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 FinancialBulletin Jan. 22, 2009 In the midst of the current economic crisis, numerous theories have circulated about what events tipped the first domino and whether existing practices are helping or hurting recovery efforts. As part of the Emergency Economic Stabilization Act of 2008, the SEC, along with the Federal Reserve and the Secretary of the Treasury, was required to submit a report to Congress about mark-to-market (or fair value) accounting standards to address six key areas, including fair value standards’ impact on last year’s bank failures, the quality of information they provide to investors and whether Statement of Financial Accounting Standards (FAS) No. 157, Fair Value Measurements, needs to be modified. Below is a summary of the 211-page report’s findings and recommendations.* Findings 1. Effects of fair value accounting standards on financial institutions’ balance sheets An ongoing debate about fair value is that it may adversely affect balance sheets. The SEC staff found that fair value, on an overall basis, is used to measure less than a majority of assets and liabilities of financial institutions, with mark-to-market accounting (for which changes in fair value are recognized in income) applied to a significantly smaller population of instruments, generally composed of trading securities and derivatives. However, for those institutions with mark-to-market accounting, the impact of changes in fair value on the income statement was significant.
The SEC staff found that, based upon the
application of U.S. Generally Accepted Accounting Principles (GAAP), fair
value accounting did not play a meaningful role in the numerous bank
failures of 2008. Some of the main contributory factors were a lack of
adequate capitalization (driven by substantial and mounting credit losses),
an inability to meet depositors’ requirements and overall market conditions
(e.g., the erosion of confidence in financial institutions as well as the
lack of a market in which to sell mortgage-related assets).
Based upon published investor views, academic
research, comment letters and roundtables discussing fair value, the SEC
staff concluded that fair value accounting provides investors the clearest
picture of an entity’s condition and increases comparability between
entities. However, the current fair value accounting rules are not a panacea
for investors and improvements are necessary.
The SEC staff analyzed how the Financial
Accounting Standards Board (FASB) develops accounting standards. The SEC
staff found that the existing process works well, and that while changes
have been made to improve the response time of the FASB and change the size
of the FAF’s Board of Trustees to accommodate the current workload and build
flexibility, further changes had been recommended by the SEC Advisory
Committee on Improvements to Financial Reporting (CIFiR). These changes
include enhancing the process for developing accounting standards,
completing post-implementation reviews of new accounting standards and
reviewing current accounting standards for continued relevance.
The SEC staff found that the suspension of fair
value in favor of returning to or introducing historical cost-based measures
would likely increase investor uncertainty and reduce investor confidence,
which could in turn adversely impact market liquidity and the values of debt
and equity securities. One suggested approach is supplementing fair value
measurements with disclosure instead of suspending fair value accounting.
However, it is unlikely that the market would view the placement of fair
value information in the footnotes and/or voluntary disclosures as equally
informative and reliable as the recognized values or the mandatory
disclosures that they would be replacing.
Overall, the SEC staff believes that the suspension of fair value accounting (in order to implement historical cost-based or other alternative valuation measures) is not advisable. The suspension or elimination of current accounting fair value requirements would likely increase investor uncertainty and adversely impact investor confidence by removing access to information at a time when the information is especially useful to investors. In addition, the SEC staff noted that with the increasing globalization of U.S. financial markets, a single set of high-quality accounting standards should remain the ultimate goal of standard-setters and regulators. Thus, the SEC staff encourages collaboration by the FASB and SEC with the International Accounting Standards Board (IASB). Recommendations
FAS 157 does not establish any requirements to account for assets or liabilities at fair value. It establishes a common definition of “fair value” for financial reporting and requires expanded disclosures. Suspending FAS 157 would reduce the comparability and consistency of fair value measurements.
The existing fair value and mark-to-market requirements were developed over several decades and were subject to extensive due process. The SEC staff feels that the elimination of fair value and mark-to-market requirements would erode investor confidence in financial reporting. Investors generally have found existing fair value accounting standards, particularly as they relate to fair value accounting for financial instruments, to have increased the quality of information available to them. In general, investors have indicated that fair value provides more relevant information reflecting the current economic reality and should not be replaced by other alternative accounting measures.
The SEC staff has found that issuers and auditors have faced challenges with the application of FAS 157 during the current global economic crises. Although application guidance has been provided, additional guidance, education and training is warranted in several areas.
There is a need for a more uniform system of impairment-testing standards for financial instruments. The FASB and the IASB have already initiated efforts to address these concerns. The development of a single model addressing the accounting for impairments could reduce the complexity and increase comparability of financial statements.
The use of judgment in accounting, auditing and regulation has increased due to the focus on more objectives-based standards and increased use of fair value estimates. Guidance regarding the application of judgment in connection with fair value measurements should keep pace with this increased use.
U.S. GAAP should not be modified to serve the needs of others at the expense of investors.
Implement a financial reporting forum, which includes key constituents from the preparer, auditor and investor communities, in which to meet with representatives from the SEC, the FASB and the Public Company Accounting Oversight Board to discuss issues in the financial reporting system. Formalize a post-adoption review process for all major FASB standards and establish a formal policy for standard-setting in circumstances that require an immediate response.
Before mandating any significant expansion in mark-to-market accounting for assets other than trading assets and derivatives, the joint boards first need to address simplifying accounting for investments in financial assets and other obstacles.
For more information * Report and Recommendations Pursuant to Section 133 of the Emergency Stabilization Act of 2008: Study on Mark-to-Market Accounting,” United States Securities and Exchange Commission, Dec. 30, 2008. http://www.sec.gov/news/studies/2008/marktomarket123008.pdf
The information contained herein is general in nature and based on authorities that are subject to change. It is not intended and should not be construed as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to or suitable for specific circumstances or needs and may require consideration of nontax and other tax factors. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Grant Thornton LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. No part of this document may be reproduced, retransmitted or otherwise redistributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, re-keying or using any information storage and retrieval system without written permission from Grant Thornton LLP.
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