Mark-to-market, also sometimes referred to as fair value accounting, is a set of the accounting standards regulating assignment of a value to a position held in a financial instrument. According to mark-to-market this value should be based on the current fair market price of the identical (if available) or similar instruments. Fair value accounting has been an important concept of United States Generally Accepted Accounting Principles (US GAAP) since early 1990s. Application of fair value measurements has steadily spread over the past decades, being primarily a response to the investors demand for financial statements that being relevant and timely would aid them in making better informed decisions.
Measuring of the investments in debt and equity securities at fair value basis in the financial statements in most cases is relevant and useful for investors, creditors, and other users as it assists in evaluation of the performance of an enterprise’s investment strategies. In order to make intelligent decisions investors should be able to assess the amounts, timing, and uncertainty of prospective net cash flows of en enterprise as they influence expected cashflows from the enterprise to them. Fair value can be viewed as the market’s estimate of the present value of the net future cash flows from these securities, discounted to reflect both the current risk free interest rate and the market’s estimate of the risk attributed to this investment.
In addition to that, market value of investment securities could be considered to be an indicator of the financial institution’s solvency. Due to use of amortized cost in reporting some of the depository institutions experienced impairment of earnings and/or capital or even failed because of speculative activities with securities and other institutions experienced an erosion of their securities portfolios liquidity as a result of market value decreases of those securities. In case of a liquidity shortage the fair value of investments gives more relevant picture of the amounts available to cover an enterprise’s obligations as compared to amortized cost.
However fair value basis has some inherited shortcomings. Major flaw in fair value is its that it often involve certain degree of subjectivity giving financial statements questionable reliability and giving rise to manipulations and fraud. Especially this is true for fair value estimation for securities that are not readily marketable.
In addition, some experts argue that fair value accounting does not implemented decision to acquire an asset, the earning effects of that decision upon realization and the ultimate recoverable value of that asset, instead it focuses on the effects events that out of the enterprise’s control, reflecting in financial statements gains and losses before they are actually realized.
The practice of mark-to-market accounting device was first started by the traders on futures exchanges in the 20th century. In 1980s this practice began to be applied far from the traditional exchanges by large banks and corporations, and starting from 1990s mark-to-market accounting began to raise issues.
In the original practice, a futures trader who wants to take a position has to deposit money with the exchange, referred to as a “margin”. Such practice was intended to protect the exchange against possible losses. At the close of every trading day, the contracts were marked according to their present market value. If the contract of such trader has increases in value by the day closing the exchange pays this profit to the trader’s account in amount of closing value exceeds the deposited amount. On the other hand, in case when the market price of this contract declined by the end of the trading day, the exchange charges trader’s account on which the margin is deposited. If the balance of deposit falls below the level of a deposit required to maintain the position, the trader is obliged to deposit additional margin immediately into his account in order to maintain this position (i.e. make a “margin call”).
Over-the-counter (“OTC”) derivatives has different nature as they are financial contracts between buyers and sellers, which are formula-based and are not publicly traded on exchanges, so their fair market values could not be easily estimated as there may be no comparable active market trading. Therefore market values for such financial instruments are not readily available and could not be objectively determined. During they years of over-the-counter derivatives’ early development, such derivatives as interest rate swaps were not frequently marked to market. Contracts were reviewed on annual or sometimes quarterly basis, to recognize gains or losses and exchange payments if required. As the practice of mark-to-market accounting began to be used by banks and corporations, some of them succumbed to a temptation to use them to manipulate with financial results and position, or simply speaking, to commit financial reporting fraud. This was especially true when the fair market price could not be objectively determined due to absence of real day-to-day market for similar instruments or when value of asset is derived from other traded commodities (e.g. crude oil futures) with assets being valuated with “marked-to-model” method in a synthetic or hypothetical manner, heavily relying on financial model assumptions. In these cases financial instruments’ value may be marked in a manipulative way to achieve desirable valuations, as for example in case of the Enron.
Recently, fair value accounting became a subject of hot debates as concerns were raised regarding its contribution towards financial crisis. Entities that applied such accounting practices had to make significant large write-downs as prices for their according to current fair value estimation rules. Financial institutions noted a disparity between their assets and liabilities economic value and the so called “fair” or “market” value determined according to current guidance.
