FASB Revises Fair Value Accounting Rules

New amendments that take effect in fiscal years beginning after Dec. 15, 2011 will make fair value standards more restrictive for public companies. Major changes include the elimination of the use of blockage factors for any level in the fair value hierarchy, the end of grouping financial assets together under an in-use valuation premise, and the introduction of a new exception to the new restrictions. Background The FASB issued Accounting Standards Update No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (the ASU) in May 2011. The ASU is effective for public companies in fiscal years beginning after December 15, 2011, including interim periods. For most calendar year public companies, this means the ASU is effective for the first reporting period ending March 31, 2012. The new rule is to be applied on a prospective basis. Retrospective application is not allowed. Any changes in fair value measurements should be recorded as a change in estimate in the income statement in the reporting period of initial application. Changes in valuation techniques and measurement inputs should be quantified and disclosed. This alert provides guidance on how to implement the ASU in the following areas:

• Premiums and discounts - The ASU provides new guidance on the application of certain premiums and discounts to financial instruments held, including disallowing the use of blockage factors.
• Financial instruments with offsetting risks - It requires that certain fair value measurements of financial assets and liabilities with offsetting market or credit risks be based on their net positions.
• Unit of account - The unit of account is the level at which a fair value measurement must be performed. Compared with previous guidance, the ASU places greater emphasis on the unit of account concept. It requires that the fair value of financial instruments be measured based on the level of the unit of account, instead of taking an aggregated (or disaggregated) approach.

A blockage factor is a discount applied in measuring the value of a security to reflect the impact on its value of selling a large block of the security at one time. Before the ASU, blockage factors could be considered for Level 2 and Level 3 measurements. Under the new rule, the use of blockage factors is eliminated, with one exception that we will discuss below. The "highest and best use" and valuation premise concepts for financial assets are also eliminated. The "highest and best use" concept established the valuation premise used to measure the fair value of the asset.  Financial assets had two possible valuation premises: "in-use" and "in-exchange."  In-use assets are valued as a group, whereas in- exchange assets are valued on an individual basis. Before the ASU, financial instruments that were grouped together for trading purposes could also be valued together. This is no longer allowed. Financial instruments must now be valued at the unit of account level specified in other guidance, which could be at the individual security level. Premiums and discounts The ASU restricts the circumstances under which premiums and discounts may be applied. The new rule separates entity specific premiums and discounts from those that relate to the characteristics of the asset or liability being valued. A blockage factor is considered to be an entity specific characteristic and is no longer allowed. A control premium is considered to be a characteristic of the asset or liability, and is still permitted. A control premium is applied when the investment's value is enhanced as a result of maintaining a controlling interest in an investee. Blockage Factor Under the ASU, companies may no longer apply a blockage factor to any fair value measurement. Blockage factors were never allowed for Level 1 fair value measurements, but they could be considered for Level 2 and Level 3 measurements. This will represent a big change for some companies, such as investment and private equity firms with non-controlling blocks of equities. In cases where the bid-ask spread is used to price a security, the price within the spread that is considered most representative of fair value should be used. Selecting a price within the bid-ask spread that is meant to reflect an adjustment for the size of the holding is not allowed under the ASU, nor is taking the view that the bid-ask spread is wider for larger positions. Companies may now face immediate recognition of a gain if a block of securities was purchased at a discount and the company is unable to apply a blockage factor. Realizing that gain would depend on whether the company sells the securities at a discount in the future. Control Premiums for Level 2 and 3 Measurements A control premium is appropriate when individual securities within a block have more value due to the block having a controlling interest. The ability to control enhances each of the individual underlying securities held. For a Level 2 or Level 3 fair value measurement involving individual securities that, as a block, have a controlling interest, a market participant would likely pay a premium to obtain control. If a company holds a block of securities with a controlling interest, a market participant would not be expected to sell the securities piecemeal and sacrifice the benefit of the controlling interest. The FASB considers control premiums to be a characteristic of the asset being measured, while it considers blockage discounts to be entity specific. A general principle in fair value measurement is that if the valuation assumption being considered is entity specific, it isn’t allowed. The assumption must first be considered a characteristic of the asset or liability, before a determination can be made about whether a market participant would make an adjustment for that assumption. Blockage factors are akin to transaction costs, which are not permitted in a fair value measurement, since they result from entity specific transaction decisions. It is possible to have a day one gain from purchasing a block of securities at a discount, but not a day one loss by purchasing at a premium a block of securities that held a controlling interest. Factors to Consider: Level 2 and 3 Discounts and Premiums Companies should still consider the following factors when deciding whether it is appropriate to apply a discount or a premium:

