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What was the SEC saying about fair value assumptions when it sent letters to a handful of CFOs last month?
Robert Willens, CFO.com | US
April 9, 2008
In March, 2008, the Division of Corporation Finance of the Securities and Exchange Commission sent an eagerly-anticipated letter to certain public companies (presumably those in the financial services "space") identifying a number of disclosure issues. Specifically, the regulator asked companies to review areas that they, "may wish to consider" in preparing Management's Discussion and Analysis (MD&A) for their upcoming quarterly reports on Form 10-Q.
The letter was addressed to the chief financial officers of those enterprises that reported a "significant amount of asset backed securities, loans carried at fair value or the lower of cost or market, and derivative assets and liabilities" in their recently-filed Form 10-K. The letter expresses the SEC's views on how these organizations might go about complying with the dictates of FAS 157, Fair Market Measurements.
The thrust of the letter was to inform the recipient that it is appropriate for CFOs to consider actual market prices (so-called "observable inputs") in assessing the value of the organization's portfolio securities — even when the market is less liquid than heretofore (i.e., volumes are not up to historical standards) unless these prices are the result of a forced liquidation or a distress sale. As a result, the letter expresses, not surprisingly, a clear preference for observable inputs, in the form of actual market prices, even though the markets are not nearly as liquid as they had been in the past.
However, the letter then goes on to say that "...current market conditions may require you to use valuation models that require significant unobservable inputs..." What can we infer from this statement? Perhaps the following syllogism is appropriate here:
• It is appropriate for you to consider actual market prices even where the market is less liquid than historical market volumes unless those prices are the result of a forced liquidation or distress sale, and,
• current market conditions may require you to use valuation models that require significant unobservable inputs for some of your assets and liabilities, therefore,
• current market conditions are characterized by prices that are the result of forced liquidations and/or distress sales with the result that the recipients of the letter may eschew the use of actual market prices and resort, with the SEC's blessing, to the more frequent use of unobservable inputs.
This appears to be one at least plausible way to read between the lines of this letter.
In all events, the SEC is requesting that if an enterprise's use of unobservable inputs is material, disclosure should be provided regarding the manner in which such inputs were determined, and how the resulting fair values have affected, or might affect in the future, the entity's results of operations, liquidity, and capital resources. Moreover, the disclosures must include an exposition of the amount and percentage of the organization's assets and liabilities and the fair market value of which was measured using significant unobservable inputs. It must also include information regarding the amount and reason for any "material increase or decrease in Level 3 [unobservable] assets and liabilities resulting from the organization's transfer of assets and liabilities from, or into, Levels 1 and 2."
One other required disclosure that strikes us as unusual and, conceivably, indicative of a more relaxed attitude on the part of the SEC with respect to the application of FAS 157, is the discussion the SEC is encouraging regarding the issue of "...whether you believe the fair values diverge materially from the amounts you currently anticipate realizing on settlement or maturity..." Therefore, even in cases in which the values derived — whether from observable or unobservable inputs — are substantially below the principal amount of the security, the SEC is encouraging companies to take a view on the issue of whether these securities are "money good." If that's the case, then presumably, will derive some degree of comfort from this fact and, perhaps, be less alarmed when apprised of the fact that these securities have experienced an interim decline in their values.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.