fas 157_v1_may_071 fas 157 fair value measurement issued sept 2006 val mulcahy may 2007

FAS 157_V1_May_07 1

FAS 157 Fair Value Measurement

Issued Sept 2006

Val Mulcahy May 2007

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Who wants Fair Value Accounting {FV}

• Relatively new concept 1959 Tax rules

• Rapid growth in popularity in profession

• Financial engineering >> presumes it

• Regulatory agencies >> base rules on it

• Analysts >> request it

• Shareholder's >> seem to grasp it

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FV Lexicon• Adjustments

– Model risk – Level 1 &2– Discount rate

• Bid – Ask spread of prices• Blocks of securities• Costs

– Transaction– Transportation

• Fair Value Hierarchy– Level 1– Level 2– Level 3

• Inputs– Observable – Non –observable– Significantly un-observable

• Liability– Non Performance risk– Credit standing

• Market Participants• Markets

– Principal market– Most advantageous market

• Measurement dates– Event date driven – Reporting date driven

• Net Value • Price

– Initial recognition price– Entry price– Exit price

• Restricted usage• Risks

– Specific risks (aka unsystematic / diversifiable)

– General risks ( aka systematic / non-diversifiable)

• Term of asset or liability• Transaction

– Initial– Hypothetical – Orderly transaction

• Unit of account• Use

– Highest & best use– In-use ( with other items)– In –exchange use ( stand alone use)

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Introduction FAS 157

• Affirms FV is market based NOT entity specific• Validates FV measurement• Provides financial techniques for FV calculation • Establishes a framework for measuring FV • Eliminates current diversity surrounding FV• Eliminates inconsistencies • Expands disclosure for FV This Statement is not intended to:

– Create any new accounting GAAP principles – Validate or impose any single method of FV

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Overview FAS 157

• Defines fair value

• Establishes a method for measuring FV

• Expands disclosures

• Simplifies & Codifies guidance

• Applies to all pronouncements (79 effected) that invoke FV

• Does not require any new FV measurements.

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Overview FAS 157

• Exchange notion is based on – an orderly transaction – between market participants – to sell an asset or transfer a liability – in the principal or most advantageous market.

• The transaction is a hypothetical transaction – at the measurement date– focuses on the price that would be received

• an exit price• not at entry price the price that would be paid.

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Overview FAS 157

• FV is a market- based measurement

• Not entity- specific

• It’s what market participants would use

• Under certain circumstances– FV permits the reporting entitie’s own

assumptions about market assumptions – developed based on the best information

available in the circumstances. .

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Overview FAS 157

• Requires assumptions about risk – What would market participants include? – Adjustment maybe difficult to determine.

• Include the effect of restrictions • on the sale or use of an asset • if market participants would consider the effect

•Disclosures required as to both • interim reports• annual periods• subsequent to initial recognition.

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Overview FAS 157

• Liability FV reflects entity’s non-performance risk. • Hence FV looks to entity’s credit risk • In all periods in which FV of liability is used

• No “Blockage Factor”– FV is measured as the product of

• quoted price x times the quantity = FV– Price is not

• adjusted for the size of the position held• even if transaction would exceed daily volume• i.e., a blockage factor

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Scope FAS 157

•Statements prepared in accordance with U.S. GAAP

•Including not-for-profit entities.

•FAS 157 applies to other accounting pronouncements that

require FV

Exceptions {very minor}•FASB Statement No. 123, Shared Based Payment, •Does not eliminate the practicality exceptions•Does not apply to “valuations similar” to FV

•Vendor specific • Inventory Pricing

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Effective Date FAS 157

• November 15, 2007 • Applied prospectively

– Beginning of the fiscal year in which is initially used – Except

• Applied Retrospectively where – A blockage factor was used previously

– “Initial recognition” under Statement 133 was used

– A hybrid financial instrument under FAS 155 that was a t” initial recognition” under Statements 133 and 155 prior to initial application of this Statement.

• Difference recognized in opening balance of retained earnings

• Disclosure applied in the first interim period of the fiscal year in which this Statement is initially applied.

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FV Defined

• FV 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.

• Orderly Transaction

• Assumes exposure to the market for a period. • A hypothetical transaction • Considered from the perspective of a market

participant

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FV Defined(cont’d)

• Objective is to determine

– Price that would be received to sell the asset or paid to transfer the liability

– Referred to as an exit price.– After allowing reasonable marketing period

• Measurement date(s) either

– Event determined >> is the case of a specific transaction; a business combination, for example

– Time determined >> is primarily by reference to the issue date of financial statements.

