Global Harmony: Fair But Not Easy

   Convergence – it’s a phrase used by accounting specialists to describe efforts to adopt similar financial reporting rules on both sides of the Atlantic. The goal is for companies which follow U.S. rules to migrate to new international rules with relative ease. Among the most recent accounting rules which standards bodies in Norwalk, Conn. and London say they have agreed on is how to calculate and report the “fair value” of financial instruments. On May 12, the Financial Accounting Standards Board, came out with a 331-page document of changes to its “generally accepted accounting principles,’’ which are used in the United States. The International Accounting Standards Board in London came out with its own 110-page document. The good news: The two pretty much match up. Now for the bad news. U.S. firms could have to make some technology and operational changes to comply with a new version of “fair value accounting,” which will require firms to reveal in far greater detail just how they value so-called called Level 3 securities. These changes are necessary, even if American firms don’t have to worry about complying with the international standards just yet. The new U.S. requirements will be effective for public companies in any annual report issued after after December 15, 2011. The rules take effect for non-public companies for their annual periods which begin after December 15. That doesn’t give firms much time to prepare. “Firms will have to review their securities masterfile, data warehousing, portfolio accounting and reporting systems to ensure they have the correct information and can aggregate the information to comply with additional disclosure requirements,” says Rick Martin, vice president of Pluris Valuation Advisors, a New York firm specializing in valuing business entities and illiquid securities. “For financial instruments categorized in Level 3, they will also have to document their internal valuation policies and procedures, ask their third party valuation firms for help in complying with new quantitative disclosures.” Firms must also ask their operations staff involved with valuations to make decisions on how to categorize many securities – such as loans -- that are not required to be valued using the fair-value rules but are subject to the same disclosure requirements. Under current rules, firms must categorize the financial instruments they value in one of three buckets – Level One, Level Two and Level Three. Securities which can be valued using quoted prices for identical securities in active markets are considered to follow Level One. Those which can be valued based on “observable inputs” such as quoted prices in similar securities are generally categorized as level two securities while those which are based on unobservable inputs – aka internal models – fall under Level Three. Fixed-income securities that trade in inactive markets often fall under Level Two while over the counter derivatives, private equity instruments, asset-backed and mortgage-backed securities often fall under Level Three. The U.S. standard setting organization, called Financial Accounting Standards Board, now wants U.S. firms to disclose even more about the methodologies and calculations they use for securities in the Level 3 category. The pricetag for the change will be significant – in the multimillions -- depending on the current preparedness of the firm and the types of securities it trades and holds. Here are just five of the new requirements:

• Disclose Numbers. Firms categorizing any securities in a Level 3 category must now provide quantitative disclosures on each of the unobservable inputs they used. “In the case of a residential mortgage-backed security a firm would have to disclose the prepayment rates used, the probability of default and loss severity, if they used these inputs in their pricing,” says Martin. Just where will they get those figures from? If they did their own securities pricing, they would likely have the figures in proprietary valuation models but if they used a third-party valuation firm they would have make reasonable efforts to obtain the information. Valuation firms currently don’t provide this amount of granular detail.
• Disclose Policies. Firms must also explain just what their valuation policies and procedures are when pricing securities in Level 3. Those valuation policies and procedures involved who at a company makes the final decision about how to price a Level 3 security, why a security was priced as a Level 3 security; and an analysis of changes in fair value measurements. Currently, firms do not report at this level of detail for Level 3 measurements. Therefore, gathering this information will require additional coordination between the front and back offices, says Martin.
• Disclose Changes. Firms will for the first time need to describe in narrative form – aka plain English -- how changes to unobservable inputs will affect the valuation of a financial instrument in a Level 3 category, as well as how those inputs are interrelated. That means they must explain whether any changes in unobservable inputs would increase or decrease the value of a financial instrument and why. Changes to unobservable inputs that might affect the fair value of a basket of collateralized mortgage obligations could range from offered quotes to comparability adjustments. “Even though firms are not yet required to provide quantitative information for all practical purposes they still need to develop it to form the basis for the new narrative disclosures,” says Martin. “IFRS goes even farther and now requires that firms provide quantitative measurement uncertainty analysis.” That analysis may involve having to develop several valuations for the same instrument.
• Disclose Reclassifications. Firms now have to disclose every time they have transferred a financial instrument from a Level One to a Level Two category and why that transfer was made. That’s a far cry from the current practice of only disclosing transfers if the firm thought the value of securities transferred was significant.“Securities an often become a Level Two category from a Level One category if the underlying inputs used to make the fair value measurement change.” For example, if a market that was previously considered active becomes inactive, securities trading on that market will no longer be eligible for Level 1 pricing.
• Disclose the Category For All Securities. Financial instruments that previously only needed to be disclosed at fair-value – and not recorded at fair value -- will now need to be assigned one of the three levels. Case in point: a company might now record a loan at amortized cost and only be required to disclose its fair-value. Under the new rule a company will have to decide which level the loan falls into. “Assigning a level is time-consuming and often involves the collaboration of research, valuation committees and auditors,” says Martin.