Section 2 of this paper (“Accounting Rulings Setting Process”) briefly describes how FASB sets accounting standards and Section 3 (“Accounting Rulings on Fair Value”) discusses background and content of value accounting guidance (SFAS 115 and SFAS 157) before amendments prompted by global crisis. Section 4 (“Recent Debates and New FASB Guidance”) reviews in detail how fair value guidance is perceived to contribute to world crisis, development of solution to the existing issues and contents of newly issued guidance. Finally, the paper ends with a brief summary and thoughts as to the impact of new fair value accounting guidance and the future of the issue.
2. Accounting Rulings Setting Process
In the US, preparation and presentation of financial statements is conducted under generally accepted accounting principles, commonly abbreviated as US GAAP. Currently the highest authority in establishing accounting principles for private and public companies in USA is the Financial Accounting Standards Board (FASB). FASB has four major types of publications:
- Statements of Financial Accounting Concepts (SFAC) – a part of the FASB’s conceptual framework project first issued in 1978, which set forth fundamental objectives and concepts for developing future standards.
- Statements of Financial Accounting Standards (SFAS) – being GAAP’s most authoritative setting publications.
- Interpretations – publications that modify or extend existing standards (SFASs)
- Technical Bulletins – guidelines on SFASs application, interpretations of SFASs and opinions, aimed to solves certain specific accounting issues. This includes FASB Staff Positions (FSP), the pronouncements aimed to give guidance on future application of SFAS on specific topics.
3. Accounting Rulings on Fair Value
3.1. Background Information
In late 1980 regulators and other interested parties expressed serious concerns regarding the recognition and measurement of investments in debt securities, especially of those held by financial institutions. In 1988 the OCC (Office of the Comptroller of the Currency) issued a circular that claimed certain investment practices to be unsuitable and therefore securities acquired in relation with such practices generally should not be recognized as a part of the investment portfolio. At the same time the Federal Home Loan Bank Board proposed statement of policy addressing classification of securities as either held for sale, held for trading or held for investment.
These regulators also questioned whether amortized cost method rather than the LOCOM (lower-of-cost-or-market) method should be applied when amortized cost method had inconsistent practices in regards of trading and sales. Specific concerns were expressed about financial institutions’ “gains trading”, an activity that implied that decisions to sell certain securities may be based on ability to report gains in the financial statements, rather then on actual benefits. In gains trading, securities with unrealized gains are sold in order to recognize gains in reported profit and loss statement, while securities with unrealized losses are held in order not to recognize losses, as the amortized cost method is applied to such securities. Such practice suggested that the securities in the portfolio are being held for sale, rather than being held for investment, therefore the LOCOM method should be more appropriate. At the same time such practices allowed financial institutions to “defer” loss recognition by using the amortized cost method even in cases when they are not in fact engage in gains-trading activities.
These concerns and inconsistent guidance on the debt securities held as assets reporting made AICPA Audit and Accounting Guides to prompt AcSEC to undertake a project regarding the measurement and reporting of debt securities held as assets by financial institutions, which led in May 1990 to the exposure for comment of a proposed Statement of Position (SOP) „Reporting by Financial Institutions of Debt Securities Held as Assets“. Later that year, in September, the SEC chairman emphasized certain of the shortcomings in reporting investments at amortized cost, claiming that for financial institutions, “serious consideration must be given to reporting all investment securities at market value.” In October 1990 AcSEC concluded that, for better efficiency, the project on debt securities held as assets by financial institutions should be performed by Financial Accounting Standards Board (FASB). Also AcSEC noted that, taking into account current economic developments, FASB should include in the scope not only depository institutions, but mortgage bankers, finance companies, insurance companies, and other commercial enterprises, which was further supported by major CPA firms.
In September 1992 the FASB issued an Exposure Draft “Accounting for Certain Investments in Debt and Equity Securities” and in December 1992 – January 1993 the FASB held a public hearing on the proposals to this Exposure Draft.
