Executive Summary
A number of criticisms have been made to the U.S. Congress about
the Financial Accounting Standards Board's (FASB's) fair value
accounting rules and their possible contribution to the financial losses
incurred in the credit crisis. In conjunction with an investigation by
the Securities Exchange Commission (SEC), "Report and
Recommendations Pursuant to Section 133 of the EESA of 2008: Study on
Mark-to-Market Accounting," which reaffirmed the soundness of fair
value reporting, the FASB issued new pronouncements to clarify the
application of fair value measurement in unstable markets. They provide
guidance on:
* estimating the fair value of an asset or liability when the
volume and level of activity for the asset or liability have
significantly decreased and transactions are not orderly
* improving disclosures about the fair value of financial
instruments for interim and annual financial statements
* assessing whether a debt security is other than temporarily
impaired and measuring the amount of the other than temporary impairment
that is recorded in earnings;
* clarifying the guidance on the fair value measurement of
liabilities
* amending the guidance to investors in certain alternative
investments (e.g., hedge funds, private equity funds, real estate funds,
venture capital funds, offshore fund vehicles) that provide their
investors with a net asset value per share
The FASB and the International Accounting Standards Board (IASB)
have accelerated their joint projects on fair value measurement of
financial instruments and on financial statement presentation and
disclosure, currently scheduled for completion by 2011.
Introduction
The Financial Accounting Standards Board (FASB) has been moving
toward fair value accounting for a number of years. Indeed, an extremely
large and increasing number of Financial Accounting Standards (FAS) and
other pronouncements include some requirement for the determination of
fair value in reporting or disclosure. The issuance in September 2006 of
FAS 157 (under the recent FASB Accounting Standards Codification, ASC
820) was merely intended to provide assistance to implementation of
previous rules, as it tells how to measure fair value when applying
standards that already require or permit fair value measurements or
disclosures, but does not add any new requirements as to when fair value
measures or disclosures are required. However, the coincidence of the
implementation of FAS 157 during 2007 and 2008 and the financial crisis
tended to focus public outrage on the fair value accounting rather than
the underlying reality of inferior investments.
The ongoing crisis in the credit and financial markets which began
mid-2007 has been characterized as the most severe economic crisis since
the Great Depression. Recent criticisms about the FASB's fair value
accounting rules and their possible contribution to the financial losses
incurred in the credit crisis have been provided to the U.S. Congress
and various politicians during 2009 by the U.S. Chamber of Commerce,
American Bankers Association, American Council of Life Insurers,
Financial Services Roundtable, real estate and home builders groups, and
the Council of Federal Home Loan Banks, among other organizations. They
believe that the inability of businesses, investors, and government to
properly value assets--especially in increasingly inactive and
disorderly markets--has created uncertainty, resulted in the fair values
of certain assets being underestimated, and caused a loss of confidence
by many market participants. They have expressed their concerns for the
need to correct the unintended consequences of mark-to-market
accounting, especially related to determining fair value for illiquid
assets in unstable markets, and the need for enhanced transparency in
the form of more meaningful disclosures.
The FASB, the International Accounting Standards Board (IASB), and
the Securities Exchange Commission (SEC) have taken a number of steps
since 2008 in response to these concerns to facilitate meaningful
measurement, reporting and disclosure rules in these turbulent times. In
this paper, we briefly discuss the role of fair value accounting in the
credit crisis, recent guidance issued by the FASB to improve fair value
accounting, and regulatory steps that have been taken to enable
financial reporting to be more truthful and expedient.
The Role of Fair Value Accounting in the Credit Crisis
Supporters of fair value accounting argue that its application
allows users to see the underlying economic reality in a changing
environment, whereas carrying assets at their original costs masks the
unpleasant truth of declining values. In a 2007 interview, KPMG Partner
Theresa Ahlstrom notes that fair value accounting "provides users
of financial statements with a clearer picture of the current economic
state of a company, making a company's financial statements more
useful or 'relevant' in the marketplace" (Casabona 2007).
