Fair-value Accounting in the Current Economic Environment

Excerpted from the November 2008 Issue of the Audit Committee Brief newsletter

Accounting rules rarely attract much interest outside the accounting world; however, with the current economic crisis, the concept of fair value, or mark-to-market accounting, is now at the center of attention.

The FASB issued Statement No. 157, Fair Value Measurements, in September 2006 to provide more clarity and increase consistency in fair-value measurements. The objective of fair-value measurement is to determine the price that would be received on the sale of an asset or liability in an orderly transaction that is not a forced liquidation or distressed sale between market participants. This statement changed the concept of fair value to an exit price instead of an approximate price to sell. However, the principle of exit price becomes increasingly difficult to apply as markets for an asset move from active to inactive.

For example, in the run-up to the current economic situation, many financial institutions invested heavily in mortgage-backed securities and other structured products linked to real estate. For many years, these securities traded in relatively active markets where it was not difficult to obtain reliable pricing information. As real estate prices began to fall and the number of foreclosures began to rise, demand for these securities and other asset-backed obligations declined to the point where the market nearly froze, resulting in major unrealized losses and associated write-downs to fair value.

The critics of mark-to-market accounting maintain that there is a disconnection between current market prices and the true economic values of certain investments. They assert that fair value, as defined in FAS 157, is not a reliable measure when an active trading market does not exist. They further contend that the write-downs under fair-value accounting have been a key contributor to the current crisis because they have reduced institutions’ regulatory capital and ability to lend, which has restricted liquidity and increased market anxiety and price pressure.

Supporters believe that fair value best reflects economic reality and is the information that investors want on current market values and associated credit and liquidity risks. They believe that changing accounting standards during a crisis would only compound market uncertainty and restrict capital flow, because it would reduce the information available to investors. However, supporters also acknowledge that market volatility and limited liquidity have made the determination of fair value complex, and they recognize the frustration in the case of companies that are characterized by current fair values that may not reflect the ultimate economic value of the assets.

In response to these pressures, the SEC and the FASB issued a joint statement on September 30, 2008, to clarify concepts of fair-value accounting in inactive markets. The FASB issued a Staff Position (FSP) on October 10, 2008, that does not change existing guidance but provides an example to clarify application issues in an inactive market.

The FSP emphasizes that even when there are limited transaction prices to measure fair value, the fair-value measurement objective remains the same, i.e., "the price that would be received by the holder of the financial asset in an orderly transaction (an exit price notion) that is not a forced liquidation or distressed sale at the measurement date." The FSP made several key points, including:

• Use of management judgment is necessary and appropriate in evaluating fair value when limited relevant market data exists.
• Assumptions used by management when relevant market inputs are not available must consider the risk of nonperformance and illiquidity of the market.
• It is not appropriate to conclude that in an illiquid market either (1) all market transactions can be excluded from consideration when determining fair value or (2) every market transaction is indicative of fair value.

The FSP was effective upon issuance and should be applied to prior periods for which financial statements have not been issued. The FSP does not require additional disclosures; however, there are disclosure requirements of Statement 157 regarding significant unobservable inputs.

The Emergency Economic Stabilization Act of 2008 was signed into law on October 3, 2008. This legislation requires the SEC to conduct a study of mark-to-market accounting that must be completed by January 2, 2009. The study will focus on the following six topics:

1. The effects of fair-value accounting rules on financial institutions’ balance sheets
2. Fair-value accounting rules and their impact on bank failures in 2008
3. The quality of financial information available to investors
4. The process used by the FASB to develop standards
5. The advisability and feasibility of modifications to those standards
6. Alternatives to the accounting standards set forth in Statement No. 157.

To help provide input into this study, the SEC hosted the first of two roundtable discussions with representatives of issuers, institutional investors, accountants, analysts, and standard-setters on October 29, 2008. Representatives for and against mark-to-market accounting debated their views, although it is not clear whether the SEC will recommend any revisions to Statement 157. The next roundtable discussion is scheduled for November 21, 2008.

We have assembled below key resources with respect to the potential impact that the credit crisis might have on your financial information.

On December 4, 2008, we will offer a webcast on Fair Value Challenges in Financial Reporting, we invite you to register to attend this very timely session.