Experts call for expanded disclosure requirements
With the financial markets in free fall and the powers in Washington bickering over which companies deserve taxpayer-funded assistance, the topic of valuation is taking center stage. It is tempting to suggest that many assets traded on various platforms have no value, but this would be a great simplification. It’s a crucial area to concentrate on when the way instruments are valued goes to the heart of the problems we are experiencing at the moment.
The fair value accounting rule, FAS 157, requires assets to be valued at the current market value. Although there is significant scope for different interpretations when applying the rule, this may be about to change. In October the Financial Accounting Standards Board (FASB) and the SEC issued guidance on how FAS 157 should be applied.
Many opponents of the rule – mostly investment banks and financial services firms – suggest that fair value has been partly responsible for the current financial crisis and is making matters worse. Why? Because institutions are being forced to write down billions of dollars from balance sheets. This is, of course, not true. The cause of the crisis is toxic assets that have no true value (regardless of how they are evaluated) and poor or non-existent risk analysis at investment firms.
Nonetheless, FAS 157 continues to attract attention and companies are pressing regulators for more clarity on how the rule should be applied. One of the major problems is that FASB guidance is in several important ways contradictory to that of the SEC.
Making matters worse
Guidance has taken several forms, confusing the situation. In September the SEC and FASB issued joint guidance releases. Then in early October both regulators issued separate guidance. While officially the SEC says it has no plans to issue yet another ream of guidance, an SEC spokesman says the Commission will come out with fresh staff comments before the end of the year. If this is not done in tandem with FASB then it is likely to confuse matters further.
Other business groups including the American Insurance Association and the Mortgage Bankers Association have sent their own letters asking the SEC to clarify its position. In a submission dated October 23, the group of banking and insurance lobbyists stated, ‘We do not believe that management, preparers, auditors and investors understand what is expected of them, or whether and how the needed judgments can be exercised. … We believe that judgment is needed to provide the fairest and most accurate disclosures possible in inactive markets.’
So why is any of this important? It would appear at first glance that the fair value rule only significantly impacts investment banks and other Wall Street firms that trade various financial instruments. But other corporations should keep an eye on what is happening. There is a real possibility that interpretations applying specifically to FAS 157 could influence other guidance released by the SEC.
For example, the SEC has mandated that fair value, and the impact it may have on the balance sheet of a company, be included in the management discussion and analysis section of the 10K. See ‘MD&A disclosure’, above.
Tell us more
For its part, FASB is being more open about its intention to issue further comment, revealing that it is working on adding disclosure requirements for fair value accounting.
Thomas Linsmeier, a FASB board member, explained at an SEC roundtable in November that adding disclosure requirements is ‘on the radar screen for us,’ noting that it’s been put on the FASB agenda. But he did not say when this expanded requirement might take effect.
The call for greater clarity was welcomed by most attendees at the roundtable, though not everyone agreed about what form this expanded disclosure should take. One suggestion that inspired some debate was the idea that companies disclose which internal valuation models they are using to price assets and how these models may or may not be affected by fair value measurements.
Cindy Ma, managing director in the financial opinions and advisory services group at Houlihan Lokey in New York, highlighted that most firms use their own valuation models and it would be of great benefit if they would disclose (either voluntarily or by regulatory mandate) more details on the specific inputs used in their selected valuation models.
Investors need to be able to understand the assumptions companies are using when valuing assets if they are going to be able to make a properly informed decision, suggested Patrick Finnegan, director of the financial reporting policy group at CFA Institute. Effective and complete disclosure goes beyond ‘this is what we say the value of our assets is’ to what models and assumptions are being used and how they are impacted by various market forces.
For now, the lack of clarity surrounding FAS 157 remains. Taking cues from SEC and FASB statements, it looks as though new guidance, and perhaps a new rule altogether, may not be too far away.
