Fair Value Framework

Question 1

• Objectives of the Fair Value Framework.
• To complete these objectives, what does ASC 820 provide?

Answer 1

• Inconsistencies have occurred in how fair value is measured. Thus FASB ASC 820 provides a framework to:
  
  • Achieve increased consistency & comparability
  • Expand disclosures
• To accomplish these, ASC 820 provides:
  
  • Uniform definition of fair value
  • Uniform framework for measuring fair value
  • Uniform disclosure requirements when fair value is used

Question 2

• 1. Define Fair Value: the price that would be ___ to sell an asset or ___ to transfer a liability in an orderly transaction between m___ p___ at the ___ date.
• 2. NOTE:
     * Fair value is an ___ price, not an ___ price. Entry price is the price paid for purchase of an asset or the price received for taking someone’s liability.
     * The fair value definition focuses on ___ to measure fair value not ___ to measure fair value.
• 3. What are the characteristics of the market participants in the Fair Value definition?
     * market participants are Willing & Able to pay for BEST IN-K.

Answer 2

• 1. received; paid; market participants (buyers and sellers of the asset or liability); measurement date.
• 2. NOTE
     * exit; entry
     * how; when
• 3. Characteristics of the market participants
  • Willing & Able, but not compelled, to transact for the asset or liability.
  • Acting in their economic Best interest.
  • Independent of the reporting entity.
  • Knowledgeable of the asset or liability and the transaction involved.

Question 3

Individual components of the Fair Value definition:

• 1. Fair value is a ___ measurement, not an ___ measurement.
• 2. The determination of Fair Value may be for a ___ asset or liability or a ___ of assets/liabilities (e.g., an asset group or a line of business).
• 3. Fair value must be applied to the ___ instrument NOT just a specific element of an instrument.
• 4. The transaction to sell the asset or transfer the liability is a ___ transaction at the measurement date.
• 5. The hypothetical transaction to get rid of the asset/liability is assumed to occur in the ___ market. If there is no principal market available for the asset/liability, ___ market must be used to determine fair value.
• 6. The principal market is the one with ___ for the asset or liability within which the reporting entity could sell the asset or transfer the liability. The most advantageous market is the market that ___ the amount received to sell the asset (or ___ the amount paid to transfer a liability), after taking into account transaction costs and transportation costs. Transportation costs are costs to get the asset/liability to the principal or most advantageous market.
• 7. Both transaction and transportation costs are taken into account in ___ the ___ market. Even though transaction cost is considered in determining the most advantageous market, it won’t be deducted from the market price to get the Fair Value. On the other hand, market price need to be adjusted for ___ to get the Fair Value.
• 8. The hypothetical transaction establishes a basis for ___ the price to sell the asset or transfer the liability.
• 9. The transaction would occur under current market conditions, NOT under a ___ ___ or ___ ___.

Answer 3

• 1. market-based; entity-specific
• 2. standalone; group
• 3. entire
• 4. hypothetical
• 5. principal; the most advantageous
• 6. the greatest volume and level of activity; maximizes: minimizes
• 7. determining; most advantageous; transportation cost
• 8. estimating
• 9. forced liquidation; distress sale

Question 4

The application of Fair Value to Assets:

• 1. The determination of Fair Value of a non-financial asset should be based on the concept of ___ of the asset by market participants, even if the ___ of the asset by the reporting entity is different.
• 2. Highest & Best use occur when the asset is:
     * ___: Maximum value to market participants through its use in combination with other assets as a group; or
     * ___: Maximum value to market participants principally on a standalone basis, that is, the price that would be received in a current transaction to sell the single asset.
• 3. Highest & Best Use must consider the following 3 aspects at the measurement date:
     * 1. ___
     * 2. ___
     * 3. ___
• 4. Does Highest & Best Use apply to measuring the Fair Value of financial assets?

Answer 4

• 1. Highest & Best Use = maximum value; intended use
• 2. In-use; In-exchange
• 3.
  
  • 1. Physically possible
  • 2. Legally permissible
  • 3. Financially feasible
• 4. NO. Highest & Best Use only applies to measuring the fair value of non-financial assets.

