The discussion that took place at the November 21 roundtable appeared to confirm the above observations, particularly on the need for further guidance on impairment. Some panelists, including KPMG’s Sam Ranzilla, suggested the SEC consider offering guidance on impairment in the short-term; he further advised that if the SEC is not going to issue guidance by year-end, to make that known, so as to set preparers and auditor’s expectations accordingly. 

Regarding disclosure, some panelists suggested additional disclosure guidance is needed, and recommended companies provide additional disclosures, particularly relating to valuation models. Former SEC chief accountant Don Nicolaisen said more standardized reference points (potentially determined by SEC economists, he suggested), and more fulsome disclosure by companies may be able to help get the markets ‘quieted down.’

Other panelists, like Kevin Spataro of Allstate (also representing GNAIE) said, “more disclosure doesn’t fix suboptimal accounting, we can look at financial statements today with exponentially more disclosure than five years ago; we still have problems more symptomatic of the accounting model that needs to get fixed, as opposed to needing additional disclosure.”  

Nicolaisen also suggested that audit firms consider whether they would want to include an “explanatory paragraph” in their audit reports this year, to “highlight and address the complexities that we’ve talked about today - that involve a tremendous range of judgments and have a significant impact on both equity and earnings. “

Panelists were split on whether there is a need for further guidance or amendment of FAS 157 to address application issues in illiquid markets. After listening to panelists’ opening remarks, Chairman Cox effectively called the question, saying: “The legislation that mandated the study that the SEC currently is conducting asks six questions and the sixth question is, that we study alternatives to FAS 157.” He added: “Going down the line [of panelists], I heard people say FAS 157 to a degree did or didn’t have an influence and to a degree does or doesn’t work, I didn’t hear anybody say that FAS 157 should be replaced, which is the question Congress wants us to answer; so, if someone wants to do that, I just want them to speak up.”

Former OTS Director Jim Gilleran, who had argued that the application of the fair value and impairment standards – particularly through Other-Than-Temporary Impairment (OTTI)  losses which were many multiples higher than the expected losses on a discounted cash flow basis - reduced earnings of a number of Federal Home Loan Banks, and thereby reduced their ability to contribute to affordable housing - said, “I think FAS 157 should be replaced by the international accounting standard’s (IASB’s) views on fair value accounting.”

The only other person who spoke up specifically in response to the Chairman’s question was Kevin Spataro of Allstate (and GNAIE) who said, “I would suggest that it [FAS 157] would need to be amended, but not replaced.”

Earlier in his remarks, Spataro gave a fairly thorough explanation – from both a conceptual and practical standpoint - as to why he believed FAS 157 needed to be amended. He observed, “It is important to note … that FAS 157 is built on the notion of hypothetical transactions developed from the perspective of a market participant using all available information.” He added, “in situations in which markets are active, orderly .. [FAS 157] typically generates values that are reliable, comparable, and consistent.” However, “In situations in illiquid, inactive, not orderly [markets]. .. the output of those valuation models [results in]  information that is [not] reliable, comparable, or understandable to financial statement users.” He added, “in the current economic environment, those [values] are more akin to liquidation values than FV,” which he noted is “inconsistent with the notion of going concern, and inconsistent with the notion of intent and ability of financial statement preparers to hold securities…”  He called for “consistency … in accounting for loans, and components of these structured credit products held in certificated form.”  

“The problem [with FAS 157],” said Spataro, “is it is an endless continuum, once you are in, you never come out; because of the notion of hypothetical transactions, market participants, and using all available information - because of the way [the standard was] constructed, that measurement can be developed, even in situations with little market information.”  To address this problem, he suggested, “In situations [where] markets are illiquid, inactive, disorderly, there should be a screen which should redirect financial statement preparers to [the underlying] standard for the structured credit product.” He continued, “in most cases, the content of those structured securities are loans… the attractiveness of our proposal, we already have sufficient authoritative guidance for all the key components of the underlying loans… bring[ing] consistency to loans held in certificated or noncertificated form. Other benefits,” he said, “would better align and harmonize US GAAP with where we believe the direction of IAS 39 is, and would not be viewed as concession, but fixing a shortcoming of 157.”

