In another strike toward a single global accounting rule book, the Financial Accounting Standards Board has published a proposed Accounting Standards Update to tweak requirements in U.S. Generally Accepted Accounting Principles for how to measure fair value and disclose information about those measurements.

The International Accounting Standards Board meanwhile published a revised proposal intended to redirect fair value measurement and disclosure under International Financial Reporting Standards, with the two proposals intended to achieve common approaches under both standards. The IASB first exposed its proposal for public comment in 2009, then revised and republished it with the FASB proposal.

The FASB overhauled fair value measurement in 2007 with Financial Accounting Standard No. 157: Fair Value Measurement, now codified in the Accounting Standards Codification under Topic 820. That rule introduced the notion of measuring fair value based solely on exit prices that would be reached in arm’s length transactions with hypothetical market participants. It also introduced the idea of measuring value based on three different levels of evidence – observable market prices, internally developed models and assumptions, and a mixture of the two – with observable market prices being most preferable.

The new proposal retains those basic principles, said David Larsen, managing director at valuation firm Duff & Phelps and a member of FASB’s Valuation Resource Group. The IASB proposal is consistent with those principles as well, he said, despite IASB reservations early on about the exclusive reliance on using exit prices for measuring fair value.

“FASB does not expect that the changes they are making will have substantive impact on fair value measurement,” said Larsen. “Until we read all 275 pages I’m not sure I can confirm that, but on the surface it looks like that may indeed be the case.”

One of the most significant changes that would arise under the proposal, said Larsen, is an increase in “sensitivity disclosure,” or disclosure regarding where subtle changes in assumptions might produce meaningful differences in certain fair value measurements. The proposal also would allow an entity to consider offsetting risks when measuring instruments that are managed together and report a net measurement rather than individual measurements – such as derivatives in a hedge, said Larsen.

FASB is accepting comments on its proposal through Sept. 7.

PricewaterhouseCoopers decided to do some research to get a sense of what investors and analysts are really looking for in the way of accounting standards to make it easier for them to grasp what’s in corporate financial statements.

They focused on the question that is front-and-center in accounting standard setting these days—whether financial assets should be reported at fair value, amortized cost, or some combination of the two. The Financial Accounting Standards Board recently floated a proposal to require all financial instruments to be reported at fair value while the International Accounting Standards Board favors the combination approach, often referred to as a “mixed measurement” model.

PwC did some in-depth interviews of 62 investment professionals and found 87 percent agree that disclosures around financial instruments need some improvement. PwC said a majority of the respondents prefer a mixed measurement approach, using fair value for shorter-lived instruments, such as those that are available for sale, and amortized cost for longer-term instruments, such as bank loans and deposits.

According to the survey results, investors consider the amortized cost approach for longer-lived assets to better match a company’s business or economic reasons for having the instrument, especially if the company intends to hold the instrument for purposes of collecting the cash flows, such as loan payments and interest.

Matt Brockwell, a national partner for PwC, said the survey represents the firm’s effort to understand “in a deeper, more nuanced fashion the views and opinions of investment professionals and how they use financial instrument information that is presented in financial statements.” The survey gives a sense for how investors believe current accounting could be improved, he said.

Brockwell said a significant number of investment advisers are looking for better disclosures about how fair values are reached, including better information about the estimation process, the assumptions that are used, and the valuation methodologies employed.

Who knew accounting could get so emotional? A proposal from the Financial Accounting Standards Board is already drawing a sizable stack of correspondence, and it certainly couldn’t be described as fan mail.

The FASB proposed in late May a pair of new Accounting Standards Updates that would require a new method of accounting for financial instruments. The first would require financial institutions to record the value of their held-to-maturity loans at fair value, and the second ASU would elevate the visibility of “other comprehensive income,” the income statement line item where changes in those fair-value marks will get recorded.

To get a sense for the rancor that is brewing over the latest fair-value proposal, just take a stroll through the early comment letters. Only a few weeks into a four-month comment period, FASB has heard from more than 40 individuals—mostly financial and investment advisers, bankers, and individual investors.

Most of the letters carry a kind of “what are you thinking?” tone to them. “What exactly are you trying to accomplish by doing this?” asks Gregory Klein, a financial adviser with Merrill Lynch, Pierce, Fenner & Smith. “Crush the recovery like a grape? Confuse matters even more?”

