By James Hamilton, J.D., LL.M.
The Acting SEC Chief Accountant told Congress that fair value accounting increases financial reporting transparency and facilitates better investment decision making and will not be suspended. In testimony before the House Capital Markets Subcommittee, James Kroeker defended mark-to-market accounting against charges that its application to the asset-backed securities of financial institutions had a pro-cyclicality effect by triggering a downward spiral of ever-increasing write-downs that did not reflect the underlying economics of the securities. Indeed, the SEC official emphasized that the abrupt removal of fair value accounting would erode investor confidence, further exacerbating instability in the financial markets.
Recently, the European Commission said that the financial crisis cast into stark relief the difficulty of applying the mark-to-market principle in certain market conditions as well as the strong pro-cyclicality impact that this principle can have. The EC’s High Level Group said that wide reflection is needed on the mark-to-market principle. While in general the principle makes sense, conceded the Group, there may be specific conditions where it should not apply because it can mislead investors and distort managers' policies.
The Acting Chief Accountant noted that most participants at recent SEC roundtables expressed a belief that fair value accounting provides useful information to users of financial reporting. However, participants also expressed the desire for accounting standard setters to continue to address issues arising out of the financial crisis, including improvements to the guidance on the measurement of fair value, particularly in inactive or illiquid markets.
In part due to the calls for additional guidance heard at the roundtables, on September 30, 2008, the SEC and FASB issued a joint public statement clarifying the application of existing fair value accounting guidance, including the guidance in FAS 157. The statement pointed out that it is acceptable for management to use estimates of future cash flows that incorporate current market participant assumptions, and include appropriate risk premiums, as a part of the total mix of information used to measure fair value in certain circumstances. The clarifications also made clear that disorderly transactions are not determinative when measuring fair value, and that distressed or forced liquidation sales are not orderly transactions.
Although the guidance relates to U.S. GAAP, the IASB publicly expressed its support for the Commission staff and FASB efforts. The IASB’s support is critical to the world-wide financial markets, said the SEC official, because fair value measurement is clearly a global issue. As a global issue, he continued, work is ongoing internationally to develop better fair value measurement guidance. For instance, in October 2008, an expert advisory panel sponsored by the IASB issued information and educational guidance for measuring and disclosing fair value.
The SEC accountant pledged that the Commission will continue to work with FASB to further clarify the assessment of investment impairment when mark-to-market accounting is not applied. The SEC supported FASB’s efforts in January 2009 to streamline the guidance on impairments through harmonization of the impairment models used for different types of securities. The Commission also supports FASB as it considers additional improvements to the impairment model for all investments, and will continue to encourage the Board to prioritize these improvements either through their own projects or on a joint basis with the IASB, as appropriate.