Question 5

The application of Fair Value to Liabilities:

• 1. The determination of Fair Value of a liability assumes the liability is ___ to a market participant at the measurement date; the liability is not ___ or ___.
• 2. The liability to the counterparty (i.e., the party to whom the obligation is due) is assumed to ___ after the ___ transaction.
• 3. ___ risk relating to the liability is assumed to be the ___ after the hypothetical transaction as before the transaction.
• 4. When a quoted price for the transfer of an identical or similar liability is not available, and the identical liability is held by another party as an asset, the liability should be measured from the perspective of ___.

Answer 5

• 1. transferred; settled or canceled
• 2. continue; hypothetical
• 3. non-performance; same
• 4. the party that holds the item as an asset

Question 6

The application of Fair Value to Shareholders’ Equity.

Answer 6

• The determination of Fair Value of SE assumes the instrument is transferred to a market participant at the measurement date and is measured from the perspective of the party that holds the SE instrument as an asset, that is, the issuer cannot report SE at Fair Value.
• When a quoted price for the transfer of an identical or similar SE instrument is not available, and the identical instrument is held by another party as an asset, the instrument should be measured from the perspective of the party that holds the item as an asset.

Question 7

Is the fair value under U.S. GAAP the same as the fair value under IFRS?

Answer 7

YES.

• There are no significant differences between U.S. GAAP and IFRS related to Fair Value, except for minor differences in wording and style.
• GAAP and IFRS have the same following as to Fair Value.
  
  • Definition
  • Measurement framework
  • Required disclosures

Question 8

• 1. Define “exit price”.
• 2. Define “entry price”.
• 3. Entry Price vs. Exit Price

Exit and Entry price are conceptually different. At the date of initial recognition, entry price and exit price may or may not be the same amount. List situations where entry price ≠ exit price.

• 4. List the dates (referred to as election date) when an entity may elect to use fair value for an eligible item.

Answer 8

• 1. The price that would be received to sell an asset or paid to transfer a liability.
• 2. The price paid to acquire an asset or the price received to assume a liability. Entry price is also called “transaction price.”
• 3. Entry Price ≠ Exit Price if:
     * The transaction is between related parties.
     * The seller is under duress (e.g., liquidation or distress sale).
     * The unit of account included in the transaction price is different from the unit of account that would be used to measure at fair value.
     * The market in which the transaction price occurred is different from the market in which the asset would be sold or the liability transferred.
• 4. Election dates occur:
  5. When the item is first recognized.
  6. When a firm commitment is established.
  7. When an event requires the item to be measured at fair value, such as a business combination or significant modifications to debt instruments.
  8. When specialized accounting for an item ceases to exist.
  9. When accounting treatment for an investment changes because it becomes subject to the equity method or ceases to be eligible for consolidation.

Question 9

• What are the 3 valuation techniques (or approaches) that should be used in determining fair value?

►MICrophone

• In some cases, a ______ valuation technique will be appropriate (e.g., using quoted prices in an active market for identical assets or liabilities).
• In some cases, _______ valuation techniques will be appropriate (e.g., when valuing an entire business).

Answer 9

• Market approach - uses prices of identical (NOT similar) items

Income approach - converts future amounts to a single present amount. Discounting future cash flows would be an income approach to determining fair value.

Cost approach (replacement cost) - uses the amount currently required to replace an asset already acquired.

• single
• multiple

Question 10

• List the items may be reported at Fair Value.
• List the items may Not be reported at Fair Value.

Answer 10

• Items may be reported at Fair Value:

1. Recognized financial assets/financial liabilities (with some exceptions SEE BELOW).
2. Firm commitments.
3. Written loan commitments.
4. Rights and obligations under insurance contracts and warranties.
5. Other financial instruments embedded in non-financial derivative instruments.

• Financial assets/liab may Not be reported at Fair Value:

1. Investment in subsidiary that is to be consolidated.
2. Employee (pension) -oriented benefits.
3. Financial assets/liabilities under lease accounting.
4. Financial instruments classified by the issuer as a component of shareholders’ equity.
5. Demand deposit liabilities of financial institutions.
6. Interest in a variable interest entity that is to be consolidated.

Question 11

When an entity is either required or permitted to measure an item initially at fair value, but the entry price at initial recognition does not equal to fair value at initial recognition, then:

• Should the item be reported at entry price or fair value?
• How should the difference between the entry price and the recorded fair value be recognized?

Answer 11

• fair value
• recognized as a gain or loss in the period of initial recognition.