Mary Barth reflects the position of the International Accounting
Standards Board (IASB) toward fair value accounting: "Fair values
are relevant because they reflect present economic conditions, i.e., the
conditions under which the users will make their decisions" (Barth
2006). Even those who oppose fair value accounting recognize that it is
not the cause of the credit crisis (see, for instance, Gingrich 2008);
however, they contend that its application in a declining economy
creates a domino effect that accelerates the decline, and that the
determination of market value in an unstable market is problematic.
Gingrich (2008), for instance, observes that in distress sales,
"the market-bottom prices ... become the new standard for the
valuation of all similar securities held by other companies under
mark-to-market" and, he points out, the result is "a downward
death spiral for financial companies large and small."
In addressing the role of fair value accounting in the credit
crisis, it is important to understand its magnitude and its application.
First of all, a large number of assets and liabilities reported in the
balance sheet are measured and either reported or disclosed at fair
value, and are within the scope of FAS 157. The following are examples
of these items, whose fair values were most impacted by current economic
environment: investments in debt and equity investments, loans and
receivables, derivatives, pension fund assets, auction rate securities,
asset-backed securities, goodwill and other intangible assets as well as
financial liabilities (including certain guarantees). In addition, the
current credit crisis and weakened economy may have adversely affected
impairment tests of all investments and assets, including goodwill and
intangible assets and property plant and equipment.
While there are a large number of assets and liabilities reported
or disclosed in financial statements, the percentages of these items and
the dollar impact on earnings may not have been exorbitant for most
companies, except for financial institutions. In 2008, only 27% of the
total assets of the S&P 500 companies that had adopted FAS 157 were
actually reported at fair value (Zion et al. 2009). While this
represents about $6.6 trillion in assets, it is still a relatively small
percentage of the assets. Because of the mixed attribute model used in
U.S. Generally Accepted Accounting Principles (GAAP), some assets are
measured using fair values while others--even very similar assets--are
measured at cost, or amortized cost, or by some other measure. The
nature of the assets held by these companies determined, to a large
extent, their exposure to risk in the credit crisis. Companies in the
financial sector had a much larger number of fair valued assets (39%)
than did, for instance, companies in consumer staples (2%). Even within
the financial sector, investment banks and insurance companies, most of
whose assets are reported at fair value, were impacted more than
commercial banks, whose largest asset is generally loans, which are not
reported at fair value.
Although the average percentage of assets subject to fair value
accounting was relatively small, the effect of marking these assets to a
declining market value was enormous, especially in some sectors. Some
financial services companies carried up to 80% of their assets in 2008
at fair value (Zion et al. 2009). Even companies closer to the industry
average were greatly impacted. For example, in its 10-K of December 31,
2008, BNY Mellon reported securities losses of $1.6 billion for 2008,
compared to $201 million in 2007. BNY Mellon adopted FAS 157 on January
1, 2008, but in its MD&A, BNY Mellon (1) clearly attributes these
losses to the failing economy:
The sharp difference between its 2007 and 2008 losses raises the
question of the efficacy of BNY Mellon adopting FAS 157 at this time,
despite its attribution of loss to economic conditions.
The Initial Response
In view of the loss of confidence caused by the inability of
businesses, investors and government to properly value assets in
inactive and disorderly markets, and the need to correct the unintended
consequences of mark-to-market accounting, the Office of the Chief
Accountant of the SEC and the FASB staff jointly issued a press release
on September 30, 2008--SEC Release 2008-234: SEC Office of the Chief
Accountant and FASB Staff Clarifications on Fair Value Accounting,
September--that provided financial statement users, preparers, and
auditors with clarification on the application of fair value accounting.
They emphasized the need for preparers and auditors to be less
conservative in assessments and for preparers to use more judgment in
valuing assets, including their own financial models, if no market
exists or if assets are being sold only at "fire-sale" prices
(Scannell 2008).
The FASB followed up on October 10, 2008, with the posting of FASB
Staff Position (FSP) FAS 157-3, Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not Active [ASC
820-10-35-55A-51. The information included in this pronouncement was
consistent with, and amplified, the guidance contained in the press
release. However, since it did not provide users with sufficient
direction in measuring fair value in illiquid and unstable markets, this
guidance was replaced by FSP FSA 157-4 (ASC 820-10), Determining Fair
Value When the Volume and Level of Activity for the Asset or Liability
Have Significantly Decreased and Identifying Transactions That Are Not
Orderly, in April 2009, as discussed below.
