Study: Most Firms Use “Triggers” To Invoke Fair Value Procedures

In a recently released study by Interactive Data Corporation, mutual fund industry professionals continue to invoke fair value procedures at an increasing rate.

The survey, which covered 134 Chief Financial Officers, Chief Compliance Officers, and valuation team members, showed an increasing attention to market volatility as it relates to fair value accounting procedures.

“The heightened level of volatility in the market draws attention to the importance of fair value practices for mutual funds investing in international equities,” said Rob Haddad, director of Evaluated Services for Interactive Data. Haddad continued, “Our survey found that mutual funds are generally well-prepared for volatile market scenarios, with predefined fair value procedures in place to handle such events, and formal back-testing processes to examine how these procedures worked in practice.”

Among mutual funds, 36% reported that fair value is being applied every day, up from only 10% in 2004. The other 64% of funds reported using “triggers” — a process that pays attention to market movements and benchmarks — to apply fair value procedures for the fund. The strategy for triggers varied greatly in method, scope, and complexity, said the study.

Wilcox: Fair Value Materially Affects Reported Earnings

In a contribution to the American Association of Individual Investors Journal, Minnesota State University professor Stephen E. Wilcox discussed Robert Shiller’s cyclically adjusted price-earnings ratio (CAPE) method of valuation.

A newly popular method of valuation, CAPE relies on inflation-adjusted earnings statements as well as averaging 10 years of reported earnings to account for business cycle effects. Wilcox says that CAPE provides “an overly bearish view of the stock market” and should be used with caution.

Fair value accounting, says Wilcox, showed how a change in accounting regulations had a material impact on reported earnings and is a key flaw in Shiller’s CAPE method.

When the Financial Accounting Standards Board (FASB) issued the fair value ruling in 2006 (and up through the financial crisis in 2008), investment securities and mortgage-backed securities made up a significant percentage of banks’ assets. Wilcox says, “The move toward more fair value accounting standards resulted in security losses having a devastating effect on the reported earnings of financial institutions” in the fourth quarter of 2008. CAPE, says Wilcox, must continue to reflect the impact of a single quarter’s massive loss even though it’s unlikely it will happen again in the next 10 years.

Sapra: Increased Transparency May Not Be the Best Fix For Crisis

In a Bloomberg editorial, University of Chicago Booth School of Business professor Haresh Sapra says that conventional thinking on financial regulation may not be entirely beneficial. “The view that greater transparency enhances market discipline and therefore economic efficiency holds true only in a ‘Robinson Crusoe’ economy, that is to say one in which a single decision maker is learning about a company whose decisions are taken as given and whose future cash flows or economic fundamentals are therefore fixed,” says Sapra.

Fair value accounting is one method that regulators have undertaken to improve transparency, requiring that assets be accounted for at market price (rather than purchase price) to give a more accurate view of a holding’s value to both insiders and outsiders of a company. But financial insiders point to increased volatility in financial statements, leading to unnecessary and unintended instability.

The more that a financial institution relies on short-term pricing and value changes, the more at-risk it is for a “feedback loop,” as “decisions of financial institutions are more likely to be based on second-guessing of their competitors than on perceived fundamentals,” says Sapra. “Put differently, in trying to enhance market discipline, reliance on market prices via fair-value accounting weakens market discipline,” he concludes.

Amen to that, Professor! Let’s do both–print holdings at purchase price and then footnote the exact mark-to-market effect. This attains both goals–it gives long-term decision-making room to think and operate and fully discloses the market value effects on the institution. Why isn’t this a perfect solution? It provides more disclosure and less volatility–win-win!

IASB Notes Further Specification on Fair Value Standard

The International Accounting Standards Board (IASB) recently clarified its tweaks to the fair value measurement. In IFRS (International Financial Reporting Standards) 13, an update on the “Fair Value Measurement” rules, international and United States accounting policies took another step at converging to a single accounting standard. Though it does not mandate the use of fair value accounting, as many had fought against, it does lay out guidance on when and how the standard should be applied to IFRS-adopted companies.

The IASB called the standards update a “five-year consolidation project” that solidified the existing rules around mark-to-market, or fair value, accounting. “This is a standard that applies to any asset or liability that requires you to make a valuation,” said IASB board member Warren McGregor. The focus remained tightly trained on financial instruments, mostly due to the global economic slump. But it’s much wider than that, said McGregor.

Budget Office: Fair Value Increases FHA Cost

The Congressional Budget Office (CBO) compiled a report showing that if fair value accounting was applied to the Federal Housing Administration’s (FHA) 2012 budget, it would result in a $3.5 billion cost, rather than the $4.4 billion savings the program promised. The CBO began the report when Representative Paul Ryan (R-WI) asked for a fair value estimate and measurement of the FHA’s budget.

The current accounting method dates back to the 1990 Federal Credit Reform Act (FCRA). The CBO said its current method’s purpose is to “make the budgetary cost of credit programs equivalent to that of other federal spending.” But the CBO acknowledged that FCRA estimates have not always met their stated goals.

The CBO says the difference in methods comes down to the fair value calculation’s inclusion of a market-based risk premium. The CBO says fair value estimates recognize “the financial risk that the government assumes when issuing credit guarantees is more costly to taxpayers than FCRA-based estimates suggest.”

There is no word yet on whether or not the budget will be adopted or revised.

