On April 2, 2009, the Financial Accounting Standards Board took action on three proposed FASB Staff Positions relating to accounting for financial instruments held by a reporting enterprise: FSP FAS 157-e, providing guidance as to the determination of the fair value of financial instruments (the "157 FSP"); FSP FAS 115-a, FAS 124-a and EITF 99-20-b, providing guidance as to the recognition and presentation of "other than temporary" impairments in debt securities held by a reporting enterprise (the "OTTI FSP"); and FSP FAS 107-b and APB 28-a, expanding existing annual disclosure requirements about the fair value of financial instruments to also apply to interim financial statements (the "107 FSP"). The 157 FSP and the OTTI FSP were originally proposed March 17, 2009, with a short comment deadline of April 1. The 107 FSP was originally proposed Jan. 30, 2009, with a comment deadline of March 2. On April 2, the Board directed that final versions of the 157 FSP, the OTTI FSP and the 107 FSP as described below be prepared for Board approval by written ballot. As of this writing, such final versions have not been published. However, the FASB did publish a summary of the Board's decisions indicating the changes approved by the Board from the FSP's as originally proposed.
The impact of these FSP's must be assessed against the backdrop of existing accounting literature on this topic, particularly SFAS No. 115 ("Accounting for Certain Investments in Debt and Equity Securities") and SFAS No. 157 ("Fair Value Measurements").
SFAS 115 requires the use of "fair value" accounting for debt securities in some circumstances, but retains the use of the amortized cost method in other circumstances. Under SFAS 115, at acquisition, an enterprise is required to classify debt securities held by it into one of three categories: "held-to-maturity," "available-for-sale," or "trading." At each reporting date, the appropriateness of the classification is to be reassessed.
"Held-to-maturity" securities are those where the reporting enterprise "has the positive intent and ability to hold the securities to maturity." Debt securities are not to be included in this classification if the enterprise has the intent to hold the security for only an indefinite period. Thus, a debt security is not to be so classified if the enterprise anticipates that the security would be available to be sold in response to changes in interest rates, needs for liquidity, changes in the availability of and yield on alternative investments, changes in funding sources and funding terms, or changes in foreign currency risk.
"Trading" securities are bought and held principally for the purpose of selling them in the near term (thus held for only a short period of time). Trading generally reflects active and frequent buying and selling, and trading securities are generally used with the objective of generating profits on short-term differences in price.
"Available-for-sale" securities are those not classified as trading securities or held-to-maturity securities.
SFAS 115 provides that changes in the "fair value" of debt securities held by a reporting enterprise are treated in different ways, depending upon whether the securities are "held-to-maturity," "trading," or "available-for-sale."
For trading securities, unrealized gains or losses (that is, gains or losses prior to any disposition of the securities), representing changes in fair value are included in earnings for each reporting period.
For available-for-sale securities, except for "other than temporary impairments" as discussed below, unrealized gains and losses are not included in earnings, but instead are reported in other comprehensive income (loss) in the reporting enterprise's balance sheet.
For held-to-maturity securities, except for "other than temporary impairments" as discussed below, unrealized gains and losses are not included in earnings and are not reported in other comprehensive income (loss) in the balance sheet. Such securities continue to be held at amortized cost.
For each of these categories, the determination of the amount of unrealized gains or losses for a particular security, which involves comparing the current fair value of the security to its cost basis, requires a determination of fair value. SFAS 157, discussed below, provides guidance as to how fair value should be determined.
As an overlay to the foregoing, SFAS 115 also describes requirements to charge against earnings amounts determined to be "other than temporary impairments" of available-for-sale and held-to-maturity securities. An impairment will exist when the fair value of the asset (determined as described below) is less than its cost basis.
For securities classified as either available-for-sale or held-to-maturity, an enterprise is required to determine whether a decline in value below the cost basis is "other than temporary." (Temporariness of an impairment is not an issue for trading securities, where a charge against earnings is required for any reduction in fair value, temporary or not.) SFAS 115 provides no real guidance as to what factors should be used in determining whether an impairment is temporary or "other than temporary." Guidance on this point has been provided, however, by a Staff Accounting Bulletin issued by the Securities and Exchange Commission (Staff Accounting Bulletin Topic 5M). The SEC staff cited a "few examples" of the factors that, individually or in combination, indicate that a decline in the value of a security is "other than temporary." These are: the length of the time and the extent to which the market value of the security has been less than cost; the financial condition and near-term prospects of the issuer of the security; and the intent and ability of the holder of the security to retain its investment in the security for a period of time sufficient to allow for any anticipated recovery in market value. In context, the SAB seems to indicate that, where the holder does not have the intent and ability to retain its investment for a sufficient time to allow for recovery in value, this strongly argues that the impairment is "other than temporary." However, the converse is not necessarily true; that is, if the other factors are present, the fact that the holder does have such intent and ability will not preclude characterization of the impairment as "other than temporary." Other factors could compel a determination that an impairment is "other than temporary" even though the enterprise's intent and ability to hold indicate that the impairment may at some point be recovered. In other words, "other than temporary" does not mean "permanent."
The determination of unrealized gains and losses, and of impairments, whether temporary or otherwise, is to be based on an assessment of the fair value of the asset. Under SFAS 157, a three-tiered "fair value" hierarchy is established to prioritize the inputs to be used in valuing assets. The objective of the fair value measurement is in all cases to ascertain the price that would be received to sell the asset in an orderly transaction between market participants at the measurement date. In the SFAS 157 scheme, the highest priority is given to quoted prices in active markets for identical assets. These could also include alternative pricing methods such as matrix pricing, a mathematical technique used to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the securities' relationship to other benchmark securities. This is level 1 in the hierarchy.
