Fair Value: Eyes Wide Open

Expect more footnotes this annual-report season, as FASB releases its new rules on fair-value disclosures.

As promised by standard-setters, fair-value accounting rules are coming more into focus this year. On Thursday the Financial Accounting Standards Board released a reworked version of Subtopic 820-10 (formerly FAS 157), the controversial rule that dictates how companies should measure the fair value of assets and liabilities under generally accepted accounting principles.

Prompted by calls from investors and other financial-statement users in search of more-granular information, the revision aims to make fair-value disclosures more robust by requiring companies to disaggregate more of the numbers they report. To do that, the rule focuses on the three-tiered hierarchy laid out in its measurement criteria. The hierarchy comprises Level 1 assets and liabilities, which are measured using “observable” inputs, such as quoted prices in active markets; Level 2 inputs, which are based on observable information, such as quoted prices in similar markets; and Level 3 items, which are the most difficult to measure, as they are illiquid assets and liabilities that must be valued using internal models.

The new requirements affect all three levels of inputs. For example, companies are now required to make separate disclosures for any significant transfers made in or out of Levels 1 and 2, as well as describe the reasons for making the transfers. The standard already required this kind of added visibility for Level 3 items, and users liked it so much that they lobbied FASB to consider expanding the provision to cover all input levels. FASB obliged, agreeing with investors that the extra disclosures do provide valuable insight into the quality of reported earnings and expected cash flow.

The revised rule also states that companies can no longer lump together information about swings in Level 3 fair-value measurements associated with purchases, sales, issuances, and settlements of financial instruments. In practical terms, that means each category must be reported on a gross, rather than net, basis. Private-equity firms and other companies with significant trading operations argued against the provision, claiming it was either too onerous or provided immaterial information. With a nod to the dissenters, FASB delayed the effective date of this provision until next year to give companies time to rework their information systems to comply with the disclosure requirement.

FASB also used the new Subtopic 820-10 to clarify several existing disclosure requirements. For example, in the standard, the board addresses an investor complaint that accuses companies of hiding behind the rule’s wording to limit disclosures. Indeed, while U.S. GAAP required companies to break down fair-value measurements into “major categories” of assets and liabilities, preparers generally took that to mean only disclosing a balance-sheet line item — a “less useful” aggregated number, according to comment letters received by the board. Agreeing that there was a need for guidance in this area, FASB emphasizes that companies should list “meaningful subsets” of balance-sheet line items as a way of describing the nature and risk of a financial instrument. Totals could be separated under available-for-sale debt securities such as residential mortgage-backed securities, commercial MBS, and collateralized debt obligations. Fund investment headings could include private equity, venture capital, and hedge-fund distressed debt.

The amended rule also says that companies should provide disclosures about the valuation techniques and inputs used to measure recurring as well as nonrecurring items that fall into either the Level 2 or Level 3 category. Recurring items are those that are marked to market, such as trading securities. Investors say that having more information about valuation methodologies and inputs makes it easier for them to compare changes in asset values from period to period and track the effect on earnings.

The new rules and clarifications are effective for periods beginning after December 15, 2009, with one exception. The provisions about disclosure of Level 3 measurement changes tied to the purchase, sales, issuances, and settlements of financial instruments will go into effect for fiscal years beginning after December 15, 2010.

The rule revision brings the U.S. standard in line with international financial reporting standards. In particular, the American rule now has fair-value disclosure requirements similar to those of IFRS 7, the international standard governing disclosures related to financial instruments.

 

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