On December 30, 2008, the Securities and Exchange Commission (the “SEC”) delivered its report to Congress as mandated by the Emergency Economic Stabilization Act of 2008 (“EESA”). The EESA required the SEC to conduct, in consultation with the Federal Reserve and the Secretary of the Treasury, a study on mark-to-market accounting standards as set forth in Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS No. 157”) issued by the Financial Accounting Standards Board (the “FASB”). Most significantly, the report, which was prepared by the staffs of the SEC’s Office of the Chief Accountant and of the Division of Corporation Finance (collectively, the “Staff”), recommends against suspension of fair value accounting, but sets forth eight sets of recommendations for improvement of fair value accounting. Prominent among them is the recommendation that the models for accounting for impairments be re-assessed.  

Context for the Report

The report was intended to address an ongoing policy debate surrounding the efficacy of fair value accounting. On one side of the debate are those who view fair value accounting, along with the accompanying guidance under SFAS No. 157, as contributing to instability in the financial markets by requiring potentially inappropriate write-downs in the value of investments held by financial institutions, most notably due to concerns that such write-downs were the result of inactive, illiquid or irrational markets that resulted in values that did not reflect the underlying economics of the securities. Proponents of this view highlight that the correlation between U.S. generally accepted accounting principles (“U.S. GAAP”) reporting and the regulatory capital requirements of financial institutions could lead to the failure of long-standing financial institutions if sufficient additional capital is unavailable to offset investment write-downs. Further, they believe the need to raise additional capital, the effect of failures, and the reporting of large write-downs will have broader negative impact on markets and prices, leading to further write-downs and financial instability.  

On the other side of the debate are those who believe that fair value accounting serves to enhance the transparency of financial information provided to the public, and that elimination of such information would weaken investor confidence and result in further instability in the markets. These market participants consider poor lending decisions and inadequate risk management, combined with shortcomings in the current approach to supervision and regulation, rather than accounting, as the prominent causes of the financial crisis. Although they concede the importance of the correlation between U.S. GAAP reporting and the regulatory capital requirements of financial institutions, they believe that adjustments to the calculation of regulatory capital (like the adjustments currently in place for available-for-sale (“AFS”) securities) can reduce this correlation where appropriate.  

Focus of the Report

As mandated under the EESA, the report addresses six key issues related to fair value accounting (which the Staff studied on the basis of empirical analysis, research of public records, analysis of public comment letters and three public roundtables on the subject) and contains eight sets of recommendations. Because SFAS No. 157 does not itself require mark-to-market or fair value accounting, the Staff, in order to ensure that the report was responsive to the policy debate discussed above, considered the issue of fair value accounting to include both mark-to-market accounting and SFAS No. 157. The Staff interprets “mark-to-market accounting standards” as accounting standards under U.S. GAAP that define fair value and/or require or permit fair value measurement in the financial statements with changes reported in the income statement.1  

Accounting standards generally have required measurement of financial instruments on a financial institution’s balance sheet at fair value. In some cases, for example when securities are actively traded, changes in fair value are required to be recognized in the income statement. This is what is meant when reference is made to “mark-to-market” accounting. However, in most other cases, such changes in fair value are generally reported in other comprehensive income (“OCI”) or equity, and these changes do not flow through the income statement unless there is an impairment.  

Issues Addressed in the Report

The six key issues addressed in the report are:  

1. Effects of fair value accounting standards on financial institutions’ balance sheets. The Staff observed that fair value measurements were used to measure a minority of assets and liabilities included in financial institutions’ balance sheets and that the percentage of assets for which changes in fair value impacted income was also low, reflecting the mark-to-market requirements for trading and derivative instruments. However, fair value measurements did significantly affect financial institutions’ reported income when applied.

2. Impact of fair value accounting on bank failures in 2008. The Staff observed that fair value accounting did not appear to play a meaningful role in bank failures occurring during 2008. Rather, bank failures in the United States appeared to be the result of growing probable credit losses, concerns about asset quality and, in certain cases, eroding lender and investor confidence.  

3. Impact of fair value accounting on the quality of financial information available to investors. The Staff observed that investors generally believe that fair value measurements provide the most transparent financial reporting of an investment and facilitate better investment decision-making and capital allocation, but concluded that there was strong support for improvement in the application of existing standards. Areas for improvement include impairment requirements, application in practice of SFAS No. 157 (particularly in times of financial stress), fair value measurement of liabilities, and related presentation and disclosure requirements of fair value measures.  

