Accounting is the language of business. People use it to make decisions about the past and devise a plan to carry them forward. With the continuing emergence of fair value reporting on financial instruments, accounting no longer just looks back at what you paid, it values those assets today.
“Say you’re putting money into your 401(k). What if you didn’t know the current values? How do you evaluate your prior investment selections and how to move forward?” says Bryan Cartwright, financial services assurance partner at Moss Adams LLP.
“Likewise, if you’re on a company’s board of directors and you have no idea how much management is awarding in stock options because the options have no assigned value, it makes it hard to be an effective board member.”
Smart Business spoke with Cartwright about the increased requirements for fair value reporting.
How has fair value reporting intensified?
Privately-held and thinly-traded securities often have no observable market activity to provide current value information. Loans, bonds, companies, or preferred or common stock are, in increasing measure, being reported at fair value.
The Financial Accounting Standards Board (FASB) and the Securities Exchange Commission (SEC) continue to drive accounting standards and requirements toward the use of fair value, rather than cost, as the basis of value for financial assets. They have gone from requiring companies to disclose fair value in the back of financial statements to including them in the statements with strong support from financial statement users.
The latest push is for companies to disclose the way they’ve ‘fair-valued’ the information for each class of security or asset, and the significant inputs or variables upon which the fair values hinge. For example, instead of simply reporting that a loan has a fair value of $1 million, the disclosures are providing supporting information about the ‘unobservable inputs’ used by management to determine that value, such as a discounted cash flow technique or an unobservable input for the discount rate such as ‘Libor plus 500 basis points.’
Does this just apply to public companies?
It applies to any company or organization reporting fair values for assets or liabilities on a recurring basis, including public and private commercial enterprises, or anyone with financial assets or liabilities on their balance sheets reported at fair value on a recurring basis.
The pressure for accuracy is mounting from the top down. The SEC has been taking action against board of directors and management that it feels haven’t taken fair reporting requirements seriously, or have shown indications of intentionally misstating values. This has been particularly true in investment management, where the SEC has jurisdiction over registered financial advisers. It has been looking into the policies and procedures used by these advisers when setting values for private-equity and other securities, which play so big a role in investment strategies used by pension and profit sharing fiduciaries.
What advantage does more fair value bring?
Regulatory authorities want fair valuations to be accurate, supportable, and based on market information when available. With better information, whether modeled (unobservable inputs) or market-based, people are more accountable for assets they use and deploy.
For example, in 2005, after nearly 10 years of delay, the value of employee stock options began to be recognized in income statements. Executives, board members and shareholders gained much better visibility into the real cost of this compensation, which heightened the understanding of their use. It’s widely believed that the migration to more balanced compensation packages emphasizing both short-term and long-term rewards were due in part to this change in accounting.
How should executives react to this trend?
Everybody can agree on what something costs, but not everyone always agrees on its fair value. Accordingly, you need to be ready to defend your approach. Companies are building systems to document how they select their chosen valuation techniques among alternatives. The work needs to incorporate validation concepts including using ‘look backs’ to determine if selected techniques and procedures are still appropriate. Based on feedback from the SEC and others, companies really need to focus on market-based information when selecting valuation techniques and determining valuation inputs — it’s becoming more of a science.
Whether fair values are determined with internal resources or outsourced, your company is ultimately responsible for the assigned values. Currently, it seems that regulators are showing higher thresholds for proving that the values you select are appropriate. You can acquire valuation models, but a model is only as good as its inputs. Someone in your organization must have the education and skill to understand valuation requirements and communicate your approach, even if you outsource the work.
Overall, fair value is improving financial reporting, although it’s certainly uncovering more differences of opinion and subjectivity than we are accustomed to dealing with. But as people begin to believe in the reliability of fair values, more decisions will be made based upon them, making them more important still. •
Bryan Cartwright is a financial services assurance partner at Moss Adams LLP. Reach him at (415) 677-8331 or [email protected].
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