Originally published 2 April, 2008

In March 2008, the Division of Corporation Finance of the Securities and Exchange Commission sent a letter 1 identifying a number of disclosure issues that public companies may wish to consider in preparing Management’s Discussion and Analysis (MD&A) for their upcoming quarterly reports on Form 10-Q.2 The letter was sent to a number of public companies that had reported in their most recent Annual Report on Form 10-K 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 particular, the letter focused on Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157), and the related MD&A disclosure requirements concerning those fair value measurements.

SFAS 157

In measuring fair value under SFAS 157, it is appropriate for a company to consider actual market prices, also called 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 market prices are not available is it reasonable for a company to use its assumptions, otherwise called unobservable inputs, of what market participants would use in pricing the asset or liability. If a company uses unobservable inputs in determining fair value, these are called Level 3 measurements under SFAS 157.3

Staff Guidance

Unobservable inputs and disclosure in MD&A. If a company uses Level 3 measurements and concludes that its use of unobservable inputs is material, it should disclose in its MD&A how it determined those unobservable inputs and how the resulting fair value of assets and liabilities, and possible changes to those values, impacted or could impact results of operations, liquidity and capital resources. In particular, the items to consider disclosing are:

  • The amount of assets and liabilities measured using significant unobservable inputs as a percentage of the total assets and liabilities measured at fair value.
  • The amount and reason for any material increase or decrease in any Level 3 assets and liabilities resulting from the transfer of assets and liabilities from or into Level 3 from other levels.
  • If a material amount of assets were transferred into Level 3 during the period, a discussion of:
    • The significant inputs that are no longer considered observable, and
    • Any material gain or loss recognized on those assets or liabilities during the period, and, to the extent that these gains or losses are excluded from the realized/unrealized gains (losses) line item in the required Level 3 reconciliation, the amount excluded.
  • With regard to Level 3 assets or liabilities, a discussion, to the extent material, of:
    • Whether realized and unrealized gains or losses affected results of operations, liquidity or capital resources during the period, and if so, how,
    • The reason for any material decline or increase in the fair values, and
    • Whether the company believes fair values diverge materially from the amounts it currently anticipates realizing on settlement or maturity, and if it does, disclosure of the reasons why and the basis for this belief.
  • The nature and type of assets underlying any asset-backed securities, for example, the types of loans and years of issuance as well as information about the credit ratings of the securities, including changes or potential changes to those ratings.

Additional MD&A disclosure considerations. Regardless of how assets and liabilities are classified for SFAS 157 purposes, the letter highlights the following items for all companies to consider disclosing:

  • The valuation techniques or models used with regard to material assets or liabilities, including a description of any material changes made during the reporting period to those techniques or models, why the changes were made, and, to the extent possible, the quantitative effect of those changes.
  • If material, the extent to which, and how, relevant market indices were used or considered in applying the techniques or models used to value material assets or liabilities.
  • Any material adjustments made during the reporting period to the fair value of any assets or liabilities based on market indices and the reasons for making those adjustments.
  • How the techniques or models used were validated.
  • How sensitive the fair value estimates for material assets or liabilities are to the significant inputs the technique or model uses.
  • If material, how increases and decreases in the aggregate fair value may affect liquidity and capital resources.

If you have any questions about this information, please contact any member of our Corporate and Securities or Securitization practices.

Learn more about our Corporate and Securities and Securitization practices.

Footnotes

1. A form of the letter is available at http://www.sec.gov/divisions/corpfin/guidance/fairvalueltr0308.htm.

2. Item 2 of Part I of Form 10-Q (Management’s Discussion and Analysis of Financial Condition and Results of Operations).

3. Level 1 measurements are those based on quoted prices in active markets, while Level 2 measurements are those primarily based on observable market information.

Mayer Brown is a global legal services organization comprising legal practices that are separate entities ("Mayer Brown Practices"). The Mayer Brown Practices are: Mayer Brown LLP, a limited liability partnership established in the United States; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales; and JSM, a Hong Kong partnership, and its associated entities in Asia. The Mayer Brown Practices are known as Mayer Brown JSM in Asia.

This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

Copyright 2008. Mayer Brown LLP, Mayer Brown International LLP, and/or JSM. All rights reserved.