ASC 820 and Its Application to Conventional Fixed-Income Investments

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1 ASC 820 and Its Application to Conventional Fixed-Income Investments June 2013 Purpose To provide concise and pragmatic 1 implementation guidance and a thought framework on ASC 820 (FAS 157) and its application to conventional fixed-income investments. In September, 2006, the Financial Accounting Standards Board (FASB) issued Statement 157, which was entitled Fair Value Measurement (ASC 820). This section of the codification defines fair value, sets out a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. 2 Key Terms, Definitions, and Reporting Requirements Within ASC 820, which applies to several asset and liability types other than investments, there are several concepts with which fixed income investors should be familiar, including Fair Value, Valuation Techniques, Input Levels, and Disclosures: Fair Value Fair value is defined in ASC as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. Furthermore, ASC states that the objective of a fair value measurement is to determine the price that would be received to sell the asset at the measurement date (an exit price). Fair value should be thought of exactly the way the FASB describes it an exit price between willing participants. Treasury departments in the past may have made 1 The words concise and pragmatic are used because existing ASC 820 implementation guidance is generally very technical and often does not address specific asset or liability classes (e.g., fixed-income investments). 2 ASC rationalizations such as, Our security is worth 85 in the market, but because of reasons X, Y, and Z, we think it s worth 95. This mindset is not acceptable to auditors and should be avoided by treasury professionals. The fair value should be the exit price under current market conditions. Valuation Techniques ASC 820 outlines the following three valuation approaches used to derive a market value: Market approach. This method uses prices and other relevant information generated by market transactions involving identical or comparable assets. Income approach. This method uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present amount (discounted). The measurement is based on the value indicated by current market expectations about those future amounts. 3 Cost approach. The cost approach is defined as a valuation technique based on the amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost). 4 Because fixed-income security prices are derived from market transactions involving identical or comparable investments, the market approach is the most appropriate for fixed-income investors. The income approach and cost approach might be more appropriately used to value a project or a fixed asset, respectively. The valuation approach selected should be used consistently across all fixed-income investments. 5 3 ASC ASC ASC Input Levels With the understanding that fair value should be determined based on market transactions, fixed income investors should next determine which of the following hierarchical levels applies to the pricing they receive for their securities: Level 1 Inputs. These are quoted prices (unadjusted) in active markets for identical assets that the reporting entity has the ability to access at the measurement date. 6 This is the most reliable evidence of fair value and shall be used to measure fair value whenever available. 7 Level 2 Inputs. These are inputs other than quoted prices that are observable for the asset either directly or indirectly. 8 If the asset has a specified (contractual) term, a Level 2 input must be observable for substantially the full term of the asset. 9 Inputs other than quoted prices include interest rates and yield curves observable at commonly quoted intervals, volatilities, prepayment speeds, loss severities, credit risks, and default rates. 10 Level 3 Inputs. These are unobservable inputs for the asset 11 and shall be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset at the measurement date. Unobservable inputs shall reflect the reporting entity s own assumptions about the assumptions that market participants would use in pricing the asset ASC ASC ASC ASC ASC C 11 ASC ASC

2 There has been much debate in the investment community on the subject of what comprises a level 1, 2, or 3 input for a fixed-income investment. The descriptions provided are, by nature, qualitative and not quantitative. Generally speaking, there is no right or wrong to the interpretation of the levels. Based on the current guidance (or the lack thereof), there is no one-sizefits-all approach to ASC 820 Fair Value level classifications. Attempts to date by certain financial institutions to develop predefined ASC 820 Fair Value matrices and level classifications for their clients have generally been unsuccessful due to varied interpretations of the statement. Each investor should define its interpretation of the levels, subject to approval by its auditors. However, the following steps could be employed by any investor in making an ASC 820 analysis: Understand the nature of pricing for the relevant security types in general. Among the parameters an investor should consider are: Liquidity of the market Activity of the market Number and availability of independent pricing sources Nuances of the structure of the security type (e.g., a structure that supports a consistent price of par) Potential for change in the pricing method for the security type For example, a private placement security with a small issue size is very different from a 90-day treasury bill. Past events in the auction rate market show how quickly an established convention of pricing at par due to security structure can quickly be replaced by confusion and uncertainty. Understand the nature of pricing for specific securities within the relevant type. Among the points to consider are: Issue size Number of market makers (potential pricing sources) Understand the pricing sources With an understanding of the security types and specific securities, an investor should understand where the prices come from. Relevant questions include: Do the prices come from independent sources? Are some sources more reliable than others for certain security types? What method is being employed to select the appropriate price from multiple pricing sources? What method is used when no data is available for a given period of time? Determine the Input Levels. Based on a review of security types, specific securities, and sources, an investor can classify the securities and their pricing into the ASC 820 Input Levels. To streamline this process, an investor should consider performing this analysis initially at the security type level and refining the analysis, if necessary, for specific securities. In determining the Input Levels, an investor should be aware that there are no penalties or Sarbanes-Oxley deficiencies in assessing something less than a Level 1 input. Granted, a Level 3 Input will require a disclosure in the notes to the financial statements, but there are no penalties associated with this. Review the decisions with the auditors. After an investor has determined the levels and has prepared support for the decisions, the investor should then review the valuation thought process, framework, and resulting information with the auditor. It is not the auditor s role to tell an investor what to do and make the classifications for the investor; rather, their role is to do just as their name implies audit the implementation of the investor s decisions. Disclosure In addition to using the guidelines set forth in ASC 820 for valuing fixed-income securities, each institution is also required to disclose enough information to allow users of the financial statements to assess the valuation techniques and inputs used to develop fair value measurements used on all assets measured at fair value. It also directs the company to include the effect of the measurements used on Level 3 securities to the net change in assets and earnings in the disclosure information. 13 Quantitative Disclosure ASC states that to meet the objectives the reporting entity shall disclose all of the information below for each interim and annual period separately for each class of assets: The fair value measurements at the reporting date... The level within the fair value hierarchy in which the fair value measurements in their entirety fall (i.e., Level 1, Level 2, Level 3) The amounts of significant transfers between Level 1 and Level 2 and the reasons for the transfers. Significant transfers into each level shall be disclosed separately from transfers out of each level. For this purpose, significance shall be judged with respect to earnings and total assets or total liabilities or, when changes in fair value are recognized in other comprehensive income, with respect to total equity. A reporting entity shall disclose and consistently follow its policy for determining when transfers between levels are recognized. 13 ASC

