Part 2 of Final Convergence in Fair Value Measurements

The SEC, FASB and IASB have been busy converging U.S. GAAP with IFRS:

• In May, the SEC released a work plan for how a transition to IFRS might work, introducing the concept of "condorsement", whereby standards would be converged one at a time instead of all at once.
• Also in May, the FASB issued ASU 2011-04, Fair Value Measurement: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS, which reflects final substantial convergence in the area of fair value accounting.
• In June, the IASB and FASB announced a modification to their convergence strategy, delaying convergence for projects for which further research and analysis is necessary.
• In July, the SEC sponsored an IFRS roundtable to discuss the impact of adopting IFRS in the U.S. The FASB and the IASB are committed to substantial convergence by the end of the year.

This alert is part two in a two part series that reviews the major provisions of the FASB’s new guidance on fair value accounting. Equity classified instruments ASC 820 (FAS 157) was quiet on how to fair value items classified in equity, such as those instruments that arise from capital markets transactions. The new rule provides that in estimating fair value, the reporting company should assume that the instrument is transferred to a market participant who will assume its rights and responsibilities. Fair value should be estimated “from the perspective of a market participant that holds the identical item as an asset” rather than from, for example, the reporting entity's perspective. New disclosures The new rule expands qualitative and quantitative disclosures. For Level 3 measurements, the new rule requires the following new disclosures:

1. Description of the valuation processes in place.
2. Disclosure of the sensitivity to changes in unobservable inputs and interrelationships between inputs, but only if a change to an input would result in a significant difference.
3. Quantitative disclosures about unobservable inputs used in a Level 3 fair value measurement. Companies are not permitted to ignore significant quantitative unobservable inputs that are reasonably available to the entity. Exception: Companies that use net asset value as a practical expedient are not required to provide quantitative disclosures about unobservable inputs for Level 3 measurements.
4. The highest and best use of a nonfinancial asset when it differs from current use, and the reason for the difference.
5. For transfers between levels, disclosures are required for any transfer between Level 1 and Level 2, not just significant transfers.
6. Hierarchy level for items not measured at fair value on the balance sheet but for which fair value is disclosed in the notes. For example, the fair value of loans is required to be disclosed in the notes even though they may be reported at amortized cost on the balance sheet. Under the new rule, companies are required to disclose that item's hierarchy level.

Contrary to the FASB's original exposure draft (ED), the final ASU does not require quantitative measurement uncertainty analysis disclosures (QMUDs). QMUDs had been proposed for Level 3 recurring fair value measurements. Companies would have been required to perform a sensitivity analysis of unobservable inputs to reasonable alternative amounts. They would also have been required to consider the effect of any relevant correlation between unobservable inputs. The FASB plans to reconsider these matters at a later time. Premiums and discounts The idea of when to apply a premium or discount in a fair value measurement has been a topic of debate since before the issuance of ASC 820. The new rule provides revised guidance that is principles based:

• Companies are expected to select fair value measurement inputs that are consistent with the characteristics of the asset or liability that market participants would take into account. In doing so, in some cases, those characteristics reflect the application of a premium or discount, such as a control premium or non-controlling interest discount.
• Fair value measurements can't apply a premium or discount if doing so is inconsistent with the unit of account required or permitted by other rules. The new rule does not deal with unit-of-accounts. If applicable, specific unit-of-account guidance relevant to the item being measured should be followed.
• Premiums or discounts that reflect size as a characteristic of the company's holding rather than as a characteristic of the asset or liability are not permitted. An example of an adjustment that would not be allowed would be a blockage factor that adjusts the quoted price of an asset or a liability because the market’s normal daily trading volume is not sufficient to absorb the quantity held by the entity. An example of an adjustment that would be allowed is a control premium when measuring the fair value of a controlling interest.  NOTE: Companies are still required to consider adjustments to fair value such as based on market liquidity, or the lack thereof, and transfer or sale restrictions.
• Prior to the new rule, if there was a quoted price in an active market, companies used that quoted price without adjustment and categorized the item being measured in Level 1. The new rule provides certain exceptions that may allow adjustments or alternative pricing methods in certain situations.

Offsetting The ASU provides an exception that allows a company to measure the fair value of a net asset or liability position in the same way that a market participant would, if the criteria below are met. This exception applies to a group of financial assets and liabilities with offsetting positions in market risks or counterparty credit risk that are managed based on a net exposure basis. Market risks being offset should be substantially the same. All of the following criteria must be met:

1. Group of financial assets and liabilities are managed on the basis of net exposure to a market risk or to the credit risk of a counterparty in accordance with a documented risk management or investment strategy.
2. Provides information on that basis about the group of financial assets and financial liabilities to the reporting entity’s management.
3. Company is required or has elected to measure the item at fair value in the statement of financial position at the end of each reporting period.

The new rule gives guidance on how companies should look at when to include the effect of its net exposure to counterparty credit risk in measuring fair value. It should be included when market participants would consider any existing arrangements that reduce credit risk in a default situation, such as a master netting agreement or collateral exchange agreement. The company must factor in whether the agreement would be legally enforceable in the event of default. Conclusion Within a few short months, the SEC is expected to make an announcement that will have an unprecedented impact on financial accounting - the timeline for adoption of IFRS. Now that fair value accounting rules are substantially converged, now is the time to assess the impact that an IFRS adoption will have on systems, policies and controls for items required or opted to be measured at fair value. Please contact Pluris to discuss fair value accounting under IFRS and how the FASB's new guidance will impact your company.