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-à-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.

FASB Releases Final FSP FAS 157-3 on Fair Value; G7 'Plan of Action' References Accounting

This evening, FASB released final FSP FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active.” This FSP was issued in record time, as part of the response of standard-setters to provide guidance for applying the fair value accounting rules in inactive markets, as have been experienced during the recent market turmoil. For further background on this FSP, see our two posts from earlier today, here and here, relating to comment letters filed (including the comment letter filed by FEI's Committee on Corporate Reporting (CCR), and summarzing the discussion at today's FASB board meeting.

Separately, the Group of Seven Finance Ministers (G7) issued a statement today, entitled, “G7 Plan of Action” in which the last of five items on the list references accounting. That item states: “Take action, where appropriate, to restart the secondary markets for mortgages and other securitized assets. Accurate valuation and transparent disclosure of assets and consistent implementation of high quality accounting standards are necessary.”

In related news, see announcement released by the IASB today, “[IASCF] Trustees Support IASB’s accelerated steps on the credit crisis."

FASB Plans To Issue Final FSP On Fair Value 'Today or Tomorrow'

UPDATE: CORRECTED NAME OF FASB STAFF MEMBER BELOW. At its board meeting earlier today, the Financial Accounting Standards Board voted to proceed with issuing a final FASB Staff Position (FSP) on fair valuing in inactive markets, and FASB project director Russell Golden told the board they plan to be able to issue the final FSP ‘today or tomorrow.’ The board agreed with the staff’s proposed approach to making certain changes to the final FSP based on comments received on Proposed FSP No. 157-d, “Determining the Fair Value of a Financial Asset in a Market That Is Not Active.”

CHANGES THAT WILL BE MADE TO THE FINAL FSP

Transaction-based, not ‘market based’ determination of distressed assets

FASB staff member Cristofer Anderson [staff name corrected from our earlier post; we apologize for error], who led the staff presentation at the board meeting, cited language from the SEC-FASB joint clarification of fair value published on September 30, which discusses orderly transactions and distressed transactions, and concluded, as described by Anderson, “Determining whether a particular transaction is … [distressed] requires judgment. “
FASB Technical Director Rusell Golden said, “We understand that some people might have interpreted the [SEC-FASB joint clarification published in the SEC] press release to say that disorderly markets equal distressed transactions,that was not our intent.

Anderson told the board, “The [FASB] staff believes that the determination that a market transaction is distressed or disorderly should be made at the individual transaction level, and should not be assumed to have occurred based on an entity’s conclusion that an entire market for the asset is distressed.” He added, “Based on the feedback received from constituents, the staff has included language in the [final] FSP for the board’s consideration to provide clarification on distressed sales. "

Wording developed by Board member Leslie Seidman will be added to the final FSP, described informally in plain English at the board meeting (more formal wording will be in the ballot draft sent to board members later today) by Seidman as follows: (1) you can’t just dismiss any prices in market that is experiencing dislocation or disorderliness, and (2) you can’ t automatically embrace any old price in a market, that is disorderly or dislocated; it’s going to require significant judgment, and the rest of the FSP hopefully goes thru a thought process in those cases where it’s inactive, but you do have some data to look at.”

Board member Tom Linsmeier, calling into the board meeting from China, asked, “Are we going to clarify a distressed market does not mean distressed sales, necessarily - that you are looking at transctions, not markets?” Seidman replied, “Yes, I think so.” Linsmeier said, “I think it’s important to make clear we are not talking about markets, but individual transactions, and when we go to the individual transaction level, there is judgment, of both types that you are talking about.” Herz later said, “it gets down to that level, rather than saying ‘everything is inactive’.”
IASB board member James Leisenring, an observer at the FASB board meeting, said, “I think that would be very constructive, I think the whole exercise is very constructive frankly, from an international perspective,” adding, “I got a letter this morning from somebody who should know better, who said all transactions should be ignored because the markets are distressed; that’s just not what 157 says, nor could it remotely be called fair value, so I think it will be very helpful, [to add to the FSP the clarification] you suggest.” The title of the FSP will likely change to reflect this transaction-based vs. market-based determination of ‘disorderly/distressed’ as well.

[NOTE: Reference should be made to FASB’s Summary of Decisions Reached which will be posted later today in FASB’s news center and in the final FSP when it is issued, to see if the reference will be to ‘individual’ transactions per se vs. types of transactions or assets. The thrust of the change is apparently to preclude overgeneralization of ‘distressed markets’ to all types of transactions in those markets.] without looking at the markets for particular types of transactions or assets.]

Changes relating to the example in the FSP
Anderson said “a number of comment letters provided suggestions, staff made changes” to the FSP, a few include: (1) adding additional detail on use of indicative broker quotes, and (2) the reporting entity’s rationale for weighing the different [factors/inputs] for use of the discount rate in the valuation technique.

Clarification will be added to the FSP that, “In determining whether an other than temporary impairment (OTTI) exists, this FSP does not amend or change the requirement in EITF 99-20 to use market participant (MP) cash flows, not contractual flows, to determine of OTTI has occurred.”

NOTE: Anderson said changes discussed at the meeting were just those in broad categories, he said additional changes are being made by the staff in response to comment letters, but they were not described in detail during the board meeting.

Disclosures
Some commenters wanted expanded disclosures relating to this FSP. Staff said they will NOT add new disclosures in the FSP but said they plan to bring to the board another disclosure project in the next 2-3 weeks, with the goal of some additional disclosures being required for year-end reporting.

NO CHANGES WILL BE MADE TO THESE ITEMS
A number of areas of concern noted in comment letters will NOT be changed, said staff, including:

• The board will NOT address whether fair value is the appropriate measurement attribute in this FSP – that is beyond the scope of this FSP (and FAS 157), which are focused on HOW to measure fair value, not when to use fair value as the measurement attribute
• the board will NOT include liabilities in the scope of the FSP,
• the board will NOT change the effective date proposed – i.e. it will be effective upon issuance for financial statements not yet issued,
• the board will NOT define “inactive’ vs. ‘active’ markets, but the ‘indicators’ or factors that can be considered will essentially be copied from the example section of the FSP to the guidance section .

Further details from today’s FASB board meeting will be posted later today in a summary on http://www.financialexecutives.org/. (FEI members only will be able to access the detailed summary, check out the benefits of FEI membership! And be sure to check out FEI’s Current Financial Reporting Issues (CFRI) conference taking place Nov. 17-18 in New York City at www.financialexecutives.org/cfri, including the special package for conference registration and first year membership in FEI! The Chairman of the SEC, FASB and IASB will be at CFRI – you should be there too! And, check out the FEI Hall of Fame Gala Nov. 17 at www.feihall.org, the 2008 Hall of Fame inductees are Susan Schmidt Bies and John F. Ruffle. And, there's more, check out the workshop sponsored by Deloitte: IFRS: Strategies for Adopting a Single Set of Standards," on Nov. 19 in NYC. All of these programs are described further on FEI's website under Networking Events.