As negative news about the current credit environment multiples, the MD&A must give investors information about companies' exposure to sub-prime securities or other higher risk loans, noted an SEC official, risks related to off-balance structures which have the potential to become on-balance sheet structures, and exposure to investments that are not easily valued. According to Associate Chief Accountant Stephanie Hunsaker, the SEC staff has been reviewing disclosures of many firms that are significantly impacted by the current environment of impairment of securities and liquidation of collateralized debt obligations and has noted some improvements from their prior MD&A disclosures.
For example, some firms have expanded their discussion of the exposure to the sub-prime industry, some have expanded their discussion about fair values, and some have expanded their disclosures about off-balance sheet arrangements. In addition, firms have added new risk factors about transactions with off-balance entities and the fact that those transactions could cause them to recognize future gains or losses, or have to consolidate the entity, or new risk factors warning that the firm may experience additional write-downs in the securities or loan portfolio.
In the associate chief accountant’s view, the MD&A is the best place to disclose information about the most difficult and judgmental areas since just complying with the minimum GAAP financial statement disclosures often will not give investors all of the information they may need to evaluate a company's results and performance.
MD&A disclosure related to the sub-prime crisis can also fall under critical accounting policies. While firms with a significant amount of financial instruments measured at fair value disclosed that the determination of fair values was a critical accounting estimate, noted the official, some of these disclosures did not provide very insightful analysis as to how the fair values were determined.
She cautioned that it is not enough to simply disclose that the valuation of financial instruments becomes more subjective and involves a higher degree of judgment where market data is not available. Also, just stating the names of other types of techniques that may be used, such as simulation models, is not helpful unless investors are familiar with these techniques and all of the key inputs into them.
When market data is not available, instructed the associate chief accountant, firms with a material amount of financial instruments measured at fair value should consider discussing the types of models used in these situations, the significant inputs into the models, disclosure of the assumptions that can have the greatest impact on the value derived, and whether and how those assumptions have changed from prior periods and, if so, why. The staff is not suggesting that every single instrument should have this level of disclosure. Rather, the staff is focused on the valuations that could have the biggest impact on the company's results of operations, liquidity or capital resources.
Thus, expanded disclosure is proper for firms with securities whose valuation is based on models and the impact of such valuation could be material to the financial statements, as well as for firms that believe that valuation of securities is one of the most significant critical accounting estimates and are disclosing that fact in risk factors and other disclosures. In these instances, the firms should disclose the specific assumptions they are using and how they were derived.
They should also give investors a real insight into how their estimates could be impacted by future events. Then, in future periods, when values materially change, either positively or negatively, the firms should consider disclosing any significant changes in their methodologies and assumptions so investors can understand what happened.