SEC Mark-to-Market Report

As attorneys, why should we care about developments in fair value accounting? In a word: Disclosure. The further clarification and guidance on fair value and mark-to-market accounting requirements appear to be heading in a direction that may require increased disclosure requirements which may in turn require our input.

Mark-to-Market Accounting Report

The latest development in this process occurred on Dec. 30, 2008, when the Securities and Exchange Commission (“SEC”) submitted to Congress its study on mark-to-market accounting, Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-to-Market Accounting (available at www.sec.gov/news/studies/2008/marktomarket123008.pdf) (the “SEC Report”). Overall, the SEC Report contains a very useful history of valuation measurements and approaches to provide historical context to the issuance of the Financial Accounting Standards Board's (“FASB”) Statement of Financial Accounting Standards No. 157: Fair Value Measurements (September 2006) (summary available at www.fasb.org/pdf/fas157.pdf), or FAS 157, and attempts to show that FAS 157 was a logical and necessary step in the evolution of the fair-value accounting process. (A discussion of the methodology used by the SEC in gathering the information for the SEC Report is beyond the scope of this paper. See SEC Report, Section II.A., p. 43.) The SEC Report also contains eight recommendations to improve fair value and mark-to-market accounting requirements, as well as suggestions for monitoring developments and implementation of standards in the future. (The Eight Recommendations are summarized in the SEC Report on pp. 7-10.)

The Impact of FAS

On this past Oct. 2, I had the opportunity to participate on a panel discussing mark-to-market issues and the impact of FAS 157. I explained to an attendee that the evolution of my views on FAS 157 reminded me of the subtitle to the movie Dr. Strangelove: “How I Learned to Stop Worrying and Love the Bomb.” She pointed out to me, however, that the movie ended with the detonation of a doomsday device that destroyed the world.

I hadn't thought of that, but apparently Congress had, since Section 132 of the Emergency Economic Stabilization Act of 2008 (“EESA”) (available at http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?bname=110_cong_bills&docid=f:h1424enr.txt.pdf) passed by Congress on Oct. 3, 2008, specifically reminded the SEC that it had the authority to suspend FAS 157, but the SEC then and now specifically rejects this as a viable option. (While Congress debated EESA [which included Section 132] on Sept. 30, 2008 the SEC released the SEC Office of Chief Accountant and FASB Staff Clarifications on Fair Value Accounting, available at www.sec.gov/news/press/2008/2008-234.htm, and the SEC Report Recommendations 1 and 2 specifically rejecting suspension).

In addition to reminding the SEC of its suspension power, Section 133 of EESA directed the SEC to prepare a report addressing at a minimum:

• the effects of mark-to-market accounting standards on a financial institution's balance sheet;
• the impact on bank failures in 2008;
• the impact on the quality of financial information available to investors;
• the process used by the Financial Accounting Standards Board in developing accounting standards;
• the advisability and feasibility of modifications to such standards; and
• alternative accounting standards to those provided in FAS 157.

The SEC Report did not stray from this minimum scope requirement.

Before going into the SEC Report, I would like to briefly review the reason why Congress believed a report was warranted in the first place.

Why a Report?

During the hearings last September that eventually led to the passage of EESA, Congress heard testimony to the effect that the dislocation in the capital markets could be largely attributable to fair value accounting's mark-to-market requirement, specifically to FAS 157. (See SEC Report, p. 177.)

But it is important to remember that FAS 157 does not in and of itself require fair valuation. Rather, as FAS 157 itself points out:

This Statement defines fair value, establishes a framework for measuring fair value [for GAAP], and expands disclosures about fair value measurements '
[T]his Statement does not require any new fair value measurements [but] for some entities, the application of this Statement will change current practice.

(See also www.fasb.org/pdf/aop_FAS157.pdf for FAS 157, as amended from the September 2006 issued Statement). FAS 157, therefore, is intended to provide the rules for determining fair value when another accounting rule requires one to be determined.

FAS 157 defines fair value as:

The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (FAS 157, p. 2).

This is a current exit price measurement that requires reference to a hypothetical transaction in a market in which the asset in question is traded in order to determine its fair value. Although FAS 157 chooses an exit price analysis, the SEC Report notes that alternative fair value measurements include current entry price (replacement value), current equilibrium price (hypothetical arm's-length transaction in a complete, perfect market) and current value-in-use (based on discounted cash flows). (SEC Report, p. 177).

