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Thursday, January, 8, 2009

David B. H. Martin (Covington & Burling LLP) examines the pros and cons of FAS 157 a year after its adoption and looks at what regulators are doing to help businesses comply with FAS 157

Examining the pros and cons of FAS 157 a year after its adoption

PLI: FAS 157 on fair value has caused much consternation among reporting companies since its adoption, and some have tried to get it suspended. Can you review FAS 157, both pro and con?

DAVID B.H. MARTIN: In March of 2007, AIG and other companies publicly raised the idea of suspending the requirements under FAS 157.¹ The complaints arose from large write-downs that companies were forced to take during the last year as a result of the collapse of the subprime mortgage market. AIG, for example, took write-downs amounting to $11 billion as a result of its mortgage-related holdings. FAS 157 was seen as the cause.

Essentially, the argument is that when there is no market for the asset, and companies are forced to use Level 3 inputs in their valuation techniques, the numbers calculated are unreliable. This was viewed as especially true in the case of the valuations done for CDOs at the time of the subprime market collapse. Up until that point, most companies were using market prices to value their CDOs and other asset-backed securities. Because there were no formal valuation models in place, when the market for those securities fell apart, companies had to move quickly to develop their own valuation models, often using conservative estimates in an effort to limit the potential for litigation. Many companies now believe that these valuations never represented their financial situations and forced them to factor in losses that will never occur.²

Parties arguing against fair value accounting also worry about the market's depressed state. With investor confidence in the market already low, critics see companies that are taking large write-downs as a result of FAS 157 as exacerbating an already negative situation. Thus, even assuming the FASB's good intentions in instituting the fair value accounting standards, many believe the new standard has had unintended negative consequences that have further injured investor confidence in the market and the economy.³

Companies also worry about the threat of increased litigation. Unlike many other accounting regulations, the fair value accounting standards leave much in the hands and judgments of those preparing the financial statements. This is especially the case when it comes to evaluating those instruments that have no Level 1 or 2 inputs available. Valuation techniques using Level 3 inputs are by their nature a judgment call on the part of the company preparing the financials.⁴ The more discretionary the decisions made by companies are, the more those decisions are susceptible to second-guessing by investors. This, combined with a downturn in the economy, increases the potential for litigation. Thus, companies holding large amounts of instruments that must be valued using Level 3 inputs are wary about the risk of investor suits over the valuation of these instruments.

A variety of suggestions have been made for how to modify FAS 157 to deal with these issues. Some advocate permitting companies to keep their holdings at book value, or relatively close to book value, and take the losses gradually over time.⁵ This would prevent any sudden shocks that may result in a run on the company's stock. Others support an idea where companies and auditors would be allowed to estimate the maximum losses they are likely to incur and only recognize those.⁶ All other unrealized losses would be recorded on the balance sheet, but not included in profit reports. Finally, at least one commentator has advocated creating two sets of financial statements, one without the fair value numbers and one clearly illustrating all of the fair value assets.⁷ Any of these changes, however, would require the approval of the FASB and the SEC before adoption.

Support for FAS 157: Most supporters of FAS 157 advocate that it is the best way to get an accurate fair value picture of a company's financial condition. It is true that the system may overvalue instruments in certain situations and undervalue them in others, but, over time, any such extremes should even out. Any valuation system is going to be imperfect, and while many companies are arguing for the use of historical cost for these assets, that valuation technique also leads to the possibility of abuse and the potential for misleading investors.⁸ Although some of the asset-backed securities held by companies may rebound at some point after the credit crunch has passed, there is no guarantee that they will reach their former levels.

Others say that, eventually, losses may have to be taken. FAS 157 is a fair value accounting standard that allows outside investors the ability to see the volatility of the market on a real time basis, rather than limiting such information to the insiders of the companies until they are forced to make it public.⁹

Supporters also point out that fair value accounting is nothing new.¹⁰ Many companies used fair value accounting on at least some or all of their holdings. Trading businesses, like Goldman Sachs, have always used fair value accounting to price their holdings.¹¹ The purpose behind FAS 157 was simply to unify the calculations that were being done and to require the companies to disclose more to investors about how the numbers were obtained.

Essentially, the argument for FAS 157 is that more information in the hands of the investors is better than less, even if the information raises concerns. Companies should trust investors to be able to evaluate all the information that is given to them without overreacting. Moreover, nothing prevents companies from supplementing the fair value measures with additional disclosures, such as with more information in the footnotes to the financial statements or in other documentation given to investors.

SEC roundtable seeks compliance solutions for businesses applying FAS 157

PLI:There are no plans to alter FAS 157, but have regulators at least looked at ways to help businesses comply?

