Can Companies Excel at Fair Value?

Finance departments are using spreadsheets to tackle FAS 157, an approach few regard as optimum.

When FAS 157 took effect last November, many finance departments and business units faced a new accounting requirement but lacked any new technology with which to address it. To determine the fair value of a wide range of balance-sheet items, they turned to that old standby, the spreadsheet, to piece together models that they hoped would make sense to shareholders and auditors.

A year later, not much has changed. Spreadsheets are often still the starting point when trying to figure out what a portfolio of credit default swaps or a series of collateralized debt obligations would fetch on the market. That’s a worrisome thought for auditors and CFOs — especially because many users construct spreadsheets so poorly that the results may be impossible to verify.

FAS 157 builds on an older rule, FAS 133, which forced companies to divulge the fair value of derivative instruments. But FAS 157 goes a major step further, telling companies how to value the assets and liabilities on their balance sheets that they mark to market. It has affected financial companies in a big way. “If the subprime crisis hadn’t happened, FAS 157 would have been a ‘Who cares?’ kind of thing,” says Jiro Okochi, CEO of Reval, a New York–based vendor that recently added a 157 module to its software for managing derivatives. “Auditors wouldn’t have paid much attention.”

They do now. But while FAS 157 introduced a much stronger emphasis on the methodology behind fair-value calculations, that has not inspired software that can automate that process. “I haven’t seen a single solution in the marketplace that would address all the issues,” says Peter Marshall, a principal in Ernst & Young’s treasury advisory practice. “People are using existing systems and doing manual workarounds.”

Information Vs. Data
Most people, anyway. Wesley Walton, vice president of finance at CBC Federal Credit Union, has managed to tap newer technology, in this case an analytics function contained in software from Brick & Associates that allows Walton to perform fair-value calculations. But a credit union with just $300 million in assets and one primary software vendor has an easier time of it than larger companies.

Indeed, big companies face the irony of having too much software. A large bank will typically use different applications to handle accounting for bond transfers, commercial-lending decisions, and foreign-exchange transactions, to cite just three of many activities potentially affected by FAS 157. Therefore, multiple vendors must modify their systems to handle the dictates of FAS 157.

It also isn’t clear that FAS 157 can even be captured in computer code. The rule is partly intended to force companies to articulate how they arrive at valuations for illiquid securities — the so-called Level 2 assets, where there may be some observable inputs in the market; and Level 3 assets, where there is nothing comparable in the market and valuations are determined by models. Explaining valuation methods amounts to disclosure notes in financial statements, a form of information that doesn’t fit neatly into the fields of a database.

Still, a database, with its central controls and its knack for forcing information into a consistent format, is ultimately where all valuation information needs to end up, according to those who understand the pressures CFOs face in tracking and accounting for hard-to-value securities. The database can be the same one a company uses for other purposes — an Oracle database with programs written in Java, for example, or a SQL Server database with programs written for Microsoft’s .NET framework. “Those are all off-the-shelf,” says Duff & Phelps valuation expert Joseph Pimbley. “It’s not a case of a specialized firm inventing something new.”

Piece by Piece
In theory, the financial assets on a company’s balance sheet are ready-made for tabulation, sorting, and what-if analyses — work that software does well. So the earliest attempts to address FAS 157 have come as enhancements to asset/liability management (ALM) systems, the software used at banks and corporate treasuries.

“Many companies came out fairly promptly with a patch or upgrade” addressing FAS 157, says Denise Valentine, an analyst who covers asset-management systems for the Aite Group in Boston. British Columbia–based analytics provider FinCad and Reval are among the software firms that have added FAS 157 functionality to products that are live with clients. Bank of New York offers its clients a FAS 157 reporting package as part of its Workbench online portal of software tools.

The difficulty of addressing FAS 157 comprehensively hasn’t stopped software companies from tackling individual pieces. Reval was among the first to make it easy to see which financial instruments have moved from Level 3 to Level 2. That’s useful, because those assets could get a company, and its auditor, into trouble if their value later evaporated and the company had to justify their recategorization.

SAP is trying to sell banks on the idea of using its accounting for financial instruments (AFI) product to comply with fair-value requirements. Introduced three years ago for European banks, AFI functions as a financial-products subledger layer between the general-ledger and operational systems, taking data from such systems and putting it into a format that lets users value most financial instruments, while allowing some work to be done in decentralized systems.

Team Obama: Today in European Finance for November 8, 2008

Team Obama

While we wait to find out who becomes Treasury Secretary, here’s what Obama’s economic advisory board might say about some more specific corporate finance issues.

President-elect Barack Obama met today with his Transition Economic Advisory Board, part of an effort to develop “a strong set of policies to respond to the economic crisis.”

Flanked by his advisers, at a press conference following the meeting — his first since the election — Obama emphasized that he did not “underestimate the enormity of the task that lies ahead.” But he refused to end rampant media speculation by answering questions about new personnel appointments. To date, Obama has named only his chief of staff, Illinios Congressman Rahm Emanuel.

Many have said that the position of Treasury Secretary, in particular, should be filled quickly as the nation struggles with its worst financial crisis since the Great Depression. One of the pundits’ top picks for that position, former Federal Reserve Chairman Paul Volcker, 81, stood immediately on the President-elect’s left as he spoke.

“I want to move with all deliberate haste,” President-elect Obama said. “But I want to emphasize ‘deliberate’ as well as ‘haste.’ It’s very important in all these positions, both in the economic team and the national security team, to get it right.”