The key component of FAS 157, however, is the creation of the Fair Value Hierarchy: Level I, Level II and Level III. Basically, you match your asset to a Level that describes the type of market pricing inputs from which the asset's value is derived:

• Level 1: Inputs for the asset in question are observable in a market, you can point to a price for the same asset in an active market;
• Level 2: Price quote is obtained by reference to: 1) a similar asset trading in an active market; 2) an identical or similar asset trading in an inactive market; 3) other observable inputs for the asset (e.g., interest rates, yield curves, default rates); and 4) inputs derived principally from correlation (FAS 157, p. 11);
• Level 3: Inputs described in Level 1 or Level 2 are not available, but are “based on the best information available in the circumstances” (FAS 157, p. 11-12).

The higher the Level, the greater the detail that is required in the disclosure explaining the methodology utilized to determined fair value, basically a description and explanation of the observable and nonobservable pricing inputs utilized to determine the fair value of the examined asset. The Levels are designed to match the financial asset being analyzed to the market in which it does, or would, trade when such asset is sold on the date of determination.

Still with me?

The problem, witnesses told Congress last September, is that FAS 157 was not designed to address the dislocation that occurred in the capital markets starting in the summer of 2007 and continuing through today, and in fact may have contributed to the instability in the capital markets. (SEC Report, p. 1).

The SEC Report, however, concluded that this may not in fact be the case:

As detailed in the filings of the issuers sampled, losses stemming from lending activities of banks have had a profound impact on all financial institutions in 2007-2008. These losses have impacted the banks directly through increased loan loss provisions, [other-than-temporary impairment], and changes in fair value. Therefore, while fair value is used to measure certain assets such as trading securities and impairment losses on [available for sale] securities, such declines in value were directionally consistent with the losses on the underlying loans and the current economic conditions, which impacted the value of these securities. (SEC Report, p. 95).

Further, the SEC Report concluded that mark-to-market accounting had little to do with bank failures in 2008:

Based on the analysis performed, the Staff believes that fair value accounting was not a primary cause of the 2008 bank failures studied ' While most of the failed banks studied did not recognize significant fair value losses, each appears to have experienced default rates on assets held that significantly exceeded default rates experienced at non-failed banks of similar size. While declines in fair value and, to a lesser extent, U.S. GAAP-based incurred credit losses, are based on estimates, defaults on actual loans are much less subjective, as they indicate, in an objective way, the decline in quality of the underlying assets held by these banks. Even as it relates to defaults, the accounting for and reporting of defaults should not be viewed as causing a failure, but rather, a means of providing information used by market participants and others to evaluate an entity. (SEC Report, p. 97).

But the SEC Report does note that all is not well since most of the assets they surveyed utilized Level 2 or Level 3 measurements, which poses problems both for the preparers (companies) and users (investors) of financial reports. In Level 2, recall, you have a financial asset whose value is determined by reference to market price quotes (observable inputs) for an identical or similar asset, but that market is inactive, and in Level 3 there is no market at all.

The Report notes that:

[A]pproximately 85% of assets reported at fair value by financial institutions studied are reported in Levels 2 and 3 (76% and 9%, respectively). The estimate of value for these assets is therefore not based solely on quoted market prices. Rather, information derived for observable inputs (in the case of Level 2) and significant unobservable inputs (in the case of Level 3) are incorporated into models in developing an estimate of value. Such estimation processes, by their nature, require exercise of significant judgment. For measurements of fair value, the relevance of historical information, if any, to an expectation of future performance can be difficult to determine. Without relevant current information, accountants are faced with challenges in evaluating expectations of future events based on uncertain forecasts. (SEC Report, p. 205).

'Decision-Useful' Information

The SEC believes that financial reporting should be designed to provide “decision-useful” information to investors (SEC Report, p. 206), “but the quality of that information is put in question due to the current application of FAS 157 in preparing such financial reporting. The Report contains 8 recommendations to improve the current state of fair value accounting. (SEC Report, pp. 200-209).

Recommendation 3 is an attempt to address the Level 2 problem. The Report's Recommendation 3 provides that:

Fair value requirements should be improved through development of application and best practices guidance for determining fair value in illiquid or inactive markets. This includes consideration of additional guidance regarding:

How to determine when markets become inactive

How to determine if a transaction or group of transactions is forced or distressed

How and when illiquidity should be considered in the valuation of an asset or liability, including whether additional disclosure is warranted

How the impact of a change in credit risk on the value of an asset or liability should be estimated

When observable market information should be supplemented with and / or reliance placed on unobservable information in the form of management estimates

How to confirm that assumptions utilized are those that would be used by market participants and not just by a specific entity

Educational efforts to reinforce the need for management judgment in the determination of fair value estimates are needed.

