According to the
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
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
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
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
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
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
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
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.
statement on fair value accounting