Fair Value Accounting: Reinforcing Organizational Transparency and Accountability

About the Authors:

Jay A. Dubow is a partner at Pepper Hamilton LLP in Philadelphia. Anthony B. Creamer III is the office managing director of the Philadelphia office of Navigant.

The Securities and Exchange Commission (SEC or Commission) recently has set its sights on registered entities and their officers and directors for overvaluing the entities' assets.

On October 17, 2012, the SEC charged Yorkville Advisors LLC (Yorkville), a $1 billion Jersey City, New Jersey, hedge fund firm, and two of its executives with scheming to overvalue assets and exaggerate reported returns in order to hide losses and increase fees collected from investors. On November 28, 2012, the SEC accepted Offers of Settlement from KCAP Financial, Inc. (KCAP), a closed-end business development company, and three of its officers. The SEC claimed that KCAP did not record and report the fair value of its assets in accordance with the Statement of Financial Accounting Standards No. 157, "Fair Value Measurement" (FAS 157). FAS 157 is now Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic 820 (ASC Topic 820). More recently, on December 10, 2012, the Commission initiated proceedings against eight former members of the boards of directors overseeing five Memphis, Tennessee, based mutual funds, RMK High Income Fund, Inc., RMK Multi-Sector High Income Fund, Inc., RMK Strategic Income Fund, Inc., RMK Advantage Income Fund, Inc., and Morgan Keegan Select Fund, Inc. for violating their asset pricing responsibilities (RMK Action).

These enforcement actions appear to be the start of a wave of such actions, especially since many investment advisers that historically were not required to be registered with the Commission now must do so under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank).

These actions raise questions about the role and responsibility of an investment adviser or investment company's management and board of directors relating to fair value determinations in financial reporting matters.

In the Yorkville matter, the SEC filed an action in federal court alleging that the firm misreported values in the midst of the financial crisis in 2008 and 2009. The SEC charged that Yorkville's funds were able to attract more than $280 million in new investments from pension and other funds, as well as more than $10 million in excess fees, based on inaccurate asset valuations. In particular, the SEC alleged that Yorkville and its president and CFO failed to adhere to its stated valuation policies; ignored negative information about certain investments held by the fund; withheld adverse information about fund investments from the firm's auditor; and misled investors about the liquidity of funds, collateral underlying investments, and the use of a third-party valuation firm. Yorkville and the two executives are fighting the allegations.

In the KCAP Action, which was settled, the SEC alleged that during the 2008-2009 financial crisis, KCAP did not account for certain market-based activity in determining the fair value of its debt securities. Moreover, KCAP issued materially misleading public filings related to its collateralized loan obligation investments. The company claimed to incorporate market data into its financial valuations but the assets in question were instead valued based on KCAP's historical cost. On May 28, 2010, KCAP restated its financial statements for all four fiscal quarters of 2008 and the first two quarters of 2009. As a result of these restatements, the SEC determined that certain KCAP assets had been overvalued by as much as 300 percent. The Commission found that KCAP's overvaluation and internal control failures violated the reporting, books and records, and internal control provisions of federal securities laws. Two KCAP executives each were ordered to pay $50,000 in civil penalties and a third KCAP executive was ordered to pay a $25,000 civil penalty.

In the RMK Action, the SEC filed an administrative proceeding alleging that the value of significant portions of the funds' assets, which contained debt securities backed by subprime mortgages, were overstated. According to the SEC, this overvaluation was the result of a lack of leadership and guidance on fair valuation determinations by members of the funds' board of directors. The SEC has criticized the directors for delegating fair valuation responsibility to a valuation committee without providing guidance on how fair value determinations should be made, not reviewing the appropriateness of the methods used to value securities, not making meaningful efforts to determine the basis of fair value determinations, and not obtaining appropriate information explaining why particular fair values were assigned to portfolio securities.

