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.
Accounting guidance establishes a fair value hierarchy, a summary for which follows. It is a hierarchy in that fair value measurements need to be made using the highest level of inputs available to management.
o Level 1 inputs: Quoted prices in an active ?market.
o Level 2 inputs: Inputs other than quoted prices that are observable.
o Level 3 inputs: Unobservable inputs, to be used to the extent that observable inputs are not available.
It is important to remember that a fair value measurement falls within the hierarchy based upon the inputs used in the valuation, not based upon the source of the valuation. For instance, a pricing service valuation for a financial instrument in an active market, but not quoted, is frequently regarded as a Level 2 fair value measurement, however, in an inactive market this same valuation source is often regarded as a Level 3 fair value measurement since the pricing service will likely have utilized unobservable inputs in determining the fair value. Similarly, internally calculated values are frequently regarded as Level 3 fair value measurements. However, if fair value measurements are calculated without relying upon significant unobservable inputs, internally calculated fair value measurements may be regarded as Level 2. In classifying financial instruments according to the hierarchy, such considerations should be documented. As the availability of fair value inputs changes, it is necessary for management to periodically reassess their fair value measurements, both internally and externally calculated, to ensure that they are properly classified within the fair value hierarchy and to evaluate whether preferred valuation inputs have become available.
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.
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. The following are some best practices that can be used in this process:
o Whenever possible, obtain multiple sources of fair value for a given financial instrument. The reliance on a sole source exposes management to the risk of unreasonable fair values.
o Develop robust analytical procedures to challenge the reasonableness of fair value measurements. Such analytical procedures frequently include trend analyses of changes in fair value over time, changes in fair value of similar financial instruments and consistency with market research, economic data and management's expectations.
o If fair value measurements are calculated internally, consider a periodic review of your valuation systems by a qualified third-party professional to provide additional assurance over the soundness of your systems and to provide meaningful suggestions for enhancement.
o If using a service provider, consider the reputation and qualifications of the service provider and ensure proper documentation of such considerations.
Of all of these best practice suggestions, it is perhaps most important for management to maintain thorough documentation of its considerations and conclusions in determining fair value measurements. Such documentation should formally outline management's consideration of any of the applicable points above. Robust documentation of this nature is valuable during any regulatory review or financial audit and helps ensure that management receives the full benefit of the time and effort that it has invested in fair value determinations.
Gary McCormick is a partner with BDO USA LLP.
He can be reached at 858-431-3463