At almost the same time, on October 3, 2008, the U.S. Congress
enacted H.R. 1424, the Emergency Economic Stabilization Act (EESA) of
2008. The EESA of 2008, commonly referred to as a bailout of the U.S.
financial system, is a law enacted in response to the global financial
crisis of 2008, authorizing the United States Secretary of the Treasury
to spend up to $700 billion to purchase distressed assets, especially
mortgage-backed securities, and to make capital injections into banks.
Asset purchases are to be made through the Troubled Asset Relief Program
(TARP), which is administered by the newly formed Office of Financial
Stability. The goals of TARP include: (a) stabilization of the economy,
(b) homeownership preservation, (c) tax payer protection, (d)
elimination of windfalls for executives and (e) strong oversight.
The EESA grants authority to the SEC to suspend FAS 157 [ASC 820].
It also required the SEC to conduct a study of mark-to-market
accounting, which would consider:
* the impact of accounting standards on bank failures
* the process used by FASB in developing accounting standards
* modifications or alternatives to existing standards
The SEC held Roundtable meetings on mark-to-market accounting and
current market conditions to provide input to this study, and in
December 2008 it completed the study, "Report and Recommendations
Pursuant to Section 133 of the EESA of 2008: Study on Mark-to-Market
Accounting," in accordance with the EESA requirements. The SEC
delivered the results to Congress on December 30, 2008. The report
addresses six key issues:
1. The effect of fair value accounting standards on financial
institutions' balance sheets.
2. The effect of fair value accounting on bank failures in 2008.
3. Fair value accounting on the quality of financial information
available to investors.
4. The process the FASB follows to develop accounting standards.
5. Alternatives to fair value accounting standards.
6. The advisability and feasibility of modifications to fair value
accounting standards.
The report concludes that existing mark-to-market accounting should
not be suspended; noting that because investors have indicated that fair
value accounting provides transparent and timely information that is
useful in making informed decisions, an abrupt removal of fair value
accounting would erode investor confidence in financial reporting.
The SEC report makes several important recommendations, which are
expected to impact the FASB's future activities, including:
* improve fair value accounting standards
* improve the application of existing fair value requirements
* readdress the accounting for financial asset impairments
* establish formal measures to address the operation of existing
accounting standards in practice
* implement further guidance to foster the use of sound judgment of
practitioners
* address the need to simplify the accounting for investments in
financial assets
The SEC report also recommends that the FASB and International
Accounting Standards Board (IASB) fast-track their joint projects on
financial statement presentation and disclosure, which is currently
scheduled for completion by 2011.
Increased Pressure to Improve Fair Value Accounting
Despite the efforts made by the SEC and FASB to clarify application
and the recommendations made in the SEC study to improve fair value
accounting, criticisms of this practice continued to emerge as the
credit crisis deepened in early 2009, the financial markets deteriorated
further, and the economy headed for a deep recession. This unrest led to
the introduction on March 5, 2009, of a House bill, HR 1349, the Federal
Accounting Oversight Board Act, which was drafted by Colorado Democrat
Ed Perlmutter and Oklahoma Republican Frank Lucas. Its provisions would
significantly increase the government's oversight over how
accounting rules are applied. The SEC would cede its
accounting-oversight powers to a newly created Federal Accounting
Oversight Board (FAOB). The FAOB would consist of five top regulators:
the Secretary of the Treasury, the chairman of the Federal Reserve, the
chairman of the SEC, the chairman of the Federal Deposit Insurance
Corp., and the chairman of the Public Company Accounting Oversight
Board. The bill states that if another federal financial regulatory
agency determines that an accounting rule has an adverse effect on the
safety and soundness of the entities it regulates, the health of the
United States financial system, or the economy, it may request
authorization from the FAOB to review such standard. The FAOB would have
the power to determine whether the rule should continue to be applied or
be removed on either a temporary or permanent basis, which could strip
FASB of its rulemaking and rule revising role.
