5.5 Financial Instruments
5.5.1 Valuation of Financial Instruments
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 in the
SEC’s Division of Corporation Finance 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.”
Footnotes
3
For more information, see the slide presentation from the forum.