MHM Executive Education Series:Financial Instruments & Fair Value                 Presented by:      Mike Loritz, Keith Pe...
A   1   Discuss basic accounting requirements for the        reporting of financial instruments at fair valueg   2   Discu...
Accounting Requirements –Financial Instruments and Fair Value                                       3
Financial Instruments & Fair ValueEntities must apply “fair value” measurements inboth recurring and non-recurring circums...
Adoption Timeline – Fair Value Measurements                                                             ASU 2010 – 06 (ado...
Financial Instruments & Fair Value
Financial Instruments & Fair ValueInvestment SecuritiesASC 320 – Debt and Equity Securities applies to:  – Investments in ...
Financial Instruments & Fair ValueInvestment SecuritiesASC 320 – Debt and Equity Securities• Debt and equity securities wi...
Financial Instruments & Fair ValueInvestment SecuritiesTherefore, the following securities not within the scope ofASC 320 ...
Financial Instruments & Fair ValueInvestment Securities - Impairment• An investment is impaired if its fair value is less ...
Financial Instruments & Fair ValueInvestment Securities - ImpairmentRecognition• If sale of Equity Securities – entire dif...
Financial Instruments & Fair ValueDerivative Financial Instruments• ASC 815 “Derivatives and Hedging” provides guidance fo...
Financial Instruments & Fair ValueFair Value OptionASC 825-10-15 provides for an entity to elect to account forcertain fin...
Financial Instruments & Fair ValueAccounting St d d Codification (ASC) 820 F iA        ti Standards C difi ti             ...
Financial Instruments & Fair ValueFASB ASC 820 i l d di l                includes disclosure requirements which are       ...
Financial Instruments & Fair ValueFASB ASC 825 10 50 provides additional guidance with respect              825-10-50     ...
Financial Instruments & Fair ValueFundamentals of Fair Value per ASC 820:1. Must use market participant view in measuring ...
Financial Instruments & Fair ValueCommon issues related to fair value of financialinstruments:  – Bid/ask prices – middle ...
Financial Instruments & Fair Value• In exchange traded markets, exit prices should be based  on closing market prices  • M...
Financial Instruments & Fair ValueMost Advantageous Market – Level One SecuritiesCompany A owns 1,000 shares of XYZ Corp c...
Financial Instruments & Fair ValueValuation techniques:When fair value is directly observable (exchange traded), the quote...
Financial Instruments & Fair Value  Market Approach           Income Approach                                    pp       ...
Valuation Concepts
Fair Value – Financial InstrumentsLoansLoans receivable that are not debt securities will bereported on the balance sheet ...
Fair Value – Financial InstrumentsLoans – Fair Value Measurements• Fair value is generally determined based on the loans  ...
Fair Value – Financial InstrumentsInvestment Securities (as defined by ASC 320)• EQUITY - Publically traded equity securit...
Fair Value – Financial InstrumentsInvestment Securities (as defined by ASC 320)• MUTUAL FUND – a mutual fund is not an exc...
Fair Value – Financial InstrumentsAlternative InvestmentsMay report the investment in these funds at the net assetvalue (N...
Fair Value – Financial InstrumentsAlternative InvestmentsRequired disclosures if the NAV is used include alldisclosures re...
Fair Value – Financial InstrumentsPrivate Company Equity Securities• If quoted prices in active markets or arm’s length  t...
Fair Value – Financial InstrumentsPrivate Company Securities• Valuation should consider the relative applicability of the ...
Fair Value – Financial InstrumentsPrivate Company Securities• Market Approach  –   Market value of equity (MVE) to net inc...
Fair Value – Financial InstrumentsSettlement Value                           Interest rate swaps are(received from the  ...
Fair Value – Financial InstrumentsInterest Rate Swaps – Income Approach1. Calculate the fixed cash flows based on the noti...
Fair Value – Financial Instruments                    9/30/11      3/31/2012     9/30/2012     3/31/2013Notional          ...
Fair Value – Financial InstrumentsInterest Rate Swap• Creditworthiness is included in the valuation of an   interest rate ...
Fair Value – Financial InstrumentsOption Contract• An option provides one party with the option, however,  not the obligat...
Fair Value – Financial InstrumentsOption ContractInputs to a basic option pricing model:1.   Underlying price (stock price...
Fair Value – Financial InstrumentsOption ContractThe Black Scholes model acts in a manner to predict theexpected intrinsic...
Fair Value – Financial InstrumentsStock Price       $5.00      $6.00      $5.00      $5.00Exercise price    $5.00      $5....
