The raging debate over how to use fair-value accounting in periods of credit turmoil has lurched forward again, with a new idea to split stated values into component parts—an approach that has intrigued the Securities and Exchange Commission.
The idea was proposed last week at an SEC forum on fair-value accounting and came from Vincent Colman, an assurance partner for PricewaterhouseCoopers. Since investors still want transparency in the current price of assets, and the financial sector still demands relief from direct losses to earnings as a result of market inactivity, Colman proposed distilling periodic changes in fair value into two components: one to reflect incurred credit losses and the second to reflect other changes in fair value, including liquidity discounts.
Colman also suggested that guidance for reporting financial asset impairments be split as well: recognize incurred credit losses in income, but all other changes in fair value in Other Comprehensive Income, until the asset is sold or matures.
He also urged the SEC to consider changing the format of the income statement to show more clearly just how items reported at fair value affect income, with other comprehensive income included on the face of the income statement.
“We believe these actions will help to enhance transparency and usefulness by providing a more consistent framework for recognizing impairment losses and by locating all changes in fair value-measured items in a single financial statement,” Colman said.
Colman’s proposal was the most provocative idea at the roundtable; most of the discussion fell along predictable lines of investor groups arguing that financial instruments be measured at fair value because it’s the best way to assess a company’s fiscal health, and the business community saying fair value doesn’t represent an asset’s true value or long-term viability when market activity has evaporated.
“The use of mark-to-market accounting, when markets are not functioning properly, has produced terribly misleading accounting and disclosures that value assets well below their true economic value,” said Bill Isaac, former chairman of the Federal Deposit Insurance Corp. He blasted the SEC for allowing accounting rules to “destroy hundreds of billions of dollars of capital in our financial system, causing lending capacity to be diminished by 10 times that amount.”
Damon Silvers, general counsel for the AFL-CIO, acknowledged the double-edged sword for investors, who on the one hand want current, fully transparent values and on the other hand have witnessed a freefall in their own investment values in recent weeks. The AFL-CIO represents labor union members whose investment accounts “were worth $5 trillion, until recently,” he said.
Silvers is among the vocal investor advocates who have called for more, not less, use of fair value to measure financial assets and liabilities—yet “in retrospect, that was somewhat naïve,” he admitted.
Still, he’s not a fan of repealing current rules specifying when to use fair value to measure securities. “At least initially, the approach ought to be looking more toward safety and soundness—acting on soundness, not on accounting rules,” Silvers said.
Linsmeier
Tom Linsmeier, a member of the Financial Accounting Standards Board, offered an “accounting 101” lecture to the panel as well as the SEC. “Some of the assertions made are as if fair value is widely prevalent and required in the current accounting system,” he said. “It’s not. The only place where it is required is in derivatives, through income, and trading securities, through income.”
FAIR-VALUE COMMENTARY
Below are excerpts of some of the comments made to the SEC about fair-value accounting.
The roots of today’s crisis have many causes, but fair value accounting is not one of
them. Those who argue that removal of volatile fair value estimates will improve
valuations are missing the point. Consistent disclosure of management’s best judgment
regarding the fair value of firm assets will narrow the margin of safety required by
investors when otherwise confronted with a lack of information. Investors value
transparency and will pay for the uncertainty that it removes ...
I urge the Commission to maintain its resolve and continue to resist pressure to repeal or
suspend fair value accounting. Resisting such calls can be difficult, but the needs of the
affected market participants are acute. Your steadfast support for fair value transparency
is greatly appreciated by those of us who invest for the long term interests of our
taxpayers and citizens.
—Scott Evans,
Executive Vice President,
TIAA-CREF
We acknowledge that the current financial crisis is testing the limits of investor confidence. We also acknowledge that extreme measures are being taken on many fronts to restore and stabilize investor confidence. However, we believe that action by the SEC to overturn a FASB standard, in the present
context of enhanced investor concern about transparency of financial information relating to financial institutions and political pressure from some industry interest groups seeking to reduce transparency, will exacerbate investors’ concerns about the reliability of financial information and
further erode market conditions.
We urge the SEC to reject the current appeals to overturn FASB standards, thus reassuring the markets that the SEC, by exercising appropriate participation and statutory oversight of the FASB, is committed to the continuation of the FASB’s independent standard-setting processes.
