How Fair Value Works When Liquidity Dries Up

My name is Colleen Cunningham, and I weigh 7 pounds, 2 ounces—at least, I do if you go by historical cost accounting.

After all, that was my weight at birth, and that’s how historical accounting works, right? Of course, if I say I weigh 110 pounds that would be much closer to reality (although still biased toward underestimating true value, unfortunately!).

At the risk of being pigeonholed as being a one-topic columnist, it is hard not to comment on what is happening in the credit markets and its inescapable link to fair-value accounting. Many point fingers of blame at securitization accounting, the bundling of loans into assets that are sold to investors. Even Barney Frank, the Massachusetts Congressman who chairs the House Financial Services Committee, recently said securitization “has severely dissolved the discipline of the lender-borrower relationship … Diversifying bad debt just spreads the poison.”

Well, securitization accounting is not to blame. The mortgage originators who ultimately intend to sell the loans use different standards for those loans than the people who ultimately intend to hold these loans use. I want to go on record: The current sub-prime meltdown is due to bad lending practices, not bad accounting standards.

That being said, the inability to value financial assets and liabilities appropriately due to illiquidity in the market is creating angst as most companies adopt Financial Accounting Standard No. 157, Fair Value Measurements. The debate over historical cost versus fair value is a long-standing one, and both sides of the argument have merit.

Yes, historical cost is easy to understand, verify, and audit. But when you can reliably verify the fair value of a financial asset or liability, it’s hard to argue that the fair value is not more relevant than the historical cost. The real issue is the ability to calculate the fair value. In my example above, 110 pounds is closer to reality than 7 pounds, but my estimate could be very easily verified; I could just step on a scale. (Not that I will, but anyway…)

If there is a ready market with observable prices, calculating fair value usually isn’t difficult. FAS 157 acknowledges that inputs to valuation models can either be observable, based on market data obtained form sources independent of the reporting entity; or unobservable, reflecting an entity’s own assumptions about what market participants would theoretically do based on information available under the circumstances.

Further, FAS 157 breaks down the observable inputs between Level 1 (quoted, unadjusted prices in active markets for identical assets or liabilities, that the reporting entity has the ability to access at the measurement date) and Level 2 (inputs other than quoted prices included within Level 1, which are observable for the asset or liability, either directly or indirectly). Level 3 inputs are simply “unobservable.”

As a result of the current turmoil in the market, companies face a huge dilemma in determining how to value financial assets and liabilities and how to classify them into the appropriate level in the hierarchy outlined by FAS 157. The market for certain financial assets and liabilities that may clearly have been Level 1 or Level 2 in the past may now have dried up. So, should companies devise a different way to value these assets based on “unobservable” inputs and move them down to Level 3? Many companies did just that.

But even that idea was called into question: At what point do we determine that a market has become illiquid? FAS 157 requires entities to use observable prices when they are available, but not to use “distressed” values based on forced sales. In the current environment, how do we determine whether thinly traded securities are being sold at distressed prices? These are tough questions that many companies are grappling with. Few have any good answers. Most have no answers at all.

We have seen many companies employ “observable” prices in thinly traded markets rather than use a model to find a fair value that may be more realistic in the long term. (Oh, and by the way—for many of these assets, no such models have been developed yet.) If they can’t convince their auditors that the “observable” price is distressed, they may have no choice but to use the “observable” data. Many companies complain that they are being forced to undervalue these financial assets, and it’s a very valid concern.

The Securities and Exchange Commission seems to have attempted to address this problem in a recent letter to financial institutions. The letter reviewed the effect of the current market conditions on measuring fair value and noted that observable information (such as market prices) may be unavailable for some assets and liabilities that are measured at fair value. As a result, valuations of those assets and liabilities may include significant unobservable inputs, requiring management’s best judgment.

I want to go on record: The current sub-prime meltdown is due to bad lending practices, not bad accounting standards.

The SEC letter focuses on disclosure in the Management’s Discussion and Analysis of known trends or any known demands, commitments, events, or uncertainties that a company would reasonably expect to have a material favorable or unfavorable effect on its results of operations, liquidity, and capital resources. Among other suggestions, the letter notes that companies should consider disclosing in MD&A the amount and percentage of assets and liabilities that were measured at fair value using significant unobservable inputs and information about assets and liabilities that were previously measured using significant observable inputs that were currently measured using significant unobservable inputs (including the specific inputs that were no longer observable). They also listed potential disclosures of any changes made to valuation techniques, why they were made, and the effects of doing so, as well as what impact on future liquidity and capital resources any increases or decreases in the aggregate fair value could have.

This letter has caused some confusion among companies about what the SEC wants them to do. Auction rate securities are a great example. These securities—previously marketed like savings accounts, basically equal to cash—are now impossible to cash in. What value should be ascribed to them if nobody wants them? Secondary markets have popped up with discounts of as much as 30 percent. So, even if a company has the intention to hold these securities until the market turns around, the “observable” price is now significantly discounted.

The SEC letter implies that companies should consider disclosing what the company thinks about the valuation techniques used and what it believes it will eventually settle or receive. So companies are put in the position of noting where the valuations make no sense and are not indicative of future cash flows. This seems to me to increase a company’s disclosure risk significantly.

Last fall, I wrote of the significant implementation issues companies were encountering in adopting FAS 157. FASB voted to defer the application of FAS 157 for non-financial assets by one year (generally 2009 for calendar year-end companies). However, they chose to keep the current timeline for financial assets and liabilities. (The vote was close; three board members voted for full deferral.)

If we are having this much trouble with the easy stuff, what is going to happen next year when the even harder-to-value non-financial assets and liabilities kick in.