ISAR 28

Application of Fair Value Measurement Requirements and Recognition and Measurement of Financial Instruments

Tuesday, 11 October 2011 Palais des Nations, Geneva

MORNING SESSION

FAIR VALUE MEASUREMENT

PRESENTED BY

Vincent Papa

Senior Policy Analyst CFA Institute

This material has been reproduced in the language and form as it was provided. The views expressed are those of the author and do not necessarily reflect the views of UNCTAD.

Fair Value Guidance- A User Perspective

Vincent Papa, CFA

Director, Financial Reporting Policy (EMEA)

11th October 2011

UNCTAD Fair value workshop presentation

Comments

− Brief CFA Institute Background

− General Perspective on Fair Value and Financial Instrument Reform

− Fair Value Disclosures- User Perspective

− Lessons Learnt from Risk Disclosure Research

CFA Institute Background

Investor organisation founded in 1963, Responsible for administering the CFA exam

104,000+ global membership of investment professional

Global presence with members present in 130+ countries. Offices in Brussels, Buenos Aires, Charlottesville, Hong Kong, London and New York

CFA Mission: To lead the investment profession globally by setting the highest standards of ethics, education, and professional excellence.

CFA Advocacy Objectives: Promote fair and open markets, investor protections, and professional standards

General Perspective

− Concern about sustenance of a myriad approaches to influence recognition of gains or losses and overstate asset values

− Reclassification from fair value to amortised cost recognition.

− Inappropriate categorisation into level 3.

− Delayed impairment of financial assets.

− Anachronistic and complex approaches remain under IFRS 9.

− Fair Value Measurement

− CFA Institute has consistently supported the fair value application for financial instruments.

− This view is consistently backed by CFA Institute member surveys

Limited Transparency

of Risk through

Financial Statement

Disorderly Market Correction

- Changing interest rates - Yield curve changes - FX fluctuations

- Sovereign exposures held by European banks

- Slow growth in Euro-periphery countries

- Large budget deficits

- Forced sales of assets - Reduced Lending - Rising Unemployment

- Lender aversion (e.g. US money market)and refinancing difficulties

State of Economic Environment & Risks

Liquidity Risk

Market Risk Credit Risk

General Perspective-Fair Value (Lessons learnt)

The 2007-2009 market crisis and the sovereign crisis: May differ in root causes (i.e. sovereign versus sub-prime exposure) but share similar characteristics in evolution.

Empirical research (Laux and Leuz, 2009) shows following:

− Detrimental role of accounting regime overstated: Uncertainty due to information asymmetry on credit quality leads to lender aversion, refinancing difficulties and panic liquidations

− Even during credit crisis, Fair value assets or liabilities was only a subset of balance sheet

− Distressed prices- Significant application of level 3 valuation (7-14.6% sample of seven US banks including investment banks.

− Overvalued book values and not excess write-downs: Financial assets book values exceed market and independent loss assessment.

− Current price to book ratios of banks shows that the same problem lingers.

Unlike credit crisis, fair value measurement is less of a ‘bogey man’ during current sovereign crisis. Have fair value concerns been a red herring?

General Perspective-Fair Value (Lessons learnt)

Illustrative IFRS Bank Data

Year end Available for

sale

FV through P and

L

Loans and

Receivables

Held to maturity

Barclays 2010 4.37% 42.34% 45.17% 0.00%

Barclays 2009 4.10% 44.29% 43.97% 0.00%

Deutsche Bank 2010 2.85% 57.78% 28.83% 0.00%

Deutsche Bank 2009 1.25% 64.33% 23.70% 0.00%

HSBC 2010 15.53% 27.82% 52.13% 0.79%

HSBC 2009 14.87% 30.00% 50.62% 0.75%

Societe

Generale

2010 9.17% 40.93% 41.63% 0.17%

Societe

Generale

2009 8.83% 39.63% 43.08% 0.21%

Nordea Bank 2010 0.99% 44.59% 50.13% 2.76%

Nordea Bank 2009 0.00% 43.30% 51.54% 3.54%

Source: 2010 Annual Reports. Reported percentages are a proportion of total assets.

