SEC issues statement clarifying 'fair value'

According to the International Monetary Fund, global losses from writedowns of non-performing or poorly performing financial instruments are likely to reach $1.4 trillion. Around $560bn of write-offs have been announced so far (as of the end of September), which leaves hundreds of billions yet to be declared. With that volume of downside lurking somewhere in the system, it’s no wonder banks remain distrustful of each other, surpressing credit market activity. And with more pain to come it is not surprising pressure remains over the use of fair value in accounting for financial instruments.

Former Lehman Brothers CEO Richard Fuld told Congress that fair value accounting rules forced the bank to write down its assets and that that was one of the reasons for the bank’s collapse.

It seems that US politicians had some sympathy with Fuld on that. Section 132 of the Emergency Economic Stabilization Act (EESA), the $700bn US bailout legislation which was passed into law at the beginning of October, allows the Securities & Exchange Commission to suspend the controversial mark-to-market rules.

Clear and fair
Just prior to being given their new powers, the SEC’s chief accountant and the Financial Accounting Standards Board issued a statement clarifying fair value. The SEC’s clarification was based on the fair value measurement guidance in FASB Statement 157 and tried to answer five questions (see Fair value clarification, below). At the heart of the answers given by the SEC is the fact that banks do not have to use fire sale prices when evaluating their hard-to-price assets.

The SEC emphasises that because fair value measurements and the assessment of impairment may require significant judgment, clear and transparent disclosures are “critical to providing investors with an understanding of the judgments made by management”.

The EESA legislation also requires the SEC to conduct a study of “mark-to-market” accounting, and so it will now look at the possible culpability of such accounting in bank failures. The study is due to be completed by the new year in conjunction with the US Treasury and the Federal Reserve. The SEC has promised it will consult interested parties, but it already knows who will say what. While US politicians and bankers railled against mark-to-market accounting, the Big Four accounting firms have already told the SEC that fair value should stay.

In Europe, given the French banks’ long-standing opposition to IAS 39, it was hardly surprising that French president Nicholas Sarkozy called for more flexibility in the rules, while EU internal market commissioner Charlie McCreevy said if others relaxed the rules, then Europe would follow suit.

But Peter Montagnon, director of investment affairs at the Association of British Insurers said, “Accounts should portray the situation facing companies as it is in reality, and the fair value approach is important to this. We do recognise that the application of fair value in very volatile conditions has exposed problems. These need to be addressed in a considered way, but now is not the moment for turning our backs on an important principle. Long-term confidence would be hurt by abandoning this concept in response to short-term pressures.”

Additional guidance
Music to the ears of the IASB board. It said the SEC clarification “is not an amendment of FAS 157, but rather provides additional guidance” which was also consistent with its own standard, IAS 39.

Crucially, the IASB pointed to the US ability to reclassify financial instruments. “US GAAP permits entities, in rare circumstances, to reclassify financial instruments that are in the form of securities from their trading portfolio (measured at fair value with changes through the income statement) to ‘held to maturity’ (measured at amortised cost and subject to testing for impairment),” it said.

The IASB has now fallen in line with the US on this accounting point. Such a move gives additional support to the idea that fair value does not have to be at fire sale prices and should help banks and auditors in this crucial audit period, while reassuring investors and politicians that while the rules are flexible, integrity is being maintained.

Fair value clarification
Q. Can management’s internal assumptions be used to measure fair value when relevant market evidence does not exist?

A. Yes. When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable.

Q. How should the use of “market” quotes be considered when assessing the mix of information available to measure fair value?

A. Broker quotes may be an input, but are not necessarily determinative if an active market does not exist. An entity should place less reliance on quotes that do not reflect the result of market transactions. Further, the nature of the quote should be considered.

Q. Are transactions that are determined to be disorderly representative of fair value? When is a distressed (disorderly) sale indicative of fair value?

A. The concept of a fair value measurement assumes an orderly transaction between market participants. Distressed or forced liquidation sales are not orderly transactions. Determining whether a particular transaction is forced or disorderly requires judgment.

Q. Can transactions in an inactive market affect fair value measurements?

A. Yes. Transactions in inactive markets may be inputs when measuring fair value, but would likely not be determinative.

Q. What should be considered in determining whether an investment is other-than-temporarily impaired?

A. In general, the greater the decline in value, the greater the period of time until anticipated recovery and the longer the period of time that a decline has existed, the greater the level of evidence necessary to reach a conclusion that an other-than-temporary decline has not occurred.

Abridged from SEC statement on fair value accounting