FCAG members were asked whether further guidance on fair value (mark-to-market) was needed. Here are a few highlights of the discussion:
- Former Comptroller of the Currency Gene Ludwig-observed, “One could say, ‘how can you be against fair value accounting, it’s fair?’” However, he added, “The issue before the house is not whether it’s fair value, but whether it should be driven by market value.” He continued, “I would put to you we’ve clearly - not just in the court of public opinion… at a time when markets don’t function, you can’t use market values to be equivalent to fair value, we have driven economic reality, we haven’t reflected economic reality.”
- An FCAG member said, “An inquiry for the accounting profession, if one doesn’t get this right, it undercuts in the public’s mind the value of accounting. If we all had to sell our houses in 24 hours, the value we would get is de minimus; we have got to have a more robust view of what values are, what we have undercut is the voracity of [financial] statements.”
- FASB Chairman Robert Herz, an observer at the meeting, said, “The standard [FAS 157, Fair Value Measurement] says ‘orderly sale,’ not a distressed sale.”
- Ludwig commented, “Another way to conceptualize this, if you took mark-to-market to its extreme and said you have to value corporations on a mark-to-market basis, simply based on the market, you’d get very distorted valuations because of volatility; at a point in time, [prices can] dramatically change.”
- Goldschmid said: “… I’ve never seen a CEO who didn’t believe there is light at the end of the tunnel…”
- IASB Board member Jim Leisenring, an observer at the FCAG meeting, later said, “The light at the end of the tunnel might be the headlight on a train.”
- Goldschmid said, “If I read the standard here [FAS 157] and the international standards correctly, there was much more room to take account of illiquid markets, distressed sales, than people were using; there was some naiveté out there, some idiosyncratic sale, [but] people [are] saying you have to take that.”
- FASAC Chairman Dennis Chookaszian, also an observer at the meeting, added that the clarification issued by FASB (presumably referring to FSP 157-3, issued in Oct. 2008) “provides a clarification that gives you lots of flexibility, but it is not being used.” As to why it is not being used, he surmised, “It is difficult to come up with something credible, and you can’t ignore that fact that if you are a CFO or an accounting firm, you [may] get second guessed, when a year or two later the real numbers come out; even tough you believe it [at the time], you may not want to take that position… cannot ignore reality in the U.S. with substantial litigation risk; changing an accounting rule won’t do anything if people are concerned about that risk.”
- Goldschmid asked Ludwig: “Are you arguing with 157 [FASB Statement No. 157, Fair Value Measurement] in the U.S.? Which parts? Category 3? Or [that] you take too long to get to Category 3?”
- Ludwig replied, “Particularly when markets don’t function, but perhaps [as a] general rule, [one should] look at other [values], e.g. discounted cash flow, as a reflection of valuation of assets.”
- A FCAG member said: “There is a difference between price and value; looking at markets [is looking at] price, not looking at value.”
- Herz said, “That’s a broad discussion, but how far are we going to go?” He added, “I might support certain things for certain classes to use discounted cash flow, in fact [FAS] 157 tells you to do that.” He added, “Application in practice may be strained now because of market conditions, behavioral implications of auditors, preparers, to just find a price, but the standard doesn’t tell you to do that.” Rather, he said, “The question is: how far can you go in ignoring market price.”
- Jerry Corrigan, former President of the Federal Reserve Bank of New York, (and now with Goldman Sachs) expressed his support for fair value accounting, and decried reports of ‘draconian’ calls for suspension of fair value. (FCAG co-chair Goldshmid observed that no one at FCAG had called for any such draconian measures.)
- Goldschmid said, referencing FCAG’s January 20 meeting in London, and also referencing the SEC staff report to Congress published Dec. 30, 2008 on mark-to-market accounting, which was led by SEC’s (then-Deputy Chief Accountant, now-Acting Chief Accountant) Jim Kroeker: “I should emphasize what we concluded in London, and what Jim Kroeker concluded, that fair value accounting had nothing to do with ...[the financial crisis] Jim [Kroeker] looked at how many banks…” [NOTE: Marie Leone of CFO.com published a summary of FCAG's Jan. 20 meeting, held in London, here.]
