What Price Fair Value Assumptions?

FAS 157 is making auditors and investors eager to find out more about your company's third-party pricing data.

The Blackstone Group nearly bared it all last month when it revealed in a regulatory filing details about financial instruments it records at fair value. In its fourth-quarter results, the asset management company provided investors with a relatively complete look at its fair value assumptions.

For example, Blackstone included a summary of dollar values of investments recorded at fair value, the change in those totals over the past year, tables showing which pricing methods were used to assess the investments, and the percentage breakdown of investments by risk level. However, the filing did not include information about the use of external pricing vendors, other than to note that “third-party fund managers” were used to determine the fair value of investments in “marketable alternative asset management,” which comprises Blackstone managed funds of funds.

The omission appears relatively minor, but such a nuance could make a difference under FAS 157, Fair Value Measurements, the Financial Accounting Standards Board’s new rule that defines fair value, establishes a framework for measuring it, and improves disclosures around the measurement. Indeed, it is likely that companies will have to explain in financial statement footnotes whether pricing data provided by third-parties are consistent with FAS 157 requirements.

At issue is the measurement of derivatives, convertible bonds, collateralized debt obligations, and other financial investments held by corporations. To value the instruments for accounting purposes, FAS 157 establishes a hierarchy for the inputs used to make the value assumptions. That hierarchy looks like this: Level 1 inputs are assets and liabilities that are measured using quoted prices in active market; Level 2 inputs, can be measured using other observable inputs, such as instruments that are marked to a model; and Level 3 inputs — considered unobservable — are thinly-traded assets and liabilities that are measured using estimates based on the value the company believes a hypothetical third party would pay for them.

For companies that use data from third parties — such as counterparties, broker-dealers, and pricing vendors — to calculate the fair value of their instruments, auditors and some investors will want to know whether the external numbers are based on Level 1, 2 or 3 inputs, opines Amy Edwards, a senior manager with Ernst & Young’s On-Call Advisory Service. “Companies using external pricing vendors will face challenges because vendors do not generally provide clients with information about whether their data complies with FAS 157,” contends Edwards.

However, last year, at least one pricing vendor began addressing the FAS 157 issue. Interactive Data Corporations put out a position paper on the topic explaining the accounting change as it pertained to third party vendors, and produced a document that gives clients a breakdown of all the asset classes the vendor evaluates and the attendant inputs, so clients would be able to come up with fair values that comply with the new rule.

In one example, the vendor started with an investment grade corporate bond that matures in June 30, 2010, and provided a pricing evaluation for March 8, 2007 of $101.15. The key components of the evaluation were a spread of 151 basis points, and the interpolated 3-year point on the benchmark Treasury curve. The data, according to Interactive Data, was corroborated by contemporaneous trades on TRACE between $101.027 and $101.188.

Auditors will have to opine on the fair value measurement if the instruments are material to a company’s financial results, as it probably would be for financial services firms, and they will have to be comfortable that the valuation is correct by comparing it to other pricing sources, says Edwards. As a result, finance chiefs will have to make sure valuations are correct and that FAS 157 disclosures are accurate, adds Edwards.

Accuracy can be especially tough in volatile markets, however. Consider that before the credit crisis sucked all the liquidity out of auction rate securities, those instruments could be valued through current trades. However, failed auctions have put the market for ARS on hold, meaning that the one-time observable prices have disappeared, pushing the instruments into the Level 3 input category, and forcing companies to rework fair value calculations.

Despite being a relatively tiny piece of FAS 157, pricing data questions have generated interest among corporations. To be sure, Interactive Data issued its position paper and input list in response to client phone calls — that still number two to three a day — made to find out what type of inputs are behind the data, says Elizabeth Duggan, a senior director at the company. She explains that before FAS 157, she dealt mostly with corporate treasurers and investment professionals who used the pricing data for modeling investments, for example. Since FAS 157 was issued last year, however, she is receiving calls from her clients’ corporate accounting staffers.

“There will be a lot more work for CFOs than there used to be,” asserts Edwards, who expects investors to be asking more questions as they pour over footnotes related to pricing data. What’s more, in December, the Public Company Accounting Oversight Board came out with a practice alert for auditors, recommending that they start examining pricing data, “to evaluate how vendors are coming up with the evaluations.”

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