Bob Traficanti, Head of Accounting Policy and Deputy Controller of Citigroup said, “I support the notion of FV in FAS 157, [it] should be left intact.” He added, “However, when looking at the market and illiquidity right now, we need to step back and take a different approach.” Traficanti continued, “When it is a pure liquidity situation in the markets, security values under FAS 157 in the available for sale model, don’t get us to a result that is entirely meaningful on [its] own; we recommend going to the loan accounting [model] under FAS 114 [Accounting by Creditors for Impairment of a Loan.]”

Sam Ranzilla,  Partner in Charge of Professional Practice, KPMG, said he supported fair value and the exit price notion in FAS 157. However, he added, “over the last couple of quarters, the discussion has moved away from FV vs. fundamental value, and the real discussion has started to evolve around the impairment model.”  He recommended the following changes to the impairment model for debt securities: (1) measure and recognize impairment losses, charge to P/L (income statement) based only on credit losses; all other changes in FV should be recognized in equity until either probable the security will be sold, or matures (2) triggering of impairment: conform impairment models that currently exist in several pieces of literature to a single model, or, possibly narrow scope of a particular piece of literature to drive additional consistency in application (3) address the appropriate impairment model for hybrid securities, such as perpetual preferred, and (4) consider changes to presentation , on P/L (income) statement, to provide more visibility into the effects of changes in FV, and to include Other Comprehensive Income (OCI) on the face of the income statement.

A number of panelists supported the need for impairment guidance, although former OTS Director Jim Gilleran disagreed with highlighting OCI on the face of the income statement, and former SEC Chief Accountant Don Nicolaisen noted it could be difficult, as a practical matter, to discern where credit losses end and liquidity losses begin. 

David Larson, Managing Director, Duff and Phelps said: “Suspending FAS 157 would reduce transparency.”  He added that in his view, “FAS 157 does not require or even allow fire sale pricing as some have indicated, it does not mandate what should be recorded at FV, other accounting standards do.” Therefore, he said, “maybe we should be focused on FAS 115, some tweaks that could be made there.”

Mark Thresher, President and Chief Operating Officer, Nationwide Financial, and Chair, Executive Roundtable Committee, American Council of Life Insurers said: “Particularly for illiquid instruments and long duration [assets]… the application, interpretation of the FV rules by accounting firms has resulted in overly conservative valuation and impairment… [with] balance sheets gravitating toward liquidation value instead of going concern….” He added there is an unlevel playing field between U.S. and non-U.S. companies, and “the current market dislocation at least partially [was caused] by a decrease in capital, partially caused by conservative FV accounting practices.”

Nicolaisen observed: “various preparers and auditors are coming to very different conclusions about securities and transactions, holdings, particularly those measured using models, that are very different in amount from each other,” adding,  “what they don’t have is some common ability to settle that.” He asked, “How do we close that gap … if you think there is a gap, between what investors think and the preparer community thinks?”

“My first rule is always, first, do no harm,” said Nicolaisen. “So, when we talk about throwing out or modifying accounting standards to give a different look because we didn’t like the look of the current model, that creates another source of distrust with the investor community.” He noted any changes to standards “should be approached with due process …and an adequate amount of time for investor consideration.”

Spataro responded, “It is not an issue of ‘not liking’ the value from FAS 157, it is the issue of us believing it is not the right value; we believe, as Mark [Thresher, of Nationwide Financial] and Rick [Jones, of Dechert LLP] indicated, there is a significant difference between what is generated by the FAS 157 model and what we believe is true economic value.”

