Documenting Fair Value Determinations in an Uncertain Economy
While the changes made to fair value accounting may seem like yesterday's news, it is still important to maintain a strong control environment and robust documentation over the valuation of financial instruments in order to ensure reliable and transparent accounting. It is critical to remember that the valuation of financial instruments is the responsibility of management and that management must be prepared to support the reasonableness of these values. This is increasingly true as the normalization of some markets may require the use of different valuation inputs than those previously used and as proposed accounting guidance may expand the scope of financial instruments presented at fair value on the balance sheet.
Unfortunately, fair value measurements are seldom as simple as drawing a number from a broker statement or obtaining a pricing service mark. In markets with reduced activity, such as with some corporate bonds, real estate loans, asset-backed and mortgage-backed securities, it is frequently necessary to scrutinize the methodology and inputs used by valuation sources. While it seems that the values provided by respected financial institutions or service providers should be reliable sources of fair value, management must still understand and accept responsibility for the methodologies and inputs used by these parties. In markets with limited activity, these institutions and services providers frequently utilize significant judgment and unobservable inputs in the determination of fair values.
It is also important to evaluate counterparty nonperformance risk when determining fair value. Nonperformance risk is the risk that an obligation is not fulfilled and should include consideration of the counterparty's credit quality and the existence of credit enhancements, if any. In the case of a liability instrument, counterparty risk should also be evaluated as it relates to the credit union issuing the instrument. It is important to continually monitor nonperformance risk to ensure that fair value measurements are regularly updated in consideration of each counterparty's current credit quality. Counterparty risk can be evaluated through reviews of credit ratings, analyst reports or other financial analysis.
Another important concept is other-than-temporary impairment. With the widespread deterioration of credit performance of many financial instruments, OTTI has become, and remains, a crucial topic in the financial sector. Techniques of evaluating for OTTI vary widely by the type of financial instrument. However, in most instances management is required to make significant assumptions. Such assumptions may include a creditor's ability to perform, timing of repayments, likelihood or timing of defaults, valuation of collateral and quality of credit enhancements. Similar to recurring fair value measurements, these judgments should be determined using observable market data when available and any judgments formed by unobservable data should be supported by strong analysis consistently applied, sound rationale and thorough documentation.