United States

Refining fair value disclosures

MUSE  | 

Everyone who lives where there is seasonal change has had the experience of waking up to temperatures (and driving conditions) much different than those that existed when the evening ended the night before. When the day greets you with subzero temperatures, dangerous winds and two more feet of snow, it would be nice to hide inside until the spring flowers show up. That is not a realistic plan for most of us!

Every now and then, the financial markets greet us with a similar overnight change, and investors cannot hide from that any more than they can from the winter weather. An example of this occurred on Sept. 30, 2014, when a federal court issued an opinion that left agencies unable to pay dividends on Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) preferred and common stock. This resulted in opening prices on Oct. 1, 2014, for the Fannie Mae and Freddie Mac stocks to be 40 to 60 percent lower than the closing prices on Sept. 30, 2014.

What price do investors that publish quarterly or annual reports, whose report date coincides with a significant overnight market change, use to value their investments: the report-date market-closing price or the next day's opening market price? Before we answer this question, let's explore why the close and open market prices differ. The following paragraph provides an example of an 'opening cross', which is the term sometimes used to refer to the market close/open process.

While the markets are closed, trades accumulate. If the market opened at the previous close, and then accumulated trades were placed in order of receipt, trading would not work as it does when markets are open, allowing investors to adjust prices on buy and sell orders based on market activity. So the markets have a process to assess all of the orders that have accumulated during the market close, to communicate prices and imbalances to dealers and to allow those dealers to place orders that consider the impact of the accumulated orders. The orders that the dealers place, based on that process, set the opening market prices. Most of the time, the difference between the market's close and open prices are not all that material. Occasionally, however, like Sept. 30, 2014 to Oct. 1, 2014, there are differences that can be material for some investors.

The question then is whether the post-market-close change in price is a recognized or a nonrecognized subsequent event. When an investor has an explicit policy defining when fair value is determined, there is little uncertainty surrounding this evaluation. Most investors do have a defined process for setting market close prices; it is just that the policy is not written nor is it disclosed in sufficient detail in the fair value footnotes to the financial statements. Investors should examine the process they have followed in the past to determine whether they have been using prices as of the 4 p.m. ET market close, or whether they have been taking into account post-market-close activity. If the investor has been consistently following a practice, it should consider continuing that practice and documenting it in a written policy. Absent a historical practice, the investor should establish one and support it with a clear written policy. Additionally, investors should expand their fair value footnotes to include the now written policy.

A written policy to support whether post-market-close activity is a recognized or a nonrecognized subsequent event is a great first step, but there are also other disclosure matters to consider. In connection with this decision, there are two key implications to be considered: fair value level impact (when post-market-close changes in value are considered) and disclosure of subsequent events (when the investor uses the 4 p.m. ET market close price and does not adjust for material post-market-close activity).

Fair value level: FASB Accounting Standards Codification (ASC) 820-10-35-41C instructs that when a quoted price is adjusted for new information, "the adjustment results in a fair value measurement categorized within a lower level of the fair value hierarchy." To use the Fannie Mae and Freddie Mac event as an illustration, investors that considered the post-market-close activity in establishing fair value would not be using a quoted market price as of Sept. 30, 2014.

Disclosure of subsequent events: ASC 855-10-50-2 requires the disclosure of a nonrecognized subsequent event when the quantitative and/or qualitative evaluation of such an event indicates the financial statements will be misleading absent such disclosure. Again, using the Fannie Mae and Freddie Mac event as an illustration, investors that had a change in value in their aggregate position that was qualitatively and/or quantitatively significant to their financial statements would have had to disclose the subsequent event.

The Sept. 30, 2014 to Oct. 1, 2014, market event impacting the common and preferred stock of Fannie Mae and Freddie Mac was significant enough that the AICPA Financial Reporting Center, at the urging of the Expert Panels for Investment Companies, Depository Institutions, Insurance, Not-for-Profit, Employee Benefit Plans and Stockbrokerage and Investment Bank, issued a short article, Reporting Considerations - The Federal Housing Finance Agency decision to permit the "sweep" of Fannie Mae's and Freddie Mac's earnings to the Treasury .