DAVID B.H. MARTIN: Despite the outcry against fair value accounting under FAS 157, Robert Herz, the FASB Chairman, has publicly stated that there are no plans to reevaluate the rules. The SEC has also declined to comment beyond issuing a letter detailing possible disclosures a company could elect to make. Since both the FASB and the SEC would have to approve any modification or suspension to the fair value accounting rules, companies should expect that they will have to continue to comply with the requirements of FAS 157, at least in the near term.

On July 10, the SEC held a roundtable on fair value accounting. While some in attendance still expressed concern over FAS 157 and the difficulties in valuing instruments in illiquid markets, the overall tenor of the discussion indicated an acceptance that fair value accounting is the best option currently available. Many participants expressed a belief that investors are capable of evaluating the financial information given to them by companies. In fact, some of the investors present stated that they would not feel comfortable investing with a company that did not provide fair value accounting information.

The focus of the roundtable was how to improve disclosure. Much of the literature on fair value accounting has also focused on this goal. Disclosure is the main tool available to companies, both to deal with the possibility of litigation and to mitigate damage caused by low fair value estimates. In the current climate of increased litigation, companies will benefit from being more transparent in the preparation of their financial statements, especially for valuation of instruments with little to no active market.¹² The more information that is made available, the harder it becomes for investors to allege the fraud necessary to have a successful claim.¹³ Additional disclosure also presents an opportunity to provide investors with more information that the company believes more accurately represents the financial picture of the company. Robert Herz has recommended that companies should make additional disclosures if they think assets are likely to recover value and provide greater cash flows than the fair value numbers indicate.¹⁴

Such disclosures could take many forms. The best place to start is the recommendations made by the SEC. In March 2008, the SEC staff circulated a sample letter about MD&A disclosures relating to FAS 157.¹⁵ In the letter, the SEC made various suggestions for disclosures that could be made to minimize the negative effects of the fall in value from using Level 3 inputs to evaluate the company's financial instruments. Specifically, the SEC encourages disclosure of the following information:

The amount of Level 3 assets and liabilities as a percentage of the total assets and liabilities measured using fair value;
The amount and reason for a material change in the Level 3 assets or liabilities;
The reasons for moving assets or liabilities from Level 1 or 2 into Level 3 and the effects that it may have on the estimates of their value;
How changes in Level 3 assets or liabilities have affected operations and whether or not the company believes that the fair values accurately represent what the company anticipates receiving for the asset or liability; and
The nature and type of assets that are underlying any asset-backed security and any expected changes to the ratings of those assets.

A point of discussion at the SEC roundtable focused on better versus more disclosure. Better organization of the disclosures may be more helpful than adding to the voluminous disclosures that are already made. Companies should consider consolidating fair value disclosures into a single section in the MD&A, with references to other sections such as critical accounting estimates and risk factors. This would permit investors to obtain all the information about the fair value accounting of the company in a more direct and clear fashion, and improving the level of transparency regarding financial risks could help in counteracting the instability in the financial markets.¹⁶ That said, there is no blanket list of disclosures all companies should make. Rather, companies should consult their accounting and legal advisors to determine what disclosures are necessary, taking into account the types of assets they hold and the models they are using to value those assets.

In addition to disclosures about the assets themselves, details about the models used to calculate the fair value measurements, and any changes to those models, should also be discussed. The SEC recommends that companies be open and honest with the valuation techniques that they use, listing not only general descriptions but also how specific models and valuation techniques were chosen, and how sensitive the measurements are to the inputs used to form the model.

Sensitivity analyses were also highly recommended by both panels at the SEC roundtable.¹⁷ Many who spoke stated that this was the key missing piece in much current disclosure. By providing investors with information on the range of values that may be appropriate for the fair valued assets and liabilities, companies allow those investors to use their own judgment to evaluate the fair value estimates.

Companies will need to keep up to date on developments in this area and revise their internal procedures in response to this evolving issue. Thomas J. Linsmeier, board member of the FASB, has stated that the FASB continues to work on the details of FAS 157.¹⁸ Congress has also announced an intention to hold hearings regarding the oversight of the financial markets, which may include discussion of fair value accounting.¹⁹

While there have been significant objections to FAS 157 by the business community, the SEC and the FASB seem committed to requiring fair value measurements for financial statements under this standard. This may be nothing more than part of a conviction that fair value accounting holds the high ground from a policy standpoint. Or, it may also be a determination that FAS 157's measurement principles are better than other problematic methods. In either case, the best option for companies to mitigate any negative effects stemming from potential questions raised under FAS 157 is through additional disclosures. This would include those disclosures recommended by the SEC and any additional disclosures based on a company's special circumstances that are helpful in giving investors a more complete financial picture of the company.

More from David B.H. Martin—download Disclosure Implications of Fair Value Accounting and the Subprime Mortgage Crisis: Download

Footnotes

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