Under pressure, FASB issues new fair value guidance

The Financial Accounting Standards Board has proposed a staff position that would amend Statement No. 157 – the US regulation that requires fair value accounting. The new guidance will allow reporting entities to rely more on their own judgment in determining if a market is distressed, and lets firms to use their own valuation techniques in to value assets in distressed markets.

The FAS 157 amendment establishes a two-step process to determine whether a market is not active and a transaction is not distressed. The first step provides a list of seven factors that indicate that a market is not active. Among these are:  if the markets have few recent transactions; price quotations are based on old information, or vary substantially over time or among market makers; there are abnormal liquidity risk premiums for quoted prices or abnormally wide bid-ask spreads; indexes that previously were highly correlated with the fair values of the asset but which are now uncorrelated with recent fair values; or if little information is released publicly. The second step provides factors that indicate whether a transaction was distressed. A transaction is not deemed to be distressed if there was sufficient time before the measurement date of a quoted price to allow for usual and customary marketing activities for the asset, or if there were multiple bidders for the asset.

David Larson, managing director for accouting and valuation firm Duff & Phelps, said the additional guidance in the proposed FAS157 is “relatively elegant, to the extent you can use the word ‘elegant’ to define an accounting process”, as the list of seven indicators of illiquid markets allows auditors to exercise more judgment when determining a financial asset’s trading price. “It is not an iron-fist rule,” he said. “It encourages people to do what they should have been doing in the first place.”

Another managing director for Duff & Phelps, Warren Hirschhorn, said the proposal is an attempt to move more towards principals-based rather than rules-based guidelines. “With rules-based standards, it would say you had to pass four of the seven, so then you could check the box and say you pass or fail, but here it says quite clearly that you evaluate, you consider the significance and the relevance of each, and then you use your judgment in determining value,” he said.

The FASB has been under pressure to deliver guidance that would increase the flexibility of mark-to-market rules lately, as everyone from industry leaders to members of Congress decried the accounting rules as a major contributor to the financial crisis.

“I heard you – I heard you – very clear,” FASB chairman Robert Herz told members of the House Financial Services Committee last week. “We could have the guidance in three weeks. Whether it would fix things is another question – I hope so.”