In response to the turmoil in the credit markets and suggestions that fair value accounting rules have been a contributing factor to the current financial crisis, on September 30, 2008, the Securities and Exchange Commission (the “SEC”) and the Financial Accounting Standards Board (the “FASB”) jointly issued guidance on determining the fair value of securities under Statement of Accounting Financial Standards No. 157 (“SFAS No. 157”).
The guidance points out that determining fair value in the “current environment” is “particularly challenging for preparers, auditors, and users of financial information.” In light of this current “credit crisis,” the SEC Office of Chief Accountant and FASB Staff felt the need to issue “immediate additional guidance” in the form of “immediate clarifications” to SFAS No. 157. The substance of those clarifications, soon to be followed by additional “interpretative guidance” later this week, generally is to reduce the weight given to anecdotal transactions and to place increased reliance on non-empirical and judgmental factors in determining fair value.
The complete SEC/FASB release can be found at: http://www.sec.gov/news/press/2008/2008-234.htm.
1. Fair Valuation in Inactive Markets
The guidance focuses principally upon the sources of information, and the relative weight that should be given to such information, that provide evidence of fair value during periods of market illiquidity. As an initial matter, “[t]he determination of whether a market is active or not requires judgment.” The guidance explains that factors relevant to this determination may include significant increases in the spread between asking and bidding prices, and a relatively small number of bidding parties.
When a market for a particular security is inactive, the guidance explains that other multiple inputs from various sources may be used to determine fair value. For example, when a market is inactive, it may be appropriate for management to use internal models which incorporate anticipated cash flows and risk premiums to obtain a better estimate of fair value. And in some instances, using unobservable inputs may be more appropriate than using observable inputs.
With respect to market or broker quotes, the guidance states that such quotes are not necessarily determinative in inactive markets. Accordingly, entities should place less reliance on quotes that do not reflect actual transactions, and should also consider whether the quote is an indicative price or a binding offer.
2. The Effect of Disorderly Transactions
The guidance further clarifies that, because fair value assumes orderly transactions, the prices of securities resulting from disorderly transactions are not necessarily determinative of fair value. Where an entity determines in its judgment that disorderly transactions are occurring, such as in distressed or forced liquidation sales, that entity should consider the circumstances of the transactions when weighing available inputs.
3. Determination of Other-Than-Temporary Impairment
Finally, the guidance addresses, in the case of operating companies, the determination of whether losses on investments should be considered long-term for accounting purposes. An investment that is valued at less than its cost is considered impaired, and such impairment can be either temporary or other-than-temporary. The guidance states that, without any bright line tests or safe harbors, determining whether an impairment is other-than-temporary requires the exercise of reasonable judgment, and the balancing of several factors. These factors include: the nature of the underlying investment, such as the financial health of the issuer; the investment’s decline in value; the probability of recovery; the period of time until anticipated recovery; the length of time over which the value has been declining; and the ability of the holder to retain its investment until the anticipated recovery. As value continues to decline and recovery becomes more remote, the level of evidence required to overcome the conclusion of other-than-temporary status increases.
In light of the political and economic uncertainties surrounding this issue, it remains to be seen what further formal guidance will be forthcoming and whether regulators will continue to provide informal guidance on how to handle fair value issues.