In May 1993 as a result of the undertaking to respond to concerns voiced by regulators and business regarding recognition and measurement of investments in debt securities held as assets FASB issued Statement of Financial Accounting Standards No. 115 “Accounting for Certain Investments in Debt and Equity Securities” (SFAS 115). This Statement addressed the accounting and reporting for certain investments in debt securities and equity securities held for resale, but retained the amortized cost method application regarding investments in debt securities that which were intended to be hold to maturity.
3.2. SFAS 115 Summary
SFAS 115 “Accounting for Certain Investments in Debt and Equity Securities” requires that the “fair value” accounting should be applied to debt securities in some cases; however it retains the application of the amortized cost method in other. Under SFAS 115 an enterprise is required upon acquisition of a debt security to classify it under one of three categories: “available-for-sale”, “trading” or “held-to-maturity”. The appropriateness of such classification should be reassessed at each reporting date.
“Trading” securities are acquired and held exclusively for the purposes of further resale in the near term and thus being held for only a limited, short, period of time. Trading in this case is an active and frequent buying and selling of the securities, and securities traded are generally used for the purposes of a profit generating resulting from short-term price fluctuation, and therefore should be liquid (implies existence of active market for such securities).
“Held-to-maturity” securities should comply with the statement that the holding enterprise “has the positive intent and ability to hold the securities to maturity.” Debt security should not be classified as “held-to-maturity” if it is expected to be sold in response to changes in economic circumstances e.g. needs for liquidity, changes in funding sources and funding terms, changes in interest rates, fluctuations yield on alternative investments or change in their availability, or changes in FOREX risk.
“Available-for-sale” securities are those that could not be classified as “trading” or “held-to-maturity” securities.
SFAS 115 provides that, depending upon the securities classification as “held-to-maturity”, “trading” or “available-for-sale”, changes in “fair value” of debt securities held by a reporting enterprise should be treated in different ways. Unrealized gains or losses (i.e. gains or losses prior to any disposal of the securities) for trading securities, representing changes in their fair value, should be recognized in profit and loss accounts of each corresponding reporting period. For the determination of the unrealized gains or losses amount of a particular security, the fair value of this security should be determined at corresponding reporting date. SFAS 157 “Fair Value Measurements” provides guidance in respect how fair value of the securities should be determined, while SFAS 115 defines the principles of securities accounting.
For securities available-for-sale, except for the cases of “other than temporary impairments” discussed below, unrealized gains and losses should not be recognized in profit and loss accounts of each corresponding reporting period, but should be reported in other comprehensive income (loss) in balance sheet of the reporting enterprise.
For securities held-to-maturity, except for the cases of “other than temporary impairments” discussed below, unrealized gains and losses should not be recognized in profit and loss accounts of each corresponding reporting period or in other comprehensive income (loss) in balance sheet of the reporting enterprise. These securities should be accounted on the amortized cost basis.
SFAS 115 also provides requirement that changes of value classified as “other than temporary impairments” (OTTI) of securities held-to-maturity or available-for-sale should be charged against earnings. For trading securities a charge against earnings is required for any reduction in fair value whether this change is temporary or not. Impairment arises when the fair value of the asset is less than its initial cost. A reporting enterprise is required to determine for securities classified as held-to-maturity or available-for-sale whether a decline in value below the initial cost is “other than temporary”. However, SFAS 115 provided no real guidance as to what factors should be used in order to differentiate a temporary impairment from “other than temporary”.
3.3. SFAS 157 Summary
The determination of amount of unrealized gains and losses, as well as impairments, whether temporary in nature or other than temporary (OTTI) of an investment should be based on the fair value this investment. SFAS 157 “Fair Value Measurements” issued in September 2006 introduced a three-tiered fair value hierarchy to prioritize the inputs to be used in the process of investment valuation. The measurement procedure was developed with the objective to ascertain that fair value in all cases would be ultimately equal to the price received for the in an orderly transaction between market participants at the date of such measurement.
In the scheme provided by SFAS 157 quoted prices of the active markets for identical investments have the highest priority, being the level 1 of the valuation hierarchy. Also these may include alternative pricing methods, e.g. “matrix pricing” which is a mathematical technique allowing to determine debt securities fair value by relying on the value securities’ correlation to benchmark securities, rather than relying exclusively on quoted prices for the evaluated securities specific securities.
