FASB Chair Emphasizes Role of Disclosure in Fair Value Accounting

In the aftermath of the role of fair value accounting in the market crisis, FASB Chair Robert Herz noted that fair value is not a new concept and is not required in many instances. Similarly, in a recent FASB issues fact sheet, the chair reminded that the use of fair value in determining writedowns in periods of down markets is not new.

While conditions in the credit markets pose significant challenges in valuing a number of asset classes, he said, the concepts and practices employed in valuing illiquid and non-marketable assets are not new. They have been used for many years in valuing a wide range of items for financial reporting purposes, including intangibles, illiquid securities, and complex derivatives. In such situations, the FASB chair emphasized that clear and ample disclosures are critical in helping investors make informed decisions.

SFAS 157 establishes a fair value hierarchy that prioritizes the inputs that should be used to develop the fair value estimate. The fair value hierarchy prioritizes quoted prices in active markets for identical assets or liabilities (Level 1). In the absence of quoted prices in active markets for identical assets or liabilities, the fair value hierarchy allows for the use of valuation techniques, such as pricing models that incorporate a combination of other inputs. Those other inputs consist of observable inputs that are reasonably available in the circumstances, including quoted prices in markets for comparable assets or liabilities (Level 2), and unobservable inputs in illiquid markets (Level 3).

While Level 3 estimates can be difficult and require the use of significant judgments, acknowledged Mr. Herz, investors have indicated that such estimates provide more relevant and useful information than alternatives that ignore current economic conditions and that can introduce management bias into the estimation process, such as those that involve smoothing techniques.

SFAS 157 requires expanded disclosures about the Level 3 estimates used for financial assets and liabilities that are reported at fair value on an ongoing basis. Those disclosures focus on the effect of the estimates on reported earnings and financial position. Recently, the SEC staff issued a letter encouraging public companies to provide additional disclosures about the Level 3 estimates used for financial assets, including asset-backed securities and derivatives, in their Management Discussion & Analysis. According to Chairman Herz, the letter does not, as some have asserted, interpret, amend, or otherwise change the application of SFAS 157.