Congress, Regulators Spar on Fair-Value Accounting

Fair value accounting became the political whipping boy in the federal bank bailout package last week, with cries all over Capitol Hill to suspend it, leave it alone, or offer better explanations of how to use it.

Some 65 members of Congress appealed to the Securities and Exchange Commission to suspend all fair value and allow troubled financial institutions to value securities as if they were planning to hold them to maturity. Legislative language in various iterations of the bailout package includes a directive to the SEC to remember its authority to override accounting rules, and to study use of fair value with a report back to Congress within 90 days.

Investor groups, including the CFA Institute and the Council of Institutional Investors, fired back with retorts that such action would undermine financial reporting and further erode whatever little confidence investors may still have in capital markets. Even the audit profession piped up, with letters from the Center for Audit Quality and PricewaterhouseCoopers trying to calm the panic.

The SEC and the Financial Accounting Standards Board responded last week with emergency guidance to clarify how fair-value accounting should be applied in today’s unprecedented period of market illiquidity. The guidance essentially reminds preparers and auditors that when markets are inactive, valuation under Financial Accounting Standard No. 157, Fair Value Measurement, requires judgment and the use of other measures. As such, it sends a not-so-subtle message to auditors to curb their own letter-of-the-law interpretations of the standard.

FASB also published its proposed guidance on how to apply FAS 157 in the current environment as promised at its Wednesday meeting.

Herz

FASB Chairman Bob Herz lamented during the meeting that the attention focused on FAS 157 is somewhat misplaced; FAS 157 didn’t require any new use of fair value when it became effective, but it did establish a framework for how to measure it that relies chiefly on the price that would be fetched in an open market.

Lobbying efforts to suspend use of fair value seem focused on the damage FAS 157 does to financial institutions’ balance sheets. “The job of financial reporting is to try to provide information to investors in capital markets,” Herz said. “It’s not there for regulatory capital, or to boost the balance sheets of financial institutions.”

To tinker with accounting rules—whether it’s FAS 157, which governs how to measure fair value, or any other rules that spell out when fair value should be used—would not serve investors, Herz said. “Whether you call it fair-value accounting, or mark-to-market, or taking an impairment charge for certain things to write them down in the current conditions, the idea of writing things down in a down market has been there for centuries,” Herz said. “It’s been the convention for a long, long time.”

Mard

Michael Mard, managing director at the Financial Valuation Group and a member of FASB’s advisory Valuation Resource Group, described the challenge of applying FAS 157 as such: “An asset on the books at cost of 100 percent might have a cash flow value of 90 percent,” he said. “However, the distressed market has no liquidity, so the latest transaction paid was a steal at 20 percent. Should fair value be the 20 percent, or perhaps the 90 percent discounted for the problems—say, to 60 percent? The auditors today are requiring the banks and investment houses to use the 20 percent.”

Mard said the SEC and FASB joint guidance clarifies that preparers and auditors must use more judgment, and where appropriate, allow the 60 percent. The 40-point difference in those two competing views “is the expense that hits the income statements in today’s headlines, creating technical and real insolvencies,” he said.

Bankers vs. Auditors

Donna Fisher, director of tax and accounting for the American Bankers Association, says bankers were doing a “dance of joy” over the SEC-FASB guidance because it clarified that judgment is necessary when market activity has vanished. Fisher says some auditors were establishing their own bright-line standards for when an asset should be written down based on how long or how deeply it had been traded below book value.

157 AMENDED

The following excerpt is from FASB’s recent proposed amendments to Statement 157:

Paragraphs A32A–A32F and the heading preceding them are added as follows:

Example 11—Determining Fair Value in a Market That Is Not Active

Note: The conclusions reached in this example are based on the assumed facts

and circumstances presented. Other approaches to determining fair value may

be appropriate.

A32A. On January 1, 2008, Entity A invests in a BBB-rated tranche of a

collateralized debt obligation security. The underlying collateral for the

collateralized debt obligation security is unguaranteed nonconforming

residential mortgage loans. Prior to June 30, 2008, Entity A was able to

determine the fair value of the collateralized debt obligation security using a

market approach valuation technique based on either (a) quoted prices in active

markets for identical collateralized debt obligation securities without any

adjustment (Level 1) or (b) quoted prices in active markets for similar

collateralized debt obligation securities with insignificant adjustments for

differences between the collateralized debt obligation security that Entity A

holds and the similar collateralized debt obligation securities (Level 2).

A32B. Since June 30, 2008, the market for collateralized debt obligation

securities has become increasingly inactive. The inactivity was evidenced first

by a significant widening of the bid-ask spread in the brokered markets in which

collateralized debt obligation securities trade and then by a significant decrease

in the volume of trades relative to historical levels as well as other relevant

factors. At September 30, 2008 (the measurement date), Entity A determined

that the market for its collateralized debt obligation security is inactive and that

markets for similar collateralized debt obligation securities (such as higher-rated

tranches within the same collateralized debt obligation security vehicle) also are

inactive. That determination was made considering that there are few observable

transactions for the collateralized debt obligation security or similar

collateralized debt obligation securities, the prices for transactions that have

occurred are not current, and the observable prices for those transactions—to

the extent they exist—vary substantially either over time or among market

makers, thus reducing the potential usefulness of those observations.

Consequently, while Entity A appropriately considers those observable inputs, ultimately, Entity A's collateralized debt obligation security will be classified

within Level 3 of the fair value hierarchy because significant adjustments are

required to determine fair value at the measurement date.