Fair Value – Financial InstrumentsCash EquivalentsMany reporting entities classify certain short-term debt andequity secur...
Fair Value – Financial InstrumentsCertificates of Deposit• Certificates of deposit are financial instruments  subject to f...
Fair Value – Financial InstrumentsFair Value – Liabilities  Absent a quoted price f a li bilit exit price should b  Ab    ...
Fair Value – Financial InstrumentsFair Value – LiabilitiesThe fair value of a company’s debt is typically determinedusing ...
Employee Stock Ownership Plans                                 45
ESOP & Valuation IssuesWhat is an ESOP?•   An ESOP is a qualified, defined contribution employee benefit plan    that inve...
ESOP & Valuation IssuesWhat is the standard of value in ESOP valuations?•   The IRS standard is "Fair Market Value".•   Fa...
ESOP & Valuation IssuesWhat is “Fair Market Value”?• Fair Market Value is the price for which property would  sell under t...
ESOP & Valuation IssuesHow is “Fair Market Value” determined?•   The Fair Market Value of business interests that is gener...
ESOP & Valuation IssuesWould the valuation methodology employed by theESOP fiduciary (i.e. Fair Market Value) vary from th...
ESOP & Valuation IssuesWould the valuation methodology employed by theESOP fiduciary (i.e. Fair Market Value) vary from th...
ESOP & Valuation IssuesMay be inconsistent when private companies are theESOP plan sponsors:• Topic 820 stipulates certain...
ESOP & Valuation IssuesWhat are we to do when inconsistencies arise?• Every situation is unique and requires careful analy...
Disclosures              54
Financial Instruments & Fair ValueDisclosuresThe following disclosures are required by ASC 820:• Th f i value measurement ...
Financial Instruments & Fair ValueDisclosures• A description of the valuation processes used to  determine fair value of L...
Financial Instruments & Fair ValueDisclosures• ASC 820 encourages companies to combine the required  disclosures under ASC...
Fair Value – Financial InstrumentsSome typical classifications within the hierarchy:   Investment                      Lev...
Speaker Biography                  Michael Loritz CPA                          Loritz,                  Shareholder, Mayer...
Speaker Biography                  Keith Peterka, CPA                        Peterka                  Shareholder         ...
Speaker Biography                  Hal Hunt CPA                      Hunt,                  Shareholder                  M...
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MHM Executive Education Series Webinar: Financial Instruments

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The accounting and reporting for financial instruments has been a significant area of focus for standard setters, investors, and other accountants for many years. This focus has been heightened by the renewed debate over fair value accounting and its impact on the financial crisis which began in 2007. Generally accepted accounting principles require most financial instruments held by companies to be either recorded or disclosed at fair value in the financial statements, however, these requirements can apply differently to entities depending on their industry, size, and nature of operations. The determination of fair value for such instruments can involve significant judgment and have significant impact on the financial statements.

This course focuses on the reporting and disclosure requirements for financial instruments, including:
Reporting and disclosure requirements for financial instruments
Application of the fundamentals of ASC 820, Fair Value Measurement, to certain financial instruments
Common fair value techniques used by companies and pricing services
Fair value issues associated with employee stock ownership plans

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MHM Executive Education Series Webinar: Financial Instruments

  1. 1. MHM Executive Education Series:Financial Instruments & Fair Value Presented by: Mike Loritz, Keith Peterka, Hal Hunt September 20 2012 20,
  2. 2. A 1 Discuss basic accounting requirements for the reporting of financial instruments at fair valueg 2 Discuss examples of valuation concepts and fundamentals for specific financial instrumentsen 3 Discuss common valuation issues for Employee Stock Ownership Plans (ESOP)d 4 Review common disclosure concepts anda requirements
  3. 3. Accounting Requirements –Financial Instruments and Fair Value 3
  4. 4. Financial Instruments & Fair ValueEntities must apply “fair value” measurements inboth recurring and non-recurring circumstances: – Valuation of debt and equity securities with readily determinable fair values (certain industries report all securities at fair value) – Year-end disclosure of financial instruments carried at other than fair value (debt, loans, etc.) – Assets/liabilities acquired (assumed) in a business combination – Asset impairment testing – Valuation of derivatives and hedged items – Measurement of asset retirement obligations and financial guarantees – Assets held for sale – Many others…