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Valuation Approach

FAS proscribes• No established valuation standards • Clarifies fair value in terms of the price in an orderly transaction

Entity must determine:

1] The particular asset or liability that is the subject

2] Including a unit of account for the asset or group of assets 3] For an asset, the valuation premise appropriate for a measurement

consistent with its highest and best use 4] The principal market for the asset or liability, and 5] The valuation technique appropriate, considering

* availability of data for inputs * level in the fair value hierarchy within which the inputs

fall.

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Valuation Premise

• The valuation objective for an asset’s FV is to assume

a use which produces • highest value• and best use • by market participants.

• The choice is either

“in-use” value used in combination with other assets

“in-exchange” value used on stand alone basis

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Valuation Premise

• Valuation Premises may vary. Examples…

A] Both may result in same valueIf asset is whole business, it is both stand alone & “in use”

B] Refinements to stand alone value can modify it to an “in use” basis

C] “In use” value may be based on individual “stand alone” components

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Exit Price

• Conceptually, Entry Prices and Exit Prices are different.

• Transaction price (Entry Price) represents the price

• paid to acquire the asset • or received to assume the liability

• In contrast, FV price ( Exit Price) that would be• received to sell the asset • or paid to transfer the liability

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Exit Price / ( & Initial Recognition)

Occasionally

Transaction price (TP) = Entry Price = Exit price = FVHence at initial recognition TP = FV

Determination conditions

A] Is the transaction between related parties? B] Does the transaction occur under duress?

C] Is the unit of account represented by the TP same as FV unit of account?

e.g if the asset or liability is only one of the elements of the multi –component transaction

D] Are both the ‘Principal’ and ‘Most Advantageous markets’ the same?

e.g. securities traded in retail v’s inter bank market

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Market Participants

Market participants are buyers and sellers in the ‘principal market’ for the asset or liability that are:

a. Independent of the reporting entity. They are not related parties.

b. Knowledgeable about the asset or liability and the transaction c. Able to transact. d. Willing to transact / motivated but not otherwise compelled to do so.

Entity • Must use FV assumptions that market participants would use • Need not identify specific market participants. • Should identify characteristics that distinguish market participants• Be parties entity would deal with

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Assets

• FV assumes the highest and best use of the asset by market participants

• At the measurement date Highest and Best use must be

• physically possible• legally permissible • financially feasible• is determined by market participants (reflect on this)

• Highest and best use is

• That which maximizes the value of the asset. • Based on the use of the asset by market participants,

– Even if entity plans are different (above)– Established by the valuation premises. Specifically:

» In- use. in combination with other assets as a group. » In-exchange.on a standalone basis.

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Liabilities

• FV assumes that the liability is transferred to a market participant at the measurement date.

• The liability to the counterparty continues.

• Nonperformance risk – is risk obligation will not be fulfilled – it affects the FV of the liability – Is the same before and after the hypo’ transaction

• Nonperformance risk includes but may not be limited to the reporting entity’s own credit risk.

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Liabilities

• The entity must assess • Its credit standing for the duration of the

liability • Terms of any credit enhancements

• FV may vary if obligation is to deliver• cash (a financial liability) • or goods or services (a performance

liability)

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(i) Principal & (ii) Most Advantageous Markets

The principal market • the greatest volume • and level of activity

The most advantageous market • yields greatest value to transaction• considering transaction costs (bit of a twist)

• FV assumes that the transaction occurs in• the principal market or, in absence of such• the most advantageous market.

• Selection is considered from entity’s viewpoint• Different entities? = maybe different markets • If there is a clear principal market

• Entity must reference it for FV• Even if the price in a different market is more advantageous• On measurement date

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• The FV price shall not be adjusted for transaction costs.

• Reason: Transaction costs are not an attribute of the asset or

liability; rather, they are specific to the transaction and will be

different depending on how the reporting entity transacts. • But: Price is adjusted for Transport costs

• If location is an attribute, the price shall be adjusted

.

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Class Exercise >>> Read details in manual

Recommendation• Strategic buyer acquires a group of assets (A, B, and C) • Determine maximum value to a market participant would

be ‘use in’ combination • As a group 3 assets FV = $650• As stand alone assets FV = $600

• Asset C is worth $70 more stand alone• But assets A & B both have lower values, $120

lower in stand alone aggregate• Entity cannot cherry–pick. It must be consistent• On balance ‘In-use’ route is Higher & Better value

.

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Valuation TechniquesThree approaches are permitted

1. Market2. Cost 3. Income

Market. • Prices generated by market transactions• Involving identical or comparable assets or liabilities • May use

– market multiples derived from a set of comparables – Method calls for judgment – Multiples might lie in the ranges with a different

multiple for each comparable – May include matrix pricing. (definition: see manual) – ** Illustrate with Municipal Market

.

