SEC To Examine: How Is Fair Value Faring?

The SEC is slated to hear from investors, auditors, issuers and others at an Oct. 29 roundtable on mark-to-market (MTM) accounting. (Note: MTM is often called fair value (FV) accounting. Although there are technical differences between the two terms, fair value accounting as defined in FASB Statement No. 157 emphasizes use of an exit price or current sale price notion of ‘market value’ as the best reference point for fair value.)

Earlier this week, the SEC posted the agenda with links to panelists’ bios, and a related press release notes the roundtable will focus on four issues: (1) usefulness of mark-to-market accounting to investors and regulators, (2) effects of mark-to-market accounting on financial reporting by financial institutions, (3) potential market behavior effects from mark-to-market accounting, and (4) whether aspects of current accounting standards can be improved, and how.

The Oct. 29 roundtable is one mechanism being used to obtain feedback to inform the SEC’s Congressionally mandated study of the impact of mark-to-market accounting on financial institutions. As noted in SEC’s Spotlight page on Fair Value, the study, as set forth under Section 133 of the Emergency Economic Stabilization Act of 2008 (EESA), “shall consider at a minimum (1) the effects of such accounting standards on a financial institution's balance sheet; (2) the impacts of such accounting on bank failures in 2008; (3) the impact of such standards on the quality of financial information available to investors; (4) the process used by the Financial Accounting Standards Board in developing accounting standards; (5) the advisability and feasibility of modifications to such standards; and (6) alternative accounting standards to those provided in [FASB] Statement Number 157 [entitled, Fair Value Measurement].

Another feedback mechanism used by the SEC in connection with this study is the issuance of two separate requests for comment: the First Request for Comment, issued on October 8 was very general in nature and carried a November 13 comment deadline; the Second Request for Comment issued on October 20 invited comment on the four areas of focus slated for the Oct. 29 roundtable, and the comment deadline was October 28.

On the eve of the Oct. 29 roundtable, eighty-two comment letters have been posted so far. If you want to get a flavor for the two sides of the fence (note: very few are ‘on the fence’ although to some the jury is still out, and to others some modifications or tweaks may suffice rather than wholesale suspension or radical amendments of the fundamental tenets of existing accounting standards) here are a couple representative letters from each side of the fence:

Proponents of MTM/FV accounting as currently constructed: See, e.g. the Oct. 15 letter sent by the Four C’s to the SEC . We refer to the “Four C’s” as shorthand for the joint letter sent by the Center for Audit Quality, CFA Institute, Council of Institutional Investors, and Consumers Federation of America. The letter states: “We are writing to express grave concern regarding recent calls for the SEC to override guidance issued by the Financial Accounting Standards Board (FASB) and the Commission’s staff that would effectively suspend fair value or mark-to-market accounting. We believe such urgings are decidedly not in the public interest.”

They continue: “a move by the SEC to suspend fair value accounting would be a disservice to the capital markets, would be inconsistent with the views of investors, would harm the credibility and independence of the standards setting process, and would run counter to fundamental notice and comment principles. With third quarter financial statements now in process and year-end 2008 imminent, such a change could jeopardize already-fragile investor confidence.”

“No one disputes that these are trying economic times,” say the Four C’s. “However, the current crisis of liquidity, credit, and confidence was not caused by fair value accounting; rather, sound accounting principles helped expose the problem. Fair value accounting with robust disclosures provides more accurate, timely, and comparable information to investors than amounts that would be reported under other alternative accounting approaches.