- Ludwig asked Kroeker (an observer at the FCAG meeting): “[Did you look at] banks or banking organizations, if you look at banks by charter, they are mostly hold-to-maturity; but by .... very large [portfolio] of trading assets [are] marked-to-market.”
- Kroeker replied, “[We looked at] financial institutions, and found nonperforming loans seemed to be the primary issue at financial institutions, it wasn’t mark-to-market.”
- Corrigan also questioned some of the statistics in the SEC’s report to Congress on mark-to-market accounting issued Dec. 30, 2008. He questioned in particular the relatively low proportion of assets marked-to-market as shown in the SEC study, and said, “I don’t think it is representative of the very large systemically important banking and universal banking groups; the incidence of the use of fair value I’m quite certain is a lot higher than the numbers that you would say for that relatively small but very important group of banks.”
- Kroeker responded, “The study took the thirty largest financial institutions, so it is included in the population.”
- Corrigan replied, “Those numbers just don’t sound right to me… I’ve looked at these numbers pretty carefully.”
- Corrigan continued, “I don’t think it’s any surprise I say as a creature of my environment, I learned at Paul Volcker’s knee, historic, cost accounting, especially for loan type products, discounted cash flow, [was like] Moses coming down from the mountain, and now after 15 yrs at Goldman Sachs where I live and breath fair value for everything, I have a somewhat different view of who Moses is or was. In conclusion, I think watering down fair value is the wrong way to go, and if anything, [the] direction [should be], as suggested earlier, to find ways to improve it, and with those improvements in place, find ways to broaden its application.”
- Goldschmid added, “Which would allow you to do a fair amount of simplification too.”
Mixed Attribute Model
- Goldschmid’s reference to ‘simplification’ above is also likely related to the stated aim of FASB and IASB’s current project to ‘simplify’ financial instruments accounting, in part by potentially requiring full fair value for all financial instruments, rather than the current ‘mixed attribute’ model. The mixed attribute model measures some balance sheet items at fair value, some at historic cost, and others at lower of cost or market or by other measures. FASB and the IASB suggest in their Discussion Paper issued in March 2008 that a move to full fair value accounting for all financial instruments would be a simplification, however, not all constituents concur on the degree of ‘simplification’ that would provide, and some, like the U.S. banking agencies, in a joint comment letter filed on the Discussion Paper in October, expressed “concerns about the wider use of fair value accounting for financial instruments.”
- Sylvie Matherat, an observer from Basel committee at the FCAG meeting, said: “Central bankers, regulators… very much prefer the mixed attribute model … for [the] reason, there are thing that are traded, things that are not.” She added, “There are two books in the prudential framework, the banking book and trading book,” and said, “we have been quite uncomfortable with some of the fair value [accounting], [and by] participating through this Financial Crisis panel, [to] try to give some guidance how to value those illiquid assets.” She added, “We are quite reticent for the future, to see all those values built on uncertainty flow through the P&L.” Noting comments made earlier by Jerry Corrigan on a lack of correlation between certain accounting practices and the strength of certain financial institutions, she continued, “There is no correlation between the quality of [certain assets] and behavior in prices.. mostly because the valuation does not depend on the way you value your own assets, but on how the others in market are valuing your asset.”
- Toru Hashimoto, Former Chairman, Deutsche Securities Limited, Japan, said, “Business purposes and management’s intent should be the keys to determine when financial instruments are carried at fair value, and when the changes in fair value should be included in earnings
- Another FCAG member said: “[With] fair value [there is a] tendency… it is important to recognize, may lead to an overstatement of risk; at the same time, [there is] probably an understatement of risk in the held-to-maturity portfolio.” This person added, “[U.S. Treasury] Secretary Geithner’s stress testing [banks] … is a fair value exercise... looking for hidden losses not discovered yet, the overall picture is, risk may be sooner understated, than overestimated.”
- Fermin del Valle of Argentina, former President of the International Federations of Accountants, said: “Let me share with you some thoughts from real experience, coming from a country where a full fair value model was adopted more than 10 years ago, and try to share with you some of the reasons why we abandoned that model and we came back to a mixed model.
