SEC Corp Fin Official Details Best Practices for Fair Value Accounting

At a recent AICPA seminar on SEC and PCAOB developments, Stephanie Hunsaker, Associate Chief Accountant in the SEC’s Division of Corporation Finance, listed a number of best practices that would help investors understand the how and why fair value accounting was applied. The best practices build on two Dear CFO letters issued by the division earlier this year. The key principle driving the Dear CFO letters and the best practices is transparency, said Ms. Hunsaker. The staff noted that the SEC’s Dear CFO letters, and now these best practices, are good examples of the types of additional disclosures that investors may find useful in the area of fair value accounting. In March 2008, the SEC staff sent 30 letters to CFOs addressing disclosures in MD&A about fair value measurements in increasingly illiquid markets. Similar follow-up letters were sent in September 2008.

In Ms. Hunsaker’s view, an important best practice is to develop a disclosure policy for when instruments are transferred into and out of Level 3 measurements, which is the FAS 157 level for inactive securities in illiquid markets. The disclosure should use a tabular presentation to separately quantity gains and losses for instruments transferred into Level 3. When the transfer of an instrument into Level 3 occurs, she continued, the company should discuss the specific inputs that become unobservable.

Another best practice is to disclose the key drivers of value for each significant Level 3 valuation. Further, the company should discuss in detail how liquidity was taken into consideration in the valuation. In addition, separate quantitative disclosure should be provided on the effects of the company’s own credit risk and counterparty credit risk on net income. The company should also discuss events that impacted the adjustment for credit and any material change during the period.

Also, the collateral underlying mortgage-backed securities and collateralized debt obligations should be disclosed. Charts should be used to give investors a quick snapshot of losses. A further best practice is to separately disclose the extent that brokers and pricing services were used. Validation procedures employed should also be discussed, including the key judgments used in arriving at the fair value.

It is a best practice to disclose any alternative valuation techniques, said the SEC official, and whether they would have resulted in materially different fair values. Finally, issuers should provide a sensitivity analysis with reference to Section 5 of Financial Reporting Release No. 72 dealing with critical accounting estimates and IFRS No. 7. Section 5 states that, since critical accounting estimates and assumptions are based on matters that are highly uncertain, a company should analyze their specific sensitivity to change, based on other outcomes that are reasonably likely to occur and would have a material effect.