During a hearing held on March 12, 2009, on mark-to-market
accounting, certain members of the House Subcommittee on Capital
Markets, Insurance, and Government Sponsored Enterprises demanded that
the FASB fix mark-to-market accounting or they would propose legislation
to fix it themselves. Since many of the complaints about mark-to-market
accounting have focused on the problem of determining fair value for
illiquid assets in inactive and unstable markets, the FASB and SEC had
previously tried to highlight the flexibility that exists in FAS 157
[ASC 820] for estimating a fair value when markets are not active.
Despite these efforts, the House Subcommittee gave the FASB three weeks
from March 12 to come up with additional fair value guidance.
As a result of recommendations made in the SEC's December 2008
fair value study, recommendations from their Valuation Resource Group,
Congressional House Subcommittee hearings and an increasing convergence
of U.S. Accounting standards with those of the IASB, FASB immediately
completed several of its "credit crisis" projects on fair
value accounting and disclosure guidance:
* FSP FAS 157-4 (ASC 820-10), Determining Fair Value When the
Volume and Level of Activity for the Asset or Liability Have
Significantly Decreased and Identifying Transactions That Are Not
Orderly
* FSP FAS 107-1 and APB 28-1 (ASC 825-10), Interim Disclosures
about Fair Value of Financial Instruments
* FSP No. FAS 115-2 and FAS 124-2 (ASC 320-10), Recognition and
Presentation of Other-Than-Temporary Impairment
* ASU 2009-05, Measuring Liabilities under FASB Statement 157
* ASU 2009-12, Investment in Certain Entities that Calculate Net
Asset Value per Share (or Its Equivalent), exposed for comment in June
2009 and adopted in September 2009
Despite all of this effort from the FASB, during November 2009,
Congress still considered the idea of making FASB subject to a new
oversight body as the House Financial Services Committee worked to pass
a proposed amendment to a sweeping financial regulatory bill (H.R.
3996). An original draft of the amendment, co-sponsored by Reps. Ed
Perlmutter (D-Colo.) and Frank Lucas (R-Okla.), would have significantly
impinged on the independence of the FASB by allowing a new federal
council of risk regulators to override accounting standards during times
of extreme financial stress. However, because of concerns by the
accounting profession and others, the House committee subsequently
modified the bill on November 19 to allow the new Financial Services
Oversight Council (that would be created by H.R. 3996) to only make
recommendations to the SEC about new and proposed accounting standards
they feel may adversely affect the U.S. financial system.
The New Pronouncements and their Effects
FSP FAS 157-4 [ASC 820-10-35-51A-51H] provides additional guidance
on estimating the fair value of an asset or liability when the volume
and level of activity for the asset or liability have significantly
decreased, and identifying transactions that are not orderly. It applies
to all assets and liabilities (financial and non-financial) within the
scope of accounting pronouncements that require or permit fair value
measurements in accordance with FAS 157 [ASC 820], but it does not apply
to quoted prices for an identical asset or liability in an active market
(that is, a Level 1 input). For example, although the volume and level
of activity for an asset or liability may significantly decrease,
transactions for the asset or liability may still occur with sufficient
frequency and volume to provide pricing information on an ongoing basis.
It is important to note that the FSP does not change the objective
of fair value measurements when market activity declines. Instead, the
FSP emphasizes that fair value is the price that would be received to
sell an asset or paid to transfer a liability in an orderly transaction
(that is, not a forced liquidation or distressed sale) between market
participants at the measurement date under current market conditions.
This reinforces FASB 157 (ASC 820) guidance that fair value is a current
market-based measurement and not an entity-specific or hypothetical
future market-based measurement. The FSP also includes an example that
provides additional explanation on estimating fair value when the market
activity for an asset has declined significantly, which is consistent
with the newly stated objectives.
FSP FAS 157-4 provides application guidance to assess whether the
volume and level of activity for the asset or liability have
significantly decreased when compared with normal market conditions.
