FASB Statement No. 157 –Fair Value Measurements

John R. Null

July 16, 2009

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Objectives

• Overview of fair value

• Valuation techniques and guidance

• Specific application to non-profits

• Disclosure requirements and examples

• Planning and other considerations

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Overview of SFAS 157

• Effective for fiscal years beginning afterNovember15, 2007

• Applies to financial and nonfinancial assetsand liabilities measured at fair value

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Overview of SFAS 157 (cont.)

•The goal of SFAS 157 is to improve financialreporting by:

– Providing a common definition of fair value

Almost 70 FASB pronouncements that require or allow fairvalue measurement

– Establish a framework for measuring fair value

– Expand disclosures on use of fair valuemeasurements

– Create principles-based standard

•Increase transparency

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Effective Date

• Financial assets/liabilities and nonfinancialassets/liabilities recognized or disclosed atfair value on a recurring basis - effective forperiods beginning after November 15, 2007.

• Other nonfinancial assets/liabilities -effective for periods beginning afterNovember 15, 2008.

• Primarily applied prospectively as of thebeginning of the fiscal year in which thestatement is initially applied.

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Definition of Fair Value

• “Fair value is the price that would bereceived to sell an asset or paid to transfera liability in an orderly transaction betweenmarket participants at the measurementdate”

• Fair value is an exit price. Previously, fairvalue generally thought to be an entry price- what a company would pay to acquire anasset

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Keys to Fair Value Measurement

• Measurement assumes an orderly transactionin the principal or most advantageousmarket

– Market with the greatest volume or level ofactivity in which an entity could sell an assetor transfer a liability

• Fair value should reflect the highest and bestuse from a market participant perspective,regardless of management’s intended use

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Valuation Techniques under FAS 157

• Market Approach – uses prices and other relevantinformation from market transactions involvingidentical or comparable assets or liabilities

• Income Approach – uses valuation techniques toconvert future amounts to a single present amount

– Discounted cash flows

– Swaps

• Cost Approach- based on the amount thatcurrently would be required to replace the servicecapacity of the asset

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Fair Value Hierarchy

Fair value hierarchy prioritizes inputs tovaluation techniques used to measure fairvalue. Valuation techniques should maximizethe use of observable inputs and minimize theuse of unobservable inputs.

– Level 1 - Observable inputs that reflect quotedmarket prices for identical assets or liabilitiesin active markets

• Example – Stock Prices

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Fair Value Hierarchy (cont.)

– Level 2 – Inputs that are directly or indirectlyobservable in the marketplace

• Examples - matrix pricing, yield curves

– Level 3 – Unobservable information

• Examples – Company’s internal information,investment manager information for privateplacement, private equity or hedge funds

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Good or Bad?

There is no formula for calculating fairvalue. Judgment plays a role in thefair value measurement and level

determination.

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Applicability to Non-Profits

• Certain statements that are specific to Non-Profits:– Statement 116 (Contributions)

– Statement 124 (Marketable Securities)

– Statement 136 (Beneficial Interests)

– Statement 159 (Contributions Receivable, Split-Interest Obligations, etc.)

– Statement 164 (NFP mergers and acquisitions)

• In addition to the many other general GAAPstandards that apply to Non-Profits– Asset impairments, derivatives, pension assets, etc.

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Investment Considerations

• Determination Level Reports can beprovided from custodians/investmentadvisors to assist in determining the levels.

• Custodians should also provide a clientcommunication package detailing thevaluation process utilized regarding theirmethodology on the level determination.

• Are there any restrictions? If so, considerLevel 3 inputs.

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Alternative Investment Considerations

• Primary issue: Does the Net Asset Value (NAV)constitute fair value presentation?

– Presently, it is common for investors to estimate thefair value of investments using the net asset valueper share without additional adjustment

– Hedge funds, private equity funds, venture capitalfunds

• Proposed guidance FSP FAS 157-g

– Final comments due July 8, 2009

– When issued will be effective immediately

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Contributions Receivable

• If expected to be collected in less than oneyear, may be measured at net realizablevalue as this is a reasonable estimate of fairvalue

• If expected to be collected greater than oneyear, income approach is appropriate

– Present Value Techniques

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Split –Interest Agreements

Generally:

–Assets are typically cash or marketableinvestments and are fairly straightforwardto determine measurement

–Liabilities – income approach used

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Disclosure Requirements

• Fair value measurement on the reportingdate

• Level within fair value hierarchy eachmeasurement falls

• A description of the valuation techniquesused to measure fair value

• Discussion of any changes in fair valuemeasurement which occurred throughoutthe period

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Disclosure Requirements (cont.)

Level 3 disclosures have expanded requirements:

– Reconciliation of the beginning and endingbalances for fair value measurements including thefollowing:

• Realized and Unrealized Gains and Losses

• Changes in Unrealized Gains and Losses

• Purchases, Sales, Issuances and Net Settlements

• Fair Value items that transfer in or out of Level 3classification

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Disclosure ExampleEffective the beginning of 2008, the Company implemented FAS 157, which defines fair value,

establishes a framework for its measurement and expands disclosures about fair value measurement. The adoptionof FAS 157 did not have an impact on the measurement on the Company’s financial assets and liabilities, but didresult in additional disclosure.