The Four C’s conclude: “Investors have a right to know the current value of an investment, even if the investment is falling short of past or future expectations. It, therefore, is imperative at this critical juncture that we not engage in activities that would further obscure reality from investors and do more to damage confidence in the marketplace. We urge the SEC to be clear in rejecting urgings that are contrary to this imperative. “

Opponents of MTM/FV accounting as currently constructed: See, e.g. the written statement of Former FDIC Chairman William M. Isaac , scheduled to testify at the SEC’s Oct. 29 roundtable, in which Isaac notes that when he was at the FDIC, after studying for over a year whether to push for mark-to-market accounting, “We finally rejected the notion for three principal reasons: (1) mark-to-market accounting could be implemented on only a portion of the asset side of the balance sheet … to attempt to do so would produce very misleading results. (2) mark-to-market accounting would make it very difficult for banks to perform their fundamental function in our economy, which is to take relatively short-term money from depositors and convert it into relatively long-term loans for businesses and consumers. Banks necessarily have some mismatch in the maturities of their assets and liabilities – it is up to bank management, regulators, and investors to make sure the mismatch is not excessive. Accounting rules made to influence behavior are no substitute for good judgment and can interfere with appropriate business conduct. (3) mark-to-market accounting would be pro-cyclical (which is never a good thing in bank regulation) and would make it very difficult for regulators to manage future banking crises.”

Isaac makes his case powerfully, stating: “I believe it is beyond dispute that mark-to-market accounting has been extremely and needlessly destructive of bank capital in the past year and is a major cause of the current credit crisis and economic downturn. The rules have destroyed hundreds of billions of dollars of capital in our financial system, causing lending capacity to be diminished by ten times that amount.” Although he “welcome[s] the partial relief from mark-to-market accounting that the FASB and the SEC provided in the past couple of weeks,” Isaac says “it is much too little, much too late,” and recommends: “I believe the FASB and the SEC should immediately withdraw SFAS 157,” and that “the SEC … recommend in its report to Congress that we abandon mark-to-market accounting altogether.”

Predicting the reaction of others who hold a different view, Isaac noted: “Some advocates of mark-to-market accounting gasp at the thought of suspending the rules. They assume it would result in a loss of transparency and an overstatement of values.” He counters, “Quite to the contrary, it is the use of mark-to-market accounting, when markets are not functioning properly, that has produced terribly misleading accounting and disclosures that value assets well below their true economic value.” He proceeds to recommend alternatives to the current FV framework, and recommends changes relating to accounting standard-setting as well.

Another comment letter which is aligned with Isaac’s views is the three sentence comment letter filed by Susan Saidens. Saidens, who presents herself as holding a litany of professional certifications in accounting (CPA), fraud prevention and detection(CFE), business valuation (ABV) and more, asserts in her comment letter: “The real issue with Mark to Market accounting is that the revised definition of "fair value" in SFAS 157 is inappropriate. The idea of using an "exit" price is wrong, and everything follows from that. The definition of "fair value" in SFAS 157 should be changed.”

FASB’s Parent Body Asks SEC To Reject Calls to Override FASB Standards
We previously reported on the letter sent by the American Bankers Association (ABA) to SEC Chairman Christopher Cox which asked the SEC to override FASB’s recent guidance on fair value in inactive markets, contained in FASB Staff Position (FSP) No. 157-3. We also previously reported on the letter filed with SEC by the Four C’s, described more fully above, which urged the SEC to reject any calls for action that would serve to “further obscure reality from investors and do more to damage confidence in the marketplace.”

FASB stepped in with a number of letters of its own, including, as we previously reported, a letter sent by Robert Denham, chair of the Financial Accounting Foundation (FAF) which oversees FASB, to House Financial Services Chair Barney Frank, and more recently (on Oct. 27), a letter from FAF Chair Denham to SEC Chair Christopher Cox urging the SEC to reject requests to overrule FASB standards (particularly as relate to fair value and FASB’s proposed revisions to securitization accounting).

Denham tells Cox in the Oct. 27 letter: “As enacted, EESA does not contain any provisions to override Statement 157.” NOTE: Some may question this statement, if they believe ‘override’ is implied in the ability of the SEC to ‘suspend’ FAS 157, a power that is directly authorized in Section 132 of EESA, entitled “Authority to Suspend Mark-to-Market Accounting.”

