By : Chris Kentouris | March, 2 2012Fair value accounting -- it's a well-known set of rules which send shivers down the spines of valuation experts at financial firms and specialist shops. Those experts have to figure out a way to come up with the correct price of a non-exchange traded financial instrument using a bit of science and a bit of judgment which won't attract regulatory scrutiny. The U.S. accounting standards board has now given those experts -- often middle and back office operations executives -- a bit more to chew on. There are some restrictions on how they can value those assets and not much time left to prepare. As of March 31, all U.S. companies which follow U.S. accounting standards will no longer be allowed to rely at will on a practice known as "blockage factor." That practice allowed them to take into account the size of the transaction made in a particular asset to value the asset. Financial firms will also no longer be allowed to always group securities together to come up with a "fair value" for a group of assets as a whole. They will have to value each asset individually. First adopted in 2007, fair value accounting rules provide firms with a standard methodology for how they were to correctly price or "fair value" assets on their books. The methodology, established in the U.S. by the Financial Accounting Standards Board, establishes a three-tiered hierarchy for the types of inputs and assumptions firms can use to value assets. Assets which fall under Level one are the easiest to price because there are typically traded on exchanges or other public venues. Those classified as level two or level three are the most difficult because calculations are based in part on opinions related to the inputs and methodologies to be used. Over the past few years, the FASB has been changing the fair-value accounting rules so the U.S. version of the rules more closely matches international financial reporting standards (IFRS) adopted in overseas markets. Regulators involved in financial reporting practices on both sides of the Atlantic ultimately want companies to use one set of "global" rules. The latest changes, first released in May 2011 are known as "Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in US GAAP and IFRS" or ASU, for short. As is always the case, financial firms must quickly evaluate just how they must change their methodologies and procedures to accommodate the changes to fair-value accounting rules. While the FASB's new restrictions will have an impact on all firms which follow U.S. accounting rules, operations executives consulted by wwwe,iss-mag.com predict they will affect large banks and brokerage firms which hold more assets in the level two and level three categories, such as swap contracts and mortgage and asset-backed securities. Those banks and brokerages might decide to lean more heavily on their own valuation experts as well as third party specialists to help figure out how they can meet the complicated criteria the FASB has set up which would allow them to be exempt from the new iteration of the fair-value accounting rules, Such exemptions would, for all practical purposes, allow them to follow older policies. "The FASB did previously allow firms to apply a discount -- or blockage factor -- when measuring the value of Level 2 and Level 3 financial assets to reflect the impact on their value by selling a large block of the assets at one time," explains Rick Martin, vice president of valuation service provider Pluris Valuation Advisors. "Although it could easily be true that a financial firm would sell a large block of a particular security for a lower price than a smaller block of the same security, the FASB no longer recognizes the economic difference between selling a large block and selling a small block." Martin cites the following example of how the old and new rules could applied. Lets say, a financial firm is valuing its 80 percent stake in a company whose securities are illiquid. Under old rules, a blockage discount would be applied against the valuation. The financial firm could end up reducing the value of the asset on its books to reflect the ct the economic reality that selling the 80 percent stake as a block will likely not yield as much as selling the shares piecemeal over time. While operations executives will likely favor eliminating "blockage discounts," because they will no longer have to deal with complex methodologies for estimating the blockage factor, chief financial officers aren't exactly happy, because it reduces their ability to use block discounts when they felt it was appropriate, says Martin. Surprisingly, the FASB will still allow firms to use a "control premium" --or increase the value of a financial asset when the asset reflects a "controlling interest" in another firm. Case in point: Let's say that a company's shares trade at $20 per share and the company has 1,000,000 shares outstanding. Although the market capitalization is $20,000,000, an acquirer purchasing 80 percent of that company would be willing to pay a premium of, say, 30 percent over that amount simply because 80% reflects a controlling interest. So, instead of paying $16,000,000, an acquirer might pay $20,800,000 for an 80 percent stake. A financial firm is likely to have paid a premium to buy a block of securities because it wanted a controlling interest in a legal entity such as a corporation, partnership, limited liability, or sole proprietorship. "If a firm holds a block of securities with a controlling interest it would not be expected to sell the securities piecemeal and sacrifice the benefit of the controlling interest," explains Martin." In other words, if you buy controlling shares of a company’s stock, those shares that create the controlling interest would be worth more than shares that did not create a controlling interest." The FASB's reasoning in continuing to allow control premiums but prohibit blockage discounts might not seem logical, but it does have some merit, "The FASB considers control premiums to be a characteristic of the asset being measured while a blockage discount is related to the entity," says Martin. "Related to any entity means that any valuation must be based on what the market is doing, not what the reporting entity is doing." The latest version of the FASB's fair value accounting rules also places greater emphasis on what is called the "unit of account." The FASB will require that the fair value of financial instruments be measured at the unit of account, which depending on the type of asset can be all the way down to the individual share level. "Previously financial assets that traded in homogeneous pools -- baskets of financial instruments with similar characterisitcs-- might be grouped together when measuring fair value," explains Martin. "Under the newASU, firms can only do so if they can establish a portfolio exception." The exception would allow companies to measure the fair value of an asset based on the net position of the portfolio instead of the individual positions within the portfolio. In valuing a group of securities in such a "portfolio basis" firms could also apply a blockage factor.