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The debate over fair-value accounting amid financial crisis

By Xin Lian
Updated: 2008-10-14 11:24

With the financial crisis escalating, some bankers, financial professionals and legislators have started to question the Federal Accounting Standards (FAS). They blame FAS 157 (on assuming ‘fair value’ of financial assets) for an excess writedown when the market dives and say the pricing mechanism does not work. It is claimed to have widened losses and capital gap, driving financial institutions into panic sales, hence the self-reinforcing process of lower prices, greater writedowns, thinner capital, bigger headcust, and even lower prices. 60 congressmen have endorsed a letter to the Securities Exchange Commission, asking to give up the fair-value standard. They claim that the market is too messy for banks to mark their holdings to. Therefore, the crisis may be defused if the mark-to-market standard is abolished.

In response to the growing skepticism, the bailout plan adopted at the Capitol authorizes the SEC to suspend FAS 157 at its discretion. It also asks SEC to submit a comprehensive review within 90 days on the impact of fair-value accounting on the financial industry.

1. Updated Interpretation Under the pressure of legislators and the corporate sector, SEC released a staff position on Sept. 30th that clarifies fair-value accounting in an inactive and irrational market. It reiterates the principle of FAS 157 and defends mark-to-market practice. But companies are allowed to, when determining the fair value of their holdings, rely on internal assumptions and reasonable subjective inputs if an active market does not exist. The staff position makes 3 points.

1) Companies are allowed to rely on in-house models or assumptions to measure fair value when market quotes are not available.

2) Figuring out whether an asset is subject to a permanent writedown requires its holder to make reasonable judgment.

3) In an inactive or disorderly market, where brokers’ quotes do not represent the market situation, companies can rely less on market prices to identify the fair value of their financial assets.

2. Implications In the staff position, SEC makes it clear that in an inactive market, companies can’t solely rely on market feeds to measure the fair value of financial assets. More important inputs will be the duration and percentage of price declines, liquidity, outcome of internal models, and reasonable assumptions.

The new regulation offers the financial sector an opportunity to improve the 3rd quarter’s financial reports. By applying reasonable assumption to fair-value identification, companies may seek remedy for overly stringent writedowns in the past, and escape from the vicious cycle between distorted market prices and shrinking asset value, hence having a better-looking bottom line for the last 3 months. However, fair-value accounting is just an indicator, rather than the root, of the ongoing crisis. Even its suspension wouldn’t put an end to the disaster.

Meanwhile, some bankers are worried that greater flexibility may lead to unreasonable overpricing in accounting, compromising reliability and the transparency of corporate data. Anxious investors may rush into panic sales on a larger scale, bringing the crisis to the next level.

The review of fair-value accounting is a real challenge for the SEC. In the mid-1990’s, America subjected financial instruments and derivatives to mark-to-market accounting, a practice that has been accepted by most countries and applied to almost all financial trading and accounting. If it is suspended, there is unlikely to develop an alternative soon. Concerns over irregularity will rise. The odds are high that FAS 157 will remain in effect, but with more flexibility for the banks. It will take time to tell how well this will work.