The Bottom Line

• Most public companies adopted ASU 2011-04’s¹ amendments to the fair value measurement and disclosure requirements in ASC 820² during the first quarter of 2012.
• Deloitte looked at 30 SEC filings from entities in several financial services industry (FSI) sectors to see how financial services companies implemented the ASU.
• Most companies from our sample disclosed that the adoption of ASU 2011-04 did not materially affect their financial position or results of operations, indicating that the ASU had little effect on measurement practices.
• The ASU’s amendments to the fair value disclosure requirements in U.S. GAAP were more significant.
• Although some entities applied the new disclosure requirements similarly, we observed diversity in practice.
• For example, the entities in our sample provided different types of quantitative information about significant unobservable inputs in Level 3 measurements (e.g., a range, weighted average, neither, or both), but many excluded information, taking advantage of the exemption from this requirement for significant unobservable inputs developed by third parties.
• Our analysis also focused on (1) disclosures about the sensitivity of Level 3 measurements, (2) valuation processes used for Level 3 measurements, (3) the interaction between certain disclosures, and (4) information about fair value measurements disclosed for assets and liabilities not measured at fair value in the statement of financial position.
• We foresee that entities will refine their disclosures in future filings to make them comparable to those of their competitors and to further align them with the letter and intent of the ASU’s requirements.
• Financial statement users will also benefit in future periods when the new disclosure information is available for multiple quarters, thereby enabling comparative analysis (e.g., comparing changes in quantitative information about significant unobservable inputs in Level 3 measurements from period to period, or with competitor holdings of similar assets or liabilities, or with macroeconomic conditions).

Beyond the Bottom Line

This Financial Services Industry Spotlight examines how 30 FSI entities implemented ASU 2011-04, which amends the fair value measurement and disclosure requirements in U.S. GAAP. The companies in our sample operate in several FSI sectors, including banking and securities, insurance, real estate, and asset management. By examining SEC filings from entities in these sectors, we can see whether and, if so, how the ASU affected their financial position or performance. We can also identify differences in the way entities apply the new or revised measurement and disclosure requirements, which may lead to further refinements in future financial statements.

Background

The FASB issued ASU 2011-04 in May 2011, converging the fair value measurement and disclosure requirements under U.S. GAAP with those in IFRS 13,³ issued by the IASB in May 2011 as well.

The ASU also clarifies the Board’s intent regarding certain underlying fair value measurement principles, including:

• The definition of a principal market.
• The use of premiums and discounts.
• The applicability of the highest-and-best-use and valuation-premise concepts to financial instruments.

The FASB also provides an optional net measurement attribute in the ASU for groups of assets and liabilities that are managed on the basis of an entity’s net exposure to a particular market risk or counterparty credit risk. See ASC 820-10-35-18D through 35-18L for more information.

In the summary section of ASU 2011-04, the FASB explains that “[f]or many of the requirements, the Board does not intend for [the ASU] to result in a change in the application of the requirements in [ASC 820].” As noted in the Key Observations section below, the amendments in ASU 2011-04 that clarify certain measurement principles and the new optional net measurement attribute did not materially affect the financial position or performance of most entities in our sample.

The ASU also significantly expands disclosure requirements for fair value measurements, particularly those classified in Level 3 of the fair value hierarchy. These new requirements resulted in substantial changes to the financial statement footnotes for many of the entities in our sample. We summarize the new disclosure requirements in the related sections below.

For more detailed information on the ASU, see Deloitte’s May 13, 2011, Heads Up.

Research

We examined the first-quarter Form 10-Q filings of 30 FSI entities from the banking and securities, insurance, real estate, and asset management sectors. Our objective was to understand how companies interpreted and applied the requirements of ASU 2011-04. The following pie chart depicts the number of companies we observed from each sector:

Number of Companies Observed in Each Sector

Unless otherwise noted, the trends we identified are not unique to a given sector. Entities from any sector may find value in the trends noted and related observations.

Key Observations

Overall Impact on Financial Statements

As noted above, the ASU’s primary purpose was not to change the application of ASC 820. In line with that expectation, virtually all of the companies we examined either (1) disclosed that the adoption of ASU 2011-04 had no material impact on their financial condition, results of operations, and cash flows or (2) made no explicit statement regarding their adoption of ASU 2011-04 (yet still adopted it). This suggests to us that the impact of adoption was largely immaterial. The following are two noteworthy exceptions from the banking and securities sector:

• In response to the ASU’s expanded prohibition against “blockage factors”⁴ in all levels of the fair value hierarchy, one company disclosed that it released reserves (of approximately 4 percent of pretax income), thereby increasing pretax income.
• Two companies disclosed that because of the amendment to the definition of principal market,⁵ they revised what the principal market would be for certain asset classes. The change in principal market resulted in a change to the fair value measurements for those asset classes.