Further evidence of heightened scrutiny by the SEC is reflected in a letter dated October 2, 2012, from the SEC Office of Compliance Inspections and Examinations (OCIE) to "Newly Registered Investment Advisers," introducing them to the National Exam Program (NEP). The OCIE examines registered advisers, including firms that advise private funds, to assess whether they are operating in a manner consistent with the federal securities laws. The OCIE is administering the NEP which is an initiative to conduct focused, risk-based examinations of investment advisers to private funds that recently registered with the Commission (Presence Exams). The examination phase is the actual on-site review conducted by the NEP staff that is directed to one or more higher-risk areas of the investment adviser's business and operations.

According to the OCIE, areas of interest include:

  • Marketing;
  • Portfolio Management;
  • Conflicts of Interest;
  • Safety of Client Assets; and
  • Valuation.

With this enhanced focus on valuation by the SEC what should hedge funds, private equity funds and other regulated entities do to avoid scrutiny and be best prepared for examinations?

Expert Accountants and Valuation Professionals are the New Norm

There was a time - not long ago - when the "historical basis" of accounting reigned supreme as the primary method of preparing a balance sheet. A company would record an asset or liability when purchased or incurred and so long as it was not impaired, then depreciate, amortize, or accrete it. There was also a time when accounting standards were far less complicated than today and CPAs did not require five years of university training to qualify. Those days are gone.

Indeed, some might legitimately argue the Codification of Accounting Standards has become as complex as the IRS Code.

What has not changed from the old days is the financial statement preparer's need to employ professional judgment. Financial statement readers must know that accounting estimates pervade the financial reporting realm and preparers often get it wrong - even when good professional judgment has been employed.

Balancing Fair Value against Hindsight

These conditions become amplified when dealing with fair value estimates because fair value is informed by and dependent in large measure on assessed future prospects. One more thing: financial statement readers and regulators enjoy the benefits of 20/20 hindsight.

Identifying Fair Value for Financial Statements

There are many financial statement captions for which a fair value determination must be made. Some examples follow.

  • Financial instruments, including derivatives. (On February 14, 2013, the FASB issued a proposed Accounting Standards Update, Financial Instruments Overall (Subtopic 825-10), that would impact the classification and measurement of financial instruments currently in effect for financial reporting. The comment period ends May 15, 2013.)
    • Trading - change in fair value is recorded directly to net income or loss on the income statement. Consists of assets expected to be sold in a relatively short period of time.
    • Available for sale - change in fair value is recorded to other comprehensive income or loss, not net income or loss, until the asset is sold. Then the gain or loss is transferred to net income or loss. Financial instruments can range from publicly traded stocks that are simple to value to private investments that require significant judgment to value.
    • Held to maturity - typically not recorded at fair value, but could be subject to fair value if the classification changes to "Trading" or "Available-for-Sale."
  • Assets and liabilities subject to impairment testing - if impairment testing determines that the fair value of assets or liabilities is less than their carrying value, the company must adjust them to fair value.
  • Goodwill and other intangibles, including acquired intangibles - must be tested at least annually to ensure the carrying value does not exceed the fair value.
  • Pension plan assets (disclosed) - similar to financial instruments, assets held in a company's pension fund are subject to fair value accounting.
  • Stock grants - stock-based compensation expense is recorded based on the calculated fair value of the stock grants.
  • Liabilities for which the fair value option is used - companies have the option to record certain liabilities at fair value even though they are not required. Changes in fair value would be recorded directly to the income statement.

Fair Value Hierarchy

Assets and liabilities subject to fair value are categorized into a three-level hierarchy based on the availability and reliability of the inputs used to value them. Level 1 assets and liabilities are simple to value since identical items are actively traded in open markets and price quotes are readily available. Level 2 assets and liabilities are more difficult to value since identical items are not actively traded. In this case, observable prices for similar items are used as a proxy. Level 3 assets and liabilities are the most difficult to value since no active markets exist for identical or similar items. Companies must rely on unobservable inputs based on their judgment and experience to value Level 3 assets.