One area in which Spataro and Nicolaisen were in synch, however, was on the difficulty of separating credit losses from liquidity losses. Spataro said, “that is not something I personally would think is practically implementable in a reliably consistent way; credit and liquidity are inextricably linked, anyone that thinks they can create a model to separate those in a reliable, comparable way, I think they’re going to have a significant challenge in front of them.”

Regarding procyclicality and whether bank regulators should adjust regulatory accounting principles (RAP) vs. FASB’s Generally Accepted Accounting Principles (GAAP), there was an implicit if not explicit acknowledgement by a number of panelists that mark-to-market accounting can have procyclical effects. Some panelists said it is the job of bank regulators to adjust regulatory capital requirements accordingly - if the regulators deem necessary – to, in effect, back out these procyclical effects which are eroding bank capital. Others disagreed.

Nicolaisen said, “I don’t see any reason why regulators have to comply with GAAP; GAAP is a measure used for general purposes, not intended for safety and soundness, regulators have the ability to see inside those institutions, they should set capital limits wherever they think they ought to be set and use whatever asset values… Jim Gilleran [former director of OTS] implied absolute certainty a bank that recognized impairment will fully recover in 25-30 years, if I felt more certain I’d go out and buy it; the discount rate implied is in reality there because market participants have a different view than a view that says [it is a ] perfectly good asset [whose] money will be received in the normal course of business.”

KPMG’s Ranzilla, agreeing with Nicolaisen, said, “If there is a regulatory solution, they ought to proceed down that path without waiting for some change in GAAP, and in fact, we should not be changing GAAP in order to satisfy regulatory issues.”  He added, “I hear a lot of that, with respect to, ‘well, if it stays in equity, it still hurts our regulatory capital,’ then somebody needs to fix the regulatory capital issues, that is , in my mind, the tail wagging the dog, if we find ourselves changing the GAAP model in order to solve [regulatory issues], because they are two different objectives.”

Former OTS director Gilleran disagreed, saying: ”The idea of going back to some notion of RAP, I remember the period when outside CPAs were giving adverse opinions on S&L clients, but what was published were statements prepared under RAP, where net worth was created for those statements showing institutions solvent, when the outside accountant’s opinion showed [the S&L’s to be] insolvent, so I am against any concept of regulatory accounting [differences], I think GAAP must contain principles for some kind of fair statement in the financial statements or disclosure, but I don’t think going back to RAP is the solution for anything.” [Note: Gilleran’s observation was not far off from similar observations by former FDIC chairman William Isaac at the SEC’s October 29 roundtable.]

Attorney Rick Jones of Dechert LLP, who works with the commercial mortgage backed securities industry,  seemed to describe creating a GAAP-RAP adjustment for regulatory capital as a ‘non-solution.” He said:  “A clear non-solution, is to try to break the nexus between this analytic model and the headline GAAP  numbers, I heard some suggest to fix the regulatory model, that’s not happening, the headline number drives the markets, to say let’s do something else that breaks the nexus is not a workable solution; there are really sophisticated investors.. the [GAAP] headline is going to distract people.”  

A number of panelists emphasized their support for the independence of the FASB and IASB. Moreover, Chairman Cox commented on this topic in his opening remarks, saying: “The issues that we’ve encountered in the current crisis, particularly those related to FV accounting, have placed an enormous burden of responsibility on independent standard setters.”  He added, “This was most recently emphasized by the attention that was given to accounting standards in the G-20 Declaration this past weekend. This domestic and international attention has also resulted in a renewed focus on the independence of the standard setters. Those entrusted to developing accounting standards in the U.S., the FASB, and internationally, the IASB, deserve our support, and the SEC has consistently stressed the importance of independent standard setting; today’s roundtable offers another opportunity for us to restate our support for the role the FASB and IASB are playing as truly independent standard-setters; their efforts to address current issues including mark-to-market accounting and FV measurements on a real time basis, are essential.”

