized cost on the balance

sheet b) Company B discloses the fair value of their financial instruments in the notes to

the financial statements, without recognition on the balance sheet c) Company C recognizes all financial instruments at fair value on the balance

sheet, with changes in fair value reflected in earnings d) Company D recognizes all financial instruments at fair value on the balance

sheet, with changes in fair value reflected in equity (other comprehensive income)


SOLUTIONS AND SUGGESTED RESPONSES 6.2 1. A: Incorrect. The objective of a valuation is to estimate the price that would be

received under existing (not optimal) market conditions.

B: Correct. According to the white paper, the objective of a valuation is to estimate the price that would be received under existing market conditions. Therefore, the assumptions used in a valuation model must be consistent with assumptions that market participants would use to price an asset at the measurement date.

C: Incorrect. The objective of a valuation is to estimate the price that would be received under existing (not illiquid) market conditions.

D: Incorrect. The objective of a valuation is to estimate the price that would be received under existing (not expected) market conditions. (See page 6-6 of the course material.)

2. A: Incorrect. A valuation model that uses significant unobservable inputs has not

been criticized for creating a downward bias on asset values.

B: Incorrect. Adjusting a market price to remove the affect of abnormal liquidity risk premiums would likely increase (not decrease) the fair value of the asset.

C: Correct. Many believe that the fair value hierarchy within ASC 820 creates a downward bias on asset values by favoring observable market transactions (i.e., the last transaction prices) even when those transactions may be “distressed” or the market for those transactions may not be active.

D: Incorrect. The income approach has not been criticized for creating a downward bias on asset values. (See page 6-7 of the course material.)

3. A: Incorrect. Few recent market transactions are an indicator that a market is inactive.

B: Incorrect. Price quotations that vary substantially among market makers are an indicator that a market is inactive.

C: Incorrect. Abnormal liquidity risk premiums are an indicator that a market is inactive.

D: Correct. This is an indicator of an inactive market. Indexes that previously were highly correlated with the fair values of the asset are demonstrably uncorrelated with recent fair values would be considered an indication that an inactive market exists. (See page 6-8 of the course material.)


4. A: Correct. Fair value is believed by some to be very “pro-cyclical” (in economic terms). In other words, it tends to magnify current financial trends, whatever they are.

B: Incorrect. Fair value is believed by some to be very pro-cyclical, not counter-cyclical.

C: Incorrect. A common criticism of fair value accounting is that it creates a downward (not upward) bias on asset values during periods of illiquid market conditions.

D: Incorrect. This criticism applied to historical cost accounting during the S&L Crisis. It does not apply to fair value accounting. (See page 6-8 of the course material.)

5. A: Correct. A ratings downgrade would decrease the fair value of the liability,

requiring a debit to the liability account. An offsetting credit would be recorded as an increase to earnings for the period.

B: Incorrect. A ratings downgrade would decrease the fair value of the liability, requiring a debit to the liability account. An offsetting credit would be recorded as an increase to earnings for the period.

C: Incorrect. A ratings downgrade would decrease the fair value of the liability, requiring a debit to the liability account. An offsetting credit would be recorded as an increase to earnings for the period.

D: Incorrect. A ratings downgrade would decrease the fair value of the liability, requiring a debit to the liability account. An offsetting credit would be recorded as an increase to earnings for the period. (See page 6-9 of the course material.)

6. A: Incorrect. It is widely believed that the IASB and FASB will ultimately require all

financial assets and liabilities to be recorded on the balance sheet at fair value (not amortized cost).

B: Incorrect. It is widely believed that the IASB and FASB will ultimately require all financial assets and liabilities to be recorded on the balance sheet at fair value.

C: Correct. It is widely believed that the IASB and FASB will ultimately require all financial assets and liabilities to be recorded on the balance sheet at fair value (with changes in fair value reflected in current earnings).

D: Incorrect. It is widely believed that the IASB and FASB will ultimately require all financial assets and liabilities to be recorded on the balance sheet at fair value (with changes in fair value reflected in current earnings). (See page 6-15 of the course material.)


CHAPTER 6 SUMMARY

• The FASB and IASB (International Accounting Standards Board) formally agreed in 2002 to work towards reducing differences between International Financial Reporting Standards (IFRS) and U.S. GAAP. The two bodies issued a “Memorandum of Understanding” which included a program of topics on which the two bodies will seek to achieve convergence, including the topic of fair value.

• The IASB released its own accounting standard that defined fair value (IFRS 13

Fair Value Measurement) in May 2011. This new standard is largely consistent with the existing fair value measurement principles in U.S. GAAP.

• It is widely believed that the IASB and FASB will ultimately require all financial

assets and liabilities to be recorded on the Balance Sheet at fair value (with changes in fair value reflected in current earnings).

• Fair value has been blamed, in part, for exacerbating the current Credit Crisis.

Many critics (including banks) believe that:

o Fair value accounting standards create a downward bias on asset values during periods of illiquid (or less liquid) market conditions.

o Fair value accounting is “pro-cyclical”

o Fair value accounting distorts current earnings, especially when applied

to financial liabilities.

