June 29, 2010

FASB Issues ASU On Improving Disclosure About Fair Value Measurements

By Linda Zhang, Manager - Assurance Services and Matthew Lyons, Senior - Assurance Services

FASB Issues ASU On Improving Disclosure About Fair Value Measurements

On January 21, 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2010-06, “Improving Disclosures about Fair Value Measurements” (ASU 2010-06 or the ASU). The ASU amends FASB Accounting Standards Codification™ (ASC) 820, “Fair Value Measurements and Disclosures” (formerly FASB Statement 157, “Fair Value Measurements”), to add certain disclosure requirements related to fair value measurements. The new rules require entities to provide greater detail about the methods and inputs used to measure the fair value of assets, bringing U.S. Generally Accepted Accounting Principles (GAAP) in line with International Financial Reporting Standards (IFRS) 7, which already requires similar disclosures. The new disclosure will help readers of the financial statements to understand the degree of subjectivity in the valuation among Levels 1, 2 and 3. Additionally, the ASU clarifies existing fair value disclosures about the level of disaggregation about inputs and valuation techniques used to measure fair value and if the valuation technique has changed, entities should disclose that change and the reason for the change. The ASU also amends guidance on employers’ disclosures about postretirement benefit plan assets under ASC 715 to require that disclosures be provided by classes of assets instead of by major categories of assets.

The Quest for Transparency

The original goal of ASC 820 was to bring greater transparency to financial statements, create a single definition of fair value for financial reporting, establish a framework for measuring fair value and expand fair value measurement disclosures. ASC 820 doesn’t specify which assets and liabilities must be reported at fair value – that’s found elsewhere in the accounting literature. Based upon feedback from the Securities and Exchange Commission “SEC” and other regulatory groups, in the wake of the economic downturn, the FASB issued ASU 2010-06 to try and fulfill its quest for transparency.

The Need for Full Disclosure

In response to demands from investors and other interested parties for more “granular” information regarding fair value, the FASB issued ASU 2010-06. The new requirements in this ASU relate to the following two activities:

1. Disclosure of transfers between Level 1 and Level 2, as well as those into and out of Level 3, of the fair value hierarchy. A reporting entity must disclose the amounts of, and reasons for, significant transfers between Level 1 and Level 2, as well as those into and out of Level 3, of the fair value hierarchy. Transfers into a level must be disclosed separately from transfers out of the level. Entities are required to judge the significance of transfers based on earnings and total assets or liabilities or, when changes in fair value are recognized in other comprehensive income, on total equity. Entities must also disclose and consistently follow their policy for when to recognize transfers into and out of the levels, which might be, for example, on the date of the event resulting in the transfer or at the beginning or end of the reporting period.

Suppose, for example, that an asset is transferred from Level 2 to Level 1 because the market for that asset becomes active again and more observable price quotes become available. Disclosing this change can help financial statement users assess the entity’s financial position more accurately.

2. Disclosure of gross activity for Level 3 fair value measurements. In the reconciliation for fair value measurements using significant unobservable inputs (Level 3), a reporting entity should present separately information about purchases, sales, issuances, and settlements (that is, on a gross basis rather than as one net number).

The FASB believes that a “net” number – which indicates that overall impact on fair value of purchases, sales, issuances and settlements – is less useful than a “grossed-up” disclosure that provides greater detail on the underlying transactions responsible for changes in Level 3 measurements. The FASB recognized, however, that some entities – particularly those with significant trading activities – may need to enhance their information systems to comply with this requirement. The board delayed the effective date of this provision to give entities time to make the necessary adjustments.

The ASU also clarifies two existing disclosure requirements:

1. Level of disaggregation. A reporting entity should provide fair value measurement disclosures for each “class” of assets and liabilities. A “class” is often a subset of assets or liabilities within a line item in the statement of financial position. A reporting entity needs to use judgment in determining the appropriate classes of assets and liabilities. Previously, the requirement was to disaggregate by “major categories of assets and liabilities”. Entities should determine a “class” based on the nature and risks of the securities. In determining the nature and risks of the securities, entities should consider activity or business sector, vintage, geographic concentration, credit quality, and economic characteristics.

For example, rather than disclosing the total value of available-for-sale debt securities, it might be appropriate to provide details about subsets of that category, such as residential mortgage-backed securities, commercial mortgage ,backed securities or collateralized debt obligations.

2. Disclosures about inputs and valuation techniques. A reporting entity should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. Those disclosures are required for fair value measurements that fall in either Level 2 or Level 3.

FASB also clarified that, if there’s been a change in valuation techniques (such as changing from the market approach to the income approach), the entity should disclose the change and the reason for making it.

For example, if an entity has investments in available-for-sale Level 3 residential mortgage-backed securities the disclosure should describe the nature of these securities (industry-geographical location, etc.), the underlying loans, and the significant valuation inputs such as: yield, probability of default, loss severity and prepayment rates as well as the technique used to fair value the instrument, such as the market or income approach.

Sensitivity Analysis

The FASB’s original proposal would have required entities to conduct a sensitivity analysis and to disclose the potential impact on fair value of “reasonably possible alternative Level 3 inputs.” This type of sensitivity analysis is required under IFRS 7.

In light of comments expressing concern about the cost and complexity of these disclosures the FASB dropped the requirement form the final rule and will revisit the issue as part of its convergence project with the International Accounting Standards board (IASB). The IASB will re-expose the proposed requirement for an entity to disclose a measurement uncertainty (sensitivity) analysis about Level 3 fair value measurements given the boards’ tentative decision to require an entity to consider the expected effects of correlation between inputs in that analysis.

Effective Dates, Additional Amendments

The amended guidance in ASU 2010-06 does not include the sensitivity disclosures in the proposed ASU, Improving Disclosures about Fair Value Measurements.

The new disclosure requirements apply to interim and annual reporting periods beginning after December 15, 2009, with one exception: The new rules regarding purchases, sales, issuances and settlements associated with Level 3 measurements will be effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years.

A special thanks to article contributor Tina Catalina.