Thomas Kilpatrick, an independent financial advisor, asks simply, “Do you not get it?”

Matthew Van De Motter, a financial advisor with Morgan Stanley Smith Barney, worries it will fuel panic when markets turn downward. “We must do all that we can to never allow that unplaced fear to take hold again,” he writes. While there’s some merit to the logic behind fair value for loans and securities, “it can turn a brush fire into an inferno when people are not acting logical,” he said.

“Mark to market loan accounting is a bad idea,” writes John Sherman, who identifies himself as a private citizen writing from an investment advisory firm e-mail account. “In my mind you are largely responsible for the market collapse in 2007, 2008, 2009.”

Mark Versella, CFO at Community Federal Savings Bank in New York, is another opponent to the proposal. “With the lack of markets for most of the assets and liabilities you propose to ‘value,’ we are left to assume that this fair value will somehow be based on some type of model,” he says. “Another valuation model is not what our financial system needs.”

Not to be outdone by the detractors, however, FASB did garner at least one supporter so far. “You can’t allow banks to lie about the value of the derivatives in your books,” writes Brian Crowell, who identifies himself as an economics teacher. “Stop asking for public comment on this crap. You already know the banks and Wall Street will be all over you about it. Restore mark-to-market accounting and don’t tell anybody … You will be a hero to the American people and not just another group of politicians that needs to be replaced.”

Crowell got inspired again a few days later and submitted a second comment letter: “Pricing something above what you could sell it for in the marketplace to most Americans is called fraud,” he says. “Of course this is what drove the economy into a ditch in the first place.”

FASB will continue to collect comments on the proposal through September 30.

In the first of an expected wave of major new accounting proposals, the Financial Accounting Standards Board has published an exposure draft on financial instruments and another on comprehensive income that are certain to ruffle feathers in the banking sector.

Although they are key components of FASB’s agreement with the International Accounting Standards Board to converge accounting rules, the FASB proposal is not consistent with IASB’s proposal on one of the most controversial elements of the rule change. The two boards have decided to float their separate ideas and sort out their differences as they analyze and review comments.

FASB’s first proposal would amend current guidance on financial instruments found in Topic 825 of the Accounting Standards Codification as well as guidance on derivatives and hedging found in Topic 815. The second proposal would modify current guidance on comprehensive income found in Topic 220.

David Larsen, managing director at valuation firm Duff & Phelps and a member of FASB’s Valuation Resource Group, said the most controversial aspect of the proposals is a requirement for banks to report the value of loans they plan to hold to maturity at both fair value and amortized cost on the face of the balance sheet. Currently, banks report those loans at amortized cost, or par, on the balance sheet, with the fair value estimate provided in footnotes, he said.

Under the proposals, the changes in fair value will not flow to net income, but to other comprehensive income in the income statement, said Larsen. It also would have no impact on how regulatory capital would be measured, he said.

“Net income is still calculated the same way,” he said. “Retained earnings is still calculated the same way, but you have this additional line item that shows other comprehensive income, which is kind of a way of saying this is something different than normal, so we’re showing it separately.”

IASB issued a different approach, proposing that banks should continue to account for held-to-maturity loans at amortized cost with fair value reported only in footnotes, said Larsen. The key difference isn’t so much the accounting, but rather the visibility. “The FASB approach is arguably more transparent,” he said.

Just as FASB issued its proposals, Grant Thornton published poll results suggesting only one-third of U.S. CFOs and senior comptrollers would support a balance sheet presentation giving equal prominence to fair value and amortized cost for assets. An equal number favored presenting only amortized cost on the face of the balance sheet, as IASB has proposed, while one-fourth favored fair value only.

John Hepp, a partner at Grant Thornton, said he was “shocked” that so many CFOs and senior comptrollers would support such a dual presentation. “But that does seem where we’re going in the future,” he said. Hepp noted, however, that only 5 percent of respondents favor putting changes in fair value through profit and loss. “Yet that’s the paradigm both FASB and IASB ultimately aspire to,” he said.

As companies are following new rules for booking a business combination, there’s good reason to put a little extra elbow grease into the initial valuations. If there are subsequent adjustments, they have to be made by revising and reissuing previously issued financial statements, warns PricewaterhouseCoopers in a recent alert.

