Fair value reforms: keep the champagne on ice

Kudos to FASB for trying to eliminate useless fair value disclosures in the financial statement, but celebrations should be deferred until some hard proposals are being advanced. 

We don’t want to overstate the importance of FASB’s work on fair value disclosures, but let’s give credit where it’s due: America's Financial Accounting Standards Board is giving serious consideration to where it can reduce clutter in the financial statement, and recognizes that fair value disclosure is a great place to start.   

For the uninitiated, financial statements are bloated with useless disclosure notes written only to appease regulators, instead of achieving their intended purpose of providing transparency and highlighting risks. For private fund CFOs, the problem manifests most when writing disclosures about their fair value estimates, which tend to be for illiquid “Level 3” assets that are tough to price (and require careful explanation).

In theory this is as it should be, but some of the disclosure requirements are downright silly. For instance, having CFOs explain the “timing of transfers between levels” between one and two in the three-level fair value hierarchy (ranging from one to three) is a waste of breath; any move up or down happens out of necessity, given the amount of observable inputs at the CFO’s disposal.

FASB sees that, and has decided to think about removing the requirement at a board meeting earlier this month.

In fact, they’re minded to go further: another disclosure requirement on the chopping block relates to aggregate details about internal valuation processes, which don’t say much about any one portfolio company. But it’s tough to say for sure what the real world implications of the developments will be until the board releases an exposure draft detailing the changes (pfm understands one will be issued before July).

On the surface, it appears likely that the “roll-forward table” of Level 3 assets will technically be eliminated. However, this may not offer much relief in practice if you still require CFOs to show when they transfer in and out of level 3 of the fair value hierarchy, observes Duff & Phelps managing director David Larsen. “Wouldn’t the table make more sense and be easier to follow?”

CFOs may also like the idea of not having to disclose the valuation methods used in their estimates, but with a requirement to still report any significant unobservable inputs in the valuation, the reform has little effect at a practical level.

Again, even one less impractical disclosure footnote in the statement would be a nice win in the fight for more sensible financial reporting and auditing; and the signals coming from FASB on the issue are indeed promising. But it’s too early to declare this a victory until the real-world implications of the coming proposals can be studied in detail.