On the surface, fair value policies, procedures and internal controls don’t seem like high priorities for review. The accounting for fair value measurements is settled GAAP, or at least should be by now. The original accounting standard (referred to then as SFAS 157) was issued way back in 2006 and effective in 2008.While the fair value requirements (known as ASC 820 today) have been amended over the years, accounting and valuation professionals alike have operated under the 2008 single definition and framework for fair value. Within the framework are considerations for applying the fair value principles that may be important, particularly after a disruptive year.
A Refresher on the Definition of Fair Value and the Related Framework
Fair value is defined by ASC Topic 820 as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the measurement date. In plain English, it is a process to determine market value, which is why it’s often referred to as “fair market value.”
The concepts of exit price, active and inactive markets, orderly transactions, observable and unobservable inputs, and market participant have remained relatively unchanged over time. What has changed are the markets themselves, and because ASC 820 stresses the importance of using market participant assumptions, a changed market may affect fair value.
What Does Good Internal Control and Governance over Fair Value Look Like?
Good corporate governance for ASC 820 starts with the underlying documentation. Recorded amounts and disclosures within company financial statements should be supported by robust documentation including policies and procedures for estimating fair value. Companies should consider including the following written policies and procedures in their formal documentation, tailored appropriately for the specific financial instruments, assets and/or liabilities held by the company:
Companies should document the controls and processes for obtaining the data necessary to complete the valuation including the sources of information used and how it is validated. This should include obtaining relevant information for determining whether a broker price quote is observable or unobservable which will drive financial statement disclosures.
Closing the Books
Prepare policies for closing the books using an estimate of the initial valuation at the balance sheet date and be clear about when your company will update this estimate if better information is subsequently obtained that results in a materially different outcome. Thresholds that require an adjustment to the financial statements should be defined.
Effective internal controls should document a clear requirement for valuation reviews at each reporting period end, including a roadmap of when expanded or additional layers of review may be necessary. In disrupted markets, such as what was caused by the global pandemic, it is advisable to perform additional layers of review. Be sure to also note your company’s requirement to support and obtain internal approval for any changes to the valuation process.
While terms in the fair value accounting are clear, application of the fair value principles leave room for interpretation. Be sure to set specific policy for defining active and inactive markets, as well as orderly transactions versus distressed sales.
Many companies have internal valuation committees consisting of a broad cross section of senior management. Such committees are responsible for the oversight of the valuation process and generally approve the recurring, non-recurring and disclosure only valuations, as well as the appropriateness of valuation methodologies and any change to the application of valuation techniques.
The disrupted market, as noted above, may result in increased non-recurring valuation work, which makes now a good time to evaluate the effectiveness of your internal valuation committee. To be effective, valuation committee members (and management) need to know what questions to ask as part of their review and approval, such as:
- Do the inputs and outputs make sense directionally given the current market environment?
- Does the value make sense?
- Did any of valuation techniques change during the period?Why and who approved?
- Does the valuation reflect the market conditions at the balance sheet date?
- Do any of the company’s instruments trade in an inactive market?
- Did any internal control processes change because of the remote work environment?
Asking the right questions is part of the way to be effective, experience with valuation and financial reporting matters is another important element for yourcommittee. Another key consideration is the reliability of your valuation work.
Thoroughly documented valuation conclusions provide the valuation committee, company leadership and the accounting function with the proper level of support for signing off on company results and disclosures. As well as addressing the points above, your valuation memorandum should include the following:
- Support for key assumptions and rational for adjustments
- Reconciliations between actual results and assumptions
- Comparison of assumptions and valuation results with external market data which may include market trends, third-party valuations, industry publications, and pricing surveys
Bottom Line: Allow for More Time for Valuation Work
The market disruption related to the global pandemic may affect several aspects of the fair value process. To prepare for these factors, management teams may want to build in additional time to their financial reporting calendars for contemporaneously preparing robust and transparent documentation of their conclusions around fair value estimates. This is particularly true in scenarios that require an additional level of management review and scrutiny.
For more information, please contact Melissa Henry or a member of our team.
Published on March 02, 2021