Where companies are required to measure assets and liabilities at fair value, they’ll have some new disclosures to provide regarding changes in how they measure those values.

The Financial Accounting Standards Board has finalized Accounting Standards Update No. 2010-06 to amend Accounting Standards Codification Topic 820 in a way that elicits new disclosures about how fair value is measured and synchronizes the disclosure requirements with international rules. It takes effect for the 2010 reporting year for calendar-year companies.

The new rule requires companies to disclose where they transfer items in and out of “Level 1” and “Level 2” measurement methods under the three-level hierarchy for measuring fair value. Level 1 measurements rely solely on objective market evidence of fair value, while Level 2 measurements are based on a mixture of market evidence and internally development assumptions or estimates.

The new rules also require companies to describe activity that takes place in Level 3 measurements, where fair values are established based solely on models and other internal estimates and assumptions. For instruments measured at Level 3, companies will be required to present separate information, not final net numbers, on purchases, sales, issuances, and settlements.

David Larsen, managing director for Duff & Phelps, said the update clarifies that fair-value measurements for major classes of assets and liabilities should be disclosed separately. It also clarifies the required disclosure of the techniques and inputs companies use to estimate fair value, he said.

“The update will require some additional effort by companies to prepare,” said Larsen. “However, all required data should be readily available.”

The final rule does not include any new requirements for a “sensitivity analysis,” said Larsen, or disclosure of the impacts if the company were to use other possible alternative inputs. FASB proposed some requirements around sensitivity analysis but dropped the requirement from the final guidance.

Larsen said FASB and the International Accounting Standards Board are working jointly on how to harmonize fair-value requirements, including whether and how to require some kind of sensitivity analysis.

When companies are testing for possible impairment of goodwill in a seemingly troubled reporting entity, the staff of the Securities and Exchange Commission has signaled it won’t be fooled by attempts to spin negative equity into a rationalization that an impairment doesn’t exist.

Evan Sussholz, professional accounting fellow for the SEC, said at the recent national conference of the American Institute of Certified Public Accountants that the staff has heard a number of questions about which valuation approach is required by Accounting Standards Codification Topic 350 Intangibles.

The rules map out a two-step test for determining whether goodwill might be impaired, or whether it may have lost some value since it was last determined and booked. The purpose of the first step, said Sussholz, is to identify potential impairment by comparing the fair value of a reporting unit to its carrying amount, including goodwill.

Fair value, according to accounting rules, is the price that would be received to sell the reporting unit as a whole, but the standard doesn’t specify whether entities should begin the analysis with “enterprise value” or “equity value.” Enterprise value is commonly defined as the sum of the fair value of debt and equity, whereas equity value refers to the sum of all ownership interests in the company, such as through stock, stock options, and other securities convertible to equity.

Sussholz said the SEC staff generally doesn’t expect the selection of the equity or enterprise value will impact the outcome of the goodwill impairment test, but it could be important if debt surpasses equity. He points out that the fair value of a reporting unit cannot be less than zero.

“In a circumstance when the carrying value of equity is negative, a reporting unit would seemingly always ‘pass’ a step-one goodwill impairment test performed on an equity basis, despite the fact that significant goodwill may exist and the underlying operations of that entity may be deteriorating,” he said. “In this example, a step-one test performed on an enterprise basis would likely provide a better indication of whether a potential impairment of goodwill exists and a step-two test should be performed.”

The second step of the impairment test requires companies to measure all assets and liabilities within the reporting unit at fair value to determine exactly what the impairment is—a significant undertaking that companies generally would prefer to avoid. But they shouldn’t try to avoid it by trying to work with a negative equity value, said Sussholz.

“In absence of further authoritative guidance, the SEC staff believes that a reporting entity may want to consider whether utilizing an alternative approach to a step-one test such as enterprise value would be a better economic indicator of goodwill impairment,” he said. The analysis should look at market participant assumptions, the potential structure of a hypothetical sale transaction, and other factors, he said.

