When credit markets all but dried up as a result of the sub-prime mortgage crisis in the late summer, auditors of investment and commercial banks that elected to adopt Financial Accounting Standard 157, Fair Value Measurements, earlier than the effective date of November 15th were called upon to play a key role in determining the market value of mortgage-backed assets when few were being traded. Many of these banks had to report huge write-downs in the third quarter from declining assets values. But auditors of public companies have made it clear in three recently published white papers from their newly formed Center for Audit Quality that despite the severity of the current market crunch, they intend to apply the fair value standard consistently, and market problems will not influence their professional judgment about the quality of valuation models and assumptions used by banks.
Cynthia Fornelli, executive director of the Center for Audit Quality, said that the papers, which discuss measurements of fair value in illiquid markets, consolidation of off-balance-sheet structured investment vehicles (SIVs), and accounting for underwriting and loan commitments, merely compiled relevant generally accepted accounting principles. "We haven't forged any new ground with these papers, but we've articulated with a single voice what the standards and current requirements are," she said in a report that appeared in Financial Week.
In the white paper addressing fair value in illiquid markets, the Center refused to consider transaction volume as an indicator of a "distressed sale," Financial Week reports, giving little comfort to banks that might have tried to make the claim. "The fact that the transaction volume in a market is significantly lower than in previous periods does not necessarily mean that these are forced or distressed sales.... It would not be appropriate to disregard observable prices, even if that market is relatively thinner as compared to previous volume."
In another statement accompanying the white papers, the Center indicated that it did not expect the crisis to end any time soon. "It is not unreasonable to expect - especially for sub-prime mortgage assets - that current conditions could persist for an extended period of time until the uncertainty is reduced."
"The auditors have to do this as a matter of self-interest and survival," said Dr. J. Edward Ketz, associate professor of accounting at the Smeal College of Business at Pennsylvania State University, in an Associated Press article. "They need to cover their own positions by getting the bad news on the books sooner rather than later."
Perhaps the greatest challenge for banks and auditors as they implement FAS 157 in the coming months will be determining the values of "Level 3" assets, which have not yet been reported. FAS 157 sets up a hierarchy of financial assets:
Level 1 is for those assets that are commonly traded like stocks and bonds;
Level 2 for those that are not actively traded but have "observable inputs;" that is, similar assets like restricted stock, for example, are traded; and
Level 3 which includes assets that do not trade in active markets or which are unique. Their value may be based on such things as anticipated cash flow or default rates. These values are determined by mathematical models.
It will be the auditors' responsibility to determine whether the values coming out of these models reflect reality, a daunting task, since the models are based on many different assumptions.
Goldman Sachs, which is carrying a large amount of Level 3 assets, many in real estate, has decided to disclose their values, although they will not be required to do so until next Spring, reports The Daily Reckoning. Goldman disputes the idea that Level 3 assets are hard to value. "Just because they're in Level 3 doesn't mean we're not pricing them correctly," Goldman Chief Accounting Officer Sarah Smith said, according to Bloomberg.com. "We mark our positions to the point where we could exit at that moment."
Charles Mulford, an accounting professor at the Georgia Institute of Technology says that investment banks might have wanted the Financial Accounting Standards Board to defer adoption of SAS 157 for a year, but they were ready for the statement. "I'm glad they didn't defer it," he said. "We desperately need disclosures of CDO and sub-prime mortgage securities that aren't actively traded, so we can understand how these assets have been valued," MarketWatch reports.
The public company auditing profession created the Center for Audit Quality in January 2007 to serve investors, public company auditors, and the markets. The Center is an autonomous body affiliated with the AICPA, with a separate governing board. It is funded by its 800 member firms. The Center's Governing Board includes executives from the American Institute of CPAs, BDO Seidman LLP, Crowe Chizek and Company LLC, Deloitte & Touche USA LLP, Ernst & Young LLP, Grant Thornton LLP, KPMG LLP, McGladrey & Pullen LLP, and PricewaterhouseCoopers LLP.