Thursday, September 25, 2008

We Didn't Start The Fire (Sale)

With the WSJ reporting Thursday afternoon “Agreement Reached on Bailout Ahead of High-Level Meeting,” [UPDATE: Friday morning: "Bailout Negotiations in Disarray"] what about related accounting issues - specifically, application of fair value or mark-to-market accounting in illiquid markets? Presumably, accounting matters won’t be part of the legislation, but some are wondering if relief from fair value accounting will be addressed through separate action by the SEC.

Earlier today, SEC staff reportedly met with representatives of the American Bankers Association (ABA), the Center for Audit Quality (CAQ - affiliated with the AICPA), and senior FASB and PCAOB staff, as reported in today's BNA Daily Report for Executives (“Bankers Seek Immediate SEC Guidance On Proxies for Fair Value in Illiquid Markets,” by Steve Burkholder and Susan Webster.)

What could the outcome of such talks be? Is it realistic to think some action may be taken to modify current accounting rules in light of the credit crisis? After listening to Fed Chairman Ben Bernanke’s testimony at the Senate Banking hearing earlier this week, the President’s remarks last night, the SEC’s Fair Value Roundtable in July (see our related post on Deconstructing Fair Value) … and looking at the American Banker’s Association (ABA) Sept. 23 letter to the SEC, the CFA Institute’s Sept. 23 letter to the SEC, the Financial Services Roundtable (FSR) Sept. 24 letter to the SEC, materials published by FASB’s Valuation Resource Group (July 2 Summary of Decisions to Date), the IASB’s Expert Advisory Panel (Sept. 16 draft guidance on Measuring and Disclosing the Fair Value of Financial Instruments in Markets That Are No Longer Active), and other articles on Fair Value, here’s what I think. (NOTE: I remind you of the Disclaimer posted on this blog that these views are my own and not necessarily those of my employer, its members, officers, directors or other staff.)

It boils down to this:

  • Some, like the ABA, have argued, “The fair value accounting rules are problematic in the current market… and are having a strong pro-cyclical impact in the marketplace.” Therefore, ABA states, “We recommend that, given current market turmoil, the SEC provide immediate guidance that intrinsic value or economic value are appropriate proxies for fair value.” Similarly, the FSR states: “Companies should not be required to rely on an illiquid market to price long term, non-trading assets or to create an educated guess of such an asset’s value. As such, the Roundtable urges that in illiquid market conditions, rather than a blanket application of fair value exit pricing, investors should be able to use alternative definitions of fair value that focus on the value to the investor if the security does not require immediate liquidation. In our previous letters to the Commission, the Roundtable has provided details on this proposal.”
  • Others, like the CFA Institute, argue, “Investors are interested in the value that a company could sell the asset for today. In this context, management has flexibility to not be bound solely by some distressed, fire-sale price. If management believes that an alternative measure is also relevant to investors, we agree that the information described by the SEC in its March 2008 letter as to why a range is appropriate, its key drivers, and how assumptions were developed, is an appropriate and acceptable practice to investors. However, the fact that there are few, if any, transactions or prices to benchmark a specific financial instrument is a reality that must not be ignored. “ Further, CFA cites from the IASB EAP Sept. 16 draft guidance, which states: “Entities sometimes place undue emphasis on the distinction between active and inactive markets …Even when markets are inactive, a current transaction price for the same or a similar instrument normally provides the best evidence of fair value … distress sales are rare and evidence is needed before it is determined that a transaction has not taken place at fair value.”
As we noted earlier this week, Fed Chairman Bernanke explained in his Senate testimony earlier this week how ‘fire sale’ pricing in today’s illiquid markets is driving down capital levels and in turn constricting credit. For all intents and purposes, he made a plain English plea for some sane reference point to be established by Treasury’s proposed auction process, to move the ‘fair value’ (fire sale) reference point closer to as an estimated ‘hold to maturity’ (HTM) amount. The theory behind the HTM amount is broadly akin to the intrinsic value, economic value, or fundamental value approach which the ABA letter supports, and the CFA Institute and IASB EAP dispute, in terms of complying with the current fair value accounting requirements. (Under current accounting rules, lest HTM be the actual transacted price, it would not receive the same consideration as an actual transacted price, even in illiquid markets.)

Complicating this further, as noted in recent press reports, (“
Economists Look at Ways to Structure Auctions” in the WSJ, “Plan’s Mystery: What’s All This Stuff Worth?” in the NYT) is the fact that some parties are concerned about the federal government potentially paying something in excess of the ‘fire sale’ price that private participants are willing to pay (if willing to transact at all) in today’s illiquid market.

This leads to the question - unless there is some relief in the application of the fair value accounting standards as currently constructed (which were written with the express assumption of relying on market prices in active markets, with willing buyers and willing sellers, and not distressed sales) – is there a risk of the tail (accounting) wagging the dog (the auction process, and more broadly, the economy)? Your view of which is the tail and which is the dog is probably based on whether you believe fair value accounting contributes to procyclicality.

Faced with seemingly opposing views as encapsulated in the ABA (FSR) and CFA letters, what’s the SEC to do? Here’s my observation: As President Bush and Secretary Paulson
said on Sept. 18, “extraordinary times call for extraordinary measures.” The SEC and FASB have taken actions akin to emergency measures in the past when warranted by events or related legislation; here are a few examples that may illustrate paths that could be taken, if they choose to take any action in this regard.

In light of the current status of guidance issued by the private sector (IASB’s EAP and FASB’s VRG), I wouldn’t be surprised if the SEC (or one of the banking agencies?) does choose to issue some form of guidance on application of fair value in the current (illiquid) market. Only time will tell. (Maybe in time to mention on FASB’s Sept. 29 webcast on fair value.) [UPDATE 9/26: FASB announced today they have postponed the Sept. 29 webcast, and will reschedule it within the next few weeks. FASB states: "Postponing the webcast will give auditors, preparers, users of financial statements, and regulators an opportunity to consider the application of FASB Statement No. 157, Fair Value Measurements, and other applicable generally accepted accounting principles (GAAP) to financial reporting issues that may arise from the pending legislation and recent market conditions. ] But, I wouldn’t necessarily place any bets on it; I’ve been raked over the coals before by people I respect like Re: The Auditor’s Francine McKenna when I raised the question a couple of months ago that if markets aren’t rational, can market values really be ‘fair.’ If you’d like some background music while you contemplate this subject, here’s a link to We Didn’t Start the Fire “ by Billy Joel. (Note: link is to video by Scott Allsop of Kings College in the U.K, illustrating historical events in the song.) If you received this blog post from ‘a friend’ and you’d like to receive our blog by email, sign up here.

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