- Hans Hoogervorst, Co-chair of FCAG, said he heard a: “General consensus the current mixed attribute system is in need of serious cleanup, needs more consistency, that we support all the efforts that should be done in the near future, and hopefully we can reach some consensus in the next meeting about the principles [under] which this exercise should be undertaken, that is something we can try to work on as well.”
Transparency vs. Financial Stability
- In response to earlier questions addressed during the meeting about who financial reporting should be directed to, and whether financial reporting should have as a stated objective ‘financial stability’ (including whether a ‘financial stability’ objective can coexist with a ‘transparency’ objective) FCAG members seemed to support investors as the primary audience to whom financial reporting should be addressed/designed, but many FCAG members argued that stakeholders of financial reporting also include depositors and lenders, with some arguing a term broader than ‘investors’ should be used to adequately reflect key stakeholders.
- FCAG co-chairman Harvey Goldschmid asked if a financial stability objective and a transparency objective can be ‘reconciled,’ and the FCAG meeting handout asked if members were concerned about potentially ‘sacrificing’ transparency for financial stability; numerous FCAG members indicated that a financial stability objective, even if not explicitly stated, can (and to some, should) coexist with a transparency objective for financial reporting.
- After hearing FCAG members share their views, Goldschmid said, ““[What’s] common to investors [is] they want transparency, integrity.” He added, “If I hear the room correctly, there is great concern about losing integrity, transparency, with any technique.”
Dynamic Provisioning, More
The highlights above include just some of the areas addressed at the FCAG meeting, another important issue discussed related to dynamic loan loss provisions, including some participants’ views that the SEC discourages financial institutions from taking provisions that they otherwise may wish to take.
You can still listen to the archived webcast of the four hour FCAG meeting if you missed it, but if you prefer reading about it (or in addition to listening to it), check out FEI’s 14-page “Detailed Summary of FASB-IASB Financial Crisis Advisory Group Meeting.” (And of course, reference should be made to the official FCAG meeting minutes when they are posted.) Our 14 page detailed summary (as well as a 2 page shorter version) are available to FEI members only, and other member benefits include our bi-weekly electronic newsletter, FEI Express, our monthly magazine, Financial Executive, reports issued by our research affiliate (FERF), discounts to attend conferences, career center services, and more; we invite you to check out the benefits of FEI membership. As a special offer to blog subscribers - if you are not currently an FEI member, (and even if you are!) if you tell a friend or colleague about the FEI blog, and they sign up for the blog by emailing email@example.com (tell them to write in the Subject line of their email: Sign Up-Special Offer – and to give us your name and email address too) – then we’ll email you and that person a copy of our detailed summary.
User Views on Fair Value
I interviewed two users of financial statements, both Chartered Financial Analysts (CFAs) (with additional certifications as well) - to share their personal views on some of the issues discussed by the Financial Crisis Advisory Group (FCAG). (The persons I interviewed are not members of the FCAG.) Watch for our next post on that subject.
My two cents
(Actually, in this market, maybe I should call this section ‘my one cent.’) I must also remind you these views are my own, see the disclaimer in the right margin of the blog, above the blogroll.
Cent One: Expressions of “Consensus”
At several points in the FCAG meeting, one or the other of its co-chairs said “I think we have a consensus” or “I heard a consensus.” However, the group did not take any formal votes, and on some issues, certain FCAG members held diametrically opposed views.
This expression by the chair of a perceived ‘consensus’ gave me a sense of déjà vu, reminding me of some of the earliest meetings of another advisory group – the PCAOB Standing Advisory Group (SAG), when it was first formed. After getting input around the table as to whether further improvements were needed to the original rules issued by the SEC and PCAOB under Sarbanes-Oxley Section 404 (internal control reporting), the then-SAG chair said he heard a consensus that no further guidance was needed. However, several of the individual members of the SAG and some of the expert panelists they had invited to speak to them had voiced the need for some change, and no formal vote was taken. Therefore, to me, personally, the chair’s expression of a ‘consensus’ appeared to be more a statement of ‘the sense of the chair’ than reflective of any group ‘consensus’ per se, and was notable in its support of the status quo/current action plan of the organization it was formed to advise. A couple of years and numerous roundtables later, the SEC and PCAOB agreed that yes, further guidance was needed, and issued such guidance (including management guidance issued by the SEC, and a new auditing standard issued by the PCAOB (AS5) replacing AS2 on internal control auditing) in 2007. I note this as a cautionary tale for readers of this summary, or meeting summaries generally, when such summaries note that the chairman of an advisory committee stated a consensus was reached, when no formal vote was taken and differing views were expressed.
