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Has the Crisis Ended the Fair-Value War?

Because of the current fragility of investor confidence, regulators should hold steady on current mark-to-market standards, many feel.
David M. Katz, CFO.com | US
November 21, 2008

Events have finally overtaken the debate on mark-to-market accounting, leaving previous rivals clinging together to the Financial Accounting Standards Board's controversial standard on fair-value measurements like shipwreck victims to a raft at sea, the drama unfolding at the Securities and Exchange Commission's final roundtable on fair value Friday seemed to indicate.

Even the representatives of financial-services institutions, up until now the fiercest opponents of the FASB standard, SFAS 157, seem wary of calling for replacement or suspension of the measure in the face of the disastrously plummeting stock market. Now, many agree, it doesn't make sense to tamper with the rule and risk losing whatever investor confidence that still remains.

Thus, when the SEC presents a mandated study on SFAS 157 to Congress early next year, a radical change in the current mark-to-market regime seems unlikely to be among the recommendations. After the 12 roundtable panelists — including investor representatives, corporate accounting executives, former regulators, and auditors — had made their opening remarks, SEC chairman Christopher Cox noted that the last of the study's six topics was a requirement that the commission look into possible alternatives to SFAS 157.

Referring to the panelists' remarks, Cox said that "going down the line, I didn't hear anyone say 157 should be replaced," and he asked them to confirm that impression. Only two of the participants — James Gilleran, former director of the Office of Thrift Supervision, and Kevin Spataro, a vice president for accounting policy and research at Allstate— raised their hands. And while Gilleran thought the FASB measure should be replaced by the International Accounting Standards Board's fair-value standard, Spataro said he thought 157 should be "amended but not replaced."

Indeed, Bob Traficanti, the head of accounting policy and a deputy controller at Citigroup who six months ago objected to the standard's effects on banks during the subprime crisis, fully supports it now. Last May he spoke at a Standard & Poor's conference provocatively titled, "Is It Time to Write Off Fair Value?"

Citing the standard's provision that fair-value prices must be based on what a hypothetical "willing buyer" might be asked to pay, Traficanti said then that some of the prices Citigroup had to come up with felt coerced, and he asked FASB to "back-test [the standard] to see how this really worked."

Friday, however, Traficanti, a former FASB project manager, said both he and Citigroup "support the notion of fair value and 157, and we believe 157 should be left intact." Indeed, he said, "the last few quarters, there's an acknowledgement that it works, that it's auditable." At the same time, he proposed changes in FASB's standard 115, covering certain kinds of debt and equity securities, to enable banks to write down debt securities in the same way they record loan losses. That would let the banks designate some debt securities as "available for sale" or "held to maturity" — often a more favorable way of recording fair value than the "exit price" concept of 157 ("the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date," according to 157). The bottom line for Traficanti, though, seemed to be: Change 115, but leave 157 alone.

To be sure, 157 still has its critics. Gilleran, who was nominated as top regulator of the savings-and-loan industry in 2001 by President Bush, said that "something should be done prior to December 31" to revise the notion of exit price. "Exit price should not be used if management can hold an investment to maturity," he said.

Gilleran, who served most recently as president and chief executive officer of the Federal Home Loan Bank of Seattle from 2005 to 2007, provided two examples of the negative effects of fair-value accounting on the effort to provide affordable housing to lower-income families.

In the Federal Home Loan Bank of Atlanta's third-quarter income statement, he noted, the bank recorded an almost $90 million other-than-temporary-impairment charge on three securities — even though the bank reported a loss of contractual cash flows of $44,000 for the securities over the period of 2005 to 2007.

Further, the Seattle Federal Home Loan Bank's third-quarter income statement reported that the bank held a few securities with discounted cash flows that would have resulted in about a $5 million shortfall, according to Gilleran. The bank, however, reported a $50 million charge against income for the quarter, he noted.

By statute, 10 percent of the earnings of the federal home loan bank system must go to affordable housing projects. "Any dollar charged against a P&L would reduce the amount that goes to affordable housing," said Gilleran.

Referring to a common complaint against mark-to-market accounting, Allstate's Spataro said he doesn't believe the worldwide credit crisis was caused by fair-value measurements. "But once it emerged, they did serve as a powerful accelerant," he added.

The accounting executive said the insurance giant "supports the use of fair value as a measurement standard in situations where markets are liquid, active, and orderly." But for other situations — particularly those involving credit securities and private placements — FASB should add a "screen" to 157 that would direct preparers of financial statements to use other accounting standards.


David Larsen, a managing director at Duff & Phelps and a proponent of mark-to-market valuation, disagreed with Spataro. "To gum up 157 with various screens is problematic," he said, noting that he and other valuation experts have long been tasked with determining the fair value of illiquid assets, particularly in the private-equity area. Perhaps the problem is that preparers aren't yet adept in coming up with estimates under 157, Larsen said.

A number of panelists contended that bank regulators, not accounting standards-setters, were responsible for addressing the credit crisis and setting minimum capital requirements. Although 157 didn't cause the massive bank write-downs, it's possible that the standard spawned some "undesirable procyclical" effects, acknowledged Wayne Landsman, a professor of accounting at the University of North Carolina at Chapel Hill. He contended, however, that "it is up to bank supervisors to address procyclicality, not accounting standards-setters."

Similarly, Sam Ranzilla, the partner-in-charge of professional practice at KPMG’s national office, said, "We should not be changing GAAP in order to solve regulatory issues." The need to fix regulatory capital requirements is a separate issue from changes in fair-value accounting, he added.

Indeed, over the past few quarters, discussions among auditors and their clients have moved away from problems with fair value to talk about how the current model for writing down impaired assets should be improved, said Ranzilla. "I don't think an amendment to 157 is the appropriate [path in the short term]," he said.

In the short term, he said, regulators and standards-setters should think about dealing by year's end with the issue of the current model of reporting impaired assets. And if that doesn't happen, Ranzilla said, "I think we ought to make sure that the constituents of financial reporting are aware that there will be at least no intent on the part of either the standards setters or the regulators to do anything before this year end, just to manage expectations."

In fact, the currently dire need for companies to hold on to the confidence of shareholders by keeping financial reporting consistent and transparent was a powerful theme at the roundtable. "As we face the worst financial crisis in 70 years, [investors] need to know what a company is worth," said David Runkle, director of quantitative research at Trilogy Global Advisors, a hedge fund. "I believe that suspending fair value would decrease investor confidence [and that] hiding financial problems would only delay the end of the crisis."




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