A Big Problem for Fair Value Accounting: Defining What's Fair—and When
Taken from: Accounting & Compliance Alert, Volume 2, No. 19
Date: Tuesday, January 29, 2008
Summary: The perfect storm that hit the credit
markets just as the financial services industry
was getting used to the new fair value rules has
given auditors plenty to think about, including
the degree of subjectivity that goes into making
fair value judgements, and whether observable
market prices means seeing is believing.
Securities and Exchange Commission officials
have become alarmed in recent weeks about what
they have deemed to be bad-faith applications of
fair value accounting rules, which they suspect
some banks of employing in order to avoid taking
the full brunt of the massive collapse in the
credit markets.
"The adoption wasn’t really substantive," said
Stephanie Hunsaker, Associate Chief Accountant
in the SEC's Corporation Finance Division, in
reference to the to disclosures reported by some
financial firms that had been early adopters of
the Financial Accounting Standards Board’s
Statement of Financial Accounting Standards
(SFAS) No. 159, The Fair Value Option for
Financial Assets and Financial
Liabilities—Including an amendment of FASB
Statement No. 115. "The principle seemed to be
avoiding reporting losses."
Hunsaker made her comments during a speech at
the SEC/FASB Conference of the New York State
Society of Certified Public Accountants on
January 23, 2008.
The problem may not be limited to be improper
application of SFAS No. 159 or the related SFAS
No. 157, Fair Value Measurements, at the end of
the valuation process.
"What we're now asking is whether the
transactions occurred at the right prices, and
if they didn't, what does that say about
tomorrow’s prices," says Ashwinpaul Sondhi, who
runs a financial advisory firm in Maplewood, New
Jersey, and is a member of the FASB's Emerging
Issues Task Force (EITF).
Backtracking now and trying to determine a value
for a deal based on a flawed assumption at the
outset would then be doubly hard. For auditors,
compliance officers, risk managers, valuation
consultants, and everyone else involved in the
business of valuing financial instruments, the
challenge is compounded by the degree of
subjectivity that goes into even good faith
attempts to properly value these instruments.
"The problem is, securitization is a much more
complicated issue than people realized, and I
don’t think we ever got our accounting right
with it," Sondhi says. "What is coming back to
the market now, is that the balance sheets did
not fairly reflect the value of the risks the
issuers retained."
"People tend to confuse the reliability of a
measure vs. the likelihood that this measure
will be precise for a reasonable amount of time
beyond the period for which it was reported,"
says Neri Bukspan, Chief Accountant for Standard
& Poor's in New York. "Even if you measure the
instruments precisely, and there is no argument
on the measurement basis, the value can change."
The problem may not matter all that much when
markets are calm. But the curtain is being
raised on the fair value rules at a time when
the market is anything but.
"The illiquidity has caused a rise in those
instruments that are valued at Level 3," says
Dina Maher, Senior Director in the Credit Policy
Group at Fitch Ratings Inc. "That will continue
to be a characteristic of the market until the
market starts correcting itself." Some of the
cause for that trend may simply be the pervasive
illiquidity now plaguing corners of the debt
market that were reasonably active until the
second quarter of 2007. Instruments that had
observable market inputs and could thus be
placed in the Level 2 bucket had to be shifted
to Level 3 as trading and observable market
prices disappeared.
Under SFAS No. 157, Level 3 instruments are
those for which the values are derived from
models where at least one of the variables is
not from an observable market. Level 2
instruments are those valued based upon quoted
prices for similar assets or liabilities, prices
from markets that are not active, or models
based upon active markets. Level 1 instruments
use quoted prices from active markets.
The increase in the proportion of instruments
assigned to the Level 3 bucket inevitably means
that there's a much greater degree of
subjectivity in valuing all instruments.
Even to the extent that market participants and
their auditors may be relying upon widely
accepted market indicators, it's not clear that
the indicators themselves are without flaw or
being applied properly. For example, Fitch
issued a report on January 24, 2008, that said
that the ABX indices, which are compiled by
Markit Group of London and New York, are used by
many investment banks and asset managers as
proxies for observable market inputs. But the
wide variety in the underlying securities for
each individual ABX index may make them less
than reliable measures of the holdings in a
given bank's portfolio.
"We don’t think the problem is with the index
itself," Maher says. The report notes that the
indices in Markit’s .HE series track the $1
trillion home equity market, but that no
individual index tracks more than $20 billion in
securities. Some of the people using one of the
indices then may not have properly allowed for
the differences in their portfolios and the
index's makeup.
In Maher's view, market participants still
haven't determined whether existing benchmarks
need to be improved, more training or
supervision is needed for the traders and
valuation consultants who use the indices, or if
the benchmarks need to be replaced.
For its part, Markit has little to say on the
matter.
"We don't follow how institutions use the ABX.HE
internally," wrote Ben Logan, a Managing
Director in Markit's New York office, in
response to an e-mail question. "That’s really
an internal decision."
S+P's Bukspan is not in a position to comment
specifically on the use of the Markit indices,
although he notes that, "The auditor's role is
to shy away from references that are
inappropriate" if the external market inputs
don't closely match the instruments held by an
entity.
Still, financial managers and auditors seem
destined to struggle in applying the fair value
rules.
Sondhi says it's up to the standards setters to
use the lessons from the recent experiences as
they draft new guidance on fair value
accounting.
"You cannot write a bank capital rule or an
accounting standard which can take into account
what is going to happen tomorrow," he says.
"It’s not going to happen. You can't write a
700-page rule that captures everything. People
are going to say, 'OK. They caught this one. I’m
going to try this other approach instead.'"
In the end, the only choice for statement
preparers and issuers may be to get used to the
rules as they've been written, and a world that
isn't going to become less complicated any time
soon.
"Look at SFAS No. 133," Accounting for
Derivative Instruments and Hedging Activities,
says George Victor, a Partner in the New York
auditing firm Partner Holtz Rubinstein Reminick.
The standard was issued in June 1998, and
despite nearly a decade of experience with the
rule, financial institutions still struggle with
applying it.
"It could be a similar thing with SFAS No. 157,"
says Victor, who chairs the Accounting &
Auditing Oversight Committee for the New York
State Society of Certified Public Accountants.
"There is so much judgment here; so there is
always going to be some variation either within
industries or from one industry to the next."
Joseph Radigan
Senior News Bureau Editor/Reporter
Accounting & Compliance Alert
Tuesday, January 29, 2008, Volume 2, No. 19
ISSN 1935-9721
Thomson Tax & Accounting - Research & Guidance
395 Hudson Street, 4th Fl.
New York, NY 10014
Tel: (212) 807 - 2908
Fax: (212) 367 - 6314
Email: joseph.radigan@thomson.com
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