SEC staff issues report to Congress on fair value accounting

By Cydney Posner

The Emergency Economic Stabilization Act of 2008 required the SEC to deliver a report to Congress regarding fair value accounting standards as applied to financial institutions. That 211-page report, which was delivered at year-end, recommends against the suspension of fair value accounting standards, recommending instead improvements to existing practice, including reconsidering the accounting for impairments and the development of additional guidance for determining fair value of investments in inactive markets. The report addresses the following six key issues:

• the effects of fair value standards on a financial institution's balance sheet;
• the impact of fair value accounting on bank failures in 2008;
• the impact of the standard on the quality of financial information available to investors;
• the process used by the FASB in developing accounting standards;
• the advisability and feasibility of modifications to the standards; and
• alternative accounting standards to those provided in FAS 157.

While the report expressly focused on financial institutions (as some bankers, politicians and commentators, in an apparent head-fake, attributed the cause of the Wall Street meltdown to use of the accounting standard), the report is likely to have broader ramifications.

Rather than a crisis precipitated by fair value accounting, the report concludes that "the crisis was a 'run on the bank' at certain institutions, manifesting itself in counterparties reducing or eliminating the various credit and other risk exposures they had to each firm. This was, in part, the result of the massive de-leveraging of balance sheets by market participants and reduced appetite for risk as margin calls increased, putting enormous pressure on asset prices and creating a 'self-reinforcing downward spiral of higher haircuts, forced sales, lower prices, higher volatility, and still lower prices.' The trust and confidence that counterparties require in one another in order to lend, trade, or engage in similar risk-based transactions evaporated to varying degrees for each firm very quickly. What would have been more than sufficient in previous stressful periods was insufficient in more extreme times." The report notes that investors generally support measurements at fair value as providing the most transparent financial reporting and facilitating better investment decision-making and more efficient capital allocation. Nevertheless, many also indicated the need for improvements to the application of existing standards..

The report makes a number of recommendations to improve the application of fair value accounting, including:

• SFAS No. 157 should be improved, but not suspended.
• Existing fair value and mark-to-market requirements should not be suspended.
• While the Staff does not recommend a suspension of existing fair value standards, additional measures should be taken to improve the application and practice related to existing fair value requirements (particularly as they relate to both Level 2 and Level 3 estimates).
  • Development of application and best practices guidance for determining fair value in illiquid or inactive markets, including consideration of additional guidance regarding:
    • How to determine when markets become inactive
    • How to determine if a transaction or group of transactions is forced or distressed
    • How and when illiquidity should be considered in the valuation of an asset or liability, including whether additional disclosure is warranted
    • How the impact of a change in credit risk on the value of an asset or liability should be estimated
    • When observable market information should be supplemented with and/or reliance placed on unobservable information in the form of management estimates
    • How to confirm that assumptions utilized are those that would be used by market participants and not just by a specific entity
    • Existing disclosure and presentation requirements related to the effect of fair value in the financial statements should be enhanced.
  • FASB should assess whether the incorporation of changes in credit risk in the measurement of liabilities provides useful information to investors, including whether sufficient transparency is provided.
  • Educational efforts to reinforce the need for management judgment in the determination of fair value estimates are needed.
• The accounting for financial asset impairments should be readdressed.
  • U.S. GAAP does not provide a uniform model for assessing impairments.
  • Current impairment standards generally preclude income recognition when securities prices recover until investments are sold.
• Implement further guidance to foster the use of sound judgment.
• Accounting standards should continue to be established to meet the needs of investors.
  • Beyond meeting the information needs of investors, general-purpose financial reporting has secondary uses that may be of additional utility to others, such as for prudential oversight.
  • General-purpose financial reporting should not be revised to meet the needs of other parties if doing so would compromise the needs of investors.
• Additional formal measures to address the operation of existing accounting standards in practice should be established.
• Address the need to simplify the accounting for investments in financial assets.
  • Many investors feel that clear disclosure of the inputs and judgments made when preparing a fair value measurement is useful.
  • While a move to require fair value measurement for all financial instruments would likely reduce the operational complexity of U.S. GAAP, the use of fair value measurements should not be significantly expanded until obstacles related to such reporting are further addressed.

The report also recommends improvements such as reducing the number of models utilized for determining and reporting impairments, considering whether the utility of information available to investors would be improved by providing additional information about whether current declines in value are consistent with management expectations of the underlying credit quality, and reconsidering current restrictions on the ability to record increases in value (when market prices recover).