Another Fair Value Antidote?

After spending a day on the congressional hot seat, FASB chairman Robert Herz and the FASB have proposed expedited guidance on fair value for a 15-day comment period. The proposal guides companies on how to determine whether an asset's market can be considered not active, and whether a transaction being used to estimate an asset's value is not distressed.

Under FAS 157, which provides a measurement framework for fair-value accounting, financial instruments' fair values cannot be based on distressed sales. Fair-value accounting has been in existence for years, but has recently been criticized for worsening the financial crisis and leading to massive write-downs in the financial-services sector. (Of course, if you ask me, blaming fair value accounting for the financial crisis is kind of like placing the blame for a burning building on the smoke alarm! Maybe we should, instead, be looking for the bank execs who are holding the matches!)

Critics imply that the current rules require banks to unduly write down their asset values, even though they believe those assets are actually worth more than the amounts they feel mandated to report. The truth in FASB's view, however, is more complex: To avoid second-guessing by auditors, firms are tending to use any price they can find when estimating the fair values of their assets — even prices that are basically unreliable and too low to truly reflect an asset's current worth, because the prices resulted from a so-called forced transaction. Those types of transactions are not representative of an asset's fair value, according to FASB.

FAS 157 calls on companies to use a three-step hierarchy when estimating the current worth of their financial assets and liabilities. The evaluations must be based on prices that have been used in orderly transactions, not those that are considered forced or distressed.

Level 3 requires the most judgment, as it is designated for thinly traded or untraded assets that have a value derived from "unobservable inputs." For that reason, there has been a stigma attached to Level-3 numbers. So financial-statement preparers have tended to reference Level 2-type prices, although they shouldn't always do so.

Firms may have been wary of exploring Level-3 pricing because those inputs do require more judgment — which can result in more scrutiny from auditors and more work on the part of their internal staff and the need for outside help, such as valuation experts. Only 9 percent of financial instruments subject to fair value were classified under Level 3 since FAS 157 was implemented, compared to 76 percent of those instruments that fell under Level 1, according to a Securities and Exchange Commission study of financial institutions' use of fair value issued late last year.

To be sure, FASB board members acknowledged, these days it seems like nearly every financial instrument's market is inactive, and nearly every transaction is distressed, making the job of accountants that much harder. If a company determines, under the new proposal, that a price cannot be relied upon, then it needs to use another valuation technique, which falls under Level 3. As it is, many (including this blogger) believe, issuers were not taking the extra steps necessary to figure out the fair value of an asset that is not actively being traded.

If approved, companies will follow a two-step approach to determine whether they're justified in straying from observable prices because those valuations aren't truly representative of an asset or liability's current fair value. First, they will consider the signs that could indicate a market is inactive, such as there being too few transactions on which to judge pricing on an ongoing basis, or that price quotations are derived from outdated information.

Then, if all the evidence indicates the market is not active, companies will evaluate whether the price they are referencing was made under a distressed transaction. If it was not, then the price can be used for estimating fair value. But if it was, companies must use alternative valuation techniques.

FASB will vote on the proposal on April 2, one day after the public-comment period ends. FASB expects companies to use “significant judgment," which Herz acknowledges could result in different companies reporting different values of the same type of asset.