Fair value accounting: are you ready?

Strategic Finance, August, 2008 by Jonathan Boyles

Financial Reporting of Fair Value Information

As I mentioned earlier, fair value accounting has moved from the footnotes to the face of the balance sheet, bringing with it many additional financial reporting concerns that companies need to address. Fair value accounting is no longer something controllers' departments do once a quarter for footnote purposes--now it's something that they must embed in the monthly close process. It isn't enough just to take information from third parties and record it in the financial statements because there's a tremendous need by senior management and the board of directors to understand what events during the period affected their financial results. Controllers and CFOs now have to determine what market events caused the changes in fair value that in turn caused volatility in earnings. Were the changes reasonable, expected, and explainable, and was the income volatility resulting from them within corporate risk tolerances? As fair value becomes the standard for financial reporting, closing the books at the end of each period won't be the responsibility of just the controller's department but will involve expertise and input from many other departments within an organization, such as the treasury, credit, and portfolio/investment departments, to help determine and/or validate valuations used in the financial statements.

Investor Relations and Education

One of the most interesting aspects of the early adoption by certain entities of SFAS No. 157 and SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities--Including an amendment of FASB Statement No. 115," has been analyst focus on the quality of the fair value information that companies used to produce their financial results. This has been accentuated by the recent meltdown in the credit and subprime markets, making the determination of fair values for certain asset-backed securities extremely difficult to determine because there has been a disconnect between supply and demand for subprime asset-backed securities. With supply exceeding demand, significant uncertainty regarding possible credit losses and the survival of entities that had provided recourse to these securitizations, and a lack of trading volume, it has been difficult for companies to determine with any degree of certainty what the assets they hold are worth. For instance, with the uncertainty in the credit markets, many collateralized debt obligations that traded easily just a year ago are much less liquid and often require a significant discount to their perceived economic price due to the lack of liquidity in the market.

SFAS No. 157 requires companies to disclose the kind or "level" of input they apply in determining the fair value used in financial reporting. The levels are based on the objective nature and quality of the inputs used in determining the fair value of an item. These levels are:

Level 1: Observable prices in active markets for identical assets and liabilities (e.g., NYSE or NASDAQ).