Glossary 1

Glossary Amortization – the allocation of an asset’s acquisition cost (or liability’s issuance cost) in a systematic manner over the estimated useful economic life so as to reflect its consumption, expiration, obsolescence or other decline in value as a result of use or the passage of time. An entity’s own credit risk – nonperformance risk associated with financial liabilities; this risk (which is generally assumed by a reporting entity’s counterparty) is the risk that the reporting entity becomes insolvent and/or is unable to meet the terms of the agreement. Cost approach – a valuation technique based on the amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost). Convergence – ongoing project initiated by the FASB and IASB to reduce the differences between U.S. GAAP and IFRS and ultimately create one single set of global accounting standards. Counterparty credit risk – nonperformance risk associated with financial assets; this risk (which is assumed by the purchasing entity) represents the probability that a financial counterparty becomes insolvent and/or is unable to meet the terms of an agreement. Day one gains and losses – gains and losses that are created when the transaction price is not deemed to represent the fair value of an asset acquired or liability assumed at initial recognition. Depreciation – expense allowance for wear and tear on an asset over its estimated useful life. Derivatives – financial instruments whose value varies with the value of an underlying asset (such as a stock, bond, commodity, or currency) or index such as interest rates. Financial instruments whose characteristics and value depend on the characterization of an underlying instrument or asset. Entry price – the price paid to acquire the asset or received to assume the liability.

Glossary 2

Exit price – the price that would be received to sell the asset or paid to transfer the liability. Fair value – (as defined by ASC 820) the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. Fair value hierarchy – concept established in ASC 820 to prioritize the inputs used in valuation techniques. There are three broad levels (Level 1 being the highest priority and Level 3 being the lowest priority). Fair value option – provides reporting entities with an option to measure many financial instruments, selected hybrid financial instruments, and separately recognized servicing assets and servicing liabilities at fair value. Once elected, the fair value option is irrevocable. Financial Accounting Standards Board (FASB) - a private, not-for-profit organization whose primary purpose is to develop generally accepted accounting principles (GAAP) within the United States in the public's interest. The FASB's mission is "to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information”. Financial asset – cash, evidence of ownership in another entity, or a contract that conveys to a second entity a contractual right (a) to receive cash or another financial instrument from a first entity or (b) to exchange other financial instruments on potentially favorable terms with the first entity. Forced transaction – the sale of an asset or liability that is the result of a forced liquidation or distressed sale. Generally Accepted Accounting Principles (GAAP) – conventions, rules and procedures necessary to define accepted accounting practices at a particular time. The highest level of such principles is set by the FASB. Highest and best use – the use of an asset by market participants that would maximize the value of that asset or group of assets. Historical cost – original cost of an asset to an entity.

Glossary 3

International Accounting Standards Board (IASB) – a privately funded, London-based organization whose goal is to establish a single set of enforceable global financial reporting standards. International Financial Reporting Standards (IFRS) – international standards, interpretations, and the “Framework for the Preparation and Presentation of Financial Statements” adopted by the IASB. Income approach – a valuation technique that uses various valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present amount (discounted). Inputs – the assumptions that market participants would use in pricing an asset or liability, including assumptions about risk. Inputs may be observable or unobservable. Market approach – a valuation technique that uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. Market liquidity – the degree to which a financial item such as an asset or security is able to be bought or sold within a market, without significantly affecting the price of the asset or losing much of its value. Market participants – buyers and sellers in the principal (or most advantageous) market for the asset or liability that are independent, knowledgeable, and willing and able to transact. Most advantageous market – the market in which the reporting entity would sell the asset or transfer the liability at a price that maximizes the amount that would be received for the asset or minimizes the amount that would be paid to transfer the liability, considering transaction costs in the respective market(s). Nonperformance risk (a.k.a. credit risk) – the risk of losses due to the fact that counterparties may be unable to fulfill their contractual obligations. Observable inputs – inputs that reflect the assumptions market participants would use in pricing the asset or liability, developed based on market data obtained from sources independent of the reporting entity.

Glossary 4

Orderly transaction – 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 and liabilities. Principal market – the market in which the reporting entity would sell an asset or transfer a liability with the greatest volume and level of activity for the asset or liability. Pro-cyclical – any aspect of economic policy that magnifies economic or financial fluctuations. Unit of account – an accounting concept that determines the level at which an asset or liability is aggregated or disaggregated for purposes of applying ASC 820, as well as other accounting pronouncements. Unobservable inputs – inputs that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances.

Index

Index

C CAQ white paper, 6-7 cost approach, 3-1, 4-2, 4-3 counterparty credit risk, 2-7, 2-8

D Day 1 gains and losses, 2-10

E entry price, 2-1, 2-9 exit price, 2-1, 2-5, 2-9, 2-10, 3-11

I in-exchange, 2-8, 2-9 in-use, 2-8, 2-9 income approach, 3-1, 4-2, 4-3, 4-12

M mortgage-backed securities, 6-5, 6-9 most advantageous market, 2-1, 2-6,

2-10

N Norwalk Agreement, 6-1

P

principal market, 2-1, 2-6, 3-11, 6-8

S

subprime mortgage market, 6-5

Documents

Fair Value Accounting - Professional Education Services | CPE