5.5 Financial Instruments | DART – Deloitte Accounting Research Tool

Fair value has become an integral part of financial reporting and is often cited by investors as the most relevant measurement attribute for financial instruments. Under U.S. GAAP, derivative financial instruments, whether freestanding or bifurcated from host instruments, must generally be reported at fair value in the balance sheet. Consequently, the SEC staff often comments on how freestanding derivatives and bifurcated embedded derivatives have been measured and reported in the balance sheet. For example, the staff has frequently requested issuers to expand fair value disclosures to include quantitative information about significant unobservable inputs used in fair value measurements. Some of the SEC staff’s additional topics of focus related to financial instrument valuation include the following:

Significant assumptions, factors, and methods used to determine fair value.
Changes in valuation of the instruments over time.
Categorization of instruments in the fair value hierarchy.
Whether an independent valuation was performed contemporaneously.
Explanations of any discounts (e.g., marketability, liquidity).

For additional observations related to frequently issued SEC staff comments, see Deloitte’s Roadmap SEC Comment Letter Considerations, Including Industry Insights.

Because of the complexity of financial instruments, simple valuation models often are not appropriate for measuring fair value. At the Forum on Auditing in the Small Business Environment hosted by the PCAOB in 2012, the staff of the Division noted that errors in valuation of financial instruments often result from entities’ failure to carefully consider and evaluate the accounting implications of contractual provisions.3 Prospective registrants are strongly encouraged to evaluate such provisions, paying attention to the identification of any embedded features that may affect an instrument’s valuation. Such features may affect the settlement amount (and thus the fair value) of the instrument or embedded feature, and the valuation method or methods selected should appropriately incorporate all relevant terms.

The fair value of freestanding financial instruments (e.g., warrants) and bifurcated derivatives (e.g., conversion options bifurcated from debt or preferred stock) can fluctuate significantly with changes in the value of the underlying stock or underlying assumptions used in determining the instruments’ fair value. As is generally the case for a prospective registrant, when no active market exists for the underlying stock associated with the financial instrument, the entity must establish appropriate valuation processes and controls related to determining the fair value of both the stock underlying the financial instrument and the financial instrument in its entirety.

Connecting the Dots

Issuers often need to determine the fair value of the stock into which a financial instrument is convertible, because either the financial instrument in its entirety must be accounted for at fair value or an embedded conversion feature must be bifurcated and accounted for separately at fair value.

As the complexity of financial instruments increases, an entity may be required to use significant judgment in measuring fair value. Prospective registrants should ensure that their disclosures include the information investors need to understand how management determined fair value. Furthermore, depending on the complexity and terms of the instrument, an independent valuation specialist may need to be engaged to assess the instrument’s fair value. Section 7(a) of the 1933 Act requires that a written consent be obtained from an independent valuation firm that is “named as having prepared or certified any part of the registration statement, or is named as having prepared or certified a report or valuation for use in connection with the registration statement.”