FASB and IASB Join Hands on Fair Value

This week, the FASB and the IASB released new fair value accounting measurement and disclosure guidance. The new guidance, set forth in IFRS 13, Fair Value Measurement and as an update to ASC 820, completes a major project of the two Boards’ joint efforts to harmonize IFRS and U.S. GAAP. This alert focuses on the FASB’s new rule and compares it to IFRS. The FASB’s new rule is known as 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 (“ASU 2011-04”, “ASU”, “Update”, or “the amendments”). Read on to get an overview of the 331 page amendment to ASC 820, the largest amended to ASC 820 since FAS 157 was issued in 2006. Background In 2006, the FASB and the International Accounting Standards Board (IASB) published a Memorandum of Understanding to create a common set of high quality global accounting standards. Consistent with the MoU and the two Boards’ commitment to achieving that goal, ASU 2011-04 is the result of the work by the FASB and the IASB to develop common requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and IFRS. Fair value now has the same meaning in U.S. GAAP and in IFRS, and measurement and disclosure requirements are now the same (except for minor differences in wording and style). The Boards concluded that the ASU will improve the comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with U.S. GAAP and IFRS. The ASU explains how to measure fair value. It does not require new or additional fair value measurements and is not intended to establish valuation standards or affect valuation practices outside of financial reporting. Who Is Affected? The ASU applies to all companies that are required or permitted to measure or disclose the fair value of an asset, liability, or financial instrument classified in a reporting entity’s shareholders’ equity in the financial statements. Some of the disclosures required by the ASU are not required for nonpublic entities. Those disclosures include the following: 1.  Information about transfers between Level 1 and Level 2 of the fair value hierarchy 2.  Information about the sensitivity of a fair value measurement categorized within Level 3 of the fair value hierarchy to changes in unobservable inputs and any interrelationships between those unobservable inputs 3.  The categorization by level of the fair value hierarchy for items that are not measured at fair value in the statement of financial position, but for which the fair value of such items is required to be disclosed. What Are the New Rules? The ASU results in common fair value measurement and disclosure requirements in U.S. GAAP and IFRSs. Consequently, the ASU changes the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. For many of the requirements, the Board does not intend for this ASU to result in a change in the application of ASC 820. Parts of the ASU clarify the Board’s intent about the application of existing fair value measurement requirements. Other parts change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. How Are the New Rules Different? The amendments in this Update change the wording used to describe the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. The amendments include the following: 1.  Those that clarify the Board’s intent about the application of existing fair value measurement and disclosure requirements. 2.  Those that change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. In addition, to improve consistency in application across jurisdictions some changes in wording are necessary to ensure that U.S. GAAP and IFRS fair value measurement and disclosure requirements are described in the same way (for example, using the word shall rather than should to describe the requirements in U.S. GAAP). The amendments that clarify the Board’s intent about the application of existing fair value measurement and disclosure requirements include the following: 1.  Application of the highest and best use and valuation premise concepts. The amendments specify that the concepts of highest and best use and valuation premise in a fair value measurement are relevant only when measuring the fair value of nonfinancial assets and are not relevant when measuring the fair value of financial assets or of liabilities. The Board decided that the highest and best use concept is not relevant when measuring the fair value of financial assets or the fair value of liabilities because such items do not have alternative uses and their fair values do not depend on their use within a group of other assets or liabilities. Before those amendments, ASC 820 specified that the concepts of highest and best use and valuation premise were relevant when measuring the fair value of assets, but it did not distinguish between financial and nonfinancial assets. The Board concluded that the amendments do not affect the fair value measurement of nonfinancial assets and will improve consistency in the application of the highest and best use and valuation premise concepts in a fair value measurement.  The amendments might affect practice for some reporting entities that were using the in-use valuation premise to measure the fair value of financial assets as described below in the section “Measuring the fair value of financial instruments that are managed within a portfolio.” 2.  