The FAF letter continues: “Notwithstanding the U.S. Congress' rejection of any such provisions, we are aware of new appeals, this time to the … [SEC], to: override the recently issued FASB Staff Position (FSP FAS 157-3); suspend a proposal on the accounting for securitizations; and, pending Congressional review of the study mandated by the EESA, suspend work on any project that would require fair value in any future accounting standard.” NOTE: This appears to be an indirect reference to the express request made in the ABA letter to the SEC. FAF’s Denham continued: “For the reasons discussed in the balance of this letter, we believe that it would be detrimental to investor confidence to overturn a FASB standard or otherwise suspend or restrict the independent standard-setting activities of the FASB in the current economic environment and in response to political pressure from some financial industry groups.”

Perhaps a middle road to maintaining existing standards vs. suspending or overriding existing standards is expressed in a joint letter filed by the U.S. Chamber of Commerce, Financial Services Roundtable, Property Casual Insurers Association of America; American Council of Life Insurers; Mortgage Bankers Association; and American Insurance Association, which asks the SEC to issue guidance on use of judgment in applying FAS 157, Fair Value Measurement, in inactive markets.

New Global Advisory Group To Operate In Sunshine
In related news, a joint press release issued by FASB and the IASB on Oct. 20 provided further details on their Global Approach to Enhance Market Confidence. The two boards noted there will be a ‘rapid’ appointment of a new ‘high level advisory group’ to guide the standard-setters on accounting and disclosure matters related to enhancing market confidence. This follows on the boards’ Oct. 16 joint press release which announced the decision to form this high level Global Advisory Group (GAG).

I found it significant that the GAG will meet in the sunshine, as stated in the Oct. 20 press release: “the advisory group will meet in public session with webcasting facilities available to all interested parties.” By holding meetings open to the public, this group will differ from existing advisory groups formed previously by IASB and FASB to advise them on fair value accounting issues, which have met in private, releasing brief summary points identifying issues discussed (in the case of FASB), and releasing a draft discussion document (soon to be finalized), as well as brief summaries of meetings (in the case of IASB). Specifically, the existing groups are FASB’s Valuation Resource Group (VRG) and IASB’s Expert Advisory Panel (EAP). Whether the form or substance of any recommendations coming from the GAG will differ from previous output from the VRG or EAP due to the public nature of meetings is an unknown, but the fact that the meetings will be open to the public, to some, may enhance confidence in the process.

Will Existing Guidance On Fair Value Be Considered, or New Guidance Only?
The scope of the GAG appears fairly broad, as described in the Oct. 20 press release: “[to] conside[r] how improvements in financial reporting could help enhance investor confidence in financial markets… [and] identify[y] the accounting issues requiring urgent and immediate attention of the boards as well as issues for longer-term consideration.”

Based on the above description, it is not clear if any of the recent guidance issued by FASB, the IASB and SEC on fair value in inactive markets (i.e., the IASB EAP draft discussion paper released in the summer, the SEC-FASB joint clarification released on Sept. 30, or FASB Staff Position (FSP) No. 157-3 released on Oct. 10) will be open for discussion.

Questions to Consider
As the SEC embarks on its study of MTM/FV, and if the FASB-IASB’s GAG decides to take a look at the recent guidance on fair value on inactive markets and the underlying standards like FAS 157, based on my review of comment letters filed on FASB’s proposed fair value guidance (proposed FSP FAS 157-d) earlier this month, and comment letters filed in response to SEC’s request(s) for comment on mark-to-market accounting, I believe questions could potentially be presented for further analysis in three broad areas:

1. Questions about consistency between and among the separate sets of recently issued guidance on fair value in inactive markets issued by FASB (FSP FAS 157-3), the IASB (the draft discussion paper released this summer by IASB’s Expert Advisory Panel) and SEC (i.e. the SEC-FASB joint clarification published on Sept. 30.)

