Companies Laboring to Make Sense of New Fair-Value Rules

With the first-quarter close rapidly approaching, companies and their auditors are still trying to determine how they will comply with a new rule that adjusts the method for measuring fair value and requires significant new disclosures.

“Companies are still working with their auditors and trying to figure out what this really means and what it is going to look like,” says Manish Choudhary, principal in financial advisory services for Deloitte. “We are probably going to see wide differences in how companies and their auditors interpret these rules, and it will probably take a few periods of these disclosures before we start to see some consensus out there.”

The new rule is Accounting Standards Update No. 2011-04: Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS, adopted by the Financial Accounting Standards Board in May 2011 to take effect for calendar-year companies with the opening of the 2012 reporting year. That means companies are putting it into play for the first time in their first-quarter 2012 financial statements.

At the same time, the International Accounting Standards Board adopted IFRS 13, Fair Value Measurements; both standards were developed in tandem to create common methods under U.S. and international rules for measuring fair value. GAAP filers saw huge changes in fair-value measurement in 2008 when Financial Accounting Standard No. 157, Fair-Value Measurement, first took effect, requiring companies to consider value from the perspective of a hypothetical market participant and assign values according to a three-level hierarchy based on how readily a given asset or liability would trade in an open market.

IFRS filers are facing many of those requirements for the first time with IFRS 13, so the changes in the current standard are more substantial under IFRS, says Rich Stewart, a partner in the national accounting standards group at McGladrey & Pullen. “The changes for GAAP were intended to be primarily for convergence and clarification, but there were a couple of aspects that resulted in real change,” he says.

For example, the new GAAP standard does away with a method companies often used to value securities at “Level 2” and “Level 3” on the fair-value hierarchy. That's where values may be established based on a mixture of market information and management assumptions, or based entirely on assumptions and estimates.

Companies became accustomed to applying “block discounts” on groups of securities, or securities valued in a block, says Tina Catalina, director of the alternative investment group for audit firm Marcum. “Now the literature says you can't take block discounts on any securities,” she says. “At Level 1, it was always prohibited. Now at Level 2 and Level 3, you have to look at this differently.”

The changes may surprise some, since, GAAP filers generally didn't expect the standard to result in any significant changes to their valuation process, says Keith Peterka, a shareholder at Mayer Hoffman McCann and a member of the firm's professional standards group. “Now that they have to deal with it, they are finding out there are some significant changes,” he says.

“The changes for GAAP were intended to be primarily for convergence and clarification, but there were a couple of aspects that resulted in real change.”

—Rich Stewart,

Partner, National Accounting Standards Group,

McGladrey & Pullen

The removal of the blockage provision means companies will have to value securities individually instead of valuing a portfolio of securities as a single financial asset, says Rick Martin, vice president at Pluris Valuation Advisors. Some companies may be glad they no longer have to calculate a blockage discount to apply to a group of securities, while others may be disappointed to lose the discretion to value securities in a block or individually, he says. The standard does provide an exception, however, for derivatives under certain circumstances. The new approach probably will require more time and effort. “If you have to value individual securities, not groups of securities, that's more valuation work,” he says.

The standard also makes a change to the use of the “highest and best use” concept in valuation, which sets value based on the use of a particular asset that produces the greatest economic benefit to the owner of the asset. Earlier fair-value measurement rules generally supported the highest and best use concept, says Deloitte's Choudhary, but the new standard says that premise doesn't hold up when valuing certain financial assets. “I'm seeing a lot of consultation between firms, and between companies and their auditors about what this means,” he says. “There's still a lot of confusion.”

PLURIS GUIDANCE

The following guidance from Pluris explains the “blockage factor” revision in FASB's new fair-value accounting rules:

Blockage Factor

Under the ASU, companies may no longer apply a blockage factor to any fair value measurement. Blockage factors were never allowed for Level 1 fair value measurements, but they could be considered for Level 2 and Level 3 measurements. This will represent a big change for some companies, such as investment and private equity firms with non-controlling blocks of equities.

In cases where the bid-ask spread is used to price a security, the price within the spread that is considered most representative of fair value should be used. Selecting a price within the bid-ask spread that is meant to reflect an adjustment for the size of the holding is not allowed under the ASU, nor is taking the view that the bid-ask spread is wider for larger positions.

Companies may now face immediate recognition of a gain if a block of securities was purchased at a discount and the company is unable to apply a blockage factor. Realizing that gain would depend on whether the company sells the securities at a discount in the future.

Source: Pluris.

It amounts to the “removal of crutches,” says David Larsen, managing director at financial advisory firm Duff & Phelps. The new guidance leaves preparers and auditors to rely on a “unit of account” to value certain assets, although there's some confusion over what “unit of account” guidance to rely on to comply, he says. “They removed those crutches, and so now we have to stand on wobbly legs as far as the unit-of-account guidance is concerned,” he says. Some of the deepest thinkers on valuation issues are pondering how best to address this particular aspect of the standard, Larsen says. In the meantime, “it has the potential to result in some different outcomes depending on interpretation,” he says.

Perhaps most significantly, the standard calls for extensive new disclosures, says Stewart. “We expect the disclosures will take up a significant amount of time and resources to comply with this, so we don't want people to fall asleep on those,” he says. For all assets measured at Level 3, the standard requires quantitative disclosure about the significant inputs that were used in the calculation but are not visible to a reader of the financial statements. It also requires companies to explain the valuation process they used to arrive at those Level 3 measurements and to discuss the sensitivity of the various unobservable inputs.

“It sounds a little esoteric,” Larsen says. “And it is. The requirements are fairly principles-based with no clear-cut guidance on how to answer the expanded disclosure requirements.” As an example, he says, an entity valuing residential mortgage-backed securities should probably plan to address various expectations around term and default, but to what extent? “That's where most are struggling now,” he says. “You can't go anywhere and see how someone else does this. It's new for everybody.”