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Valuation Techniques

Three approaches are permitted … .

Cost. • $’s currently required to replace the service capacity of an asset

• What would it cost a market participant – to acquire or construct substitute asset of comparable utility– adjusted for obsolescence.

• Obsolescence encompasses • physical deterioration• functional obsolescence• and/or economic

– obsolescence is broader than depreciation for financial reporting purposes.

.

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Valuation TechniquesThree approaches are permitted

Income. • Converts future amounts to a single present amount. • Based on current market expectations about those future

amounts.• Discounted by appropriate interest rate • Those valuation techniques include present value

techniques, – option-pricing models, such as Black Sholes formula

and a binomial model, which incorporate present value techniques

– multi-period excess earnings method, used to measure the fair value of certain intangible assets.

.

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.

• Either may be appropriate:• Single valuation technique• Multiple valuation techniques

• If multiple, the results will be• evaluated • and weighed • considering the reasonableness of the range indicated.

• FV is the point where range is most representative

• Techniques shall be consistently applied.• Change permitted if more more representative of FV• Say change in weightings / arrival of new products

• Impact handled as “change in accounting estimates” • No adjustment to opening P&L • The disclosure provisions of Statement 154 are not required

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.

• Class Exercise >>> Read details in manual • Recommendation• The entity assesses whether market value use in combination with other assets is highest value use. • The cost approach may apply too,• The income approach is not used because the machine does not have a separately income stream. • a. Market approach. • Using quoted prices / for similar machine. • In its current condition and location, thereby including installation and transportation costs. • Approach ranges from $40,000 to $48,000.

• b. Cost approach. • The cost to construct a substitute machine of comparable utility/ includes installation costs. • Approach ranges from $40,000 to $52,000.

Market approach is deemed more representative That determination is based on the relative reliability of the inputs, • a. The inputs used in the market approach require less subjective adjustments • b. The range indicated overlaps with, but is narrower than, the range indicated by the cost

approach.• c. No other differences.

• Higher end of the range because the majority of relevant data points at high end FV= $48,000.

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Inputs to Valuation Techniques

.

• Inputs are assumptions that market participants would use• Including assumptions about risk. Observable inputs • Inputs based on market data • Obtained from sources independent of the reporting entity. Unobservable inputs • Inputs that reflect the reporting entities own assumptions

– About the assumptions market participants would use – In pricing the asset or liability developed – Based on the best information available in the circumstance.

Valuation techniques shall • maximize the use of observable inputs • and minimize the use of unobservable inputs

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Fair Value Hierarchy

.

• To increase consistency, Inputs are prioritized into three broad levels.

• Highest priority to • quoted prices I• in active markets • for identical assets or liabilities

• Lowest priority to unobservable inputs. • Inputs used might fall in different levels of the fair value hierarchy.

• The Entity’s Overall Hierarchy Ranking • shall be determined based on• the lowest level input that is significant. • Assessing the significance requires judgment, considering factors specific to

the asset or liability.

• The availability of inputs and the relative reliability of the inputs might affect the selection of appropriate valuation techniques.

• It is important to note, the fair value hierarchy prioritizes– The inputs to valuation– NOT the valuation techniques.

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Fair Value Hierarchy Level 1

.

• Level 1 inputs are

• unadjusted quoted prices

• in active markets for identical assets or liabilities

• that the reporting entity has the ability to access

• at the measurement date

• a Level 1 input maybe available in multiple active markets.

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.

• Determination of selected market– a. The principle market or, the most advantageous market, considered

from the perspective of the reporting entity; and

– b. Whether the reporting entity has the ability to access the price

• An active market is a market in which transactions occur– with sufficient frequency

– and volume to provide pricing information on an ongoing basis.

– quoted price in an active market provides the most reliable

evidence of FV

– It shall be used to measure fair value whenever available.

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.

Exceptions -

Matrix Pricing allows an array of similar securities to be valued via interpolation

• A number of grid points are inputs from valid quotes

• The blank cells are then interpolated via historic correlation

• Beware the resultant FV ranks lower on hierarchy level than pure Level 1

If significant events occur after the close of a market but before the measurement date

• The reporting entity should identify & evaluate impact of those events.

• Adjustment for new information, renders lower hierarchy level

“ Blocks “ do NOT give rise to adjustments.

• Valued as” quoted price x quantity held = FV”.

• The use of a blockage factor is prohibited,

• even if • market’s normal daily trading volume is not sufficient to absorb the quantity held

• placing orders to sell the position in a single transaction might affect the quoted price.