3 For fair value measurements using significant unobservable inputs (Level 3), a reconciliation of the beginning and ending balances, separately presenting changes during the period attributable to any of the following: Total gains or losses for the period (realized and unrealized), separately presenting gains or losses included in earnings and gains or losses recognized in other comprehensive income Purchases, sales, issuances, and settlements (each type disclosed separately) Transfers in and/or out of Level 3 and the reasons for those transfers The amount of total gains or losses for the period (from Level 3 securities) included in earnings that are attributable to the change in unrealized gains or losses relating to those assets and liabilities still held at the reporting date and a description of where those unrealized gains or losses are reported in the statement of income. For...Level 2 and Level 3, a description of the valuation technique (or multiple valuation techniques) used and the inputs used in determining the fair values of each class of assets or liabilities. If there has been a change in the valuation technique(s) the reporting entity shall disclose that change and the reason for making it. ASC mandates that these quantitative disclosures be issued using a tabular format in all periods (interim and annual). Using the information provided below, the following are sample tabular disclosures: The sample disclosure below is from ASC Institutions should note, however, that this format is not obligatory since the guidance states that the tabular categories should be done for each major category of asset. Some institutions plan to issue the disclosure using asset categorizations that tie to other investment disclosures in order to ensure consistency and facilitate ease of preparation. Figure 1: Sample Tabular Disclosure

4 In addition to the quantitative disclosures discussed above, qualitative disclosures are required. To illustrate, excerpts from the Goldman Sachs Group s K filing are below: The fair values for substantially all of the firm s financial assets and financial liabilities are based on observable prices and inputs and are classified in Levels 1 and 2 of the fair value hierarchy. Certain Level 2 and Level 3 financial assets and financial liabilities may require appropriate valuation adjustments that a market participant would require to arrive at fair value for factors such as counterparty and the firm s credit quality, funding risk, transfer restrictions, liquidity, and bid/offer spreads. Valuation adjustments are generally based on market evidence. The table below presents the valuation techniques and the nature of significant inputs generally used to determine the fair values of each type of Level 3 cash instrument. Level 3 Cash Instruments Loans and securities backed by commercial real estate. They will often display the following characteristics: Collateralized by a single commercial real estate property or a portfolio of properties May include tranches of varying levels of subordination Valuation Techniques and Significant Inputs Valuation techniques vary by instrument, but are generally based on discounted cash flow techniques. Significant inputs are generally determined based on relative value analyses and include: Transaction prices in both the underlying collateral and instruments with the same or similar underlying collateral and the basis, or price difference, to such prices Transaction prices in both the underlying collateral and instruments with the same or similar underlying collateral and the basis, or price difference, to such prices Market yields implied by transactions of similar or related assets and/or current levels and changes in market indices, such as the CMBX (an index that tracks the performance of commercial mortgage bonds) Recovery rates implied by the value of the underlying collateral, which is mainly driven by current performance of the underlying collateral, capitalization rates and multiples Timing of expected future cash flows (duration) Figure 2: Level 3 Cash Instruments Fair Value Valuation Techniques Additional Guidance for Clearwater Users Pricing Methods The purpose of this section is to provide information about the Clearwater pricing methodology to assist investing institutions with their level classification process. Clearwater s hierarchical pricing model provides our clients with pricing transparency, auditability, and defensibility, while providing access to one of the industry s premier pricing sources, S&P Capital IQ. Under Clearwater s model, each security s price will come from the highest priority pricing source within each client s selected pricing source hierarchy. Secondary pricing sources will be used for filling gaps and for price comparisons. Default Hierarchy The default hierarchy starts with any client-provided pricing overrides. Calculated pricing on select security types is then applied. S&P Capital IQ pricing is then assigned to the remaining securities, with Account Source pricing as the final source. 1. Pricing Overrides 2. Calculated Prices 3. S&P Capital IQ 4. Account Source Although most clients have elected to use the default hierarchy listed above, the pricing hierarchy is customizable and can be applied at the individual account level. Pricing Sources Pricing Overrides Some clients hold distressed, illiquid, or alternative investment types and choose to provide Clearwater with prices for these securities. Pricing overrides can be provided periodically, and the price will remain static until the next pricing update is provided. Pricing overrides will be used in favor of any sources or calculated prices.

