Fair Value Accounting: Five New Disclosure Requirements

Fair Value Accounting: Five New Disclosure Requirements

Operations and IT executives at firms following U.S. accounting standards will soon have a lot more work to do when it comes to valuing their financial instruments.

“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.

On May 12, the Financial Accounting Standards Board came out with a 331-page document of changes to its “generally accepted accounting principles,’’ for fair-value accounting used in the United States. 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.

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. 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.

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.