FASB Leaves Mark-to-Market Rules Unimpaired April 6, 2009 At a meeting on April 2, 2009, the Financial Accounting Standards Board ( FASB ) met to revise the guidance for identifying inactive markets and distressed transactions and determining whether an investment be considered as other-than-temporary impaired. These revisions apply to fair value accounting under U.S. generally accepted accounting principles. Fair value accounting, often referred to as mark-to-market accounting, has been blamed for exacerbating the current financial crisis by forcing banks and other financial institutions to write down the value of their holdings of corporate debt, structured investments and equities. Whether or not the criticisms of fair value accounting have been valid, FASB came under tremendous pressure in the past year to change the mark-to-market rules. This Stroock Special Bulletin reviews certain of the actions taken by the FASB at its recent meeting in revisiting the mark-to-market rules. Inactive Markets and Distressed Transactions Guidance On March 17, 2009, FASB issued proposed Staff Position FAS 157-e ( FAS 157-e ) to provide additional guidance on determining whether a market for a financial asset is not active and a transaction is not distressed for fair value measurements under FASB Statement No. 157, Fair Value Measurements ( FAS 157 ). FAS 157, issued two and a half years ago, established a single definition of fair value and a framework for measuring fair value under U.S. generally accepted accounting principles. FAS 157 also expanded disclosures about fair value measurements in order to improve the quality of information in financial statements. It did not require any new fair value measurements. Over time, criticism arose that FAS 157 did not provide sufficient guidance on how to determine inactive markets and distressed transactions. Further, FAS 157 appeared to give more weight to a firm s use of quoted prices over the firm s own assumptions even when quoted prices arose in markets that the firm believed were not active or in transactions believed to be distressed. stroock & stroock & lavan llp new york los angeles miami 180 maiden lane, new york, ny 10038-4982 tel 212.806.5400 fax 212.806.6006 www.stroock.com
In order to change the prevailing bias to use quoted prices even in markets believed to be inactive, FAS 157-e as originally proposed established a two-step approach for determining whether a market is not active and, if so, whether a transaction is distressed. In step one, the firm determines whether there are factors present indicating that the market for the asset is not active as of the measurement date. Factors to examine include whether: 1. there are only a few recent transactions (based on volume and level of activity in the market); 2. price quotations are not based on current information; and 3. price quotations vary substantially, either over time or among market makers. If the firm concludes, based on an evaluation of these and other factors, that the market is inactive, step two of FAS 157-e as originally proposed created the presumption that the quoted price is associated with a distressed transaction - unless the firm has evidence that the observed transaction meets two specific criteria. The first criterion is that sufficient time transpired before the measurement date to allow for usual and customary marketing activities (i.e. the transaction was not part of a forced fire sale). The second criterion is that there were multiple bidders for the asset. The presumption that a quoted price in an inactive market is to be associated with a distressed transaction unless the firm can prove otherwise represented a change from current practice. Of course, if, on the basis of the results of the second step, the firm concludes that the quoted price is not associated with a distressed transaction, then the quoted price would be considered by the firm for purposes of estimating fair value. At its April 2nd meeting, FASB decided that the final version of FAS 157-e would be changed to: Eliminate the proposed presumption that all transactions in inactive markets are distressed unless proven otherwise. Instead, the final guidance will require a firm to base its conclusions about whether a transaction was not orderly on the weight of the evidence. Include additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is inactive. Require a firm to disclose a change in valuation technique, and the related inputs, resulting from the application of FAS 157-e and to quantify its effects, if practicable. Additionally, FASB affirmed its previous decision that FAS 157-e would be applied prospectively only and that retroactive application would not be permitted. FASB decided that FAS 157-e would be effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. Other-than-Temporary Impairment Guidance When FAS 157-e was issued, a second FASB Staff Position, FAS 115-a, FAS 124-a, and EITF 99-20-b ( FAS 115-a ), was also proposed. FAS 115-a amends FASB Statement No. 115, Accounting for Certain 2
Investments in Debt and Equity Securities ( FAS 115 ), the basic fair value accounting guidance for investments in debt and equity securities, to provide greater clarity on how a firm assesses whether an other-than-temporary impairment ( OTTI ) has occurred and to improve the presentation of an OTTI event in financial statements. Under current accounting rules, if the fair value of a debt or equity security is less than its cost basis, a firm is required to assess the impaired security to determine whether the impairment is other than temporary. To avoid considering an impairment to be other than temporary, management must assert that it has both the intent and the ability to hold the impaired security for a period of time sufficient to allow for any anticipated recovery in fair value. If management does not believe that it will recover its full cost basis, it must write down the security to fair value, taking the difference