It’s not a new twist on Accounting Standards Codification Topic 805, Business Combinations, originally adopted as Financial Accounting Standard No. 141(R), Business Combinations, and effective in 2009. Instead, PwC is calling attention to the fact that valuation adjustments can’t be made simply by adjusting future statements.

Under current rules, when companies acquire a business, they establish fair values for the individual assets and liabilities. If the valuation process is not complete for any particular items at the end of a reporting period in which the combination occurs, companies book “provisional” amounts. As new information emerges during the fair-value measurement period, the provisional amounts must be adjusted to reflect that new information.

“The provisional amounts should be adjusted to reflect new information about facts and circumstances that existed as of the acquisition date that, if known, would have affected the measurement of the amounts recognized or not recognized,” PwC writes. “These adjustments, commonly referred to as ‘measurement period adjustments,’ should be applied retrospectively as of the date of the acquisition.”

That means going back and revising earlier published statements, an unpleasant pill to swallow. Jay Seliber, a partner at PwC, told Compliance Week previously that companies generally are getting more cautious and deliberate about establishing valuations as a result of this requirement. “The risk is if there is a change from the preliminary to the final allocation and it is material to the financial statements, the company will have to go back and revise the previous series of financial statements to reflect the final numbers,” he said.

The PwC alert walks through an example to illustrate how a change from provisional to final measurements would impact financial reporting. The firm reminds preparers that the guidance for “measurement period adjustments” is different from the guidance related to discontinuing operations, changes in segment presentation, and retrospective accounting changes.

Where companies are required to measure assets and liabilities at fair value, they’ll have some new disclosures to provide regarding changes in how they measure those values.

The Financial Accounting Standards Board has finalized Accounting Standards Update No. 2010-06 to amend Accounting Standards Codification Topic 820 in a way that elicits new disclosures about how fair value is measured and synchronizes the disclosure requirements with international rules. It takes effect for the 2010 reporting year for calendar-year companies.

The new rule requires companies to disclose where they transfer items in and out of “Level 1” and “Level 2” measurement methods under the three-level hierarchy for measuring fair value. Level 1 measurements rely solely on objective market evidence of fair value, while Level 2 measurements are based on a mixture of market evidence and internally development assumptions or estimates.

The new rules also require companies to describe activity that takes place in Level 3 measurements, where fair values are established based solely on models and other internal estimates and assumptions. For instruments measured at Level 3, companies will be required to present separate information, not final net numbers, on purchases, sales, issuances, and settlements.

David Larsen, managing director for Duff & Phelps, said the update clarifies that fair-value measurements for major classes of assets and liabilities should be disclosed separately. It also clarifies the required disclosure of the techniques and inputs companies use to estimate fair value, he said.

“The update will require some additional effort by companies to prepare,” said Larsen. “However, all required data should be readily available.”

The final rule does not include any new requirements for a “sensitivity analysis,” said Larsen, or disclosure of the impacts if the company were to use other possible alternative inputs. FASB proposed some requirements around sensitivity analysis but dropped the requirement from the final guidance.

Larsen said FASB and the International Accounting Standards Board are working jointly on how to harmonize fair-value requirements, including whether and how to require some kind of sensitivity analysis.

When companies are testing for possible impairment of goodwill in a seemingly troubled reporting entity, the staff of the Securities and Exchange Commission has signaled it won’t be fooled by attempts to spin negative equity into a rationalization that an impairment doesn’t exist.

Evan Sussholz, professional accounting fellow for the SEC, said at the recent national conference of the American Institute of Certified Public Accountants that the staff has heard a number of questions about which valuation approach is required by Accounting Standards Codification Topic 350 Intangibles.

The rules map out a two-step test for determining whether goodwill might be impaired, or whether it may have lost some value since it was last determined and booked. The purpose of the first step, said Sussholz, is to identify potential impairment by comparing the fair value of a reporting unit to its carrying amount, including goodwill.

Fair value, according to accounting rules, is the price that would be received to sell the reporting unit as a whole, but the standard doesn’t specify whether entities should begin the analysis with “enterprise value” or “equity value.” Enterprise value is commonly defined as the sum of the fair value of debt and equity, whereas equity value refers to the sum of all ownership interests in the company, such as through stock, stock options, and other securities convertible to equity.

