The initial challenge in meeting the requirements of FAS 157 entails sorting each fair-value estimate into one of three levels, or “buckets,” as Paul Farr, CFO of PPL Corp., calls them. Since the fall of 2007, the finance and technology departments of PPL, an Allentown, Pennsylvania-based diversified energy company, have been hard at work filling those buckets with information about how the company gauges the fair value of the derivatives it buys and sells. “We’ve had a 157 project under way for nine months,” Farr said in May. “The last six months have been the most intense, as we were ‘bucketizing’ the various transactions.”
In bucket 1, the value of an asset or liability stems from a quoted price in an active market; in bucket 2, it is based on “observable market data” other than a quoted market price; and in bucket 3, fair value can be determined only through “unobservable inputs” and prices that could be based on internal models or estimates. It’s that third bucket that critics say has some serious holes.
Even FASB has struggled with how to place a market value on a transaction for which there is no market. Complicating the issue is that the board defines fair value as an “exit” price — “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date,” as the standard says.
The need to conjure up an exit price can force corporate borrowers to try to figure out, for example, what they would pay someone to take on debt no one is likely to buy. Not for nothing did an exasperated Robert Herz, chairman of FASB, declare in an April meeting that by requiring companies to estimate the fair value of such liabilities, “we’re forcing people to do mental gyrations in parallel universes.”
In the throes of the subprime crisis, some financial-services firms found themselves ill-equipped to perform such acrobatics. Finance executives in the sector complained that the fair-value rules were “pro-cyclical” — that they were a self-fulfilling prophecy forcing banks to sell their securities in plummeting markets.
Under FAS 157, FASB calls on companies to price an asset or liability as would market players “willing” to buy or sell the asset or liability but who aren’t “forced or otherwise compelled to do so,” noted Bob Traficanti, head of accounting policy and deputy controller of Citigroup, at a conference held by Standard and Poor’s last spring. Calling on FASB to test the 157 valuation hierarchy in light of companies’ first-quarter experience, Traficanti asserted that some of the prices Citigroup had to come up with had indeed felt coerced.
The Bucket List
Herz and the board, however, seem unlikely to budge on FAS 157. What’s more, finance executives outside the banking sector haven’t griped all that much about the measure, with some saying that it doesn’t change their companies’ underlying accounting at all.