Part I of this article appeared in the December 2008 issue of The Metropolitan Corporate Counsel.
The SEC staff hopes to elicit "clearer and more transparent disclosure" in the Management's Discussion and Analysis ("MD&A") section of periodic reports regarding the fair-value measurements of financial assets that are not currently actively traded and that have, or are reasonably likely to have, a material effect on the company's financial statements. In particular, the staff seeks information about the judgments and assumptions made by management in formulating those fair-value determinations, the sensitivity of such measurements to management's assumptions, together with details about the method used for valuation purposes and the various inputs applied. Summarized below are highlights from the guidance recently issued by the SEC and FASB.
Since this guidance was issued, the SEC initiated a study of fair-value accounting in response to a Congressional mandate.1Outgoing SEC Chairman Christopher Cox gave a preliminary report on the progress of this study in the context of remarks delivered during a recent conference; the final report must be sent to Congress no later than January 2, 2009. This article concludes with a brief description of Chairman Cox's remarks.
Highlights From The SEC And FASB Guidance Issued September 30, 2008
Determining Fair Value When an Active Market Does Not Exist
• Companies may use management estimates that include market participants' expectations of future cash flows from the particular financial asset, along with "appropriate risk premiums," but only when an active, orderly market for that security does not exist. Discounted cash flow analysis is just one technique that can be applied in the absence of reliable "observable inputs" or market data points. FAS 157 discusses a range of information and valuation techniques that may reasonably be used to estimate fair value when relevant market data may be unavailable, including, in appropriate circumstances, expected cash flows from an asset.
• The preferred approach under FAS 157 would be to begin with a "mark-to-market" classification of assets under Level 1. An asset may be dropped into Level 2 - thereby enabling management to look to market prices of similar assets, or "observable inputs," for measurement purposes - only where "observable inputs" in the form of market prices for that asset are unavailable. Even where observable inputs under a Level 2 classification may be determinable, however, the staff acknowledges that categorizing an asset as Level 3 and using unobservable inputs may be preferable to making significant adjustments to Level 2 inputs.
• Multiple inputs from a variety of sources may provide better evidence of fair value than actual market prices for a financial asset (Level 1) or comparable asset prices (Level 2); in such cases, anticipated cash flows (appropriately discounted) would be one consideration. How much weight to give each of these inputs involves "significant judgment" and depends on the extent to which each provides (individually or in the aggregate) reliable information about the value of the asset and are otherwise relevant in arriving at a reasonable estimate. The trade-off for such flexibility is that management must outline in the MD&A those judgments and assumptions that were made in determining the classification of a financial instrument and, ultimately, its fair value, where material to the company's financial condition and/or results of operations.
• Determining whether a market is active or inactive itself requires judgment, and companies should discuss the criteria used to make this determination. If an asset that is identical to the asset being valued is traded in an active market, then the quoted market price must be used, in most cases, without adjustment. If the market for the asset is inactive, transactions in that market may be inputs, but would not be determinative. While orderly transactions should be considered as evidence, adjustments may need to be made if the prices in the inactive market do not reflect current prices for the same or similar assets. Other indicators include the spread between the "asking" price and the "bid," or whether the asset is thinly traded.
• Management should review any policies and/or procedures related to the company's process for determining fair-value measurements and related disclosure, particularly those that are susceptible to management override. These policies/procedures may need to be revised to reflect the company's financial condition (including its credit risk or that of counterparties) and fast-changing market conditions, and possibly disclosed in the upcoming periodic report if such changes will, or are reasonably likely to, have a material effect on the company's internal control over financial reporting.
Fair Value and Distressed Transactions
• An important concept in fair-value determinations is the existence of orderly transactions between market participants. Distressed or forced liquidation sales are "disorderly" transactions and therefore should not be used to determine fair value. As a consequence, the fact that a transaction was disorderly should be considered along with other relevant evidence of fair value. Management's determination whether a given transaction is disorderly or distressed itself requires considerable judgment.
The Use of Market Quotes to Determine Fair Value Based on a Mix of Information
• Broker quotes are not determinative of fair value in the absence of an active market for the security or other asset, although they may be an input to be considered along with other factors.