FAS 157 defines fair value as the price that would be received to sell an asset or liability (i.e., exit price)in an orderly transaction between market participants at the measurement date. FAS 157 requires disclosures thatcategorize assets and liabilities measured at fair value into one of three different levels depending on theassumptions (i.e., inputs) used in the valuation. Level 1 provides the most reliable measure of fair value, whileLevel 3 generally requires significant management judgment. Financial assets and liabilities are classified in theirentirety based on the lowest level of input significant to the fair value measurement. The FAS 157 fair valuehierarchy is defined as follows:

Level 1 - Valuations are based on unadjusted quoted prices in an active market for identical assetsor liabilities.

Level 2 - Valuations are based on quoted prices for similar assets or liabilities in active markets,or quoted prices in markets that are not active for which significant inputs are observable, eitherdirectly or indirectly.

Level 3 - Valuations are based on prices or valuation techniques that require inputs that are bothunobservable and significant to the overall fair value measurement. Inputs reflect management’sbest estimate of what market participants would use in valuing the asset or liability at themeasurement date.

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Disclosure Example (cont.)

The Company’s financial instruments consist primarily of cash and cash equivalents, accounts receivable,contributions receivable, investments, accounts payable and long-term borrowings.

The carrying amount of cash and cash equivalents, accounts receivable, contributions receivable andaccounts payable approximate their fair value due to the short-term nature of such instruments.

The fair value of assets and liabilities at December 31, 2008 is as follows:

Level 1 Level 2 Level 3 Total

Assets:

Investments $ 10,000,000 $ - $ 2,000,000 $ 12,000,000

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Total assets at fair value $ 10,000,000 $ - $ 2,000,000 $ 12,000,000

Liabilities:

Long-term borrowings $ 2,000,000 $ 11,000,000 $ - $ 13,000,000

Total liabilities $ 2,000,000 $ 11,000,000 $ - $ 13,000,000

The fair value of investments categorized as Level 1 are based on quoted market prices for identicalsecurities traded in active markets that are readily and regularly available to the Company.

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Disclosure Example (cont.)

The valuation of the Company’s investments in limited partnerships requires significant judgmentdue to the absence of quoted market prices, inherent lack of liquidity, heavy reliance on Level 3 inputs, and thelong-term nature of such investments. Limited partnership investments are valued initially at their transactionvalue, and subsequently adjusted to reflect expected exit values at the measurement date by utilizing assumptionsthat market participants would normally use in estimating a fair market value. These valuation adjustmentsinclude, but are not limited to, material changes in a company’s operations and or financial performance,subsequent or anticipated rounds of equity financings, specific rights or terms associated with the investment (e.g.,conversion features, liquidation preferences or restrictions), expected exit timing and strategy, industry valuationsor comparable public companies, changes in economic conditions, and changes in legal or regulatoryenvironments.

The changes in investments measured at fair value for which the Company has used Level 3 inputs todetermine fair value are as follows:

Balance, June 30, 2008 $ 3,000,000

Purchases 2,000,000

Realized loss, net (1,000,000)

Unrealized depreciation, net (2,000,000)

Balance, June 30, 2009 $ 2,000,000

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Disclosure Examples (cont.)

The carrying value of the Company’s long-term borrowings for its line of credit agreement approximates fairvalue at June 30, 2009, since the interest rates are market-based and are generally adjusted periodically, representLevel 1 measurements. The remaining long-term borrowings primarily contain interest rates that are fixed andmarket-based. The fair value of these borrowings are based on inputs that are observable either directly orindirectly, which represent a Level 2 in the FASB hierarchy.

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Expect your Auditors to do or ask the following:

• Does management have a documentedprocess for determining fair value,particularly for alternative investments?

• Test management’s assumptions

– Are they reasonable and consistent withmarket information? If assistance is comingfrom third parties, are they competent?

• Develop an independent estimate of fairvalue to corroborate management’smeasurement.

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Expect your Auditors to do or ask the following:

• Ensure levels are appropriate based uponthe valuation methodologies used.

• How are prices determined? How recent isthe pricing data? Is there a review processto ensure pricing is accurate?

• Compare prior year fair valuemeasurements to actual results todetermine reliability of management’sassumptions.

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Other Considerations

• FASB’s continued efforts to improvetransparency and provide necessaryimplementation guidance

• Regulatory reform

• Convergence with internationalstandards/IFRS

• Economy in general, including liquidityconcerns

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Planning Considerations/Action Items

• BE PROACTIVE – communicate internally andwith auditors, custodians, fund managersand investment advisors

• Prepare an inventory of existing financialassets and liabilities along withcorresponding fair value measurements

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Planning Considerations/Action Items

• Determine and document valuationmethodology for assets/liabilities

• Perform preliminary identification ofhierarchy inputs

• Determine information needed fordisclosures, especially information neededfor Level 3 inputs

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Questions ??

FASB Statement No. 157