Question 12

Consistent Application of Fair Value Approach/Technique

• 1. Valuation techniques used to measure fair value should be __________ applied.
• 2. However, a change in valuation technique is appropriate if the change will result in a ____________fair value. (e.g., if new markets develop, new information becomes available, previous information is no longer available).
• 3. How would the change in the amount of Fair Value due to the change in valuation approach be reported?

Answer 12

• 1. consistently
• 2. more representative
• 3. The change in the amount of Fair Value due to the change in valuation approach is reported as a change in estimate.
     * Recall that change in estimate is a prospective change and impacts current and future income. Thus, change in estimate is an income stmt account.
     * Recall that change in accounting principle is a retrospective change. Change in accounting principle is recorded as an adjustment to the beginning balance of retained earnings. RE is an OE account.

Question 13

Fair Value option requirements:

1. If a firm elects to use Fair Value option, does it have to be applied to all instruments issued or acquired in a single transaction?
2. Fair Value option must be applied to an ________ instrument not just to specific portions of an instrument.
3. Fair Value option is _______ unless under a ________ for the specific item.
4. How will Held-To-Maturity securities be treated if they are recorded at Fair Value?

Answer 13

1. NO, The fair value option may be applied on an instrument by instrument basis. The fair value option may be elected for a single eligible item without electing it for all other identical items.
2. entire
3. irrevocable; new election date
4. HTM securities will be treated and reported as Trading securities if they are elected for Fair Value Option. Their gains & losses will be reported in Net Income.

Question 14

What measurement methods can be used to measure HTM sec?

Answer 14

• Both Amortized Cost and Fair Value may be used to measure and report HTM.
• Amortized Cost is the traditional measurement method for HTM.
• HTM can be measured at Fair Value at the option of the firm.
  
  • If Fair Value option is elected for HTM, gains & losses of HTM will be recorded in Net Income.

Question 15

What are the 2 types of Fair Value measurement inputs?

Answer 15

• Observable inputs. External. Inputs that are developed based on market data obtained from sources independent of the reporting entity.
• Unobservable inputs. Internal. Inputs that are based on the entity’s own assumptions. Developed based on the best information available in the circumstances.
• Valuation techniques should maximize the use of observable inputs and minimize the use of unobservable inputs.

Question 16

• What are the 3 levels of the Fair Value hierarchy? What does each level consist of?
• What purpose does the Fair Value hierarchy serve?

Answer 16

• 3 levels of Fair Value hierarchy:

► Both Level 1 & Level 2 are observable inputs. Only Level 3 are unobservable inputs.

1. Level 1: Highest level.
   
   • Observable.
   • Provide the most reliable evidence of fair value
   • Quoted prices in active markets for assets and liabilities identical to those being valued.
   • Quoted prices should not be adjusted.
   • Quoted market prices should not be adjusted for a “blockage factor” when a firm holds a sizable portion of the asset being valued.
2. Level 2: Observable inputs other than quoted prices in Level 1.
   
   • Observable.
   • Quoted prices for similar assets or liabilities in active markets.
   • Quoted prices in an inactive market for identical or similar assets or liabilities (inactive means few relevant transactions, prices are not current or vary substantially, or little information is publicly available).
   • Observable inputs other than quoted prices, e.g., interest rates, yield curves, implied volatilities and credit spreads.
   • May be adjusted for factors such as condition, location, and the level of activity in the relevant market.
3. Level 3: Lowest level.
   
   • Unobservable.
   • Level 3 is the lowest level in the fair value hierarchy. It consists of unobservable inputs and requires the greatest amount of disclosures.
   • The entity’s own assumptions about what market participants would assume
   • Based on the best information available in the circumstances, which might include the entity’s own data.
   • Used to determine Fair Value only if observable inputs are not available.
   • Expected cash flow is not an observable, external, market-based value, but rather is based on the entity’s assumptions as to cash flow.
   • If significant unobservable inputs are used to adjust observable inputs, it may be categorized in Level 3.

• Purpose of the hierarchy: To prioritize the inputs to valuation techniques used to measure fair value.

Question 17

GAAP requires disclosures for the following when fair value is used:

1. Assets and Liabilities that are measured at Fair Value on a _________ basis.
2. Assets and Liabilities that are measured at Fair Value on a _________ basis.
3. Firms which elect to measure financial assets and financial liabilities at fair value are required to make significant additional disclosures in both _____ and _____ periods.
4. Firms which elect to measure assets and financial liabilities at fair value are required to make significant additional disclosures in both _____ and _____ (financial stmts).