Fair value/Total Assets- 9 quarters 2007-2009

Four US Bank Holding companies- 18.7- 36.4%

Three Major US Investment Banks- 43.2-55.2%

General Perspective-IFRS 13

− Welcomes IFRS 13 guidance:

− Provides relatively converged model.

− Clarification of how to apply fair value (e.g. when is a market disorderly) will enable consistent practice

− Addressing user disclosure requirements

− Expert Advisory Panel (Template of desirable interaction between issuers, regulators, auditors and users)

− Focus comments on disclosures

− Supportive of:

− focus on principal market as reference market,

− exit value as fair value,

− treatment of liabilities.

Fair Value Disclosures- Observations

− Fragmentary information- Covers only a subset of overall risk disclosures.

− Understanding measurement uncertainty is important but it is being restricted to a subset of assets through limited sensitivity analysis.

− Illustrative Societe Generale (Level 3 assets)

Bigger picture perspective required for investors- Need to integrate with entity-wide risk disclosures (e.g. market risk).

Societe Generale

2010 2009

Level 3 assets 13,633 17,690

Total assets 1,132,072 1,023,701

% (Level 3/Total

assets) 1.2% 1.7%

Fair Value Disclosures-Observations

− Perspective on Proposed disclosures

− Support retention of measurement uncertainty analysis,

− Support disclosure of migration across levels of hierarchy,

− Strongly support hierarchy representation of all fair values , and

− Support disclosure of ‘highest and best use’.

− Empirical evidence shows that investors price level 3 assets differently and at a discount relative to their pricing of level 1 assets.

− 3 empirical studies show discounts range from 20-30% relative to level 1 pricing

− Smaller discounts found when numbers were more credible

High quality disclosures will result in investors having a better appreciation of risk/uncertainty of reported numbers and reduce discount on level 3 assets.

Idea is not for investors to second guess management valuation but have an appreciation of accounting measurement risk

Fair Value Disclosures-Measurement Uncertainty Analysis

It should not only be required for level 3 assets;

Meaningful disaggregation required by risk category and asset class;

Better explanation and application of reasonably probable assumptions;

Integration required with IFRS 7 market risk disclosures.

CFA Research on Risk Disclosures

Lessons from Financial Instruments Risk Disclosures Research

Worry about emphasis on qualitative disclosures: Qualitative disclosures need to be more informative

Some of the qualitative disclosures are a little too cookie cutter in nature- CFA Research respondent

Qualitative disclosure is limited to simple definitions and its usefulness could be improved- CFA Research respondent

Top down and integrated messaging on overall risk management required.

There is very little integration of how different risk categories influence each other. There should be a scenario analysis that ties together different types of risk; it seems unlikely that risks would be entirely independent of each other- CFA Research respondent

Company Credit Risk Liquidity Risk Market Risk

Number of dimensions in index 13 12 11

Banking Financial Institution 1 92% 71% 59%

Banking Financial Institution 2 88% 71% 27%

Banking Financial Institution 3 100% 79% 59%

Banking Financial Institution 4 92% 75% 91%

Inconsistent Risk Disclosures

Banks- Barclays, Deutsche Bank, HSBC, RBS

Limited Transparency

of Risk through

Financial Statement

Disorderly Market Correction

- Changing interest rates - Yield curve changes - FX fluctuations

- Sovereign exposures held by European banks

- Slow growth in Euro-periphery countries

- Large budget deficits

- Forced sales of assets - Reduced Lending - Rising Unemployment

- Lender aversion (e.g. US money market)and refinancing difficulties

State of Economic Environment & Risks

Liquidity Risk

Market Risk Credit Risk

END