—Robert E. Denham,
Chairman,
Financial Accounting Foundation
Our recommendation is that the SEC should consider taking this opportunity to simplify the rules that provide guidance on accounting for all financial instruments. Specifically, the SEC should consider issuing guidance that all financial instruments, except trading securities, should be carried at cost. Financial instruments classified as trading should continue to be carried at liquidation (or exit) prices. If a financial instrument, other than a trading position, is considered impaired (and the company has the intent and the ability to hold the security), charges should be recorded against income based on net realizable value and not liquidation (or exit) value.
Further, the SEC should consider continuing its fair value projects but direct their efforts towards improving the disclosures that would accompany the financial statements. The SEC should consider building on the SFAS 107 disclosures and require that estimates of liquidation (or exit) prices should be provided for all financial instruments and presented as a disclosure in the footnotes. As noted above, under this recommended framework, impaired financial instruments would be carried at net realizable value in the financial statements unless the position was transferred to a trading account. To ensure continued transparency under this recommended model, the SEC should require enhanced disclosures surrounding impaired securities that provide ranges for estimated liquidation (exit) values.
If the SEC does not wish to overhaul the current accounting model for financial instruments, at a minimum, the proposed agenda should consider amending the definition of fair value for available-for- sale and held-to-maturity securities to approximate net realizable value. This would place investors in debt securities on equal footing with entities that hold loan portfolios for investment. Securitized loans should not be treated differently than unsecuritized loans when the intent to hold to the investments is
present in both cases.
—Todd M. Adams,
Chief Financial Officer,
Members United, Corp. FCU
Source
SEC (October 2008).
In the case of securities available for sale, he said, the fair value is reported on the balance sheet with the effect flowing to Other Comprehensive Income, which does not affect capital requirements set by banking regulators.
“Some of the assertions are as if current standards require all these assets to be marked down to fair value, where that’s just not the case,” Linsmeier said. Even if more assets were reported using historical or amortized cost (as banking proponents demand), “there would still be the necessity under certain circumstances to mark to market,” he said.
The Split Theory
Colman said streamlining the literature on impairment (that is, on writing down values of securities) “would be very, very helpful, so it’s not a form-driven impairment-type test, but it’s substance driven.” He said there would be little disagreement on recording an impairment for credit losses: “We can figure that out; we do that today in certain areas.”
As for transparency for investors, that could be achieved by reporting in Other Comprehensive Income and moving it to the face of the income statement, he said. “You’ve harmonized the various triggers and application, you’ve separated credit from liquidity risk, and kept the principle of ultimate transparency for investors.”
Isaac acknowledged that Colman’s approach is “common ground,” but wanted to verify what would happen to the “headline” net income figure under Colman’s proposal.
“You would show in net income the impairment as it relates to the current incurred loss relating to credit, not liquidity,” Colman replied. “Liquidity would go into Other Comprehensive Income and would move to the face of the income statement. You would have a reduction of equity of the entity on the face of the income statement, but it would not be in the determination of net income.”
Scott Evans, executive vice president at TIAA-CREF, described it as a “constructive suggestion, where you’re clearly parsing the credit-related impairment from liquidity-related impairment.”
Ray Ball, accounting professor at the University of Chicago, and others on the panel had some concerns about whether it’s possible to distinguish impairments related to credit vs. liquidity problems. Ball also expressed some doubts about whether management at financial institutions could be trusted to follow the principles.
“I’m not sure you ought to give financial institutions an incentive to encourage illiquidity by taking the effects of it out of the income statement,” he said. “It’s remarkable that we have a trillion dollar capital market … and you say it’s illiquid. Maybe we should address the issue instead of taking it out of the income statement.”
Ma
Cindy Ma, a managing director and valuation specialist at Houlihan Lokey Howard & Zukin, said the valuation community could benefit from some new guidance from FASB regarding when a market should be deemed inactive, and therefore no longer a good indicator of value. Linsmeier said he feared guidance on narrow aspects of measuring fair value would lead to excessive, bright-line rules that would discourage a more principles-based approach from developing.
The SEC commissioners themselves took no formal action on Colman’s proposal at the roundtable. The Commission is, however, pulling together as much information about fair-value accounting as it can, as part of a study of fair value that was mandated when Congress passed the Emergency Economic Stabilization Act. The SEC is supposed to present that study to Congress at the start of January.
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