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Plans on Reporting Distressed Assets Advance

By Tammy Whitehouse — March 31, 2009

he Financial Accounting Standards Board is drafting new guidance to steer the valuation of distressed assets away from today’s floundering market prices, in an attempt to jumpstart the troubled capital markets by rewriting accounting rules.

The guidance is intended to address the needs of financial institutions that are bleeding capital and teetering on insolvency; it will help banks preserve earnings when marking down failing loans. But the reforms may also help operating companies stuck holding securities they can’t sell.

“These days, you could find toxic assets on just about any entity’s balance sheet,” says Bruce Pounder, president of accounting education firm Leveraged Logic.

Chris Mann, managing director at the consulting firm MorganFranklin, agrees. Many companies well removed from the financial sector also carry debt, securities, derivatives, or similar instruments on the balance sheet these days, he says, and the dizzying pace of debate and reform of fair-value accounting rules leaves them wondering what they’re supposed to put in their financial statements.

“The guidance is coming out in rapid fire mode now,” Mann says. Companies are left to wonder: “How does it impact me in the very near term, given the short time I have to file a 10-K or a 10-Q? How do I make sure I’m coming up with reasonable assumptions? How are we making sure we’ve got the right level of judgment involved in coming up with the fair value using measures other than observable transactions or quoted market prices?”

FASB’s latest guidance should help on that front, according to a number of financial reporting experts. The guidance would more clearly define when markets should be deemed inactive for purposes of applying Financial Accounting Standard No. 157, Fair Value Measurements. The guidance says that if a company determines the market is not active for a particular asset or liability, it would be directed to use measures other than market pricing to establish the fair value.

For example, companies could rely on indicators such as transaction volume, the age of information, variations in price quotes, correlation of indices with recent fair values, liquidity risk premiums, bid-ask spreads, and the visibility of information to the public when determining if a market for a given asset is active.

FASB is under pressure from Congress to revise fair-value rules; at a hearing earlier this month, a House sub-committee chairman threatened to intervene with legislation of its own if FASB didn’t act by mid-April. FASB took comments on the guidance through March, and now plans to finalize the changes in time for first-quarter filings.

David Larsen, managing director at Duff & Phelps and a member of FASB’s Valuation Resource Group, says the guidance should help entities navigate “Level 3” valuations, where values are established using indicators other than market prices. He says preparers and auditors have been fighting a battle of public opinion that valuations performed at Level 3—the highest level in FASB’s three-tier hierarchy of fair-value measurement—are somehow tainted.

“Level 3 doesn’t mean bad,” Larsen says. “It’s not an indictment on the quality of the asset. The guidance as clearly as possible lets people know they should not be stuck in Level 2 pricing, and it gives a number of factors for when to move away from it.”

Pounder says the guidance will help companies that have erred on the side of conservatism, either because they fear being second-guessed and later sued, or because their auditors do. “Preparers and auditors will benefit by having specific guidance from FASB that says, ‘Here’s what you must do under these circumstances,’ so auditors and preparers can both see that,” he says.

Michael Mard, managing director at the Financial Valuation Group and another member of FASB’s VRG, says preparers and auditors tend to gravitate to recent transaction prices, even if distressed, because it’s safe and concrete.

“It takes a lot of economic principles to coalesce together to get the final result in a valuation,” he says. “That takes work, and it takes judgment. There is major confusion over this that will last another two to three years.”

Bank Shot

In a second, more banking-oriented proposal, FASB offers a subtle but significant tweak to impairment rules that will let banks bolster their earnings figures. FASB proposes to alter the treatment of securities deemed to have an “other than temporary impairment.”

Sydney Garmong, an executive at auditing firm Crowe Horwath, says banks will have some latitude to take into account their intent and ability to hold a troubled security to recovery before being required to take a full charge to earnings.

Under the proposal, if a financial institution plans to hold a troubled asset until its price recovers or until it matures, the entity would only recognize losses to the extent that they result from credit losses. Any other loss in value would show up in “other comprehensive income,” which is not a direct hit to earnings.

“It’s a subtle difference, but a very important one,” Garmong says.

Wallace Enman, an accounting analyst with Moody’s Investors Service, says the impairment guidance “lowers the hurdle” for banks in avoiding impairment charges related to their intent to hold a security to recovery. “Now they can say, ‘I don’t have any intent to sell it and I think it’s more likely than not that I’m not going to have to sell it’,” he says. “That’s a lower bar.”

Enman says investors aren’t likely to get too many benefits from the new approach to impairment. “Absent incremental disclosures, I’m not sure investors benefit from it,” he says. “The banks obviously will benefit, as will any firm that believes its been forced to take an uneconomic charge to the income statement.”

Garmong notes that FASB has already proposed, and discarded, an idea to allow banks to better explain their losses through disclosure. That staff position would have applied to debt securities classified as held-to-maturity or as available-for-sale, and to loans and other long-term receivables measured at fair value with changes reflected in earnings.

The guidance would have required entities to provide disclosure in tabular format, showing each group of instruments at fair value, as reported in the financial statements, and at the incurred loss amount.

That idea was generally criticized as too complex, so FASB scrapped it and decided to direct that energy to a longer-term project with the International Accounting Standards Board on accounting for financial instruments more broadly.

IASB has taken heed of FASB’s latest crisis guidance, and has asked its own constituents to comment on it as well. IASB is working on its own standard for fair-value measurement, and board members have openly disagreed with FASB’s strict adherence to an exit-price notion of establishing fair value. IASB’s exposure draft is due early in the second quarter.

“When preparing an exposure draft the board will consider the requirements” of FAS 157, IASB wrote in its call for comments on FASB’s most recent guidance. “However, IASB’s exposure draft might differ from FAS 157 in its requirements and wording.”