Herz Tells FCAG, 'Rethinks' Exit Value In Certain Circumstances

In response to a question posed by Harvey Goldschmid, co-chair of the Financial Crisis Advisory Group (a joint advisory group of FASB and the IASB) on whether there is anything left for the FCAG to say on fair value in inactive markets - given FASB's recent guidance (and IASB's potential guidance) in that area - FASB Chairman Robert Herz noted that in light of recent discussions he had in formulating FASB's new guidance, “I have begun to question… to what extent do markets provide a good valuation or not.”

Alluding to the mark-to-market vs. mark-to-model debate, Herz indicated he didn’t think there was a better indication of fair value than market value - if the market value incorporated ‘fundamental factors’ and ‘good information’ - particularly compared to ‘just having one set of managers look at something,’ considering the potential for management bias.

However, he noted, “we have markets that have not only been illiquid, [lacking] proper price discovery and proper clearing mechanisms,” but also, "one has to question whether [market values are] being driven at points in time with other than fundamental factors.” In such circumstances, he added, although "using those, everybody has comparability... whether they have the most relevance - that’s another question." He also noted that while some issues are beyond the FCAG's, FASB or the IASB 's scope, such as actions being taken by regulators with respect to market structure and operation, "I am concerned that non-fundamental factors influence prices."

Herz reiterated this point in the afternoon session, saying, “What we’ve done over the last month or so, [we] talked to lots of people, one of the things we learned among many others, [were] factors that have a real impact on market price, demand, supply, [include] some processes of rating agencies... something rated investment grade [that is downgraded] to noninvestment grade, can all of a sudden take a good chunk of demand out of the market as well.”

“A lot of these things led me to rethink some of my basic thinking,” said Herz.

He added, “It seems to me the mark-to-market exit price is a very good and appropriate measure when .. [there is] activity, [but when there is a lack of activity] maybe less faithful to the objective of accounting which is supposed to provide information to people’s understanding of the amount, timing and uncertainty of future cash flows.”

“For those kind of situations,” he continued, “it gave me at least pause, to at least question, whether that provides relevant information.” He added, “If you think market price always provides that information, you would gravitate to that in all circumstances. The question is," he continued, "if you stick to [the] objective [of financial reporting], to understand information relevant to the amount, timing, uncertainty of future cash flows, you start questioning the premise that markets [are] functional, you start to look at alternatives.” (Observation: This sounds reminiscent of some of the things Vinny Catalano, CFA, a former President of the New York Society of Securities Analysts has been talking about in his blog, Musing on the Markets, e.g. his April 16 post on Antique Economic Theories, and in our interview of Vinny Catalano and Randy Randy Schostag earlier this year on User Views on Fair Value.)

NOTE: Herz was expressing his personal view in the remarks above cited from the FCAG meeting, not an official position of the FASB board; nonetheless his comment was very interesting with respect to the 'exit value' market value approach, which is the fundamental approach in FAS 157, Fair Value Measurement, although FAS 157 does permit other valution methods to be used (including as noted in FAS 157, paragraph 18: the market approach, the income or discounted cash flow approach, and the cost approach), although the emphasis (aka 'level 1' of the three level hierarchy) is on the market approach - when observable market prices are available, or hypothetical observable market prices can be arrived at based on other observable factors, as explained in FAS 157 and further expanded on in FSP 157-4, the recent guidance on fair value in inactive markets.

FCAG To Issue Report in July
The FCAG discussed matters including the standard-setters independence and due process, and continued prior discussions regarding fair value, impairment, off-balance-sheet accounting (including securitizations) and loan loss provisioning (including potential consideration of moving from the current ‘incurred loss’ model to an ‘expected loss’ model such as dynamic provisioning or through-the-cycle provisioning, the latter of which was considered more in the prudential regulators’ purview at a macro level, than generic expected losses on an individual entity basis or micro level)

As noted in a recent letter FCAG sent to the G-20, FCAG is aiming to issue a final report in July.

Although according to its charter, "The primary function of [FCAG] is to advise the boards about standard-setting implications of (1) the global financial crisis and (2) potential changes to the global regulatory environment," and, "[FCAG's] role is not to reach a consensus or to vote on the issues that it considers at its meetings," it appears FCAG may include some recommendations or statements of consensus in its final report, which is currently expected to be issued in July, as noted in FCAG's recent letter to the G-20.

FASB project manager Jeff Mechanick explained after the meeting, “Where FCAG has reached a general consensus, we will make recommendations to the boards [i.e. FASB and IASB].” He added, "In areas where there is not general consensus, we will likely summarize key points of view to help inform the boards.”

During the public portion of the meeting, it was not clear what if any ‘consensus’ was reached on particular areas, given differing points of view expressed, but FCAG convened in private session after the public portion of its meeting. The next scheduled meeting of FCAG is May 22 in London, with a final tentative meeting scheduled for July 10 in New York, 'if necessary'.

It will be interesting to see if FCAG will, e.g. post a draft copy of its recommendations and discuss them at a public meeting, similar to the SEC Advisory Committee on Improving Financial Reporting (CIFiR) or the U.S. Treasury Department's Advisory Committee on the Auditing Profession (ACAP) did last year, prior to issuing their final reports, although CIFiR and ACAP were bound by laws impacting the operation of Federal Advisory Committees or FACAs.

We will post additional details on the FCAG meeting in a summary on FEI's website.

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