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Friday, September 19, 2014

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SRC Insights: Fourth Quarter 2007

Implications of Fair Value Accounting for Financial Institutions

Advocates for fair value accounting believe fair value, which is based on market value, is the most relevant measure for financial reporting. Others, however, believe historical cost, which is more clearly verifiable, provides a more useful measure. So, which is more appropriate? The Federal Reserve's longstanding position on this issue is to ensure that financial institutions follow sound accounting policies and practices. These practices should support enhanced financial disclosures, improve transparency, and provide useful information for decision makers.1

In September 2006, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 157, Fair Value Measurements (FAS 157). This standard provides a framework for how companies should measure fair value when they are required to use a fair value measurement for recognition or disclosure purposes under generally accepted accounting principles (GAAP). In February 2007, the FASB issued a Fair Value Option Standard (FAS 159). This standard permits an entity to elect the fair value option on an instrument-by-instrument basis, upon origination or purchase, or after a business combination. The Fair Value Option is intended to address certain problems of a mixed-measurement accounting model and the complexity in current hedge accounting standards.

Both FAS 157 and 159 are effective as of the beginning of an entity's first fiscal year that begins after November 15, 2007. This article summarizes the key provisions of FAS 157 and FAS 159, and it discusses the implications for financial institutions.

FAS 157-Fair Value Measurement
FAS 157 provides for a more common definition of fair value and more consistent, comparable, and improved disclosures. Prior to this statement, there were different definitions of fair value and limited guidance for applying those definitions in GAAP. FAS 157 defines fair value as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." Market participants are defined as buyers and sellers.

To increase consistency and comparability in fair value measures, FAS 157 establishes a three-level hierarchy to prioritize the input used in valuation techniques. In measuring fair value for a financial statement item, FAS 157 gives the highest priority, known as Level 1 inputs, to quoted prices in active markets. Examples of Level 1 inputs are actively traded securities.

The second hierarchy is Level 2 inputs, which are directly or indirectly observable. Examples of Level 2 inputs are less frequently traded instruments or pricing models with observable market data. Finally, Level 3 inputs are unobservable inputs such as pricing models using the entity's assumptions. Concerns raised about the reliability of fair value measures based on Level 3 inputs resulted in expanded disclosure requirements, which are addressed later in this article.

The implications of FAS 157 are that current accounting practices will change based on the definition of fair value, the prescribed methods for measuring fair value, and the expanded disclosure requirements. Some accounting practices that FAS 157 will impact include the following.

Market-based measures. Since the term fair value is intended to mean market-based, FAS 157 gives the highest priority to quoted prices in active markets. However, FAS 157 also permits the use of unobservable inputs for situations for which there is little, if any, market activity. Whether there is significant market activity or not, companies should consider the risk inherent in a particular valuation technique (such as option pricing models) and/or the risk inherent in the inputs to the valuation technique. Accordingly, an adjustment for risk should be included in the fair value measurement, if market participants would include such an adjustment in pricing a specific asset or liability.

Valuing credit risk. FAS 157 clarifies that in measuring the fair value of a liability, a company should take into account the effect of its own credit standing. This practice could possibly create misleading financial results. For example, if a company is performing poorly and its credit quality deteriorates, the company could recognize a gain in the income statement because its liability would be worth less, as the fair value of a liability would decrease as credit quality deteriorates.

Investment blocks. The AICPA permits companies to adjust the fair value of large holdings of securities (blocks) to reflect blockage factors. A blockage factor is a discount applied to the security price to reflect the lack of trading volume in the market. FAS 157 does not allow this. The fair value of a security is equal to the quoted price without any adjustment to reflect the blockage factor.

Restricted securities. Securities where a sale is restricted for a period of less than one year under FAS 115 may not be reduced to reflect the quoted price of an identical but unrestricted security. However, since FAS 157 requires companies to reduce the quoted price of an identical unrestricted security, FAS 157 essentially amends the FAS 115 requirement.

