Fair Value: A Matter of Judgment

Comments submitted to regulators criticize FASB's rushed proposal for helping banks apply fair value to financial assets in inactive markets.

When the Securities and Exchange Commission and Financial Accounting Standards Board issued proposed fair-value accounting guidance last week, they may have eased the minds of many conservative, honest accountants who are wary of basing estimates largely on their own assumptions. Under pressure from lawmakers and angry bankers to loosen the fair-value rules, the regulator and standard-setter acknowledged that “significant judgment” is required for marking financial instruments to market.

Last week’s clarification officially made it acceptable for companies to rely on their internal models and assumptions — such as expected cash flow — for determining the fair value of financial assets and liabilities that don’t have a current market. Soon after, FASB came out with more detailed guidance by proposing an example of how a company would apply fair value in an illiquid market that the board plans to add to its existing FAS 157 literature. The two-year-old standard explains how to measure fair value through a three-step hierarchy; companies are directed to use Level 3 data as a last resort when they have no “observable inputs” on which to make their estimates of a security’s current worth.

Critics of this latest proposal — which FASB is expected to discuss at a meeting on Friday — want the board to zero in on the subject of judgment and better explain how in FASB’s hypothetical example, the company came up with its final estimate after taking all the factors it had to consider into account. Other commentators have used the proposal as a way to vent their frustration and plead with the board and the SEC to revisit the practicality of mark-to-market accounting. Under the $700-billion bailout package signed by President Bush last week, the SEC has the power to suspend mark-to-market accounting.

In the proposed example, FASB walks through how a hypothetical company, “Entity A,” would estimate the fair value of a collateralized debt obligation security whose market has dried up. The company will disclose that its estimate falls under Level 3 since there are no current, consistent prices for similar CDO securities. The company considers many factors, including old quoted prices for similar securities, analyst and rating agency reports, as well as nonbinding quotes from brokers, before deciding to use a 22 percent discount rate for discounting the security’s contractual cash flow.

The example has done little to appease the concerns of finance executives at financial institutions, who contributed to the more than 40 letters FASB has received from CFOs, financial reporting experts, and CPAs. (The deadline for responding is today.)

“The exit price is virtually impossible to come up with, at least for the common person, and the results are accepted by the auditors, trying to apply FAS 157, only if the results are in a range of what they have seen elsewhere,” wrote Jeffery Aberdeen, controller at Commerce Bancshares. “We find no expertise available to determine what an exit price really is in these dysfunctional markets.”

FASB’s guidance leaves Financial Reporting Advisors unsure of how to much to include observable inputs and broker quotes in illiquid markets. The consultancy considers the FASB example not useful in practice as it doesn’t explain how judgment was applied.

Moreover, the Center for Audit Quality, which represents 800 audit firms, also asked FASB to give more detail in its illustration. “The proposed example is unclear as to the judgments necessary when evaluating and weighing the respective indicative quotes as compared to management’s own estimation in order to reach an ultimate determination about an appropriate point within the range that is most representative of a market participant’s assumption of a rate of return,” wrote Cynthia Fornelli, executive director of the CAQ.

To be sure, many of the comment letters did not specify how FASB could improve its proposed guidance. Instead, they shared their hatred for fair value accounting, blaming FAS 157 and FASB’s members for creating the credit crisis.

Others are worried that the mission of fair value accounting — to create more transparent, up-to-date values for investors — will not be reached. “I am concerned that the proposed revisions to the rule could further exacerbate the current financial crisis, rather than help it, by essentially making the financial health of a company that has non-performing assets on its books seem better than it actually is,” wrote Judith Gross, a principal at JG Advisory Services, which advises hedge funds, private equity, and broker/dealers. “What the rule is essentially doing is allowing a company to assign a value that is based on ‘assumptions’ to an asset that has no market and is therefore actually, in the real world, worthless.”

Robert Herz, FASB’s chairman, has acknowledged that fair value works best in liquid markets and that the concept is more difficult during times of illiquidity. However, he said in a speech last month, “the harsh reality is that we can’t just suspend or modify the financial reporting when there is bad news.”

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