as a charge to income. Under the guidance of proposed FAS 115-a, in order to avoid recognizing an impairment loss, management would be required to assert that (a) it does not have the intent to sell the security and (b) it is more likely than not that it will not have to sell the security before recovery of its cost basis. In other words, an impairment loss would be recognized only in cases where management intends to sell the impaired security or it is more likely than not that it will be required to sell the impaired security before recovery. At its April 2nd meeting, FASB decided that the change to existing guidance for determining whether an impairment is other than temporary should be limited to debt securities. FASB replaced the existing requirement that the firm s management assert it has both the intent and ability to hold an impaired security until recovery with the requirement described above that management assert it does not have the intent to sell the security and that it is more likely than not it will not have to sell the security before recovery of its costs basis. When a firm makes both of these revised assertions, it will recognize the credit component of an OTTI of a debt security in earnings and the non-credit component in other comprehensive income. Prior to FAS 115-a, if an impairment was other than temporary, both credit losses and non-credit losses were recognized in earnings as an OTTI. In connection with non-credit losses on held-to-maturity debt securities recognized in other comprehensive income, FASB also decided that a firm will be required to amortize the losses over the remaining life of the security in a prospective manner by offsetting the recorded value of the asset unless the security is subsequently sold or there are additional credit losses. The final guidance will stipulate that credit losses should be measured on the basis of a firm s estimate of the decrease in expected cash flows, including those that result from an increase in expected prepayments. A firm will be required to present the total OTTI in the statement of earnings with an offset for the amount recognized in other comprehensive income. FASB also decided at its meeting to modify and enhance the disclosure requirements of FAS 115 to require a firm to provide (a) the cost basis of available-for-sale and held-to-maturity debt securities by major security type and (b) the methodology and key inputs, such as performance indicators of the underlying assets in the security, loan to collateral value ratios, third-party guarantees, levels of subordination, and vintage, used to measure the portion of an OTTI related to credit losses by major security type. This new guidance also will be effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. For both the FAS 157-e guidance and the OTTI guidance, FASB directed its staff to proceed to draft the final guidance for vote by the board. 3
Mark-to-Market Softened but not Impaired The changes to the OTTI guidance will probably have a bigger impact on mark-to-market accounting than the changes to determining whether a market for a financial asset is inactive or a transaction is distressed. Firms have been given greater flexibility to use their own judgment when measuring the fair value of financial assets. So long as a firm s management can assert that it has no intention to sell, rather than assert it intends to hold or assess whether an impaired security will recover in value, an OTTI impairment to earnings can be avoided. This change may allow firms to assign higher values to their financial assets than would be the case if the new OTTI guidance had not been adopted. On the other hand, the new guidance does not represent an abandonment by FASB of mark-to-market accounting for assets in inactive or illiquid markets. FASB s staff recommended to the board that it emphasize that the new guidance does not change the objective of a fair value measurement. The staff said that even when there has been a significant decrease in market activity for a financial asset, the fair value objective remains the same. Fair value is the price that would be received to sell the asset in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date in the current inactive market. The staff also recommended that FASB consider highlighting and expanding the final guidance on the relevant principles in FAS 157 that should be considered in estimating fair value when there has been a significant decrease in market activity for the asset. Consistent with the staff requests, FASB affirmed the above principles in its summary of board proceedings. By Allan N. Krinsman, a Partner in the Financial Reform Working Group of Stroock & Stroock & Lavan LLP, and Courtney A. Reichuber, an associate in Stroock s Corporate and Securities Practice Group. Additional Information This Stroock Special Bulletin is part of a series of similar announcements by Stroock s Financial Reform Working Group to keep friends and clients of Stroock informed of significant developments impacting our capital markets and the nation s economy. If you have questions regarding this Stroock Special Bulletin, contact any of the Stroock attorneys listed below. For recent Stroock Special Bulletins go to http://www.stroock.com/sitecontent.cfm?contentid=57. 4
Stroock s Financial Reform Working Group Hedge Funds Securitization Tax Hillel Bennett 212-806-6014 hbennett@stroock.com Rick Fried 212-806-6047 rfried@stroock.com Micah Bloomfield 212-806-6007 mbloomfield@stroock.com Sarah Davidoff 212-806-5578 sdavidoff@stroock.com Allan Krinsman 212-806-5746 akrinsman@stroock.com Jeffrey Uffner 212-806-6001 juffner@stroock.com Mel Epstein 212-806-5864 mepstein@stroock.com Craig Mills 212-806-5630 cmills@stroock.com Derivatives Real Estate Litigation Anthony Schouten 212-806-5516 aschouten@stroock.com Bill Campbell 212-806-5415 wcampbell@stroock.com Dan Ross 212-806-5811 dross@stroock.com 5
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