I hope Dr. Bill Lutz (viewed as sort of the ‘father’ of plain English, who is advising SEC on its 21st Century Disclosure Initiative) sits in on SEC’s Oct. 29 roundtable on fair value, since it is challenging to parse the words within the triangulation of statements made by the SEC, FASB and IASB in recent weeks in the separate guidance listed above as to whether each believes that their individual sets of guidance are “consistent” with the other, or whether some are simply acknowledging the ‘efforts’ of the other. More than a triangulation, maybe it’s a quadrangulation, considering wording contained in the joint statement of European regulators (CESR et al) published last week. (Hat tip to BNA for providing link to the European statement). One of the points made in various comment letters with SEC, FASB, and the IASB (see para. 24a in this IASB summary) has been on the level of consistency between and among the separate sets of guidance.

FASB board member Tom Linsmeier, serving as an observer at the PCAOB Standing Advisory Group (SAG) meeting last week, and slated to serve in a similar role at the SEC’s Oct. 29 roundtable, remarked on this issue of consistency. Linsmeier told the SAG, “The boards [FASB and the IASB], [at their] joint meeting on [Oct. 20 and 21], made a commitment going forward, at all times possible, to issue guidance in words that are identical, to limit the potential political or reporting arbitrage to the lowest common denominator.”

2. Questions about consistency between the recent guidance issued by FASB and the IASB vis-à-vis their underlying standards, including FAS 157, Fair Value Measurement. Some commenters on FASB’s proposed guidance (including the comment letter filed by FEI’s Committee on Corporate Reporting) suggested FASB modify certain language referencing current markets and related liquidity discounts to make it more applicable to inactive markets. FASB did not change the wording referencing observable transactions in current markets, but added a sentence to paragraph 11 of the final FSP noting the example contained in the FSP assumed there were observable transactions that were not forced or distressed.

However, the applicability of a scope sentence specifying there are observable transactions that are not forced or distressed in a guidance on “Determining Fair Value of a Financial Asset When the Market for that Asset is Not Active” may lead to questions. Further, the draft paper published by IASB’s Expert Advisory Panel (EAP) in July (version posted on IASB website Sept. 16) reached conclusions which some have questioned, including that there has been “Entities sometimes place undue emphasis on the distinction between active and inactive markets when measuring fair values,” and that “distress sales are rare.” According to Agenda Paper 5B presented at this week’s joint FASB-IASB meeting, the EAP draft paper is set to be posted in final form on IASB’s website this month. IASB did not formally request comment on the EAP draft paper, although it was posted on IASB’s website and comments were welcomed. However, comments received have not been publicly posted because this was not a formal request for comment, given that the EAP document is not ‘authoritative’ but is being published for ‘informational’ purposes. Similarly, FASB’s VRG is deemed a nonauthoritative group. More generally, some have noted a concern about the role of nonauthoritative or quasi-GAAP guidance, as expressed by the SEC Advisory Committee on Improvements to Financial Reporting (CIFIR) which issued its final report earlier this year.

3. Questions about whether there is a need for a fundamental reconsideration of the underlying standards, including but not necessarily limited to FAS 157, Fair Value Measurement, and IASB standards, particularly to the extent those standards as originally written emphasized the usefulness of data obtained in observable or hypothetical transactions in ‘current’ markets by relying on an express or implied presumption that current markets were orderly and active. The current market turmoil and questions about the potential procyclical effect of accounting (referenced in the joint statement of European regulators (CESR et al) cited above, as well as in the written statement of SEC panelist and former FDIC Chairman William Isaac and the comment letter filed with the SEC by Susan Saidens referenced above) have amplified the question of whether a presumption of orderly markets in the original accounting standards on fair value measurement raises the need to consider a fundamental amendment to those standards. Some may question if this ‘fresh look’ threatens the independence of the standard-setters, although others may argue it is worth doing a debriefing or ‘reality check’ some number of months or years after a new standard is issued, or the environment changes (or both), similar to some of the discussion held by the SEC Advisory Committee on Improvements to Financial Reporting (CIFIR or the “Pozen Committee’ for chair Robert Pozen). Others may posit the emphasis in any such fresh look or post-adoption review should be on the reliability and relevance of the resultant financial reporting.

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