Sensitive information

CFOs in the US were recently spared the burden of having to conduct time-consuming sensitivity testing on their investments, but as greater alignment is sought with international standards, the issue may be revived during this year.

A recent Financial Accounting Standards Board (FASB) update eliminated a potentially burdensome disclosure requirement, but the issue may come up again in the US as more convergence is sought with international accounting standards.

In January FASB released Accounting Standards Update 2010-6, which stated that sensitivity testing is not required. The lack of such disclosures puts FASB at odds with the International Accounting Standards Board (IASB), and came after FASB received numerous complaints in the US saying that the difficulty in conducting sensitivity testing would lead to confusion.

“The concept of sensitivity disclosure conceptually makes some sense; it’s the practical application that makes it problematic,” said David Larsen, a managing director at Duff & Phelps. “They want to see whether there are reasonably possible alternative inputs and what would those alternative inputs result in from a fair value estimate. So if you are just valuing one investment you might get some interesting data.”

For instance, in one hypothetical example, to come up with fair value of an investment a private equity fund may use a multiple of trailing EBITDA to arrive at a value of 1,000. But they could also use a multiple of future EBITDA to arrive at a value of 1,200.

“So you could say if I used this set of inputs I get 1,200 and if used a different set I might get 900, and for a single investment that kind of makes sense,” Larsen said. “It all falls apart when you now start to aggregate, such as for, argument’s sake, if you have 10 investments.”

In such an example, the fair value for all 10 may be 1,000, with 1,500 for the upper end of the range and 800 for the lower end. Suddenly, the fair value of the portfolio is 10,000. The range would then extend from 8,000 to 15,000. Because of that portfolio effect, the information derived is not very meaningful.

“The problematic piece is using one set of inputs to come up with an alternative,” Larsen said. “Many private equity firms use multiple techniques and multiple inputs, so there was some feeling you could end up with, for a single investment, six different ways of looking at it. And then if you multiply that by 20 investments in a portfolio, all of a sudden you’ve got 120 different ways of looking at it, and how do you disclose that and how does that make sense?”

Larsen noted that in Europe, where firms must conform to IFRS accounting standards, sensitivity testing is not as rigorous as it would be under the guidance of US auditors, and therefore the requirement tends to be less burdensome in practice.
Such considerations led FASB to remove the sensitivity testing requirement, but it may not be gone for good, as both it and the IASB are currently working to achieve a common set of financial accounting standards, including a common fair value standard, in 2010. “There is the possibility that it could be added back in some fashion,” Larsen said. “At this point there is no requirement, just the conceptual backdrop that FASB and the IASB are working on convergence, so you can infer from that that either FASB will adopt something, or that IFRS will change or eliminate it, or that they will harmonise along some middle ground.”