Revisions to Mark-to-Market Accounting Standards

The concept of Mark-to-Market accounting that establishes “fair value” for a company’s assets is generally defined by FASB Statement 157 – Fair Value Measurements, the following revisions are effective March 15, 2009. 

 Background:

Statement 157 was issued in September 2006, primarily as a result of the problems surrounding the failure of the Enron Corporation.   The original purposes of the statement were to establish a single definition of fair value and a framework for measuring fair value in generally accepted accounting principles (GAAP), and describe disclosures about fair value measurements that were intended to provide quality information to users of financial statements.

 The “fair value” concept is defined by saying “A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale).”

 The notion that a price for a forced liquidation or distress sale does not represent fair value is also discussed in paragraphs 10 and 17 of Statement 157.

Reasons for Modification of FASB Statement 157

The problem with the then existing interpretation of Statement 157 was that fair value hierarchies stated in the statement may be interpreted to use the concept of a “last transaction price” as the basis for establishing fair value, even when there is evidence that the market may not be functioning properly.  

Additionally, the Emergency Economic Stabilization Act of 2008 mandated a study of the Mark-to-Market accounting standard.  The Securities and Exchange Commission agreed that there should be additional modifications made to the standard. 

 Revisions:

The Financial Accounting Standards Board modified rules, providing guidance to help determine whether a market is not active and a transaction is not distressed, by establishing a two-step process of evaluation.  The reporting entity is given considerable latitude in this two step process. 

 Step 1: Is the Market Active?

The reporting entity makes the determination of whether or not a market is active based on the significance and relevance of a variety of factors, including but not limited to the following:

1. Few recent transactions (based on volume and level of activity in the market). Thus, there is not sufficient frequency and volume to provide pricing information on an ongoing basis.
2. Price quotations are not based on current information.
3. Price quotations vary substantially either over time or among market makers (for example, some brokered markets).
4. Indexes that previously were highly correlated with the fair values of the asset are demonstrably uncorrelated with recent fair values.
5. Abnormal (or significant increases in) liquidity risk premiums or implied yields for quoted prices when compared with reasonable estimates (using realistic assumptions) of credit and other nonperformance risk for the asset class.
6. Abnormally wide bid-ask spread or significant increases in the bid-ask spread.
7. Little information is released publicly (for example, a principal-to-principal market).

 Step 2: Does the Quoted Price represent a Distressed Transaction?

After making a determination that a market is not active, the reporting entity must assume that a quoted price is distressed unless there is evidence that both:

1. There was sufficient time before the measurement date to allow for usual and customary marketing activities for the asset; and
2. There were multiple bidders for the asset.

 If the reporting entity concludes that the quoted price is distressed, then other valuation techniques, such as income approach, should be used to establish fair value.  Variables used in the present value calculations should represent an assumption of an orderly transaction between market participants as well as reflect risks inherent in the asset.  A reasonable risk premium should take into account the ”uncertainty that would be considered in pricing the asset in a non-distressed situation.”

Impact on Mortgage-Backed Securities
 According to an article in the Wall Street Journal, this new rule “says that once an asset is other than temporarily impaired, only losses related to the underlying creditworthiness would affect earnings and regulatory capital. Losses attributed to market conditions would be disclosed and accounted for elsewhere.”  It is thought that this would help unfreeze the mortgage-backed securities market, which has seen little activity in trading of these securities. 

References:
FASB Staff Position on FSP FAS 157-e
Scannell, Kara “FASB Eases Mark-to-Market Rules ” Wall Street Journal Online Edition, April 2, 2009