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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks Before the 2006 AICPA National Conference on Current SEC and PCAOB Developments


Cheryl K. Tjon-Hing

Valuation Specialist, Office of the Chief Accountant
U.S. Securities and Exchange Commission

Washington, D.C.
December 13, 2006

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publications or speeches by any of its employees. The views expressed are those of the speaker and do not necessarily reflect the views of the Commission or other Commission staff.


Many of the fair value measurement issues we see at the Commission can be characterized as a subset of one overarching problem: an insufficient understanding of how certain guidance, in current authoritative accounting literature, may impact fair value methodologies and assumptions. Now, when I say an "insufficient understanding", I mean that preparers of certain fair value measurements (that is, management which may also include a retained valuation specialist), and/or their auditors, were unaware of certain relevant accounting guidance that affected the fair value measurements in question.

At this time, it seems appropriate to remind everyone that fair value is a financial reporting concept. I say that because, well for one thing, fair value is defined in Financial Accounting Standards ("FAS"), most recently FAS 1571. In addition, when certain accounting guidance is established, such as there should be no consideration of blockage discounts in derivations of fair value, the term fair value starts to distinguish itself from other traditional valuation premises such as fair market value. Thus, it follows that to come up with a particular appropriate fair value measurement for financial reporting purposes, one would need to understand all the relevant accounting guidance that would affect that measurement. Unfortunately, we are seeing far more cases in which this knowledge is clearly lacking.

Let me give you a few examples of some of the problems we are seeing:

Exclusion of Tax Amortization Benefits

Tax amortization benefits (TAB) represents, as its name implies, the cash flow generated to an owner of an asset as a result of being able to write-off the full fair value of that asset for tax purposes — generally, this benefit may impact a fair value conclusion, derived using an income approach, by as much as 20% to 30%. Now, it seems logical that the fair value of an asset should not change just because of the way a transaction is structured. So TABs should be taken into account, in determining asset fair values, no matter what the tax attributes of a transaction are. But for those requiring more specific guidance, FAS 109, paragraph A1292 implicitly states that TABs should be factored into an asset's fair value. To the extent that a portion of the step-up value is not deductible for tax purposes, that is what deferred tax liabilities are for. In fact, preparers of fair value measurements should be aware that if a TAB is not factored into the fair value of an asset, there may be a mismatch if any associated deferred tax liability is recorded, for accounting purposes, in an acquisition transaction. Now, despite the aforementioned accounting guidance, we often see that TABs are excluded from asset fair values measured for business combinations effected through a purchase of shares — usually, this is because preparers argue that any step-up in fair value over tax value is not deductible for tax purposes.

Fair Value of Compound Embedded Derivative Instruments

In another example, FAS 1333 requires that embedded derivatives be separated from their host contract and accounted for as a separate instrument at fair value (unless a fair value election is made pursuant to FAS 1554). Where a single, hybrid financial instrument with multiple embedded derivative features is involved, DIG Issue No. B15 clearly states that those features must be bundled into a single, compound embedded derivative instrument.5 Hence, based on this accounting requirement, it follows that those features should also be measured at fair value accordingly; that is, in a single valuation model. However, once again, despite the clear accounting guidance, we often see separate fair value measurements derived for each embedded derivative component which are then added together for accounting purposes. Not only is this inconsistent with the accounting literature, but it likely produces an inappropriate valuation since multiple options in the same document would usually affect each others' values, in way that cannot be captured if each option is valued separately. Often when we point this out to registrants, a more complex valuation model is required than was originally used to value each of the individual embedded derivative components.

Quality Fair Value Measurements

The aforementioned examples, as well as others not discussed here, have nothing to do with differences in professional judgment or reliability of measurement. Instead, it is clearly the case that the derived fair value measurements are inconsistent with guidance as set out in authoritative accounting literature.

This problem may only grow as more and more financial accounting standards and related guidance are issued that may have an impact on fair value measurements. Especially, since relevant guidance is also written, more subtly, in the form of accounting requirements and, thus, it is up to preparers of fair value measurements to pick out what aspects of the accounting standards and related guidance may impact a particular fair value measurement.

This may not be so easy a task as not all relevant guidance is labeled, "fair value implications — so please read". While FAS 157's6 title, "Fair Value Measurements" makes it pretty clear that it should be read by fair value measurement preparers and reviewers; it may not be so clear, for example, that FAS 109, "Accounting for Income Taxes"7 also has, although implicitly, fair value measurement guidance written into it.

Preparing quality fair value measurements requires not just a competency in valuations (the level of which may vary depending upon what is being valued), but also an understanding of relevant accounting literature.

I would like to remind you that it is management's responsibility to ensure that fair value approaches and assumptions are consistent with authoritative accounting guidance. If, in preparing their fair value measurements, management feels it does not have the competency to carry out this task, in its entirety, then they should consider retaining appropriate services such as those of a valuation specialist.

However, as noted before, some of the relevant fair value guidance may not be that obvious as they may be obscured by accounting requirements. As such please be aware that it is our experience that retained valuation specialists may or may not be that familiar with all the relevant accounting literature impacting fair value measurements. But, that is understandingly so — historically, for example, deferred taxes is not a topic typically found in valuation curriculums; just as contingent claims analysis is not a concept familiar to many accountants.

Nevertheless, management still needs to ensure that the valuation and accounting competencies are appropriately combined.

Now, I want to make it very clear that I am in no way suggesting that valuation specialists should all of a sudden rush out and make interpretations about accounting literature — far from it. Rather, management should gain an understanding of where the valuation specialist's core competencies lie and plan accordingly. It may be the case, for example, that management, whom is knowledgeable in accounting, may need to work more closely with the valuation specialist to ensure quality fair value measurements are derived.

Auditors also need to keep abreast of accounting guidance that will impact fair value measurements in order to properly audit those measurements.


Whatever the way forward, it should not be left up to the SEC staff to point out these type of, what I would describe as, "non-subjective" fair value issues to preparers and reviewers of fair value measurements in order for compliant values to be provided to investors.

This concludes my prepared remarks. Thank-you.



Modified: 01/12/2007