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.

Example – Level 1 ( See detail in manual)

• A financial asset is traded on two different exchanges with different prices.

• The entity transacts• in both markets

• has the ability to access the price in both markets

• for the asset at the measurement date.

• In Market A, $26 -$3= $23 .

• In Market B, $25 -$1= $24

Easy case If Market A is the principal market FV = $26

• If neither market is the principal market . An interesting twist occurs

• The FV price in the most advantageous market drives the decision.

• Most advantageous market is the one with best “NET” market value = B• Notwithstanding “transaction costs” are not part of FV

• FV = $25 would be measured using the price in that market ($25).

• Transaction costs are considered in determining the most advantageous market,

• But FV is not adjusted for those costs.

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.

Level 2 Inputs • Other than quoted prices included within Level 1• That are observable for the asset or liability• Either directly or indirectly • Must be observable for the term of the asset or liability.

Level 2 inputs include the following:

• Quoted prices for similar assets or liabilities in active markets • Non active market Quoted prices for same or similar items. • Inputs other than quoted prices that are observable for items

for example, interest rates and yield curves observable at commonly quoted intervals,

volatilities, prepayment speeds, loss severities, credit risks, and default rates.

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.

(cont’d) Inputs that are derived principally from or corroborated by observable market data by correlation or other means.

Adjustments to Level 2 inputs

•Will vary depending on factors specific to the asset or liability. • Those factors include

• the condition • and/or location of the item• the extent to which the inputs relate to items that are comparable to

the item • the volume and level of activity in the markets within which the

inputs are observed.

•Significant adjustments might render the FV a Level 3

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.

Examples – Types of Level 2 Inputs a. Receive-fixed, pay-variable interest rate swap based on the LIBOR swap rate.

LIBOR swap rate if that rate is observable for the full term of the swap. b. Three-year option on exchange-traded shares.

implied volatility for the shares derived through extrapolation to year 3

c. Licensing arrangement. recently negotiated / unrelated party by the acquired the royalty rate at inception.

d. Finished goods inventory at retail outlet.

price to customers in a retail market /or a wholesale price to retailers in a wholesale market, adjusted for /condition / location / requisite selling efforts

e. Building held and used. the price per square foot for the building derived from observable/ multiples derived from prices in observed transactions / comparable buildings / similar locations.

f. Reporting unit. multiple of earnings / revenue /or a similar performance measure / from observable market data /comparable businesses/ considering operational market, financial and nonfinancial factors.

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.

Level 3 inputs

Unobservable inputs for FV of the asset or liability.

• Only if observable input are not available

• Reflect the reporting entity’s own assumptions

• Including risk that market participants would use in pricing the item

• Based on the best information available.

Deriving market participants assumption; Entity:-

• Need not undertake all possible efforts to obtain information about market

participant assumptions.

• Shall take reasonable steps to deduce market participant assumptions

• Need not incur undue cost in this research

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.

Examples - Level 3

Asset retirement obligation at initial recognition. • Expected cash flows developed using the entity’s own data• Appropriate risk weighted discount rate applied • FV is the resulting PV

FV of a Reporting unit.

• Level 3 input would include a financial forecast of cash flows or earnings developed using the entity’s own data

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.

Examples - Level 3

Inputs Based on Bid and Ask Prices

Price within the bid-ask spread that is most representative of fair value Regardless of where in the fair value hierarchy the input falls (Level 1, 2, or 3)

FAS 157 does not preclude

– the use of mid-market pricing – other pricing conventions– practical expedients for FV within a bid-ask spread.

– Note: Buy at the ask ( high side) and sell at the bid ( low side) is a well established convention.

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Restricted Assets

• Assessment by market participants in driving force in FV

Example – Restriction on Sale of Security

• The entity holds a security of an issuer for which sale is legally

restricted for a specified period; a “section144 a” security.

• The restriction would transfer to market participants.

• ‘Clean’ market quote would be reduced for restriction

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Liabilities & Credit Risk

• Nonperformance risk relating to a liability includes the entity’s

credit risk.

• The entity should consider the effect of its credit standing on the

fair value of the liability

• In all periods in which the liability is measured at fair value

• Assumers of the debt will examine entity’s credit standing in FV

price

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Liabilities & Credit Risk

(cont’d)

• For example, assume that Entity X and Entity Y each enter into a

contractual obligation to pay cash ($500) to Entity Z in 5 years.

• Entity X has AA credit rating and can borrow at 6 percent

• Entity Y has BBB credit rating and can borrow at 12 percent.