Yet even as speculation continues about who will hold the top titles within an Obama administration, the makeup of the President-elect’s advisory board provides a possible window into some specific corporate finance issues, from the move to international financial accounting standards to the future leadership of the Securities and Exchange Commission.

For example, Obama’s board contains both a former SEC chairman, William Donaldson, and a former commissioner, Roel Campos. Although SEC commissioners, including current chairman Christopher Cox, serve for set terms, Cox has said he will step down at the end of the Bush administration.

Donaldson, Cox’s immediate predecessor, would be an intriguing choice to once again lead the commission. The 77-year old Republican announced his resignation in June 2005, a move many thought was forced by the Bush Administration after he proved an aggressive regulator who did not offer the relief from section 404 of the Sarbanes-Oxley Act that some companies had hoped for. He also sought to extend the SEC’s authority over hedge funds.

This year, Donaldson has been sharply critical of “pendulum pushers” — those who he says have sought to move the regulatory pendulum too far toward deregulation. And although it was under Donaldson that the SEC first proposed a roadmap for eliminating the requirement that foreign companies reconcile their financial statements to U.S. generally accepted accounting principles, he has recently been critical of the rapid movement toward adopting International Financial Reporting Standards in the United States, referring to them obliquely as “vague, principles-based” financial reporting.

Choosing Donaldson, who recently called financial regulation as basic as the need for “stoplights on a highway,” would comply with Obama’s pledge to have a bipartisan administration, while also signaling an intent to rigorously police the financial markets.

Another possible, and younger, pick would be Democrat Roel Campos, who left the SEC in September 2007. Campos, the first Hispanic to serve on the SEC, pushed for shareholder access to proxy statements and other positions that were unpopular with the corporate community. He was also an advocate for small business, arguing in 2006 that that smaller companies should have more time to comply with the costly internal-control provision of the Sarbanes-Oxley Act.

Campos represented the commission in dealing with international regulators and served as vice chair of the Technical Committee of the International Organization of Securities Commissions. A Campos pick for SEC chairman could suggest a continued move toward global regulation of securities markets, albeit with much stronger shareholder controls.

Former Federal Reserve Chairman Paul Volcker’s position at Obama’s left during the press conference may represent no more than the importance that Volcker currently holds as an adviser, and if Obama were to appoint him to any position in the administration, it would almost certainly be as Treasury Secretary.

Yet most media descriptions of Volcker overlook his stint in 2000 as chair of the organization that created the modern International Accounting Standards Board. The speed of the recent move to adopt International Financial Reporting Standards in the United States, a move championed by current SEC Chairman Cox, is almost certain to come under scrutiny in an Obama administration. Yet Volcker would likely still support the overall goal of moving to international standards, even if the timetable were to change.

Obama’s Transition Economic Advisory Board includes:

• David Bonior (member, House of Representatives 1977-2003)
• Warren Buffett (chairman and CEO, Berkshire Hathaway) who participated via speakerphone
• Roel Campos (former SEC commissioner)
• William Daley (chairman of the midwest, JP Morgan Chase; former secretary, U.S. Dept of Commerce, 1997-2000)
• William Donaldson (former chairman of the SEC 2003-2005)
• Roger Ferguson (president and CEO, TIAA-CREF and former vice chairman of the Board of Governors of the Federal Reserve)
• Jennifer Granholm (governor, State of Michigan)
• Anne Mulcahy (chairman and CEO, Xerox)
• Richard Parsons (chairman of the board, Time Warner)
• Penny Pritzker (CEO, Classic Residence by Hyatt)
• Robert Reich (University of California, Berkeley; former secretary, U.S. Dept of Labor, 1993-1997)
• Robert Rubin (chairman and director of the Executive Committee, Citigroup; former secretary, U.S. Dept of Treasury, 1995-1999)
• Eric Schmidt (chairman and CEO, Google)
• Lawrence Summers (Harvard University; managing director, D.E. Shaw; former secretary, U.S. Dept of Treasury, 1999-2001)
• Laura Tyson (Haas School of Business, University of California, Berkeley; former chairman, National Economic Council, 1995-1996; former chairman, President’s Council of Economic Advisors, 1993-1995)
• Antonio Villaraigosa (mayor, City of Los Angeles)
• Paul Volcker (former chairman, U.S. Federal Reserve 1979-1987)

Financial crisis: The end of optimism

The hits just keep on coming. Between Oct. 6 and Oct. 10, the Dow Jones industrial average plunged more than 1,800 points, as forced sell-offs led to one of the biggest drops in the history of the index. Major markets are now down between 30% and 40% from last year. For anyone managing money or a business, or hoping to retire soon, it is a distressing, anxious time. The mood, on Wall, Bay and Main streets, is bleak.

Small wonder. After all, even the experts have been thrown off balance. Ben Bernanke, the head of the U.S. Federal Reserve, seems to be innovating policy on the fly, along with policy-makers around the western world. Multibillion-dollar economic decisions that would otherwise have involved years of debate are being made in minutes, between just a few people, and behind closed doors. And so actions that are designed to instil confidence end up working in reverse.

These are not normal times. The global financial system is in shock, and central bankers are trying to keep the body warm until the vital organs — credit markets — start working again. But the shock waves from the financial sector are just now beginning to move into the real economy. That suggests we’re going to see disappointing earnings, budget chaos, shutdowns and layoffs in the months ahead. We are also going to see the cost of capital rise as the economy enters a period of lowered expectations. It’s going to be harder to do business at every level.

To help you navigate the turbulence, we’ve prepared an emergency response kit: Where do you put your money? How do you manage your company through this? What are small businesses doing to shelter from the storm? And perhaps most satisfyingly: Who’s to blame for this mess?