How to Handle FASB s Unfair Value Standard

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1 How to Handle FASB s Unfair Value Standard By Colleen Cunningham November 4, 2008 I had planned to write a completely different column for this month but, much like the Treasury Department, was inspired by recent events regarding the credit crisis to change course. Let s talk about fair value accounting. First, it amazed me that the so-called Bailout Bill, as passed, had provisions associated with fair-value accounting in it. Congress isn t exactly the group that should be determining accounting standards! Last I looked, neither the House nor the Senate had any working accountants in their membership. If they only took the time to study what the Financial Accounting Standards Board was doing in the first place, they might have been able to voice their concerns well in advance of when Financial Accounting Standard No. 157, Fair Value Measurements, actually arrived. I ve been outspoken about the implementation issues associated with FAS 157, well in advance of its issuance. I do not, however, believe that this particular accounting standard should take all the blame for the current crisis. We all know that this financial crisis has many contributing factors. A quick refresher of FAS 157: It establishes a framework for how fair value of an asset or liability should be measured. Prior to the standard, accountants and auditors had many different definitions and applications of fair value. Those inconsistencies, combined with a lack of guidance, created confusion that added to financial reporting complexity. FAS 157 attempted to address those issues by delineating different types of values: those with active markets, and those that rely on more unobservable inputs. In the former, known as Level 1 of the fair value hierarchy, a liquid market exists where buyers and sellers can determine a fair value. For example, a financial asset traded on multiple exchanges might be considered a Level 1 market. At the other end of the spectrum, Level 3, no ready market exists to value assets or liabilities. Level 3 values are largely based on assumptions and estimates of how a market participant might value the asset or liability. FAS 157 stresses that fair value is a market-based measurement, not a measure based on what the owner of the asset or the obligor of the liability believes. In other words, fair value should be determined based on a hypothetical transaction with a market participant, in contrast to what the entity actually plans to do with the asset or

2 liability. These measurements are a good deal more theoretical than real, certainly, particularly in the current state of our capital markets. This is the crux of the issue. If you are an investor of a particular company, why would you think a value that doesn t consider the company s intent makes any sense? I don t. If my intent as an investor is to hold an investment for the long-term, I absolutely would want to know what the company viewed as its value based on its intended use, or length the company intended to hold the asset or liability. That is what would be relevant to me. FASB disagreed. As I have stated in this column before, the accounting for these transactions isn t to blame for the current crisis. But the intense lobbying of FASB and the International Accounting Standards Board by theorists purporting to represent the user community can share some of the blame. Specifically, in supporting FAS 157, they had a duty to inform investors that the accounting in the standard is not relevant in determining current operating results for a company that is a going concern and that intends to hold to maturity the assets in question. The reality is that fair value according to the FAS 157 hierarchy really is going to be a liquidation value in today s extreme market conditions. FASB and the Securities and Exchange Commission can issue all the guidance they want telling companies that they should consider that illiquid markets may not reflect market values but when a company s auditors are being scrutinized for verifiable evidence in the invasive and granular inspections by the Public Company Accounting Oversight Board, the auditors have every incentive to err on the side of pointing to a market transaction to substantiate the value. Lacking a transaction, auditors must do a lot of difficult, timeconsuming work to validate management s assumptions of value and take what they view as unnecessary risks. And yes, they may actually have to invoke the J clause: exercise professional judgment something they have been loathe to do over the last five years. It is much easier for all to have a value, even if that value is completely irrelevant and based on the distressed, illiquid state of the capital markets. In bowing to a theorist view of fair value, FASB chose to focus on an extremely short term view of investing: What s the value if I liquidated everything today? It kills me that the regulators continue to criticize companies for managing using a short-term focus, yet they continue to issue standards that basically leave companies with little choice! I ve even heard of some companies that have actually sold some of their assets to create a value that they can use as evidence for accounting purposes, even when they initially had no intention of selling these assets in the near term. Worse, the sharp decline in fair values has forced other companies to sell these assets at these severely depressed prices to raise cash for liquidity. That simply adds to the frenzy and fear that is consuming our markets. This snowball effect has been playing out for more than a year, and has come to a head in recent weeks. How is that helpful for investors?