In Wake of Fair Value Assessment, Auditors Play Detectives

With financial reporting methods constantly in a state of flux, especially in global markets, financial auditors are kept on their toes. A recent Financial Timeseditorial by Adam Jones profiles auditor Ian Powell and his experience not just reviewing financial reports, but deeply assessing the overall health of a business to get a clearer picture of the numbers in the financial report. Powell disagrees with the notion that the “malleability” of auditors and subsequent oversight of unhealthy companies with impossibly healthy financial books signals an issue with the overall system. Rather, it comes down to basic reporting standards.

“Accountants also suggest that the evolution of financial reporting might have muddied the waters. There is now more subjective assessment by management of a company’s accounts, making verification less of a black-and-white issue,” says Jones. Areas like fair value assessment often yield vague or multiple answers that auditors are looking for. Auditors, now faced with increasingly robust but often subjective financial statements, are more apt to be skeptical in the interest of better performance. “On tricky areas, such as fair value assessments, there could be more of an onus on the auditor to push a company to disclose how it arrived at its figure,” says Jones.

Fair Value Looms as a Top 2010 Reporting Change

For 2010 year-end financial reporting, new fair value disclosures top the list of reporting changes to be mindful of, according to SmartPros, a business and legal information house. Although the Financial Accounting Standards Board (FASB) did not continue to press for its proposal that would require banks to list loans and most other financial instruments at fair value, there are still some fair value concerns and changes for 2010.

In 2010 reports, companies are now required to provide additional disclosures for items measured at fair value. Specifically, “significant transfers in and out of Level 1(quoted market price) and Level 2 (valuation based on observable markets) must be disclosed separately, along with the reasons for the changes.” Level 3 items (valuations based on internal information) also requires additional disclosure on purchases and sales. The FASB recently ruled not to exempt private companies from these new rules, a potentially time-consuming task for companies but an additional insight for investors.

FASB and International Accounting Standards Board (IASB) convergence rounds out the “Developments to Watch in 2011” list. Fair value measurement has been the largest sticking point in the two standards boards reconciliation of respective accounting rules.

Bernanke “Very Cautious” About Mark-To-Market on Long Term Loans

Federal Reserve Chairman Ben Bernanke faced questioning at the hands of the Financial Crisis Inquiry Commission (FCIC) recently. Bernanke’s comments indicated some reservation about the scope of the proposed fair value accounting changes.

“I think we should do our best to get appropriate market values of assets” when they don’t have a market price, Bernanke said. “Now this is a somewhat different issue (when) you’re dealing with long-term credit in the banking book.”

“I’m in favor of accurate accounting. I think that there are sometimes problems when markets are very illiquid. The FASB tried to move in the direction of clarifying how to deal with so-called level 3 assets in illiquid markets.”

“But I’m also very cautious about applying mark-to-market accounting to the long-term loans,” he said.

The FCIC also asked about mark-to-market accounting’s relation to the financial crisis.

“I think it exacerbated it, somewhat,” said Bernanke, noting that while the nature of financial markets often move asset prices frequently, accurate valuations are a better long-term solution to eliminating the issue.

Mortgage Bankers Association Publishes Fair Value Opposition Letter to FASB

The Mortgage Bankers Association (MBA) submitted and published a comment letter to the Financial Accounting Standards Board (FASB), countering many of the assertions of the board’s proposed accounting rule changes.

The MBA stated that the application of fair value measurement to all financial instruments will “unnecessarily increase the complexity in financial statements that would adversely impact preparers, users and regulators.”

While the FASB has said in its exposure draft that application of fair value measurement will heighten transparency and understandability of financial statements, the MBA countered that notion in certain applications.

“Fair value is not the most relevant measurement for assets and liabilities for which the business strategy is to collect or pay contractual cash flows,” the MBA wrote. It suggested that amortized cost better reflects expected cash flows. “MBA especially disagrees with the notion of including in the fair value of an entity’s liabilities the change in the entity’s own creditworthiness through earnings.”

MBA concludes its position: “MBA believes qualitative along with quantitative information is more user-friendly, which is why MBA believes the current balance sheet presentation along with robust footnote disclosures is preferable.”

Experts: Herz Resignation Likely to Delay Fair-Value Rule Changes

Coming on the heels of Financial Accounting Standards Board (FASB) chairman Robert Herz’s resignation, the quick progress the organization had been making may be in jeopardy, according to some financial experts. Herz, whose resignation takes effect on October 1, 2010, left the post two years shy of when his term was scheduled to end, and in the middle of crucial changes to Generally Accepted Accounting Principles (GAAP).

John Hepp, partner in Grant Thornton’s accounting principles group and former FASB project director, spoke to CFO Magazine about the magnitude of the changes.

“The exposure drafts that are out there right now…are proposing a whole new framework for accounting,” and Herz’s retirement, according to Hepp, “is like Eisenhower resigning as the troops were landing on the beach on D-Day.”

The fair-value measurement rule aimed at banks’ financial statements (called Topic 820) was set to wrap up public comments on September 7 with a final vote expected in January 2011, but that now appears to be an unreachable goal. Herz had previously been the deciding vote on the five-member FASB, generally voting opposite of acting chairman Leslie Seidman. With the board now likely split evenly, Hepp believes the FASB will delay putting it to a final vote.

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