A frustrated accounting standard setter told an audience full of accountants that someone needs to pry the gorilla of banking regulators off his back.

Robert Herz, chairman of the Financial Accounting Standards Board, made perhaps his most detailed and impassioned plea yet that the regulation of financial institutions needs to be “decoupled” from U.S. Generally Accepted Accounting Principles that are meant to serve investors’ needs. He all but pleaded with those attending the American Institute of Certified Public Accountants conference on current financial reporting issues to help him spread the religion that investors need different information than banking regulators do.

Accounting standards have been under threat throughout the economic crisis as banks and their regulators have pushed FASB and even Congress for changes that would minimize the reporting of losses arising from failed loans. “It should be made clear that the results of GAAP financial statements do not dictate regulatory requirements,” Herz said. “Rather, they are but one source of data to inform the prudential judgments made by regulators.”

He didn’t directly call on Congress to wrestle the beast, but he noted that it was an act of Congress in the wake of the savings and loan crisis of the 1980s that required bank regulators to begin their determination of capital requirements with GAAP numbers. He bristled at suggestions from Congress that accounting principles shouldn’t be so protected that their impact on public policy should be ignored. “Accounting standards also should not be so malleable that they fail to meet their objective of helping to properly inform investors and markets or that they should be purposefully designed to try to dampen business, market, and economic cycles,” he said.

Drawing greater distinction between investors’ needs and safety-and-soundness needs “could enhance the ability of both FASB and the regulators to fulfill our critical mandates,” Herz said. “We can continue to work with independence and an unwavering dedication to market transparency; at the same time the bank regulators can utilize their authority to take whatever actions are required to keep the financial system stable and healthy.

More recently, FASB has drawn bankers’ ire for suggesting banks should use more fair value to report the value of financial instruments carried on the balance sheet, despite banks’ demands for relief from fair-value requirements. In FASB’s defense, Herz cited a 1991 report from the General Accountability Office that said “the key to successful bank regulation is knowing what banks are really worth.”

by Melissa Klein Aguilar

U.S. and international accounting standard setters are still hashing out their differences with hopes of reaching a converged standard on accounting for financial instruments, according to officials speaking at a financial reporting conference this week.

While their current approaches differ markedly, with the United States supporting more use of fair value, leaders of the Financial Accounting Standards Board and the International Accounting Standards Board said they’re continuing to work toward a converged answer.

“We’re going to expose our views, and hopefully … reconcile those differences to arrive at a comparable solution,” Russell Golden, FASB Technical Director, said during a panel discussion at a conference sponsored by Financial Executives International. “What that might mean is that both numbers—both costs and fair value—are relevant and both may be presented on statement of performance as well as the statement of financial position, or maybe that a comparable solution will be arrived at though disclosure.”

IASB released its revised financial instruments standard, IFRS 9, last week, notably without the endorsement of the European Commission.

“In some respects I consider that a silver lining in that it will allow us to work closely with FASB and finish this time next year with a standard that’s more likely to be … more converged,” IASB member Patrick Finnegan told reporters during a press Q&A.

Finnegan said the EC’s concern relates to the classification conditions in the standard for determining whether an instrument is eligible for using fair value or amortized cost.

“That’s something they want the board to continue focusing on,” he said. “They also want to have the benefit of seeing the three phrases of the project finished and evaluate the standards as a package.”
During the panel discussion, Finnegan said based on what he heard while gathering feedback on IFRS 9, “It’s clear to me from talking to people … in Asia and Europe that they want see a single standard … the same words with respect to accounting for financial instruments, particularly as it applies to banks. “

Asked later about the likelihood of a converged answer, FASB Chairman Robert Herz told reporters, “I’ve found that in standard setting, you never know where you’re going until you completely get there and go through the process.”

Finnegan said he’s supportive of having both fair value and amortized costs presented on the balance sheet.

