During 2008 and 2009, the use of fair value to measure financial instruments was blamed for creating the financial crisis – despite the fact that there is little to no empirical evidence to support this claim. Hand in hand with the protest against the use of fair value to measure financial instruments came complaints regarding how fair value measurements were derived.
Much – though not all – of the debate was focused on Level 3 fair value measurements where the inputs are most unobservable and valuation techniques most subjective and judgmental. These “market-to-model” valuations came to be known by some as “mark-to-make-believe” valuations.
Just as a refresher, the accounting fair value hierarchy classifies fair value measurements into three levels:
- Level 1 consists of the most “observable” market inputs (e.g., liquid investments), generally those with quoted market prices in active markets.
- Level 2 includes assets and liabilities valued using observable inputs other than quoted prices used to value Level 1 securities.
- Level 3 is the measure with the most “unobservable” inputs.
During the financial crisis, attention was focused on the judgments and assumptions underlying a company’s Level 3 fair value measurements, the sensitivity of the measurements to those assumptions, and the details about the methodology and inputs used given the significant management judgment involved in these measurements. Attention also was focused on Level 2 measurements because companies argued the fair value measurement guidance forced them to value securities using market quotations in illiquid markets or what represented distressed sales – prices at which they believed they would never have to transact.
Investors Value Greater Transparency as to Fair Value Measurements
The investor community called for more transparent disclosure regarding fair value measurements during the financial crisis. For example, CFA Institute issued a letter to the Financial Accounting Standards Board (FASB) in October 2009 with suggested improvements in disclosures.
Transparency regarding these fair value measurements is important to valuing the organization appropriately. A study, Market Pricing of Banks’ Fair Value Assets Reported under SFAS 157 during the 2008 Economic Crisis, showed that investors price Level 1, Level 2, and Level 3 assets at $0.85, $0.63, and $0.49, respectively, of the reported fair value amounts. This is an indication of the varying level of investor confidence in reported fair value amounts, as well as how the value amounts depend on the subjectivity of the inputs and techniques. This study illustrates that, without sufficient risk-related information, investors may misprice securities. Understanding the nature of these risks is essential to valuing the enterprise since investors discount for uncertainty of reported numbers. Though many preparers balk at the need for greater disclosures, the aforementioned study shows that the lack of transparency could have significant price impact on the valuation of the underlying enterprise. It also demonstrates that it’s worthwhile economically to produce disclosures which create greater transparency and higher valuations.
Level of Disclosure Has Evolved Since the Crisis
The FASB issued guidance in early 2010 which began to make several modifications to the fair value measurement disclosures in 2010 by:
- Requiring disclosures of the significant transfers between Level 1 and 2 measurements
- Increasing the disaggregation of fair value measurements
- Requiring more disclosure regarding input and valuation techniques for Level 2 and Level 3. The requirement to show gross presentation (e.g. purchases and sales separately rather than net of each other) of activity in the Level 3 rollforward was not required until 2011.
Following publication of the newly revised and joint standard on Fair Value Measurement in May 2011 by the FASB and the International Accounting Standards Board (IASB) (known collectively as the Boards), further disclosures will be added in the first quarter of 2012. These disclosures are some of the most controversial. Here’s what’s in store:
1) Quantitative Information on Unobservable Level 3 Inputs – Previously a company was required to provide a description of the inputs used when measuring fair value for an item categorized as Level 2 or Level 3. The standard was not explicit about whether that description needed to include a quantitative expression of inputs. The new disclosures require that companies provide quantitative information about the significant unobservable inputs used in determining Level 3 (but not Level 2) fair value measurements. Such disclosures may help users understand the measurement uncertainty inherent in the fair value measurement because there is limited or no information publicly available about these inputs.
2) Valuation Processes Used in Level 3 Measurements – The new standard also requires a reporting entity to disclose the valuation processes used for Level 3 measurements (including, for example, how a company decides its valuation policies and procedures, and how it analyzes changes in fair value measurements from period to period). This new disclosure will provide information about a company’s valuation processes which may allow users to assess the relative subjectivity of the company’s fair value measurement, particularly any categorized within Level 3.