The level 2 of this hierarchy are inputs, other than quoted prices of level 1, which are also observable on the market for the corresponding investments. These include quoted prices for assets of similar kind which are traded in active markets, quoted prices for assets of identical nature which are traded in markets which are not active, inputs other than quoted prices, but which are observable in the market (e.g. prepayment speeds, volatilities, yield curves, loss severities and default rates), and inputs that are based on observable market data, derived from correlation analysisor other statistic methods.
The level 3 of this hierarchy, which has the lowest priority, are inputs such as own assumptions of the reporting entity about the bases which would be used by market participants in case of the pricing corresponding assets for concluding sale-purchase deal. Such inputs are considered to be unobservable as they could not be observed in the market and are not readily available. Inputs of these level should be used to estimate fair value of the investment only in case observable inputs are not available, e.g. when there is little to no market activity for the relevant assets.
4. Recent Debates and New FASB Guidance
4.1. Recent Debates and their Outcomes
Fair value accounting became a subject of hot public debates since early 2008, when concerns were raised regarding possible fair value concept contribution towards financial crisis. Many of the entities that applied fair value accounting for financial reporting, and therefore disclosing the value of their assets based on current market prices, had to make a series of large write-downs as prices of their assets have fallen and for certain securities, such as the mortgage-backed securities and auction rate securities, active markets have disappeared. These write-downs undermined investors’ trust, not only preventing recovery of the normal activity on those markets, but rather further reducing it and provoking activity drop on adjacent markets.
Besides contributing to the global crisis development fair value accounting raise another issue – whether fair value accounting guidance do provide for “fair value” in conditions when markets are inactive and distressed transactions are common. In many cases, as market participants have noted, the fair value of these assets, as determined according to current accounting guidance is in fact less than the present value of their expected cash flows. Financial institutions also noted a disparity between their assets and liabilities economic value and the so called “fair” or “market” value determined according to SFAS 157. As SFAS 157’s relies on recent market quotes of instruments to determine their fair value, the question of the appropriateness and accuracy in reflecting a reporting entity’s current position for preparing financial statements of this and related standards. Although FAS 157 allows a reporting entity to use a price of an asset other than the most recent trading price in case of the transaction being a distressed sale, it was not clear how broadly the exception regarding distressed sale could be applied.
Many of the reporting entities disagreed with their auditors, who insisted that fair value being the traded prices, and therefore reflected objective value of measurements, regardless of the nature of the market current state, and appealed that current low market prices were in fact distressed sales. However, existing guidance in this area did not provide enough comfort to auditors accept such claims.
As a result of the hot debates over FAS 157, SEC was mandated by the Emergency Economic Stabilization Act (EESA) to perform study and issue a report on mark-to-market accounting. SEC issued corresponding report on 30 December 30, 2008 (SEC “Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting”) setting forth recommendations for further consideration and implementation by FASB.
Following the publication of this report, the Valuation Resource Group of FASB’s conducted a meeting and on 18 February 2009 the FASB agreed to provide additional guidance regarding fair value standards for determining when under FAS 157 a market could be considered being “not active” and a transaction “not distressed”. FASB proposed to issue rulemaking in the second quarter of 2009; however industry participants were dissatisfied with such late issue and required immediate remedies. The U.S. Chamber of Commerce requested the Treasury Department to implement solutions for the SEC’s report findings in conjunction with other measures under the Troubled Asset Relief Program (“TARP”), emphasizing that the efforts under the TARP program are likely to be undermined in case the valuation problems associated with “toxic assets” will persist.
On 6 March 2009, the ABA sent a letter to the Committee requesting to urge the FASB to issue fair value accounting guidance, addressing also issues relating to “other then temporary impairments” (OTTI). In addition, speeches by Ben Bernanke, Federal Reserve Chairman, and Mary Schapiro, SEC Chairman, as well as issue of recommendations by the Group of Thirty urged to develop additional fair value guidance, particularly regarding valuing illiquid assets. On 9 March 2009, the ABA, the Federal Home Loan Bank and 18 industry groups sent a letter to the SEC requesting to stimulate immediate action from the FASB.