A lower priority is to be given to inputs, other than level 1 quoted prices, that are also observable in the market for the asset. These inputs would include quoted prices for similar assets in active markets, quoted prices for identical assets in markets that are not active, inputs other than quoted prices that are observable in the market (such as yield curves, volatilities, prepayment speeds, loss severities and default rates), and inputs that are derived from or corroborated by observable market data by correlation or other means. This is level 2 in the hierarchy.
The lowest priority is to be given to inputs such as the reporting entity's own assumptions about the bases that market participants would use in pricing the asset (including assumptions about risk). These are considered unobservable inputs, in the sense that they are not observed in the market. This is level 3 in the hierarchy. Level 3 inputs are to be used to measure fair value to the extent observable inputs are not available, such as where there is little if any market activity for the asset.
The 157 FSP
The 157 FSP, as originally proposed March 17, expanded upon the factors that should be used in ascertaining whether the market for the debt securities to be valued is an "inactive" one. Such factors include a low number of recent transactions, prices not based on current information and that vary substantially, indexes that previously were but no longer are correlated with recent fair values, abnormal liquidity risk premiums and bid-ask spreads, and a lack of publicly available information. As originally proposed, the 157 FSP then provided that if the market is not active, any quoted transaction price in that market would be presumed to be associated with a "distressed transaction," that is, a transaction that is not orderly, unless the reporting entity had evidence that there was sufficient time to allow for usual and customary marketing activities for the asset, and there were multiple bidders for the asset.
Such a presumption could have encouraged reporting entities to establish fair value of financial assets in situations where it could be concluded that the market was inactive, by utilizing internal (non-market) valuation techniques, such as estimating cash flow over time, rather than utilizing actual transaction prices, on the theory that, based on the presumption in the 157 FSP, such transactions were "distressed" and not orderly, and therefore not relevant as valuation inputs.
The FASB issued a summary of the Board decision at its April 2 meeting that states that "significant revisions" were made to the proposed FSP. In particular, the Board determined to eliminate the proposed presumption that transactions in an inactive market are distressed unless proven otherwise. Instead, the 157 FSP will require an entity to base its conclusion about whether a transaction was not orderly on the "weight of the evidence." It is not clear whether this represents any real change from current requirements. In particular, it is not even clear, pending release of the final FSP, whether the determination that a market is inactive will bear any weight at all in determining whether a particular transaction in that market is distressed.
The OTTI FSP
A more substantive change is represented by the OTTI FSP. This FSP does not provide further guidance on how a reporting entity should decide that a financial asset has been impaired in a way that is "other than temporary." Here, previous authority with its ambiguity remains in force. The OTTI FSP does specify a change in recognition and presentation for securities where the reporting enterprise asserts that it does not have the intent to sell the security, and that more likely than not, it will not have to sell the security before recovery of its cost basis, but where nevertheless by operation of other factors the impairment is determined to be "other than temporary." (The FASB has indicated that the final version of the OTTI FSP will discuss in greater detail the interaction of such an assertion with other relevant factors in making a determination as to whether the impairment is "other than temporary.")
In this situation, only part of the impairment of the security (that is, the amount by which the fair value is less than the cost basis) that is determined to be "other than temporary" will be recorded as a charge against earnings. This is the portion of the "other than temporary" impairment that the reporting enterprise determines to be credit related, i.e., related to the credit of the issuer of the security. The remainder of the "other than temporary" impairment, representing the portion that is not credit-related, will be recognized in other comprehensive income (loss) in the balance sheet. This is a substantial difference from the current regime, which requires in this circumstance that the entire "other than temporary" impairment be charged against earnings. From a presentation standpoint, the entire amount of the "other than temporary" impairment would appear as a line item in the income statement, followed by an offset indicating the amount of such impairment that is not credit-related, so that only the net number, representing the credit-related portion, would operate as a reduction of earnings.
This new required treatment is applicable to both available-for-sale and held-to-maturity securities, where the required management assertion can be made. The OTTI FSP does not change the current requirements with respect to unrealized losses that do not constitute "other than temporary" impairments. For available-for-sale securities, these will continue to be recorded as a change in other comprehensive income (loss) in the balance sheet. For held-to-maturity securities, these will continue to be unrecorded in the financial statements.
The 107 FSP
The 107 FSP, which has generated less controversy than the 157 FSP and the OTTI FSP, expands on existing disclosure requirements in SFAS 107. Under SFAS 107, reporting enterprises are currently required to include, in annual financial statements, a disclosure either in the body of the financial statements or in the accompanying notes, of the fair value of financial instruments for which it is practicable to estimate that value. The 157 FSP expands that requirement to also apply to interim financial statements.
The 157 FSP, the OTTI FSP and the 107 FSP are to be effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009 (which would include the first quarter of 2009 for calendar year companies). However, an entity early adopting the 157 FSP must also early adopt the OTTI FSP, and vice versa. That is, both must be early adopted or neither. The entity may early adopt both the 157 FSP and the OTTI FSP without early adopting the 107 FSP. However, if the entity does elect to early adopt the 107 FSP, it must also early adopt both the 157 FSP and the OTTI FSP.