4. Process used by the FASB in developing accounting standards. The Staff’s analysis of the FASB’s processes used to develop accounting standards reaffirms its belief that an independent accounting standard-setter is best positioned to develop neutral and unbiased accounting guidance, though enhanced timeliness and transparency issues should be addressed.  

5. Alternatives to fair value accounting standards. The Staff observed that suspension of fair value accounting in favor of historical cost-based measures would likely increase investor uncertainty, but that actions to improve the application and understanding of fair value requirements are required, including re-addressing accounting for impairments. The Staff noted that there are multiple different models for recording impairments for investments in securities. Additionally, existing impairment guidelines for securities are not consistent with the reporting guidelines for impairment charges for other non-securitized investments (for example, direct investments in loans). As a result, according to the Staff, investors receive information that is not recognized, calculated or reported on a comparable basis. Moreover, the information provided is not sufficient to enable a reader to fully assess whether declines in value are related to changes in liquidity or to probable credit losses. In addition, subsequent increases in value generally are not reflected in the income statement until the security is sold.  

6. Advisability and feasibility of modifications to fair value accounting standards. The Staff summarized steps taken, and underway, to improve current accounting requirements, and also provided certain recommendations on the advisability and feasibility of modifications to existing accounting standards.  

The Recommendations

We discuss below the recommendations and the related findings of the Staff on the basis of their observations relating to the six issues discussed above.  

1. SFAS No. 157 should be improved, but not suspended. Rather than establishing a requirement to account for assets or liabilities at fair value, SFAS No. 157 provides a common definition of fair value for financial reporting and a common framework for its application. Accordingly, the Staff concluded that suspending SFAS No. 157 would increase inconsistencies by removing standardized measurement and disclosure requirements without removing the requirement (or choice) to account for assets or liabilities at fair value. Further, the Staff believes that suspending SFAS No. 157 would in effect hinder the ability of investors to obtain decision-useful comparable information on a consistent basis from financial statements.  

2. Existing fair value and mark-to-market requirements should not be suspended. The Staff believes that the abrupt elimination of existing fair value and mark-to-market accounting requirements, which were developed over several decades, would erode investor confidence in financial reporting. Furthermore, the Staff’s analysis of bank failures indicated that for substantially all failed banks studied, fair value accounting was applied to only a small minority of assets, and losses recorded as a result of applying fair value accounting did not have a significant impact on the capital of the affected banks. It did not appear to the Staff that the application of fair value accounting could be considered to have been a proximate cause of the bank failures.  

Existing accounting standards generally require mark-to-market accounting only for certain derivatives and investments that financial institutions hold for “trading” purposes (i.e. those assets where management has indicated an intent to actively trade assets), which for many financial institutions represent only a minority of total investments.  

The Staff also found that over 90% of investments that are marked-to-market are valued based on observable inputs, such as market quotes obtained from active markets, and that investors generally feel that fair value accounting provides meaningful and transparent financial information, though certain improvements are desirable.  

3. Additional measures should be taken to improve the application of existing fair value requirements. The Staff recommends that measures should be taken to improve the application and practice related to existing fair value requirements (particularly for Level 2 and Level 3 (unobservable) inputs), including, among others, the following:  

(a) consideration of the need for additional application guidance or best practices for determining fair value in illiquid or inactive markets;  

(b) enhancement of existing disclosure and presentation requirements related to the effect of fair value in the financial statements;  

(c) educational efforts, including efforts to improve the application, where appropriate, of management’s reasonable judgment and analysis in the determination of fair value estimates;  

(d) examination by the FASB of the impact of liquidity in the measurement of fair value, including whether additional application and/or disclosure guidance is warranted;  

(e) assessment by the FASB of whether the incorporation of a company’s own credit risk in the measurement of liabilities provides decision-useful information to investors, and if sufficient transparency is currently provided; and  

(f) continuation by the FASB of efforts to address fair value measurement issues related to the valuation of liabilities (such as through Proposed FASB Staff Position FAS 157-c).2  

The Staff also believes that additional assistance in the form of guidance, education and training is warranted in several areas. These include further tools to make judgments relating to (i) determining when markets become inactive; (ii) determining if a transaction or group of transactions is forced or distressed; (iii) how and when illiquidity should be considered in the valuation of an asset or liability; (iv) how to estimate the impact of a change in credit risk on the value of an asset or liability; (v) when to supplement observable market information with, and/or rely on, unobservable information in the form of management estimates; and (vi) how to confirm that assumptions utilized are those that would be used by market participants and not just by a specific entity.  