“It’s my personal view that one measurement attribute can’t have primacy over the other in terms of information that’s provided to users,” he said. “If you’re going to measure financial instruments using amortized costs, other users may feel fair value is more decision-useful. That should be made available to them and it shouldn’t be somewhere where they have to go hunt for it.”

Finnegan said he’s “optimistic that will be an element of the converged solution.”

“I don’t think ultimately it’s a very challenging thing to implement,” he said. However, he said an objection he’s heard to the idea heard is “a belief that by displaying fair value prominently, you create unnecessary volatility.”

However, he refuted that objection, saying, “That’s the reality. Financial instruments fluctuate … and to hide that information isn’t serving anybody’s needs.”

The two boards published an updated version of their Memorandum of Understanding this month in response to calls from the G-20 to redouble their convergence efforts. Under the agreement, Golden noted that the two boards have agreed to meet monthly.

It was “inefficient” for both boards to meet separately and conclude and then reconcile their differences, he said. Particularly on controversial issues, he said the boards will meet face-to-face so their respective members can understand what each board is thinking.

“In times past, one board has leap frogged the other,” he said. “We agreed that the leading board will reconsider its conclusions as the lagging board gets up to speed.”

U.S. and international accounting rule makers spent three days this week making progress on a number of outstanding projects on the road to a unified accounting rule book, most notably trying to iron out their different ideas about how to improve accounting for financial instruments.

The economic meltdown exposed big problems in U.S. and international requirements for how fair value is measured and applied to complex financial instruments. It also spotlighted where there are differences between the two approaches and punctuated the need for a more consistent approach to assure comparability of entities around the globe.

The two boards are working on new standards for International Financial Reporting Standards and U.S. Generally Accepted Accounting Principles that would dramatically alter how financial instruments are accounted for currently. Most notably, both boards want to require much more use of fair value, though they’re not entirely in agreement on just how much and how values should be presented in financial statements.

In a series of joint meetings, the boards agreed on a set of core principles for how to end up with a converged standard. According to a Deloitte account of the discussion, the boards agreed that the new requirements should enhance comparability, provide transparency to risk and strategy, and give prominent and timely fair-value information for instruments that have highly variable cash flows or are held for trading.

The boards also agreed amortized cost and fair value, rather than settlement with a third party, is relevant for instruments where principal amounts are held for collection or payment, though board members had concern about how an entity’s own credit worthiness affects fair value of liabilities. They agreed they want a consistent impairment approach for financial assets held for collection of contractual cash flows.

Currently, FASB is considering an impairment model that IASB hasn’t fully endorsed. The boards are forming an expert advisory panel to consider the operational aspects of what FASB has developed to help both boards sort through the ultimate solution.

The boards also compared notes on how to measure fair value, where FASB has had a standard in place since 2007, now contained in the Accounting Standards Codification under Topic 820, and IASB is still working on an exposure draft. The boards agreed they want to end up with a converged standard, but IASB has expressed reservations about FASB’s approach.

FASB has stood its ground on its definition of fair value and its approach to measuring it, but the board told IASB it will take a look at comments IASB has received on its exposure draft and consider whether U.S. GAAP should be changed as a result.

In other business, the boards picked away at ongoing projects to revise rules on revenue recognition, discontinued operations, financial statement presentation, insurance, leases, income taxes, and financial instruments with characteristics of equity.

The Financial Accounting Standards Board has finalized new guidance that provides a practical solution to measuring the fair value of certain alternative investments.

FASB’s Accounting Standards Update 2009-12 amends ASC 820-10 Fair Value Measurements and Disclosures to clear up uncertainty about how to measure fair value of investments in certain entities that calculate net asset value per share. The guidance is intended to shore up diversity in how investors estimate the fair value of alternative investments such as hedge funds, private equity and venture capital funds, real estate funds, offshore fund vehicles, and funds of funds.