• If the asset inputs include quotes or bids, review the process used by the broker-dealer or valuation expert to gather this information, which may also constitute part of management's review of any changes to internal control over financial reporting during the reporting period.
Factors to Consider in Determining When an Investment is Other-Than-Temporarily Impaired
• In determining whether a financial asset's impairment is other-than-temporary, management should use reasonable judgment based on the facts and circumstances of each investment, starting with an assessment of the nature of the underlying asset ( i.e. , whether the asset is debt, equity or a hybrid) and the probability of recovery.
• SAB Topic 5M, Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities , and AU 332, Auditing Derivative Instruments, Hedging Activities, and Investments in Securities , provide a number of factors to be considered here. These standards do not provide an exhaustive list of factors, and others may require consideration. Primary factors include:
• The length of time and extent to which the market value has been less than cost;
• The issuer's financial condition and near-term prospects, including any specific events that may influence the issuer's operations; or
• Management's intention, and the company's ability, to hold the securities long enough for them to recover their market value. All available information must be analyzed in determining the applicable recovery period.
• Management should be careful when using pre-established parameters, such as a determination that an asset is other-than-temporarily impaired once an asset's fair value has fallen below a certain percentage of its cost or has remained under a certain threshold for a specified period of time. While these triggers may provide an analytical starting point, a consistently applied and documented policy regarding the determination of when an asset is other-than-temporarily impaired is helpful and likely to be requested in any event by the independent auditor.
Highlights Of FAS FSP 157-3, Issued By FASB On October 10, 2008
FAS FSP 157-3 illustrates how FAS 157 should be applied in an inactive market and clarifies that the existence of a disorderly market does not mean that companies should automatically conclude that all transactions in that market are also disorderly or distressed. Companies need to make this determination at the transaction level, taking into account the facts and circumstances, which may require the use of significant judgment.
FAS 157-3 focuses on three primary application issues that have arisen in "markets that are not active":
• How the reporting entity's own assumptions (that is, expected cash flows and appropriately risk-adjusted discount rates) should be considered in the fair-value measurement process when relevant observable ( i.e. , market) data do not exist;
• How available observable inputs in a market that is not active should be evaluated when measuring fair value;
• How the use of market quotes - such as broker quotes or pricing services for the same or similar financial assets - should be considered when assessing the relevance of observable and unobservable data available to measure fair value.
Highlights Of SEC Staff Guidance From The September 2008 "Dear CFO" Letter
In mid-September 2008, the accounting staff of the SEC's Division of Corporation Finance sent a letter to the CFOs of certain public companies discussing disclosure issues management should consider in preparing the MD&A for the upcoming Form 10-Q and Form 10-K. When reviewing the staff's September 2008 "Dear CFO" Letter, companies should give appropriate weight to the SEC staff's suggestion that companies include in their fair-value disclosure the credit risk-related information required by FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities ("FAS 159"), regarding gains or losses on financial instruments that companies choose (but are not otherwise required) to carry on their balance sheets at fair value and that have, or are reasonably likely to have, a material impact on the company's results of operations. In this regard, the credit risk of both the company and its counterparty on the valuation measurement should be explained. The MD&A disclosure guidance set forth in this recent letter is intended to build on the staff's previous MD&A disclosure guidance in the March 2008 "Dear CFO" Letter, which has continuing relevance to MD&A drafting and is discussed further below.
Highlights Of SEC Staff Guidance From The March 2008 "Dear CFO" Letter
The guidance delineated in the March 2008 "Dear CFO" Letter covers such topics as the determination of material unobservable inputs, a description of valuation techniques or models used for determining the fair value of material assets, and the classification (or change of classification) of assets within Level 1, 2, or 3 of the FAS 157 fair-value hierarchy. More specifically, the staff's letter offers guidance on MD&A disclosure regarding the use of valuation models for Level 3 measurements under FAS 157, including management's judgment and assumptions as to how the market would price that particular asset for purposes of financial reporting. Where the use of unobservable inputs is material to the company's financial statements, the company should disclose in its MD&A how those inputs were determined (by asset class) and how the resulting fair value of those assets, and possible changes to that value, affected or might affect the company's results of operations, liquidity, and capital resources.
