"Market, Market, Dare You Stall, What’s the Fairest Fair Value of All?” is one of the hottest issues in accounting today - along with calls for more transparency around off-balance sheet items – among the multitude of issues being discussed surrounding the subprime crisis and current market turmoil.
Q&A With Michael Young, Willkie Farr
If you couldn’t get into the sold out Directors Roundtable program covering this topic today, we have additional insights from one of the speakers, Michael Young of Willkie Farr & Gallagher, here.
Earlier this week, two major organizations issued policy papers calling for, among other things, a look at how fair value accounting as set forth in FASB’s FAS 157 (Fair Value Measurement) and in related IASB standards reflected, or in some minds may have directly or indirectly impacted, the downward spiral in transaction prices and accounting valuations of subprime mortgage-backed securities and related credit instruments, and potentially the related liquidity of entire firms (e.g. Bear Stearns).
International Monetary Fund (IMF) Report
The International Monetary Fund (IMF)’s April 8 report, “Global Financial Stability Report: Containing Systemic Risks and Restoring Financial Soundness,” provides a wide-ranging analysis of the current market turmoil. Key themes noted in the IMF’s Executive Summary include: (1) a collective failure to appreciate the extent of leverage taken on by a wide range of institutions—banks, monoline insurers, government-sponsored entities, hedge funds—and the associated risks of a disorderly unwinding, (2) a lag of private sector risk management, disclosure, financial sector supervision, and regulation vs. the rapid innovation and shifts in business models, leaving scope for excessive risk-taking, weak underwriting, maturity mismatches, and asset price inflation, (3) overestimates in amount of risk transferred off bank balance sheets, and (4) continuing strain in the financial markets - notwithstanding unprecedented intervention by major central banks – compounded by a more worrisome macroeconomic environment, weakly capitalized institutions, and broad-based deleveraging.
Regarding accounting, the IMF observes, “The absence of active markets for complex structured credit products and the observed sales at values below the theoretical value of their underlying cash flows have presented challenges to financial institutions as to the degree to which they could be considered 'orderly sales' and hence depended on as a measure of fair value." IMF continues, "The major audit firms have argued collectively that the presence of a price below theoretical valuation does not necessarily represent a distressed sale. In such cases, the auditors require firms to demonstrate why a sale price is not indicative of fair value before accepting a reclassification of an asset to level three. For example, a sale in a thin market at a heavy discount by a liquidator may qualify as a distressed sale, while a similar sale by a solvent entity may not.” IMF notes this approach is to minimize ‘cherry picking’ values.
The ‘distressed sale’ issue is, to some, the crux of the matter in determine fair value in today’s markets – when is an illiquid market a ‘forced sale,’ ‘distressed sale,’ or other than an ‘orderly market’ sale? As we have noted previously, the Center for Audit Quality (CAQ) issued its own guidance on this point, and the SEC recently issued guidance in the form of a ‘sample letter’ sent to companies on fair value disclosures in MD&A. Some, like Bloomberg’s Jon Weil, in his April 2 article, "SEC Fuels New Mark-To-Market Conspiracy Theories," called upon the SEC to ‘set the record straight’ whether they were creating a ‘loophole’ in FAS 157. Others, like Credit Suisse’s David Zion, as we noted previously, noted that the SEC guidance reflected almost verbatim what was in FAS 157. In fact, Emily Chasan of Reuters reported yesterday, “FASB consulted with US SEC on mark-to-market letter.”
The IMF report continued: “External auditors are likely to adopt a cautious approach to minimize the risks of material post-balance-sheet-date writedowns that would leave the auditor open to charges of negligence,” observes IMF. “Hence, the level of additional writedowns in the audited financial statements will likely reflect the convergence of the entity’s valuation assumptions with those adopted by the auditors.” However, IMF cautions, “The adoption of the auditors’ approach raises the risk of a negative bias in the valuations.”
Further, IMF notes: “The prospects of forced sales triggered by fair value below some threshold will need to be examined thoroughly. Ways of guiding firms to review the elements underlying the valuation without being forced to sell would be helpful. The extent to which such fair value “triggers” are either encouraged or mandated in regulation and supervisory guidance would need to be re-evaluated.”
