FASB Adopts Mark-to-Market Guidance in Reaction to Congress' Desire

Under intense pressure from Congress to ameliorate the application of mark-to-market accounting in asset-backed securities in illiquid markets, the FASB adopted guidance on whether a market is not active and a transaction is not distressed. New FAS 157-e affirmed that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction, not a forced liquidation or distressed sale, between market participants at the measurement date under current inactive market conditions. The guidance includes additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is inactive. Board officials said they expect to issue the text of 157-e next week.

In reaction to comment letters, FASB eliminated the proposed presumption that all transactions are distressed unless proven otherwise. Instead, the guidance requires a firm to base its conclusion about whether a transaction was not orderly on the weight of the evidence. The guidance will also require an entity to disclose a change in valuation technique, and the related inputs, resulting from the application of 157-e and to quantify its effects, if practicable. During the Q&A, Floyd Norris of the New York Times wondered how many firms will find that it is not practicable to quantify the effects of the change.

Responding to a question on how 157-3 would impact mortgage-backed securities, Board officials said that the valuation of mortgage-backed securities could change depending on market liquidity. Also, there will be significantly more disclosure around credit losses. There will also be quarterly disclosure of the value of these securities.

The Board also emphasized that the guidance would be applied prospectively and that retrospective application would not be permitted. The Board decided that 157-e would be effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009.

The FASB also adopted guidance providing a clearer benchmark for when an other-than-temporary impairment exists and needs to be recorded on securities held outside of a firm’s trading book, and to transparently disclose the amount of the impairment directly associated with probable cash flow declines. The changes would provide greater clarity than exists today about the nature of losses. The Board decided that the change to existing guidance for determining whether impairment is other than temporary should be limited to debt securities.

The Board replaced the existing requirement that the firm’s management assert it has both the intent and the ability to hold an impaired security until recovery with a requirement that management assert that it does not have the intent to sell the security; and it is more likely than not it will not have to sell the security before recovery of its costs basis. When a firm does not intend to sell the security and it is more likely than not that the firm will not have to sell the security before recovery of its cost basis, it will recognize the credit component of an other-than-temporary impairment of a debt security in earnings and the remaining portion in other comprehensive income.

A firm will be required to recognize noncredit losses on held-to-maturity debt securities in other comprehensive income and amortize that amount over the remaining life of the security in a prospective manner by offsetting the recorded value of the asset unless the security is subsequently sold or there are additional credit losses. The guidance also stipulates that credit losses should be measured on the basis of an entity’s estimate of the decrease in expected cash flows, including those that result from an increase in expected prepayments. A firm will be required to present the total other-than-temporary impairment in the statement of earnings with an offset for the amount recognized in other comprehensive income.

The guidance significantly enhances disclosure by requiring the disclosure of the cost basis of available-for-sale and held-to-maturity debt securities by major security type. The firm must also disclose the methodology and key inputs, such as performance indicators of the underlying assets in the security, and loan to collateral value ratios, used to measure the portion of an other-than-temporary impairment related to credit losses by major security type.

This guidance will also be effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009.