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In its just-issued staff proposal, the board would steer bondholders away from valuing their holdings according to scattered market sales.
David M. Katz, CFO.com | US
March 18, 2009
Fighting an apparently uphill battle against a reading of its fair-value measurement standard that has mistakenly led to fire-sale asset pricing, the Financial Accounting Standards Board on Tuesday night proposed new guidance on mark-to-market accounting.
The proposed guidance would come, if it's approved after a comment period ending on April, in the form of two FASB staff positions. One would 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."
The proposal addresses situations in which an asset once valued according to transactions in an active market might have to value the asset by using a theoretical pricing model. Among the conditions in which "mark-to-model" valuation applies are illiquid markets and sales made under the duress of pricing pressure.
The second FASB staff position would provide asset holders with guidance on how to account for securities losses on "Other-Than-Temporary Impairments." Issuers must record losses on such assets, which holders either can't or won't hold to maturity, at fair value. If both proposals are approved, they would be effective for interim and annual periods ending after March 15, 2009.
Pressured by members of Congress and by banks who have claimed that its rules have helped spawn the current banking meltdown, FASB is acting with almost unprecedented speed to make the two staff positions official. If the staff positions are enacted on April 2, it would be only slightly slower than the speed with which FASB and the Securities and Exchange Commission enacted earlier fair-value guidance last October after a mere 10-day comment period.
The staff positions, particularly the first one, are aimed at breaking the grip management and auditors have on the use of data based on the last available asset sale, according to David Larsen, a Duff & Phelps managing director and a member of FASB's Valuation Resource Group. Speaking at a D&P press briefing on Wednesday, he referred to the issue as "stickiness" in the use of observable data in fair-value measurement.
Under FAS 157, the board's standard on fair-value measurements, 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.
Many FASB constituents, however, mistakenly use "an observable market transaction even when that transaction may be distressed or the market for that transaction may not be active," according to the staff proposal.
"Constituents have indicated that this emphasis on the use of the so-called last transaction price as the sole or primary basis of fair value even when a significant adjustment may be required," the staff wrote, "has resulted in a misapplication of Statement 157 when estimating the fair value of certain financial assets."
Larsen claims that corporate managements and auditors have a longstanding attachment to the use of level 2 data and tend to use it even when the standards indicate that models should predominate.
Last October's guidance, FAS 157-3, stated, for example, that all available information should be taken into account in coming to a fair-value assessment, the D&P partner noted. It also stressed that "if your broker quotes are not based on real transaction data, they should not be used."
Nevertheless, the valuation specialist said, "the stickiness of level 2 has remained." Using the example of a bond with a par value of $100, Larsen explained how misinterpretations occur. If the holder of the bond considers the underlying cash flows of the bond during these recessionary times, he might determine that its current worth would be $90 and might further adjust it downward to $80 to take into account a risk premium and the time value of money.
If however, the bondholder observes on Bloomberg that five people have sold the same bond at $20, he might well be prone to value it at that price because of a predisposition to use observable prices. In an active market, $20 might well be the right value to assign, according to Larsen. But in a distressed market, if the holder has 100,000 bonds, "that might not be the right value," he said.
The contention that 157 requires fire-sale pricing is "blatantly false," he said. "In fact, it prevents you from using fire-sale pricing. If you use fire-sale pricing you are not in accord with generally accepted accounting principles."
The newly proposed FASB staff position on determining whether a market isn't active and a transaction isn't distressed purports to help asset holders negotiate the difficult waters between level 2 and level 3. It sets up a two-step process. In step 1, asset holders would assess at least seven factors in gauging whether to pronounce a market inactive. ("Those factors should not be considered all inclusive because other factors may also indicate that a market is not active," FASB cautions.) The factors are:
—There are few recent transactions in the market.
—Price quotes aren't based on current information.
—The quotations vary heavily, either over time or among brokers.
—Indexes that in the past were highly linked to the asset's fair values "are demonstrably uncorrelated with recent fair values."
—Abnormally big liquidity risk premiums or yields on the assets.
—Abnormally wide bid-ask spreads or big hikes in the spreads.
—Little publicly released information.
After the asset holder does a thorough evaluation using those factors, it must "use its judgment in determining whether the market is active." If it concludes in step 1 that the market for the asset isn't active, then it would proceed to step 2.
In step 2, the asset holder would have to presume that a quoted price stems from a distressed transaction unless the asset holder can prove that there was enough time before the measurement date to allow for normal marketing activities for the asset. There would also have to be many bidders for the asset for the price to be deemed not distressed.