Sussholz said the SEC staff generally doesn’t expect the selection of the equity or enterprise value will impact the outcome of the goodwill impairment test, but it could be important if debt surpasses equity. He points out that the fair value of a reporting unit cannot be less than zero.

“In a circumstance when the carrying value of equity is negative, a reporting unit would seemingly always ‘pass’ a step-one goodwill impairment test performed on an equity basis, despite the fact that significant goodwill may exist and the underlying operations of that entity may be deteriorating,” he said. “In this example, a step-one test performed on an enterprise basis would likely provide a better indication of whether a potential impairment of goodwill exists and a step-two test should be performed.”

The second step of the impairment test requires companies to measure all assets and liabilities within the reporting unit at fair value to determine exactly what the impairment is—a significant undertaking that companies generally would prefer to avoid. But they shouldn’t try to avoid it by trying to work with a negative equity value, said Sussholz.

“In absence of further authoritative guidance, the SEC staff believes that a reporting entity may want to consider whether utilizing an alternative approach to a step-one test such as enterprise value would be a better economic indicator of goodwill impairment,” he said. The analysis should look at market participant assumptions, the potential structure of a hypothetical sale transaction, and other factors, he said.

A frustrated accounting standard setter told an audience full of accountants that someone needs to pry the gorilla of banking regulators off his back.

Robert Herz, chairman of the Financial Accounting Standards Board, made perhaps his most detailed and impassioned plea yet that the regulation of financial institutions needs to be “decoupled” from U.S. Generally Accepted Accounting Principles that are meant to serve investors’ needs. He all but pleaded with those attending the American Institute of Certified Public Accountants conference on current financial reporting issues to help him spread the religion that investors need different information than banking regulators do.

Accounting standards have been under threat throughout the economic crisis as banks and their regulators have pushed FASB and even Congress for changes that would minimize the reporting of losses arising from failed loans. “It should be made clear that the results of GAAP financial statements do not dictate regulatory requirements,” Herz said. “Rather, they are but one source of data to inform the prudential judgments made by regulators.”

He didn’t directly call on Congress to wrestle the beast, but he noted that it was an act of Congress in the wake of the savings and loan crisis of the 1980s that required bank regulators to begin their determination of capital requirements with GAAP numbers. He bristled at suggestions from Congress that accounting principles shouldn’t be so protected that their impact on public policy should be ignored. “Accounting standards also should not be so malleable that they fail to meet their objective of helping to properly inform investors and markets or that they should be purposefully designed to try to dampen business, market, and economic cycles,” he said.

Drawing greater distinction between investors’ needs and safety-and-soundness needs “could enhance the ability of both FASB and the regulators to fulfill our critical mandates,” Herz said. “We can continue to work with independence and an unwavering dedication to market transparency; at the same time the bank regulators can utilize their authority to take whatever actions are required to keep the financial system stable and healthy.

More recently, FASB has drawn bankers’ ire for suggesting banks should use more fair value to report the value of financial instruments carried on the balance sheet, despite banks’ demands for relief from fair-value requirements. In FASB’s defense, Herz cited a 1991 report from the General Accountability Office that said “the key to successful bank regulation is knowing what banks are really worth.”

by Melissa Klein Aguilar

U.S. and international accounting standard setters are still hashing out their differences with hopes of reaching a converged standard on accounting for financial instruments, according to officials speaking at a financial reporting conference this week.

While their current approaches differ markedly, with the United States supporting more use of fair value, leaders of the Financial Accounting Standards Board and the International Accounting Standards Board said they’re continuing to work toward a converged answer.

“We’re going to expose our views, and hopefully … reconcile those differences to arrive at a comparable solution,” Russell Golden, FASB Technical Director, said during a panel discussion at a conference sponsored by Financial Executives International. “What that might mean is that both numbers—both costs and fair value—are relevant and both may be presented on statement of performance as well as the statement of financial position, or maybe that a comparable solution will be arrived at though disclosure.”

IASB released its revised financial instruments standard, IFRS 9, last week, notably without the endorsement of the European Commission.

