The concept of fair value accounting was driven by the Financial Accounting Standards Board (FASB) and Securities and Exchange Commission (SEC) in an effort to provide greater disclosure, transparency and consistency in financial statements. The objective was to improve the quality, consistency and comparability of financial reporting to provide superior and thorough information to the investment community. Accounting Standard Codification 820, “Fair Value Measurements,” formerly known as Statement of Financial Accounting Standards (SFAS) No. 157, ASC 820, provided a uniform definition for fair value and put an emphasis on the use of market inputs when valuing an asset or liability. This is also referred to as “mark-to-market” accounting since financial statements are now required to clearly state upon which of the three-level hierarchy inputs the reported values are based on.
Defining Fair Value Using Market Inputs
Although ASC 820 was first introduced in 2006, it went into effect for the financial statements of entities classified as “investment companies” with a period beginning January 1, 2008. As the economy began to spiral downward in 2008, and companies were required to start adjusting asset values in accordance with ASC 820, some financial institutions began writing-down the underlying value of certain assets. This brought into question the ability of some institutions to meet regulatory capital requirements and led to a push for emergency remedies – specifically, the suspension of ASC 820.
The debate between the opponents and proponents of fair value continued through the rest of 2008 with opponents blaming mark-to-market accounting for the struggling economy, with proponents favoring increased transparency. In response, Congress directed the SEC to research the issue as part of the Emergency Economic Stabilization Act, which created the Troubled Assets Relief Program (TARP). The SEC issued its report in December 2008, concluding that the credit crisis was not caused by fair value accounting and that it should not be suspended or substantially modified. Ultimately, the first debate swung in favor of FASB and ASC 820, resulting in a few changes being implemented in April 2009 with the issuance of FASB Staff Positions, including No. 115-2 and 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments” and 157-4, “Determining the Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.”
Expanding Fair Value to Loans
The FASB recently met in August 2009 to discuss additional changes to fair value rules, parallel with the International Accounting Standards Board (IASB), to expand the guidelines. The FASB proposal would require that all financial instruments, including loans, be presented on the balance sheet at fair value. Any changes in value would then be recognized in net income or other comprehensive income. It is anticipated that the revised rule could go into effect as early as 2011. This could require banks to accelerate the recognition of losses, triggering lower earnings and book values. Financial institutions are already beginning to protest, most notably through the American Bankers Association. At the center of the debate is mark-to-market. Financial institutions have been pushing to decrease the use of mark-to-market accounting for assets that are hard to price due to a lack of comparables and the FASB and IASB now want to extend mark-to-market to all financial instruments.
This round of debate over the expansion of fair value accounting is further complicated as the U.S. continues to transition from Generally Accepted Accounting Principles (GAAP) to International Financial Reporting Standards (IFRS). The FASB is working with the IASB, but the two groups have presented different models and deadlines for completion pertaining to the proposed standard. There is concern that the differences between the FASB and the IASB will result in a lack of due process on the part of FASB or a divergence between IFRS and GAAP. And then there is the involvement of the SEC, which has been working with both the FASB and the IASB on the transition to international standards, and is being pressured by members of Congress in response to the initial discourse.
Bottom Line: Companies Should Assess Exposure
Every company should make an assessment of its exposure as it relates to fair value measurement. For many, these measurements will be an integral part of their financial statements and can impact performance. The process is complex and management should have a keen understanding of what inputs are being utilized in the business valuation models and how to interpret the output in order to ensure the reliability of its financial statements. Management should be knowledgeable and have a basic understanding for how amounts were determined by the party providing the pricing information. Addressing the changing landscape of value and learning as much about these changes as possible will benefit companies, boards and advisors.
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