Pressed by members of Congress, the Financial Accounting Standards Board (FASB) has announced significant changes to its standards for mark-to-market accounting (also known as fair value accounting) and has reaffirmed its commitment to advance harmonization of the standards of U.S. generally accepted accounting principles (GAAP) with International Financial Reporting Standards (IFRSs) developed by the International Accounting Standards Board (IASB). Proposals to reform mark-to-market accounting rules were announced just four days after a Congressional Subcommittee hearing in mid-March was convened to push the regulators to act quickly on the heels of a report the Securities and Exchange Commission (SEC) issued in connection with the Emergency Economic Stabilization Act of 2008. That report had recommended that “additional measures should be taken to improve the application and practice related to existing fair value requirements.” On April 2, 2009, the FASB held a Board meeting to evaluate all comment letters and other input received on the proposals and decided in favor of their adoption with significant revisions to the initial proposals. The Board directed the staff to proceed to a draft of the final FASB Staff Positions (FSPs) for vote by written ballot. The final FSPs were issued April 9, 2009.

FSP FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly, provides further detail to principles presented in FASB Statement No. 157, Fair Value Measurements. Statement No. 157 was issued in September 2006 and is effective for financial assets and liabilities issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Statement No. 157 had defined fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the measurement date (as opposed to the price that would be paid to acquire the asset or received to assume the liability (an entry price)). The Statement also gave methods for measuring fair value, expanded disclosure about fair value measurements, and emphasized that a fair value measurement should be arrived at based on the assumptions that market participants would use in pricing the asset or liability, including observable inputs based on market data and unobservable inputs where there is little or no market activity for the asset or liability at the measurement date. As industry participants were affected by the recent economic crisis, many of them requested further authoritative guidance in connection with determining whether a market is active or inactive, and whether a transaction is distressed. The principal concern expressed by the critics of Statement No. 157 was a perceived bias toward reliance on the most recent transaction data even when the market was thin and the reference transactions might be thought to be forced or distressed sales. FSP FAS 157-4 was the product of those inquiries.

The FASB decided at its April 2, 2009 Board meeting that the final FSP FAS 157-4 would address various concerns of the comments to the initial proposal and apply to all fair value measurements when appropriate. The final FSP upholds the previously stated objective that fair value when the market for an asset (references herein to assets should also be deemed to refer to a liability that must be valued) is not active is meant to be the price that would be obtained in a sale of the asset in an orderly transaction between market participants at the measurement date. Additionally, the FSP includes 8 factors that should be taken into account, among relevant factors not listed, in determining whether there has been a significant decrease in volume or level of activity for an asset when compared with normal market activity for that asset or similar assets, and the FSP directs reporting entities to reach their conclusion based on the “weight of the evidence.” If the reporting entity concludes there is a significant decrease in the volume or level of activity in the market for a particular type of asset, further analysis is required and a significant adjustment to actual transaction pricing or market quotes may be necessary to assess fair value. The FSP includes an example that provides additional explanation on estimating fair value when the market activity for an asset has declined significantly. The FSP also requires an entity to disclose a change in its valuation technique and the related inputs resulting from the application of the FSP and to quantify its effects, if practicable.

The FSP does not instruct on any particular method for making such significant adjustments. If there has been a significant decrease in the volume and level of activity for the asset or liability, the FSP prescribes using “significant judgment” and a fact-based inquiry to come to the price at which willing market participants would transact. Nevertheless, the FSP reaffirms that fair value calculations are meant to be based on the market, and that accordingly, the reporting entity’s intention to hold the asset is not relevant. However, the FSP indicates that where there has been a significant decrease in volume or level of activity the use of multiple valuation techniques may be appropriate and specifically refers to the use of a market approach and a present value technique and provides that when weighing the indications of fair value resulting from the use of multiple valuation techniques, the reporting entity shall consider the reasonableness of the range of fair value estimates with the objective to determine the point within that range that is most representative of fair value under current market conditions. The FSP provides that: (a) if a transaction is an “orderly transaction” it should be given such weight in the determination of fair value as is appropriate under the facts and circumstances; (b) if a transaction is not an “orderly transaction” the reporting entity should place little if any weight on that transaction in estimating fair value; and (c) if the reporting entity cannot determine whether a transaction is or is not orderly it should be given less weight than transactions that it knows to be orderly transactions.

The FSP also provides guidance for the analysis on whether a transaction is an “orderly transaction.” In general, an orderly transaction is one that results where the asset has had an adequate exposure to the market for a period before the measuring date to allow for marketing activities that are usual and customary for similar transactions and is not transferred in a forced sale by a distressed seller. Whether a given transaction is an orderly transaction is to be based again on the “weight of the evidence,” with some example circumstances laid out for consideration. For example, the fact that the seller is at or near bankruptcy, the fact that the resulting price is an “outlier,” and the fact that the asset was marketed to only one potential buyer would each be a factor indicating that the transaction is not an orderly transaction.

FSP FAS 157-4 expands upon Statement No. 157 with further guidance, but judgments might continue to be difficult. While the FASB has confirmed that there is flexibility for judgment calls, the objective of fair value remains to be the exit price. It would seem to be prudent for reporting entities to be prepared to thoroughly explain and justify their conclusions and any changes in fair value, as governmental bodies could subsequently second-guess a reporting entity’s judgment.