In short, the preparers and users of financial reports would benefit from a little more clarity on connecting the types of assets being valued and the financial environment within which that asset exists. Thus, the emphasis in Recommendation 3 to improve the process (“particularly as they relate to both Level 2 and Level 3 estimates”). (SEC Report, p. 202).

Help, however, is not on the way anytime soon. The SEC Report notes on page 21 the work of the FASB and International Accounting Standards Board (“IASB”) in creating uniform international accounting standards (see 2006 Memorandum of Understanding, Completing the February 2006 Memorandum of Understanding: A Progress Report and Timetable for Completion, September 2008. (available at: www.fasb.org/intl/MOU_09-11-08.pdf), with a specific emphasis on addressing the shortcomings of fair value accounting, but as the SEC Report notes on page 209:

[T]he [FASB and IASB] should expedite their efforts around financial statement presentation and disclosure, particularly the joint presentation project that is scheduled to be completed by 2011. The joint project on the presentation of financial statements should serve to clarify for investors where, and how, fair value impacts a company's financial condition and its operating performance by distinguishing changes in fair value from other components of income.

What Do We Do?

So what, as legal counsel, do we do in the meantime? Fair value accounting is not going away, in fact, the SEC Report on pages 200 and 201 says this twice, just to be clear about where they stand on Section 132 of EESA. (“1. Recommendation'SFAS No. 157 Should be Improved, but not Suspended” and “2. Recommendation'Existing Fair Value and Mark-to-Market Requirements Should not be Suspended”).

Recommendation 7, however, may offer some assistance in that it calls for the creation of sort of an accounting rapid response team that would establish a financial reporting forum, a past statement review process and the “establishment of a formal policy for standard-setting in circumstances that necessitate near-immediate response.” (SEC Report, pp. 206-207).

If past practice is any indication of future requirements, further refinement and clarification of the fair value and mark-to-market accounting standards will mean more disclosure. We will therefore need to keep an eye on clarifications offered by the FASB and IASB, and find a valuation expert who can help explain to us the various permutations as they are revealed, since we will more than likely be required to assist our clients in translating into words the valuation metrics permitted and/or required by these future refinements.

Marvin J. Miller Jr. is a partner in the Corporate Department of the New York office of Winston & Strawn LLP.

As attorneys, why should we care about developments in fair value accounting? In a word: Disclosure. The further clarification and guidance on fair value and mark-to-market accounting requirements appear to be heading in a direction that may require increased disclosure requirements which may in turn require our input.

Mark-to-Market Accounting Report

The latest development in this process occurred on Dec. 30, 2008, when the Securities and Exchange Commission (“SEC”) submitted to Congress its study on mark-to-market accounting, Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-to-Market Accounting (available at www.sec.gov/news/studies/2008/marktomarket123008.pdf) (the “SEC Report”). Overall, the SEC Report contains a very useful history of valuation measurements and approaches to provide historical context to the issuance of the Financial Accounting Standards Board's (“FASB”) Statement of Financial Accounting Standards No. 157: Fair Value Measurements (September 2006) (summary available at www.fasb.org/pdf/fas157.pdf), or FAS 157, and attempts to show that FAS 157 was a logical and necessary step in the evolution of the fair-value accounting process. (A discussion of the methodology used by the SEC in gathering the information for the SEC Report is beyond the scope of this paper. See SEC Report, Section II.A., p. 43.) The SEC Report also contains eight recommendations to improve fair value and mark-to-market accounting requirements, as well as suggestions for monitoring developments and implementation of standards in the future. (The Eight Recommendations are summarized in the SEC Report on pp. 7-10.)

The Impact of FAS

On this past Oct. 2, I had the opportunity to participate on a panel discussing mark-to-market issues and the impact of FAS 157. I explained to an attendee that the evolution of my views on FAS 157 reminded me of the subtitle to the movie Dr. Strangelove: “How I Learned to Stop Worrying and Love the Bomb.” She pointed out to me, however, that the movie ended with the detonation of a doomsday device that destroyed the world.

I hadn't thought of that, but apparently Congress had, since Section 132 of the Emergency Economic Stabilization Act of 2008 (“EESA”) (available at http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?bname=110_cong_bills&docid=f:h1424enr.txt.pdf) passed by Congress on Oct. 3, 2008, specifically reminded the SEC that it had the authority to suspend FAS 157, but the SEC then and now specifically rejects this as a viable option. (While Congress debated EESA [which included Section 132] on Sept. 30, 2008 the SEC released the SEC Office of Chief Accountant and FASB Staff Clarifications on Fair Value Accounting, available at www.sec.gov/news/press/2008/2008-234.htm, and the SEC Report Recommendations 1 and 2 specifically rejecting suspension).

