Fair-Value Guidance Arrives, Amid Criticism

The banking industry now has two powerful new tools in its accounting arsenal to cover up losses from bad loans and make balance sheets look more healthy.

As expected, the Financial Accounting Standards Board last week rushed through two pieces of guidance intended to help address the banks’ ongoing economic turmoil. The first steers entities away from using troubled market prices as they establish fair values for their assets; the other carves up losses related to troubled debt securities so that only a portion is recognized in earnings. A third piece of guidance also approved by the board calls for more fair value disclosure in quarterly financial reports.

The new guidance is a victory for the financial sector, since banks will now be able to make their toxic assets look much more attractive in their financial statements. Investor advocates opposed the changes, saying they will only prolong banks’ ill health by masking the toxic assets’ true value. But in March Congress gave FASB a direct threat: Fix the mess of fair-value accounting rules, or lawmakers would do the job themselves. Hence last week’s changes.

The first piece of the two-part crisis package is guidance related to Financial Accounting Standard No. 157, Fair Value Measurements. While FAS 157 already says fair value should not be based on distressed transactions, the banking sector has said auditors have insisted on using recent transaction prices or broker quotes to establish fair values, even as market activity for certain financial instruments ground to a halt.

FASB’s staff position focuses on how preparers and auditors should determine that a market is not active and a transaction is not distressed, to help steer entities away from using market prices as indicators of fair value when recent activity isn’t orderly. In 366 comment letters that flooded FASB in a short, two-week comment period, the board heard a mix of support for the approach and concern that it would be perceived as a relaxation of fair-value measurement and an invitation to inconsistency.

In its final guidance, FASB will tweak its original language to clarify that preparers and auditors must use judgment and weigh available evidence in determining when to use measures other than market pricing to establish fair value.

Richard Dietrich, accounting professor at Ohio State University, says FASB’s guidance preserves the original principles of FAS 157, but provides more direction on when valuations should be based on inputs other than market prices.

“It gives seven guidelines that are not intended to be all-inclusive, but indicative,” he says. “It provides more details to help people understand: If I see any trade, does it mean I have to use that trade? This helps clarify what the original language meant.”

More controversial, however, is the second part of FASB’s package: a staff position that alters the usual treatment of certain debt securities that are deemed “impaired” because underlying loans are failing and cash flows are suffering. Under existing rules, if a bank deems a debt security has an “other than temporary” impairment, it must measure the security at fair value and record the loss through earnings.

According to FASB’s new staff position, if a bank says it doesn’t plan to sell that security and doesn’t expect to be required to sell it, the loss can be carved up so that only the portion directly related to the decline in cash flow is recorded to net income. The remainder, which presumably relates to its diminished marketability or problems with liquidity, is recorded through “other comprehensive income.”

Siegel

Only three of FASB’s five board members supported the guidance. FASB member Marc Siegel and Tom Linsmeier opposed it. The current approach “is confusing to everybody,” Siegel said. “I’m afraid this change will result in fewer impairments being recognized, and I don’t think that will help investor confidence in balance sheets.”

“From a risk-management perspective, these changes complicate the assessment of the health and true state of an entity.”

— Bill May,

Senior Analyst,

Global Association of Risk Professionals

FASB’s own Investors Technical Advisory Committee penned a 14-page protest to FASB’s guidance, focused primarily on the change to impairment. It viewed the guidance as driven solely to accommodate banks and their regulatory capital requirements, rather than investors’ need for accurate information.

“The job of financial reporting is to provide complete, accurate, and timely information essential to investors’ decision making,” ITAC wrote. “Financial reporting is not and cannot be used as yet another tool for papering over or covering up the effects on companies’ operations of managers’ bad decisions and delaying, perhaps permanently, the negative consequences of those decisions.”

Fisher

Donna Fisher, senior vice president at the American Bankers Association, says the change to the impairment rule “is long overdue.” Fisher noted that even FASB members have acknowledged the current approach to impairment has been problematic. FASB has committed to taking a fresh look at impairment in tandem with the International Accounting Standards Board in a more comprehensive overhaul of how to account for financial instruments.