According to FASB, many investors in such complex funds often rely on net asset values per share provided to them by the fund managers as indicators of current fair value. Others, however, believe net asset values should be further adjusted to account for attributes such as restrictions on redemption or transaction prices based on broker arrangements.

FASB determined in some cases it made sense to allow the net asset value to equal the fair value for financial reporting purposes, assuming certain conditions apply. The accounting standards update provides guidance on those conditions. It also maps out some disclosure requirements addressing, for example, redemption restrictions and any unfunded commitments an investor may have in the investment. The disclosure requirements apply to all investments within the scope of the guidance, whether the entity uses the net-asset-value measurement approach or not.

While the guidance provides the practical expedient of allowing net asset value to equal fair value, it specifically prohibits the practice when an entity deems it “probable” that the investment will be sold at a price other than net asset value. A recent alert from Deloitte & Touche notes the criteria are similar to those used to determine when a long-lived asset must be classified as held for sale.

The American Bankers Association is appealing to the U.S. Treasury and the Federal Reserve to stoke the fire over accounting issues at the upcoming G-20 meeting in Pittsburgh Sept. 24-25, especially regarding proposals to require more use of fair value on bank balance sheets.

Edward Yingling, ABA president and CEO, sent a 41-page packet to Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke pointing out how the International Accounting Standards Board and the Financial Accounting Standards Board are developing different proposals for requiring more use of fair value for measuring financial instruments. Yingling says the proposals are not consistent with G-20 recommendations and are not consistent with the overarching objective to converge U.S. and international accounting rules.

The IASB is developing a plan to require all financial instruments to be reported at either fair value or amortized cost, depending on complex criteria for what should get recognized how. The IASB has already published an exposure draft and hopes to finalize its rule in time for option year-end adoption. The FASB’s tentative plan also includes a mixture of fair value and amortized cost with changes flowing to net income or other comprehensive income, but with OCI more prominently displayed.

The ABA says both proposals will cause accounting to become more procyclical after the G-20 recommended standard setters work toward accounting rules that are less procyclical. Yingling also says the proposals undermine the relevance of the business model typically followed by banks, which will make it harder for investors and regulators to understand the banking business.

If rules move in the direction IASB and FASB propose, the result will be reduced lending, changes in the types of products available to customers, increases in the cost of capital to the banking system and increases in the cost of credit to borrowers, Yingling says. “These results would contradict the overall G-20 program, which focuses on stabilizing, rather than dramatically changing, the traditional business of banking,” Yingling wrote.

Now that users of financial statements have had a chance to study fair value measurements under the still relatively new three-level hierarchy, they’re looking for more disclosures.

The Financial Accounting Standards Board is proposing an Accounting Standards Update to the disclosures around fair value measurements to give greater insight into the sensitivity of various assumptions that go into model-based measurements. They’re also looking for more information about movement of instruments among the three levels and more gross information about purchases, sales, issuances and settlements for instruments that are measured using models.

FASB said the proposed update to accounting standards would improve on the requirements of ASC 820-10, which became effective in early 2008 as Financial Accounting Standard No. 157: Fair Value Measurements. FAS 157 defined fair value as a market-based method of measuring value based ideally on market prices for the same or similar assets and liabilities. Instruments measured at Level 1 are indexed to current market prices while Level 2 measurements represent a mix of market prices and management assumptions. Those measured at Level 3 can rely solely on assumptions and pricing models.

Inspired by users of financial statements, the disclosures would flesh out more information about instruments measured at Level 3 of the fair value hierarchy, where entities rely almost entirely on unobservable information or internal modeling to establish values, FASB said. The proposal also would require entities to provide more segregated information for different classes of assets and liabilities that are determined according to their nature and risk characteristics, as well as their placement in the hierarchy.