• For many companies, the valuation of financial instruments may be highly subjective and complex where market data are not available, and thus may qualify as a critical accounting estimate. A sensitivity analysis should be used where appropriate to help investors understand that a particular reported result may be the product of several estimates/judgments, and therefore might well vary if those estimates and/or judgments were to be altered - meaning ultimately that where sensitivity analyses are reasonably available and would be useful to investors, they should be undertaken and a range of values disclosed.
Preliminary Results Of The SEC's Fair-Value Study
The SEC staff has been working on the Congressionally mandated study on mark-to-market accounting in consultation with the Secretary of the Treasury and the Board of Governors of the Federal Reserve System. The study focuses on six areas related to mark-to-market accounting - 1) the effects of FAS 157 on a financial institution's balance sheet; 2) the impact of mark-to-market accounting on bank failures in 2008; 3) the impact on the quality of financial information provided to investors; 4) the advisability and feasibility of modifying such accounting standards; 5) alternative accounting treatments to those presented in FAS 157; and 6) FASB's procedures for developing accounting standards.2
In recent remarks to the AICPA, SEC Chairman Cox indicated that, whle the study is still ongoing, the staff has reached some preliminary conclusions. First, the staff has observed that, at least for financial institutions, investments subject to mark-to-market accounting on a quarterly basis constitute only a minority of the total investment portfolio held by those institutions. Securities and loans classified as available-for-sale make up the bulk of those institutions' portfolios and so are not marked-to-market each quarter. Nevertheless, available-for-sale securities present difficult issues for management in determining whether and when those securities have been other-than-temporarily impaired, to which the FASB will respond in the near future. Second, investors' need for transparency in financial reporting, in particular fair-value measurements of investments, should not be subjugated to the needs of other users of financial statements, such as regulators, which we read to mean that FAS 157 will not be suspended. Third, there must be a continued effort to provide best practice guidance for both auditors and preparers of financial statements, especially guidance that establishes common ground for the determination of fair-value measurements of securities traded in inactive or illiquid markets.3
The SEC expects to issue the final results of its study by January 2, 2009, as mandated by Congress.
With the ongoing turbulence in world markets, the valuation of financial assets likely will continue to be difficult for companies. Therefore, it is critical for management to review the latest SEC and FASB guidance - as well as the recent PCAOB Staff Audit Practice Alert No. 3 urging auditors to focus on fair-value measurements and other difficult topics brought to the forefront by the current economic crisis4- and update their companies' internal control over financial reporting and related disclosure controls and procedures as necessary or appropriate to ensure that the information to be disclosed and certified in periodic reports, including the MD&A, is accurate, complete and reported in a timely manner. 1 Section 133 of the Emergency Economic Stabilization Act of 2008, Pub. L. No. 110-343 (2008). Additionally, the SEC's Division of Corporation Finance staff issued an updated Financial Reporting Manual that provides guidance on a number of MD&A disclosure issues, such as whether equity-linked instruments constitute off-balance sheet arrangements and a number of examples applying appropriate MD&A analysis to given or assumed fact patterns. See Topic 9 of Division of Corporation Finance Financial Reporting Manual, updated as of Sept. 30, 2008, available at http://www.sec.gov/divisions/corpfin/cffinancialreportingmanual.shtml . The PCAOB issued guidance for auditors on auditing fair-value measurements, accounting estimates and the adequacy of disclosures (among other matters). See PCAOB Staff Audit Practice Alert No. 3, Audit Considerations in the Current Economic Environment, Dec. 5, 2008 ("PCAOB Staff Audit Practice Alert No. 3"), available at http://www.pcaobus.com/Standards/Staff_Questions_and_Answers/2008/12-05_APA_3.pdf.
2 Remarks of SEC Chairman Christopher Cox (Dec. 8 2008), available at www.sec.gov.
. 4See PCAOB Staff Audit Practice Alert No. 3 (full citation in note 1, above).
Catherine T. Dixon is a Partner in the Washington, DC office of Weil, Gotshal & Manges and Theresa Hyatte is a consulting attorney with the firm. Note: The following is a summary of a November 5, 2008 briefing issued by Weil, Gotshal & Manges LLP, as updated to reflect subsequent developments of interest. As such, it is not meant to be comprehensive, but to provide an overview of the complete briefing, available at http://www.weil.com/news/pubdetail.aspx?pub=9214.