  5. 5. Adoption Timeline – Fair Value Measurements ASU 2010 – 06 (adopt 2010) FAS No. 107 & 115 - Disaggregate hierarchy disclosures by “nature Investments valued at fair value and risk” class for all assets and liabilities - Disclose transfers between Level 1 and Level 2 - Other new disclosures FAS No. 157 (adopt 2008) - Apply new fair value definition - Hierarchy disclosures (level) ASU 2010-06 (adopt 2011) Expanded disclosure of Level 3 activity FSP FAS No. 157-4 (adopt 2009) Disaggregate hierarchy disclosures by ASU 2011-04 (adopt 2012) “nature and risk category for equity and nature risk” - Description of valuation processes for Level 3 debt securities - Unobservable inputs table (quantitative) for L3 - Public entities to disclose all L1 and L2 transfers - Public entities to provide narrative description ASU 2009-12 “NAV” (adopt 2009) 2009 12 NAV of sensitivity of FV to changes in unobservable f iti it f t h i b bl- Use of NAV as a practical expedient for alt invest. inputs (qualitative) for L3- Additional disclosures and hierarchy guidance
  6. 6. Financial Instruments & Fair Value
  7. 7. Financial Instruments & Fair ValueInvestment SecuritiesASC 320 – Debt and Equity Securities applies to: – Investments in equity securities that have readily determinable fair values • The fair value of an equity security is readily determinable if sales prices or bid-and-asked quotations are currently available on a bid and asked securities exchange registered with the U.S. Securities and Exchange Commission (SEC) or in the over-the-counter market, provided that those prices or quotations for the over-the-counter market are publicly reported by the National Association of Securities Dealers Automated Quotations systems or by Pink Sheets LLC. Restricted stock meets that definition if the restriction terminates within one year – All i investments i d bt securities t t in debt iti
  8. 8. Financial Instruments & Fair ValueInvestment SecuritiesASC 320 – Debt and Equity Securities• Debt and equity securities within the scope of ASC 320 must be classified as either: a. Trading b. Available-for-sale c. Held-to-maturity**Although not reported at fair value, HTM securities are subject to fairvalue disclosures under ASC 825 as well as non-recurring OTTImeasurement when appropriate. appropriate
  9. 9. Financial Instruments & Fair ValueInvestment SecuritiesTherefore, the following securities not within the scope ofASC 320 are not required to be recorded at fair value on arecurring basis:  Cost method equity securities • Includes equity securities that do not meet the definition of “readily determinable fair value”  Equity securities that are accounted for under the equity method (ASC 323)  Investments in consolidated subsidiaries * Derivative instruments are recorded at fair value, however, are not within the scope of ASC 320.
  10. 10. Financial Instruments & Fair ValueInvestment Securities - Impairment• An investment is impaired if its fair value is less than cost. An analysis must be performed to determine if the impairment is considered other-than-temporary (OTTI).• Analysis performed on an individual security basis – Equity Securities – Qualitative assessment – Debt Securities – An entity shall compare the present value of cash flows expected to be collected from the security with the amortized cost basis of the security If the security. present value of cash flows expected to be collected is less than the amortized cost basis of the security, an other than temporary other-than-temporary impairment shall be considered to have occurred.
  11. 11. Financial Instruments & Fair ValueInvestment Securities - ImpairmentRecognition• If sale of Equity Securities – entire difference between cost and fair value (impairment) is recorded in earnings• Debt Securities – Probable – Same as equity securities (difference between cost basis and fair value is recorded to earnings) – If sale is not probable – The amount of the impairment related to credit l l d di loss i recorded through earnings and the is d d h h i d h amount related to other factors is recorded in AOCI.
  12. 12. Financial Instruments & Fair ValueDerivative Financial Instruments• ASC 815 “Derivatives and Hedging” provides guidance for the recognition and measurement of derivative financial instruments. i t t• All derivatives are recorded on the balance sheet at fair value• Specialized accounting may apply if a transaction qualifies for hedge accounting and the proper election is made • Th special accounting applies t th h d d it The i l ti li to the hedged item (f i value) (fair l ) and offsetting entry (cash flow) • Derivative is always recorded at fair value
  13. 13. Financial Instruments & Fair ValueFair Value OptionASC 825-10-15 provides for an entity to elect to account forcertain financial instruments at fair value (recurring basis);• A recognized financial asset and financial liability• A firm commitment that would otherwise not be recognized at inception and that involves only financial instruments• A written loan commitment• The rights and obligations under certain insurance contracts• The rights and obligations under certain warranties• A host financial instrument resulting from the separation of an embedded nonfinancial derivative from a nonfinancial hybrid instrument under paragraph 815-15-25-1 815 15 25 1
  14. 14. Financial Instruments & Fair ValueAccounting St d d Codification (ASC) 820 F iA ti Standards C difi ti 820, FairValue Measurements and Disclosures provides guidancewith respect to: p• Defines fair value• Sets out a framework for measuring fair value, which refers to certain valuation concepts and practices• Requires certain disclosures about fair value measurements ASC 820 does not provide guidance with respect to p g p the recognition or classification of financial instruments.