Companies typically value Level 3 assets and liabilities using complex internal models or they may hire an outside valuation firm. Additional disclosure for Level 3 assets and liabilities is also required in the notes to the financial statements, including the methods and inputs used to arrive at the fair value determinations as well as a reconciliation of the beginning and ending balance. The increased focus on Level 3 assets is meant to give the reader of the financial statements a complete understanding of how the company valued these assets so that they can make more informed decisions.

Due to the highly judgmental nature of valuing Level 3 assets and liabilities, audit firms have come under scrutiny by the PCAOB regarding the sufficiency of audit testing of fair value determinations. The PCAOB (and the SEC) has called for increased audit documentation surrounding assumptions as well as for audit firms to gain a better understanding of the inputs and methodologies used in determining fair value. The increased scrutiny on the auditors will have a direct impact on company management, since the company must ultimately take responsibility and ownership of every fair value determination on the balance sheet - even if an outside valuation firm was used.

Is Your Organization Up to the Task?

Is the company comfortable that it has the expertise in house to value assets and liabilities?

  • If a company does not have the expertise in-house to value a complex asset or liability, they can choose to hire an outside firm to help with the valuation. However, company management must still understand and agree with all approaches and judgments made by the outside valuation expert. Companies should take this into account when they invest in or acquire complicated assets or liabilities that will require significant time and expense just for the fair value determination.

Who is in charge of making fair value determinations (accounting, finance, treasury, separate valuation group)? What is their experience and credentials (CPA, CFA, ABV)?

  • If a company does decide to keep the fair value work in-house, they should consider who is best suited to complete the valuation work. They need to decide if the accounting and finance teams will have enough bandwidth to take on the extra task of valuing assets and liabilities during the quarter and year-end crunch times. If the company has significant assets and liabilities subject to fair value, the company may be able to justify a separate valuation group whose sole purpose is to perform the complex valuations that are required under Generally Accepted Accounting Principles (GAAP). Companies should ensure that the people in place who are making fair value determinations have the right experience and credentials. CPAs are well suited to perform valuations; however, there are many complex securities that even a well-seasoned CPA may have difficulty valuing.

What are the company policies surrounding determination of fair value and validation of the results? Are there specific policies for specific types of assets and liabilities? Are these policies consistently followed? Are there any exceptions to the policy and how are these exceptions reviewed with management?

  • The key to an effective policy is making sure it is known and enforced. There should be a policy manual available to all employees in the accounting and finance department and it should be reviewed and updated as needed. The policy should spell out all of the necessary processes and procedures to valuing a particular asset or liability. Management and directors must also agree with the policies and procedures and propose adjustments as necessary. Any deviations from the specific policies should be brought to the attention of management, who should gain a complete understanding of the reason for the deviation before signing off. Frequent management overrides of a policy should be a red flag that action is needed to either change the policy or investigate further the reason for the over-ride requests.

What valuation models are used in the fair value determination of each asset or liability? What would be the impact of switching from one model to another or using an average of multiple methods? For key judgments in the fair value calculations (future cash flows, discount rate, risk premium, comparable transactions), how were they determined and what would be the impact on fair value if these key judgments changed (sensitivity analysis)?

  • Management and directors should understand all significant inputs and judgments in the fair value determinations on the balance sheet. They should also understand how a change in an interest rate or a change in a cash flow assumption would affect the valuation reported in the financial statements. This will help management not only evaluate the reasonableness of the assumptions but also help them plan for the impact that changes in the overall economic environment might have on the company.
  • Valuations should be reviewed independently each period to leverage a fresh perspective. Assumptions should not simply be carried forward period after period without question.
  • Management should also pay particular attention to any changes in valuation methodologies from period to period. They should understand the reasons for changes in methodologies and the impact that the change has on the financial statements.

Are there any indications of other than temporary impairment (OTTI) for assets in an unrealized loss position?

