Fair Value Today: Just Document Everything

Following a flurry of confusion and demands for guidance on how to measure fair value in the midst of economic chaos, the accounting practice is settling on the immediate solution: document everything.

Valuation and financial reporting experts say the current approach is simply to bury auditors in documentation to validate the many assumptions and conclusions accounting departments are using to form the basis of fair-value measurements.

Evola

“We are seeing companies spending a lot of time on documentation,” says Ken Evola, managing director for Huron Consulting Group. “Folks are reconfirming that what we have in fact reflects an exit price. The time it takes to do this analysis is significant for companies.”

Yes, experts say, that fair-value assessment will get easier as the market stabilizes and companies and their auditors gain more experience in the new ways of fair-value measurement. Until then, however, documentation is the antidote.

“The burden of justification is on the companies,” says Chris Wright, managing director at consulting firm Protiviti. “There’s a bit of tension, but it’s not inordinate, between companies and their auditors as they try to find common ground … We will see it evolve, but that’s largely dependent on what the market does. If the market stabilizes, then the conclusions and the processes arising from the conclusions should stabilize.”

Wright

Measuring financial assets and liabilities at fair value took a dramatic turn in 2008 as two different but related events collided. The housing and credit crisis caused markets for structured financial instruments first to plunge, and then freeze up entirely. At the same time, Financial Accounting Standard No. 157, Fair Value Measurement, took effect, telling companies to pay closer attention to market prices when establishing fair value.

The banking sector, sagging under the weight of toxic assets with massive spreads between bid and ask prices, demanded relief from FAS 157’s requirements. Auditors, they said, were clinging to transaction prices as indicators of value, even when markets ground to a halt and transactions practically ceased to exist.

Congress then played hardball with the Financial Accounting Standards Board, telling it to relax FAS 157 or Congress would do the job itself. Ultimately, FASB published new guidance in April that helped settle debates over when inactive markets should not be relied upon as sole indicators of fair value. FASB also permitted a workaround where banks could show most of their fair-value losses through equity rather than through earnings, which helped prop up bank capital.

Carol Stacey, vice president at the SEC Institute and a former chief accountant at the Securities and Exchange Commission, says the new FASB guidance ultimately does not change the substance of measuring fair value. It does, however, prod both preparers and their auditors to use more judgment. “It probably helped for companies to see it in writing and to take it to their auditors,” she says. But in terms of changing the rules around how to measure fair value, “I don’t think it moved the ball much.”

The Controllers Leadership Roundtable studied a random sample of 100 companies’ 10-K and 10-Q reports before and after the FASB guidance, to see how the new guidance might have changed reporting. It examined where companies value items on the three-tier hierarchy of measuring fair value. (Level 1 relies on market prices, Level 2 on a combination of market prices and other inputs, and Level 3 wholly on inputs other than market price.)

The study concluded that FASB’s call for more judgment didn’t have a meaningful impact on whether companies moved the valuation of particular assets or liabilities to different levels in the hierarchy. That led the Roundtable to conclude that the new guidance didn’t have a significant effect on the valuation process itself, except to end stalemates where companies wanted to move away from market prices and auditors resisted.

“It means the guidance wasn’t trying to fundamentally change how fair value is happening,” says Joey Borson, senior analyst with the Roundtable. “It changed the conversation with the auditors.”

CORRECT JUDGMENT

Below is an excerpt of the Controllers Leadership Roundtable report on fair-value measurement and how it should be applied.

Applying correct judgment takes more effort than simply plugging in a formula based on a specific accounting rule. In addition, the Big Four (and internal corporate leadership) have become more conservative. Fearful of a material weakness or a PCAOB penalty, they have demanded multiple sets of independent valuation tests, such as vendor quotes on difficult-to-value assets from multiple companies, with full disclosure of their methodologies.

Even though the valuation exercises themselves may not be difficult, often involving cash-flow analysis and other relatively basic techniques, debating and determining correct assumptions and methodologies is a time consuming process. This has required some companies to dedicate more of their senior accounting teams to the process, and to have them spend significant time on these activities, when in the past it would have been a relatively minor part of their role. In addition, auditors are consulting more frequently with their national offices for guidance, adding time to the overall process.

To confront this, we have seen leading companies take the following steps:

Get a clear sense of what burden of proof external auditors expect. Companies who use vendor quotes should find out early how much detail their auditors desire about their methodologies. They need to understand expectations up front to gather the evidence as early as possible—and not waste time on unnecessary evidence.

Do a frank assessment of the “input levels” of your fair valued assets: Companies should leverage the additional FASB guidance issued last month to take a fresh look at assets, apply managerial judgment, and make the case (if appropriate) that assets should be valued with level three inputs through internal modeling.

Understand any additional audit fees upfront: Audit cost associated with fair value accounting increased by about 5%—companies should have upfront conversations with their auditors about productivity expectations and be prepared to tell them that, as one client said, “their inability to estimate the hours required is their problem.”

As the economy stabilizes, fair value accounting will be less of a concern, and we can expect a new normalcy to emerge. However, companies need to start building new processes into their valuation procedures, and developing clear ground rules with their auditors about what should—and should not—be part of a valuation justification.

Source

The Controllers Leadership Roundtable Study.

How Documentation Is Changing

The new guidance has also led to a good deal more work, he says. “The fair-value process is taking a lot longer for companies. Before, you dealt with the audit partner at the engagement level. Now it’s fairly routine that determinations have to go to the national office. That builds in a lot of time and cost. At the company level, that’s burdensome.”

The Roundtable says audit costs related to fair-value measurement alone have increased by about 5 percent, giving companies good reason to have more dialogue with auditors, and sooner, about what they can expect in the audit process.

Alfonso

Anthony Alfonso, president of Trenwith Valuation, says companies have been caught unprepared by the documentation exercises necessary to support fair-value measurements. “Last year, if the company had a portfolio of investments, they were able to give a brokerage statement and the auditors simply accepted it as an indicator of value,” he says. “This year, that’s no longer acceptable.”

For example, companies holding auction rate securities that they can no longer sell are forced to provide detailed cash flow testing to establish values. “That’s where companies are having the biggest heartburn,” he says. “It’s almost like a trinomial decision tree at every auction date. You need a cash-flow model with various scenarios that could happen at every auction date.” And if the security goes into default, there are additional assumptions about recovery, he says.

Lee Duran, a partner with BDO Seidman, says the documentation exercises are beginning to coalesce into some common practices. “FASB made it clear their intention was for people to use judgment,” he says. “Now that people have listened to that, we’re starting to see a more reasoned approach. As long as it makes sense and it’s objective and supportable, people are calmer in reaching valuations.”

Duran

He still sees some differences in interpretation when determining entity-level measurements. Some would like to value a large-scale entity as a whole, while others would prefer to pick apart and analyze the sum of the parts. “Maybe there are many assets here that could be broken apart and that might increase the value,” he says. “Do we recognize the value of each segment? How far down do you go?”

Nathan Powell, head of financial sector research for RiskMetrics Group, says he wants to see more disclosure around fair-value measurements and impairments, especially as banks segregate losses between earnings and equity as allowed by FASB. He is concerned that a backlog of unrealized losses is building in investment portfolios, but it’s hard to see based on the way numbers are reported now.

“We are expecting impairments to pick up, but it’s difficult to say what the impairments would have been [if not for FASB’s guidance],” he says. “We don’t have information about individual securities to determine what the impairment would have been.”