Q&A With Michael Young, Willkie Farr & Gallagher, On Fair Value Accounting

April 9, 2008

FEI Summary

Financial Executives International (FEI’s) Financial Reporting Blog asked Michael Young, a partner at law firm of Willkie Farr & Gallagher, and author of Fair Value Accounting and Subprime,” to expand on the issues raised in his paper through some questions & answers below. 

1. Do you think investors (including retail investors) understand what is meant by "fair value" and the sources of "fair value," particularly for level 3 assets/liabilities?

Michael Young: Unfortunately, this entire area is fraught with both complexity and confusion.  Probably many investors do not completely understand the concepts and accounting literature behind the use of fair value and fair value accounting.

 

The volume of literature itself is daunting. The governing standards include FAS 115 (on trading securities and available-for-sale securities), FAS 133 (derivatives), FIN 45 (guarantees at inception), and FAS 159 (the fair value option). To illustrate with just one of the standards, FAS 133 and its supporting literature by themselves span more than 800 pages.

 

Cutting through all the literature and getting to the heart of things, one of the most difficult challenges for investors is to keep in mind the lack of precision in some fair value estimates, in particular estimates that are made based on "Level 3" inputs. Applied to mortgage-related instruments, for example, those estimates may involve such predictions as the future of housing prices, the future of interest rates and how homeowners might be expected to react to such things. When everyday investors see a writedown of, say, $3 billion, they may presume a level of precision that numerical presentation often implies. Often forgotten is the extent to which these writedowns are based on predictions of an inherently unknowable future.

2. Related to Q1 above, do you think there is an "expectation gap" by calling level 3 "fair value" per se, and by emphasis on approximating a market participants’ approach when there is no market?

Michael Young: I don't know that I would call it "an expectation gap." But I certainly would agree that seeking to derive fair values -- that is to say market values -- in the absence of an active, observable market is a formidable challenge. For those who do not understand the extent to which such fair value estimates must be based upon predictions, perhaps an "expectation gap" is not a bad description.

3. Trying to work back to a hypothetical "market participants" approach, do you believe level 3 fair value requirements in FAS 157 may be an example of "avoidable complexity," as that term is defined by the SEC Advisory Committee on Improvements in Financial Reporting (CiFIR or the Pozen Committee) in the committee's progress report issued for public comment posted here http://www.sec.gov/rules/other/2008/33-8896.pdf ?

Michael Young: As an abstract proposition, the notion of using fair value as the basis to record assets is about as simple as things can get: You look at the trading price and that's that. The challenge, of course, comes about in the absence of an active, observable market. I don't know that I would characterize the resulting challenge as "complex," as accounting experts refer to "complexity" today, as much as difficult and inherently uncertain. Complexity, in contrast, often develops when we try to find substitutes for the concept of fair value to avoid, for example, the resulting volatility.

4. Your article “Fair Value Accounting and Subprime” closes by saying “No responsible accountant or auditor will want to make difficult judgment calls when doing so is almost necessarily a career-terminating event,” and adds, “The subprime crisis, therefore, may present the opportunity for us to come to grips with a much bigger question. That is the extent to which we are to permit our present system of litigation and regulatory second guessing to impede continued evolution in financial reporting.” What are your thoughts on the concept of a professional judgment framework?

Michael Young: When I was first introduced to the possibility of a "professional judgment framework," my immediate reaction was to think, "Gee, that's pretty neat. Maybe that would go a long way to solving the problem of well-meaning judgment calls being second-guessed by trial lawyers or regulators."  However, the more I have thought about this issue the less clear my reaction has become. For example, would a "professional judgment framework" diminish the ability of auditors to challenge incorrect management applications of GAAP?  Would the framework simply become a mindless "check-the-box" exercise? Would the paperwork become too cumbersome? Would the absence of documentation be turned against auditors who nonetheless exercised good judgment? On balance, it may turn out the idea's a good one. But we should let the debate proceed a little further before making up our minds.   

 

Prepared April 11, 2008 by Edith Orenstein, Director, Technical Policy Analysis, Financial Executives International (FEI). This summary does not represent FEI opinion unless specifically stated above.