• Entity X will receive about $374 in exchange for its promise (the

percent value of $500 in 5 years at 6 percent).

• Entity Y will receive about $284 in exchange for its promise (the

present value of $500 in 5 years at 12 percent).

• The fair value of the liability to each entity (the proceeds)

incorporates that entity’s credit standing.

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Present Value Techniques

Present value converts – uncertain future cash flows– to a present value – using a discount rate.

Comprises

a. An estimate of future cash slows.b. Expectations about possible variations in the amount and/or

timing of the cash flows.c. Risk-free interest rate. d U.S. Treasury securities determines the appropriate risk-free

interest rate. e.g. Risk premium, the price for bearing the uncertainty

inherent in the case flows . • In the case of a liability the obligor’s own credit risk.

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General Principles

a. Cash flows and discount rates should reflect assumptions that market participants would use.

b. Cash flows and discount rates should consider only factors attributed to the asset (or liability) being measured.

c. Assumptions behind cash flows and discount rates should be internally consistent. For example consistently handle:-

inflation

after-tax v’s pre-tax cash flows

underlying economic factors of the currency

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Discount Rate Adjustment Technique (the “point estimate”)

• One stream of cash flows selected from all possibilities

• One discount rate that approximates observed rate for

valued item

• Looks to comparable items

• Attention to variables outcomes is accommodated via

• “ Adjusting the Discount rate for the accumulated risks”

It’s a direct technique sullied by obvious shortcomings

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Expected Present Value Technique

• Seeks to ameliorate other methods shortcomings

• Uses an array of possible cash flows

• These are then weighted by their probability of

• This yields expected value outcomes.

• The resulted weighted cash flow is no longer event dependent

• Market participants want risk free investments

• ‘Specific risk’ aka unsystematic (diversifiable) risk.

• ‘General market’ risk, aka systematic (non-diversifiable) risk.

• Market participants will be compensated only for bearing the

systematic or no diversifiable risk inherent in the cash flows.

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Expected Present Value Technique

Method 1

• Method 1 adjusts the expected cash flows for the systematic risk

• It explicitly takes out a “risk premium” from the regulate business

cash flows by subtracting a cash risk premium (risk-adjusted

expected cash flows).

• Results in a certainty-equivalent cash flow

Method 2

• Takes turns the other lever in the equation

• Method 2 adjusts for systematic (market) risk by adding a risk

premium to the risk-free interest rate.

See manual for

A] Worked example

B] Probabilistic forecasting primer

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Disclosures

[A] Fair Value Measurements on a Recurring Basis Information enabling users of financial statements to assess the inputs used to FV Effect on P&L from using FV unobservable inputs (Level 3) For each major category of assets or liabilities the following information For each interim and annual period separately

A. The fair value measurements at the reporting date; B. The level within the hierarchy in which the measurements, in their entirety, fall,

segregating quoted prices in active markets for identical assets or liabilities (Level 1), other observable inputs (Level 2), and unobservable inputs (Level 3);

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Disclosures

(cont’d)

[A] Fair Value Measurements on a Recurring Basis

C For fair value measurements using unobservable inputs (Level 3), a reconciliation of the beginning and ending balances, separately presenting changes during the period attributable to the following;

(1) Total gains or losses for the period (realized and unrealized) and where those gains or losses are reported in the statement of income (2) Purchases, sales, issuances, and settlement (net), and (3) Transfers in or out of Level 3 (for example, transfers due to changes in the observability of significant inputs);

D The total gains or losses for the period in subparagraph (c)(1) above, that are

attributable to the change in unrealized gains or losses relating to those assets and liabilities still held at the reporting date, and, where those unrealized gains or losses are in the statement of income;

E In annual periods only, the valuation techniques(s) used to measure fair value and a

discussion of changes in valuation techniques, if any, during the period. The information might be presented as shown in the manual

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Disclosures

[B] Fair Value Measurements on a Non Recurring Basis

Enable users to assess the inputs used to develop FV items. Disclose the following information for each interim and annual period

separately for each major category of assets and liabilities: a. The fair value measurements recorded during the period and the

reasons for the measurements; b. The level within the fair value hierarchy in which the fair value

measurements, in their entirety, fall; c. For fair value measurements using significant unobservable inputs,

a description of the inputs and the information used to develop the inputs; and

d. In annual periods only, the valuation technique(s) used to measure fair value and a discussion of changes, if any, in the valuation

techniques used. See table in manual

fas 157_v1_may_071 fas 157 fair value measurement issued sept 2006 val mulcahy may 2007

Documents

fv price

liability fv

fv of liability

fv calculation

market participants

single method of fv

blockage factor fv

new fv measurements