The IMF also supports further consideration of off-balance sheet accounting and disclosure issues. Under the caption “Incentives to Set Up SIVs [Structured Investment Vehicles] and Conduits,” the IMF states: “In principle, Basel II provides less incentive than Basel I to transfer risks to such entities for the purpose of lowering regulatory capital charges. Nonetheless, a strict implementation of Basel II by national supervisors, possibly armed with stronger guidance regarding conditions for risk transfer and appropriate capital relief, will be needed. Accounting standards setters, in cooperation with supervisors, should revisit consolidation rules to address incentives that may encourage a lack of transparency regarding off-balance-sheet activities and risks.”
Institute of International Finance (IIF) Issues Report
Separately, the Institute of International Finance (IIF), a global association of banks, issued a Policy Letter on April 3 in advance of the release of the Interim Report of IIF’s Committee on Market Best Practices (CMBP) issued on April 9. The IIF’s Policy Letter calls for “multiple and coordinated policy responses” and recommends reforms to various industry practices, including: risk management, credit underwriting, liquidity risk management and conduits, valuation (see below), ratings, incentives and compensation.
Regarding ‘valuation,’ the IIF calls for : “strengthening internal governance and framework around valuation processes, and considering means of enhancing the effectiveness of fair value accounting in circumstances where market liquidity has dried up.”
Additionally, the IIF states: “Over the past decade, fair-value / mark-to-market accounting has proven highly valuable in promoting transparency and market discipline and continues generally to be an effective and reliable accounting method for securities in liquid markets." IIF emphasizes: "However, in circumstances where there is no or severely limited liquidity in secondary markets, current valuation methods for certain structured products have the potential to mislead investors and contribute to unintended procyclical consequences which could prolong credit market problems. To help mitigate such risk, there is an urgent need in the present circumstances for refined methodologies or alternative techniques to be considered, obviously in close consultation with accounting standard setters and other public sector bodies in order to preserve the positive features of fair-value accounting while minimizing its unintended negative effects.”
The IIF adds, “Moreover, the official community, including the IMFC, should lend its support to the establishment of a high-level commission to examine broader issues relating to the implementation of fair value accounting in today’s financial markets––while respecting the independent role of the accounting standard setters.”
Further details from the IMF and IIF reports can be found in this summary.
Long standing debate
Going back to the IMF report, one point I found particularly of interest - the IMF stated: “Accounting standard setters will increasingly need to take into account the financial stability implications in their accounting practices and guidance.”
I noted in a number of recent posts that the debate over whether accounting can or should reflect – or impact – economic activity is an ‘age-old’ debate. It reminds me of some quotes from leaders in the profession which I included in a paper I wrote for my favorite professor, Dr. David Solomons, in 1982.
Dale Gerboth wrote in 1973: “The public accounting profession has acquired a unique quasi-legislative power that, in important respects, is self-conferred. Furthermore, its accounting ‘legislation’ affects the economic well-being of thousands of business enterprises and millions of individuals, few of whom had anything to do with giving the profession its power or have a significant say in its use. By any standard, that is a remarkable accomplishment.” [Gerboth, Dale L., "Research, Intuition, and Politics in Accounting Inquiry" The Accounting Review, Vol. 48, No. 3 (July 1973), pp. 475-482, published by the American Accounting Association (cite is on pg 481).]
And, Stephen Zeff wrote in 1978: “The [FASB] board is thus faced with a dilemma which requires a delicate balancing of accounting and nonaccounting variables. Although its decisions should rest – and be seen to rest – chiefly on accounting considerations, it must also study – and be seen to study – the possible adverse economic and social consequences of its proposed actions.” [Zeff, Stephen A., "The Rise of Economic Consequences," Journal of Accountancy, December 1978, pp. 56-63, published by the American Institute of CPAs (cite is on pg. 63).]
It is positive that healthy debate continues on these matters.
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2 comments:
For example, a sale in a thin market at a heavy discount by a liquidator may qualify as a distressed sale, while a similar sale by a solvent entity may not.
Hi, nice reading your blog
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