FEI PANEL: LEGAL AND ACCOUNTING PERSPECTIVES ON FAIR VALUE

Fair value accounting was the focus of a breakfast panel at Financial Executives International’s (FEI’s) Current Financial Reporting Issues conference on Nov. 18, 2008. The panel, entitled Current Financial Controversies: Legal and Auditing Perspectives, presented by   SmartPros Ltd., featured Kenneth N. Goldmann, SEC Practice Director, J.H. Cohn LLP, and Michael R. Young, Co-Chair of the Securities Litigation Practice Group at Willkie Farr & Gallagher LLP. The panel was moderated by Colleen Cunningham, Regional Managing Director, Resources Global Professionals, and former President and CEO, FEI.

Background material provided to conference attendees included Young’s article Fair Value Accounting and Subprime (included in an FEI summary earlier this year: Q&A with Michael Young). Referenced during the panel were the primary accounting pronouncements on how to measure fair value: FASB Statement No. 157, Fair Value Measurement (FAS 157), and FASB Staff Position No. 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active (FSP FAS 157-3).

Young, who previously served on the Financial Accounting Standards Advisory Council (FASAC) with Cunningham, noted that the crux of the issue on choosing a valuation methodology or attribute was described by former FASB member Ed Trott a few years ago as: do you want to report something, say, a building, at its historical cost (depreciated historical cost) – a number that is objectively reliable, but may be completely wrong in terms of representing its current value – or do you want to report it at something that approximates the current value – although that value may not be as objectively reliable? In other words, there are pros and cons along the relevance/reliability spectrum.

‘As fate would have it,’ noted Young, FAS 157’s fair value measurement requirements kicked in at the same time as the subprime crisis hit. “Financial executives were placed in a completely uncharitable situation,” he added, noting they had to adopt the new accounting model (which emphasized  a ‘marketplace participants approach’) in an environment characterized by a dearth of trading. Additionally, he noted, there was an absence of tested, reliable valuation models. Therefore, he noted,  “We shouldn’t be surprised values had to be refined as models got better,” acknowledging the process was “painful.”

Young observed that fair value accounting applied during the subprime crisis is an illustration of a broader trend that is not going away – the trend toward principles-based accounting. Although the principles vs. rules distinction can be “a little artificial,” noted Young, as we move from a U.S. centric to international model, the focus on principles-based accounting is likely to increase. This trend toward principles-based accounting will result in three things, said Young: (1) increased need for judgment in financial reporting. Young likened this, “to some extent, [to] using a crystal ball, trying to predict the future, so there is a lot of opportunity for…(2) ncreased opportunity for second guessing, and (3) increased volatility in reported results.

 Young said that someone had pointed out to him that securities litigation was down before the subprime crisis - but one reason for the decline at that time was the absence of stock market volatility;  the less volatility, the less litigation, because you can’t prove damages. “Those days are over,” he said. “We are seeing volatility like rarely before – as a consequence of that, there will be more litigation.” He added, “The good news is, litigation is about judgment calls, trying to predict the future.” He added “good faith [based] judgment calls are hard to second guess; there may be more [law]suits, but it should be easier to win; as long as executives give their best shot, use good judgment, good faith.”

Audit partner Ken Goldmann, SEC Practice Director of J.H. Cohn LLP, reacted to Young’s remarks. Noting that IASB Chairman Sir David Tweedie spoke about principles-based standards on the first day of the FEI conference, including the need to document files, consult between the partner and client, and have the courage to live with principles-based decisions, Goldmann observed, “Michael Young said if you do all that, you ‘should’ be OK.”  But, ‘should’ may not be enough, he noted, observing, “The Public Company Accounting Oversight Board has a habit  of coming in and playing gotcha, and the SEC will also second guess some of your filings.” The plaintiff’s bar comes calling as well. Therefore, Goldmann said,  “Auditors will go kicking and screaming into the world of principles-based accounting,”

Goldmann observed,  “If you read FAS 157, FSP 157-3, there are a lot of vague terms. What is ‘market dislocation’? ‘Inactive’ markets? ‘Illiquid’ markets?”  However, he noted, “The FSP did a nice job of walking through how you go from Level 2 to Level 3,” referring to the 3 level hierarchy for measuring fair value established in FAS 157.  “But, if I as an auditor can point to certain transactions in the marketplace, and a client has gone to Level 3, which are we willing to choose?” He added, “It is a difficult decision to make,” noting “auditors are going to have to look at the case put together by the company…. The more evidence the company can put together, the better.”