• Market participant assumptions - A core principle of the fair value guidance is that a fair value measurement is determined based on the assumptions that market participants would use to price the asset or liability being measured. Market participants are assumed to transact in a manner that is in their economic best interest. Therefore, under the new guidance, an entity would continue to incorporate premiums or discounts (except for discounts or premiums related to size, such as blockage factors) in a Level 2 or Level 3 fair value measurement, if market participants would do so.
• Unit of account as defined by other guidance for the asset or liability being measured - While the determination of fair value is rooted in market participants’ assumptions, it can’t contradict the unit of account for the asset or liability being measured under the new guidance. ASC 820 does not define the unit of account for any asset or liability.  Rather, unit of account is based on other guidance.
• Unit of measurement (see the “portfolio exception” below regarding the exception provided for portfolios of financial instruments with offsetting market and/or credit risks) - ASC 820 does provide guidance on the unit of measurement in the case of the portfolio exception.
• Premium or discount calculations - Whether the premium or discount is related to the size of the entity’s holding of the asset or liability, or is reflective of a characteristic of the asset or liability itself.
• Impact of the premium or discount - Whether the impact of the premium or discount is already contemplated in the valuation.

Types of Level 2 and Level 3 Discounts and Premiums The ASU does not specify what types of premiums or discounts should still be considered, but here are some examples:

• Lack of marketability discounts
• Non-controlling interest discounts
• Premiums or discounts related to cash-flow uncertainty
• Premiums for significant influence for an equity method investment accounted for under the fair value option
• Premiums when making an impairment assessment of an equity method investment
• Adjustments for default or collateral risk related to holdings in mortgage-backed securities

Discount and Premium Examples

• A block of securities held by an investment company – A control premium may apply if the block has a controlling interest that a market participant would consider. Other discounts and premiums may apply.
• A block of securities held by all other companies – A control premium is not applicable, as the investment would be consolidated. Other discounts and premiums may apply.
• Equity method investment for which the fair value option is elected – A control premium is not applicable, because there is no control.  Other discounts and premiums, such as a premium for significant influence, may apply.
• Derivatives - Typical discounts may include those for illiquidity and certain risks.

Financial Instruments with Offsetting Risks Before the ASU, companies often applied an “in-use” valuation premise under the “highest and best use” concept when measuring the fair value of financial instruments. This allowed companies to look at how they trade and manage securities, and value them accordingly. For example, financial assets and liabilities that trade in homogenous pools are often grouped together when measuring fair value. Under the ASU, the grouping of financial assets under an in-use valuation premise is not permitted. Fair value must be measured at the unit of account level called for under other guidance, which often means at the individual share level. There is one exception.  For certain derivatives, if a company manages its market and counterparty credit risks within a portfolio on a net basis, the “portfolio exception” should be considered. The Portfolio Exception The portfolio exception is available on an election basis and there are hurdles to qualify. The exception allows companies to measure the fair value based on the net position of the portfolio instead of the individual positions within the portfolio. For example, this would be the price that would be received to sell a net long position or net short position for a particular market or credit risk exposure. The portfolio exception exempts companies from having to measure at the unit of account level proscribed by other GAAP. Without the exception, aggregation or offsetting of instruments to determine fair value is not allowed. When portfolio exception is elected, the unit of measurement becomes the net position of the portfolio, and size becomes a characteristic of the portfolio. The securities are valued based on the price that a market participant would pay to purchase the whole portfolio in one transaction. An adjustment based on size is allowed if it would be applied by market participants. Therefore, if the portfolio election is properly made, instruments can still be grouped together for a fair value measurement and blockage factors can still be applied. Qualifying The requirements to qualify for the portfolio exception are based on how a company manages the portfolio.  To qualify, a company must:

• Manage the group of financial assets and liabilities on a net basis; that is, the basis of the company’s net exposure to a specific, identified market or counterparty risk, and
• Report information to management about the group of financial assets and liabilities on a net basis

