FASB Change Doesn't Ease the Fair Value Rule

Last Updated May 1, 2009 3:47 PM EDT

At the demand of Congress, the Financial Accounting Standards Board is once again modifying its accounting standard on fair value measurement -- FAS 157, for short -- in a meeting today. But FASB isn't really easing the rule, as the WSJ suggested yesterday. Instead, it's really just clarifying how financial institutions can use different ways to value assets via methods that are already in use.

FASB "is proposing significant changes to its mark-to-market rules, allowing banks to set their own values for certain hard-to-value troubled mortgages, corporate loans and consumer loans," according to the WSJ. But the spirit of FAS 157 has all along allowed companies to value financial instruments according to their own models -- mark to model -- in certain circumstances. There's nothing new here.

The best way to come up with a fair value measurement is to use quoted prices for a specific type of asset, which FASB calls level 1 inputs. If the market for a specific asset is inactive, companies can rely on quoted prices for similar assets in other markets, which FASB calls level 2 inputs. If there are no useful prices around because markets have frozen up, producing fire-sale prices, companies must rely on unobservable assumptions such as future cash flow to determine fair value. FASB calls these level 3 inputs.

By definition, level 2 and 3 inputs inputs lead to subjective asset prices since they allow companies more leeway in determining fair value. (See page 44 of the original 157 rule -- it's a PDF link -- issued several years ago for the fair value hierarchy of these inputs.)

With level 3 inputs, for instance, FASB has always said (see page 47 of the original 157 rule):

[U]nobservable inputs should be used to measure fair value to the extent that observable inputs are not available, allowing for situations in which there might little, if any, market activity for the asset or liability at the measurement date.... Therefore, unobservable inputs should reflect the reporting entity's own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances.
FASB never said companies should use fire-sale or distressed prices if markets are inactive. So in its new guidance out today, FASB will help financial institutions determine when markets are inactive and when transactions are distressed.

In the proposed additional guidance, FASB reiterates its definition of level 1 inputs. It also offers a two-step test to determine if level 2 inputs should be used. That test consists of determining whether a market is active via criteria such as frequency and volume of recent transactions and the difference between bid-ask spreads. Once it's been determined that a market is indeed inactive, the second step consists of determining whether a transaction is a distressed one. If the transaction isn't distressed, companies can rely on that price. But if it is distressed, they have to rely on level 3 inputs, meaning solely on their own assumptions and valuation methods.

"They are adding some criteria for further determining the character of the investments being measured so as to allow further room for judgment," Paul Rohan, managing director with accounting firm UHY Advisors, told me in a phone conversation Wednesday. He said there won't be any dramatic changes such as abandoning FAS 157. After all, 157 doesn't even set fair value but merely provides guidance on how to measure it. So what FASB is doing this week, is providing more specific definitions. Or as Rohan sees it, "it's like adjusting a carburetor.

Update: My BNET Finance colleage Daniel Harrison offers his own take on the FASB rule change here.