5 Calculated Prices Securities with short maturities and infrequent secondary market trades are typically priced via mathematical calculations. For example, in the case of a certain issue of commercial paper, Clearwater will accrete from purchase price at trade date to face value at maturity to calculate a daily price. In the event that another transaction is observed for the same security within the account, the price on that subsequent transaction clearly reflects the market price on that day, and Clearwater will adjust the price in the account to the observed transaction price and follow a revised accretion schedule to determine the daily price. Calculated Pricing applies to the following security types: CP and CD market price follows amortization/ accretion schedule from purchase to maturity Repurchase Agreements and Auction Rate Securities are priced at par Money Market Funds are priced at $1 S&P Capital IQ S&P Capital IQ, a business line of The McGraw-Hill Companies (NYSE:MHP), is a leading provider of multi-asset class and real-time data, research, and analytics to: institutional investors; investment and commercial banks; investment advisors and wealth managers; corporations; and universities around the world. S&P Capital IQ s Valuation Service has provided a cross-market approach to assessing value in portfolios for more than 35 years. It provides over 3.2 million global fixedincome securities and hard-to-price instruments using both market approach and model valuation methods. Its coverage includes global corporate, government, mortgage-backed, asset-backed, agency, and U.S. Municipal securities. Security types include bills, bonds, debentures, derivatives, mortgages, and medium-term notes. Additionally, it provides access to over 1.8 million actual trade and indicative prices sourced from third-party providers on a daily basis, and offers visibility to the trade data used to create its valuations. S&P Capital IQ Valuations Services also collects, maintains, and manages extensive real-time, fixed income terms and conditions on more than two million fixed-income securities. Clearwater can provide additional documentation regarding S&P pricing methodology upon request. Account Source Account Source pricing refers to the pricing received in the daily feed sent to Clearwater by the client s custodian or other financial institution. Interactive Data SM Clearwater has also made available Interactive Data pricing, subject to additional fees. Interactive Data pricing can be used daily or monthly. If used monthly, the pricing hierarchy will incorporate the additional source only at month end. For additional information regarding options and fees, please contact your Account Manager. NAIC Automated Valuation Service (AVS) NAIC Automated Valuation Service pricing is applicable only to insurance clients. The AVS provides fair market values that regulators will be using in their examination processes. Insurance clients who choose to use AVS pricing will need to execute an independent contract with the NAIC and designate Clearwater as a third-party administrator. Pricing Challenges and Questions Clearwater welcomes questions regarding the pricing applied to a security or the methodology used by a pricing vendor. Please don t hesitate to reach out to your Account Manager with questions or to further discuss pricing. Creating the ASC 820 Matrix The following are sample steps an institution using Clearwater can take to create the ASC 820 matrix disclosure: Read the aforementioned material Determine what the ASC 820 level will be for each security type Identify any individual securities that may be exceptions to the classifications Fair Value levels can be administered within the Clearwater system. For access to and instructions about the process, please contact your Account Manager. Alternatively, a list of your ASC 820 levels can be sent to your Account Manager to help input them into the Clearwater system. Conclusion The principles and steps outlined in this document provide investors with guidance on how to comply with ASC 820 for conventional fixed-income securities. Please do not hesitate to contact Clearwater with feedback or questions. Disclaimer The information provided in this article is the result of experience with investment accounting issues and interaction with accountants and investment service providers. It is not intended to be relied upon substantively; rather, it is intended to inform and provide a discussion framework that treasury practitioners, internal management, and accounting and audit staff can use to discuss the impairment process Clearwater Analytics All rights reserved. This case study is for informational purposes only. Clearwater makes no warranties, express or implied, in this summary. All technologies described herein are either registered trademarks or trademarks of their respective owners in the United States and/or other countries.