Article re coping with FAS 157

By Cydney Posner

There is an interesting Compliance Week article by former SEC Chair, Harvey Pitt, today addressing approaches, from disclosure and governance perspectives, to coping with FAS 157, Fair Value Measurement, in light of the continuing financial crisis. FAS 157 requires companies to adjust on their balance sheets the value of their financial assets (and, in some cases, other assets) to market value, rather than reflecting the historical cost of those assets. However, Pitt contends, "relative" pricing models were ineffective in valuing structured instruments because the values of those instruments were really more a function of "the structure of, and anticipated payments on, the underlying collateral." Moreover, in many cases, the absence of active markets meant that companies were unable to determine a market price and ultimately were required to mark these assets to unrealistically low values.

However, as Pitt notes, FAS 157 did not cause the problem: "It didn’t create the adverse market conditions that brought down the market; it merely reflected that after the fact. To some degree, fair-value accounting did what it was supposed to do; by requiring holders to mark their securities to falling market prices, it focused attention on the weaknesses in structured debt instruments, and identified the extremely high degree of risk associated with them. But, FASB’s fair market value accounting rule does raise problems. It focuses on the 'here and now' of asset values, without regard to whether 'here and now' is the appropriate perspective from which to measure particular assets, and without regard to temporary anomalies—including illiquid markets—when and where the asset values are being determined. Because fair-value accounting hadn’t been fine-tuned to deal with anomalies like the market turbulence of the past few months, it certainly exacerbated recent market events." As discussed in my email of 9/30, copied below, the SEC and FASB have provided interpretive guidance on FAS 157 intended to address the problem of measurements in the midst of illiquid markets.

As discussed in more detail in the article below, Pitt argues that managements and boards need to become more familiar with valuation models and techniques, and companies need to use a bottom-up analysis to inventory their difficult-to-value assets, plan for the possibility of future problems with appropriate policies and procedures, confirm their plans with their accountants, seek two independent sources to price difficult-to-value assets by hiring an independent expert in addition to the financial institutions that hold their securities (which may very well have conflicts of interest in pricing), engage in reality checks against generic credit indices (documenting the reasons for any differences and periodically reexamining all assumptions), identify and explain underlying assumptions and sensitivities (including the impact of volatility and changes in fair value on results) and keep detailed records to identify companies' thought processes.