Ready or Not, Fair Value Arrives

They might face uncertainty, awkward disclosure, and mountains of data scattered among many systems, but companies are trudging forward to implement the first modern accounting standard that rests on principles rather than rules: fair value measurement.

Financial Accounting Standard No. 157, Fair Value Measurement, took effect for calendar-year companies with the start of the 2008 fiscal year. That means disclosure of how the standard will affect them is only a few months away, when first-quarter reports start to be filed.

Even as FAS 157 settles into place, movements are afoot to have it delayed another year while companies and countless external advisers—valuation and systems specialists, and of course auditors—debate the details. They wrestle with how to define a “market participant,” a “principal market,” and “highest” or “best” use of an asset, along with numerous other concepts that are established in the standard but include no bright-line tests and boundaries.

The Financial Accounting Standards Board has indicated it will delay FAS 157’s effective date for non-recurring, non-financial assets and liabilities while its Valuation Resource Group tries to help the market establish some common understanding of the core concepts. Many see that as at least some relief, but others still hope that the public comment period on that partial delay will ultimately lead to a full delay of the whole thing.

Hart

“I know there’s discussion that some firms will be taking the position, ‘We do not believe a partial deferral is appropriate,’” says Jolene Hart of the auditing firm McGladrey & Pullen. “There is still a call for a full deferral. Institutions and companies just are not ready. They’ve significantly underestimated the impact FAS 157 will have on their financial statements.”

That doesn’t necessarily mean companies are shirking implementation while they wait for a deferral. At General Electric, for example, David Alexander, global controller for GE’s Center of Excellence, says the partial deferral will ease FAS 157’s compliance burden, but implementation proceeds for “thousands” of asset and liabilities nonetheless.

“From the technical side, we’re working vigorously with our audit firm in understanding the standard and in understanding the guidance … to understand what our methodologies and enhancements will be,” Alexander says. “We’ve been working on this upwards of a year, making sure we’re on the same page as firms are developing their views.”

Alexander says GE and other companies closely watch the work of FASB’s Valuation Resource Group, looking for consensus or guidance on some of the more perplexing aspects of FAS 157. “It’s good it was established to help provide guidance, but it would be nice if they met more frequently and if preparers had a say in what’s on the agenda,” he says. “It would help if something were effectively published instead of letting information flow through the national offices” of the leading accounting firms.

Some views are starting to crystallize, Alexander says, but others still differ. Example: “We’re seeing a more rational approach in terms of how much scouring you have to do to find a market participant if one isn’t readily apparent,” he says.

Considerable discussion centers on how to value a portfolio of loans when they are packed and sold as a securitized asset—principally, whether it should be valued as a single package or as a series of individual assets. “Whether there’s truly a difference when you boil it down is up for some debate,” Alexander says. GE hasn’t formulated a firm view on how it will value such assets, he says, adding, “We don’t have much time to figure this out.”

Taking It to the Next Level

Wright

Chris Wright, managing director for consulting firm Protiviti, says prepared companies are following a logical process of inventorying assets and liabilities to determine which are subject now to FAS 157 and are then deciding how their fair value should be measured under the new rules.

FAS 157 establishes three hierarchies for measuring fair value, beginning at “Level 1” with observable market data as the preferred approach and proceeding to “Level 3,” where entity-specific, unobservable data can be used as a last resort when market data is not available.

ALERT EXCERPT

Below is an excerpt of a recent PCAOB audit practice alert on auditing fair value measurements, which outlines the three levels that should be used to determine the fair value of an asset.

Under FAS 157, a company must determine the appropriate level in the fair value hierarchy for each fair value measurement. The fair value hierarchy in FAS 157 prioritizes the inputs, which refer broadly to assumptions market participants would use in pricing an asset or liability, into three levels. It gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The level in the fair value hierarchy within which a fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety.

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

Level 2 inputs are inputs other than quoted prices within Level 1 that are observable for the asset or liability, either directly or indirectly. A significant adjustment to a Level 2 input could result in the Level 2 measurement becoming a Level 3 measurement.

Level 3 inputs are unobservable inputs for the asset or liability.

Because there are different consequences associated with each of the three levels of the hierarchy, the auditor should be alert for circumstances in which the company may have an incentive to inappropriately classify fair value measurements within the hierarchy. For example, an asset or liability with Level 1 inputs generally must be measured using unadjusted quoted prices in an active market, while an asset or liability with Level 2 inputs is measured using observable market inputs other than quoted prices included in Level 1. Accordingly, a Level 2 measurement might allow for more discretion or judgment on the part of management than a Level 1 measurement. As another example, the required disclosures associated with Level 3 measurements are more extensive than those associated with Level 1 and Level 2 measurements.

Source

PCAOB (Dec. 10, 2007).

Wright says many companies will have to rely on outside expertise to comply with FAS 157, especially for the more complex valuations in Levels 2 and 3. “It’s going to be a good time to be in the valuation business in 2008 and 2009,” he quips. Many companies are now deep into preparing their first-quarter disclosures under FAS 157, where they must describe the expected effect of adopting the new standard.

Nicholas

Stamos Nicholas, a valuation specialist for Deloitte Financial Advisory Services, says the Level 3 process can flummox companies for several reasons. Not only are the valuations more complicated when using a company’s own data, he says, but disclosing that internally generated data isn’t something companies are eager to do. “Management is interested in that, even anxious about it,” he says. “They’re concerned about giving out confidential information.”

For example, Nicholas says, companies may decide to use a discounted cash methodology for valuing a particular asset, but that forces the company to disclose the discount rate it uses. “That’s something competitors would love to know,” he says.

Hart says a Level 3 valuation might lead to the disclosure of strategic information in a business combination, for example. “You may bid more for a business than someone else because of something you know that someone else doesn’t, and that may affect the valuation,” she explains. “You’re going to have to give away some competitive advantages because you’re disclosing these assumptions.”

Another challenge for Level 3 valuations is producing the roll-forwards required in FAS 157, says Lisa Filomia-Aktas of Ernst & Young. FAS 157 specifies that for Level 3 valuations during a given period, companies must reconcile the beginning and ending balances, showing total gains or losses (both realized and unrealized) through earnings and other comprehensive income, as well as purchases, issuances, settlements, and transfers into or out of Level 3.

Filomia-Aktas

Filomia-Aktas says there are diverse views on how to define a number of the components required in the roll-forward. For example, she says, companies and advisers are working through how to reflect the total gain or loss that’s unrealized in a given period, and how to define what belongs in a beginning or ending balance based on when a particular asset moves in or out of Level 3 analysis.

Then comes the tedious process of gathering the data necessary to produce the roll-forward, since it may be contained in numerous systems across multiple business units. For companies further along in that process, efforts are already underway to develop tools to automate data collection, she said.

At GE, the roll-forward is a time-consuming process, Alexander says. “Our systems don’t necessarily have that information ready at hand,” he explains. “It involves going through and extracting that information. And that’s exacerbated by having numerous platforms across numerous businesses.”

Despite the uncertainty and complexity, Alexander says, implementation proceeds. “We feel pretty good about where we’re at,” he says. “Like for everyone, it’s challenging, and there are always competing priorities. But we’ll get there.”