GAAP and IFRS

Fair Value Guidance to Go Live

FASB nips and tucks its FAS 157 guidance for quick release so companies can use the clarification to file third-quarter results.
Marie LeoneOctober 10, 2008

The Financial Accounting Standards Board will likely issue final guidance on fair value accounting by Monday. The board is working today and perhaps over the weekend to tweak some of the language to clarify how assets in illiquid markets are valued.

FASB decided to rework two sections of the draft document that was put out for public comment one week ago — but stuck to its guns regarding mandating companies to use significant judgment when valuing financial assets in inactive markets.

The guidance clarifies items contained in FAS 157, the accounting rule that governs how to measure assets and liabilities using the fair value method. FAS 157 provides a measurement hierarchy that outlines ways to value securities depending on how liquid they are. Regularly traded securities are valued on their selling price, whereas securities that are thinly traded or in illiquid markets have a different set of inputs. In practice, however, many experts suspect that banks and financial institutions gave undue weight to the last observable selling price of their securities before the markets froze completely.

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The FASB staff will slightly rework the language that defines an inactive market, but will stop short of giving a “bright line” definition. FASB chairman Robert Herz commented that the definition will explain that owners of financial instruments will be required to drill down to the asset level — as opposed to just assessing the market — to determine whether the market for that instrument is active. Further, FASB member Thomas Linsmeier added that the language should clarify that determining whether a market is inactive “is a matter of judgment” and that the guidance should include some factors that financial statement preparers may want to consider before making that decision.

Similarly, the FASB staff will tidy the language that describes a distressed sale. FAS 157 requires that owners of financial instruments value the instruments according to what price the asset will fetch in an orderly market — not in a forced liquidation or distressed sale. If the transaction being used to mark the asset to market is a distressed sale, then the owner is permitted to consider other factors — including management’s internal estimates — when valuing the asset.

In the new guidance, FASB will emphasize that the transaction, not the market, must be distressed to allow companies to consider factors other than price. Indeed, “orderly” transactions can take place in a distressed market, as is the case currently, noted FASB member George Batavick. The guidance must make clear “the difference between distressed transactions and distressed markets,” he asserted.

“This is the most difficult aspect of writing the [guidance] because we are trying to [instruct preparers to] exercise judgment over transactions that are few and far between,” noted Lawrence Smith, a FASB member. However, Smith was adamant, as was the entire five-member board, that the asset owner must stay focused on the transaction when using fair value accounting.

“[Preparers] cannot dismiss market prices just because that market is dislocated,” nor can they “automatically inject any old price into a dislocated market. You will have look at other data,” opined FASB member Leslie Seidman.

While the guidance includes an illustrative example of how to apply the new guidance, Smith offered his own example of how judgment figures into fair value acccounting even when an observable price is available. In Smith’s example, an asset owner wants to value a financial instrument that has dropped in price because the market for it has dried up. The owner looks to three comparable transactions, but notices that the range of prices among them is very wide. Smith contrasts that scenario with one in which the three reference transactions have a very narrow price range.

He explains that while both examples include observable inputs, significant judgment is required on the part of the owners in the first scenario to determine which of the trio of prices reflects the appropriate fair value. How would Smith value an instrument that has only one reference transaction? “I would look at underlying data,” he insists.

For a loan that was secured by mortgages, for example, Smith would want to examine default rates and the population holding the mortgages. “It’s not easy. We are saying that a lot of judgment is required and that people will have to dig further when there are situations in which transaction prices don’t make sense,” he says.

FASB received more than 90 comment letters within a one-week span referencing the new guidance. The letters, from corporations, investors, academics, regulators, accounting firms, and industry trade groups, wanted the board to zero in on the subject of judgment and better explain how, in FASB’s hypothetical example, the company came up with its final estimate after taking all factors into account.

Other commentators have used the proposal as a way to vent their frustration and plead with the board and the Securities and Exchange Commission to revisit the practicality of mark-to-market accounting. Under the $700 billion bailout package signed by President Bush last week, the SEC has the power to suspend mark-to-market accounting.

In addition, some letters asked for more time to implement the new guidance. But at today’s meeting, the board refused to extend the implementation date, noting that the guidance would be effective upon issuance — which could be later today. For calendar-year companies, the guidance would likely affect how financial assets are valued in third-quarter financial statements, if companies have not already issued results for that period.

The guidance will not address how to measure liabilities at fair value, but Herz and others members hope that some “common sense” will prevail with regard to that issue. FASB members reckoned that the fair value of liabilities will be measured in much the same way as assets, but mention of that specific concern will likely be relegated to a different guidance document.

Despite FASB’s efforts to finalize the guidance as soon as possible, the board acknowledged that additional guidance may be needed to respond to the Treasury Department’s program to buy up toxic mortgage assets.

Treasury officials are working to figure out which mortgages will be eligible for the program, and at what price they will be bought. Some officials estimate that the so-called TARP (troubled assets relief plan) will be finalized within two weeks. FASB expects that it will have to address issues of how to measure TARP-related asset price and associated disclosures once the plan’s details are issued.

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