In recent months, mark-to-market accounting rules have come under increasing criticism for having contributed to the current credit crisis. Under U.S. GAAP, mark-to-market – the act of assigning a value to a financial instrument based on a current market price for that (or similar) instrument – is governed by Statement of Financial Accounting Standards No. 157 (fair value measurements) (“SFAS 157”) issued by the Financial Accounting Standards Board (“FASB”), which is now a focus of significant attention by chief financial officers, lawmakers and regulators.
SFAS 157 defines fair value, establishes a framework for measuring fair value under U.S. GAAP and expands disclosures about fair value measurements. The fair value definition focuses on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction. The statement classifies the inputs used to measure fair value into three hierarchies.
Even though the markets have already witnessed significant write-downs (beginning in the third quarter of last year), concern remains that further distressed sales of assets will lead to another round of write-downs by market participants. In response to general concerns, lawmakers and regulators have recently taken the following actions, among others:
- In the Emergency Economic Stabilization Act as approved by the Senate last night, the SEC is to be given the authority to suspend the application of SFAS 157 and is directed to study the mark-to-market accounting standards and report its findings to Congress.
- On September 30, 60 members of Congress urged SEC Chairman Cox to suspend the use of mark-to-market accounting and replace it with a form of “mark-to-value” approach.
- Also on September 30, the Office of the Chief Accountant of the SEC and the FASB Staff issued a joint release (the “Joint Release”) to clarify certain aspects of fair value accounting. (The SEC did not suspend the mark-to-market requirements). The clarifications are intended to give companies more flexibility when it comes to accounting for certain assets and, in particular, to allow valuations to be based on expectations rather than actual trades that may be occurring concurrently in the market.
- At its October 1 meeting, the FASB voted to issue, on an expedited basis, proposed guidance on the application of SFAS 157. The guidance, which would be in the form of an FASB staff position (“FSP”), is expected to be consistent with, but to expand on, the Joint Release. The FSP would include a specific example applying the principles of SFAS 157 in an inactive market. The FSP is likely to have a seven-day comment period, and to be voted upon on October 10.
The Joint Release addresses what the Chief Accountant and the FASB Staff view as the most urgent mark-to-market questions in the current environment, namely:
- Can management’s internal assumptions (e.g., expected cash flows) be used to measure fair value when relevant market evidence does not exist?
- How should the use of “market” quotes (e.g., broker quotes or information from a pricing service) be considered when assessing the mix of information available to measure fair value?
- Are transactions that are determined to be disorderly representative of fair value? When is a distressed (disorderly) sale indicative of fair value?
- Can transactions in an inactive market affect fair value measurements?
- What factors should be considered in determining whether an investment is other-than-temporarily impaired?
he Joint Release clarifies that:
- when an active market for a security does not exist, management can use estimates that incorporate projections of future cash flows and include appropriate risk premiums;
- broker’s quotes can be used when measuring fair value, but are not necessarily determinative if an active market does not exist for the security (brokers may be using models with inputs based on information available only to it, and not market transactions);
- distressed or forced sales (described as “disorderly transactions”) are not determinative when measuring fair value; similarly, transactions in inactive markets (potentially determinable based on increased bid/asked spreads or relatively few bidding parties) may serve as inputs but would likely not be determinative; and
- whether a market is active, and whether a particular transaction is forced or disorderly, requires the exercise of “judgment.”
The Joint Release reminds registrants that clear and transparent disclosures are critical to providing investors with an understanding of the judgments made by management under SFAS 157, and makes reference to the two letters posted by the SEC’s Division of Corporation Finance in March and September of this year providing guidance on fair value measurement disclosure in MD&As.