Notwithstanding the minimal impact on fair value measurements, the adoption of ASU 2011-04 did significantly affect the amount and type of information about fair value measurements that was disclosed in companies’ financial reports.

Quantitative Disclosures About Significant Unobservable Inputs

ASU 2011-04 requires reporting entities to disclose quantitative information about the significant unobservable inputs used in arriving at Level 3 fair value measurements (recurring and nonrecurring).⁶ Before the issuance of ASU 2011-04, reporting entities were required to disclose only qualitative information about valuation technique(s) and inputs used.

Nature and Type of Information Disclosed

Although the standard does not specify the type of quantitative information to disclose, the ASU’s sample disclosures suggest that for each class of asset or liability, a reporting entity might disclose a range of values and a weighted average for each significant unobservable input.

The majority of the companies in our sample presented both a weighted average and a range in their Level 3 quantitative input disclosures. The following chart summarizes how the 30 companies we observed satisfied this new disclosure requirement:

Nature of Quantitative Information Disclosed

Financial statement users and others may benefit from these disclosures by comparing (1) the same entity’s disclosures from period to period and (2) an entity’s current-period disclosures with those from competitors measuring similar assets and liabilities.

Disaggregation or “Amount” of Information Disclosed

Some entities disaggregated an input into components, while other entities disclosed what could be an aggregation of those same components at a higher level (e.g., separately disclosing prepayment speeds, default rates, and other inputs used to develop a discount rate for measuring mortgage-backed securities (MBSs) versus disclosing just the discount rate).

Sample inputs used in Level 3 fair value measurements of common assets are shown below:

Third-Party Pricing Information

Level in the Fair Value Hierarchy

The majority of fair value measurements provided by third-party pricing services were classified in Level 2 of the fair value hierarchy. Some companies disclosed that if the pricing information received from third parties did not reflect market activity, the company challenged the price through a formal process with the pricing service. In these cases, if the pricing service updated the price to be consistent with current market observations, the asset or liability remained in Level 2. Otherwise, these companies used internally developed valuations and nonbinding broker quotes to override the third-party price, classifying those measurements as Level 3 in the fair value hierarchy.

We observed that most valuations that were based on broker quotes were classified as Level 3. However, some valuations were classified as Level 2 if the broker quote could be corroborated with observable market data. Consideration was given to whether the broker quote was executable (i.e., binding). Assets and liabilities based on executable broker quotes were generally included in Level 2. Those assets and liabilities typically included certain corporate bonds, credit default swap contracts, and debt securities, less liquid and restricted equity securities, forward contracts, and certain over-the-counter derivatives. Indicative broker quotes were generally classified as Level 3 unless they could be corroborated with market-observable data.

Companies that obtained appraisals on real estate assets classified those valuations as Level 3. While prices may be available for comparable properties that were sold around the measurement date, companies disclosed that significant unobservable inputs were used, including capitalization rates, conditions of sale, physical characteristics of the property, rental income, fees associated with rental income, expenses associated with the property (e.g., taxes, payroll, and insurance), and other items.

Quantitative Information About Inputs

Some companies disclosed that quantitative information was not readily available. These companies based their fair value measurements on either net asset values or third-party pricing information. ASC 820-10-50-2(bbb) states that entities are not required to create “quantitative unobservable inputs [that] are not developed by the reporting entity . . . (for example, when a reporting entity uses prices from prior transactions or third-party pricing information without adjustment).” This paragraph goes on to say that “when providing this disclosure, a reporting entity cannot ignore quantitative unobservable inputs that are significant to the fair value measurement and are reasonably available to the reporting entity.”

Out of the 30 companies we observed, 24 used third-party pricing services to determine the fair value of various classes of assets and liabilities. Of those 24 companies, 16 did not disclose quantitative information regarding the significant unobservable inputs used by the third-party pricing services.⁹

The remaining eight companies provided quantitative information about significant unobservable inputs used in the third-party prices. In certain cases, these entities disclosed the prices provided, though in others they disclosed a range of input amounts used by the third party. Some entities also disclosed the percentage of the fair value of a class of assets or liabilities that was determined by using third-party pricing (e.g., “non-binding broker quotations represent less than 0.6% of the total estimated fair value of fixed maturity securities”). In addition, companies that obtained more than one third-party price disclosed the use of the median or the average of the prices.