Expanded disclosures. FAS 157 requires disclosures regarding the extent to which companies use fair value to measure assets and liabilities, the methods and assumptions used, and the effect of fair value measures on earnings. Concerns raised about the reliability of fair value measures based on Level 3 inputs resulted in expanded disclosure requirements. For each category of assets or liabilities using Level 3 inputs, a reconciliation of beginning and ending balances, including total gains and losses, is required. Additionally, a company must disclose the amount of total gains and losses attributable to the changes in unrealized gains and losses related to Level 3 input-based assets and liabilities and a description of where those gains and losses are reported in the income statement. This may mean modifying information systems and developing new reports to comply with this requirement.2

FAS 159-Fair Value Option
FAS 159 includes an option to elect to account for certain assets and liabilities, including stocks, bonds, loans, warranty obligations, and interest rate hedges, at fair value versus historical cost. This is done on an instrument-by-instrument basis, and once an election is made, it is irrevocable.

A transition provision at initial adoption of FAS 159 provides a one-time opportunity, when appropriate, to record changes to fair value directly to the equity section of the financial statements as a cumulative-effect adjustment to beginning retained earnings, with no charges to earnings. Subsequent changes to fair value for elected instruments flow directly to the income statement.

A loophole in FAS 159 resulted in some companies using the one-time transition provision to re-measure all the underwater stocks in their investment portfolio or the expensive loans on their balance sheets (e.g., held to maturity stocks that are underwater, or loans with interest rates much lower than current market rates).3 Applying FAS 159, the current fair value of the stocks or loans is measured, and any resulting loss is recorded in retained earnings, bypassing the income statement. The stocks or loans are then sold immediately, and replacement assets are purchased and subsequently valued at historical cost, thus indicating that there had been little or no intent to utilize the fair value option going forward.

While the FASB and the Securities and Exchange Commission did not ban this practice outright, both commented that this practice lacks economic substance, would hide losses from investors, and violates the spirit of FAS 159.

Implications for Financial Institutions
So how will FAS 157 and FAS 159 impact financial institutions? First, a thorough evaluation of both existing assets and liabilities, as well as those items for which the fair value option is elected, should be performed to understand and comply with the changes in the definition of fair value. Some of those changes include using a fair value that represents an exit price, not an entry price, and using a fair value from the perspective of the market participant, not the company. Other considerations are:

Increased financial statement disclosure requirements. Both statements will require tables indicating the level inputs in the fair value hierarchy and additional disclosures regarding gains and losses.

The impact of management's prior assertions. Inconsistencies in financial reporting may result where underwater securities previously classified as held to maturity are marked to fair value and sold.

Establishing proper internal controls. Companies should have in place the proper controls, including policies and procedures for future evaluations; proper ongoing evaluation; possible information system changes; and required documentation.

Required regulatory reporting guidance. Institutions filing their call reports will need to use a new Schedule RC-Q, "Financial Assets and Liabilities Measured at Fair Value." There are also changes to Schedule RC-R, "Regulatory Capital," which removes any income recorded from incorporating any declines in a company's credit rating on liabilities and changes to Schedule RI-E to report the net changes in the fair values of financial instruments accounted for under a fair value option. Currently, the available-for-sale adjustment for banks and savings institutions is excluded for regulatory capital purposes. If fair value is adopted, regulatory capital will be affected by an adjustment to opening retained earnings due to the one-time transition provision.4

Loans represent a significant portion of a commercial bank's business activity; however, loans typically do not have market prices. Financial institutions are challenged in how to measure the fair value of loans and loan commitments. Some institutions use fair value as a loan management tool and for communicating information to senior management. Loan management uses include managing credit risk and determining loan pricing.

Since most loan facilities do not have secondary market prices, the fair value must be estimated by the bank. Some institutions use a modeling approach where assumptions are made on default probability and loan facility payments. These assumptions are objective, limit the specificity of information, and require the exercise of judgment in the modeling process. Additional challenges are present when trying to value assets backed by subprime mortgage loans, as this type of asset recently experienced severe price volatility as a result of increased credit risk and reduced liquidity in the marketplace.

The board and senior management should have a good understanding of fair value accounting and consider all of the implications before implementing either standard. For more information on FAS 157 and FAS 159, please refer to the full text of the statements on the Financial Accounting Standards Board's website.External Link If you have questions about this article, please contact Supervising Examiner Jacqueline P. Fenton (jacqueline.p.fenton@phil.frb.org) at (215) 574-6234 or Supervising Examiner Eddy Hsiao (eddy.hsiao@phil.frb.org) at (215) 574-3772.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.