SEC to Study Fair Value Accounting’s Impact on Bank Failures

The $700 billion rescue package for the U.S. financial system approved by lawmakers in October calls on the SEC to study fair value accounting’s impact on recent bank failures and the quality of financial information available to investors. The study will be conducted in consultation with the Treasury secretary and the Board of Governors of the Federal Reserve System.

The rescue package, the Emergency Economic Stabilization Act of 2008, allows the Treasury Department to buy up problem assets in an effort to improve the balance sheets of financial institutions and keep credit flowing. The final version of the plan passed by Congress and signed by President Bush on Oct. 3 also reaffirms the power of the SEC to suspend the use of mark-to-market accounting under FASB Statement no. 157, Fair Value Measurements, for any issuer or any class or category of transactions.

Some financial institutions have said that mark-to-market rules hurt their balance sheets and exacerbated the credit crunch by forcing them to write down certain securities. Others including Federal Reserve Chairman Ben Bernanke have said that suspending mark-to-market accounting would deprive investors of needed information.

On Sept. 30, the day after House lawmakers rejected an earlier version of the economic rescue plan, FASB and the SEC released clarifying guidance on fair value accounting. On Oct. 3, FASB separately released a proposed FASB Staff Position that clarifies the application of Statement no. 157 in an inactive market and provides an illustrative example to demonstrate how the fair value of a financial asset is determined when the market for that financial asset is not active. The proposed FSP is available at www.fasb.org/pdf/fsp_fas157-3.pdf. Although the proposed FSP would amend FASB Statement no. 157 to clarify its application in an inactive market, the principles established by Statement no. 157 for measuring fair value remain unchanged.

The joint SEC/FASB guidance (available at www.sec.gov/news/press/2008/2008-234.htm or www.fasb.org/news/2008-FairValue.pdf) addressed five key points and reinforced the role of clear and transparent disclosures in providing investors with an understanding of the judgments made by management. Among the points was that management’s internal assumptions, such as expected cash flows from an asset, can be used to measure fair value when no relevant market evidence exists.

“In some cases, multiple inputs from different sources may collectively provide the best evidence of fair value,” the joint guidance reads. “In these cases expected cash flows would be considered alongside other relevant information.”