Courtesy of the DechartOnPoint Bulletin, we offer a look at how fair-value accounting stands in the light of new statements from the SEC and FASB. It offers details of how investments and assets should be assessed, especially under FAS 157. The new rules may provide a measure of comfort to companies that reasonably believe current market prices for certain assets reflect fire-sale prices or transactions in disorderly markets.

In response to recent market events, the Securities and Exchange Commission (SEC), Financial Accounting Standards Board (FASB), and Congress have taken steps to clarify mark-to-market valuation. This DechertOnPoint addresses the following regulatory developments regarding valuation: (1) the SEC and FASB staff joint statement issued on September 30, 2008;^[1] (2) the Emergency Economic Stabilization Act of 2008 provisions pertaining to fair value accounting;^[2] (3) the FASB staff position issued on October 10, 2008;^[3] (4) the SEC no-action letter to the Investment Company Institute ('ICI') issued on October 10;^[4] and (5) the SEC roundtable discussion regarding fair-value accounting on October 29, 2008.

Background

The Statement of Financial Accounting Standards 157 (FAS 157) defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosure requirements for fair-value measurements. Under FAS 157, fair value generally means the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the principal or most advantageous market at the measurement date.^[5]

FAS 157 establishes a three-tiered fair-value hierarchy that prioritises the assumptions that market participants use in determining this price, also known as 'inputs'.

• Level 1 designates assets with quoted prices in active markets
• For Level 2, a category for assets with prices that are not readily available on the measurement date, firms can, for example, establish prices by reference to similar assets that trade actively
• For Level 3, firms determine prices based on their own assumptions about how market participants would price the asset

Levels 1 and 2 rely on 'observable inputs', or inputs that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the reporting entity. Level 3, meanwhile, contains 'unobservable inputs', or inputs that reflect the reporting entity's own assumptions.^[6]

Due to recent market conditions, FAS 157 has come under scrutiny, as some blame adherence to FAS 157 for unnecessarily large write-downs on companies' balance sheets as companies sought to reflect current market prices in their valuations. Given recent turbulence in the markets, in which certain sales have been distressed and otherwise active markets have at times been dislocated, the criticism is that a recent market price may significantly undervalue the price of an asset.

SEC and FASB staff release clarifying fair-value accounting

On September 30, 2008, the SEC Office of the chief accountant and FASB issued Release 2008-234. The purpose of the Release is to clarify certain aspects of FAS 157 in light of current market conditions. Written principally in a question and answer format, the Release addresses the following topics:

1. management's internal assumptions;
2. the use of "market" quotes;
3. disorderly transactions;
4. transactions in inactive markets;
5. factors to consider in determining whether an investment is other-than-temporarily impaired; and
6. disclosure

Management's internal assumptions

The Release states that when an active market for a security does not exist, the use of "management estimates that incorporate current market participant expectations of future cashflows, and include appropriate risk premiums, is acceptable." The Release emphasises that significant judgment is often required in making fair-value determinations and that multiple inputs - including management's assumptions regarding cashflows - may need to be considered. The Release goes on to say that Level 3 (unobservable) inputs may be more helpful than Level 2 inputs when significant adjustments are necessary to arrive at fair value using observable inputs.

The use of 'market' quotes

The Release states that where an active market does not exist for a security, 'market' quotes may be factored in as an input, but they are not determinative. The Release states that, in determining the quote's weight as an input, an entity should consider: (1) the nature of the quote, such as whether it is a binding offer; and (2) whether the quote is based on market transactions or a broker's own information.

Disorderly transactions

The Release states that disorderly transactions are not determinative of fair value. It explains that the concept of fair value assumes orderly transactions in which both parties are willing participants. The Release continues to say that, while a fair-value measurement may include a distressed or forced liquidation sales price as an input, the fact that it is from a disorderly transaction should be taken into account. Here too, the Release emphasises the importance of exercising judgment in reaching valuation determinations, in particular with respect to determination of whether a transaction is disorderly.^[7]

Transactions in an inactive market

Similarly, the Release states that transactions in inactive markets typically are not determinative, but may be considered as inputs. In evaluating whether the market is inactive, the Release states that entities should look for relatively few bidding parties in the market and a significant increase in the difference between bids and asks. Again, the Release emphasises the importance of exercising judgment in reaching valuation determinations.

Factors used in determining whether an investment is other than temporarily impaired

The Release provides the general principle that the greater the price decline, the longer the period of the decline, and the greater the anticipated time until recovery, the greater the level of evidence needed to support a conclusion that an 'other than temporary decline' has not occurred. Here too, the Release emphasises the propriety of exercising judgment, adding that there are no 'bright line' rules under GAAP on this point and that "reasonable judgment based upon the specific facts and circumstances of each investment" is required. With reference to SAB Topic 5M, which discusses other than temporary impairment of certain securities investments, the Release lists several factors to be considered when making the determination of whether an investment is other than temporarily impaired:

• length of time during which the market value has been less than cost, as well as the magnitude of the difference between market value and cost;
• the financial condition of the issuer, including its near-term prospects;
• and the intent and ability of the holder to hold the investment until any anticipated recovery in market value

Disclosure

The Release also notes the importance of clear and transparent disclosures about any judgments made by management in determining values.

Legislative developments regarding fair-value accounting

The Stabilization Act, which was signed into law on October 3, 2008, contains two potentially significant provisions regarding mark-to-market accounting. First, it gives the SEC the authority to suspend FAS 157 for any issuer or class or category of transaction if the SEC determines that "it is necessary or appropriate in the public interest and is consistent with the protection of investors."

