financial services industry accounting reform implemented just a
few years ago, is under attack for its role in the failure of
giants such as AIG and Washington Mutual. However, many proponents
of the principle argue that tampering with it could cause
irreparable harm.
A battle royal is raging between proponents of fair value
accounting (FVA) standards and those that believe FVA has played a
seriously negative role in exacerbating the global financial
crisis.
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At the heart of FVA is the concept of valuing a financial asset
at the price at which a transaction would occur between market
participants at the measurement date – the so called mark-to-market
principle.
All fine under normal market conditions, but these are not
normal conditions, argue FVA opponents. Their attacks on FVA
revolve around the inability to gauge the fair value of financial
assets when the market for that asset is not active or where forced
liquidations or distressed sales result in unrealistic
valuations.
Companies must declare these values on their financial
statements even if they have no intention of, or immediate need to,
sell them.
As a result FVA standards devastated financial institutions’
balance sheets and precipitated failures of many banks including
Washington Mutual, the biggest US bank failure to date.
Even with the government’s $700 billion support package
authorised by the Emergency Economic Stabilization Act enacted on 3
October, more problems may lie ahead. For example, Jaret Seiberg,
an analyst at private wealth management firm Stanford Financial
Group predicts that more than 100 US banks will fail in 2009.
FVA has also taken a heavy toll on insurers, not least of these
being American International Group (AIG), the subject of a $123
billion bailout by the government and the Federal Reserve Bank of
New York.
Testifying before the House of Representatives’ Oversight
Committee on 7 October, Martin Sullivan, AIG’s CEO between March
2005 and June 2008, laid the blame for AIG’s woes squarely on
shortcomings of the US Financial Accounting Standards Board’s
(FASB) rule 157 (FAS157) which defines FVA principles. FAS157
became effective for companies with fiscal years beginning after 15
November 2007.
“However well FAS157 operates under any reasonably foreseeable
market conditions, in the unprecedented credit crisis which began
in the summer of 2007, FAS157 had, in my opinion, unintended
consequences,” said Sullivan.
Assets that dealt AIG the severest blow were credit default
swaps – in essence, insurance to counterparties in the case of
default on underlying bonds. Credit default swaps were the core
business of AIG’s Financial Products unit.
Sullivan noted that the underlying bonds were very highly rated,
and risk of default viewed as extremely remote. However, as AIG
found in spectacular fashion, risks existed in abundance.
“When the credit markets seized up, like many other financial
institutions, we were forced to mark our swap positions at
fire-sale prices as if we owned the underlying bonds, even though
we believed that our swap positions had value if held to maturity,”
stated Sullivan.
“The company nevertheless began reporting billions of dollars of
unrealised losses on the basis of then-current market valuations,”
he continued. “Suddenly, a company with a trillion dollars of
assets was reporting unrealised losses on its income statement that
ultimately climbed into the tens of billions. As AIG’s reported
losses mounted, there was a domino-like series of
repercussions.”
In Japan the government has already capitulated to anti-FVA
lobbyists and on 28 October announced acceptance of a
recommendation of the Accounting Standards Board of Japan to relax
FVA rules.
In the US, the Security and Exchange Commission (SEC) and the
FASB have acted to ease the negative impact of FVA and on 30
September 2008 issued a joint clarification on the application of
FAS157. The clarification’s focus is guidance on the approach to be
adopted by financial companies in periods of disrupted market
activity, with the overriding message being the key role of human
judgment in determining fair value.
On illiquid markets the SEC and FASB note in their guidance:
“When an active market for a security does not exist, the use of
management estimates that incorporate current market participant
expectations of future cash flows, and include appropriate risk
premiums, is acceptable.”
Disorderly transactions
The guidance also addresses disorderly transactions: “Distressed
or forced liquidation sales are not orderly transactions, and thus
the fact that a transaction is distressed or forced should be
considered when weighing the available evidence.” This, noted the
guidance, “requires judgment.”
The guidance also addresses the complex issue of determining
whether value impairment of an asset is other-than-temporary.
Again, it was stressed that this was a matter of “reasonable
judgment” based on factors such as the length of the time and
extent to which the market value has been less than cost, in
addition to the issuer’s financial condition and near-term
prospects and the intent and ability of the holder to retain its
investment for a period of time sufficient to allow for any
anticipated recovery in market value.
In his testimony Sullivan lamented: “Of course, AIG did not have
the benefit of this guidance during my tenure.”
Absence of guidance during his tenure was not for want of calls
for one to be produced. As early as April 2007 the American Council
of Life Insurers’ (ACLI) chief actuary Paul Graham made just such a
call.
In addition, he noted that the ACLI believed the FASB should
maintain a permanent process to respond to valuation issues.
“Financial reporting is ever evolving requiring the need for a
continuing effort to address these issues and provide interpretive
guidance,” said Graham in a submission to the FASB.
He added in the ongoing development of financial reporting
standards the FASB should call on assistance of experts when
needed.
“As an example, we would expect consultation with the
professional actuarial groups such as the American Academy of
Actuaries when addressing valuation issues related to contracts
issued by insurance enterprises,” advised Graham.
Debate continues
Though Sullivan would have welcomed the SEC/FASB guidance, it
was poorly received by the president and CEO of the American
Bankers Association, Edward Yingling.
In a submission to the SEC, Yingling slammed the guidance as
being “too narrow and too complex.”
His view was echoed by major insurance industry bodies, the
ACLI, the Property and Casualty Insurers’ Association of America
and the American Insurance Association.
In a joint submission to the SEC in late-October the insurance
bodies, the Financial Services Roundtable, the US Chamber of
Commerce and the Mortgage Bankers Association stressed: “We do not
believe that management, preparers, auditors and investors
understand what is expected of them, or whether and how the needed
judgments can be exercised.”
But the guidance is far from the final word on FVA, which faces
the prospect of significantly more wide-ranging change.
Indeed, Congress has granted the SEC authority to suspend
mark-to-market accounting requirements embedded in FAS157.
A battle is waging between those in favour of radical change to
FVA and their opponents in a series of three roundtable discussions
convened by the SEC. The discussions were convened as part of a
90-day study into FVA ordered by Congress following the enactment
of the Emergency Economic Stabilization Act.
One of the strongest opponents of the lobbyists for change of
FAS 157 is Robert Denharn, chairman of the Financial Accounting
Foundation (FAF), the body responsible for oversight of the
FASB.
In a submission to the House of Representatives’ Oversight
Committee, Denharn wrote: “We believe that once Congress starts
setting accounting standards through its political process, the
integrity of US accounting standard setting and the credibility of
US financial reporting will be dangerously compromised.
“If Congress sends the message that special interests are able,
through legislation, to overturn expert accounting judgment arrived
at through an open and thorough due process, necessary and timely
improvements in financial reporting will likely become
impossible.”
Other members of the accounting profession have also made their
view clear on the FVA issue which is now also raging across
Europe.
In a submission to the SEC, PricewaterhouseCoopers’ US assurance
managing partner and national professional practice leader Vincent
Colman wrote: “We continue to believe that fair value reporting,
despite its imperfections, is the best method for providing the
level of transparency that our markets need to function
effectively. Any fundamental change to fair value reporting runs
the risk of reducing confidence among investors and other market
participants, which in turn would likely restrict the flow of
capital.”
Clearly FVA is set be the focus of more heated debate in the
weeks ahead.
