Monday, July 7, 2008

Deconstructing Fair Value

According to the agenda and list of panelists released in advance of SEC’s July 9 Fair Value Roundtable, the panels will address “the benefits and potential challenges associated with existing fair value accounting and auditing standards.”

The SEC’s roundtable and other forums such as the IASB’s Expert Advisory Panel on Valuation in Inactive Markets are responding to requests by the G-7, the Financial Stability Forum, and Presidents Working Group (PWG) to address concerns about application of fair value accounting in illiquid markets.

To illustrate these concerns, some observers (e.g. Blackstone CEO Steven Schwarzman in Andrew Ross Sorkin’s NYT Dealbook July 1, “Are Bean Counters to Blame,” and Prof. Tom Selling in his blog, The Accounting Onion) have questioned the accounting standards - primarily FAS 157, Fair Value Measurement - for requiring portfolios to be written down to an observed or hypothetical market value when applied in illiquid or inactive markets. Some observers would challenge those who would accuse them of simply not wanting to face reality, by noting that in illiquid markets, ‘reality’ is difficult to pin down (ask anyone trying to sell a house these days). They believe that when actual transaction prices (or hypothetical versions thereof) are few and far between, the resulting liquidity discount overstates risk and understates the underlying value of the security if it were held to maturity (or even for the intermediate if not long term). More ominously, some have further claimed that accounting standards may have contributed to a downward spiral in the subprime market and credit markets generally, allegedly causing procyclical effects due to credit or investment standards requiring portfolio liquidations in response to steep drops in valuation of certain securities, leading in turn to pressure to sell those securities at even more deeply discounted prices, with the remaining portfolio then marked to the now-lower market value, thereby repeating the cycle.

For further background see our June 2 “Detailed Summary of FASB Webcast on Credit Markets” [this summary can downloaded by FEI members only, see info on FEI membership], and “Subprime: Not Ready for Prime Time,” in the July-August issue of Financial Executive Magazine [nonmembers will be prompted to create free online login account to read magazine article]

Holistic Approach Needed
Note the important inclusion of “and auditing standards” in the agenda for SEC’s upcoming “Roundtable on Fair Vale Accounting.” As noted previously in this blog (see last two bullets of our March 24 post), many observers on the fair value scene talk almost exclusively about the accounting standard, FAS 157 and its fairness (or alleged lack thereof) - when applied in the kind of illiquid markets (subprime and credit markets generally) that coincidentally arose when FAS 157 became effective in 2007 - without connecting the dots to the role auditing standards and ‘nonauthoritative guidance’ can play in implementing a FASB standard.

It seems to me there are five sets of issues that perhaps could be considered holistically with respect to fair value, at least in the U.S. market, taking into account authoritative and nonauthoritative guidance in the realm of accounting and auditing standards. Such guidance includes, besides FAS 157, the white papers issued by the Center for Audit Quality (CAQ - affiliated with the AICPA) in Oct. 2007 (including CAQ’s White Paper on Measurements of Fair Value in Illiquid (or Less Liquid) Markets), and the PCAOB’s Staff Audit Practice Alert No. 2 issued in Dec., 2007 on “Matters Related to Auditing Fair Value Measurements of Financial Instruments and the Use of Specialists.” The five issues are:

  1. Does FAS 157 permit flexibility in adjusting ‘market prices’ (observable or unobservable ‘hypothetical’ market prices) in arriving at ‘fair value’ for securities? [Note: Hypothetical values are based on a transaction that ‘would have’ occurred, a required construct companies must consider under FAS 157 when there are no observable market values for an instrument or a similar instrument. (The answer according to FAS 157 para. 7, 29 and 30 appears to be ‘sometimes,’ with particular criteria listed.)
  2. Is flexibility for adjusting actual market prices (or ‘hypothetical’ market prices) for identical or similar instruments only available when sales are ‘forced’ or ‘distressed’? And, are illiquid conditions (inactive markets) considered ‘forced’ or ‘distressed’? If not, does FAS 157 otherwise offer flexibility in adjusting market prices in illiquid markets other than when ‘forced’ or ‘distressed’? (This is a key question which CAQ’s and PCAOB’s guidance tries to address in attempting to distinguish between ‘forced’ sales and ‘illiquid’ or ‘inactive’ markets. It would be instructive to see if there are still divergent views on what FAS 157, para. 7 permits in this regard, particularly since the CAQ guidance appears to be ‘nonauthoritiative’ and even PCAOB staff guidance appears to be ‘nonauthoritative’ in the same sense that SEC staff speeches are deemed ‘nonauthoritative.’ See, e.g. the disclaimer at the top of the PCAOB’s Staff Audit Practice Alert: “The statements contained in Audit Practice Alerts are not rules of the Board and do not reflect any Board determination or judgment about the conduct of any particular firm, auditor, or any other person.”)
  3. If it is determined that, as currently written, FAS 157 (or related guidance) does not provide sufficient flexibility for adjusting market prices to arrive at ‘fair value’ in illiquid markets, what should be done (e.g. amendments? further guidance?)
  4. In light of efforts like those of the SEC Advisory Committee to Improve Financial Reporting (CIFiR or Pozen Committee for chair Robert Pozen) are any of the current requirements in FAS 157 and related guidance unnecessarily complex to achieve useful, understandable financial reporting?
  5. Is disclosure under FAS 157 appropriate to inform investors and other users of financial statements that a range of values may be obtainable for certain securities (financial instruments), and regarding factors that could cause underlying values to change? If not, and in light of the responses to #3 and #4 above, could disclosures be improved?
Observations on Nonauthoritative Guidance Pertaining to FAS 157
CAQ’s white paper on measuring fair value in illiquid markets states, “The purpose of this paper is to discuss existing guidance on measurement of fair value, most of which is contained in Statement of Financial Accounting Standards No. 157, Fair Value Measurements (FAS 157).”
Before we deconstruct CAQ’s guidance, let’s focus on scope for a moment. In general, when Party A ‘discuss[es] existing guidance’ of Party B, (unless Party A is the SEC, FASB or PCAOB, and particularly the commission or boards thereof, vs. their respective staff), Party A’s guidance is generally called ‘interpretive’ or ‘implementation’ guidance. Moreover, CAQ’s guidance falls into the ‘nonauthoritative’ camp, which the SEC’s ‘complexity’ committee (CIFiR) focused on in ‘developed proposal 2.4’ (pdf pg 53) in their Feb 14 Progress Report. As noted in FEI’s summary of CIFiR’s May 2 meeting, a panel testifying to CIFiR provided diverse views on the extent to which they believe nonauthoritative guidance increases rather than decreases complexity, with auditors on the panel generally looking at nonauthoritative guidance more favorably. CAQ guidance was among the sources of nonauthoritative guidance mentioned by panelists and CIFiR members.

On this topic, it is also interesting to note that when the SEC released guidance in March in the form of a sample letter sent to public companies on MD&A disclosure re: FAS 157, some members of the press initially alleged SEC was creating a new ‘loophole’ for FAS 157 – see e.g. NYT’s Floyd Norris’ blog post, “If Market Prices Are Two Low, Ignore Them, which Norris later updated to say: “the posting should have noted that the phrases the S.E.C. used [in its disclosure guidance] are taken from the original rule [FAS 157].” See also “SEC Spurs New Mark to Market Conspiracy Theories” by Jon Weil in Bloomberg, April 2. In reality, if the SEC did not stray from FAS 157– then why did it appear to have done so to established commentators like Norris and Weil? Here is where the role of nonauthoritative guidance may be at play, albeit below the surface, in that SEC’s guidance may have been perceived as different from FAS 157 in light of the playbook released by CAQ.

CAQ, an affiliate of the AICPA, seeks input from investors and others at ‘town hall’ gatherings, conducts research, makes recommendations (e.g. in comment letters filed), and “issue[s] technical support for public company auditing professionals.” Does CAQ’s issuance of ‘technical support’ equate to ‘auditing standards’? Technically, in the post-Sarbanes-Oxley era, only the PCAOB issues auditing standards for public company audits, although to some it appears murky as to the role of CAQ vis-à-vis the PCAOB.

As noted above, PCAOB issued a Staff Audit Practice Alert on fair value a couple of months after CAQ issued their white papers in 2007. The PCAOB staff alert addressed the central question, as did the CAQ white paper, on differentiating between ‘forced’ sales and illiquid markets, by stating:” the fact that transaction volume in a particular market is lower than in previous periods may not necessarily support an assumption that transactions in that market constituted forced or distressed sales.”