In its proposal, FASB says it believes users will benefit by getting information that amounts to a range of fair value if an entity were to use reasonably possible alternatives for model-based measurements and transfer instruments among the three levels of the hierarchy. The proposal is open to comment through Oct. 12. The board expects to finalize the requirements in time for it to be effective for interim and annual periods ending after Dec. 15, except for the sensitivity disclosures, which would be effective the following quarter.

Another fair-value showdown is taking shape, this time over whether fair value should reach even further than it currently does into balance sheets. But don’t expect the shootout to begin anytime soon.

The Financial Accounting Standards Board met this week to pick away at its comprehensive plan to change the way financial instruments are recognized and measured in financial statements. Most notably, the board has said it wants to move toward requiring all financial assets and liabilities, except an entity’s own debt in some instances, to be measured and recognized at fair value. The International Accounting Standards Board is following a similar course.

The mere suggestion has sent financial institutions scurrying to protest. The American Bankers’ Association sent FASB an 18-page letter and white paper describing how the board should take the banking business into account as it writes accounting standards. The banking group is taken aback that FASB is even considering such an idea.

“During the current economic crisis, preparers of financial statements, external auditors, regulators, and others have agreed that ‘mark to market’ accounting (MTM) estimates have lacked a sufficient level of reliability,” wrote Donna Fisher, senior vice president for the ABA. “With this experience, it is surprising that IASB and FASB would both establish new accounting models that expand the use and prominence of MTM rather than either reduce it or at least maintain the current level.”

Before the board even launched into discussions this week, FASB Chairman Robert Herz reiterated that the board is in the early stages of the project. He expects the board to issue a proposal late this year or early next year with a final rule taking effect no earlier than 2011. “I want to make these points clear again because we’ve been getting some calls from people who actually believe today was going to be the final meeting before issuing an exposure draft,” he said. “We’ve got lots more meetings to occur … a lot more work to do.”

The board tentatively decided that the balance sheet should reflect not only financial instruments whose changes in fair value are recognized in other comprehensive income, but also those that are reflected in net income. Nothing would prohibit an entity from reflecting amortized or historical cost if it chose to present that information as well. Where an entity would elect to present its own debt at amortized cost, the income statement should reflect interest accruals and any realized gains or losses, FASB has determined.

A recent survey provides more evidence that market turmoil has given fair-value accounting a big reputation problem to overcome.

It’s not just that fair value is harder to establish when folks aren’t buying, according to Valuation Research Corp., which conducted the poll of financial professionals. Some 58 percent of respondents say fair values are flawed and invalid when no one’s buying. Of those, 34 percent say it might be a good idea to revert to historical cost accounting as an alternative.

As the economic crisis reached fever pitch, banks in particular bemoaned fair-value requirements, saying depressed current prices didn’t reflect long-term plans to hold assets that no one was buying immediately. Investors and analysts, however, generally say fair value provides the most relevant, current insight into an entity’s financial state at a given point in time, which facilitates investment decision making.

“When you’re relying on the market, but the market may not be so reliable, it’s hard to show the impact of that in the financial statements or to do impairments studies based on market-based input,” said P.J. Patel, senior vice president of VRC.

The survey results suggest finance professionals are circumspect about the capability of publicly traded banks to reasonably estimate values for their own hard-to-value financial assets, such as those that are not publicly traded and don’t have easily accessible values. Some 44 percent believed the bank values were within an accuracy of 10 percent while another 40 percent thought values were as much as 30 percent off base.

Hedge fund and private equity valuations for hard-to-value assets were even further off, respondents said; 36 percent believed they were accurate within 10 percent and 49 percent said they were up to 30 percent off the mark.

Nearly one-third of respondents said they revised their projections based on interaction with external auditors, changing purchase allocation projections, revising goodwill impairment projections or revising fair-value estimates.

Patel said the raging debate over fair value through market chaos serves as a reminder of how market pricing works. “The market may not be correct on any given day, but over the long run it does tend to be correct,” he said. “In short-term periods, you can have extreme levels of volatility. In the short run the market may not be the best indicator of value.”