  15. 15. Financial Instruments & Fair ValueFASB ASC 820 i l d di l includes disclosure requirements which are i t hi hidentified as measurement on a recurring basis ornonrecurring basis. g• Disclosure requirements include the valuation techniques and inputs used to develop fair value measurements for • assets and liabilities that are measured at fair value on a recurring basis in periods subsequent to initial recognition and • non-recurring measurements recorded during the period.• Th level within th f i value hi The l l ithi the fair l hierarchy i which th f i value h in hi h the fair l measurement in its entirety falls
  16. 16. Financial Instruments & Fair ValueFASB ASC 825 10 50 provides additional guidance with respect 825-10-50 id dditi l id ith tto fair value disclosures for (1) all public companies, (2) allnonpublic companies with total assets greater than $100 million,and (3) any company that holds or uses derivative financialinstruments.• Requires fair value disclosure of all financial instruments on the company’s balance sheet as well as the methods and significant assumptions used to determine fair value.• The disclosure requirements apply regardless of the recognition and measurement of the financial instruments in the financial statements.• ASU 2011-04 now requires disclosure of the classification within the fair value hierarchy as well.
  17. 17. Financial Instruments & Fair ValueFundamentals of Fair Value per ASC 820:1. Must use market participant view in measuring fair value (not entity specific view)2. Fair value represents an exit price in the entity’s p principal or most advantageous market p g – The price that would be received for selling an asset – The price that would be paid to transfer a liability3. Provides3 Pro ides for a hierarch that req ires the use of hierarchy requires se observable market inputs when available – Entity specific inputs are allowed when observable market data is not available, however, it must be from a market participant’s view!
  18. 18. Financial Instruments & Fair ValueCommon issues related to fair value of financialinstruments: – Bid/ask prices – middle range allowed – Transactions costs – should not be included – Blockage discounts – should not be included – Inclusion of an entity’s own credit risk - required – Net Asset Value (NAV) – may not be fair value – Control premiums – may be applied to Level 2 or 3 securities – Restricted Securities – restriction must be included
  19. 19. Financial Instruments & Fair Value• In exchange traded markets, exit prices should be based on closing market prices • May need policy election if equity securities traded on a continuous or foreign market• In broker/dealer markets, bid/ask prices are more readily available th closing prices: il bl than l i i • Fair value represents the price within the bid/ask spread that would be received to acquire the asset or transfer the liability. • Mid-market pricing or other pricing conventions can be used as a practical expedient for fair value measurements. • Offsetting positions should be consistent between the long and short positions.
  20. 20. Financial Instruments & Fair ValueMost Advantageous Market – Level One SecuritiesCompany A owns 1,000 shares of XYZ Corp common stock. XYZstock trades on the NYSE and the Tokyo Stock Exchange routinely in y g yboth markets. Company A believes they could sell the entire block ofshares at a $.25 per share discount. Information as of December 31,2011 is as follows: Closing Costs Net Proceeds NYSE $5.00 $.50 $4.50 TSE $5.45 $5 45 $1.00 $1 00 $4.45 $4 45 What if the transaction What is the fair value of the costs in NYSE were th t i the shares held by Company A? same as TSE?
  21. 21. Financial Instruments & Fair ValueValuation techniques:When fair value is directly observable (exchange traded), the quotedmarket price must be used for measuring fair value, g p g , generally without yany adjustments. - Possible exceptions for inactive markets• ASC 820-10-35-24A describes three commonly accepted valuation techniques: – Market approach – Income approach – Cost approach
  22. 22. Financial Instruments & Fair Value Market Approach Income Approach pp Cost Approach• Level 1 securities • Interest rate swap Generally not• The fair value of a discounted cash applicable to financial private equity security flows instruments (start up may be estimated • Option Black phase company h based on observable Scholes, Monte equities possibly) EBITDA multiples, Carlo model (or market caps, etc. for other option models similar companies • Private company equities - DCF
  23. 23. Valuation Concepts
  24. 24. Fair Value – Financial InstrumentsLoansLoans receivable that are not debt securities will bereported on the balance sheet using one of three models: • Held-for-sale - Lower of cost or fair value* • Loans held for investment - Amortized cost less an allowance for credit losses.* • Fair value for loans for which the option under ASC 825-10 has been elected.*However fair value disclosures may still be required under ASC 325 However,
  25. 25. Fair Value – Financial InstrumentsLoans – Fair Value Measurements• Fair value is generally determined based on the loans expected future cash flows discounted at market rates. – Impairments are measured using the loan’s effective rate• Mortgage loans held for sale may use a market approach. (as market observable data may be available)• Credit impaired loans – the credit impairment may be incorporated into the estimated cash flows or the discount rate. t• Collateral dependent - A company must measure impairment based on the fair value of the collateral once the creditor determines foreclosure is probable.
