Profession struggles with varying models

What are the challenges from the accounting standards’ (IFRS versus US GAAP) different valuation models – mark to market versus mark to comparators versus mark to model and different types of assets and jurisdictions?

Accounting standards may seem a dry and technical topic but the significant differences in how the same instrument or asset can be valued depending on which accounting standards are followed was beginning to cause some concerns. Some recent developments have made it less confusing, although there are still significant challenges confronting those undertaking valuations and audits.

Both sets of accounting standards would benefit from the provision of more detailed guidance covering the definitions of active and inactive markets, together with the impact on disorderly transactions, says the team at KPMG. They believe challenges are presented when questions arise, such as whether the use of a model is appropriate, if that model is sufficiently complex to address the valuation of the particular instrument and the appropriate data inputs.
For hard-to-value securities, the key challenge remains the ability to observe market data, KPMG says.

Anthony Pace and Noel Mizzi at KPMG in Malta agree the main challenges in accounting are those in the measurement of assets for which no active market exists or for which it is not easily determinable that no active market exists. 

They point out that the Financial Accounting Standards Board (FASB) issued FAS 157-3 and 157-4. These are to be followed in the evaluation whether there is a significant decrease in the volume and level of activity for the asset (or liability) when compared with normal market activity for the asset (or liability).

The International Accounting Standards Board (IASB) issued ED/2009/5 dealing with fair value measurement. Taking away a few differences, the ED substantively re-proposes the amendments under FAS 157-4 and is now in line with US generally accepted accounting principles (GAAP).

The significance of this is relevant in the choice of method to determine ‘fair value’, note Pace and Mizzi. While the existence of an active market will call for a mark-to-market measurement, evidence to the contrary will allow the use of a mark-to-model (FAS) and valuation techniques (IAS).

The type of assets being measured has a bearing on the valuation technique and on the type of inputs to the valuation technique, notes the pair. The ED makes reference to three levels of input covering the range by reference to the extent of how observable the inputs are. Normally it is relatively easy to identify level 1 market inputs since these represent straight-quoted prices in an active market. The difficulty arises when models have a mix of observable and non-observable inputs.

The financial reporting disclosures resulting from such changes will also be significant as International Financial Reporting Standards (IFRS) 7 will require classification of all assets and liabilities according to the input level used to determine their valuation, concludes Pace and Mizzi.

At KPMG in Dublin, Barry Winters and Garrett O’Neill also believe there are numerous challenges in the area of accounting standards. The most important of these, they say, were highlighted in a report by the Financial Crisis Advisory Group, set up by the IASB and FASB and issued in July 2009.

The report emphasised the need to address areas of accounting that have been highlighted as possible weaknesses by the global financial crisis. Such areas include difficulties in applying fair value in illiquid markets; timing and quantum of loss recognition for impaired assets; accounting for off-balance sheet structures; the level of complexity and detail in current standards; and the need for a common set of high-quality global standards, otherwise known as convergence.

Model challenges
When looking at the challenges from different valuation models, the two point out that if the market for a financial instrument is not active, then accounting standards require the use of a valuation technique or model. Particularly at a time of market dislocation, one of the key challenges for market participants is to ensure that the model or technique used results in a valuation that represents fair value, they say.

There are other challenges in using model-based valuations and valuation techniques, one of which is ensuring that the models arrive at consistent and comparable valuations, say Winters and O’Neill.

Another challenge is ensuring that valuation models are robust. To do this models should be calibrated against observable current market transactions or any observable market data.

Valuation models need to be transparent to investors. To do this a comprehensive disclosure framework, as required by SFAS 157 and IFRS, is useful in helping users to assess methods and inputs used to develop fair-value measurements and the impact of changes in the inputs used.

Many challenges are also presented by different asset classes. A number of asset classes have experienced significant challenges over the last year, point out Winters and O’Neill. Recent market conditions have introduced uncertainty into the securities markets with restricted trading and greater price volatility. This has given rise to difficulties in pricing securities.

These asset classes include asset-backed securities, collateralised mortgage obligations (CMOs), structured products and securities issued by Lehman Brothers.

Other asset classes, including bonds, private equity and property, have also experienced significant liquidity issues and reputational damage.

One of the overreaching challenges facing most if not all investment managers in all asset classes is restoring investor confidence in the ability of various asset classes to deliver performance, say Winters and O’Neill.
Finally, there are differences in jurisdictions that can also affect valuations. Operating in a number of jurisdictions continues to give rise to a variety of operational challenges, according to Winters and O’Neill. One challenge facing the industry is global distribution.

Lack of cohesion
At present there are many access points such as consultants, banks and private wealth managers, resulting in a very fragmented distribution with no large global or pan-European distributor. Marketing continues to be expensive due to the need for local market knowledge.

Other longstanding challenges arising from operating in different jurisdictions include differences in jurisdictions relating to product demand, culture, language, distribution channels, taxation and regulation.

The launch of Ucits IV legislation should allow asset managers greater flexibility in the domiciliation of funds and the use of master-feeder funds as a pooling technique, concludes Winters and O’Neill. This should result in reduced costs and ease the path for cross-border fund mergers and distribution, they say.

Stuart McLaren at Deloitte reiterates that both IFRS and US GAAP have recently issued specific guidance on fair value accounting, including definitions of fair value and significant disclosure requirements which funds must come to grips with and apply. “This year funds applying IFRS will have to begin disclosing the valuation category where each of their investments fall, as US GAAP applicants have done in the past. Additionally, funds and their managers need to stay abreast of the newly released (US GAAP) and the proposed changes (IFRS) to consolidation requirements,” he says.

Funds, notes McLaren, are required to mark to market where possible, but this is not always possible and often investments must be marked to model. “The challenge with models is that they require a level of judgement. Two very knowledgeable individuals can value the same security differently, which thus makes identifying the ‘right’ value very difficult,” declares McLaren, adding that assets trading in illiquid markets continue to represent the largest challenges.

PricewaterhouseCoopers’ Colin Hanson in the Cayman Islands agrees with colleagues that both IFRS and US GAAP are experiencing a period of significant change creating many challenges for the accounting profession.

“Disclosure requirements are quite extensive and many clients are challenged to find sufficient and appropriate internal human and technical resources to meet such demands,” he points out.

“It is important to note that IFRS and US GAAP are undergoing a period of convergence with the objective of eliminating significant differences,” he continues.

Models can vary by client and by asset type and can be based on cash flow or the market. Mark to market is relatively straightforward, but the volume of trading/level of market activity requires careful consideration, points out McLaren, adding that model-based valuations can involve “very judgemental and subjective inputs”.

“Assets that experienced significant decreases in liquidity, for example, asset-backed securities, have caused the greatest challenge as the lack of observable data inherently results in the use of more unobservable data,” he notes.
For McLaren, jurisdiction is less relevant, although certain jurisdictions “inherently have significantly less liquidity and transparency, which leads to greater use of unobservable data inputs in the valuation,” he concludes.