Narrative Description of Sensitivity to Changes in Unobservable Inputs

Under ASU 2011-04, reporting entities must now provide “a narrative description of the sensitivity of [recurring Level 3 fair value measurements] to changes in unobservable inputs if a change in those inputs to a different amount might result in a significantly higher or lower fair value measurement.”¹⁰

In addition, to the extent that there are interrelationships between those inputs and other unobservable inputs used in the fair value measurement, the ASU requires a reporting entity to describe those interrelationships and how they might magnify or mitigate the effect of changes in the unobservable inputs on a fair value measurement. At a minimum, the narrative description must include the unobservable inputs for which quantitative information is disclosed.¹¹

Many companies inserted a sentence or two — generally either after the disclosure of quantitative information for each significant unobservable input or as part of the disclosure of valuation techniques — that provided guidance on how a change to each significant unobservable input would affect the relevant fair value measurement. In several instances, the directional guidance was included in the tabular disclosure of quantitative information about unobservable inputs.

Valuation Processes for Level 3 Fair Value Measurements

For both recurring and nonrecurring Level 3 fair value measurements, ASU 2011-04 now requires reporting entities to provide a description of the valuation processes they used. This description may include, for example, how a reporting entity decides its valuation policies and procedures and analyzes changes in fair value measurements from period to period.¹² The Board decided to introduce this disclosure requirement because financial statement users believed that such information would be helpful to assessing the relative subjectivity of the reporting entity’s fair value measurements, particularly for those categorized in Level 3 of the fair value hierarchy.¹³

We observed a wide range in the level of detail for disclosures about the valuation processes for Level 3 fair value measurements. The level of detail ranged from a short paragraph covering all Level 3 measurements to several paragraphs covering valuation processes for each class of asset or liability separately. ASC 820-10-55-105 suggests items to include in a disclosure of the valuation processes for Level 3 measurements. We observed that only one entity from our sample disclosed all of them. Not all suggested items may be relevant. However, we noted that virtually all companies in our sample provided some of the suggested information.

The following table illustrates the percentage of companies in each sector that provided certain of the items suggested by ASC 820-10-55-105:

Level 3 Fair Value Processes by Sector

We observed that some companies did not disclose much information about their valuation processes, possibly because of a misunderstanding regarding the distinction between valuation processes and the long-standing requirement to disclose information about valuation techniques and inputs. While the latter focuses on the technique used to derive the fair value measurement (e.g., discounted cash flow approach), the former is meant to provide more detailed information about companies’ policies and procedures associated with the fair value measurements and methods they used to develop or test related information (e.g., third-party quotes or unobservable inputs used in a fair value measurement). See ASC 820-10-55-105 for more information.

Companies that employed third-party information to measure the fair value of assets or liabilities used varying levels of detail to describe their process for determining whether the information was developed in accordance with ASC 820.

Many companies asserted that prices are reviewed and approved by a valuation committee consisting of members of management who have relevant expertise and are independent of those charged with executing investment transactions. Those same companies disclosed that they assessed the observability of inputs used in fair value estimates received from third parties by determining whether the inputs could be corroborated by observable market data.

Examples of other common procedures performed by the companies in our sample included, but were not limited to, initial and ongoing review of third-party pricing methods, review of pricing statistics and current market trends, and back-testing of prior-period measurements.

Interaction Between Disclosure Requirements — Quantitative Information About Unobservable Inputs and the Fair Value Hierarchy

We observed that the majority of the companies in our sample used the same asset and liability classes in their quantitative information table as they used in their leveling tables. In eight cases, however, the companies had more disaggregated information in their quantitative inputs table than in their leveling table. In a few instances in which the classes were further disaggregated, the ranges disclosed for each significant unobservable input were narrower and, therefore, potentially more meaningful to users than disclosures that contained a more aggregated class for the asset or liability.