FSP FAS 157-4 applies prospectively and retrospective application is not permitted. The FSP is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The FSP requires that if an entity early adopts either FSP FAS 115-2 and FAS 124-2 or FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments, the reporting entity also must adopt early FSP FAS 157-4. Furthermore, if the reporting entity chooses to adopt early FSP FAS 157-4, it must also adopt FSP FAS 115-2 and FAS 124-2.

FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments, was meant to present further guidance calculated to produce uniformity in accounting for and presenting impairment losses on securities. This staff position only addresses reporting entities that do not regularly mark investments of the type in question to market. In such cases, if there is an impairment that is temporary, there is no charge to earnings. Other-than-temporary impairment (OTTI) analysis under GAAP is meant to determine whether the holder of an investment in a debt or equity security for which changes in fair value are not regularly recognized in earnings should recognize a loss in earnings when the investment is impaired. An investment is impaired if the fair value of the investment is less than its amortized cost basis. At its April 2 meeting, the FASB decided that the change to existing guidance for determining whether an impairment is other than temporary should be limited to debt securities. Prior to this FSP, in order to conclude that an impairment in such securities was an OTTI, the reporting entity had to assert that it had the intent and ability to hold the investment for a period sufficient to allow for any anticipated recovery in fair value. The Board decided to change its standard so that management must assert that it does not have the intent to sell the security and that, more likely than not, it will not have to sell the security before recovery of its cost basis. In addition, in determining whether it is more than likely that the reporting entity will recover its adjusted cost basis, it must calculate the present value of the expected cash flows and must take into account factors that can reasonably be expected to affect that cash flow. In particular, the FSP states that a reporting entity must not wait for an event of default or other actual cash shortfall to conclude that some or all of the cash flows are not likely to be collected, rather it should make a “careful assessment” of all available information, including the 7 factors specifically enumerated in the FSP.

FSP FAS 115-2 and FAS 124-2 also changes the presentation on financial statements. When an entity does not intend to sell the security and it is more likely than not that the entity will not have to sell the debt security before recovery of its cost basis, it will recognize the credit component of an OTTI of a debt security in earnings and the remaining portion in other comprehensive income. An entity is required to recognize noncredit losses on held-to-maturity debt securities in other comprehensive income and amortize that amount over the remaining life of the security in a prospective manner by offsetting the recorded value of the asset unless the security is subsequently sold or there are additional credit losses. An entity is also required to present the total OTTI in the statement of earnings with an offset for the amount recognized in other comprehensive income. An entity will also be required to present separately in the financial statement, where the components of other comprehensive income are reported, amounts recognized in accumulated other comprehensive income related to the noncredit portion of OTTI recognized for available-for-sale and held-to-maturity debt securities.

FSP FAS 115-2 and FAS 124-2 changes the disclosure requirements of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, and FSP FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. Those requirements have now been modified to require an entity to provide (1) the cost basis of available-for-sale and held-to maturity debt securities by major security type, (2) the method and primary inputs used to measure the portion of an OTTI related to credit losses by major security type, and (3) a rollforward of amounts recognized in earnings for debt securities for which an OTTI has been recognized and the noncredit portion of the OTTI that has been recognized in other comprehensive income. Statement 115 and FSP FAS 115-1 and FAS 124-1 have also been modified to require that major security classes be based on the nature and risks of the security and additional types of securities will be included in the list of major security types listed in Statement 115. The additional disclosures, as well as all existing Statement 115 and FSP FAS 115-1 and FAS 124-1 disclosures, are required for interim periods.

FSP FAS 115-2 and FAS 124-2 is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. An entity may early adopt this FSP only if it also elects to early adopt FSP FAS 157-4, Determining Whether a Market Is Not Active and a Transaction Is Not Distressed. Additionally, if the entity elects to early adopt FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments, or FSP FAS 157-4, it must also elect to early adopt this FSP.

In addition to these recent actions, the FASB has also announced its continued commitment to advance harmonization of the standards of GAAP with IFRSs. Historically, there has been a distinction between U.S. and international accounting rules. U.S. standards tend to be exact and explicit. The international rules, on the other hand, rely more on broad principles, giving companies greater flexibility to make their own judgments. After a joint meeting in September 2002, the FASB and the IASB issued their Norwalk Agreement acknowledging their commitment to the development of compatible accounting standards that could be used for both domestic and cross-border financial reporting. In his testimony before the Subcommittee at the March 12 hearing, the Chairman of the FASB, Robert H. Herz, signaled that the Group of Twenty Finance Ministers and Central Bank Governors (G-20), the Financial Stability Forum, and the SEC have all been continuing to push the FASB to have its standards more in-line with international standards. The FASB now has a joint project with IASB aimed at more broadly reforming and converging their respective standards on financial instrument accounting.

The full text of the FSPs described above together with official explanations are available at www.fasb.org. Seward & Kissel LLP is not a certified public accounting firm and does not express opinions on accounting principles. However, the firm follows accounting developments that may be of interest to its clients and believes that the developments described above fall in that category.