FASB Eases 'Fair Value' Accounting Rules

Yesterday, the Financial Accounting Standards Board (FASB) affirmed its earlier decision to allow companies greater discretion in accounting for certain investments, including mortgage-backed securities. Under previous guidelines, companies were required to mark assets on a quarterly basis to reflect market prices. FASB's decision, effective for interim and annual periods ending after March 15, 2009, relaxes the "fair-value" accounting rules that were previously in place and allows companies to use significant judgment in assessing the value of investments. As a consequence, banks and other holders of mortgage-backed securities may reduce writedowns, thereby boosting earnings. Less clear is whether, as a result of these guidelines, holders of "toxic" securities will find less urgency to participate in the Treasury Department's program to sell those securities.

FASB's decision is the latest step in a process that was triggered by the Emergency Economic Stabilization Act of 2008. In response to criticism that the then-existing fair value accounting rules contributed to the economic crisis, Congress required the Securities and Exchange Commission (SEC), in consultation with the Treasury Department and the Federal Reserve Board, to conduct a study on the impact of the mark-to-market accounting standards under FASB's FAS 157 and whether the SEC should suspend application of FAS 157. The SEC issued its report on December 30, 2008, and announced that it did not believe mark-to-market accounting was a cause of the economic crisis, and as a result would not suspend the application of FAS 157. The SEC, however, recommended fair value accounting requirements should be improved through the development of guidance for determining fair value in illiquid or inactive markets.

FASB accordingly proposed FAS 157-e. Under FAS 157-e, companies will now apply a two-step process. A reporting entity first must determine whether a market is active in reference to a number of factors, including whether there have been few transactions in the market and "[i]ndexes that previously were highly correlated with the fair values of the asset are demonstrably uncorrelated with recent fair values." If the company determines the market is not active, it then may "presume that a quoted price is associated with a distressed transaction unless the reporting entity has evidence that (a) there was sufficient time before the measurement date to allow for usual and customary marketing activities for the asset and (b) there were multiple bidders for the asset." If the reporting entity has evidence that both factors are present for a given quoted price, then the quoted price is not, under FAS 157-e, presumed to be associated with a distressed transaction. In that case, the reporting company may use the quoted price as "a relevant observable input that should be considered in estimating fair value." If the reporting entity does not have evidence of both factors, the quoted price is considered to be associated with a distressed transaction and the company must use a valuation technique "other than one that uses that quoted price without significant adjustment."

For more information, please contact Justin P. Klein at 215.864.8606 or kleinj@ballardspahr.com, or John C. Grugan at 215.864.8226 or gruganj@ballardspahr.com.