The chart below summarizes our observations regarding the classes used for the leveling disclosure compared with the classes used for the quantitative inputs disclosure.¹⁴

Disaggregation of Disclosures by Sector

Disclosures Related to Classes of Assets or Liabilities Not Measured at Fair Value in the Statement of Financial Position but for Which Fair Value Amounts Are Disclosed

Before the amendments in ASU 2011-04, ASC 820 required reporting entities to disclose the level of a fair value measurement in the fair value hierarchy only for items measured at fair value in the statement of financial position.¹⁵ ASU 2011-04 now requires reporting entities to also disclose the level for each class of assets and liabilities not measured at fair value in the statement of financial position but for which fair value is disclosed (e.g., loans measured at amortized cost).¹⁶ Entities are also required to disclose the valuation techniques and inputs used, although this was previously required for financial assets and liabilities under ASC 825. The Board added these disclosures to provide information about the relative subjectivity of the fair value measurements.¹⁷

The most common approach that the companies in our sample used to satisfy this new disclosure requirement was a table similar to the tables currently used for leveling disclosures. Companies generally presented this information separately from leveling information for items that are measured at fair value in the statement of financial position. Other times, the information was presented in a combined table but clearly labeled.

In addition, the levels assigned to various classes of assets and liabilities often differed. Two examples were loans and a company’s own debt.

Disclosures About the Level for Loans

The companies we observed generally categorized their loans in Levels 2 and 3 of the fair value hierarchy. The following chart summarizes our observations by sector regarding disclosures about the leveling of information for loans:

Leveling of Loans by Sector

The companies in our sample generally did not explain the reason that loans were classified in Level 2 versus Level 3 and vice versa beyond explaining that Level 3 loans used unobservable inputs. One insurance company included a small percentage of loans in Level 1, while no companies in the other three sectors disclosed any instances of loans categorized in Level 1. The asset management and real estate companies that did not provide leveling information for loans were not holding any loans.

Disclosure of the Level of a Company’s Own Debt

Regarding the leveling of a company’s own debt that was not measured at fair value in the statement of financial position but for which the fair value was disclosed, we observed that a company’s own debt was generally categorized in Level 2 or 3 of the fair value hierarchy. Entities generally decided whether to classify debt as Level 1, Level 2, or Level 3 on the basis of the frequency and volume of the debt instrument’s trading activity, the observability of significant inputs into the measurement, and the price range of the debt instrument available from third-party pricing vendors.

The following chart summarizes our observations by sector for the companies’ leveling of their own debt:

Level of a Company’s Own Debt by Sector

Debt categorized in Level 1 of the fair value hierarchy represented publicly traded debt.

Items for Which Carrying Value Approximates Fair Value

ASC 825 requires entities to provide the fair value disclosures for financial instruments even if the carrying amount of a financial instrument approximates fair value. We observed that the items for which carrying value approximates fair value differed from company to company. Some of the more common items included cash and cash equivalents, accounts receivable and payable,¹⁸ time deposits, short-term borrowings, and other short-term investments. Most of the companies that disclosed items for which carrying value approximates fair value disclosed the level of those items, while one asset management company, for example, did not provide a level for those items.

In addition, we observed that the levels disclosed for certain of those items differed from company to company. For example, most of the companies in our sample classified cash and cash equivalents in Level 1 of the fair value hierarchy. However, one banking and securities company classified them in Level 2, noting that its cash equivalents are generally valued by using observable inputs other than quoted prices. Further, some companies classified restricted cash as Level 1 while one banking and securities company classified it as Level 2.

Thinking Ahead

The adoption of ASU 2011-04 has led to a noticeable increase in the amount and type of information that financial services companies have disclosed about fair value measurements. Although there is some consistency in the industry regarding how the new disclosure requirements are being met, diversity remains. Financial services companies will most likely refine their disclosures to reduce the diversity in practice as well as to bring their disclosures further in line with the letter and intent of the new disclosure requirements. How regulators interpret the requirements will most likely play a significant role in any future refinements.

On the basis of our observations, companies should consider refining the following aspects of their fair value disclosures:

• The level of aggregation used to disclose quantitative information about significant unobservable inputs.
• Quantitative and qualitative disclosures about Level 3 fair value measurements, specifically those based on third-party pricing information.
• The sensitivity analysis of Level 3 fair value measurements, specifically the interrelationships among the unobservable inputs.

Appendix — Sample Disclosure: Quantitative Information About Significant Unobservable Inputs

The examples below contrast two different approaches for disclosing quantitative information about significant unobservable inputs.

Valuation Techniques and Inputs

This presentation may be confusing to financial statement users because it is not clear whether (1) two different techniques were used to measure different portions of the $25 million in residential mortgage-backed securities (RMBSs) held by the company or (2) both techniques were used to develop a range of estimates. An entity that develops a range of estimates must evaluate the reasonableness of the range and choose a point within the range that is most representative of fair value. If this is the case, other unobservable inputs might include (1) the weight applied to each technique or (2) a valuation adjustment.

