Getting Ready: Q1 Statement 157 Disclosures

If I haven't mentioned it lately, I'll say it again: Statement 157 is nothing new under the sun. While those who would like to blame accounting for their mistakes (and that's what it does: the accounting shows their mistakes) continue to bleat about the unfairness of fair value reporting, the fact remains that Statement 157 had nothing to do with changing the measurement of fair values. It changed the disclosures: now we can look at reported values and know how much they were the results of quoted markets or black magic. It was always that way - it's just that until Statement 157, we never had a good idea of the prevalence of black magic in financial reporting.

With all the misguided bashing of Statement 157 going on , it's hard to remember that it hasn't even become effective yet . Not until this quarter.

Last month the SEC put in its two cents. The Division of Corporation Finance released a letter it had sent earlier in the month to unspecified financial institutions regarding their pending application of Statement 157. The letter is not an amendment of Statement 157; it's an amplification of Statement 157. The FASB cannot tell companies what to include in the "Management's Discussion & Analysis" section of SEC filings: that's the SEC's turf. Therefore, Statement 157 didn't include any mention of what kinds of disclosures to make in the MD&A. That will be particularly of interest to investors when firms have to use "unobservable inputs" (Level 3) to estimate the fair values of assets. This letter fills that guidance void:

If you conclude that your use of unobservable inputs is material, please disclose in your MD&A, in a manner most useful to your particular facts and circumstances, how you determined them and how the resulting fair value of your assets and liabilities and possible changes to those values, impacted or could impact your results of operations, liquidity, and capital resources. Depending on your circumstances, the following disclosure and discussion points may be relevant as you prepare your MD&A:

• The amount of assets and liabilities you measured using significant unobservable inputs (Level 3 assets and liabilities) as a percentage of the total assets and liabilities you measured at fair value.
• The amount and reason for any material increase or decrease in Level 3 assets and liabilities resulting from your transfer of assets and liabilities from, or into, Level 1 or Level 2.
• If you transferred a material amount of assets or liabilities into Level 3 during the period, a discussion of:
- the significant inputs that you no longer consider to be observable; and
- any material gain or loss you recognized on those assets or liabilities during the period, and, to the extent you exclude that amount from the realized/unrealized gains (losses) line item in the Level 3 reconciliation, the amount you excluded.
• With regard to Level 3 assets or liabilities, a discussion of, to the extent material:
- whether realized and unrealized gains (losses) affected your results of operations, liquidity or capital resources during the period, and if so, how;
- the reason for any material decline or increase in the fair values; and
- whether you believe the fair values diverge materially from the amounts you currently anticipate realizing on settlement or maturity. If so, disclose why and provide the basis for your views.
• The nature and type of assets underlying any asset-backed securities, for example, the types of loans (sub-prime, Alt-A, or home equity lines of credit) and the years of issuance as well as information about the credit ratings of the securities, including changes or potential changes to those ratings.

Over at "Notions on High and Low Finance", Floyd Norris worries that a sentence in the letter provides the magic weasel words for companies to avoid writing down damaged goods to an estimated fair value:

Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability.

That sounds to me like an invitation to fudge. Some people on Wall Street think that nearly every sale today is a forced sale..."

Worth worrying about, but I don't think that's what the SEC meant in the letter. And if anyone tries to use that as an excuse to avoid Level 3 estimation, they should be immediately dispatched to the lowest circle of fair value hell. And anyone who tries to such an excuse in these words will find that hell: they'll be compared to those who don't take the low road. There's only one default position in Statement 157: fair value, whether it's easy or hard to derive. Maybe the SEC needs to clarify that statement.

Comments

[lindlou]

We should absolutely trust them to report everything in an honest & forthright manner--they have done such a stellar job of this to date. Why should we think that these paragons of virtue would try to jump through this large loophole and not fairly value thieir assets?

[John Egan]

I worked for a very large insurance company for many years and had a supervisor, who was very politically astute (within the confines of the company structure, that is.. )... His favorite saying was "Image is everything, John! Personally, I find that offensive, and contrary to good business practices.. However, he was correct in the company hierarchy and probably is doing very well to this date..

When GE reported, the CEO came across like a liar, and after supporting his guidance just 2 weeks before. Neither GE, nor the CEO come across as liars.. So I'm guessing that the all-pervasive internal attitude "Image is everything" came to roost at the last minute in GE... And apparently it seems to be a problem throughout business reporting in general.. Wait till the financials hit this week...And again next quarter... It'll be the same old story until these compounding problems are triaged out of the system ...

Thx jegan ;-/