Thursday, July 17, 2008

SEC Seeks Comment on Fair Value Accounting By July 23; Additional Highlights From July 9 FV RT

A ‘Request for Comment’ was included in SEC's 'Notice of Roundtable Discussion” posted July 3 (Fed Reg, July 9) in advance of their July 9 Roundtable on Fair Value Accounting. This was briefly referenced by Chief Accountant Conrad Hewitt and Deputy Chief Accountant Jim Kroeker at the roundtable. It is not uncommon for SEC to include a request for comment in conjunction with a roundtable or advisory committee meeting, to solicit wider input. Comments, due July 23, are being posted on SEC’s website.

We previously reported that SEC Chairman Christopher Cox concluded the July 9 roundtable by saying: “We heard from investors today fair value can be extremely useful,” but “some … institutions and some public companies have told us [of] significant challenges… and when fair value is unreliable, it can result in unintended consequences.” He stated, “The Commission and staff will meet with FASB and PCAOB to consider next steps, making certain Fair Value accounting truly serves the interest of investors and all users of financial statements.”

As promised, we have posted additional Highlights from SEC’s Fair Value Roundtable. If you’re an FEI member, you’ll be able to read our 13 page summary; if not, here’s some highlights from our highlights:

Investors want fair value [FV] information
Kurt Schacht, Managing Director of CFA Institute’s Centre for Market Integrity cited results from a survey of its analyst members, noting over three quarters support fair value. [NOTE:

One result not cited, was that 55 percent of their respondents answered “Yes” to the question: “Are fair value requirements aggravating the global credit crisis.] Schacht urged there be no ‘moratorium’ on FV measurement, saying any such moratorium, “particularly in the context of the current credit crisis, would be a disaster in our view.” He rejected arguments of procyclicality, saying, “We have seen FV described as ‘gas on the fire,’ …‘madness’ … that it somehow perpetuates the cycle of breached capital ratios and covenants. To that we say: nonsense, we think there are lots of things that caused the crisis, fraud[ulent] underwriting, credit rating reform issues…. the list of causes goes on, [but] what is not on that list, in our view, is accounting policy.” Schacht said although FV is “not perfect by any stretch, particularly with regard for implementation around illiquid instruments,” more FV information is needed, and disclosures need to be improved.

Jane B. Adams, Managing Director, Maverick Capital (previously a Deputy Chief Accountant at the SEC and project manager at the FASB and AICPA), said “Investors are best served if all financial instruments are marked to fair value each period through profit and loss.” She added, “The present debate in the press is not about fair value, rather it is about suspending accounting for impairment.” Separately, she noted, “We invest at Maverick with imperfect information we have on real tangible book value based on fair value of … positions.”

Russell Mallet, a partner with PwC, said, “The credit crisis has fueled debate on a variety of issues including FV accounting,” but noted, “while others may not agree, we believe for now FV is the best available method to reflect market conditions.”

Wes Williams, Executive-In-Charge of Crowe Chizek and Company’s Assurance Professional Practice group, said, “Financial reporting data must be relevant, and relevance is measured by availability of timely and accurate information to assist users in their decision making.” He added, “FV is most relevant accounting measure for financial instruments, period.”

Hal Schroeder, Director of Relative Value Arbitrage at Carlson Capital and a member of FASB’s Emerging Issues Task Force (EITF), said, “It’s been 15 years since I was a partner at Ernst & Young, so I’m far enough away and removed from accounting to not get too balled up in a lot of the details.” He said, “Hopefully I can give you perspective from an investor, I oversee a team of investors who over a year will trade over $50 billion of stocks, at the heart of what we do is analysis of financial statements, so FV accounting is extremely important to us.”

Matt Schroeder, Managing Director and Global Head of Accounting Policy at Goldman Sachs, said, “For us, FV is the oxygen of the firm, we live by it, it’s part of our fabric, we follow daily discipline of marking to market at our firm.” He added that FV accounting “allows us to make economic decisions whether to buy or sell without regard to triggering a gain or loss, [without having to ask] is it going to taint my portfolio, it allows us to be free from those constraints.”

Difficulty in fair valuing in illiquid markets
Gary Kabureck, chief accounting officer, Xerox Corporation, (and a member of FEI’s Committee on Corporate Reporting (CCR)) said: “I believe FV accounting is more important today than ever and FASB is absolutely correct in their focus. That said, and while FV measures clearly do belong in more places than in the past; I am concerned that perhaps we have gone too far in trying to apply FV in too many places where at least arguably it doesn’t belong or produces an arguably misleading result.”

