Global Harmony: Fair But Not Easy
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Global Harmony: Fair But Not Easy

By: Chris Kentouris | May 23, 2011

Convergence – it’s a phrase used by accounting specialists to describe efforts to adopt similar financial reporting rules on both sides of the Atlantic.

The goal is for companies which follow U.S. rules to migrate to new international rules with relative ease.

Among the most recent accounting rules which standards bodies in Norwalk, Conn. and London say they have agreed on is how to calculate and report the “fair value” of financial instruments.

On May 12, the Financial Accounting Standards Board, came out with a 331-page document of changes to its “generally accepted accounting principles,’’ which are used in the United States. The International Accounting Standards Board in London came out with its own 110-page document.

The good news: The two pretty much match up.

Now for the bad news. U.S. firms could have to make some technology and operational changes to comply with a new version of “fair value accounting,” which will require firms to reveal in far greater detail just how they value so-called called Level 3 securities.

These changes are necessary, even if American firms don’t have to worry about complying with the international standards just yet. The new U.S. requirements will be effective for public companies in any annual report issued after after December 15, 2011. The rules take effect for non-public companies for their annual periods which begin after December 15.

That doesn’t give firms much time to prepare. “Firms will have to review their securities masterfile, data warehousing, portfolio accounting and reporting systems to ensure they have the correct information and can aggregate the information to comply with additional disclosure requirements,” says Rick Martin, vice president of Pluris Valuation Advisors, a New York firm specializing in valuing business entities and illiquid securities. “For financial instruments categorized in Level 3, they will also have to document their internal valuation policies and procedures, ask their third party valuation firms for help in complying with new quantitative disclosures.”

Firms must also ask their operations staff involved with valuations to make decisions on how to categorize many securities – such as loans -- that are not required to be valued using the fair-value rules but are subject to the same disclosure requirements.

Under current rules, firms must categorize the financial instruments they value in one of three buckets – Level One, Level Two and Level Three. Securities which can be valued using quoted prices for identical securities in active markets are considered to follow Level One. Those which can be valued based on “observable inputs” such as quoted prices in similar securities are generally categorized as level two securities while those which are based on unobservable inputs – aka internal models – fall under Level Three. Fixed-income securities that trade in inactive markets often fall under Level Two while over the counter derivatives, private equity instruments, asset-backed and mortgage-backed securities often fall under Level Three.

The U.S. standard setting organization, called Financial Accounting Standards Board, now wants U.S. firms to disclose even more about the methodologies and calculations they use for securities in the Level 3 category. The pricetag for the change will be significant – in the multimillions -- depending on the current preparedness of the firm and the types of securities it trades and holds.

Here are just five of the new requirements: