Friday, November 14, 2008

SEC Urged Not to Suspend Fair Value Accounting; but Rather Use MD&A to Help Investors Understand FAS 157 in Illiquid Markets

In a letter to the SEC giving input on the Commission’s study of mark-to-market accounting mandated by the Emergency Economic Stabilization Act, the Center for Audit Quality said that the current use of fair value measurements for financial instruments under FASB Standard No. 157 is appropriate and should not be changed. Blaming the current financial crisis on the use of fair value measurements in financial reporting, continued the CAQ letter, misreads the fundamental economic and regulatory underpinnings of the crisis. Importantly, CAQ emphasized that disclosure, particularly in the MD&A, could be employed to enhance the use of FAS 157 in illiquid markets. While fully aware of the great challenges in applying fair value measurements in today’s distressed markets, CAQ believes that fair value remains the most relevant and useful measure for users of financial statements. CAQ is affiliated with the AICPA.

CAQ also urged the SEC not to suspend FASB 157 since the suspension of fair value accounting, even on an emergency basis, would be a radical change in financial reporting resulting in severe economic dislocation. If alternatives to FAS 157 are to be developed, reasoned CAQ, that development should be through a new FASB rulemaking following formal notice and comment.
In addition, the center cautioned that fair value measurements cannot simply be suspended without putting something else in their place. Reverting to historical cost accounting (including amortized cost) would result in values that would bear no relationship to actual current values, warned CAQ, and using intrinsic values based on management’s subjective judgments would result in inconsistent and unverifiable results.

And both of these alternatives would result in diminished transparency and comparability for investors, said CAQ, representing an abandonment of the last thirty years of improvements in financial reporting. At the end of the day, reminded the center, financial reporting is undertaken for the benefit of investors, who need timely, complete, accurate, and consistent information in order to evaluate the potential risk and return of securities and determine appropriate valuations for them.

That said, CAQ acknowledged the need to improve FAS 157, especially in light of efforts to value securities in the current illiquid markets. For example, guidance could be provided on the circumstances in which it is appropriate to shift from Level 2 to Level 3 inputs when valuing an asset in a time of disrupted market conditions. Moreover, guidance on determining when a market is active or inactive, or when a particular transaction would be considered a distressed sale not constituting evidence of fair value, would assist in exercising judgment in this area. In addition, while FAS 157 creates a valuation method based on first principles and provides certain examples in its appendices, providing more specific examples of the fair value measurements of various types of assets and liabilities under varying assumed market conditions would be very useful.

More broadly, noting that FAS 157 is a principles-based standard relaying on professional judgment, CAQ urged the SEC and PCAOB to develop a framework for the exercise of accounting and audit judgment. Recently, the SEC advisory committee on financial reporting recognized the trend toward increasing the exercise of accounting and audit judgments and urged the SEC and the PCAOB to adopt policy statements clarifying how the reasonableness of such judgments would be assessed.

CAQ also suggested that the SEC consider using disclosure to enhance the transparency of the application of FAS 157 in illiquid markets. Disclosure could include information about the conditions present in a particular market and the assumptions and methods applied in the fair value measurement process.

Entities applying fair value accounting to financial assets and liabilities should also consider providing disclosure in the Management’s Discussion and Analysis about the hold-to-maturity values of those assets and liabilities. In CAQ’s view, such disclosure would help address concerns that fair value accounting forces institutions to use overly pessimistic market prices to value their assets. Investors could look to these disclosures to make an informed judgment about the financial position and estimated future cash flows of the entity.

CAQ noted that the SEC’s Dear CFO letters are good examples of the types of additional disclosures that investors may find useful. In March 2008, the SEC staff sent 30 letters to CFOs addressing disclosures in MD&A about fair value measurements in increasingly illiquid markets. Similar follow-up letters were sent in September 2008.