New guidance issued by the Securities and Exchange Commission and the Financial Accounting Standards Board seems to suggest that banks and other holders of illiquid securities were being too conservative with their fair value estimates. In the clarifying memo released on Tuesday afternoon, the SEC and FASB broke down the guidance into five key points to help companies correctly apply mark-to-market accounting to illiquid assets.
The clarification, which provides no changes to current rules, addresses nagging questions that companies, auditors and investors have had about applying FASB’s fair value measurement rule, FAS 157, which was issued in 2006. Most notably, the guidance affirmed what many valuation experts have been arguing over the past few weeks: that companies can rely on their internal models and assumptions — such as expected cash flow — to determine the fair value of financial assets and liabilities when a market for the securities does not exist.
The guidance comes amid a swelling chorus of calls from bank lobbyists, trade groups, lawmakers, and the Bush Administration to suspend fair value accounting. Indeed, the bailout bill defeated yesterday in the House of Representatives included sections giving the Securities and Exchange Commission power to suspend mark-to-market accounting “for any issuer” and to launch a probe into the question of whether it contributed to the crisis.
Fair-value is being blamed as either a cause or an accelerant in the current financial crisis as banks have been forced to write down the values of illiquid securities. That in turn, has compromised both their balance sheets and their regulatory capital ratios, affecting their actual or perceived ability to lend.
FAS 157 provides a so-called measurement hierarchy that provides ways to value securities depending on how liquid they are. Regularly traded securities are valued on their selling price, where as securities that are thinly traded or in illiquid markets have a different set of inputs. In practice, however, many experts suspect that banks and financial institutions gave undue weight to the last observable selling price of their securities before the markets froze completely. The new guidance, which applies not just to banks, but to all companies that use generally accepted accounting principles, explains that if a market for a security does not exist, a company may use a combination of factors to produce a fair value estimate of the securities. That means, for instance, that banks could work up an estimate by looking at expectations of future cash flows in combination with appropriate risk premiums.
The guidance does not necessarily make it easier to measure fair value. Indeed, many company executives are likely to find the exercise even more disconcerting, since the guidance emphasizes that companies have wide leeway to consider the most logical assumptions in determining a mark-to-market value, rather than dictating one specific methodology. “The determination of fair value often requires significant judgment. In some cases, multiple inputs form different sources may collectively provide the best evidence of fair value,” noted the guidance.
The guidance, with its heavy reliance on judgment, is in line with FASB’s recent efforts to make accounting rules less prescriptive, more “principles-based,” and more akin to international accounting standards, which tend to offer fewer bright-line rules.
The guidance also addresses the use of market quotes from brokers or pricing services to establish the fair value of illiquid assets. If the broker quote is not based on actual transactions, but on the broker’s models, then the asset owner “should place less reliance on quotes,” concludes the document. Many companies had complained that broker prices — which often serve as a valuation input — had grown wildly unrealistic, and in some cases predatory, in recent months.
In addition, the SEC and FASB emphasized that since the concept of fair value is based on an “orderly transaction” — and not a fire sale, using the mark-to-market method of accounting when valuing distressed assets remains a judgment call. “The fact that a transaction is distressed or forced should be considered when weighing the available evidence,” wrote the officials.
An inactive market — such as a failed auction — in which there are significant spreads between the asking and bidding price, is also something requires more judgment, says the guidance. And while preparers of financial statements cannot rely on any bright-line tests or safe harbors in existing U.S. GAAP, the guidance notes, there are a number of “rules of thumb” available to issuers to determine whether an investment’s loss, or impairment, is long-term. In accounting parlance, a long-term loss is usually characterized as being “other than temporary.”
Those rules of thumb, which are based on certain characteristics of the investment in question, are listed in the SEC’s Staff Accounting Bulletin Topic 5M. Among the factors preparer should consider are: the length of time and the extent to which the market value has been less than cost; the financial condition and near-term prospects of the issuer; and the intent and ability of the holder to retain the investment long enough to anticipate a recovery in market value.
The guidance also underscores the importance of “clear and transparent” disclosures, and says that in addition to the requirements already written into FAS 157, companies should consider following the suggestions made by the SEC’s Division of Corporate Finance to provide real-time disclosures.
FASB is expected to provide additional guidance on fair value accounting in the coming months. The clarification issued today in conjunction with the SEC’s Office of the Chief Accountant, was designed to address the most pressing issues related to fair value measurement. On Monday, FASB postponed a webcast on fair value accounting, citing “recent events in the financial markets and the legislation under consideration” as the reason for canceling the discussion.