“In some respects I consider that a silver lining in that it will allow us to work closely with FASB and finish this time next year with a standard that’s more likely to be … more converged,” IASB member Patrick Finnegan told reporters during a press Q&A.

Finnegan said the EC’s concern relates to the classification conditions in the standard for determining whether an instrument is eligible for using fair value or amortized cost.

“That’s something they want the board to continue focusing on,” he said. “They also want to have the benefit of seeing the three phrases of the project finished and evaluate the standards as a package.”
During the panel discussion, Finnegan said based on what he heard while gathering feedback on IFRS 9, “It’s clear to me from talking to people … in Asia and Europe that they want see a single standard … the same words with respect to accounting for financial instruments, particularly as it applies to banks. “

Asked later about the likelihood of a converged answer, FASB Chairman Robert Herz told reporters, “I’ve found that in standard setting, you never know where you’re going until you completely get there and go through the process.”

Finnegan said he’s supportive of having both fair value and amortized costs presented on the balance sheet.

“It’s my personal view that one measurement attribute can’t have primacy over the other in terms of information that’s provided to users,” he said. “If you’re going to measure financial instruments using amortized costs, other users may feel fair value is more decision-useful. That should be made available to them and it shouldn’t be somewhere where they have to go hunt for it.”

Finnegan said he’s “optimistic that will be an element of the converged solution.”

“I don’t think ultimately it’s a very challenging thing to implement,” he said. However, he said an objection he’s heard to the idea heard is “a belief that by displaying fair value prominently, you create unnecessary volatility.”

However, he refuted that objection, saying, “That’s the reality. Financial instruments fluctuate … and to hide that information isn’t serving anybody’s needs.”

The two boards published an updated version of their Memorandum of Understanding this month in response to calls from the G-20 to redouble their convergence efforts. Under the agreement, Golden noted that the two boards have agreed to meet monthly.

It was “inefficient” for both boards to meet separately and conclude and then reconcile their differences, he said. Particularly on controversial issues, he said the boards will meet face-to-face so their respective members can understand what each board is thinking.

“In times past, one board has leap frogged the other,” he said. “We agreed that the leading board will reconsider its conclusions as the lagging board gets up to speed.”

U.S. and international accounting rule makers spent three days this week making progress on a number of outstanding projects on the road to a unified accounting rule book, most notably trying to iron out their different ideas about how to improve accounting for financial instruments.

The economic meltdown exposed big problems in U.S. and international requirements for how fair value is measured and applied to complex financial instruments. It also spotlighted where there are differences between the two approaches and punctuated the need for a more consistent approach to assure comparability of entities around the globe.

The two boards are working on new standards for International Financial Reporting Standards and U.S. Generally Accepted Accounting Principles that would dramatically alter how financial instruments are accounted for currently. Most notably, both boards want to require much more use of fair value, though they’re not entirely in agreement on just how much and how values should be presented in financial statements.

In a series of joint meetings, the boards agreed on a set of core principles for how to end up with a converged standard. According to a Deloitte account of the discussion, the boards agreed that the new requirements should enhance comparability, provide transparency to risk and strategy, and give prominent and timely fair-value information for instruments that have highly variable cash flows or are held for trading.

The boards also agreed amortized cost and fair value, rather than settlement with a third party, is relevant for instruments where principal amounts are held for collection or payment, though board members had concern about how an entity’s own credit worthiness affects fair value of liabilities. They agreed they want a consistent impairment approach for financial assets held for collection of contractual cash flows.

Currently, FASB is considering an impairment model that IASB hasn’t fully endorsed. The boards are forming an expert advisory panel to consider the operational aspects of what FASB has developed to help both boards sort through the ultimate solution.

The boards also compared notes on how to measure fair value, where FASB has had a standard in place since 2007, now contained in the Accounting Standards Codification under Topic 820, and IASB is still working on an exposure draft. The boards agreed they want to end up with a converged standard, but IASB has expressed reservations about FASB’s approach.

FASB has stood its ground on its definition of fair value and its approach to measuring it, but the board told IASB it will take a look at comments IASB has received on its exposure draft and consider whether U.S. GAAP should be changed as a result.

In other business, the boards picked away at ongoing projects to revise rules on revenue recognition, discontinued operations, financial statement presentation, insurance, leases, income taxes, and financial instruments with characteristics of equity.