- On 12 March 2009 the ABA issued statement to the Committee recommending to take the following actions:
to improve the definition of “fair value” by replacing current reference to “exit price” with price “between a willing buyer and a willing seller in an arm’s length transaction that is not a forced sale”;
- to update “other than temporary impairment” accounting based on improved version of international standards as outlined in International Accounting Standard 39 “Financial Instruments: Recognition and Measurement” (“IAS 39”), where OTTI is based on economic loss, rather than on market loss, and can be reversed upon any recovery through earnings account;
- to abandon any efforts to expand fair value accounting application until a proper review is performed.
Committee members after examination of testimony from industry regulators, lawmakers and participants, warned that if the SEC and FASB fail to act promptly on standards improvement, Congress would take action to improve guidance under FAS 157 and FASB Chairman Robert Herz committed to issue corresponding guidance within three weeks.
As a result on 2 April 2009 the FASB took action on three proposed FASB Staff Positions (FSP) regarding to accounting of financial instruments held by a reporting entity: FSP FAS 157-e, which provides guidance on the determination of financial instruments the fair value; FSP FAS 115-a, FAS 124-a and EITF 99-20-b, which provide guidance on the recognition and presentation in financial statement of “other-than-temporary” impairments in value of debt securities held by a reporting entity; and FSP FAS 107-b and APB 28-a, which expand already existing annual disclosure requirements of financial instruments fair value on interim financial statements.
On 9 April 2009 the Financial Accounting Standards Board (“FASB”) issued final version of guidance aimed to clarify its position regarding fair value determining for financial instruments in the absence of normal market activity (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, FSP FAS 157-e, Determining Whether a Market is Not Active and a Transaction is Not Distressed) and to specify the procedures of revision of “other-than-temporary impairments in value (FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments).
Significant efforts were undertaken by FASB in order to respond to business and regulators concerns that the standards of fair value accounting failed to provide sufficient guidance under conditions of extreme market disruption, which has been experienced during the current financial crisis.
New the Financial Accounting Standards Board guidance (the Guidance), issued on 9 April 2009 consists of the following FASB Staff Positions (FSP) relating to accounting of financial instruments held by a reporting entity, including:
- 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” (the “157 SFP” or the “Fair Value Guidance”) clarifies how to determine fair value of the investment when the volume and level of activity regarding similar assets or liabilities have significantly decreased compared to normal market activity for the very same or similar assets or liabilities;
- FSP 115-2 and FAS 124-2 “Recognition and Presentation of Other-Than-Temporary Impairments” (the “OTTI Guidance ) revises accounting procedures for other-than-temporary impairment (OTTI) in order to address the different factors, which may impact the market value for certain securities and the way these values should be recognized in financial reporting.
The Guidance is intended to be effective for reporting periods, both interim and annual, ending after 15 June 2009, with permitted early adoption for periods ending after 15 March 2009. In case early adoption is chosen by a reporting entity, this entity must adopt early both of the Guidance components, the Fair Value Guidance and OTTI Guidance. The Fair Value Guidance must be applied only to future transactions, while the OTTI Guidance is permitted to be applied to both, already existing investments held by a reporting entity and new as of the beginning of the interim period in which the OTTI Guidance is adopted.
4.2. New “Fair Value Guidance” (157 SFP)
The Fair Value Guidance does not amend existing fair value accounting rules set forth in SFAS 157; it rather emphasizes the available currently flexibility regarding determining the assets’ fair value taking into account illiquidity of the markets. Unlike a presumption provided in the initial release (FSP FAS 157-e “Determining Whether a Market is Not Active and a Transaction is Not Distressed”) that transactions performed in inactive markets have distressed nature, the Fair Value Guidance is not based on such a presumption. Instead 157 SFP requires that a reporting entity should determine whether current market prices represent an orderly transaction (e.g. not a distressed sale, or forced liquidation), based on the “weight of the evidence” available for observation. In case if orderly transactions reflecting the price that would be reached between a willing seller and a willing buyer are absent, a reporting entity is not obliged to use the existing market prices to determine fair value of its investments.