  • Assets that are in an unrealized loss position require additional scrutiny from management and directors. GAAP requires additional disclosure for these assets, but it is up to management to judge whether these assets have been other than temporarily impaired. This judgment is critical since changes to fair value are not typically recorded in net income or loss on the income statement until an asset is sold. If the company makes the determination that the value will not recover, then the loss has to be recorded in net income or loss on the income statement even before the asset has been sold.

How are other companies valuing similar assets and liabilities? Can the company justify using the same or different methodologies? Does the company think its method is better than peer methods?

  • One gauge to the current state of the market is evaluating peer methodologies. Outside auditors will no doubt have insight into the methodologies that other companies are using for similar assets, but management should ensure that they are keeping up with the rapidly changing landscape if they have any new or complex types of assets. Companies should continually evaluate whether their valuation methodologies are reasonable in relation to the methodologies used by their peers.
  • Internal consistency is also important. Many companies these days are multi-national conglomerates that may consist of several public and private companies controlled by a single parent company. The parent company must ensure that there is consistency among the valuations of similar assets in its consolidated financial statements. For similar assets at different subsidiaries, the parent must ensure that assumptions and valuation techniques are consistent.

If fair value assets or liabilities were sold or settled during the period, what was the difference between the company's latest fair value determination and the actual sale price? What is the reason for any significant differences? If significant differences exist, is it an indication of a flawed fair value determination?

  • A good indication of the reasonableness of a company's fair value determinations comes when an asset is sold or a liability is settled. As an example, if a company sells their investment in a private company for half of the fair value that it was recorded on their balance sheet, this could indicate a flawed fair value determination. There are factors that could explain this discrepancy (decline in demand, increased competition), but this should be an immediate signal to management and directors that further review is required. Material discrepancies should be evaluated by management and directors and action should be taken to revise policies and valuation methodologies as necessary to result in more accurate and reliable fair value determinations.

What percentage of assets or liabilities is fair-value based on internal models versus external pricing quotes? Does the company perform internal valuations to validate external pricing quotes, and vice-versa, does the company obtain external pricing quotes to validate internal valuations?

  • There are often several different sources to value an asset or liability. Even if a company relies on an outside valuation or price confirmation from a broker for a specific asset, it is reasonable for a company to perform their own valuation to validate the external data. If a discrepancy arises, the company needs to understand the differences and be able to justify the stance that it takes when deciding to use one value over the other. This is a healthy exercise that can help companies refine their valuation expertise, but companies will always need to be prepared to reconcile and explain any discrepancies in calculated fair values.

Conclusions

These cases should serve as a reminder to investment advisers and other regulated entities that the SEC is focused on proper valuation, reporting and oversight with regard to determining the fair value of assets. In particular, understanding ASC Topic 820 and its standards will be important, especially when using Level 3 inputs to value such assets. In cases where markets are inactive or where transactions in the market are forced or distressed, Level 3 unobservable inputs, such as management estimates and assumptions about the market, may be all that are available. ASC Topic 820 requires companies using these inputs to also report the methodology used to determine fair value. Hedge fund, private fund, and mid-sized advisers should take special note of the requirements of ASC Topic 820 as Dodd-Frank requires these advisers to register with the Commission and comply with the Advisers Act as well as SEC rules.

The SEC's stated focus and recent enforcement action should alert investment advisers, hedge funds, BDCs, and similar entities that the SEC plans to look more closely at their investments and methodology for valuing assets. In response, such entities must strengthen internal controls and processes and increase disclosure of decision-making inputs. This is all the more pressing for those entities that must value Level 3 assets since such Level 3 asset valuations rely on unobservable inputs that are usually firm-supplied estimates. There is a higher chance of misstatement or inaccurate assessments if a culture of accountability and review has not been put in place. With the expected increase in SEC investigations and enforcement actions relating to asset valuation, it is important to be prepared.

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