Joe Price, CFO Bank of America (BofA), said, “At Bank of America, our core business is banking, [and] banks have a clear longer term interest… We also have a securities business, with a capital profile different from the banking business.” He added, “the FV model must be consistent with the business.” Price said, “We believe a mixed attribute model has a place in accounting. Those business models with high velocity, FV is not only appropriate, but an integral part of the control system.” He acknowledged there are “difficulties in application of FV,” and that “additional guidance on measurement in distressed markets would be helpful.”

Charlie Holm, chief accountant, bank supervision, Federal Reserve Board (FRB), said, “As a bank supervisor, we recognize there are both positive and negative aspects related to FV accounting.”

He continued, “For actively traded positions such as bank trading accounts, FV accounting provides the most relevant information and promotes strong risk management for these positions.” And, he noted, “the FRB has long supported footnote disclosures of FV information for all financial assets and liabilities, which can provide useful information …” [Note: so far, this regulator’s comments would seem to substantiate the claim made in ITAC’s May 23 letter to FASB on fair value, which stated: “The ITAC has been gratified that not only financial reporting standard-setters and investors, but regulators of financial institutions across the spectrum have endorsed fair value measurement for financial instruments.” We discussed some of the claims in ITAC’s letter previously here, but didn’t get to address this particular point, although it struck me that ITAC’s claim may not have been consistent with comment letters previously filed by banking regulators with FASB. Read on:] Holm added, “Notwithstanding conceptual benefits, for many years the FRB has raised supervisory concerns about broadening the FV accounting framework. Some of our concerns include the extent to which FV can be reliably measured for illiquid instruments, and we have particular concerns whether smaller institutions are ready for a broad FV framework.” He added, “Before significantly expanding FV, we need to evaluate whether [FV] is the most appropriate presentation for liquid assets and liabilities that will be held for the long term.”

Leonard (“Lee”) Cotton, Vice Chairman, Centerline Capital Group, and a former president of the Commercial Mortgage Securities Association, said, “Fair market value is a good idea with liquid assets, it is not such a good idea with illiquid assets.”

Matt Schroeder of Goldman Sachs said, “Is it harder [to measure FV] in illiquid markets, yes, you’ve got to look for more information, it requires you to be proactive.” He said firms need to seek out and put together a body of evidence to support the value they put on their instruments.

James Tisch, CEO of Loew’s Corporation, said, “We are not dealing with the New York Stock Exchange here, where securities trade every day in voluminous size.” Rather, firms are sometimes faced with valuing “securities where maybe there are three different holders… chances are it doesn’t trade for months or even years at a time.” He described an example in which his company received a very low quote for valuation purposes for something they would have actually been willing to pay much more to buy. “I promise you there were no transactions taking place at that price, the dealer would not have sold at that price.” Tisch emphasized, “What I am trying to express, for a lot of the fixed income market, there is no market,” and he noted the level of precision implied for the financial statements is “totally unrealistic.” “While I am not advocating marking to model,” said Tisch, ”I am also saying using market price for our portfolio is marking to fantasy.”

Joe Price, CFO of BofA added, “there are not only pressures from outside quotes, pricing services, there are pressures around what’s the appropriate price internally too.” He gave as an example, “you reassign a portfolio to a new trader, he wants to mark it down as low as possible [when it is transferred into his portfolio], he gets compensated on that too.” He said there are instances with ‘lowball’ bids, and situations particularly in leveraged lending and complex structured instruments where some deals “aren’t moving… there aren’t good quotes out there.”

He said “there’s no shortage of opinions how to value those types of instruments; your search became what is the most observable component,” and that it was “quite challenging for collateralized debt option securities,” in which searching for price inputs would go down to individual QSIPs” or individual underlying securities.

Not Necessarily Whether To FV, But How to FV, and Whose FV?
SEC Commissioner Paul Atkins said the question for the roundtable was “Not necessarily whether FV accounting is good or bad, we’ve had it for a long time, got to do it for investors sakes,” but “the real question is, what is FV?” He added, “From [my] prior experience at accounting firms and law firms, I would have to question the competence of accountants in the field, or ulterior motives of dealers providing values; [for] many securities there is no market, and you get a value out of the blue from an investment bank which may or may not be [the] correct value, that is the rub of the whole issue here that has to be explored.”

