When the Financial Accounting Standards Board (FASB) decided to move forward with changes to FAS 157, Accounting for Fair Value, with the proposed FAS 157-e, "Determining Whether a Market is Not Active and a Transaction is not Distressed," it did so in the face of strongly worded comment letters from the American Institute of Certified Public Accountants (AICPA) and the Center for Audit Quality (CAQ), which expressed serious reservations about the proposed changes. Neither organization supported the draft FASB Staff Position (FSP), and both called for major revisions. The Board acknowledged the feedback in these and other comment letters and decided to make significant revisions to the proposed FSP.
Without specifically commenting on what transpired during the House Financial Services subcommittee hearing, when under pressure FASB Chairman Robert Herz agreed to review and make changes to FAS 157, the AICPA and the CAQ both affirmed their support for an independent standards board.
"We are an independent standard setter and it's important that we maintain our independence," said FASB Board member Lawrence Smith, according to The Wall Street Journal. But he said the board can't "ignore what's going on around us" as banks plead for help.
John Czapla, Senior Vice President, Valuation Research, thinks that some people are misinterpreting the changes to FAS 157. "A quick take, since valuation professionals have a lot of work at the end of the quarter, is that FASB is recognizing that the markets are distressed, and taking FAS 157 one step further, saying that in these circumstances, you may have to exercise more judgment. Nothing is going to change that much from a practical standpoint. In the secondary market you need to be careful and most valuation firms are already doing that."
Czapla says that there are checks and balances to protect investors, as auditors question the valuations and management's judgment. "A company will always have to go through an audit, and management will have to explain their assumptions, but this allows more flexibility."
Some of the objections raised by the AICPA and the CAQ were:
Change in Assumption about Whether a Market is Active
Jay D. Hanson, Chairman of the AICPA's Accounting Standards Executive Committee wrote, "Overall, AcSEC does not support the issuance of this FSP as it is constructed. We believe that the FSP's presumption that transactions in a market that is not active are distressed is inconsistent with the objectives of the fair value measurements standard (FASB Statement No. 157), and the FSP may lead to measurements that ignore observable data and do not represent fair value. We are unable to reconcile the fair value objective in the FSP to the underlying exit price notion embedded in FASB Statement No. 157."
In Step 2 of the FSP's recommended test for an active market, FASB says "The reporting entity shall presume that the quoted price is associated with a distressed transaction unless the reporting entity has evidence that indicates that both of the following factors are present for a given quoted."
The two factors listed are:
- There was a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities (for example, there was not a regulatory requirement to sell).
- There were multiple bidders for the asset.
Deloitte and Touche expressed a similar objection in an analysis published in their Heads Up e-mail. "The Step 2 represents a significant change from the current practice of entities generally presuming that a quoted price in an inactive market is not distressed unless evidence exists to the contrary. Under the two-step approach, the opposite is true."
Problems with Implementation
In her comment letter, Cindy Fornelli, executive director of the CAQ, called for "additional implementation guidance to support the new measurement principle used in the proposed FSP, including a clear articulation by the FASB regarding the objective of this new measurement. Without appropriate application guidance, the proposed FSP will be operationally difficult to implement and will effectively 'shrink' what are considered to be active markets and expand what are considered to be inactive markets resulting in less objective measurements."
Fornelli also expressed concern about the cost of developing new valuation methods and the possibility that the new rule could preclude the use of pricing services and brokers to determine the fair value of an asset. She went on to say, "Further, given the additional cost and operational burden presented by the proposed FSP, we believe that some preparers of financial statements will not be able to implement this FSP by the proposed effective date."
Addressing some of these concerns, the FASB Board announced that revisions to the proposed standard would:
- Affirm that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions (that is, in the inactive market).
- Clarify and include additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active.
- Eliminate the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise. The FSP will instead require an entity to base its conclusion about whether a transaction was not orderly on the weight of the evidence.
- Include an example that provides additional explanation on estimating fair value when the market activity for an asset has declined significantly.
- Require an entity to disclose a change in valuation technique (and the related inputs) resulting from the application of the FSP and to quantify its effects, if practicable.
- Apply to all fair value measurements when appropriate.
Barry C. Melancon, AICPA president and CEO, acknowledged that not all stakeholders will be happy with the outcome, CCH reported. "All participants in the financial reporting system have an obligation to move forward and provide the most transparent and reliable information on hard-to-value assets so that our capital markets can use that information to allocate capital efficiently," Melancon said in a written statement.
The Board also discussed comment letters received on proposed FSP FAS 115-a, FAS 124-a, and EITF 99-20-b, Recognition and Presentation of Other-Than-Temporary Impairments (OTTI), a designation that triggers an automatic writedown, at their April 2nd meeting, and decided, that the change to existing guidance for determining whether an impairment is other than temporary should be limited to debt securities.
Under the new rule, adopted by a 3-2 vote, the Journal reports, companies could avoid the classification by stating that they intend to hold on to the asset and that it is more likely than not that they will.
The Board directed the staff to prepare a final version incorporating changes for a written vote.