  26. 26. Fair Value – Financial InstrumentsInvestment Securities (as defined by ASC 320)• EQUITY - Publically traded equity securities and publically traded debt are level 1 securities and should use the closing price on the applicable exchange.• DEBT - Most debt securities (including most US ( g Treasuries) are valued using a pricing model and are level 2 securities. – Proprietary models used by pricing services services. – Use inputs such as credit risk and interest rates. – To be level 1, the bond must be traded and have a market observable price price.
  27. 27. Fair Value – Financial InstrumentsInvestment Securities (as defined by ASC 320)• MUTUAL FUND – a mutual fund is not an exchange traded instrument – Classification may depend on the level of activity. Most open-end funds sell shares to the public every p p y business day which are priced at net asset value (NAV). – Closed end funds and some open ended funds that Closed-end open-ended are infrequently traded may be level 2 measurements (or considered a NAV practical expedient).
  28. 28. Fair Value – Financial InstrumentsAlternative InvestmentsMay report the investment in these funds at the net assetvalue (NAV) in certain instances instances. – Entities that apply the investment guide and meet certain criteria (ASC 946-10-15-2) –Entities that report a NAV or it equivalent ( (real estate fund) f ) Definition Investments in private investment funds; including investments in hedge funds, private equity funds, venturecapital funds, commodity funds, real estate funds, offshore fund hi l f d vehicle, and f d f f d as well as b k d fund-of-funds, ll bank common/collective trust funds.
  29. 29. Fair Value – Financial InstrumentsAlternative InvestmentsRequired disclosures if the NAV is used include alldisclosures required by ASC 820 plus several specificdisclosures regarding each major investment categoryreported at the NAV. – Liquidation restrictions, including estimated period of time –Unfunded commitments Unfunded –Redemption rights and other restrictions –Potential sale at amount other than NAV Potential
  30. 30. Fair Value – Financial InstrumentsPrivate Company Equity Securities• If quoted prices in active markets or arm’s length transactions have occurred for the entity’s equity entity s securities, use that information first.• If not, then management should select the valuation g method(s) that are appropriate for their industry, life cycle, etc. – A single valuation method may be appropriate – Or, it may be more appropriate to use multiple valuation methodologies (typically market and income approach)
  31. 31. Fair Value – Financial InstrumentsPrivate Company Securities• Valuation should consider the relative applicability of the valuation techniques used given: – Nature of the industry – Current market conditions – Quality, reliability and verifiability of the data used in each model – Comparability of public entity or transaction data used – Additional considerations unique to the entity q y• Consideration should be given to significant differences in valuation methodologies (why are they different?)
  32. 32. Fair Value – Financial InstrumentsPrivate Company Securities• Market Approach – Market value of equity (MVE) to net income or book value – Enterprise value to EBIT – Enterprise value to EBITDA – Enterprise value to revenue – Enterprise value to debt free cash flows – Enterprise value to book value of assets• I Income Approach A h – Discounted cash flows – Probability weighted cash flows y g Typically, a combination of these methods is appropriate.
