Ball of Confusion: FASB Affirms Fair-Value Principles

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.

In level 3, which often applies to asset valuations in illiquid markets or in "distressed" sales (sometimes called "fire sales"), fair value can be determined only through "unobservable inputs" and prices that could be based on internal models or estimates.

Some critics of last month's proposed guidance on how to apply 157 and a companion proposal on other than temporary impairments (OTTI) said that the measures represent a capitulation to bankers' demands for weaker standards-and some even saw them as a symptom of the weakening of FASB itself.

In a press conference following the meeting, a reporter asked FASB chairman Robert Herz to react to charges by the CFA Institute that the two staff positions indicated a lack of independence on the part of the board. He also asked Herz to answer the institute's charge that the speed with which FASB came up with the proposals suggests that it was bowing to "special interests" (in this case, presumably, the banks).

The FASB chairman replied that the board had "reached out to 40 major investors in financial institutions" in addition to the CFA for input on the proposed staff positions. Unlike the institute, most of the investors, while calling for additional disclosures of fair-value measurement methods, approved of the direction in which FASB was headed, he contended, noting that that was especially true of the OTTI proposal. 

Acknowledging that the two-week comment period was "accelerated and expedited," Herz went on to say that the board engaged in "full due process" and that FASB probably got more input than it gets on proposals with three-month comment periods.

To accusations of a lack of independence by the board, Herz said, "What I don't like really is that when you don't agree with our end outcome you impugn our motives. That's not fair-or appropriate."

In letters to the board, some respondents voiced worries that the proposal on inactive markets and distressed transactions "would result in a relaxation of fair value requirements and reduce consistency and comparability in financial statements," according to a board meeting handout.

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