Second, the Stabilization Act directs the SEC to conduct a study of FAS 157 to be submitted to Congress by January 2, 2009. The study is to address the impact of fair-value accounting on financial institution balance sheets, bank failures in 2008, and the quality of financial information available to investors; FASB's process in developing accounting standards; alternatives to FAS 157; and the advisability and feasibility of modifying the fair-value accounting standards.

FASB staff position FSP 157-3

On October 10, 2008, FASB issued FSP 157-3, 'Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active'. FSP 157-3 asserts that the guidance it provides "is consistent with and amplifies the guidance contained in [the Release]." To that end, FSP 157-3 largely reiterates what was stated in the Release. In addition, it amends FAS 157 to include Example 11, which illustrates the determination of fair value for collateralized debt-obligation securities when the market for those assets is not active. The example details the various inputs that may be considered. In particular, the example demonstrates:

1. the use of a reporting entity's own assumptions in determining fair value in the absence of observable inputs;
2. the use of observable inputs in an inactive market; and
3. the use of market quotes in assessing relevance of inputs.

FSP 157-3 became effective upon issuance and applies to any prior accounting periods for which financial statements are not yet issued.

SEC staff no-action letter

On October 10, 2008, the SEC staff issued a no-action letter to the ICI stating that it would not recommend enforcement action under section 2(a)(41) of the 1940 Act and rules 2a-4^[8] and 22c-1^[9] thereunder if a money market fund uses amortized cost value, rather than market quotations, in 'shadow pricing' certain portfolio securities pursuant to rule 2a-7 under the circumstances described in the letter. Money market funds may use the amortized cost method for valuing securities with remaining maturities of 397 days (13 months) or less, but must engage in periodic 'shadow pricing' whereby they determine the difference between net asset value per share calculated using amortized cost and market prices of their portfolio securities. The no-action letter permits money market funds to use amortized cost value (rather than current market price) when 'shadow pricing' so long as:

1. the portfolio securities have remaining maturities of 60 days or less;
2. the portfolio securities are First Tier Securities as defined in paragraph (a)(12) of rule 2a-7;
3. the fund has a reasonable expectation of holding the securities until maturity; and
4. the particular circumstances (that is, impairment of the issuer's creditworthiness) do not indicate that use of amortized cost is inappropriate

We understand that the SEC staff permits a blended approach to valuation on the basis of the no-action letter, meaning that some securities may be valued using amortized cost while others may be valued at market price. However, the approach must be reasonable and consistent. A fund may not alternate on a security-by-security basis depending upon which method results in a higher value. Rather, a fund must use reasonable tests, based on whether market price is a reliable indicator of value, to determine the types of securities that will be valued at market price and the types that will be valued at amortized cost.

We also understand that the SEC staff has taken the position that a money market fund that relies on the no-action letter to use amortized cost valuation will be in compliance with the requirements of the Money Market Guarantee Program (the 'Program'). This position is well supported by the terms of the Program documents, which require that participating funds operate in compliance with rule 2a-7 of the 1940 Act. By complying with the letter, a fund presumably is in compliance with rule 2a-7.

SEC roundtable on mark-to-market accounting

On October 29, 2008, the SEC held a roundtable for the purpose of examining fair value accounting as used by financial institutions. This was the first of two roundtables to be held in connection with the SEC's study on fair-value accounting standards, with the second to be held on November 21, 2008. The roundtable consisted of two panels representing various aspects of the financial industry.^[10]

A major topic discussed at the roundtable was whether mark-to-market accounting caused or contributed to the financial crisis. Panellists largely agreed that the standards did not cause the financial crisis, but felt that the standards were procyclical and thus did not help the economy once the financial crisis began. Many agreed that FAS 157 does contribute to transparency and felt that its suspension at this stage would create further problems. Some, however, believed that mark-to-market accounting significantly contributed to the crisis and argued for FAS 157's suspension. Many suggested that the SEC should be looking at the underlying causes of the crisis.

Suggestions regarding how to improve FAS 157 varied. Again, some argued that mark-to-market accounting is inappropriate, preferring approaches such as historical-cost accounting. Others suggested there is nothing fundamentally wrong with mark-to-market accounting but that additional guidance is needed for its application given current market conditions. One panellist stated that the debate about fair-value accounting is largely due to the misconception that fair value automatically equates to mark-to-market valuation, and urged application of FAS 157 in a manner consistent with the intent and principles behind the standard. Some suggested that companies could distinguish between credit impairment and liquidity impairment for valuation purposes. Lastly, some felt that mark-to-market valuation could appear separately, possibly in a footnote to the financial statements, rather than being used on a company's balance sheet and in calculating net income.

Conclusion

The guidance provided by the SEC and FASB staff is significant in that it emphasises the importance that judgment plays in making FAS 157 valuation determinations, particularly in challenging market environments. Thus, it may provide a measure of comfort to companies that reasonably believe current market prices for certain assets reflect fire-sale prices or transactions in disorderly markets. Moreover, the no-action letter provides important relief for some money market funds.

Nonetheless, it is important to note that if there is some flexibility in the guidance, it is that firms may, after a reasonable analysis, conclude that transactions in a distressed market are not controlling as to asset valuations. However, firms still must consider such transactions as data points in their analysis. Firms may not ignore such transactions when they conclude that the market is distressed.^[11]

For funds, FAS 157 is generally thought to be more important in terms of disclosure than actual valuation processes, as Section 2(a)(41) of the 1940 Act governs fund valuation. Therefore, the impact of the clarifications and any changes to FAS 157 that may result from the SEC study may have a less significant impact on fund valuation.

© 2008 Dechert LLP. All rights reserved. Materials have been abridged from laws, court decisions, and administrative rulings and should not be considered as legal opinions on specific facts or as a substitute for legal counsel. This publication, provided by Dechert LLP as a general informational service, may be considered attorney advertising in some jurisdictions. Prior results do not guarantee a similar outcome.