  33. 33. Fair Value – Financial InstrumentsSettlement Value Interest rate swaps are(received from the not traded on ancounterparty) vs Fair exchange, exchange thus theValue income approach is typically used to• Settlement value does not consider measure fair value counterparty (CVA) or company specific creditworthiness (DVA), thus does not represent fair value• Many times the amount Interest Rate reported by the counterparty includes Swaps accrued interest receivable/payable
  34. 34. Fair Value – Financial InstrumentsInterest Rate Swaps – Income Approach1. Calculate the fixed cash flows based on the notional amount, amount fixed rate frequency of payments etc rate, payments, etc.2. Calculate the variable (floating leg) cash flows by: 1. Building a zero coupon y g p yield curve to determine the spot rate p for each date on which a cash flow settlement occurs 2. Convert the zero coupon yield curve to a forward curve 3. Calculate each floating-leg cash flow based on notional amount, floating leg forward rate, etc.3. Compute the present value of the fixed and variable cash flows using the zero coupon yield curve (need to consider creditworthiness)
  35. 35. Fair Value – Financial Instruments 9/30/11 3/31/2012 9/30/2012 3/31/2013Notional $25,000,000 $25,000,000 $25,000,000 $25,000,000Fixed rate 5.75% 5.75% 5.75% 5.75%Days 183/360 182/360 183/360 181/360Fixed cash flows $(730,729) $(722,743) $(734,722) $(722,743)Forward rate 6.00% 6.50% 7.03% 7.55%Floating cash $762,500 $817,052 $898,403 $949,240flowsNet cash flo s flows $31,771 $31 771 $94,309 $94 309 $163,681 $163 681 $226,240 $226 240Discount rate 6.00% 6.25% 6.51% 6.77%Discount factor .97 .94 .91 .87Present value $30,831 $88,621 $148,474 $197,939Net PV 465,865
  36. 36. Fair Value – Financial InstrumentsInterest Rate Swap• Creditworthiness is included in the valuation of an interest rate swap by adjustment to the zero coupon rate used to discount the expected cash flows. – Practice issue: typically little or no credit spread adjustment is applied related to the large f financial institutions (BOA, Chase, ( O C JPMorgan, etc.)• The best source for credit spread adjustments is the j credit default swap market.• Also may need to consider entry/exit markets (liquidity discounts)
  37. 37. Fair Value – Financial InstrumentsOption Contract• An option provides one party with the option, however, not the obligation, to buy or sell something in the future obligation future.• Some options are publically or exchange traded, however, most are not.• Options issued as share based compensation typically are not the same as traded options.• O ti Options are typically valued using th i t i ll l d i the income approach h (if market observable data is not available). – Black-Scholes Merton – Monte-Carlo
  38. 38. Fair Value – Financial InstrumentsOption ContractInputs to a basic option pricing model:1. Underlying price (stock price)2. Strike (exercise) price3.3 Term (time to expiration) e piration)4. Risk-free interest rate5.5 Expected dividends6. Volatility
  39. 39. Fair Value – Financial InstrumentsOption ContractThe Black Scholes model acts in a manner to predict theexpected intrinsic value of the instrument on the date the optionwill be exercised (an expected forward stock price is determined). –Growth is assumed at the risk-free rate. –Holding costs (di id d b H ldi t (dividends, borrowings, etc.) are d d t d i t ) deducted. – Use of implied volatility to project a range of stock prices at the exercise date. – Differences between estimated stock prices and the strike price are weighted to determine the expected intrinsic value. – The expected intrinsic value is discounted using the risk free interest rate.
  40. 40. Fair Value – Financial InstrumentsStock Price $5.00 $6.00 $5.00 $5.00Exercise price $5.00 $5.00 $5.00 $5.00Current date 1/1/2011 1/1/2011 1/1/2011 1/1/2011Expiration 1/1/2016 1/1/2016 1/1/2021 1/1/2016dateVolatility 25% 25% 25% 60%Risk free rate 3.00% 3.00% 3.00% 3.00%Dividend yield 1.00% 1.00% 1.00% 1.00%Fair Value $.7865 $1.3076 $.8926 $2.0337
  41. 41. Fair Value – Financial InstrumentsCash EquivalentsMany reporting entities classify certain short-term debt andequity securities such as treasury bills commercial paper securities, bills,and money market funds, as part of cash equivalents. – These securities represent financial instruments and p are still subject to the fair value disclosure requirements of ASC 820. – Given the short maturity in most cases there will be no maturity, significant difference between the carrying value and fair value.
  42. 42. Fair Value – Financial InstrumentsCertificates of Deposit• Certificates of deposit are financial instruments subject to fair value disclosures disclosures. – A bank CD typically does not meet the definition of a security (as defined in ASC 320), thus is not subject to the classification guidance in ASC 320. – Additionally, a CD typically would not be considered a security for purposes of applying the Not-for-Profit Not for Profit measurement guidance. However, if the NFP holds any negotiable CDs, you would likely need to evaluate further further.
  43. 43. Fair Value – Financial InstrumentsFair Value – Liabilities Absent a quoted price f a li bilit exit price should b Ab t t d i for liability, it i h ld be determined from the perspective of a market participant that holds the identical liability as an asset, even when y the asset is not traded (level 3 measurement).