The portfolio must be scoped into ASC 815, Derivatives and Hedging, and ASC 825, Financial Instruments, before these two conditions can be considered. As such, the portfolio exception is designed for financial assets and liabilities that must be fair valued on a recurring basis, either because the FVO was elected or because fair value is required. It has to be scoped into both rules to qualify. For example, a physically-settled commodity derivative contract would generally not meet the definition of a financial instrument. As described above, non-financial instruments are currently excluded from the portfolio exception. The FASB has indicated this exclusion was not intentional and will be corrected. When this correction will be made is unknown at this time. The concepts of the valuation premise and “highest and best use” may still be considered for non-financial instruments. The FASB's correction will probably address portfolios that contain a mix of financial and non-financial instruments. For example, some banks have physically-settled commodity contracts that are managed together with cash-settled derivatives. Some financial instruments are not measured at fair value on a recurring basis. Others are fair valued on a recurring basis, but only the amounts are disclosed. They aren't reported on the balance sheet. Such instruments would not qualify for the portfolio exception. Accounting policy To adopt an accounting policy that permits the portfolio exception, companies need to support their assertion that the portfolio is managed based on the company’s net exposure to market risk or credit risk. Examples of support include documentation of the company’s risk management and investment policies, meeting minutes and management reports. It’s important to think about what the company has done in the past and make sure it’s consistent with the support. The exception must be applied consistently from period to period and business unit to business unit. Companies should document at each reporting period whether risk exposures continue to be managed on a net basis. The election is not irrevocable. If a company's risk exposure preferences change, it can be required to cease using the exception. Such changes are expected to be rare and infrequent. Financial statement presentation The portfolio exception does not deal with financial statement presentation. Whether an instrument can or must be presented on a net or gross basis in the financial statements is a separate determination, driven by other guidance. It's possible to have a difference, such as when the portfolio exception allows grouping for fair value measurement purposes, but an allocation to a more granular level is required for financial statement presentation purposes. For example, it is possible to have a situation in which a portfolio of financial instruments that is managed within a group may be determined based on the net position when using the portfolio exception, but at the same time the company is required to allocate the resulting fair value based on the unit of account required by other guidance for those same instruments. The new ASU does not provide any allocation guidance. Any allocation of the fair value of a portfolio of financial instruments to a lower level of detail should be done in a reasonable and consistent manner. Managing On a Net Basis The first criterion to meet the portfolio exception is that the portfolio must be managed on a net basis. This means it is managed on the basis of the company’s net exposure to market risk or counterparty risk. Offset.  To meet this requirement, the market risks that are being offset must be offset in an acceptable manner. The ASU does not say how much of a long or short position needs to be offset to qualify. As long as a company's risk and investment strategies are in sync with the nature of the portfolio being managed, 100% offset is not required. If a company enters into an offsetting position with the portfolio exception in mind, it should be careful to ensure that the position has substance. If offset does not occur on the measurement date due, the portfolio exception can still be used, as long as the lack of offset can be shown to be temporary and the cause of the lack of offset was related to unexpected market events or other circumstances. One last thought on offset -- managing a portfolio based on value-at-risk (VAR) does not guarantee that the portfolio is being managed on a net basis. Duration. To meet the first criterion, the market risk being offset must have substantially the same duration. When portfolios have offsetting positions with different maturities, fair value adjustments to the net portfolio position should be made to account for duration mismatches. Companies should be aware of any positions in the portfolio with maturity differences, because they will result in an adjustment to the net position. For example, in a portfolio of interest rate swaps with long positions of 25 years to maturity that are offset with short positions of 15 years to maturity, the 10 years of unmatched longs would be measured as part of the net position, even though the company qualifies for the portfolio exception for the net position for interest rate risk. Basis differences. To the extent that there is any basis difference for dissimilar risks, an adjustment should be made to the fair value of the net position. For example, a company may include financial instruments with different interest rate bases in one portfolio, as long as the company manages its interest rate risk on a net basis (and there is high correlation among the different bases). An adjustment should be made to fair value to account for differences in how interest is driven. For example, an adjustment would be required to account for the difference between the London Interbank Offered Rate (LIBOR) and U.S. Treasury rates. Master netting agreements When using the portfolio exception where counterparty credit risk is managed on a net basis, companies should consider the expectations of market participants as to whether any risk-mitigating agreements in place are legally enforceable. For example, market participants may not reflect an expectation that a master netting agreement designed to mitigate counterparty credit risk is legally enforceable in the event of default. In this situation, any adjustment for credit risk could be applied to the net exposure to the counterparty, rather than to each individual instrument. For a net asset position, the adjustment should be applied to the net position, based on a particular counterparty's credit risk. For a net liability position, the adjustment should be applied to the net position, based on the company's own credit risk. The ASU does not affect the separate requirement to factor in a credit (or debit) valuation adjustment on a net open asset (or liability) position. Convergence with IFRS The ASU is a joint effort with the International Accounting Standards Board (IASB), which issued International Financial Reporting Standards (IFRS) 13, Fair Value Measurement, in May 2011. Most of the ASU's changes bring IFRS and U.S. GAAP in closer harmony; however, significant differences remain. Conclusion Pluris specializes in fair value accounting matters and can assist you in understanding how the new fair value accounting rules should be applied in your financial statements. For example, the ASU assumes a company's ability to define the unit of account in other guidance, but doing so for loans and insurance products can be challenging. Pluris can also help you determine whether you qualify for the portfolio exception. Contact Pluris to learn more about how best to implement the new rule.