The Financial Accounting Standards Board will break with procedure and issue new guidance on fair value accounting after only a seven-day comment period. The additional guidance will provide a concrete example of how companies should value illiquid assets under the fair value accounting method described in FAS 157, the rule related to fair value measurement.
The five-member board voted unanimously on Wednesday to issue a staff proposal that contains the example. The accelerated comment period will likely end on October 9, and FASB’s plan is to have the board finalize the draft at its meeting on October 10. When finalized and issued, the guidance will go into effect immediately.
By issuing an illustrative example, the board hopes to quell the controversial issue of how to measure the value of a financial asset under FAS 157 when no market exists for the asset. The additional guidance follows yesterday’s clarification released by FASB and the Securities and Exchange Commission, to reiterate that companies with illiquid financial assets are allowed to use management assumptions — including expected cash flow projections — in their fair value analysis.
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 on Monday 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.
Those who blame fair-value accounting as either a cause or an accelerant in the current financial crisis do so because it forces banks 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. Defenders of fair value counter that the accounting simply exposed serious problems with bank investments, and that suspending it would be the equivalent of ignoring those problems, as Japanese banks did during their so-called “lost decade.”
FAS 157 provides a 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.
“We are just elaborating on the brief release that was issued yesterday,” noted FASB member Leslie Seidman at today’s meeting. She said the decision to issue extra guidance in the form of an example is a way of publishing authoritative accounting literature that cross references the paragraphs of FAS 157 that address the measurement of illiquid assets.
“We cannot overemphasize that [the proposal] does not change the objective of FAS 157 regarding the market participation rule,” added George Batavick, another FASB member.
The example will include clarification on how companies should use the prescribed measurement hierarchy that separates assets and liabilities into three categories based on risk-related criteria. That hierarchy looks like this: Level 1 inputs are assets and liabilities that are measured using quoted prices in active market; Level 2 inputs, can be measured using other observable inputs, such as instruments that are marked to a model; and Level 3 inputs — considered unobservable — are thinly-traded assets and liabilities that are measured using estimates based on the value the company believes a hypothetical third party would pay for them.
The guidance issued yesterday by the FASB and the SEC will be included in next week’s staff proposal, and will apply not just to banks, but to all companies that use generally accepted accounting principles. It will 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 related to default or liquidity risk, for example.
FASB board member Lawrence Smith says that he hopes the example serves to eliminate the question of whether “a good level 3 input trumps a bad level 2 input.” Smith contends that the question is flawed, because if the level 2 inputs are “bad,” then the company should not have been using them in the first place. “Whether the market goes up or down, [companies] should consider the changes in the marketplace . . . and include those trends in the models used to determine today’s fair value,” opined Smith.
“I know [illiquid markets] are more pervasive now, but it is not a new problem,” asserted FASB member Thomas Linsmeier. “We have been dealing with inactive markets for years.”
The proposal will be “very fact specific” and stress the use of judgment in the example, said FASB chairman Robert Herz, who also noted that the draft will only consider assets, and not the treatment of liabilities under FAS 157. Herz made a point of noting that the accelerated comment period was in response to an “unprecedented period,” referring to the current credit crisis, and is not aimed at squelching comments from market participants.
In general, board members were adamant about conveying to financial statement users, preparers and auditors that the new guidance does not change FAS 157 or suspend the use of fair value accounting for financial instruments.
Herz, adding a personal note as an accounting expert, rather than a FASB representative, contended that the purpose of financial reporting is to provide good information to financial statement users. “It is not there for regulatory capital or to boost the balance sheets of financial institutions,” he said. “This is not new . . . whether you call it fair value, or mark to market, or taking an impairment charge . . . the idea of marking things down in a down market has been the convention for a long, long time,” said Herz.