This assessment should consider whether there are factors present that
indicate that the market for the asset is not active at the measurement
date, such as:
* There are few recent transactions based on volume and level of
activity in the market
* Price quotations are not based on current information
* Price quotations vary substantially either over time or among
market makers (for example, some brokered markets)
* There is a significant increase in implied liquidity risk
premiums, yields, or performance indicators (such as delinquency rates
or loss severities)
* There is a significant decline or absence of a market for new
issuances
These factors are not all inclusive. Refer to paragraph 12 of ASC
820 [FSP 157-4] for a listing of factors an entity should consider. Note
that preparers will need to use judgment in determining whether the
market is active.
If, based on analysis, it is judged that there has been a
significant decrease in the volume and level of activity, the quoted
price may not be determinative of fair value and may require a
significant adjustment.
FASB 157 does not prescribe a specific approach in calculating the
adjustment to the quoted price, but it does recommend three valuation
techniques (that is, market, income and/or cost approach) that may be
used to estimate fair value. FSP FAS 157-4 clarifies that the valuation
technique may be changed or multiple valuation techniques may be used in
determining fair value when there has been a significant decline in the
volume and level of activity. According to paragraph ASC
820-10-35-51A-51C:
Note, however, that even if there has been a significant decrease
in the volume and level of activity for an asset or liability, it is not
appropriate to conclude that all transactions are not orderly (that is,
distressed or forced). Therefore, it must be determined whether or not a
quoted price (that is, a recent transaction or broker price quotation)
is orderly or not (i.e., associated with a distressed transaction) by
considering the available evidence (events and circumstances) for the
given quoted price. For example, you must assess whether factors such as
the following exist, to determine if a transaction is not orderly:
* There was not an adequate exposure to market (before the
measurement date) to allow for marketing activities for the asset that
are usual and customary under current conditions
* The seller marketed the asset to only a single buyer
* The seller is in or near bankruptcy or receivership, or required
to sell the asset to meet regulatory requirements (that is, a forced
transaction)
* The transaction price is an outlier when compared with other
recent transactions (for same or similar assets or liabilities)
Note that entities may consider additional factors in addition to
those explained in FSP FAS 157-4. But the evaluation of the
circumstances to determine whether the transaction is orderly is based
on the weight of the evidence, which may be more difficult if there has
been a significant decrease in the volume and level of activity for the
asset or liability. However, if based on the weight of evidence an
entity concludes that the transaction is not orderly, little if any
weight should be given to the transaction in estimating fair value. If
the transaction is considered orderly, then it should be considered in
determining fair value, although it may not be used as the
"sole" or "primary" basis for determining fair value
in an inactive market. Also note that the fair value measurement should
include appropriate risk adjustments (market participant view),
including a premium for liquidity risk.
FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of
Financial Instruments, amends FAS 107, Disclosures about Fair Value of
Financial Instruments, to require disclosures about fair value of
financial instruments for interim reporting periods of publicly traded
companies, as well as in annual financial statements. It also amends APB
Opinion No. 28, Interim Financial Reporting, to require those
disclosures in summarized financial information at interim reporting
periods. The requirement is to disclose in the body or in the
accompanying notes of its summarized financial information for interim
reporting periods and in its financial statements for annual reporting
periods the fair value of all financial instruments for which it is
practicable to estimate that value, whether recognized or not recognized
in the statement of financial position, as required by FAS 107. Fair
value information disclosed in the notes should be presented together
with the related carrying amount, in a form that makes it clear whether
the fair value and carrying amount represent assets or liabilities, and
how the carrying amount relates to what is reported in the statement of
financial position. It requires the disclosure of the methods and
valuation techniques used to measure fair value, and a discussion of any
changes in valuation techniques and related inputs, if any, during the
period. The disclosure must include the major categories of equity and
debt securities, based on the nature and risks of the security. For
financial institutions, the categories would include, at a minimum:
* Equity securities (segregated by industry type, company size, or
investment objective
* Debt securities issued by the U.S. Treasury and other U.S.
government corporations and agencies
* Debt securities issued by states of the United States and
political subdivisions of the states
* Debt securities issued by foreign governments
* Corporate debt securities
* Residential mortgage-backed securities
* Commercial mortgage-backed securities
* Collateralized debt obligations
Also note that FASB Accounting Standards Update (ASU) 2010-06,
Improving Disclosures About Fair Value Measurements, was issued in
January 2010. ASU 2010-06 amends ASC 820 (formerly Statement 157) to add
new requirements for disclosures about transfers into and out of Levels
1 and 2, and separate disclosures about purchases, sales, issuances, and
settlements relating to Level 3 measurements. It also clarifies existing
fair value disclosures about the level of disaggregation and about
inputs and valuation techniques used to measure fair value.