It comes down to, Goldmann noted,  “Who’s going to be first – to make that judgment call and take the chance the plaintiff’s bar won’t try to make an example of that auditor or that company?”

Quoting from a recent article by panel moderator Colleen Cunningham, which appeared in Compliance Week on Nov. 4, Goldmann read: “FASB and the Securities and Exchange Commission can issue all the guidance they want telling companies that they should consider that illiquid markets may not reflect market values—but when a company’s auditors are being scrutinized for “verifiable evidence” in the invasive and granular inspections by the Public Company Accounting Oversight Board, the auditors have every incentive to err on the side of pointing to a “market transaction” to substantiate the value. Lacking a transaction, auditors must do a lot of difficult, time-consuming work to validate management’s assumptions of value and take what they view as unnecessary risks.” Goldmann added:  “Well said, Colleen.” 

Moderating the panel, Cunningham observed, “Did accounting cause the (financial market) crisis? I don’t think FAS 157 was the cause, but it didn’t help.” Cunningham added that FASB’s proposed change to the Conceptual Framework “effectively elevates relevance over reliability.” She added: “When you’re forced to make up values, that’s not very relevant, [or] forced to put in liquidation values, [when] intent doesn’t matter.” As a proposed solution, Cunningham advocated for disclosure of fair value, rather than necessarily recording fair value under the FAS 157 constructs and related standards.

Following are a couple of the questions (and related answers) raised during the panel.

Francine McKenna, author of the Re: The Auditors blog, asked the panel:  “Why do you think auditors haven’t yet come under the spotlight in terms of the financial crisis – why haven’t they been called to Congress? The rating agencies have been demonized – why not the auditors?”

Young replied the auditor’s responsibility relates in part to timing of their involvement. “The auditor gets in trouble,” said Young, “when it doesn’t report a problem that, e.g. straddles year-end… by the time the fiscal year ended in 2007, the problems [with subprime] were out in the open, financial statements were loaded with disclosures.”

McKenna asked why there were no going concern opinions among companies that failed or were rescued in 2008.

Young responded, “Some would make the argument some things happened pretty fast.” He added, “Let’s not lose sight of what’s happening in reality – values are going down – that’s just the way it is. The values went down – things changed.”

Edith Orenstein, author of the FEI Financial Reporting Blog, asked the panel to comment on the impact, if any, of a new sentence added by FASB to the final version of FSP FAS 157-3 (which was not in the proposed version), relating to the example for Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active. The new sentence in the FSP said: “[T]his example assumes that the observable transactions considered in determining fair value were not forced liquidations or distressed transactions.”

Goldmann replied, “The FSP reiterates what’s in FAS 157,” acknowledging, “a lot of statements in FAS 157 are nebulous.” He added he could see IASB Chairman Sir David Tweedie’s influence on the FSP, in that “we’re going to have to apply judgment.” 

Cunningham observed, “FSP 157-3 didn’t quite get there, exactly for that sentence [quoted above],” and for other aspects of the FSP which she noted some had described as “circular,” including as relates to liquidity risk. She called it “a difficult FSP to implement.”

As noted above, more detailed summaries of the SEC's Nov. 21 mark-to-market roundtable, and the FEI panel on legal issues as they relate to fair value, can be found at: Highlights From SEC Roundtable On Mark-to-Market Accounting, and FEI CFRI Conference Features Panel on Fair Value.