Congress Members Fume at Fair Value

Lawmakers bear down on FASB chairman Robert Herz to modify fair-value rules.

In their most public flogging to date, fair-value accounting rules were vilified in a congressional hearing today for causing major writedowns at financial institutions and allowing the crisis to continue.

For more than a year, the standards have been blamed for bringing volatility to financial reporting and acting as a major contributor to the U.S. financial downturn. The latest criticism came from both Republicans and Democrats during a House Financial Services subcommittee hearing today. To be sure, the critics stopped short of calling for the suspension of fair-value accounting.

But they pressed standard-setters and regulators, who traditionally use lengthy due-process procedures before making major changes, to alter existing related rules immediately. “This is an emergency situation that requires expeditious action, not academic treatises,” said Rep. Paul Kanjorski, a Pennsylvania Democrat who chairs the subcommittee. “They must act quickly.”

In effect, anti-fair-value members of the subcommittee appeared to blame the accounting for the problems they are having in their districts: rising foreclosure rates, unemployment, and small businesses that can’t get bank loans. Their reasoning appeared to follow the path that major banks have taken in arguing that mark-to-market accounting rules helped push the economy into a downward spiral. ”We can no longer deny the reality of the pro-cyclical nature of the mark-to-market accounting has produced numerous unintended consequences and exacerbated the ongoing financial crisis,” Kanjorski said.

Under FAS 157, which provides the current framework for fair-value measurements, companies must use a three-level hierarchy when estimating the current worth of their financial assets and liabilities. Level 3 is designated for thinly traded or untraded assets that have a value derived from “unobservable inputs.” Fair-value critics say this category of assets has caused extreme volatility and massive writedowns in the financial-services sector. The volatility and the writedowns have led firms to violate their regulatory capital requirements, they contend.

But most of the valuations done by financial institutions were based on observable inputs, according to an Securities and Exchange Commission study done last year. The regulator concluded that fair-value-related losses did not a have a “significant” effect on hurting banks’ capital.

Moreover, the Financial Accounting Standards Board has disputed bank advocates’ notion that fair-value accounting has resulted in excessive writedowns of their securities. In a review of publicly traded banks, the board’s staff found that 52 percent of them were trading at less than tangible book value up until last November.

For their part, representatives from the FASB and the SEC tried to discourage House members from blaming the rules themselves for keeping the crisis going. “Accounting did not cause this crisis and accounting will not end it, but accounting should not make it worse,” said James Kroeker, acting chief accountant for the SEC.

Rather, part of the problem may be how the rules are interpreted, they note. For that reason, FASB is working on guidance that could change how companies assess an asset’s fair value in an inactive or illiquid market. This advice will stress the need for judgment and move practitioners away from the tendency to consider the last price for which a financial instrument has been traded as its fair value. Herz is hoping more preparers will realize they can use expected cash flows of an asset as an alternative to trying to nail down market prices when making difficult valuations. The lack of internal expertise at financial institutions, however, may be discouraging them from doing so.

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