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FASB Topic 820 Update No. ASU 2011-04
Why are these Amendments Needed?
These amendments are intended to result in common fair value measurement and disclosure requirements under United States Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). These amendments clarify the Financial Accounting Standards Board’s intent regarding the application of existing fair value measurement and disclosure requirements and also change certain principles and requirements for measuring fair value. The amendments also include changes in required financial statement disclosures so that the disclosure requirements of GAAP and IFRS are more consistent with each other.
Clarification of the Financial Accounting Standards Board’s Intent:
- Previous guidance stated that fair value measurement assumes the highest and best use of the asset by market participants, considering the use of the asset that is physically possible, legally permissible, and financially feasible at the measurement date. The amendment specifies that the concept of highest and best use in a fair value measurement is only relevant when measuring the fair value of nonfinancial assets and is not relevant when measuring the fair value of financial assets or liabilities because financial assets and liabilities do not have alternative uses.
- The amendments include requirements specific to measuring the fair value of an instrument classified in a reporting entity’s shareholders’ equity, such as an equity interest issued as consideration in a business combination. Those amendments are consistent with the requirements for measuring the fair value of liabilities and specify that a reporting entity should measure the fair value of its own equity instrument from the perspective of a market participant that holds that instrument as an asset.
- Disclosures about fair value measurements for investments that are categorized within Level 3 of the fair value hierarchy should include quantitative information about the unobservable inputs. This information should be presented in a tabular format and include the documentation of valuation techniques and unobservable inputs used, as well as a weighted average range for any metrics used in the valuation of the investments (for example, weighted cost of capital, long-term growth rates, discounts for lack of marketability and control premiums). The disclosure requirements also include qualitative information on how the reporting entity determines its valuation policies and procedures, as well as a discussion of the changes in fair value measurements from year to year.
- The update does not require the entity to create and report on quantitative information for quantitative unobservable inputs used for measuring fair value that are not generated by the entity. Some examples of unobservable inputs that would not be developed by the reporting entity are prices of prior transactions and the use of reported net asset value as a practical expedient.
- The amendments clarify that in the absence of a Level 1 input, a reporting entity should apply premiums or discounts when market participants would do so when pricing the asset or liability for an individual unit of account. However, premiums or discounts related to size as a characteristic of the reporting entity’s holding (specifically, a blockage factor) rather than as a characteristic of the asset or liability (for example, a control premium or a noncontrolling interest discount) are not permitted in a fair value measurement.
Other Amendments that Change Principles or Requirements for Measuring or Disclosing Information about Fair Value:
- New guidance permits offsetting of particular market risk components or counterparty credit risk when managed on a net exposure basis within the same portfolio, provided specific criteria are met. The following criteria must be met in order to use the exception to allow offsetting:
- The group of financial instruments must be managed on the basis of the reporting entity’s net exposure to a particular market risk or to the counterparty credit risk of a particular counterparty in accordance with the reporting entity’s documented risk management or investment strategy, and the reporting entity must be able to provide evidence of this basis of management.
- The reporting entity must provide information on the net exposure basis about the group of financial assets and financial liabilities to its management.
- The reporting entity must be required or must have elected to measure the financial instruments at fair value on a recurring basis.
The guidance also provides the following information regarding the offsetting exception:
The reporting entity must make an accounting policy decision to use the exception.
The reporting entity should apply the price within the bid-ask spread that is most representative of fair value to the net position. The bid-ask spread guidance can be applied to the reporting entity’s net position in a particular market risk only if the market risks that are being offset are substantially the same.
The reporting entity must have a legally enforceable right of offset with its counterparty to apply this exception to counterparty credit risk.
The exception to measure the portfolio risks on a net basis does not extend to the reporting entities’ financial statement presentation. The considerations for requiring net or gross presentation of financial instruments in the financial statements are distinct from those for requiring net or gross measurement. GAAP and IFRS differ in this regard.
- The amendments expand the disclosures regarding fair value measurements to include:
- More information regarding the valuation process used by the reporting entity for valuing Level 3 investments
- Disclosures regarding the sensitivity of the fair value measurement to changes in unobservable inputs and the interrelationship between unobservable inputs used, if any. This disclosure is only required for public entities.
- Information about when the current use of a nonfinancial asset measured at fair value differs from its highest and best use
- Fair value hierarchy categories must be disclosed for items that are not measured at fair value in the statement of financial position but for which the fair value is required to be disclosed. This disclosure is only required for public entities.
- Any transfers between Level 1 and 2 of the fair value hierarchy, not just significant transfers as previously required. However, this disclosure is only required for public entities and nonpublic entities will be exempt from making any disclosures about transfers between Level 1 and 2 upon adoption of the amendments.
The amendments in this update are to be applied prospectively. For public entities the amendments are effective during interim and annual periods beginning after December 15, 2011. For nonpublic entities, the amendments are effective for annual periods beginning after December 15, 2011. Early application by public entities is not permitted. Nonpublic entities may apply the amendments early, but no earlier than for interim periods beginning after December 15, 2011.
Some notable differences between GAAP and IFRS that have not yet been resolved are as follows:
- IFRS does not have specific investment company guidance. Therefore IFRS has not addressed the GAAP Topic 820 practical expedient that permits a reporting entity to use the reported net asset value of an investment company, without adjustment, as long as the reporting entity’s net asset value was calculated in accordance with GAAP.
- For U.S. GAAP, the fair value measurement of a demand liability is the amount payable on demand at the reporting date; however, under IFRS the fair value cannot be less than the present value of the amount payable on demand.
- GAAP allows non-public entities an exemption from disclosing quantitative sensitivity analysis information for financial instruments categorized within Level 3, however IFRS does not allow this exemption.
- IFRS generally does not allow net presentation for derivatives, so the amounts disclosed for fair value measurements categorized within Level 3 of the fair value hierarchy might differ from amounts disclosed under U.S. GAAP.
We expect more guidance to come as the Boards continue to work on the convergence project.
Contact the Decosimo Financial Services Group
Decosimo is a PCAOB-registered firm, and our Financial Services Group provides tax, audit and advisory services to hundreds of investment companies both in the U.S. and offshore. Our financial services professionals are eager to provide you with the information you need to interpret these new disclosure and fair value measurement requirements.
Karl Jordan, CPA | Domestic and International Principal
Marshall Harvey, CPA, CPE | Assurance Principal
Renee Ford, CPA | Assurance Principal
Brad East, CPA, ABV | Assurance Principal