Cent Two: Do We Have to Choose Between “Transparency” and Financial Stability
The phrasing of certain questions posed verbally to FCAG members at the meeting, and detailed in the FCAG meeting handout, referencing terminology such as, if there should be a potential ‘sacrifice’ of transparency for financial stability, whether one could ‘reconcile’ transparency with a financial stability objective for financial reporting, etc., could be viewed as ‘leading’ questions, which as constructed may have only one logical answer, thereby potentially impacting the range of discussion. This point was alluded to by former Comptroller of the Currency Gene Ludwig, when he stated, “How can you be against fair value – it’s ‘fair.’” But he continued, “The issue before the house is not whether it’s fair value, but whether it should be driven by market value.” (See the rest of his remarks above.) Ludwig’s remarks open the kimono, so to speak, on the need to consider the meaning of the word ‘transparency’ as relates to fair value as currently reported in accordance with FAS 157.
What if, at the extreme (and today’s distressed market conditions could probably be characterized as fairly extreme) the only observable market price is a single market quote – or a ‘hypothetical’ market quote – obtained in accordance with FAS 157 as it is currently interpreted in practice? (Although FASB Chairman Robert Herz noted at the FCAG meeting FAS 157’s direction to use market values expressly states it applies to orderly markets, FCAG members noted, as did members of FASB’s Valuation Resource Group at the February 5 VRG meeting, that in practice, financial statement preparers and auditors feel pressured to use market values, even in distressed markets, when interpreting FAS 157 – and FSP 157-3 issued last October, as those standards are currently worded.)
Is it the case that because the word ‘market,’ ‘market participant,’ or ‘hypothetical market participant’ – words at the core of the FAS 157 fair value model - are used in arriving at ‘fair value,’ that even in distressed, illiquid, or virtually nonfunctioning markets, that value is ‘transparent’? What does such a value really represent - the ‘fair value’ of the asset, a ‘fire sale’ price, or something else? How does one reconcile – conceptually- when there is a material difference between a fundamental valuation (e.g. discounted cash flow analysis) vs. third party real or ‘hypothetical’ market quotes in a dysfunctional market? These questions get at the heart of the ‘transparency’ of certain fair value measures, and some may say these questions are the primary questions that call for consideration, (similar to questions 5 and 6 covered at the FCAG meeting, on fair value accounting), rather than pitting financial stability vs. transparency (the question teed up as question 2 at the FCAG meeting).
Although some people appear to argue that accounting can’t serve two masters – investors who want ‘transparency’ – and bank regulators interested in financial stability (and people in that camp sometimes argue that bank regulators can, if they wanted to, adjust out fair value marks from banks’ financial statements for regulatory capital or prudential supervisory purposes) – I reflect back on testimony of former FDIC chairman William Isaac at the SEC’s Oct. 29, 2008 roundtable on mark-to-market accounting (see transcript), when he said:
“… I want to take back the words ‘fair value.’ You can’t have those words. You can’t own those, because I am for fair value accounting. So we’re arguing about what is fair value, and I’m telling you that I don’t believe marking to a computer model or fire sale prices based on distressed sales is fair value.” …. (pg. 46 of transcript) “I am also concerned… we keep on making the distinction between what the regulators can do with capital versus the balance sheet effect. And I think in the world we’re in with short-sellers and the rating agencies, and a lot of volatility in the markets...” (pg. 62 of transcript) …"I just don't think it's appropriate to mark something arbitrarily to an index or to a market price when the market’s not functioning and destroy value, run it through the income statement, and take it out of the capital accounts of the company. And it doesn't matter what the regulators think. I don’t believe that a regulator would have wanted to close down Wachovia, but the market was sure closing it down. I don’t think a regulator would have wanted to close down WaMu, but the market sure wanted to close it down, because of these reports we're forcing them to make about their losses and the depletion of their capital. So nobody even asks what the regulators think.” (pg 49-50 of transcript)
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