FAIR-VALUE RECOMMENDATIONS

The following excerpts from FASB meeting handouts discusses staff recommendations regarding fair value in inactive markets:

ISSUE 1 - OBJECTIVE OF THE FSP

5. The most significant comment provided by many constituents was to clarify the objective of the measurement described in the FSP. Specifically, many constituents were confused by the example included in the proposed FSP and questioned whether the Board is changing the objective of a fair value measurement in an inactive market. Based on the

example in the proposed FSP, constituents asked if the objective of a fair value

measurement in an inactive market should be:

a. Fair value in the current inactive market;

b. A hypothetical fair value in an active market (that is, a “normally active and

functioning market”); or

c. The midpoint between a. and b.

6. The Staff does not believe the Board’s intent was to change the objective of a fair value measurement. However, the staff believes determining fair value in a market where there has been a significant decrease in the volume and level of activity for the asset at the measurement date is inherently complex, depends on the facts and circumstances and involves significant professional judgment.

STAFF RECOMMENDATION

7. The staff recommends that the Board emphasize that the FSP does not change the

objective of a fair value measurement. That is, even when there has been a significant

decrease in market activity for the asset, the fair value objective remains the same. Fair

value is the price that would be received to sell the asset in an orderly transaction (that is,

not a forced liquidation or distressed sale) between market participants at the

measurement date in the current inactive market. The Staff also recommends that the

Board consider highlighting and expanding on the relevant principles in Statement 157

that should be considered in estimating fair value when there has been a significant

decrease in market activity for the asset in the final FSP.

QUESTION FOR THE BOARD

Does the Board agree with the staff’s recommendations?

ISSUE 2 – FACTORS THAT INDICATE THAT THERE HAS BEEN A SIGNIFICANT DECREASE IN THE VOLUME AND LEVEL OF ACTIVITY FOR THE ASSET IN A MARKET THAT IS NOT ACTIVE

8. Constituents were largely in agreement that the factors included in paragraph 11 of the

proposed FSP that could indicate that the market for an asset is not active are appropriate. Some respondents requested clarification of some of the factors or suggested additional factors. Some respondents also questioned how the factors should be considered for assets that normally transact in a market that is not active. Those respondents indicated that for those assets, a transaction price occurring in a market that is not active may not require significant adjustment to be considered a relevant observable input to a fair value measurement.

9. Based on those comments, the staff reconsidered how the factors should be applied. To avoid potential unintended consequences, the staff believes that the factors should be

used to determine whether there has been a significant decrease in the volume and level

of activity for the asset when the market for that asset is not active. The staff has added

language to clarify that the factors should be considered in relation to the normal market

activity for the asset. The staff has also added additional factors suggested by

constituents to the proposed FSP.

Source

Financial Accounting Standards Board.

“This really does improve the income statement,” Fisher says. “It makes it more clear that credit losses are being recorded through income rather than market gains and losses related to impairment. It’s a very logical result.”

Dietrich says that whether the earnings result is perceived as positive or negative, the new approach provides some transparency that doesn’t exist currently. “Investors are going to get more information than they had before,” he says. “Investors will be no worse off with this change and may well be better off with this change. And if it helps the regulators to do their job better, it’s better all around.”

Bill May, senior analyst at the Global Association of Risk Professionals, says the new rules give management more discretion; that, in turn, puts the burden on investors to read financial statements more carefully. “From a risk-management perspective, these changes complicate the assessment of the health and true state of an entity,” he says. “It makes the assessment of the earnings and the assets of the entities harder to ascertain from an outsider’s perspective.”

Although flogged by Congress and ordered to act quickly, FASB Chairman Bob Herz defended the board’s views on both the fair value and impairment guidance. He says the board worked not only from comment letter feedback but also from direct interaction with some 40 major or institutional investors.

In a press conference after FASB’s meeting, Herz said that while not everybody agreed with the board’s approach, “most that we talked to thought the direction on [other-than-temporary impairment] was a useful improvement.”

“There’s a lack of transparency around financial institutions’ holdings right now,” Herz said, “and the extra disclosures I think are pretty fulsome and very important.”

Herz

Herz also deflected criticism that the board skirted its usually rigorous due process to rush the guidance through under a threat of Congressional intervention. He was called to testify to a House sub-committee in mid-March, where members of the sub-committee threatened to introduce legislation related to fair value if FASB didn’t produce its own by mid-April.

“We went through full due process, accelerated and expedited,” Herz said. “We probably got more input on this than on a project (that usually would span) a three-month period.”