IASB Forms Working Panel on Fair-Value Rules

The International Accounting Standards Board has formed an expert advisory panel to better examine the controversial issue of valuing securities in illiquid markets.

The IASB established the panel in response to a request by the Financial Stability Forum, an international grouping of central bankers and regulators, to address market concern over the more than $300 billion of writedowns for securities that suddenly can’t be sold, meaning the fair value of those securities is anyone’s guess.

Smith

“As part of that, they’re trying to determine what went wrong, why, what has to be done to ensure something like that does not happen again, and whether there are actions to be taken now to stabilize,” IASB member John Smith tells Compliance Week.

The Financial Accounting Standards Board said they have no comment on the working group.

In addition to representatives from the Big 4 accounting firms and regulatory agencies, the advisory panel includes representatives from American International Group, Goldman Sachs, Swiss Reinsurance Co., and other financial institutions.

Smith says that by collaborating with those who have previously dealt with an illiquid market, IASB hopes to better understand current issues and if necessary incorporate better guidance into its standards. “We’re hoping this panel will help us decide to what extent we might want to modify what FASB has in their standard on fair-value measurement for our own project on the subject, and if we can give better guidance on how to measure fair value.”

FASB issued Financial Accounting Standard No. 157, Fair Value Measurements, in late 2006, and it became effective with the start of the 2008 fiscal year—just as the credit crisis struck, a colossal stroke of bad timing. Although FAS 157 requires no new use of fair value, opponents have argued that its rules on how to measure fair value contribute to the downward spiral in valuation and liquidity.

In a June 2 Webcast hosted by FASB to discuss the credit crisis, fair-value supporters countered those arguments. They said greater use of fair value provides an early warning that something is amiss, said Matt Schroeder, global head of accounting policy at Goldman Sachs.

Investor Support

Raymond Beier, a partner at PricewaterhouseCoopers, pointed out that fair value has “provided more transparency to investors, more clarity to circumstances that companies find themselves in, and that’s a very good thing.”

“Fair value has provided more transparency to investors, more clarity to circumstances that companies find themselves in, and that’s a very good thing.”

— Raymond Beier,

Partner,

PricewaterhouseCoopers

“Speaking generally, most investors would prefer to see fair value,” said Jack Ciesielski, publisher of The Analyst’s Accounting Observer.

The Investors Technical Advisory Committee fired off a letter to FASB and IASB last month making exactly that claim. In the May 23 letter, ITAC said it believes that fair-value measurement is of “fundamental importance to financial statement users and the functioning of markets at all times.”

Without reliable, timely information on market values, ITAC wrote, uncertainty increases and investors either withhold their money or demand higher returns. “A cornerstone of the restoration of investor confidence must be to provide the information investors need to make risk-based decisions,” the letter said.

ITAC cited a recent survey of its membership by the CFA Institute. In the survey, 79 percent of the 2,000 respondents said fair-value measurement requirements for financial institutions improve transparency and contribute to investor understanding of the risk profiles of the institutions.

The letter also discussed the “pro-cyclical” characteristics of fair-value measurement—the argument that fair-value measurement and the recognition of losses results in a feedback loop that propels values downward. But such an argument “ignores the basic economic functioning of markets,” ITAC said. “It is the job of capital markets and investors in those markets to receive information, analyze and process the information, and form pricing judgments for assets based upon the analyses.”

Ciesielski

Ciesielski agreed. “If you’re trying to come up with a value that you say is better than what the market presents, you’re saying you know better than what the markets themselves are saying about the company,” he said. “So I’m not so sure that the procyclicality being worsened by fair value is an argument that completely holds up.”

HOW FAIR VALUE FARES

The following results are from the CFA Institute’s fair-value questionnaire.

Question:

Response:

Do fair-value requirements for financial institutions improve transparency and contribute to investor understanding of the risk profiles of these institutions?

Yes: 79%

No: 21%

Are fair-value requirements aggravating the global credit crisis?

Yes: 55%

No: 45%

What is the overall impact of fair-value requirements on market integrity?

Improve: 74%

Hurt: 19%

No Impact: 7%

Source

CFA Institute Fair Value Survey Results (March 2008).

Ciesielski added: “What would you prefer: something that’s exactly wrong like historical cost, or vaguely right like current estimates of fair value? I think investors would prefer to be vaguely right than exactly wrong.”

A Look Ahead

Critics of fair value can find comfort that there won’t be any move—at least, not any time soon—to apply fair value across the entire balance sheet. “I don’t think we should be rushing toward a universal application of fair value on an ongoing basis to non-financial items,” said Robert Herz, Chairman of the FASB.

Before any such changes can come about, some tweaks still need to be made. For example, IASB is still determining whether its own fair-value measurement standard will allow any choice for using an “entry price” to judge fair value versus using an exit price, which is what FAS 157 requires. “We may want to [give some flexibility], just because we think it may add some clarity,” Smith says. “But that is different from how to measure fair value when the markets are illiquid.”

Still, financial accounting can’t be made simple just by dumbing it down, Herz said. Tables, footnotes, and clear descriptions that aren’t legalese would help a great deal, he said, “but I cannot take complicated structures, complicated instruments, and financial arrangements and make them simple. I don’t have that magic.”

As for IASB’s new working group, the first of a series of meetings was held in London on June 13 to discuss the project’s scope. During the first meeting, participants of the panel were asked to submit a description of practical issues experienced with the valuation and disclosure of financial instruments in the current market environment.

The discussions of the panel members over the next few months will give the Board insight into the type and extent of additional guidance that might be necessary in this area and the form of any such guidance, IASB said.