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What Price Hard-to-Price Assets

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By: Chris Kentouris | August 08, 2010

Additional requirements proposed by the Financial Accounting Standards Board on what firms must disclose in their financial statements about how they value so called hard-to-price assets could translate into a lot more data to process – and additional expense for fund managers and other financial firms.

As part of proposed changes to Topic 820, otherwise known as fair-value accounting, the FASB, the U.S. accounting standards body, has resurrected a previously discussed requirement that firms explain not only how they came up with the price of a security but any alternative “significant” prices they would have come up with. Comments are due by Sept. 7.

The FASB’s new disclosure requirement was first unveiled last year but subsequently dropped as the result of industry opposition. Topic 820, formerly known as FAS 157, has been one of the most controversial provisions of accounting standards. The goal of FAS 157, which went into effect in 2009, was to establish a common methodology for measuring the “fair value” of assets and liabilities but during the market downturn was criticized by banks for increasing the volatility of their assets – namely reducing their book value.

The FASB’s new disclosure requirement would apply to Level 3 securities which are the toughest to price. That is because their valuation is typically based on unobservable inputs or internally priced models which can be pretty subjective. Over-the-counter derivatives, private equity investments, asset-backed and mortgage-backed securities often fall under Level 3.

The FASB didn’t define the term significant but suggested that it would mean a situation in which the fair value of an asset would change when a different- but just as reasonable – input is used in the pricing calculation. For example, in the case of private equity investments, say valuation experts, a discounted cash flow of 25 percent could be just as reasonable to use as one of 35 percent.

If adopted, the change to Topic 820 would mean that firms must disclose just how it came up the price it valued the private equity investment based on a 25 percent discounted cash flow but also how they could have come up with another price valued at using a 35 percent discounted cash flow. The FASB recommended that firms use a table format to display the alternative inputs and changes in fair value.

But it remains to be seen just how effective the disclosure will be for investors. “The FASB is hoping that investors gain some measure of confidence in understanding whether a company’s management is comfortable or not with its valuations of Level 3 assets,” says Espen Robak, president of New York-based valuation firm Pluris Valuation Advisors. “However, they could still find it difficult to make correct comparisons between companies valuing the same asset.”

Because some Level 3 assets can easily be prone to a far wider range of valuations than other types of assets it won’t be easy for investors to completely understand the reasoning behind a firm’s choice of pricing models and inputs which make up its calculations.

Level 3 securities are one of three categories of securities for firms to value under Topic 820. Securities which can be valued using quoted prices in active markets – typically exchange traded equities -- are considered Level 1 assets while those which can be valued based on “observable inputs” such as quoted prices in similar securities are categorized as Level 2 securities. Fixed-income securities typically fall under Level 2.

Bottom line: the costs of preparing financial statements will easily will easily increase depending on the investment strategy and number of hard to price assets. For firms with only a handful of Level three assets the difference in cost won’t be substantial but for those with only a few but for those with several hundred the difference could easily come to over $1 million annually, say accountants. Depending on the investment strategy, a hedge fund could easily classify over 50 percent of its trades in the Level three category.

For starters, firms will need additional computing power to make more calculations and add database capacity to store both the alternative valuations and the data behind them. That is because for each calculation of the fair value of a Level 3 asset there may be at least two additional estimates required using reasonably possible alternatives to come up with an understanding of significant differences.

Firms will also need to aggregate data such as volatility, expected rates of return, yield curves, and exit multiples necessary to make the calculations themselves from external pricing vendors and internal databases. They will also need to ensure that their internal valuation committee review the alternative prices before they are published. If they don’t have one they will likely need to create one because there will be a lot of judgement calls to make. The potential members- the chief financial officer, chief trader, portfolio manager, and risk manager for starters.

“Firms will also need to hire outside valuation firms to help make judgments,” says Vince Calcagno, principal for the accounting and auditing firm of Rothstein Kass in Beverly Hills, Calif. Those which already rely on valuation companies to provide a range of values for each Level 3 asset must now ask for more details on the methodologies, models and inputs used to calculate the fair value of each asset separately. Firms will also need to pay more fees to auditors to do additional work to determine whether the multiple methodologies and inputs used to price the asset or liability are accurate.

The one saving grace: as the economy improves, there could be fewer securities categorized as Level 3. A study conducted in 2008 by the Securities and Exchange Commission showed that 9 percent of financial instruments subject to fair value were classified as Level 3, compared to 76 percent for Level 1.