The CAQ white paper, as noted above, said the existing guidance on fair value measurement was ‘most[ly]’ in FAS 157. There are three areas in which CAQ’s white paper goes beyond FAS 157.

  • CAQ cites a key paragraph from FAS 157, para. 7, [which begins: “A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date”] but CAQ adds a twist by saying: “As discussed in FAS 157, paragraph 7, if orderly transactions are occurring between market participants in a manner that are usual and customary for transactions involving such assets, then those transactions are not “forced” sales.” Note that the precise wording of FAS 157, para 7 does not contain an ‘if…then’ clause when it references forced or distressed sales. Rather, one could potentially interpret FAS 157 para. 7 that if you don’t reject the “usual and customary’ or ‘orderly transaction’ hurdle on its own in light of current market illiquidity, the ‘forced or distressed’ sale hurdle would stand on its own as an indicator that current transaction prices in the market may require significant adjustment before they can be taken as an indicator of, or as FAS 157 likes to say, an ‘input’ in determining fair value.
  • CAQ generically references an SEC enforcement release, implying precedent for issues of fair valuation in illiquid markets. Although not identified by name/number in the white paper, based on the description of the AAER and the date CAQ says it was issued (2004) it appears to be AAER 2132, in which the SEC states, in part, “Morgan Stanley overvalued certain bonds in the portfolio in 2000 by taking a ‘longer view’ as to their value, which entailed discounting current market conditions such as imbalances in supply and demand. Morgan Stanley's taking a ‘longer view of the market’ was not in conformity with GAAP.” Some may argue market conditions in 2007 arising from the crash of the subprime market and related credit market turmoil pose a uniquely different precedent-setting situation then that contemplated by AAER 2132 in 2004.
  • CAQ provides its own definition of ‘longer view’ (which is not defined as such in the AAER it cites) as ‘a view that assumes equilibrium will occur and facilitate transacting at more ‘rational’ prices.’
If Markets Are Not ‘Rational’ – Can Market Prices Be ‘Fair’?
But, if markets aren’t ‘rational’ – can market prices be ‘fair’? Analysts like Vinny Catalano, CFA, author of the Musing on the Markets blog, President and Global Investment Strategist with Blue Marble Research and a past President of the New York State Society of Security Analysts, would probably think not, as noted in our coverage of Catalano’s comments in our March 21 summary, “Articles On Subprime Crisis, Market Turmoil That Mention Accounting.

CAQ does acknowledge, “Some observers of current market conditions have asserted that market pricing is irrational, and they have suggested that entities should instead default to a model-based measurement that is based on the economic ‘fundamentals’ of the asset.” CAQ then notes that, “FAS 157 states that the use of an entity’s own assumptions about future cash flows is compatible with an estimate of fair value, as long as there are no contrary data indicating the marketplace participants would use different assumptions. If such data exist, the entity must adjust its assumptions to incorporate that market information.” How companies and their auditors interpret how to ‘incorporate that market information,’ even when based on ‘irrational’ markets, is where the rubber meets the road.

What Did The CFA Institute Survey Show?
As an analyst or CFA, Catalano’s views sometimes differ from those of the CFA Institute, which released survey results in April on analysts’ views of the usefulness of FAS 157.
One thing of note is the CFA Institute’s survey results are sometimes portrayed homogenously - including as portrayed in an ITAC comment letter filed on May 23 with FASB and the IASB by FASB’s Investors Technical Advisory Committee (ITAC), signed by ITAC member Rebecca McEnally, Senior Policy Analyst at the CFA Institute - in support of fair value measurement.

However, a closer analysis of the CFA’s survey results depicts some diversity of opinion even among its analyst members. For example, 55 percent of CFA’s survey respondents answered “Yes” to the question: “Are fair value requirements aggravating the global credit crisis” - a statistic not cited on the face of CFA Institute’s press release, but available if you drill down by clicking on the link to the underlying survey results, and not cited in ITAC’s comment letter to FASB/IASB. The results on the other 2 survey questions shown on the face of CFA’s press release and in ITAC’s letter note that 79 percent of CFA’s analyst member respondents believe that fair value requirements improve transparency and contribute to investor understanding of financial institutions’ risk, and 74 percent think fair value requirements will improve market integrity. Perhaps ITAC left out the first statistic cited above if they considered the 55/45 split to be statistically insignificant, but it is significant to note the cc’s on the ITAC letter included Sen. Chris Dodd, Chair of the Senate Banking Committee, Congressman Barney Frank, Chair of the House Financial Services Committee, other members of key congressional committees, the SEC commissioners, and CIFiR chair Robert Pozen.