  44. 44. Fair Value – Financial InstrumentsFair Value – LiabilitiesThe fair value of a company’s debt is typically determinedusing an income approach (DCF) which is driven by twomain inputs: 1. Interest rates 2. The Company’s own creditworthiness – A decrease in an entity’s creditworthiness can be included in two different ways: » Adjusting the discount rate » Adjusting the estimated cash flows (payments) The Th carrying amount of variable rate d bt i t i ll not i t f i bl t debt is typically t equal to fair value!
  45. 45. Employee Stock Ownership Plans 45
  46. 46. ESOP & Valuation IssuesWhat is an ESOP?• An ESOP is a qualified, defined contribution employee benefit plan that invests primarily in the stock of the employer company.• ESOPs are “tax-qualified” in return for meeting certain rules designed to protect the interests of plan participants and beneficiaries.• ESOP sponsors (and selling shareholders in certain situations) also receive various tax benefits.• A valuation of ESOP shares by an independent third party is required by the Department of Labor (DOL) and the Internal Revenue Service (IRS) to insure that the value is determined by a party who does not have a personal or financial interest in the valuation res lt al ation result.
  47. 47. ESOP & Valuation IssuesWhat is the standard of value in ESOP valuations?• The IRS standard is "Fair Market Value".• Fair Market Value has a great deal of case law behind it.• The definition of Fair Market Value is most clearly defined by the IRS in Revenue Ruling 59-60.• The DOL substantially embraces all of the aspects of Fair Market y p Value as defined in Revenue Ruling 59-60, but the ERISA legislation imposes additional considerations.• ERISA mandates that all qualified p q plans have a trustee, and the , trustee has to act in the best interests of the plan participants.• ERISA imposes fiduciary responsibilities on all of the trustees. Fiduciary responsibilities are often at the center of ESOP based y p valuation litigation.
  48. 48. ESOP & Valuation IssuesWhat is “Fair Market Value”?• Fair Market Value is the price for which property would sell under the existing market conditions for such g property as established in arms-length negotiations between knowledgeable and independent parties.• The “Market” implied in definitions of Fair Market Value encompasses all potential buyers and sellers of the property involved.
  49. 49. ESOP & Valuation IssuesHow is “Fair Market Value” determined?• The Fair Market Value of business interests that is generating earnings is determined to a large degree on the basis of what a knowledgeable b k l d bl buyer would be willing t pay f th earnings stream ld b illi to for the i t considering available rates of return on relatively risk-free investments and the risks associated with the investment being appraised. appraised• The present value of future earnings using a risk adjusted market rate is one of the most common approaches, referred to in business valuations as Discounted Future Earnings (DFE) (DFE).• Reference to the results of mathematical formulas is not the sole determinant of Fair Market Value.• Court Co rt cases contin e to s pport the usage of both Disco nts for continue support sage Discounts Lack of Control and Discounts for Lack of Marketability under the Fair Market Value standard.
  50. 50. ESOP & Valuation IssuesWould the valuation methodology employed by theESOP fiduciary (i.e. Fair Market Value) vary from that ofTopic 820 (i.e. Fair Value)?• May be consistent when public companies are the ESOP plan sponsors:• Topic 820 stipulates that “fair value must be determined fair value” based upon observable inputs (e.g. quoted market prices) where available.• Th tax code stipulates that only ESOP’s h ldi shares The t d ti l t th t l ESOP’ holding h traded on an exchange that is registered under Section 6 of the Securities Exchange Act of 1934 may rely upon quoted prices as th measurement of value. All other securities must i the t f l th iti t be subject to valuation based upon an independent appraisal.
  51. 51. ESOP & Valuation IssuesWould the valuation methodology employed by theESOP fiduciary (i.e. Fair Market Value) vary from that ofTopic 820 (i.e. Fair Value)?• However, the two rules may be in conflict when: – The securities are traded on the Over-the-counter Bulletin Board ( (“OTCBB”). The OTCBB may constitute an active market for ) y certain securities, but in Notice 2011-19, the IRS emphasized that such securities must still be valued based upon an independent appraisal for purposes of those Code sections which rely on fair value of ESOP securities. – The fiduciary uses the market to set the ESOP price, but it is the average of the 20 trading days prior to year-end, rather than the year-end price. Topic 820 would require the year-end price.
  52. 52. ESOP & Valuation IssuesMay be inconsistent when private companies are theESOP plan sponsors:• Topic 820 stipulates certain constraints with respect to p p p the measurement of fair value with which the fiduciary may not agree.• For example, premiums or discounts based upon the example size of a holding are not recognized under GAAP.• The fiduciary might, however, conclude that such y g , , premiums or discounts should be recognized for purposes of the Employee Retirement Income Security Act and the Internal Revenue Code (IRC) (IRC).
