SEC: Fair Value’s Savior

In a report to Congress, the commission defends mark-to-market accounting but expects standard-setters to better explain how to implement the rules.

The Securities and Exchange Commission, as expected, has decided not to suspend mark-to-market accounting — against the wishes of many banking lobbyists. But the debate over how to measure financial assets and liabilities is far from over.

In fact, the SEC’s decision, outlined in a 211-page report sent to lawmakers late yesterday, provides several recommendations — mostly for the Financial Accounting Standards Board, which the commission oversees — for guiding companies on how to apply fair value. Among the commission’s suggestions: Give companies help in deciding when an asset’s market has dried up and for determining how to consider illiquidity when valuing an asset or liability.

Still, the SEC staffers acknowledge that the fair-value rules aren’t perfect, even though they went through standard-setters’ extensive due process. That passage is one of the reasons they give for trying to dissuade lawmakers from interfering with FAS 157, FASB’s fair-value rule. They recommend that FASB develop a process for reviewing future standards after they’ve been adopted to uncover their practical issues.

The SEC also is calling on FASB to simplify accounting for the impairment of financial assets and address issues that have arisen for measuring the value of liabilities. The report requests new disclosures to explain the effect fair value has on financial statements and more guidance on figuring out the fair value of an asset that has no active market. This fall, in response to demands by financial institutions and their sympathizers, FASB issued a hypothetical example for how to estimate the fair value of a collateralized debt obligation security in an inactive market; however, the SEC notes, this rushed guidance still has practitioners confused.

With the passage of the Emergency Economic Stabilization Act, Congress gave the SEC 90 days to study the effects of fair-value accounting. The new law also gave the SEC the authority to suspend mark-to-market accounting if the regulator deems such a move “necessary or appropriate in the public interest.”

Instead, SEC staffers report that investors believe fair value provides them with the best view of the current values of their companies’ assets. “General-purpose financial reporting should not be revised to meet the needs of other parties if doing so would compromise the needs of investors,” the report notes. Also supporting fair-value advocates’ cause: the SEC determined that the accounting method “did not appear to play a meaningful role in the bank failures that occurred in 2008.”

Moreover, after reviewing three years’ worth of financial data for 22 failed banks, the SEC concluded that fair-accounting had had little effect on the failures; the method has been used only for a small number of assets and the fair-value-related losses did not have a “significant” effect on the banks’ capital.

The bulk of the SEC’s report offers Congress a history lesson on standard-setting, fair value’s rising popularity over historical cost accounting, and the globalization of accounting rules through convergence of U.S. GAAP with international financial reporting standards, which use more fair value.

In addition, the SEC deflates the mistaken belief by observers in non-accounting circles that the two-year-old fair-value rule FAS 157 created a brand-new wave of mark-to-market accounting. Rather, FAS 157 defines fair value and provides a framework for measurement along a three-step hierarchy. Under the third level, assets that are thinly traded or not at all are held up against “unobservable inputs.” It is under this method that fair-value critics say the accounting standard creates too much volatility and leads to a pro-cyclical, downward effect on the economy. What those critics don’t say is that Level 3 is not used very often: In a review of 50 financial institutions, the SEC found that more than 90 percent of investments held up against fair value were based on observable inputs.

Put together by the SEC’s staff in the chief-accountant and corporation-finance departments, the report pushes aside concerns that fair value interferes with comparability and leads to more volatility in companies’ reported income by reasoning that historic-cost accounting has its own bag of comparability issues and that the current value of an asset better reflects the true economic risk firms have adopted.

The SEC further believes that bank failures derived from their ballooning credit losses, doubts about the quality of their assets, and skittish investors and lenders.

“Rather than a crisis precipitated by fair-value accounting, the crisis was a ‘run on the bank’ at certain institutions, manifesting itself in counterparties reducing or eliminating the various credit and other risk exposures they had to each firm,” according to the SEC, citing the collapses of Bear Stearns, Lehman Brothers, and Merrill Lynch as examples.

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