SEC and FASB Relax Fair Value Rules; Controversy Continues
By Edward G. Eisert and Mark D. Perlow
On September 30, the Office of the Chief Accountant of the Securities and Exchange Commission (“SEC”) and the Staff of the Financial Accounting Standards Board (“FASB Staff”) issued guidance on the determination of “fair value” under FAS 157 (the “FAS 157 Guidance”), addressing the use of internal assumptions, the use of broker quotes, and transactions in disorderly or inactive markets to measure fair value. On October 10 , the FASB published a FASB Staff Position (“FSP”) intended to clarify the application of the FAS 157 Guidance. FAS 157, which became effective in November 2007, defines “fair value” as the price that would be obtained in an orderly transaction between market participants in the principal or most advantageous market.
The FSP provides an illustrative example to demonstrate how the fair value of a financial asset might be determined when there is a “disorderly” or “inactive” market and the basis on which a determination could be made that a market is, in fact, "inactive." Although the FSP provides helpful commentary on the FAS 157 Guidance, it does not eliminate the need for investors and auditors to make difficult judgment calls.
The FAS 157 Guidance and the FSP were issued in response to a campaign by the banking industry, based on the argument that the emphasis under FAS 157 on “fair market” valuations for financial assets was forcing banks to write down performing assets to “fire sale” or distressed prices, compelling them to sell more assets to raise capital, and thereby depressing prices further in a downward spiral. Conversely, many supporters of FAS 157, including investors’ groups, have expressed the view that current market values provide a more accurate picture of the health of financial institutions than values based on cost or cash flow models. The SEC rarely involves itself in FASB policy-making, and the SEC’s action is clearly an attempt to reach a compromise between the two positions: it relaxed the interpretation of some of FAS 157’s market valuation provisions, but did not suspend market valuation, as some have requested.
The compromise has not appeased either side in the debate. Some in the industry continue to believe that the FAS 157 Guidance and the FSP do not go far enough. On October 13, in a letter to Chairman Cox of the SEC (the “October 13 Letter”), the American Bankers Association (“ABA”) commented that FASB’s fair value standard “needs serious work,” that it “is always going to create a downward bias on values” and requested the SEC “to use its statutory authority to step in and override the guidance issued by FASB.” http://www.aba.com/aba/documents/press/ChrmnCoxLtr.101308.pdf. Two specific issues highlighted by the October 13 Letter are the requirement in the FSP that “liquidity risk from the buyer’s perspective” be included in cash flow calculations that can be used to determine fair value and that the FSP did not address “other than temporary impairment” in an illiquid market. In addition, a number of members of Congress have been making public statements calling upon the SEC to suspend mark-to-market accounting, thereby politicizing the issue.
Apparently in response to the October 13 Letter and Congressional pressure, on October 15, in a joint letter to Chairman Cox, the Center for Audit Quality, the Consumer Federation of America, the CFA Institute and the Council of Institutional Investors “expressed grave concern regarding recent calls for the SEC to override [the FAS 157 Guidance] that would effectively suspend fair value or mark-to-market accounting.” http://www.thecaq.org/newsroom/pdfs/SECJointLetter2008-10-15.pdf. The joint letter did not specifically mention the October 13 Letter or address the specific issues it raised.
Underlying these positions is a basic disagreement as to the role that the adoption of FAS 157 has played in the liquidity and credit crisis. The ABA believes that FAS 157 has had a significant detrimental impact on the crisis, while auditor and investor groups believe that the crisis was not caused by fair value accounting and that, in fact, FAS 157 has been helpful in exposing problems.
In time-honored Washington fashion, this controversy is now being simultaneously addressed and avoided through a study group. The Emergency Economic Stabilization Act mandates that the SEC “in consultation with the [Federal Reserve Board and the Secretary of the Treasury] shall conduct a study on mark-to-market accounting standards as provided in [FAS 157], as such standards are applicable to financial institutions, including depository institutions.” The SEC is required to submit a report of such study (the “SEC Study”) no later than January 2, 2009 (that is, after the election, but before the new Congress takes office), including “such administrative and legislative recommendations as the [SEC] determines appropriate.”
Work on the SEC Study has commenced and the SEC has announced that it is scheduling public roundtables to obtain input from “investors, accountants, standard setters, business leaders, and other interested parties.”
With the preparation of third quarter financial statements now in process, presumably in reliance on the FAS 157 Guidance and the FSP, and the SEC Study underway, with further public input to be provided, it appears likely that any further regulatory action on these issues will be deferred until 2009, when it will unquestionably be a subject for further debate during the upcoming effort by Congress to reform financial regulation.
We will continue to provide updates on these important issues as events unfold.