  53. 53. ESOP & Valuation IssuesWhat are we to do when inconsistencies arise?• Every situation is unique and requires careful analysis.• Where such circumstances arise it is important that our arise, terminology clearly distinguishes what amount that is the ESOP fiduciary’s determination of value, as opposed to the Topic 820 measurement of fair value value.• Next course of action would involve the ESOP trustee, the valuation firm, ERISA counsel and others. ,
  54. 54. Disclosures 54
  55. 55. Financial Instruments & Fair ValueDisclosuresThe following disclosures are required by ASC 820:• Th f i value measurement at th end of th reporting period The fair l t t the d f the ti i d• The level within the fair value hierarchy (Level 1, 2, or 3) (1)• The amounts of any transfers between Level 1 and Level 2 of y the fair value hierarchy (recurring only)*• A description of the valuation technique(s) and the inputs used in the fair value measurement for Level 2 and 3 instruments. (1)• A reconciliation from the opening balances to the closing balances f L b l for Level 3 i t l instruments as well as realized and t ll li d d unrealized gains/losses.
  56. 56. Financial Instruments & Fair ValueDisclosures• A description of the valuation processes used to determine fair value of Level 3 instruments• A narrative description of the sensitivity of the Level 3 fair value measurements to changes in unobservable g inputs*• Disclosure not required by non public entities non-public(1) Denotes disclosure required for financial instruments in which fair value is disclosed in accordance with ASC 825 only (public companies only – not applicable to non-public entities) non public
  57. 57. Financial Instruments & Fair ValueDisclosures• ASC 820 encourages companies to combine the required disclosures under ASC 820 and ASC 825 if applicable 825, applicable, however, such combined presentation is not required.• The guidance in ASC 820 requires the fair value g q disclosures (quantitative and qualitative) to be disaggregated by class of assets and liabilities rather than by major category category. –As a result, fair value measurements will typically require greater disaggregation than the related line item(s) in the balance sheet. b l h t
  58. 58. Fair Value – Financial InstrumentsSome typical classifications within the hierarchy: Investment Level Traded equities Level 1 US T-Bills Level 1/2 US Treasuries Level 2 Municipal M i i l securities iti Level 2 L l US Agency securities Level 2 Private (hedge) funds Level 2/3 Private company equities Level 3 Private company debt Level 3 Funds - Net Asset Value (NAV) Level 2/3 Certificates of deposit Level 2 Mutual Funds Level 1/2
  59. 59. Speaker Biography Michael Loritz CPA Loritz, Shareholder, Mayer Hoffman McCann P.C. 913.234.1226 mloritz@cbiz.comMike has 15 years of public accounting experience with financial and service basedcompanies, including the engineering and construction industry. He is a member of theMHMs Professional Standards Group, providing accounting knowledge leadership in theareas of derivative financial instruments, share-based compensation, fair value, leasing, p grevenue recognition and others.Mikes experience includes over 14 years with a Big Four firm where he was responsiblefor client service for large and small SEC filers and non-public entities audit/accounting entities,technical expertise and training instruction and delivery.
  60. 60. Speaker Biography Keith Peterka, CPA Peterka Shareholder Mayer Hoffman McCann P.C. 610.862.2744 kpeterka@cbiz.comWith more than 19 years of experience in public accounting, Keith performs national firmresponsibilities for IFRS, fair value accounting and auditing, revenue recognition andbusiness combinations. He has also developed national training programs for accountingpronouncements and complex accounting t i t d l ti topics.Keith is a subject matter expert for IFRS, SEC reporting and fair value accounting inMHM’s Professional Standards Group. He also is a member on the IFRS Foundations pSmall & Medium-sized Entities (SMEs) Implementation Group.
  61. 61. Speaker Biography Hal Hunt CPA Hunt, Shareholder Mayer Hoffman McCann P.C. 913.234.1012 hhunt@cbiz.comHal leads MHM’s Employee Benefit Plan Audit Practice. With over 25 years of diverseexperience with employee benefit plan accounting, auditing and compliance issues, he isalso a member of the firm’s Professional Standards Group as subject matter expert onEBP plan audits, as well as B i l dit ll Business C bi ti Combinations and L d Leasing. iAs the National Practice Leader for EBP Audits, Hal is responsible for providing internaltraining on the subject, along with providing technical support to engagement teams, g j g p g pp g gserving as engagement quality reviewer and developing resource tools for our EBP auditprofessionals.
  62. 62. Questions?
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