157 SFP provides a two-step method to determine whether the volume and level of activity for the assets or liabilities decreased significantly as compared to the normal market activity for such the assets or liabilities. First of all, the reporting entity should determine whether there are factors that indicate that the market has decreased as of the measurement date. Such factors should distinguish between transactions that normally occur in the markets with consistent trade volumes and those transactions that take occur in markets where trading is not frequent. These factors include:
- Small quantity of recent transactions;
- Substantial variation in price quotations, either over time or among different market participants;
- Price quotations based on outdated information;
- Disruption in correlation between market value of the assets and indices (i.e. when asset which had high correlation with certain indices begins to show little to no correlation with such indices);
- Abnormal growth in implied yields and/or liquidity risk premiums for quoted prices as compared to estimates of credit and other nonperformance risks for this class of assets;
- Abnormally growth in bid-ask spread;
- Absence or significant reduce of new issuances in the market;
- Scarce public release of information.
If evaluation significance and relevance of these factors, together with weight of the available evidences, support an assumption that there has been a significant decrease in the volume and level of activity for investment, the reporting entity should proceed to the second step.
According to March FASB proposal, as noted above, a quoted price from an inactive market, if supported by the analysis under first step, has to be presumed to be associated with a distressed transaction. However, under final the Fair Value Guidance, reporting entities should weigh all available evidence in order to identify whether such transaction is orderly or not orderly. Accordingly, if a significant decrease in volume and activity on the market has been identified in the first step, it does not result in a presumption that such transaction is not orderly. The second step allows determining whether the quoted price is associated with a transaction other than an orderly. For this purposes a reporting entity should consider the following:
- Whether there was sufficient period of time prior to the measurement date in order to allow for marketing activities, which has usual and customary nature for transactions with such assets;
- Whether, while there was a usual and customary marketing period, the seller has marketed the asset or liability only to a single market counterpart;
- Was the seller of is in or close to bankruptcy or receivership (i.e. distressed), or was the seller obliged to perform sale in order to meet legal or regulatory requirements (i.e. forced);
- Whether the transaction price can be considered to be an outlier when compared to other recent transactions for the very same or similar assets or liabilities.
When a significant decrease in the volume and level of activity on the market for the asset did have place, the reporting entities must consider the following for the purposes of asset valuations preparation:
- In case the weight of the evidence indicates that the corresponding transaction is not orderly, little or no weight, as compared to other indications of fair value, should be placed to such transaction price when fair value or market risk premiums are estimated.
- In case the weight of the evidence indicates that the corresponding transaction is orderly, such transaction price should be considered, when fair value or market risk premiums are estimated ,and the weight assigned to that transaction price when compared to other indications of fair value should depend on the circumstances and relevant facts.
In case there is no sufficient information to conclude whether the transaction is orderly or not orderly, the transaction price should be considered, when fair value or market risk premiums are estimated, however, such transaction price should not be determinative toward fair value valuation (i.e. such transaction price may not be primary or, moreover, the sole basis for fair value or market risk premiums estimation). Whenever there is no sufficient information to determine, whether the transaction is orderly or not, less weight should be assigned to the transaction price, as compared to the weight on transactions, which are explicitly orderly.
Therefore, a reporting entity in its determinations cannot ignore information that is available without undue efforts and costs, specifically it is expected to be able to conclude whether a transaction is orderly or not, if the entity was a counterpart in such transaction.
In cases when a reporting entity, in order to determine fair value of the investment, has to apply third level measurements (as described above in “SFAS 157 Summary”), the results of the valuation should not derive solely from the inputs based on the quoted price of the transaction that are not orderly. Instead, the inputs should reflect orderly transactions performed by the market participants as of the measurement date. Also the nature of a price quote should be considered (indicative price, binding offer, actual transaction price), when the available evidence are weighted, with less weight given to indicative quotes than to those that do reflect the results of transactions. All risks inherent in the asset should be taken into account in valuation models based on orderly transactions, including reasonable profit margins estimation for bearing risks (uncertainty) that are expected to be considered by willing sellers and willing buyers in pricing corresponding asset in an orderly transaction as of the measurement date.
Any changes in applied valuation techniques and the related inputs, resulting from the application of the Fair Value Guidance, as well as the quantification of its effects, if practicable, must be disclosed by the reporting entities.
