In accordance with the requirements of the Emergency Economic Stabilization Act of 2008 (the “Act”), the Office of the Chief Accountant and the Division of Corporate Finance of the Securities and Exchange Commission (the “SEC”) recently reported to Congress (the “Report”) the SEC’s recommendation that fair value accounting standards be left in place.
The 200+ page Report also recommends certain improvements to existing practices, including the development of additional guidance (particularly with respect to determining fair value of investments in inactive markets), enhanced disclosure requirements and reassessment of existing impairment models. Among the key findings noted in the Report are investors’ general belief that fair value accounting increases financial reporting transparency and facilitates better investment decision-making, and a conclusion that fair value accounting did not appear to play a meaningful role in the bank failures that occurred in 2008.
The Report, reflecting the results of the SEC’s study (the “Study”) on mark-to-market accounting standards set forth in the Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“FAS 157”), as applicable to financial institutions, addresses the following six issues mandated by the Act:
- the effects of fair value accounting standards on financial institutions’ balance sheets;
- the impact of such accounting on bank failures in 2008;
- the impact of such standards on the quality of financial information available to investors;
- the process used by the FASB in developing accounting standards;
- alternatives to fair value accounting standards; and
- the advisability and feasibility of modifications to fair value accounting standards.
In addition, although not mandated by the Act, the Study also looked at the larger financial crisis that led to the distress of financial institutions other than banks, including The Bear Stearns Companies, Inc., Lehman Brothers Holdings Inc. and Merrill Lynch & Co., Inc. The Report concludes that the current financial crisis resulted from a “run on the bank” at certain institutions, with counterparties reducing or eliminating the various credit and other risk exposures they had to each firm. The Report also concludes that the crisis resulted in part from the massive de-leveraging of balance sheets by market participants and a reduced appetite for risk as margin calls increased, putting pressure on asset prices and creating a self-perpetuating, downward spiral.
The Study was based on empirical analysis of data from a cross-section of financial institutions, as well as input from a cross-section of market participants through a public comment letter process and a series of public roundtables and research of various public records. Based on the Study, the Report makes the following eight recommendations:
1. FAS 157 Should be Improved, but Not Suspended. The Report concludes that suspension of FAS 157 is not advisable. The Report notes that FAS 157 does not establish any requirements to account for assets or liabilities at fair value but simply establishes a common definition of the term fair value for financial reporting and provides for expanded disclosures in cases where preexisting standards require (or permit) the use of fair value. The Report states that without FAS 157, issuers would return to practices that existed prior to the issuance of the standard, which were based on varying definitions of fair value and relied upon limited or conflicting guidance for applying those definitions. The Report goes on to say that suspending FAS 157 would reduce the comparability and consistency of fair value measurements currently being performed and therefore hinder investors’ ability to obtain useful information on a consistent basis from financial statements. However, the Report does indicate that further improvements to the existing application of fair value are necessary. The improvements suggested by the Report are discussed below.
2. Existing Fair Value and Mark-to- Market Requirements Should Not be Suspended. The Report concludes that the suspension or elimination of existing fair value and mark-to-market accounting requirements is not advisable. The Report points out that existing fair value and mark-to-market accounting requirements were developed over several decades, in some cases specifically to address perceived weaknesses previously identified, and were subject to extensive due process. The Report states that investors generally have found existing fair value accounting standards, particularly as they relate to financial instruments, to have increased the quality of information available to them, providing more relevant information and reflecting current economic reality that should not be replaced by other alternative accounting measures. The Report also indicates that the abrupt elimination of fair value and mark-to-market requirements would erode investor confidence in financial reporting, noting that many investors indicated that investor confidence is reinforced by providing transparency relating to the underlying asset value of their investments.
In addition, the Report highlights that existing accounting standards generally require mark-to-market accounting only for certain derivatives and investments that financial institutions hold for “trading” purposes and therefore it is often required for only a minority of investments. The Report goes on to say that the SEC’s analysis of bank failures indicates 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 thereof did not have a significant effect on the banks’ capital and, in each case, it does not appear that the application of fair value can be considered to have been a proximate cause of the failure. Rather, the Report indicates that bank failures in the U.S. appeared to be the result of growing probable credit losses, concerns about asset quality and, in certain cases, eroding lender and investor confidence.
As a result, the Report recommends against suspending or eliminating existing fair value and mark-to-market requirements but does note that investors have indicated a need to consider improvements to existing practice, including reconsideration of impairment standards and the application of FAS 157 to illiquid investments. The Report also notes that investors have acknowledged the need for additional measures related to assisting in the understanding of the impact of fair value through presentation and disclosure requirements.
3. Additional Measures Should be Taken to Improve the Application of Existing Fair Value Requirements. The Report suggests a number of improvements to the application and practice related to existing fair value requirements (particularly as they relate to both Level 2 and Level 3 estimates1) including:
- considering the need for additional application guidance or best practices for determining fair value in illiquid or inactive markets;
- enhancing existing disclosure and presentation requirements related to the effect of fair value in the financial statements;
- educational efforts, including efforts to improve the application, where appropriate, of reasonable judgment and analysis in the determination of fair value estimates;
- 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; and
- 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, including whether sufficient transparency is provided currently in practice.
The Report also states that additional assistance in the form of guidance, education and training is warranted in several areas, including further tools to make judgments regarding how to determine when markets become inactive; how to determine if a transaction or group of transactions is forced or distressed; how and when illiquidity should be considered in the valuation of an asset or liability; how the impact of a change in credit risk on the value of an asset or liability should be estimated; when observable market information should be supplemented with and/or reliance placed on unobservable information in the form of management estimates; and how to confirm that assumptions utilized are those that would be used by market participants and not just by a specific entity. In addition, the Report recommends that the FASB continue efforts to address fair value measurement issues related to valuation of liabilities and indicates that the current guidance has the potential to result in confusion in the marketplace.
The Report recommends that the FASB consider which of the above issues could be resolved through a review of the objectives of FAS 157 and which issues would be best addressed by the valuation community, noting that the FASB’s Valuation Resource Group (“VRG”) and the Expert Advisory Panel of the International Accounting Standards Board (“IASB”) have already discussed many of these issues and may be best equipped to recommend immediate guidance. The Report also recommends that the FASB consider working with valuation and appraisal associations and organizations to develop additional valuation guidance and best practice documents and consider whether changes to how the FASB uses the VRG (including potentially expanding its role to function more like the FASB’s Emergency Issues Task Force, the use of subcommittees for specific issues, and increasing the openness of the process through public meetings) would be beneficial in fostering a common understanding in practice of the issues considered by the VRG.
4. The Accounting for Financial Asset Impairments Should be Readdressed. The Report recommends that the FASB reassess current impairment accounting models for financial instruments, including considering the narrowing of the number of models that currently exist in U.S. GAAP; considering increasing the prominence of Other Comprehensive Income (OCI) by requiring a separate statement or presentation on the face of the income statement; reconsidering preclusion of reporting future increases in value after recording an impairment and prior to a security being sold; and evaluating the need for modifications (or the elimination) of current Otherthan- Temporary Impairment (OTTI) guidance to provide for a more uniform system of impairment testing standards for financial instruments. In addition, the Report states that the utility and consistency of information provided to investors should be improved, including the implementation of measures to provide investors with insight into management’s expectations of probable cash flow declines. The Report notes that the accounting for impairment was identified as one of the most significant areas of necessary improvement during the course of the Study.
5. Implement Further Guidance to Foster the Use of Sound Judgment. The Report recommends that the SEC and the Public Company Accounting Oversight Board (“PCAOB”) consider whether statements of policy related to the application of judgment in making fair value measurements would be appropriate. The Report indicates that the use of judgment in accounting, auditing and regulation has increased due to the focus on more objectives-based standards (such as FAS 157) and increased use of fair value estimates, and that guidance regarding the application of judgment in connection with fair value measurements should similarly keep pace. The Report notes that the SEC Advisory Committee on Improvements to Financial Reporting (“CIFiR”) previously recommended that the SEC issue a statement of policy articulating how it evaluates the reasonableness of accounting judgments (including the factors that it considers when making the evaluation) and that this recommendation included a suggestion that the PCAOB should also adopt a similar approach with respect to auditing judgments.
6. Accounting Standards Should Continue to be Established to Meet the Needs of Investors. The Report recommends that U.S. GAAP should continue to be developed to meet the needs of investors. The Report notes that while financial reports using U.S. GAAP are valuable tools considered by other users of information and may serve as the starting point for such other users (such as prudential regulators), U.S. GAAP should not be established or modified to serve the needs of others at the expense of investors. The Report further indicates that, to the extent that the interaction of fair value accounting and regulatory capital requirements has resulted in concerns about pro-cyclicality (including whether accounting standards are resulting in the sale of assets or the need to raise capital in down markets), 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 Report 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 implementing CIFiR’s recommendation for a financial reporting forum, including key constituents from the preparer, auditor, and investor and other user communities, to meet with representatives of the SEC, the FASB and the PCAOB to discuss issues in the financial reporting system; implementation by the FASB of a post-adoption review process; and establishment of a formal policy for standard-setting in circumstances that necessitate near-immediate response. The Report notes that CIFiR has identified enhancements that, if adopted, could result in improvements to the FASB standard-setting process and the Report highlights the need for further consideration of measures to strengthen communications between market participants dealing with financial reporting matters.
8. Address the Need to Simplify the Accounting for Investments in Financial Assets. The Report recommends the continued joint work by the FASB and the IASB to simplify the accounting for investments in financial instruments. The Report notes that a common theme at the SEC roundtables and in comment letters is that the accounting for financial instruments can be challenging and that current financial reporting standards for such investments are complex. The Report also notes that investors have said that understanding the resulting financial reports also can be difficult. Accordingly, the Report concludes that the FASB and the IASB should work to simplify the accounting for investments in financial instruments, including the continued exploration of the feasibility of reporting all financial instruments at fair value. However, the Report also notes that significant obstacles continue to exist related to such a move, including concerns about the degree of relevance and reliability, and concerns about how changes in fair value should be recognized in the income statement, and that the FASB and the IASB should expedite their ongoing efforts and projects around financial statement presentation and disclosure in order to address such challenges.
The entire text of the Report may be found at www.sec.gov/news/studies/2008/marktomarket123008.pdf.