Investors: Stem the Anti-Fair Value Tide

Investors, perhaps futilely, call on FASB to rethink proposals issued under high political pressure.
Sarah JohnsonApril 1, 2009

Investor advocates are hoping the Financial Accounting Standards Board has been playing some cruel April Fool’s Day joke that will unravel on Thursday morning.

Chances are, though, that FASB will move ahead with two speedily crafted proposals that would change some of the ways companies apply fair-value accounting to their financial assets. After all, it’s highly unlikely that the board’s chairman, Robert Herz, wants to once again be hauled before Congress and badgered into turning around new guidance expeditiously or risk legislative intervention. “We can have the guidance in three weeks, but whether that will fix everything is another [issue],” he told lawmakers last month during a heated discussion.

If at least three of the five FASB members vote in favor the proposals at their meeting on Thursday morning, Herz will have met his promised deadline, just as the G20 leaders wrap up their latest meeting on the financial crisis in London. But the quick turnaround isn’t impressing investor advocates, who are hoping — possibly against hope — that FASB won’t give in to the political pressure and instead slow down the consideration of their two fair-value proposals. The comment period ends today, giving the board only hours to go over more than 400 letters.

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The feedback has ranged from generally favorable (mainly from financial institutions) to harshly critical. Jack Ciesielski, president of RG Associates, an investment research firm, and publisher of the Analyst’s Accounting Observer newsletter, said the new “flawed” and “hastily developed” guidelines “will create difficulties for the FASB’s long-term credibility as a standard-setter.”

The CFA Institute Centre for Financial Market Integrity, a research and policy organization representing investment professionals, gave FASB a similar warning. In the organization’s letter, managing director Kurt Schacht and chairman Gerald White expressed their “objections to the FASB flouting its own due process rules and requiring hasty and significant amendments” and “concerns about the politicization of accounting standard-setting and erosion of the credibility of the FASB.”

Without investors’ support of the new changes, any assumption that a perceived rollback of the fair-value rules will improve the financial downturn could be moot. “It will be counter-productive,” says Robert Willens, a frequent contributor who runs a tax and accounting consultancy, “because investors will know that the numbers don’t mean anything, and the level of cynicism about FASB will rise.”

The critics view the proposed FASB staff positions as crippling the concept of fair-value accounting and believe they will result in untimely data for investors, lack of transparency, reduced comparability, inconsistency, and possible manipulation as more judgment would be allowed by management.

Banks have fired back that the current fair-value measurement standards don’t allow them to reflect the true economic reality of their financial instruments. Instead, they say, the strictures have unduly led to large writedowns, exacerbating the widespread financial crisis by spawning a so-called procyclical effect in the credit markets.

Investors, however, are saying that the proposed changes will allow firms to make their financial condition appear rosier than reality.

First Up: FAS 157

At the meeting tomorrow, FASB will first consider issuing new guidance to its fair-value measurement standard, FAS 157. If it’s approved as written in the proposal, companies would follow a two-step process to figure out when a price a company references to gauge the current worth of a financial asset was made in an inactive market and whether it was derived from a distressed transaction.

Under FAS 157, companies aren’t supposed to base financial instruments’ fair values on distressed sales. So if the only observable prices a company can find are based on an illiquid market, then the valuators can move to using computer modeling to, presumably, come up with the most accurate fair values.

The American Bankers Association, which is largely in favor of the proposed changes to FAS 157, said the current guidance has been ineffective because firms subject to second-guessing by auditors, have feared moving beyond the “lowest tangible quotes.” Under FAS 157, holders of financial assets recorded in fair value must report on how they came up with their values by using a three-level hierarchy when estimating the current worth of their financial assets and liabilities. In Level 1, the value of an asset or liability stems from a quoted price in an active market, and in Level 2, it’s based on “observable market data” other than a quoted market price.

More subjectivity arises from Level 3. That level is designated for thinly traded or untraded assets that have a value derived from “unobservable inputs.” Observers believe the new guidance would likely mean Level 3 measurements would increase, clouding up investors’ understanding of how companies come up with their evaluations. It would raise the possibility that companies would liberally pick and choose values between Level 2 and Level 3 (even though Level 2-type data should always be used before Level 3 if it’s available).

“This guidance has ventured well past accounting standards and become more of a handbook for settling preparer-auditor squabbles by defining market conditions,” wrote Ciesielski. He further believes the new guidelines makes FAS 157 stray from its principles-based nature and would require even more FASB guidance in the future to “create a comfort zone for preparers and auditors.”

That’s not to say that auditors are in favor of the new guidance.  The Center for Audit Quality, a trade group representing hundreds of accounting firms, including the Big Four, believes the staff position would give credibility to companies wanting to ignore relevant market transactions. Jeffrey Ellis, a managing director at Huron Consulting, shares a similar concern, noting in his letter that some classes of financial assets do not trade in active markets even during an economic upswing.

The Disappearing Writedowns?

Ciesielski further criticized second FASB proposal up for a vote on Thursday, saying it would result in “less investor-useful information than is currently provided.” The proposal would amend how companies record other-than-temporary impairments (OTTI) for debt and equity securities they have no current plans to sell.Those charges reflect the difference between the fair value and carrying value of the impaired assets.

The amended rule could cut the OTTI charges firms have been taking in their income statements, since it allows them to split credit losses from non-credit losses such as declines in value because of changing interest rates or a lack of liquidity. The non-credit charges would be recorded in other comprehensive income (OCI) and no longer be a part of a company’s total earnings calculation. The result: possibly higher profits and fewer writedowns than we’ve seen in recent months.

At the same time, many observers say that bank income statements won’t be affected significantly by a change in the fair-value rules because most of the banks’ financial assets and liabilities are in the form of loans. Loans are carried at historical cost and tied to bad debt reserves.

However, that may not be the case. “It’s my assumption that many banks decided to use FAS 159 to bring loans into the mark-to-market category, and now they are stuck there,” says Willens.

Issued in February 2007, FAS 159 gave companies the option to irrevocably account for some financial assets and liabilities — including stock, bonds, loans, and interest hedges — using the fair-value method of accounting, rather than the more traditional historical-cost method. If the asset or liability is re-measured under fair value, the change — either a gain or loss — is entered into the equity section of the financial statements as retained earnings, bypassing the income statement and therefore not affecting earnings.

Additional reporting by Marie Leone.