The third FSP issued in April 2009, FSP FAS 115-2 and FAS 124-2,
Recognition and Presentation of Other Than Temporary Impairments,
provides guidance on how to determine whether the holder of an
investment in a debt security for which changes in fair value are not
regularly recognized in earnings (such as securities classified as
held-to-maturity or available-for-sale) should recognize a loss in
earnings when the investment is impaired. An investment is impaired if
the fair value of the investment is less than its amortized cost basis.
FSP FAS 115-2 and FAS 124-2 eliminates the old requirement for the
preparer to assert the intent and ability to hold a debt investment
(whose fair value is less than its amortized cost basis) until
forecasted recovery to avoid recognizing an impairment loss. Instead, it
turns the intent and ability assertion around. If the preparer either
(a) intends to sell the security, or (b) more likely than not will be
required to sell the security before recovery of its amortized cost
basis less any current-period credit loss (e.g., for working capital
requirements or contractual or regulatory obligations), the OTTI will be
recognized in earnings equal to the entire difference between the
investment's amortized cost basis and its fair value at the balance
sheet date. When a credit loss exists, but there is little likelihood of
sale of the security, the total impairment is separated into (a) the
amount of the total impairment related to the credit loss and (b) the
amount of the total impairment related to all other factors, and the
OTTI related to the credit loss is recognized in earnings. The amount of
OTTI related to all other factors (e.g., illiquidity, change in interest
rates) is recognized in a new component of other comprehensive income,
reported separately from other unrealized gains and losses on
available-for-sale securities, net of taxes. The total OTTI is presented
in the statement of earnings with an offset for the amount recognized in
other comprehensive income.
FSP FAS 115-2 and FAS 124-2 does not explain exactly how to
determine the amount of credit loss; instead, it refers to FAS 114 [ASC
310-10-35], Accounting by Creditors for Impairment of a Loan. Under
these rules, the loss is measured by taking the expected future cash
flows from the instrument (as determined by the preparer), discounted at
the instrument's original effective yield, and comparing it with
the current value on the balance sheet (i.e., amortized cost). The
difference is the credit loss (i.e., the present value of the expected
future cash shortfalls). Clearly, this process is highly subjective. On
the other hand, FSP FAS 115-2 and FAS 124-2 does not require that the
methodology in FAS 114 [ASC 310-10-35] is used, so in theory different
preparers could arrive at different credit losses on the same security
(as presently occurs with the asset fair values). For certain interests
in securitized assets, the reference is made to EITF 99-20 [ASC
325-40-35-4 and 35-5], Recognition of Interest Income and Impairment on
Purchased Beneficial Interests and Beneficial Interests That Continue to
Be Held by a Transfer in Securitized Financial Assets, for guidance on
determining credit losses. As with the guidance in FAS 114 [ASC
310-10-35], preparers would use the present value of expected cash flows
to estimate credit losses.
For both available-for-sale and held-to-maturity securities, if
recovery subsequently occurs, the portion of the credit loss that was
reported in earnings is treated as a prospective yield adjustment and is
recovered over time (not all in one period) through higher interest
income, as the discount that was created on the balance sheet by the
impairment charge to the asset is accreted back into earnings over the
remaining life of the asset (as in current practice). On
held-to-maturity securities, the noncredit losses that are reported in
other comprehensive income ("OCI") will also be reversed over
time, but will not result in higher earnings. Instead, the debt discount
will be accreted back through accumulated OCI. That is, the noncredit
portion for held-to-maturity securities recorded in OCI will be
amortized prospectively over the remaining life of the security as an
increase to OCI and an increase to the investment balance. This new
standard also enhances the disclosure requirements in FAS 115 [ASC 320],
Accounting for Certain Investments in Debt and Equity Securities, and
FSP FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments, which are now
required for both annual and interim periods. ASU 2009-05, Measuring
Liabilities at Fair Value, finalized in August 2009, clarifies FAS
157's (ASC 820's) guidance on the fair value measurement of
liabilities. This standard indicates that if an identical liability is
traded in an active market, the quoted price of that liability
represents a Level 1 fair value measurement. If a quoted price for an
identical liability traded in an active market is not available, an
entity must use one of the following approaches to maximize the use of
relevant observable inputs and minimize the use of unobservable inputs:
1. The "quoted price of the identical liability when traded as
an asset in an active market."