Measuring the fair value of an instrument classified in a reporting entity’s shareholders’ equity. The amendments include requirements specific to measuring the fair value of those instruments, such as equity interests issued as consideration in a business combination. Those amendments are consistent with the requirements for measuring the fair value of liabilities and specify that a reporting entity should measure the fair value of its own equity instrument from the perspective of a market participant that holds that instrument as an asset. Before those amendments, ASC 820 stated that the definition of fair value should be applied to an instrument measured at fair value that is classified in shareholders’ equity, but it did not contain explicit requirements for measuring the fair value of such instruments. The Board concluded that including requirements on how to apply the principles of ASC 820 when measuring the fair value of an instrument classified in a reporting entity’s shareholders’ equity will improve consistency in application and will increase the comparability of fair value measurements among reporting entities applying U.S. GAAP or IFRSs. The Board does not expect those amendments to affect current practice. 3. Disclosures about fair value measurements. The amendments clarify that a reporting entity should disclose quantitative information about the unobservable inputs used in a fair value measurement that is categorized within Level 3 of the fair value hierarchy. The Board concluded that those amendments do not change the objective of the requirement but that explicitly requiring quantitative information about unobservable inputs will increase the comparability of disclosures between reporting entities applying U.S. GAAP and those applying IFRS. The amendments in this Update that change a particular principle or requirement for measuring fair value or disclosing information about fair value measurements include the following: 1. Measuring the fair value of financial instruments that are managed within a portfolio. A reporting entity that holds a group of financial assets and financial liabilities is exposed to market risks (that is, interest rate risk, currency risk, or other price risk) and to the credit risk of each of the counterparties. The amendments permit an exception to the requirements in ASC 820 for measuring fair value when a reporting entity manages its financial instruments on the basis of its net exposure, rather than its gross exposure, to those risks. Financial institutions and similar reporting entities that hold financial assets and financial liabilities often manage those instruments on the basis of their net risk exposure. That exception permits a reporting entity to measure the fair value of such financial assets and financial liabilities at the price that would be received to sell a net asset position for a particular risk or to transfer a net liability position for a particular risk in an orderly transaction between market participants at the measurement date. Before those amendments, reporting entities that applied U.S. GAAP or IFRS reached similar fair value measurement conclusions when measuring the fair value of such financial assets and financial liabilities. That was the case even though the requirements in U.S. GAAP and IFRS for measuring the fair value of those financial instruments were expressed differently. As a result of the amendments, U.S. GAAP and IFRS have the same requirements for measuring the fair value of such financial instruments. The Board concluded that the amendments do not change how such financial assets and financial liabilities are measured in practice for many reporting entities. However, those amendments might affect practice for reporting entities that have been applying the in-use valuation premise more broadly than was intended. For example, if a reporting entity used the in-use valuation premise to measure the fair value of financial assets when it did not have offsetting positions in a particular market risk (or risks) or counterparty credit risk, that entity might arrive at a different fair value measurement conclusion when applying the amendments than that reached before the amendments were effective. 2. Application of premiums and discounts in a fair value measurement. The amendments in this Update clarify that the application of premiums and discounts in a fair value measurement is related to the unit of account for the asset or liability being measured at fair value. The amendments specify that in the absence of a Level 1 input, a reporting entity should apply premiums or discounts when market participants would do so when pricing the asset or liability consistent with the unit of account in the Topic that requires or permits the fair value measurement. The amendments clarify that premiums or discounts related to size as a characteristic of the reporting entity’s holding (specifically, a blockage factor) rather than as a characteristic of the asset or liability (for example, a control premium) are not permitted in a fair value measurement. The amendments might affect practice for reporting entities that apply a premium or discount when measuring the fair value of an asset or a liability if the reporting entity applies ASC 820 on the basis of the quantity at which it might transact when that quantity differs from the unit of account specified in U.S. GAAP for fair value measurements categorized within Level 2 or Level 3 of the fair value hierarchy. The Board does not expect the amendments to affect practice for fair value measurements categorized within Level 1 of the fair value hierarchy. 3. Additional disclosures about fair value measurements. The amendments expand the disclosures about fair value measurements. The Board has received input from users of financial statements requesting more information about the following: a. For fair value measurements categorized within Level 3 of the fair value hierarchy:

1. The valuation processes used by the reporting entity
2. The sensitivity of the fair value measurement to changes in unobservable inputs and the interrelationships between those unobservable inputs, if any.

