More or Less: Some Assets Will Get More Than One Price
September 21, 2009
An asset-backed security is trading at a price of $100. Suddenly, the market freezes and only a handful of transactions take place. The last one is for $20.
One fund manager prices the security at $20 and yet another one using projected future cash flows and taking into account the somewhat illiquid market picks $60 as the correct price. Each fund manager discloses the price of the asset on a financial report.
Sounds fair enough. But the Financial Accounting Standards Board, the standards setter for the U.S. accounting industry, is now proposing that firms disclose not only how they came up with their valuations for such a hard-to-price asset, but a range of fair values they could have also created. The range would be based on using different reasonable sets of assumptions to come up with significantly different prices.
The possible requirement is now out for public comment until October 12. It would become effective for reporting periods after Dec. 15, 2009.
"A number of constituents have recommended that the board improve disclosures about fair-value measurements," said Robert Herz, the FASB's chairman announcing the issuance of what it calls an "exposure draft" issued on August 28." The board believes that increased transparency resulting from the proposed disclosures would benefit financial statement users," said Herz about the draft for "improving disclosures about fair value measurements."
Middle- and back-office executives who will have to comply with the FASB's proposal, known as a "sensitivity analysis," don't think its all that fair. Providing more information on the proprietary methodologies and inputs used to value hard-to-price, or so-called Level 3 assets, could spell lots of administrative headaches. There is no mention of hefty additional costs in making multiple assessments of prices.
"The new rules proposed in the exposure draft raise the question of how much additional work will be required to provide a new sensitivity disclosure," says David Larsen, managing director at Duff & Phelps, a New York financial advisory firm. "Would the (price of) $20 need to be disclosed or would another pricing model using other reasonably possible inputs be required," he asks.
Interpreting the requirement won't be easy, agrees Nicholas Tsafos, a partner in the New York accounting firm of Eisner LLP. "A valuation expert might think that a ten percent different in valuation should be disclosed while a regulator might think it should be one percent. Taking two different approaches could get valuations which differ by as much as 20 or 30 percent," he says.
The FASB's proposal would most directly affect the Level 3 securities, where values are based on "unobservable inputs" or a company's "own assumptions." Level 3 securities represent one of three types of pricing methodologies, the FASB established in 2006 to comply with its interpretation of fair-value accounting.
The values of Level 1 assets are based on real prices, such as those of stocks traded on an exchange. Level 2 assets will be priced based on prices of similar assets. Because they are only traded in secondary markets--and are sometimes even illiquid--the fair value of Level 3 assets can only reflect a company's own ideas about the assumptions which market participants would use in their valuations of the asset or liability.