2. The "quoted price of the identical liability or the
identical liability when traded as an asset" in an inactive market.
3. The "quoted price for similar liabilities or similar
liabilities when traded as assets" in an inactive market.
4. "Another valuation technique that is consistent with the
principles of Statement 157," such as an income approach or a
market approach.
The ASU emphasizes the importance of maximizing the use of relevant
observable inputs and minimizing the use of unobservable inputs,
regardless of the method employed. It specifies that restrictions on the
transfer of the liability--unlike restrictions on the sale of an
asset--should not result in a separate adjustment in estimating fair
value, as the restriction is already factored into the price of the
liability at inception. ASU 2009-12, Investment in Certain Entities that
Calculate Net Asset Value per Share (or Its Equivalent), issued in
September 2009 provides guidance to investors in certain alternative
investments (e.g., hedge funds, private equity funds, real estate funds,
venture capital funds, offshore fund vehicles) that provide their
investors with a net asset value per share that has been calculated in a
manner consistent with U.S. GAAP for investment companies [Topic 946 in
the Codification]. Because of the complexities and practical
difficulties in estimating fair value for these investments, this ASU
permits using the net asset value per share of the investment if it has
been calculated in a manner consistent with the measurement principles
in Topic 946 (incorporated from the AICPA Audit and Accounting Guide,
Investment Companies). Disclosures are required by major category of
investment about the attributes of applicable investments, including the
nature of any restrictions on redemption, any unfunded commitment, and
the investment strategy of the investee.
The FASB and the IASB
Pursuant to the SEC's mark-to-market report (2008), in March
2009, the FASB and IASB announced that they will fast-track their
efforts to reduce complexity in the accounting for financial instruments
by replacing existing requirements with a simplified and improved
approach. While it is a joint project, the Boards will continue to work
separately and then reconcile their approaches as they develop.
In July 2009, the IASB issued an Exposure Draft (ED), Financial
Instruments: Classification and Measurement, which was finalized as IFRS
9 on November 12, 2009. This standard is part of lASB's ongoing
project to replace IAS 39, which includes an ED on derecognition (issued
March 2009) and EDs on impairment and hedge accounting (forthcoming at
the time this article was written).
IFRS 9 replaces the existing classification and measurement
requirements in IAS 39, Financial Instruments: Recognition and
Measurement, for financial assets. It changes the manner in which
entities classify and measure investments in debt and equity securities,
loan assets, trade receivables and derivative financial assets by
requiring entities to classify financial assets as being measured at
either amortized cost or fair value, depending on the entity's
business model and the contractual cash flow characteristics of the
asset.
The issuance of IFRS 9 represents the completion of the first phase
of the IASB's project to replace IAS 39. The project addresses
classification and measurement of financial assets as well as the
accounting for financial liabilities, recognition and measurement of
impairments, hedge accounting, and derecognition. The IASB expects to
replace the remaining portions of IAS 39 during 2010.
At the same time, the FASB is developing proposals to replace the
current accounting requirements for financial instruments under U.S.
GAAP The FASB plans to issue a comprehensive exposure draft (ED) in the
first quarter of 2010 that will address classification and measurement
of financial instruments, as well as impairments and hedge accounting.
In a Joint Statement issued by the FASB and the IASB on November 5,
2009, the two boards indicated that they are committed to working
together on this project, and to issuing standards by the end of 2010
"that provide international comparability."
While there is similarity in many of the decisions reached by the
FASB and the IASB on simplifying the classification and measurement of
financial instruments, including the preference for income statement
reporting of changes in fair value and disclosure requirements, the
issue of applying fair value measurement consistently remains at the
center of the difference. Both Boards are continuing their work in this
area.