3 Determining Fair Value We must also remember that valuation processes and procedures not only need to be analyzed under FAS 157; they then need to be documented and audited. When determining fair value under FAS 157, one must first identify the valuation premise appropriate for the measurement consistent with its highest and best use. That phrase has no relationship to how the entity intends to use the asset. Rather, assumptions must be made about what the highest and best use is based on its likely use by other market participants. One critical question for which we currently have no guidance is whether the market participant is a financial buyer (such as private equity) or a strategic buyer (a competitor). The differences in valuation inherent in that choice can be significant. One must also determine the valuation techniques appropriate for the measurement of the asset or liability. This is complex; you must weigh the availability of data that can help develop measurement inputs, and where in the fair-value hierarchy those inputs fall. (That is, are the inputs observable or unobservable?) In addition, the inputs should represent the assumptions that market participants would use in pricing the asset or liability. The inability to determine an appropriate value is vital. Valuation is hard to do, and whatever a company may come up with, it will likely be wrong. For example, I know one company that has fully insured residential mortgage-backed securities that are valued at 35 cents on the dollar, in accordance with FAS 157. These securities were the most senior tranche, were highly rated at the date of purchase, and they have incurred no actual losses, nor are they expected to in the future. If losses ultimately do materialize, they will be covered by guaranty insurance. So how is the use of this fair value reflective of economic reality? Is this really in the interest of investors? Why not simply disclose potential current fair values rather than record them on the financial statements? That middle ground would provide theorists with their fair values, and if real working analysts want to take that into consideration, it s there for them to use. But it would not distort the going concern value of a company. The current environment requires a company to provide a value relevant only if it were to liquidate everything today. Is that realistic? As a long-term investor, how does that value make any sense to me? We must abandon this short-term view of analyzing and valuing companies! FAS 157 in Today s World As a result of the current market crisis, companies are encountering a huge dilemma in determining how to value and how to classify financial assets and liabilities into the appropriate level in the hierarchy. The market for certain financial assets and liabilities that may have clearly been classified as a Level 1 or Level 2 in the past, may have dried up. So should companies now come up with a different way to value these assets based on unobservable inputs and move them down to Level 3? Many companies did just that. But even that was called into question: At what point do we determine that a market has become illiquid?

4 FAS 157 requires entities to use observable prices when they are available, but not to use distressed values based on forced sales. In the current environment, how do we determine whether thinly traded securities are being sold at distressed prices? These are tough questions that many companies face. The SEC and FASB guidance that was issued in early October, while recognizing that a company can consider the illiquidity of the markets, does little to change the PCAOB inspection process or the auditor s aversion to anything without direct verifiable evidence that they can cite. (In fact, the PCAOB issued an audit alert to help auditors as they work through the intricacies of FAS 157 with their clients.) The SEC also issued two letters to address additional disclosure that companies should consider when using Level 3 valuations. The letters note that observable information, such as market prices, may be unavailable for some assets and liabilities measured at fair value. As a result, valuations of those assets and liabilities may include significant unobservable inputs, requiring management judgment. The SEC letters focus on disclosure in Management s Discussion and Analysis of known trends or any known demands, commitments, events, or uncertainties that a company would reasonably expect to have a material effect on its results of operations, liquidity, and capital resources. Among other suggestions, the letters note that companies may want to disclose in MD&A the amount and percentage of assets and liabilities that were measured at fair value using significant unobservable inputs, as well as information about assets and liabilities that were previously measured using significant observable inputs that were currently measured using significant unobservable inputs (including the specific inputs that were no longer observable). They also listed potential disclosures of any changes made to valuation techniques, why they were made and the effects, as well as the effect on future liquidity and capital resources any increases or decreases in the aggregate fair value could have. FASB issued FASB Staff Position 157-d to clarify how to apply fair value accounting in illiquid markets. The way it is written, however, doesn t give much clarity. Some view the FSP as allowing for the use of more judgment; others believe it points you right back to where we are today. I find it interesting that FASB and the SEC chose to issue their recent guidance simply as clarifications of existing provisions in FAS 157, rather than undertake any real analysis of the criticisms they have been receiving since the first exposure draft FAS 157 long ago. Those criticisms at the time predicted that we would have an outcome where our financial statements no longer reflected economic reality and become misleading to investors. Companies could have told them that years ago oh, wait. We did.

5 RELATED RESOURCES Compliance Week Columnist Colleen Cunningham is the former president and CEO of Financial Executives International. She was named managing director of the New York tristate area for Resources Global Professionals in June In this role, she oversees the operations, financials, and recruiting while mentoring teams and offering strategic guidance to the six practices within the region. An internationally recognized expert on corporate financial reporting and accounting, Cunningham served as CEO of FEI for nearly four years, during which time she had significant influence in legislative and regulatory matters including Sarbanes- Oxley, pension reform, and financial accounting standards. The former chief accountant of AT&T, Cunningham was previously the SVP and CFO, North America, of Havas Advertising, which was, at the time, the fifth largest advertising holding company in the world. In that role, she was responsible for North American financial operations, including tax, controller, and treasury functions, SEC and U.S. GAAP reporting, and worldwide accounting policies. She began her career in public accounting with the firms formerly known as Touche Ross and Coopers & Lybrand. Colleen Cunningham can be reached via at Compliance Week provides general information only and does not constitute legal or financial guidance or advice.