b. A reporting entity’s use of a nonfinancial asset in a way that differs from the asset’s highest and best use when that asset is measured at fair value in the statement of financial position or when its fair value is disclosed on the basis of its highest and best use. c. The categorization by level of the fair value hierarchy for items that are not measured at fair value in the statement of financial position but for which the fair value is required to be disclosed (for example, a financial instrument that is measured at amortized cost in the statement of financial position but for which fair value is disclosed in accordance with ASC 825, Financial Instruments). The Board concluded that the amendments in this Update achieve the objective of developing common fair value measurement and disclosure requirements in U.S. GAAP and IFRS and improve their understandability. When Will the Amendments Be Effective? The amendments in this Update are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011. For nonpublic entities, the amendments are effective for annual periods beginning after December 15, 2011. Early application by public entities is not permitted. Nonpublic entities may apply the amendments in this Update early, but no earlier than for interim periods beginning after December 15, 2011. How Do the New Rules Compare with IFRS? The amendments in this Update are the result of the work of the FASB and the IASB to develop common requirements for measuring fair value and for disclosing information about fair value measurements. Consequently, those amendments improve the comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with U.S. GAAP and IFRS. In their deliberations, the FASB and the IASB discussed the significant differences between the requirements in U.S. GAAP and the proposals in the IASB Exposure Draft, Fair Value Measurement, which was published in May 2009. The Boards worked together to ensure that, to the extent possible, ASC 820 and IFRS 13, Fair Value Measurement, are identical. The following style differences remain: 1. There are differences in references to other U.S. GAAP and IFRS— For example, regarding related party transactions, U.S. GAAP refers to ASC 850, Related Party Disclosures, and IFRS 13 refers to IAS 24, Related Party Disclosures. 2. There are differences in style—For example, U.S. GAAP refers to a reporting entity and IFRS 13 refers to an entity. 3. There are differences in spelling—For example, U.S. GAAP refers to labor costs and IFRS 13 refers to labour costs. 4. There are differences in whether references are to a particular jurisdiction or are generic—For example, U.S. GAAP refers to U.S. Treasury securities and IFRS 13 refers to risk-free government securities. The Boards concluded that those differences will not result in inconsistent interpretations in practice by entities applying U.S. GAAP or IFRS. In addition, ASC 820 and IFRS 13 have the following differences: 1. There are different accounting requirements in U.S. GAAP and IFRS for measuring the fair value of investments in investment companies. ASC 946, Financial Services—Investment Companies, requires an investment company to recognize its underlying investments at fair value at each reporting period. ASC 820 provides a practical expedient that permits a reporting entity with an investment in an investment company to use as a measure of fair value in specific circumstances the reported net asset value without adjustment. IAS 27, Consolidated and Separate Financial Statements, requires an investment company to consolidate its controlled underlying investments. Because IFRS do not have accounting requirements that are specific to entities that are investment companies, the IASB decided that it would be difficult to identify when such a practical expedient could be applied given the different practices for calculating net asset values in jurisdictions around the world. For example, entities that are investment companies may report in accordance with national GAAP, which may have recognition and measurement requirements that differ from those in IFRS (that is, the underlying investments might not be measured at fair value or they might be measured at fair value in accordance with national GAAP, not IFRS). The Boards are reviewing the accounting for investment companies as part of a separate project. 2. There are different requirements for measuring the fair value of a deposit liability. In U.S. GAAP, ASC 825, Financial Instruments, and ASC 942, Financial Services—Depository and Lending, describe the fair value measurement of a deposit liability as the amount payable on demand at the reporting date. In IFRS, IFRS 13 states that the fair value measurement of a financial liability with a demand feature (for example, demand deposits) cannot be less than the present value of the amount payable on demand. That requirement in IFRS 13 was relocated unchanged from IAS 39 and IFRS 9 as a consequence of the IASB’s fair value measurement project. 3. There are different disclosure requirements in U.S. GAAP and IFRSs. For example: a. Because IFRS generally do not allow net presentation for derivatives, the amounts disclosed for fair value measurements categorized within Level 3 of the fair value hierarchy might differ. The Boards are reviewing the presentation requirements for offsetting financial assets and financial liabilities in their joint project on offsetting. b. IFRS require a quantitative sensitivity analysis for financial instruments that are measured at fair value and categorized within Level 3 of the fair value hierarchy (that disclosure was previously in IFRS 7, Financial Instruments: Disclosures). The Boards will analyze the feasibility of incorporating information about interrelationships between unobservable inputs into a quantitative measurement uncertainty analysis disclosure. After completing that analysis, the Boards will decide whether to require such a disclosure. c. There are different requirements for nonpublic entities. In developing the amendments to ASC 820, the Board concluded that some of the disclosures should not be required for nonpublic entities because of the characteristics of the users of the financial statements of those entities. The Board considered the ability of those users to access information about the financial position of the entity and the relevance to those users of the information that would be provided by the requirements in the disclosure amendments. In contrast, the IASB recently completed a project on the accounting for small and medium-sized entities. As a result, the International Financial Reporting Standard for Small and Medium sized Entities addresses (1) the accounting for entities that do not have public accountability and (2) the disclosures about their fair value measurements. Questions? Please contact Pluris at 212-248-4500 or info@pluris.com if you would like to discuss any of the differences between IFRS and U.S. GAAP, or how the adoption of IFRS would affect your fair value measurements.