4.3. New “OTTI Accounting” (OTTI FSP)
A more substantive changes regarding investment valuation were included into OTTI FSP. Application of the “other-then-temporary” impairment (OTTI) provided in OTTI Guidance is limited to debt securities. An OTTI event occurs when it is probable that a reporting entity will not be able to collect all amounts due on a security or to obtain a par value on disposal of that security, regardless of whether any actual loss has been incurred. Before the introduction of the OTTI Guidance, in order to determine whether an impairment of the security is other than temporary, a reporting entity had to assess whether it has an intent and ability to hold a security to its recovery to basis cost level. In case impairment was other than temporary, i.e. OTTI event, both market losses and credit losses should be recognized in profit and loss as an OTTI.
The OTTI Guidance dismissed the requirement towards reporting entities to assert their intent and ability to hold a debt security to recovery by creating a new category in other comprehensive income for non-credit losses, by the following formulation:
If the entity doesn’t intend to sell the debt security and it isn’t likely that the entity will be required to sell such security before recovering such security’s cost basis, only the portion of the impairment loss representing credit losses would be recognized in earnings as an OTTI. The balance of the impairment loss would be recognized as a charge to other comprehensive income.
There are number of factors to be considered, when assessing whether a credit loss does exist and what is an expected period over which the debt security is to recover its value, which include, but are not limited to:
- The duration of the period and the extent to which the fair value of an asset has been lower than its valuation on amortized cost basis;
- The adverse conditions specific to that security, corresponding industry(s), geographic area, etc.;
- The historical and implied volatility of the evaluated security’s fair value;
- The repayment schedule of the evaluated debt security and the probability of the issuer being able perform interest or principal payments according to this schedule;
- Possible changes to the rating of the security assigned by the rating agencies; and
- Possible recoveries or additional impairments in asset’s fair value subsequent to the reporting date.
For debt securities which are within the scope of FAS 115 “Accounting for Certain Investments in Debt and Equity” and FAS 124 “Accounting for Certain Investments Held by Not-for-Profit Organizations” a reporting entity should estimate the impairment charge representing corresponding credit losses using its best estimates of the impairment amount resulting from an increase in the associated with the specific instrument credit risks. For a debt securities which are within the scope of EITF 99 – 20 “Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets” a reporting entity should estimate an amount of a total impairment charge comprising the credit losses according to the EITF 99 – 20.
Unless an impaired security is subsequently sold or additional credit losses were incurred, subsequent non-credit losses for the debt security held-to-maturity should be recognized in balance sheet as other comprehensive income. Accordingly they should be amortized over the remaining life of this debt security. The amortization should be recognized in other comprehensive income with an offset to the asset and should not affect the earnings.
Measurement of the subsequent credit losses should be performed on the basis of estimate of the decrease in expected cash flows made by a reporting entity. For the purposes of expected cash flows estimation, a reporting entity must consider all available relevant information regarding a collectability of the security, which includes information on past events, current conditions, as well as reasonable and supportable forecasts and projections. A reporting entity may take use of sector credit ratings, industry analyst reports and forecasts and other available market data for the following information: the financial condition of the issuer(s), the expected defaults, remaining payment terms of the security, prepayment speeds, effects of credit enhancement on the performance of the security; the value of underlying collateral, if available.
The reporting entities are obliged to disclose amounts specifically related to the non-credit portion of OTTI recognized regarding held-to-maturity and available-for-sale debt securities, which were reported in accumulated other comprehensive income (in case there were other components of other comprehensive reported). Also the reporting entities will be obliged to disclose the cost basis of debt securities held-to-maturity and available-for-sale, separately for major security types; key inputs and the methodology behind measurement of the portion of the OTTI related to credit losses separately for major security types; and a rollforward of amounts recognized in earnings for debt securities for which an OTTI has been recognized and the non-credit portion of OTTI that has been recognized in other comprehensive income.
When initially applying the OTTI Guidance in cases when OTTI for a debt security was previously recognized, while the reporting entity does not have intend to sell it, that more likely than not, it will not be forced to sell the security before it recovers amortized cost basis of the security, the reporting entity should recognize the cumulative effect of such application as an opening balance adjustment to retained earnings with a corresponding adjustment to accumulated other comprehensive income.