A32C. Entity A determines that an income approach (present value technique)

that maximizes the use of observable inputs and minimizes the use of

unobservable inputs will be equally or more representative of fair value than the

market approach used at prior measurement dates. Specifically, Entity A uses

the discount rate adjustment technique described in Appendix B of Statement

157 to determine an indication of fair value.

A32D. Entity A determines that the appropriate discount rate21a used to

discount the contractual cash flows of its collateralized debt obligation security

is 22 percent after considering the following:

The implied rate of return at the last date on which the market was

considered active for the collateralized debt obligation security was 15

percent. Based on an analysis of available market data for mortgage-related

debt securities, Entity A determines that market rates of return generally

have increased in the marketplace since the last date on which the market

was considered active for the collateralized debt obligation security. Entity

A determines that credit spreads have widened (100 basis points) and

liquidity risk premiums have increased during that period (400 basis points).

Other risks (for example, interest rate risk) have not changed. Thus, Entity A

estimates that an appropriate rate of return is 20 percent. In making that

determination, Entity A considered all available market information that

could be obtained without undue cost and effort. For this collateralized debt

obligation security, the available market information used in assessing the

risks in the security (including nonperformance risk [for example, default

risk and collateral value risk] and liquidity risk) included (a) quoted prices

that are not current that represent orderly transactions for the same or similar

collateralized debt obligation securities, (b) relevant reports issued by

analysts and ratings agencies, (c) any directional movements in relevant

indexes, for example, interest rate and credit risk indexes, and (d) other

relevant market data.

Indicative quotes (that is, nonbinding quotes) for the collateralized debt

obligation security from brokers or independent pricing services based on

proprietary pricing models (that is, Level 3 inputs) imply a rate of return of

25 percent.

A32E. Because Entity A has two indications of the appropriate rate of return

that it determines market participants would consider relevant in estimating fair

value, it evaluates and weighs, as appropriate, the respective indications of the

appropriate rate of return, considering the reasonableness of the range indicated

by the results. Entity A concludes that 22 percent is the point within the range

that is most representative of fair value in the circumstances. Entity A's conclusion is based in part on the fact that the relative indications of the

appropriate rate of return are reasonable in relation to each other given the

nature of the asset and current market conditions.

A32F. In accordance with the requirements of Statement 157, Entity A has

determined that the risk-adjusted discount rate appropriately reflects the

reporting entity's best estimate of the assumptions that market participants

would use in pricing the asset in a current transaction to sell the asset at the

measurement date. Risks include nonperformance risk (that is, default risk and

collateral value risk) and liquidity risk (that is, the compensation that a market

participant receives for buying an asset that is difficult to sell under current

market conditions).

Source

FASB Statement 157 Amendments (October 2008).

“We were hearing if the security had been under water six to nine months, or if it was more than 35 percent below book value, you had an other-than-temporary impairment,” she says—which would result in a writedown that would nick earnings. “That is not in the standard. [The guidance] says clearly that there are no bright lines.”

David Larsen, managing director at financial advisory firm Duff & Phelps, says while the guidance emerged under political pressure, it will help to shape expectations about using FAS 157. “Practice was starting to develop, and to some extent it was mandated by the auditors, to focus on the last transaction price because it was observable,” he says. “They probably kept on that a little longer than was necessary.”

The Center for Audit Quality and the Big 4 firms declined to discuss the guidance that’s been issued so far, or the extent to which it was intended to counter the emergence of their own FAS 157 interpretations.

Garmong

Sydney Garmong, an executive at second-tier firm Crowe Horwath (formerly Crowe Chizek), says she didn’t witness bright lines forming.

“This is a highly judgmental area,” she says. “So much depends on what asset you’re trying to value. If you got a third-party quote, what was it based on? Was it actual transactions or similar transactions? How old are they? There are a lot of factors that go into it.”

Barbara Roper, director of investor protection at the Consumer Federation of America, says she worries the guidance will be stretched to prop up wobbly balance sheets and will weaken auditors’ efforts to attempt to call out abuses.

Roper

“While the guidance doesn’t appear to say anything that is in direct conflict with FAS 157, it does suggest that the SEC will be far more tolerant of those who seek to avoid marking assets to market,” she says. “The fact that it was so enthusiastically embraced by the ABA and other industry groups lobbying to weaken mark-to-market accounting suggests to me that it is likely to be misused in ways that will later come back to haunt us.”

While 65 members of Congress appealed to the SEC to suspend all use of fair value, Fisher says she does not expect anything that dramatic any time soon.

Banks have lobbied for the ability to mark values based on their plans to hold them to maturity rather than selling them in a down market. But their more immediate need, she explains, was the power to exercise more judgment in time to issue third-quarter filings later this month.

Fisher

“Held-to-maturity is the sort of change to the standard that would take a longer period of time to resolve than we have,” Fisher says. “We’re days from banks issuing earnings releases, so our thought process was we have to work within the current standard.”

Roper says allowing any movement toward weakening fair value will only prolong the current credit crisis. “Allowing financial institutions to keep assets on their books at inflated values doesn’t fool the market,” she says. “That’s why so many financial institutions today have market values well below their stated book values. Until investors trust that they are getting accurate information that reflects the true value of financial institutions, investors are going to continue to be unwilling to provide these institutions with capital, and they will continue to be leery of lending money to each other.”