Answer 17

1. recurring
2. nonrecurring
3. interim (quarterly, etc.) and annual
4. Balance Sheet and Income Stmt

Question 18

For assets and liabilities that are measured at Fair Value on a recurring basis:

1. Disclose in __________, for each __________ period, for each major __________ of asset and liability.
2. Disclose the fair value ___________ at the reporting date.
3. Disclose the ____________________ within which the fair value measurements fall.
4. Disclose __________ each level and __________ each level. Disclose the amounts of any transfers between Level 1 and Level 2, the reasons for such transfers, and the policy for determining when those transfers occur.
5. For Levels 2 & 3: disclose description of the ___________ and __________, disclose discussion of _________ in valuation techniques during the period, if any.
6. For Level 3, disclose __________ of the beginning and ending balances. - THIS IS ONLY FOR RECURRING BASIS.
7. For Level 3, disclose description of the ____________ used; quantitative information about the ___________ inputs used; description of the __________ of the fair value measurement to changes in unobservable inputs.
8. For nonfinancial assets, disclose if _____________ differs from current use and why.
9. Quantitative disclosures required above must be presented using a ________ format (examples are provided in ASC 820-10-55-100 through 820-10-55-107.)

Answer 18

1. Balance Sheet; interim & annual; category
2. measurements
3. level of the fair value hierarchy
4. transfers into; transfers out of
5. valuation techniques; inputs; changes
6. reconciliation
7. valuation process; unobservable; sensitivity
8. highest and best use
9. tabular

Question 19

For assets and liabilities that are measured at Fair Value on a nonrecurring basis:

1. Disclose in __________, for each major _________ of asset and liability.
2. Disclose the fair value ____________ at the reporting date and the reasons for the measurement.
3. Disclose the ____________________ within which the fair value measurements fall.
4. For Levels 2 & 3, disclose description of the _______________ and ________ used to measure fair value, disclose discussion of ________ in valuation techniques during the period, if any.
5. For Level 3, disclose description of the _____________ used and quantitative information about the ___________ inputs used.
6. For nonfinancial assets, disclose if ______________ differs from current use and why.
7. Quantitative disclosures required above must be presented using a ________ format (examples are provided in ASC 820-10-55-100 through 820-10-55-107.)

Answer 19

1. Balance Sheet; category
2. measurements
3. level of the fair value hierarchy
4. valuation techniques; inputs; changes
5. valuation process; unobservable
6. highest and best use
7. tabular

Question 20

• NOTE: Reporting entities are __________, but not __________, to combine disclosures about fair value measurements required by all accounting pronouncements.

Answer 20

• encouraged; required

Question 21

What significant fair value disclosures are required only in annual statements?

Answer 21

The methods and significant assumptions used to estimate fair value.

Question 22

Distinguish between assets and liabilities measured at fair value on a recurring basis and nonrecurring basis.

Answer 22

• On recurring basis:

Assets and liabilities measured at fair value are adjusted to fair value period after a period.

• On nonrecurring basis:

Assets and liabilities measured at fair value are adjusted to fair value only at the time of a particular event (e.g., significant modification of debt).

Question 23

• 1. What comparisons of fair value disclosures intend to facilitate?
     * 1. different entities
     * 2. the same entity
• 2. The disclosure requirements are intended to:
     * 1. Enable users to understand management’s _________ for electing or partially electing the fair value option.
     * 2. Enable users to understand how ________ in fair value affect _________ for a period.
     * 3.To provide the same kind and amount of information that would have been provided if the fair value option _______________.
     * 4. Enable users to understand the differences between fair values and contractual ___________ for certain items.
• 3. To achieve these comparisons and outcomes, required disclosures must be provided in both ____________ period.

Answer 23

• 1. Comparisons that Fair Value disclosures aim to achieve:
     * 1. different entities use different measurement methods to estimate similar assets and liabilities.
     * 2. the same entity uses different measurement methods to estimate similar assets and liabilities.
• 2. Outcomes that Fair Value disclosures aim to achieve:
     * 1. reasons
     * 2. changes; earnings
     * 3. had not been elected
     * 4. cash flows
• 3. interim and annual