ASC 820 Podcast

Travis Quast, Vice President of DerivActiv, covers FASB Topic 820 including the new definition of fair value, the three-tier hierarchy of inputs used to determine fair value, and how to measure non-performance risk. 03/26/2010 8 min. 22 sec.

 

Cynthia –  This is Cynthia Heneage of MuniMarket Pulse.  I'm speaking with Travis Quast, a Vice President at DerivActiv LLC and our topic today is FASB Topic 820.  Thanks for joining us today Travis.

 

Travis– Good to be here.

 

Cynthia –  Travis, the Financial Accounting Standard Board, or FASB, issued FAS 157, the Fair Value Measurement Standard in September 2006.  So it's been in place for a few years now.  And then in December, 2009, FASB changed the name of FAS 157 to Topic 820.  Can you explain the change?

 

Travis– Yes.  The FASB Accounting Standards Codification, which is FAS 157, now it's Topic 820, the codification is now the source of authoritative, generally accepted accounting principles recognized by the FASB to be applied to non-governmental entities.  The codification is effective for interim and annual periods ending after September 15, 2009 and all previous standards issued by a standard setter are superseded by the codification.  Standard setters include the EITF or the Emerging Issues Task Force, the Derivative Implementation Group or DIG and the American Institution of Certified Public Accountants, or AICPA, among others.  The primary goals in developing the codification were to simplify user access by essentially codifying all authoritative US GAAP into one spot.  In addition a goal was to ensure that the codified content accurately represented authoritative US GAAP and create a codification research system that is up-to-date for the release results of standard setting activity. 

 

Cynthia –  Can you give us a brief summary of Topic 820 and why is it relevant to our listeners?

 

Travis– Well prior to Topic 820 there were different definitions of fair value and limited guidance for applying those definitions in GAAP.  Topic 820 sets a uniform definition of fair value and expands the disclosures about fair value measurements to be used in financial statements.  It's relevant for entities that use derivatives since derivatives are required to be reported at fair value and it's also relevant for entities that issue debt and are required or choose to report that debt at fair value.

 

Cynthia –  So what is the purpose of Topic 820?

 

Travis– The primary goals were to create a uniform definition of fair value, increase the consistency and comparability in fair value measurements, and expand disclosures about fair value measurements.

 

Cynthia –  What is the definition of fair value according to Topic 820?

 

Travis– Topic 820 defines fair value as the 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.

 

Cynthia –  So in other words the new definition of fair value represents the exit price, not the entry price of a transaction.

 

Travis– Yes.

 

Cynthia –  Topic 820 describes a three tier hierarchy of inputs to be used in determining the fair value of assets and liabilities for disclosure purposes.  Can you describe what inputs can be used for each level?

 

Travis– Yes.  So there's three levels of inputs.  Level One are inputs that are quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.  A common Level One input might be the price of a stock where we can easily determine fair value by multiplying the share price by the number of shares.  The Level Two inputs are inputs other than quoted prices included within Level One that are observable where the asset or liability either directly or indirectly.  Level Two inputs could include interest rates, yield curves, default rates, prepayment speeds, and credit risk, among others.  And then finally Level Three inputs, Level Three inputs are unobservable inputs for the asset or liability.  Level Three inputs could include an entities own data or assumption of earnings, discounted cash flows, or an option pricing model.  The definition of unobservable inputs is:  inputs that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability, developed based on the best information available and the circumstances. 

 

Cynthia –  What is non-performance risk and how is it measured?

 

Travis– The definition is certainly easier than the application.  Non-performance risk refers to the risk that the obligation will not be fulfilled and affects the value of which the liability is transferred.  Non-performance risk includes, but may not be limited to, the reporting entity’s own credit risk.  The actual measurement of non-performance risk can be done several ways.  A common approach is what Topic 820 refers to as the discount rate adjustment technique.  This method involves present value and contractual promised, or likely cash flows by a risk adjusted discount rate or curve.  Another approach is the market approach.  The market approach uses prices and other relevant information generated by actual market transactions involving identical or comparable assets or liabilities.  And a third option could include maximum exposure curves, cumulative default rates and a credit adjustment based on predicted default probabilities. 

 

Cynthia –  Regarding adjustments for derivative transactions, what are some ways to adjust values for non-performance risk?

 

Travis– The most common method we use at DerivActiv is the discount rate adjustment method.  At any point in time the mid-market value of a vanilla interest rate swap can be calculated as the sum of estimated future cash flows, present valued by an appropriate discount rate.  The discount rate adjustment method involves adding an appropriate spread to the discount curve and essentially re-present valuing estimated future cash flows.  The difference between the mid-market value and the credit adjusted value represents non-performance risk. 

 

Cynthia –  A derivative can be considered either an asset or a liability depending on market conditions.  Are assets and liabilities dealt with differently under Topic 820?

 

Travis– Well non-performance risk applies to the party with the obligation or for derivatives who would have to pay to get out of the transaction.  So in periods when the derivative is a liability, we assess the entities credit to determine an appropriate spread to add to the discount curve.  In periods when the derivative is an asset, we look to the counterparty's credit.

 

Cynthia –  If an issuer has bonds that are credit enhanced, how does that issuer determine the fair value of their bonds?

 

Travis– There was EITF Issue 08-5 that's included in now the Topic 820 codification.  And the fair value of the issuer's bonds should not include the third party credit enhancement.  Essentially by issuing debt combined with a guarantee, the issuer is able to more easily market its debt, but the credit enhancement does not remove the debt obligation of the issuer.  Any payments made by the guarantor under the guarantee results only in a transfer of the issuer's debt obligations from the investor to the guarantor.  And the obligation to the guarantor is not guaranteed.

 

Cynthia –  How does Topic 820 impact hedge accounting, Topic 815?

 

Travis– I don't believe Topic 820 has a significant impact on the use of hedge accounting.  However because derivatives are required to be recorded at fair value and fair value does include a credit adjustment for non-performance risk, Topic 820 has probably added a little more complexity to the periodic journal entries.

 

Cynthia –  Have there been any recent amendments to Topic 820?

 

Travis– There were a few amendments that became effective for annual or interim periods beginning after December 15, 2009.  For the most part the amendments add disclosure requirements for Level One and Level Two assets and liabilities, and in addition clarify existing disclosure requirements within Topic 820.  There's also an amendment regarding Level Three activity, but that amendment doesn't come into effect until 2011.