FASB board member Tom Linsmeier, an observer at the meeting, responded, “FAS 157 states you need to use FV that would be an exchange price in an orderly market.” He added, “It is not acceptable under 157, if you read it, to just accept a price you know is not right, for FV… [FAS] 157 suggests, if a price thrown out by a dealer [is] not a representative price, you need to make adjustments or move to a model-based measure using inputs or cash flows, which is more work [for the issuer].”

Atkins noted there is a “reality where issuers are trying to deal with excessive conservatism from the accounting profession.”

Gary Kabureck, chief accounting officer of Xerox noted, “The fact that you have to look at hypothetical transactions that you won’t do is an intellectual challenge for a lot of people.” He added, “The issue is less one of should you have an alternative to FV, as opposed to, whose FV?” He noted the fundamental premise in FAS 157 is the exit price notion, “you’re supposed to look from the eyes of an outsider,” but in certain market conditions, you may need to consider more of an entry price or internal estimates, and less input from outside sources. Referring to FAS 157’s 3 level hierarchy, he noted, “There is a debate out there: is a good level 3 estimate better than a bad level 2,” adding, “the paradigm where 157 works is in an active market, but what happens when market is inactive or dysfunctional?”

Liabilities and fair value
PCAOB Chairman Mark Olson (formerly a member of the Federal Reserve Board of Governors), an observer at the roundtable, asked about fair valuing liabilities, saying, “Not from a PCAOB standpoint, but a broader public policy role, if the fundamental economic purpose of the banking industry is as a financial intermediary, the question in my mind, on the liability side, is if you mark debt to market; core deposits would carry a premium; I’m wondering if there is an extent
to which mark to market in that environment obfuscates the fundamental role of banks as

Academic Kathy Petroni said many find it counterintuitive to mark liabilities to market, although she did not. She said it would be preferable to have symmetry, but some of the assets are not FV’d; if they were, the decline in FV of those assets would offset the rise in FV of liabilities.
Wayne Carnall, chief accountant in the SEC's Divison of Corporation Finance, asked FRB’s Charlie Holm, “Do you think this is confusing to investors?”

FRB’s Holm responded, “I have to explain this to other bank supervisors, I do think it is confusing, it presents issues for bank supervisors, can have effect of increasing reported income and equity at time an institution is [having trouble].” He added, “we instruct regulated banking organizations to back out the effects when determining their regulatory capital.”

Loew’s Tisch said fair valuing liabilities “destroys the nature of the income statement, makes it unusable for investors.” He added, “I don’t understand how a company can monetize a decline in value of [their] debt; no doubt the company would have to pay that debt back upon maturity; in a philosophical sense, [FV’ing liabilities] may make sense, but to me, it undermines income statements and has no practical use.”

BofA CFO Joe Price said, “inability to monetize this ‘gain’ [on FV’ing liabilities] is very troubling, we personally have not availed ourselves of [FV’ing liabilities] for that reason.” He added, We are strongly opposed to FV measurement for noncontractual liabilities, most notably litigation.”

“Other Than Temporary” Impairment Due to Interest Rate Fluctuations
Loew’s CEO James Tisch called for further guidance on impairment under FAS 115, noting issuance of EITF 03-01, The Meaning of Other-Than-Temporary Impairment, and a related EITF pronouncement had created a “de facto standard” in which “securities with any level of interest rate impairment are either impaired with a charge taken through the income statement, or in effect are deemed to be held to maturity.”

Combined with the effects of statutory accounting in the insurance environment, Tisch said, this creates a “hobbesian choice: impair today and reduce statutory capital to retain trading flexibility, or state an intention to hold and be forced to expect to retain the security until maturity.” He added, “neither decision is reasonable, and neither in my opinion is within the original intent of FAS 115.”

Separately, IASB board member Jim Leisenring, an observer at the roundtable, said to Tisch, “some parts of the world do exactly what you say would be disastrous, they do in fact FV insurance liabilities, and many jurisdictions around the world have asked IASB to get on with .. [that] accounting, so the mismatch goes away.” He added, “There is a proposal out for comment at the present time from the IASB that says insurance liabilities should be at FV.”

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