A Fair Value Antidote Is Rushed by FASB

In newly proposed guidance, board encourages companies to use more judgment — and do more work — when assessing the current value of assets stuck in an inactive market.

The Financial Accounting Standards Board is encouraging companies to do more legwork when estimating the fair value of assets that are not actively traded.

FASB has proposed expedited guidance for a 15-day comment period in response to pressure by bankers, regulators, and lawmakers that the fair-value accounting rules be modified. The proposal guides companies on how to determine whether an asset’s market can be considered not active, and whether a transaction being used to estimate an asset’s value is not distressed. Under FAS 157, which provides a measurement framework for fair-value accounting, financial instruments’ fair values cannot be based on distressed sales.

Fair-value accounting has been in existence for years, but has recently been criticized for worsening the financial crisis and leading to massive writedowns in the financial-services sector. Indeed, just four days ago, FASB chairman Robert Herz was in the congressional hot seat as members of a House Financial Services subcommittee demanded that he modify accounting rules quickly to help turn the economy around. He made no promises. “We can have the guidance in three weeks, but whether that will fix everything is another [issue],” he said at the hearing.

Critics imply that the current rules require banks to unduly write down their asset values, even though they believe those assets are actually worth more than the amounts they feel mandated to report. The truth in FASB’s view, however, is more complex: To avoid second-guessing by auditors, firms are tending to use any price they can find when estimating the fair values of their assets — even prices that are basically unreliable and too low to truly reflect an asset’s current worth, because the prices resulted from a so-called forced transaction. Those types of transactions are not representative of an asset’s fair value, according to FASB.

FAS 157 calls on companies to use a three-step hierarchy when estimating the current worth of their financial assets and liabilities. The evaluations must be based on prices that have been used in orderly transactions, not those that are considered forced or distressed.

Level 3 requires the most judgment, as it is designated for thinly traded or untraded assets that have a value derived from “unobservable inputs.” For that reason, there has been a stigma attached to Level-3 numbers. So financial-statement preparers have tended to reference Level 2-type prices, although they shouldn’t always do so. “Hopefully [the new guidance] will make people feel better about clarifying things as Level 3,” said one FASB member at an early morning meeting on Monday.

Firms may have been wary of exploring Level-3 pricing because those inputs do require more judgment — which can result in more scrutiny from auditors and more work on the part of their internal staff and the need for outside help, such as valuation experts. Only 9 percent of financial instruments subject to fair value were classified under Level 3 since FAS 157 was implemented, compared to 76 percent of those instruments that fell under Level 1, according to a Securities and Exchange Commission study of financial institutions’ use of fair value issued late last year.

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