4. The accounting for financial asset impairments should be re-addressed. The Staff recommends that the FASB re-assess current impairment accounting models for financial instruments, including considering narrowing the number of models that currently exist under U.S. GAAP, as U.S. GAAP does not currently provide a uniform model for assessing impairments.  

More specifically, the Staff recommends that the FASB evaluate the need for modifications (or the elimination) of other-than-temporary-impairment (“OTTI”) guidance to provide for a more uniform system of impairment testing standards for financial instruments. The Staff believes, for example, that a model that would require recognizing impairments through income related only to credit losses (calculated based on incurred loss consistent with loan impairments), while the remaining decline in fair value of an investment (the portion that is not related to incurred losses) would be recognized in OCI has the potential to bridge the gap between the current fair value and the value expected from holding investment positions until markets return to normal liquidity levels. However, it also recommends that other models, including the elimination of OTTI in favor of more prominent reporting of impairments in OCI, be evaluated. The Staff also recommends that the FASB consider whether the “ability and intent to hold to recovery” test under SFAS No. 115 is sufficiently operational, including whether the operation of the model in practice is consistent with the notion of an AFS security.  

The Staff also recommends that the FASB consider increasing the prominence of OCI by requiring a separate statement or presentation on the face of the income statement.  

5. Implement further guidance to foster the use of sound judgment. The Staff recommends that the SEC and the Public Company Accounting Oversight Board (the “PCAOB”) consider whether additional guidance and/or statements of policy related to the application of judgment in making fair value measurements would be appropriate.  

6. Accounting standards should continue to be established to meet the needs of investors. The Staff recommends that the primary purpose of U.S. GAAP should continue to be the satisfaction of the needs of investors and not of other users of financial reporting, particularly in situations where the other users of financial information have the ability to dictate the form and content of such information. The Staff did not consider the appropriate form and content of information provided to other users, for example, prudential regulators.  

The Staff also recommends that, to the extent that the interaction of fair value accounting and regulatory capital requirements has resulted in concerns about procyclicality (including resulting in the sale of assets or the need to raise capital), such concerns should not be addressed through changes in accounting standards that would reduce investor confidence.  

7. Additional formal measures to address the operation of existing accounting standards in practice should be established. The Staff recommends that additional formal measures should be adopted to facilitate the identification and resolution of issues encountered in the application of existing accounting standards in practice, including the following:  

(a) implementing the recommendation of the SEC Advisory Committee on Improvements to Financial Reporting for the creation of a financial reporting forum that includes key constituents from the preparer, auditor, and investor and other user communities, to meet with representatives from the SEC, the FASB and the PCAOB to discuss issues in the financial reporting system overall;  

(b) implementation by the FASB of a process of post-adoption review of major standards in order to identify unintended consequences or other practice issues; and  

(c) establishment of a formal policy for standard-setting in circumstances that necessitate near-immediate response.  

8. Address the need to simplify the accounting for investments in financial assets. The Staff believes that it is advisable for the FASB and the International Accounting Standards Board (the “IASB”) to work to simplify accounting for investments in financial instruments, including the continued exploration of the feasibility of reporting all financial instruments at fair value. However, since there are significant obstacles related to such a move, including concerns about the degree of relevance and reliability, and how changes in fair value should be recognized in the income statement, particularly during times when the value of securities is impacted significantly by declines in liquidity, the Staff believes that it is advisable to further address potential obstacles prior to any significant expansion to mandate the use of mark-to-market accounting for assets other than trading assets and derivatives.

The Staff recommends that in order to address these challenges, the FASB and the IASB expedite their efforts around financial statement presentation and disclosure, particularly their joint project on the presentation of financial statements scheduled to be completed by 2011, with the joint project serving to clarify for investors where, and how, fair value impacts a company’s financial condition and its operating performance by distinguishing it from other components of income.  

The Staff expects that the FASB and the IASB will work closely with the Staff to explore the complete integration of interactive data as a tool to bridge the gap between historical cost measures and fair value. Further, the Staff believes that sensitivity disclosures of fair value estimates – as well as appropriate supplemental measures that management could elect to provide, for example, held-to-maturity valuations of certain debt instruments – could assist investors in making more informed decisions about capital allocation. Accordingly, the Staff expects that the FASB and IASB will work closely with the Staff to explore the complete integration of interactive data with respect to these disclosures.  

Lastly, the Staff recommends that the FASB and the IASB complete the measurement phase of the conceptual framework project in order to inform future decisions about appropriate measurement attributes in accounting standards.