In addition to reminding the SEC of its suspension power, Section 133 of EESA directed the SEC to prepare a report addressing at a minimum:

• the effects of mark-to-market accounting standards on a financial institution's balance sheet;
• the impact on bank failures in 2008;
• the impact on the quality of financial information available to investors;
• the process used by the Financial Accounting Standards Board in developing accounting standards;
• the advisability and feasibility of modifications to such standards; and
• alternative accounting standards to those provided in FAS 157.

The SEC Report did not stray from this minimum scope requirement.

Before going into the SEC Report, I would like to briefly review the reason why Congress believed a report was warranted in the first place.

Why a Report?

During the hearings last September that eventually led to the passage of EESA, Congress heard testimony to the effect that the dislocation in the capital markets could be largely attributable to fair value accounting's mark-to-market requirement, specifically to FAS 157. (See SEC Report, p. 177.)

But it is important to remember that FAS 157 does not in and of itself require fair valuation. Rather, as FAS 157 itself points out:

This Statement defines fair value, establishes a framework for measuring fair value [for GAAP], and expands disclosures about fair value measurements '
[T]his Statement does not require any new fair value measurements [but] for some entities, the application of this Statement will change current practice.

(See also www.fasb.org/pdf/aop_FAS157.pdf for FAS 157, as amended from the September 2006 issued Statement). FAS 157, therefore, is intended to provide the rules for determining fair value when another accounting rule requires one to be determined.

FAS 157 defines fair value as:

The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (FAS 157, p. 2).

This is a current exit price measurement that requires reference to a hypothetical transaction in a market in which the asset in question is traded in order to determine its fair value. Although FAS 157 chooses an exit price analysis, the SEC Report notes that alternative fair value measurements include current entry price (replacement value), current equilibrium price (hypothetical arm's-length transaction in a complete, perfect market) and current value-in-use (based on discounted cash flows). (SEC Report, p. 177).

The key component of FAS 157, however, is the creation of the Fair Value Hierarchy: Level I, Level II and Level III. Basically, you match your asset to a Level that describes the type of market pricing inputs from which the asset's value is derived:

• Level 1: Inputs for the asset in question are observable in a market, you can point to a price for the same asset in an active market;
• Level 2: Price quote is obtained by reference to: 1) a similar asset trading in an active market; 2) an identical or similar asset trading in an inactive market; 3) other observable inputs for the asset (e.g., interest rates, yield curves, default rates); and 4) inputs derived principally from correlation (FAS 157, p. 11);
• Level 3: Inputs described in Level 1 or Level 2 are not available, but are “based on the best information available in the circumstances” (FAS 157, p. 11-12).

The higher the Level, the greater the detail that is required in the disclosure explaining the methodology utilized to determined fair value, basically a description and explanation of the observable and nonobservable pricing inputs utilized to determine the fair value of the examined asset. The Levels are designed to match the financial asset being analyzed to the market in which it does, or would, trade when such asset is sold on the date of determination.

Still with me?

The problem, witnesses told Congress last September, is that FAS 157 was not designed to address the dislocation that occurred in the capital markets starting in the summer of 2007 and continuing through today, and in fact may have contributed to the instability in the capital markets. (SEC Report, p. 1).

The SEC Report, however, concluded that this may not in fact be the case:

As detailed in the filings of the issuers sampled, losses stemming from lending activities of banks have had a profound impact on all financial institutions in 2007-2008. These losses have impacted the banks directly through increased loan loss provisions, [other-than-temporary impairment], and changes in fair value. Therefore, while fair value is used to measure certain assets such as trading securities and impairment losses on [available for sale] securities, such declines in value were directionally consistent with the losses on the underlying loans and the current economic conditions, which impacted the value of these securities. (SEC Report, p. 95).

Further, the SEC Report concluded that mark-to-market accounting had little to do with bank failures in 2008:

Based on the analysis performed, the Staff believes that fair value accounting was not a primary cause of the 2008 bank failures studied ' While most of the failed banks studied did not recognize significant fair value losses, each appears to have experienced default rates on assets held that significantly exceeded default rates experienced at non-failed banks of similar size. While declines in fair value and, to a lesser extent, U.S. GAAP-based incurred credit losses, are based on estimates, defaults on actual loans are much less subjective, as they indicate, in an objective way, the decline in quality of the underlying assets held by these banks. Even as it relates to defaults, the accounting for and reporting of defaults should not be viewed as causing a failure, but rather, a means of providing information used by market participants and others to evaluate an entity. (SEC Report, p. 97).

