Banks win slack from FASB on fair value

The Financial Accounting Standards Board (FASB) has proposed amendments to fair-value accounting, which would allow financial institutions employing internal models to valuate assets and liabilities in illiquid markets.

Announced on March 16, the proposals would also alter the way in which other-than-temporary impairment (OTTI) is reported, separating losses due to credit deterioration from losses related to other market factors.

In its study on fair-value accounting submitted to Congress on December 30, 2008, the US Securities and Exchange Commission recommended the FASB reassess these particular aspects of its accounting standards. Auditors have been especially wary of changes to fair-value accounting, emphasising that the practice merely reflects the current value of an asset. But financial institutions facing massive writedowns have lobbied for certain adjustments to the standard, which they claim exaggerates the frailty of balance sheets during illiquid markets.

Analysts believe the FASB's proposals show that the financiers have won the argument. "To some extent, this is what financial institutions wanted out of the FASB and Congress. The proposals provide more leeway to financial institutions to ignore transaction prices in those markets that they deem to be illiquid or distressed," said Wallace Enman, a senior accounting specialist at Moody's Investors Service in New York.

The clarification of FAS 157 - the accounting standard thatgoverns how market participants should determine the fair value of an asset - provides a number of criteria that may indicate whether a market is inactive, or whether the sale of an asset is distressed. If the only quoted prices in the market are of distressed sales, the entity may then resort to alternative valuation techniques, typically using internal modelling.

According to the proposals, tell-tale signs of an inactive market include: few recent transactions; substantial variance in price quotations; abnormally wide bid-ask spreads; little information released publicly; and unusually high liquidity risk premiums or implied yields for quoted prices.

If market participants observe the above traits, they should then assume the quoted price is derived from a distressed transaction unless there was sufficient time before the measurement date for "usual and customary marketing activities for the asset", or there were multiple bidders for the asset.

"This clarification has a potential shift of emphasis. Previously, you assumed something was not distressed, even if it was in an inactive market. Now, this has reversed, as the assumption is that a transaction is distressed unless you can prove otherwise," said Andrew Spooner, a London-based financial instruments partner at Deloitte.

The process is dependent on entities exercising significant judgment as to whether the above criteria have been fulfilled. As such, analysts cite disclosure as the key to allaying investor fears about the validity of such valuations.

"Provided that the amendments are accompanied by robust disclosures regarding companies' use of internal subjective evaluation models, they should not be detrimental to investors. However, if users perceive that the accounting changes result in financial statements that are more opaque, we could witness a decline in investor confidence," said Enman.

Elsewhere, the proposed amendments to OTTI envisage separating impairment losses due to credit deterioration - which would appear in earnings - from impairment losses related to other market factors, which would appear in other comprehensive income. The alterations would apply both to debt and equity securities, as long as the company could demonstrate the intent and ability to hold the impaired security long enough to benefit from recoveries in its fair value.

Edward Yingling, chief executive of the American Bankers Association (ABA), has expressed concerns related to OTTI, which he felt were not entirely addressed by the FASB's proposals. However, the banking sector has generally welcomed the proposals. "We are pleased the FASB is acting in a timely fashion," wrote Yingling on the ABA website on March 16.

The comment period for both proposals ends on April 1. If the proposals are adopted, they would be effective for reporting periods ending after March 15, 2009. Analysts say the effect on balance sheets is still unclear.

In the meantime, the proposals do little to harmonise US Generally Accepted Accounting Principles (Gaap) and International Financial Reporting Standards (IFRS). In particular, the proposed amendments to valuations in illiquid markets would diverge markedly from similar guidelines released by the International Accounting Standards Board (IASB) on October 31, 2008.

"The IASB's Expert Advisory report emphasised a transaction is not distressed unless you can prove otherwise. If the FASB were to come to a different conclusion (as the proposals suggest) that would influence behaviour accordingly, resulting in more valuations based on internal models under US Gaap than under IFRS. Ultimately, we may see fair valuations under IFRS and US Gaap differ," says Spooner.

See also: IASB amends fair-value disclosure
Fair enough?