Fair Value Tweaking on a Global Scale

The IASB releases a draft proposal that aims to deliver more fair value disclosures to investors — it's third fair value notice this week.
Marie LeoneOctober 15, 2008

In response to the global credit crisis, the International Accounting Standards Board has made its third announcement in as many days about slight changes to fair value accounting rules. The proposal issued today is a tweak to IASB’s financial instrument disclosure rule, which is out for public comment until December 15.

The proposal streamlines disclosure requirements related to changes in valuation techniques for financial instruments. Rather than specifying what circumstances trigger new disclosures, the proposal simply requires that any change in valuation techniques be disclosed, — plus the disclosure must include the reason for making the switch. The draft rule, which is a proposed amendment to IAS 39, applies to each class of financial instruments a company holds.

The draft also requires companies to provide more details about liquidity risk, and calls for a “maturity analysis” for derivative and non-derivative financial liabilities based on how the company manages the risk associated with the instruments. The existing rule demands less detail about the required maturity analysis.

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This most recent announcement has been in the works since April, when the Financial Stability Forum issued a report on the global markets that included recommendations on how to improve financial reporting. The forum is a group charged with providing recommendations to the finance ministers and central bank governors of G7 countries. More recently, IASB responded to the credit crisis by announcing it would review asset and liability valuation rules — more specifically, fair value accounting rules — in light of America’s new law that provides $700 billion worth of assistance to failing banks and financial institutions.

“The credit crisis has heightened concerns about liquidity risk and pointed to the need for entities to explain more clearly to the outside world how they determine the fair value of financial instruments,” noted IASB chairman David Tweedie in a statement released today. To be sure, the draft proposal on disclosures gets to the heart of the fair value controversy: how best to value troubled assets in an illiquid market. This particular amendment, however, focuses solely on disclosure requirements, rather than valuation methodology.

Earlier in the day, accounting regulators from the European Union voted in favor of an IASB fair value rule revision issued on Monday. The revision allows companies to reclassify financial assets to avoid marking the assets to market in some limited cases. The proposal must still be approved by the EU Parliament before taking effect.

The reclassification rule, which is part of a revised IAS 39, was finalized on October 13, and mirrors an existing U.S. standard — FAS 115. As a result, companies can, “in rare circumstances,” reclassify financial assets that are currently held in trading accounts as “held for maturity.” Rare circumstances, according to IASB, may include the deterioration of the world’s financial markets that has occurred during the third quarter of this year.

Financial assets that are held for trading are subject to fair value accounting, while financial instruments that are recorded as being “held for maturity” are not. There is no immediate benefit for companies that make the switch to hold for maturity, points out accounting expert and blogger Jack Ciesielski, editor and publisher of the Analyst’s Accounting Observer. Indeed, on the day the assets are reclassified, any gains or loss associated with the switch must be recorded in the company’s financial statements. If the original value of the instrument has dropped, then a reclassification will show the loss. But it does help companies avoid fair value accounting in the future.

Ciesielski doesn’t like the rule change. In a recent blog he writes: “The ‘held for trading’ transfer exception sought by the [IASB] only adds to the complexity and inanity of attempts to mollify critics of fair value accounting for financial instruments.” IASB says it issued the exception as a way to “level the playing field” with companies that use U.S. generally accepted accounting principles — which already allow companies to reclassify instruments held for maturity in limited circumstances.

The call to suspend fair value accounting continues to be a hot button around the world. In the United States, bank lobbyists, industry trade groups, lawmakers, and even the Bush Administration are calling for a return to the historical cost methodology for financial instruments in inactive markets. Meanwhile, the Emergency Economic Stabilization Act, the law that authorizes the Wall Street bailout package, also requires the Securities and Exchange Commission to conduct a 90-day study on the effects of fair-value accounting, and gives the regulator the power to suspend fair value “for any issuer.” That study is due out in January.

The third IASB announcement released this week was issued yesterday, and was a clarification of existing fair value rules. The standard-setter’s Expert Advisory Panel issued guidance emphasizing that the objective of a fair value measurement is the price at which an orderly transaction would take place between market participants on the measurement date, and not the price set during a forced liquidation or distressed sale.

The panel confirmed that distressed transactions should not be considered in fair value measurement, while noting that even in times of “market dislocation” not all activity “arises from forced liquidations or distressed sales.” The U.S. Financial Accounting Standards Board reached a similar conclusion last week — and issued similar guidance for companies that use U.S. GAAP.

Further, earlier this month, FASB clarified existing guidance saying that companies were allowed to use their own assumptions about future cash flows and appropriate risk-adjusted discount rates when observable inputs into fair value formulas were not available. IASB issued a similar clarification on October 14.