5. Summary and Conclusions
Despite advantages of the fair value accounting principles for the fairness of the financial statements, existing guidance on this subject overlooked possible impacts of markets going inactive and transactions which are distressed by nature. Failure of the existent standards to provide reasonable guidance for such situation contributed to the global crisis development and put many of the market participants into trouble. As a result of public concern, in spring 2009 FASB issued new guidance, consisting of OTTI Guidance and Fair Value Guidance.
Although OTTI Guidance and Fair Value Guidance were just released, many of market participants doubt whether provisions of these guidance go far enough to address existing concerns regarding investment valuation. Some believe that the Guidance still do not explain clearly proper investment valuation methods and in absence of more comprehensive guidance, disagreements of the reporting entities with their auditors over valuation methods will persist (Sloan, Hopkins. 2009).
Although the Guidance does address some of OTTI accounting issues the FASB did not amend the standard to permit reversal of the economic losses through earnings, as permitted by corresponding international accounting standard, IAS 39.
The FASB also declined to make a change in the Guidance according to recommendation of the American Bankers Association (ABA), which proposed that OTTI should be relevant only to the credit losses for securities held-to-maturity. Although now losses can be treated as credit losses or market losses, market losses are still required to be recorded against other comprehensive income and, therefore, capital of the reporting entity will still be depleted. Even though the OTTI Guidance can be implemented, and a corresponding adjustment can be made to assets and liabilities held as of the implementation date, it is permitted to be done only to the debt classified as held-to-maturity. This made ABA to express its concern that the Guidance issued by FASB may have only limited impact on the financial condition of reporting entities that are financial institutions – many of which have already performed impairment write-downs.
Also the Guidance frustrated many market participants, who hoped that its norms would be retroactively applied and so that the reporting entities could take certain advantage of the accounting guidance changes for current period year-end reporting.
In addition, market participants are closely watching how the Guidance may the potentially impact on the ultimate success of recently announced Private-Public Investment Program (“PPIP”) sponsored by the government. Potentially the Guidance may encourage reporting entities to hold assets suffering market losses until maturity (but not credit losses), rather than to sell them to the PPIP and face additional immediate write-downs.
Political pressure on the FASB to continue reforms persists. So on 2 April 2009, the same day when the FASB voted regarding the Guidance issue, Representative Steve Cohen introduced a bill that directs the SEC suspending in all financial reports required to be filed with the SEC the application of fair value accounting starting from 1 January 2008 (Cohen 2009 1). While it is unlikely that this bill and similar efforts will move forward, especially considering FASB’s release of additional guidance, critics are likely to continue to call for SFAS 157 suspension and other measures regarding investment valuation issues.
Similarly fair value accounting guidance received much critic in other countries, including Europe, where local and/or International Financial Accounting Standards are applied. In some of these countries regulators dropped fair value accounting requirement for the purposes of mandatory reports and exerted pressure on standard setting organizations, such as IASB, to review guidance on investment valuation. IASB opposes fair value principles abandonment, though recognizes existing issues with its application, a number of temporary solutions were introduced and workgroups created to develop remediation for these issues. As a result mixed valuation approaches (elaborating mark-to-market with mark-to-model and/or amortized costs method) were proposed as an alternative to the existing mark-to market valuation as well as procedures aimed to improve mark-to-market procedures.
Cohen, Steve. H. R. 1909 To direct the Securities and Exchange Commission to suspend the application of mark-to-market accounting. 2 Apr.2009. Retrieved 22 Apr. 2009 <http://thomas.loc.gov/cgi-bin/query/z?c111:H.R.1909.IH>
FASB. 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. 9 Apr. 2009.
FASB. FSP 115-2 and FAS 124-2 “Recognition and Presentation of Other-Than-Temporary Impairments. 9 Apr. 2009.
FASB. SFAS 115 Accounting for Certain Investments in Debt and Equity Securities. May 1993.
FASB. SFAS 157 Fair Value Measurements. Sep.2006
SEC. Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting. 30 Dec.2008. Retrieved 22 Apr. 2009 <http://www.sec.gov/news/studies/2008/marktomarket123008.pdf>
Sloan, Steven; Hopkins, Cheyenne. “FASB Bows: Fair Value to Get Overhaul” American Banker (17 Mar. 2009).
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