Ball of Confusion: FASB Affirms Fair-Value Principles

Okaying a proposal on how to gauge the price of financial instruments in illiquid markets, the board says that preparers should use their judgment.

Straining to overcome the confusion that resulted from its recently issued fair-value proposals, the Financial Accounting Standard Board this morning approved an altered version of its proposed guidance on how to determine whether a financial market is inactive and an asset sale isn’t distressed.

Both conditions are crucial in measuring the fair value of a financial instrument under FASB’s controversial Statement No. 157, Fair Value Measurements. According to the standard, a fair value can’t be applied to an instrument sold in a distressed, or forced, transaction-like when a company has entered bankruptcy. Determining when a market is inactive is crucial, because that would make measurements derived from it less reliable under 157.

Board members have long stressed that financial statement preparers should use judgment in valuing assets in markets where there’s little hard and fast pricing information, and that principles should hold sway over rules. Somehow, however, many users of financials quickly got the impression that in FASB’s new proposed guidance, it was now favoring a more rigid approach to valuation in illiquid markets.

After a 15-day comment period that began with the speedy issuance of the proposal on March 17, the board acknowledged, in the words of one member, that it was “screwing things up” in the minds of financial statement users-especially in terms of the overall objective of the proposal.

The measure purports to guide asset holders who mark their holdings to market through a two-step process to help them decide “whether a market for a financial asset that historically was active is not active and whether a transaction is not distressed.”

In response to the comment letters, FASB reasserted that the objective of its fair-value measurement standard holds firm even in inactive markets or ones with rapidly declining volume; clarified that judgment needs to be exercised in determining when a market is inactive; required new disclosures of valuation techniques; and delayed the effective date of its guidance for issuers who don’t want to adopt it early.

In its final reporting guidance, which is expected to be out next week, the board will require that the measure will be effective for periods ending after June 15, 2009, with early application permitted for periods ending after March 15, 2009. Retrospective application will not be permitted. In its proposal, the staff had asked that the measure simply be effective for periods ending after March 15, 2009.

Over 300 letters had flooded FASB by the end of the proposal’s comment period yesterday, and many constituents wondered if the board had changed the objective of a fair-value measurement in an inactive market under FAS 157.

Under the standard, holders of financial assets recorded in fair-value must report on how they came up with their values. They must classify the measurements into three levels of assumptions, depending on how “observable” the information is. In level 1, the value of an asset or liability stems from a quoted price in an active market. In level 2, it’s based on “observable market data” other than a quoted market price.

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