Fair value accounting: are you ready?

Strategic Finance, August, 2008 by Jonathan Boyles

The Financial Accounting Standards Board (FASB) has long believed that fair value accounting is the most relevant basis of accounting and has had a long-stated goal of having it as the primary method of accounting. Over the past 15 years, the FASB has taken baby steps to get companies and analysts accustomed to fair value accounting and disclosures, but the move is now on to accelerate the pace of implementation. At this point, companies have to make the transition from resistance to implementation and governance, which will require considerable resource allocation, process control, and oversight. In this article I'm not going to delve into whether fair value accounting is the appropriate accounting model but instead will focus on whether companies are truly prepared for it.

In many respects, fair value accounting makes the accounting policy decisions easier for companies, but it brings along with it a tremendous amount of additional corporate governance, reporting, and investor relations issues.

THE FUNDAMENTALS OF FAIR VALUE

With fair value measurements becoming an integral part of an entity's financial statements and a significant driver of its performance during a period, it's critical that companies develop a solid governance framework over the determination of fair value. With the complexities and subjectivity in determining the fair value of many of the assets and liabilities on a company's balance sheet that may be recorded at fair value now or in the future, it's imperative that management understand what inputs are being used and how models are utilized to determine fair value. Without adequate controls, the reliability of an entity's financial statements could be questioned by auditors, regulators, investors, and analysts.

GOVERNANCE, FINANCIAL REPORTING, INVESTOR RELATIONS

Let's look at three issues regarding the reporting of fair value that companies need to know about.

Governance Over Fair Value Accounting

Once a company has decided to record more of its assets at fair value, it should adopt certain fair value governance policies to ensure accurate and reliable measurements. Previously, when fair values were primarily reported in financial statement footnotes, the values didn't always receive the rigorous internal control and detailed reviews that amounts recorded in the financial statements received. One of the primary reasons for this is that accountants aren't typically trained to evaluate the accuracy and validity of fair value amounts and have relied on quotes from pricing services or from fair value amounts calculated from internal models used by other departments within the organization. It has been difficult for a classically trained accountant (one who hasn't had much finance training) to determine if the fair value amount they were given for financial statement disclosure purposes was reasonable.

Good corporate governance over fair values should include a fair value committee that evaluates the quality of both external fair value information and internal methodologies employed to determine fair values that will be used in a company's financial statements. This committee should be responsible for setting standards for fair value models, evaluating the quality of the inputs to be used within the fair value models, ensuring model validation is performed regularly, evaluating the quality of the fair value amounts received from third parties, and certifying the amounts that are recorded in the company's financial statements. In addition, this committee should review the sources and quality of information from third parties regarding fair values that will be used for financial statement purposes. Management can't blindly rely on third parties to provide fair values without understanding the reliability of those quotes.

It's important to understand the quality of the fair value information received from third parties, particularly with the requirement to disclose the fair value hierarchy level under Statement of Financial Accounting Standards (SFAS) No. 157, "Fair Value Measurements." Under SFAS No. 157, it becomes management's responsibility to disclose to the public the reliability and level of subjectivity used in determining fair value amounts recorded in a company's financial statements. Because of the detailed footnote disclosures required by this Standard, management must understand the underpinnings of how the amounts are determined by their third parties who are providing them with pricing information. For example, companies must understand the source of the valuation inputs used by the third-party vendor to determine how to classify the valuation among Levels 1, 2, or 3 in accordance with the disclosure requirements of SFAS No. 157.

Companies often will hire third-party valuation experts to come into their organization and provide fair value validation services to give management comfort that, in fact, they do have adequate policies, procedures, and models in place to reliably report fair value amounts in their financial statements.