But the SEC Report does note that all is not well since most of the assets they surveyed utilized Level 2 or Level 3 measurements, which poses problems both for the preparers (companies) and users (investors) of financial reports. In Level 2, recall, you have a financial asset whose value is determined by reference to market price quotes (observable inputs) for an identical or similar asset, but that market is inactive, and in Level 3 there is no market at all.

The Report notes that:

[A]pproximately 85% of assets reported at fair value by financial institutions studied are reported in Levels 2 and 3 (76% and 9%, respectively). The estimate of value for these assets is therefore not based solely on quoted market prices. Rather, information derived for observable inputs (in the case of Level 2) and significant unobservable inputs (in the case of Level 3) are incorporated into models in developing an estimate of value. Such estimation processes, by their nature, require exercise of significant judgment. For measurements of fair value, the relevance of historical information, if any, to an expectation of future performance can be difficult to determine. Without relevant current information, accountants are faced with challenges in evaluating expectations of future events based on uncertain forecasts. (SEC Report, p. 205).

'Decision-Useful' Information

The SEC believes that financial reporting should be designed to provide “decision-useful” information to investors (SEC Report, p. 206), “but the quality of that information is put in question due to the current application of FAS 157 in preparing such financial reporting. The Report contains 8 recommendations to improve the current state of fair value accounting. (SEC Report, pp. 200-209).

Recommendation 3 is an attempt to address the Level 2 problem. The Report's Recommendation 3 provides that:

Fair value requirements should be improved through development of application and best practices guidance for determining fair value in illiquid or inactive markets. This includes consideration of additional guidance regarding:

How to determine when markets become inactive

How to determine if a transaction or group of transactions is forced or distressed

How and when illiquidity should be considered in the valuation of an asset or liability, including whether additional disclosure is warranted

How the impact of a change in credit risk on the value of an asset or liability should be estimated

When observable market information should be supplemented with and / or reliance placed on unobservable information in the form of management estimates

How to confirm that assumptions utilized are those that would be used by market participants and not just by a specific entity

Educational efforts to reinforce the need for management judgment in the determination of fair value estimates are needed.

In short, the preparers and users of financial reports would benefit from a little more clarity on connecting the types of assets being valued and the financial environment within which that asset exists. Thus, the emphasis in Recommendation 3 to improve the process (“particularly as they relate to both Level 2 and Level 3 estimates”). (SEC Report, p. 202).

Help, however, is not on the way anytime soon. The SEC Report notes on page 21 the work of the FASB and International Accounting Standards Board (“IASB”) in creating uniform international accounting standards (see 2006 Memorandum of Understanding, Completing the February 2006 Memorandum of Understanding: A Progress Report and Timetable for Completion, September 2008. (available at: www.fasb.org/intl/MOU_09-11-08.pdf), with a specific emphasis on addressing the shortcomings of fair value accounting, but as the SEC Report notes on page 209:

[T]he [FASB and IASB] should expedite their efforts around financial statement presentation and disclosure, particularly the joint presentation project that is scheduled to be completed by 2011. The joint project on the presentation of financial statements should serve to clarify for investors where, and how, fair value impacts a company's financial condition and its operating performance by distinguishing changes in fair value from other components of income.

What Do We Do?

So what, as legal counsel, do we do in the meantime? Fair value accounting is not going away, in fact, the SEC Report on pages 200 and 201 says this twice, just to be clear about where they stand on Section 132 of EESA. (“1. Recommendation'SFAS No. 157 Should be Improved, but not Suspended” and “2. Recommendation'Existing Fair Value and Mark-to-Market Requirements Should not be Suspended”).

Recommendation 7, however, may offer some assistance in that it calls for the creation of sort of an accounting rapid response team that would establish a financial reporting forum, a past statement review process and the “establishment of a formal policy for standard-setting in circumstances that necessitate near-immediate response.” (SEC Report, pp. 206-207).

If past practice is any indication of future requirements, further refinement and clarification of the fair value and mark-to-market accounting standards will mean more disclosure. We will therefore need to keep an eye on clarifications offered by the FASB and IASB, and find a valuation expert who can help explain to us the various permutations as they are revealed, since we will more than likely be required to assist our clients in translating into words the valuation metrics permitted and/or required by these future refinements.

Marvin J. Miller Jr. is a partner in the Corporate Department of the New York office of Winston & Strawn LLP.