Conclusion
It is possible that the SEC's continued support of fair value
accounting, and the FASB's recent pronouncements and IASB
converging standards guiding preparers to properly value assets during
the credit crisis in inactive and disorderly markets, have restored some
confidence in financial reporting, if not in the economy. Some firms in
the financial services sector already seem to have benefited from the
new guidance. For instance, BNY Mellon, in its first quarter 10-Q for
2009, indicates that its early adoption of FSP FAS 157-4 has
significantly reduced the amount of fair value losses reported. The
securities losses reported on BNY Mellon's income statement for the
first quarter of 2009 were $295 million, contrasted to losses of $1,241
million in the fourth quarter of 2008.
The SEC's and FASB's call for companies to use judgment
in estimating fair value apparently needed to be institutionalized in
the pronouncements for preparers to overcome their fear of being
second-guessed.
The FASB continues to work to improve fair value accounting. In
2008, it formed a group of valuation practitioners and accountants,
representing a cross section of industry representatives including
financial statement preparers, auditors, and valuation experts, to
provide input to the FASB staff on valuation guidance. The Valuation
Resource Group (VRG) does not make any authoritative decisions; rather
the VRG provides the FASB staff with information on the existing
implementation issues surrounding fair value measurements used for
financial statement reporting purposes and the alternative viewpoints
associated with those implementation issues. Also in 2008, the IASB and
FASB established a Financial Crisis Advisory Group, made up of current
and former regulators and financial services executives, and co-chaired
by Harvey Goldschmid, a former commissioner for the Securities and
Exchange Commission, and Hans Hoogervorst, a regulator from the
Netherlands.
The 18-member board has been given the mission of staving off undue
interferences in accounting rulemaking. Their initial objective is to
address both how financial reporting helped uncover the current problems
and how it helped hide them as the crisis unfolded in the U.S. and
abroad. The group will also explore the ties that mark-to-market
accounting and off-balance-sheet accounting had to the collapses on Wall
Street.
FASB Chairman Robert Herz has said, regarding the setting of
standards, that "the emphasis should be on providing useful
information to those who read financial statements, including those who
use them to make investment and credit decisions" (Kranacher and
Morris 2007). Hopefully, the additional implementation guidance and
continued efforts of the FASB, IASB, SEC, and others, to improve the
application of fair value accounting will further this end.
References
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Endnote
(1) BNY Mellon is a financial services company in the S&P 500.
On October 1, 2006, The Bank of New York acquired JPMorgan Chase's
Corporate Trust business in exchange for its retail and regional middle
market banking businesses; on July 1, 2007, it then merged with Mellon
Financial Corporation into The Bank of New York Mellon Corporation, with
BNY Mellon being the surviving entity.
Patrick Casabona, The Peter J. Tobin College of Business, St.
John's University
casabonp@stjohns.edu
Victoria Shoaf, The Peter J. Tobin College of Business, St.
John's University
shoafv@stjohns.edu
The ongoing disruption in the fixed income securities market has
resulted in additional impairment charges, as well as an increase in
unrealized securities losses. In 2008, we recorded impairment charges
on our securities portfolio of $1.6 billion, pre-tax, or $0.85 per
common share. These losses were primarily driven by lower market
values of Alt-A, home equity lines of credit ("HELOC") and
asset-backed collateralized debt obligations ("CDO") securities. The
market value of these securities was severely impacted by the
depressed housing market and deterioration in the broader economy.
The unrealized loss on the securities portfolio, which is recorded in
other comprehensive income, was $4.1 billion at Dec. 31, 2008,
compared with $342 million at Dec.31, 2007.If there has been a significant decrease in the volume and level of
activity for the asset or liability, a change in valuation technique
or the use of multiple valuation techniques may be appropriate (for
example, the use of a market approach and a present value technique).
When weighting indications of fair value resulting from the use of
multiple valuation techniques, the reporting entity shall consider
the reasonableness of the range of fair value estimates. The
objective is to determine the point within that range that is most
representative of fair value under current market conditions. A wide
range of fair value estimates may be an indication that further
analysis is needed.