SEC Allows Range of Values in Fair Value Accounting Measurements

In a significant move given current market conditions, the SEC will allow issuers to provide in their MD&A a range of values for hard-to-value illiquid securities. In a letter to chief financial officers, the SEC staff also urged issuers to describe in the MD&A the technique or model they use to value the illiquid securities, as well as any changes to the model made during the reporting period. To the extent a range of values is provided, issuers should discuss why they believe the range is appropriate, identify the key drivers of variability, and discuss how they developed the inputs used in determining the range.

FASB Statement of Financial Accounting Standards No. 157 requires that assets be measured at fair value and provides for three levels of fair value measurement. Level 1 measurements are the quoted price of the instrument in active markets. If quoted prices are not available, Level 2 allows for measurement of similar securities in less active or active markets. For illiquid instruments, Level 3 allows the use of models for measurement.

Regardless of how issuers classify their assets and liabilities within the SFAS 157 hierarchy, the SEC staff urges them to provide in their MD&A a general description of the valuation models they used and any material changes they may have made to them, as well as the extent to which they used relevant market indices in applying the models. Issuers should discuss how they validate the models, including how often they calibrate and test them. Importantly, the MD&A should also discuss how sensitive the fair value estimates are to the significant inputs the model uses, including how the fair value estimate could potentially change as the significant inputs vary.
In the letter, the SEC staff reminded that SFAS 157 allows an issuer 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, said the staff, is it appropriate to use unobservable inputs reflecting assumptions of what market participants would use in pricing the asset or liability. Current market conditions may require the use of valuation models for some assets. Thus, as of January 1, 2008, those assets should be classified as Level 3 measurements under SFAS 157.

If an issuer concludes that its use of unobservable inputs is material, its MD&A should disclose, in a manner most useful to its particular circumstances, how the issuer determined them and how the resulting fair value of assets could impact the results of operations, liquidity, and capital resources. In addition, the amount of Level 3 assets and liabilities measured as a percentage of the total assets and liabilities measured at fair value could be relevant.

If a material amount of assets or liabilities were transferred into Level 3 during the period, continued the staff, there should be a discussion of the significant inputs no longer considered observable; and any material gain or loss recognized on those assets or liabilities during the period. With regard to Level 3 assets or liabilities, there should be a discussion of whether realized and unrealized gains (losses) affected the results of operations, liquidity or capital resources during the period, and if so, how.

There should be disclosure of the reason for any material decline or increase in the fair values and whether the issuer believes the fair values diverge materially from the amounts the issuer currently anticipate realizing on settlement or maturity. Moreover, the nature and type of assets underlying any asset-backed securities may be relevant to the MD&A, such as the types of loans, as well as the years of issuance and information about the credit ratings of the securities, including changes or potential changes to those ratings.