New additions to fair value accounting standards have been proposed by the Financial Accounting Standards Board (FASB) with the release of Exposure Draft 1830-100, Fair Value Measurements and Disclosures (Topic 820), on June 29, 2010. If approved, these standards will impact businesses and entities of all sizes. And while the changes will make reporting much more transparent for financial statement readers, it is significantly more work for financial statement preparers, says Daniel Figueredo, manager at Burr Pilger Mayer.
“The new standards in the exposure draft will help converge the U.S. generally accepted accounting principles (GAAP) with international financial reporting standards (IFRS),” says Figueredo. “It’s a pretty robust draft with many new disclosure requirements. If it’s issued as is, it will be challenging for businesses.”
Smart Business spoke with Figueredo about how the new standards will impact businesses and what you can do now to prepare for the changes.
How do the disclosure requirements in the exposure draft change how financials are reported?
One of the most significant disclosure requirements that could affect businesses is the need to disclose a sensitivity analysis that attempts to measure the uncertainty in your fair value measurements categorized as level 3, which are the items that require the most management judgment to value. What this requirement says is, ‘If you change one or more of the assumptions used in your fair value formula to a different amount that could have reasonably been used, what are the effects on fair value and how much would it have changed?’ You will have to disclose the range of that price change, thus giving a reader a sense of the degree of possible swings to your balance sheet for other likely fair values that one could have arrived to.
For example, say a company such as a bank has mortgage-backed securities in its portfolio. These instruments require a fair amount of judgment by management to value, and would likely be categorized as level 3. Factors considered in measuring the value of a mortgage-backed security could include pre-payment assumptions, default rates, loss severities and discount rates, to name a few.
Under the sensitivity analysis, management would need to determine which assumptions in the valuation are most significant and then come up with other likely amounts that could have been used for them to arrive at another theoretical fair value.
What other provisions are contained in the new draft?
As part of the new provisions, the exposure draft indicates that you should not consider blockage factors for level 2 or 3 fair value measurements. That essentially means that you should not take further discounts to fair value just because you own a large chunk of shares, such as with large investors like Warren Buffet’s Berkshire Hathaway or hedge funds. If you have a large position and you need to liquidate, that sale will affect the price of the stock (typically downward). But you could very easily sell smaller chunks of stock over longer periods of time. Blockage discounts are viewed as transaction costs, and the effects should be recognized when the decision to sell a block is carried out, rather than as period to period fair values.
In addition, the new draft contains certain disclosure requirements when an asset is used in a way that differs from its highest and best use. Also, the highest and best use premise should only be applied to nonfinancial assets, and not financial assets or liabilities. An example of a nonfinancial asset might be in-kind donations such as clothing, food and furniture to a nonprofit charity. The proposal has some additional provisions relating to measuring fair values for items classified as shareholders’ equity, financial instruments managed within a portfolio and other disclosure requirements for financial instruments, which have not been covered in much depth in this article.
How will the changes impact businesses?
Financial statement preparers have already commented that it will entail significant effort and money to obtain this additional information. It is not information that is readily available, and it is very judgmental. It will require significant time to be incurred, especially for companies that have a significant number of level 3 assets and liabilities. For example, a financial institution enters into thousands of these types of transactions each year.
What types of companies will the changes affect?
Unfortunately, as it stands, they will affect a broad spectrum of entities, such as for-profits, nonprofits, pension plans and investment companies. No specific industry is scoped out of the exposure draft at the moment, although representatives from various industries are lobbying to have these standards not apply to them. Most of this is targeted toward public companies that file with the SEC. Unfortunately, everyone else gets pulled into it because there’s no scope of size or type of entity currently in the draft.
What can companies do now to prepare for the proposed changes?
Because this is still in exposure draft form and is not effective yet, companies have until September 7 to provide comment letters to the FASB. If it does become effective, it will take a good amount of time and effort to get the systems in place to capture data for these disclosure requirements. People who prepare financial statements should start the process of planning for the change well ahead of time, because it will become effective fairly quickly.
Do not take the fair value standards lightly. They are here to stay. Try to get up to speed as quickly as possible. Consult with your advisers and your auditors early. It is much easier to collaborate with consultants and auditors up front than to run into surprises when you have to issue your final report.
Daniel Figueredo is a manager at Burr Pilger Mayer. Reach him at (415) 288-6284 or DFigueredo@bpmcpa.com.