Monday, March 31, 2008

WAG

The SEC recently sent out letters to CFOs about Fair Value accounting. It seems the SEC wants to be sure that companies are not valuing illiquid securities at too low a price:

Item 303 of Regulation S-K requires you to discuss, in your Management's Discussion and Analysis, any known trends or any known demands, commitments, events or uncertainties you reasonably expect to have a material favorable or unfavorable impact on your results of operations, liquidity, and capital resources. We note that you reported a significant amount of asset-backed securities, loans carried at fair value or the lower of cost or market, and derivative assets and liabilities in your financial statements in your recent Form 10-K. Statement of Financial Accounting Standards No. 157, Fair Value Measurements, defines fair value, provides a framework for you to measure the fair value of your assets and liabilities, and requires you to provide certain disclosures about those measurements.

Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability. Current market conditions may require you to use valuation models that require significant unobservable inputs for some of your assets and liabilities. As a consequence, as of January 1, 2008, you will classify these assets and liabilities as Level 3 measurements under SFAS 157.


What this means is that if a large hedge fund is forced to dump securities in a fire sale due to a margin call, you don't have to use those prices to value the same securities on your balance sheet. You can use "unobservable inputs" to determine the value. What are "unobservable inputs"? It's a WAG - Wild A** Guess and CFOs everywhere will be rejoicing now that they have the leeway to value these assets at whatever they need them to.

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