In addition, when all RMBSs are aggregated into one class, users cannot understand how the nature and risks differ for assets within this class. If, for example, RMBSs backed by subprime mortgages are grouped with those that are guaranteed by U.S. government agencies, the information is less useful. Finally, a range of amounts used for each unobservable input, though helpful, may not tell the full story. Users might assume that there is more uncertainty in the inputs than actually exists. The example below addresses these concerns.

Alternative Presentation — Disaggregating Class and Inputs

This presentation alternative gives users more relevant information than in the previous example, enabling them to better understand and evaluate the techniques and inputs used. The benefits to this presentation alternative include:

• It is clear what technique was used to measure the fair value for respective portions of the company’s RMBSs.
• Disaggregating the asset class also gives users insight into the different assumptions used when risk and other characteristics differ.
• Disaggregating the discount rate into individually significant inputs also increases the transparency of the assumptions used by management and sources of potential uncertainty in the fair value measurement.
• Disclosing a weighted-average value for each input helps users understand the values used for a majority of the securities in a given class.

Regarding the second item above, an entity identifies the classes of assets and liabilities for both this quantitative disclosure about unobservable inputs and the hierarchy disclosure in accordance with ASC 820-10-50-2B. A best practice may include showing the same classes in both tables.

Contacts

If you have questions about this publication, please contact the following Deloitte industry professionals:

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1 FASB Accounting Standards Update No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, was issued in May 2011 and, for public companies, is effective for annual or interim periods beginning after December 15, 2011.

2 For titles of FASB Accounting Standards Codification (ASC) references, see Deloitte’s “Titles of Topics and Subtopics in the FASB Accounting Standards Codification.”

3 IFRS 13, Fair Value Measurement.

4 ASC 820-10-35-36B (added by ASU 2011-04) states, in part, “Premiums or discounts that reflect size as a characteristic of the reporting entity’s holding (specifically, a blockage factor that adjusts the quoted price of an asset or a liability because the market’s normal daily trading volume is not sufficient to absorb the quantity held by the entity . . . ) are not permitted.” Further, in the summary section of ASU 2011-04, the Board explains that adoption of the standard “might affect practice for reporting entities that apply a premium or discount when measuring the fair value of an asset or a liability if the reporting entity applies [ASC 820] on the basis of the quantity at which it might transact . . . for fair value measurements categorized within Level 2 or Level 3 of the fair value hierarchy.”

5 As explained in paragraphs BC21–BC23 of ASU 2011-04, the amendment to the definition of principal market was meant to “clarify that the principal market is the market for the asset or liability that has the greatest volume or level of activity for the asset or liability [not necessarily the reporting entity].” ASU 2011-04 amended the definition of “principal market” as follows: “The market with the greatest volume and level of activity for the asset or liability.”

6 See ASC 820-10-50-2(bbb).

7 An entity must use judgment in deciding what type of quantitative information to provide. ASC 820-10-55-103 states, in part, “A reporting entity might disclose [a range and weighted-average amount] . . . in accordance with 820-10-50-2(bbb)” (emphasis added). However, implementation guidance in ASC 820-10-55-104 states that “[i]n addition [to the quantitative disclosures about significant unobservable inputs and a description of valuation techniques and inputs exemplified in ASC 820-10-55-103], a reporting entity should provide additional information that will help users of its financial statements to evaluate the quantitative information disclosed” (emphasis added).

8 ASC 820-10-35-37A states, in part, “The fair value measurement is categorized in its entirety in the same level of the fair value hierarchy as the lowest level input that is significant to the entire measurement.”

9 Five of the 16 companies explicitly stated that they were availing themselves of the exception to the disclosure requirement.

10 See ASC 820-10-50-2(g).

11 See footnote 10.

12 See ASC 820-10-50-2(f) and ASC 820-10-55-105.

13 See paragraph BC91 of ASU 2011-04.

14 Observations were classified as “not applicable” if the observed company did not present a quantitative information table.

15 See ASC 820-10-5-2(b) before it was amended by ASU 2011-04.

16 See ASC 820-10-5-2(b) and ASC 820-10-50-2E.

17 See paragraph BC104 of ASU 2011-04.

18 ASC 825-10-50-14 contains an exception to ASC 825’s requirement to provide disclosures about the fair value of financial instruments for trade receivables and trade payables for which the carrying values approximate fair value.