Monday, October 13, 2008

What's The Impact of FASB's New Guidance on Fair Value?

From the divergent headlines coming out about the new FASB fair value guidance issued on Friday Oct. 10, FSP FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active," one may wonder if “Accounting Board Adopts Guidance to Ease Crisis,” as reported by AP’s John Christoffersen, or if “FASB Approves Fair-Value Guidance, Avoids Flexibility,” as reported by Ian Katz on Bloomberg Oct. 10.

It may not be that easy to tell which take is right, and the truth may lie somewhere in between. For instance, one can look to the discussion that took place at the October 10 FASB board meeting (detailed in this FEI Summary) particularly with respect to the effective date of the new guidance, in which FASB board members alluded to ‘two groups’ of companies, those that had essentially been interpreting FAS 157, Fair Value Measurement, all along in a manner consistent with the FSP, and those who had not, with the implication that companies that had interpreted FAS 157 consistent with the FSP would not have significant changes. (A number of comment letters on the proposed FSP noted that point as well – i.e. they did not believe the FSP would cause much to change - although some called for modifications to the proposed guidance for that reason.)

Further consideration of the potential impact of the new guidance may also center on a new sentence added to paragraph 11 of the final FSP (FSP FAS 157-3) which was not in the proposed version of the FSP (Proposed FSP FAS 157-d), which states: “Also, this example assumes that the observable transactions considered in determining fair value were not forced liquidations or distressed transactions.” The ‘assumption’ that observable data does not come from ‘forced liquidations or distressed transactions” is interesting in that the title of the guidance is directed at determining the fair value of an asset ‘when the market for that asset is not active.’ As further detailed in the FEI Summary, FASB decided, consistent with earlier discussion of a FASB advisory group (the Valuation Resource Group), to retain the principles based approach of providing ‘indicators’ or ‘factors’ to consider in determining if the market for an asset was inactive, rather than a bright line definition of inactive markets. However, some may ask if the parenthetical definition of ‘forced transaction’ in paragraph C25 of FAS 157 (including the reference to a seller ‘experiencing financial difficulty’) would have any application to determining whether a ‘forced liquidation’ or ‘distressed transaction’ exists, and how that impacts the consideration of observable inputs or implied or extracted inputs from observable data for those assets.

Among other points of note in the final FSP is insertion of the word ‘relevant’ in the paragraph 11 of the final FSP, shown in the amended paragraph A32C of FAS 157, in which the example now states (new words added to the final FSP vs. proposed version highlighted in bold/italics] “Entity A determines that an income approach valuation technique (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be equally or more representative of fair value than the market approach valuation technique used at prior measurement dates, which would now require significant adjustments.21a “ [Note: footnote 21a in the FSP references paragraphs 20, 21 of FAS 157 which define ‘valuation technique’ including ‘observable’ and ‘unobservable’ inputs.]

Other changes in the final FSP include a new point number 4 in the example (i.e. in the amendment to para. A32D of FAS 157), regarding the need to consider not only quoted prices, analyst reports and indexes, but also “information about the performance of the underlying mortgage loans, such as delinquency and foreclosure rates, loss experience, and prepayment rates.” Additionally, in response to comments received on the proposed FSP, FASB now explains the basis of how it arrived at a the 20 percent and 22 percent discount rates in the example shown in the FSP, by adding an explanation in footnote 21d, and adding more narrative to the amended paragraph A32E.

In determining the impact of the new guidance, some may weigh the changes FASB made in the final FSP such as those listed above, vis-√†-vis some of the specific suggested wording changes supplied in some of the 100 comment letters filed on the proposed FSP. For example, the American Banker’s Association (ABA) had said in its comment letter: “[R]easonable judgment should be applied in determining what a representative liquidity premium would be for a functioning market, so that the liquidity premium is not distorted based on the illiquidity of a frozen market…. [W]e believe the proposed FSP would be more helpful if it included guidance for determining when observable evidence represents market participants not forced or compelled to transact.” And, FEI’s Committee on Corporate Reporting (CCR) had suggested in its comment letter that the following words be added to example in the FSP which would amend para. A32C of FAS 157, in which FEI CCR suggested [suggested new words in bold/italics]: “Entity A determines that an income approach (present value technique) that maximizes the use of observable inputs in an active market and minimizes the use of unobservable inputs or observable inputs in markets that are either inactive or disorderly will be equally or more representative of fair value than the market approach used at prior measurement dates.” The letter added: "[FEI] CCR would support the issuance of the FSP if Paragraph A 32C is amended as noted above. Alternatively, CCR would not object if the FASB decides not to issue the FSP, since we believe it does not currently improve upon, and may conflict with, the guidance provided in the SEC-FASB joint statement."

Now that FASB has issued FSP FAS 157-3, and the SEC and FASB issued their ‘joint clarification’ of fair value on September 30, is there still a need for further guidance or clarification of FAS 157 (Fair Value Measurement) and/or other fair value standards? As announced last week, the SEC has already commenced its study of the impact of the fair value or ‘mark-to-market’ accounting standards, a study required by Section 133 of the recently enacted Emergency Economic Stabilization Act of 2008. Additionally, senior bankers spoke out last week at a meeting of the International Institute of Finance (IIF), as reported by Ian Katz in Bloomberg Oct. 12, Citigroup's Rhodes Says Modify Rule When Markets Fail, in which Citigroup Senior Vice Chairman William Rhodes reportedly said: “Nobody wants to throw [FAS 157] out, but I think in times of illiquid markets, sometimes you need some modifications,'' and Deutsche Bank AG Chief Executive Officer Josef Ackermann, (IIF’s chairman) reportedly “urged an ‘immediate high-level dialogue’ on fair-value accounting issues.” Some other recent commentary evidencing a range of views can be found in: Reverse Leverage of Mark-to-Market Wrecks Banks, by John M. Berry in Bloomberg, Oct. 12, and Don't Write Mark-to-Market's Obituary Just Yet, by Jonathan Weil, in Bloomberg Oct. 8. Additionally, we previously reported that the G7 Plan of Action, released on Friday, shows accounting and disclosure as one of the elements on the global radar screen as part of the plan for stabilizing global markets.

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