Fair Value Convergence Sheds More Light on L3 Mark-to-Myth

By Dwight Cass

More disclosure about valuation models and their inputs could be a headache for bank treasurers. 

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have issued their final rules for fair value measurements and disclosures, meant to harmonize US GAAP and IFRS fair-value accounting rules. The boards issued their new convergence guidance on May 12 with an effective date for public companies of December 15 for annual and interim reporting.

Russ Golden, FASB board member, noted, “This is a significant step toward convergence. The primary objective was to align our definitions of fair value. But it doesn’t talk about when to use fair value, it talks about how to use fair value.”

Speaking at the spring meeting of The NeuGroup’s Bank Treasurers’ Peer Group, representatives of accounting firm Deloitte noted that this and other convergence projects will not result in a transition to IFRS by US filers, but nonetheless it will have a significant impact on US GAAP and all US registrants.

Differences remain

In the US, the update will supersede most of the guidance in Topic 820 (dubbed Accounting Standards Update No. 2011-04, Fair Value Measurement Topic 820: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in US GAAP and IFRSs, and in IASB jurisdictions as IFRS 13 – Fair Value Measurement and which modified FAS 157),  although many of the changes are clarifications of existing guidance or wording changes to align the new rules with IFRS 13. It also exempts non-public entities from a number of new disclosure requirements.

Although most of the remaining differences in the two standards are cosmetic, a few issues are still handled differently. For example, US GAAP allows unadjusted net asset value to be used for valuing investments in fund companies; IFRS does not.

To bring the two fair value approaches in line, FASB agreed to several changes to Topic 820. Most of the principles of fair value measurement under US GAAP remain the same. But others have become somewhat more onerous. Some financial institution treasury officials could find that they have their work cut out for them.

All’s Fair…

In particular, the new update requires companies to disclose more information regarding Level 3 mark-to-model (or “mark-to-myth,” as skeptics say) assets.

“A consistent meaning of the term ‘fair value’ will improve the consistency of financial information.”
— FASB Chair Leslie Seidman 

Companies must now also include a quantitative analysis of their valuation models and any unobservable inputs used for Level 3 valuations, as well as a qualitative discussion of the sensitivity of Level 3 valuations to changes in those inputs. Companies must also describe their valuation processes, and disclose all transfers between the Level 1 and Level 2 categories.

“Having a consistent meaning of the term ‘fair value’ will improve the consistency of financial information around the world,” said FASB Chair Leslie Seidman in a press release. “We are also responding to the request for enhanced disclosures about the assumptions used in fair value measurements.”

While this adds to financial institutions’ treasury workload, it could have been worse. The boards decided to postpone making a decision on another proposal, which would have forced companies to disclose in quantitative terms how using different inputs in Level 3 pricing models would affect the results. That type of sensitivity analysis would be far more demanding than the narrative descriptions the boards decided to require in the new rules.

Banks lobbied hard to have the quantitative sensitivity analysis requirement excluded from the new rules, arguing that it would involve a massive amount of work and yield very little beneficial insight. But the idea has not been abandoned; rather, the boards want to gather more evidence of its potential usefulness and drawbacks before deciding.

A Clarification

Aside from the Level 3 issues, 2011-04 clarifies two aspects of earlier fair value rules:

• The concepts of “highest and best use” and “valuation premise” in fair value measurement should be applied only when measuring the fair value of non-financial assets, to avoid the temptation to inflate the value of financial instruments.
• The fair value of an instrument classified within a reporting entity’s shareholders’ equity should be measured from the perspective of a market participant who holds that instrument as an asset. The new rules also change previous practice in several ways. These include:
• Provided that certain criteria are met, a reporting entity that holds a group of financial assets and financial liabilities that exposes it to market risks and counterparty credit risk can apply an exception to the requirements in Topic 820, which permits the fair value of those financial instruments to be measured on the basis of the reporting entity’s net risk exposure.
• Premiums or discounts can now be applied in a fair value measurement to the extent that they are consistent with the unit of account and market participants would consider them in a transaction for the asset or liability. However, adjustments commonly referred to as “blockage factors” are not permitted in fair value measurements. 

“The big takeaway is that you have to stay close to this stuff; it’s changing very fast so you have to stay engaged,” according to Michael Barkman, partner in the financial services group at Ernst & Young. Speaking at an E&Y conference last month, Barkman said, “How you adopt it is another story.”