Narrative comments shown on CFA Institute’s 32 page detailed survey results shed further light on some of the nuanced views of the analyst respondents. Many of the comments not surprisingly are fully consistent with the ¾ favorable response rate supporting fair value, as shown in these responses:

  • “Reporting at fair value simply reveals the volatility that already does not introduce volatility as some would argue,” and
  • “while this hurts the current situation as 'fair market value' is hard to find, this does encourage management not to 'hide' l[o]sing positions.”
Other comments disclose some concern among some of the analyst respondents, even among those who voted ‘yes’ to the ‘improve transparency/ contribute to investor understanding’ question regarding fair value, and ‘yes’ to the ‘improve market integrity’ question. Such comments included:

  • “While fair value produced improved results (and bonuses) when economy and overall scen[a]rio was good, the reverse is true with a greater degree and killing effect. Afterall the trust in each other is eroded a great deal mainly due to complexity in measurement of fair value of diverse products in the ab[s]ense of liq[u]idity. If there are no customers to bid for a product, how do you value them? Does it mean that it is worthless, [e]specially a home or an a[p]artment? It is high time we learn from this crisis and put in place a system that will help to avoid similar pro[bl]ems.”
  • “We have been debating this internally at my organization for a while now. Since all of us are first CPAs, we are very familiar with the increasing use of fair value as an accounting measurement and because we work in the financial services industry (both traditional and investment banking) we have always supported the use of fair value as the most relevant measurement for financial instruments. However, recent market events have caused us to question whether the use of fair value is appropriate when market participants become irrational as a result of rumors and fear. For example, the ABX indices, which are being used by many as a basis for FV measurements are being driven down each time another financial institution reports a loss, which puts more pressure on the indices and leads to more writedowns. It has been argued that the fundamentals of the underlying securities do not warrant such writedowns and we tend to agree. In this case the use of fair value seems to have created a self fulfilling prophecy of writedowns. However, we do believe that this is an a[b]er[ra]tion and do not believe that the use of fair value (for financial instruments) should be abandoned …”
  • “These questions are tough because there is a lot of gray area. Fair value requirements do help investors, but only compared to not having them. There does seem to be room for guidelines that better define these requirements by, for example, asking for ranges of fair value. What is the value of a fully performing residential mortgage? I would say that on the books, it is par, but if you tried to sell it, you would likely not find a willing buyer at that price.” Here is one more:
  • “In the absence of trading fair value is rather difficult to establish. The traders and hedge funds are currently 'being killed' by the momentum fad they themselves made so big. The real money is just waiting for the last of the leveraged players to 'leave the field'.”
Let the Roundtable Begin!
In a speech at USC on May 29, SEC Chief Accountant Conrad Hewitt referenced the ITAC letter, and said, “While I must admit that I believe the use of fair value has its limitations for certain transactions, I believe that, as it relates to the type of financial instruments that we are dealing with in the context of the current credit turmoil, fair value has better informed investors than historical cost or a smoothing method would have.”

Hewitt added, “We have heard from investors and many preparers that the use of fair value has provided a level of transparency that is needed particularly in the current market place. While fair value also introduces volatility, I believe that when this volatility reflects the underlying change in the economics of a transaction, investors are better informed. Now, in order to make sure the issue gets discussed in a more public setting rather than on the internet blogs, the SEC will be holding a roundtable on fair value on July 9th to discuss the issue. “

As a blogger, I hope you’ve found some of the information we provide useful, on this topic and others, but personally, I am glad to see the SEC bring the conversation about fair value out into the open; as they say, ‘sunshine is the best disinfectant’. In spite of emotions running high on this topic, as was the case when SEC convened two roundtables on another topic a couple of years ago - implementation of Sarbanes-Oxley Section 404, those roundtables led to important improvements in SEC and PCAOB standards, following the input on the implementation experience. The challenge in some ways may be greater now in trying to tame financial market turmoil, but getting views of a wide range of parties at a public roundtable is a great start, in addition to other efforts underway at the IASB, FASB and elsewhere.

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1 comment:

About Medicine Blog said...

More ominously, some have further claimed that accounting standards may have contributed to a downward spiral in the subprime market and credit markets generally