3) Qualitative Description of Sensitivity to Changes in Unobservable Level 3 Inputs – Most users agree that a well performed sensitivity analysis is one of the most useful disclosures for investors since it enables forecasting of future financial statement and cash flow effects when key inputs — such as interest rates, prices, and exchange rates — change between reporting periods. Sensitivity disclosures have the benefit of increasing investor confidence in financial statements.
Under the new requirements, companies must provide a qualitative description (by class of asset or liability) of the sensitivity of Level 3 fair value measurements to changes in unobservable inputs used in the measurement if a change in those inputs would result in a significantly higher or lower fair value measurement. If there are interrelationships between those inputs and other unobservable inputs, a company must provide a description of those interrelationships, including how they might magnify or mitigate the effect of changes in the unobservable inputs on the fair value measurement. The thinking here is that these disclosures would provide users with information about how the selection of unobservable inputs affects the valuation of a particular class of assets or liabilities.
Although the disclosures have been expanded, it should be noted that this disclosure is only a qualitative description of the sensitivity of the inputs, and falls short of a robust quantitative sensitivity analysis or a disclosure of a quantitative range associated with the fair value measurement — something we requested and supported in our 2009 comment letter. The Boards originally proposed a sensitivity analysis disclosure that would have provided a range of fair values (exit prices) that could have been reasonably reported. Many from the preparer community opposed this disclosure, citing operational concerns and questioning the usefulness of the information. Therefore, the Boards decided not to require these disclosures and to address this in a separate discussion topic. The Boards have yet to add this to the agenda.
We think that the qualitative description of sensitivity analysis may be a bit helpful, but are disappointed that the Boards did not go further by requiring a more robust quantitative sensitivity analysis with a range of exit values. Also, we are disappointed by the fact that these disclosures, and the disclosure of quantitative inputs, only apply to unobservable Level 3 inputs, as this limits the overall usefulness of sensitivity-related information that companies provide. We believe that the Boards should have extended the Level 3 sensitivity analysis to all Level 3 inputs given the subjectivity which exists within that category.
4) Disclosure of Fair Value Levels for Items not Measured at Fair Value – For the first time, companies in 2012 will be required to disclose the level of the fair value hierarchy (i.e., Level 1, 2, or 3) in which an asset or liability (financial or non-financial) would be categorized if that asset or liability had been measured at fair value in the financial statements. An example would be a financial instrument that is measured at amortized cost in the basic financial statements. This will provide additional insight into the value of assets and liabilities not carried at fair value.
5) Transfers Between Levels 1 and 2 – Prior to the recent changes, a company was only required to disclose the amounts of significant transfers into or out of Level 1 and Level 2 and the reasons for those transfers. Now all transfers into or out of Levels 1 and Level 2 must be disclosed, which will enable users to assess changes in market and trading activity.
Some Progress on Level 3, More Focus Needed on Level 2
These new disclosures may help to shed light on the judgments and assumptions used in Level 3 fair value measurements, but we also think that the Boards could have achieved a better result for investors by requiring a more robust quantitative sensitivity analysis. We see this process as evolutionary and will advocate for greater transparency for Level 3 measurements in the future.
As stakeholders to the standard setting process have become more familiar with fair value measurements we see regulators (e.g., the PCAOB and SEC) becoming more interested in the manner in which Level 2 assets are being priced by pricing services. Many have not understood the subjectivities and limitations inherent in such Level 2 measurements. These Level 2 measurements represent a substantially greater percentage of the assets measured at fair value than Level 1 or Level 3 – or Level 1 and Level 3 combined – by multiples. In our October 2009 letter, we commented on the need for greater transparency and disclosure associated with the methods used to arrive at these Level 2 measurements, including providing examples. We are pleased to see greater focus on such measurements, given the magnitude of financial instruments classified as Level 2, but we believe the Boards and regulators still have work to do to provide investors with greater insight into Level 2 measurements.