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Fair Value Accounting And The Current Financial Crisis

Oct 01, 2008

In light of the recent debate over fair value accounting and to what extent it contributed to the current financial crisis, below is a quick summary of the basics of the concept. 

Fair Value Basics Explained*

  • What is fair value accounting? Fair value accounting, also called "mark-to-market," is a way to measure assets and liabilities that appear on a company's balance sheet and income statement. Measuring companies' assets and liabilities at fair value may affect their income statement. SFAS 157 was issued in 2006 by the Financial Accounting Standards Board (FASB) effective for fiscal year 2008. SFAS 157 defines in one place the meaning of "fair value."

  • Why is it important today? Huge losses reported by financial firms on subprime assets have led to a debate over the implementation of SFAS 157 in circumstances where markets collapse and price inputs aren't readily available.  In the current crisis, banks and investment banks have had to reduce the value of the mortgages and mortgage-backed securities to reflect current prices.  Those prices declined severely with the collapse of credit markets as mortgage defaults escalated.

  • What is FASB? FASB is the independent U.S. accounting standard-setting body based in Norwalk, Conn., that sets U.S. generally accepted accounting principles used by all U.S. publicly-traded companies.   

  • How does mark-to-market work? SFAS 157 provides a hierarchy of three levels of input data for determining the fair value of an asset or liability.
    • Level 1 is quoted prices for identical items in active, liquid and visible markets such as stock exchanges.
    • Level 2 is observable information for similar items in active or inactive markets, such as two similarly situated buildings in a downtown real estate market.
    • Level 3 are unobservable inputs to be used in situations where markets don't exist or are illiquid such as the present credit crisis. At this point fair market valuation becomes highly subjective.

  • What does SFAS 157 apply to? The fair value accounting standard SFAS 157 applies to financial assets of all publicly-traded companies in the U.S. as of Nov. 15, 2007. It also applies to non-financial assets and liabilities that are recognized, or disclosed, at fair value on a recurring basis. Beginning in 2009, the standard will apply to other non-financial assets. SFAS 157 applies to items for which other accounting pronouncements require or permit fair value measurements except share-based payment transactions, such as stock option compensation.

As reported in The New York Times this week, the Securities and Exchange Commission this week issued an interpretation of SFAS 157 that could make it easier for banks to report smaller losses. Basically, the interpretation gives banks more leeway in using the more favorable Level 3 approach to value securities instead of Level 2 in the case of an inactive market that consists of only "forced or disorderly" transactions.

The move by the SEC drew priase from the American Bankers Association, which had complained that auditors were forcing banks to value assets at unrealistically low "fire sale" prices, rather than at the higher values the banks believe the assets should be worth in an orderly market.

Some congressmen had pressed to order a suspension of the fair-value rule as part of the bailout bill that the House defeated earlier this week but may be revived later in the week. That bill stopped short of that, but did require a study of the rule and authorized the SEC to suspend it.

* Source: The American Institute of Certified Public Accountants

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