Making mark-to-market work

In response to a chorus of critics, and the prodding of the SEC, the FASB will issue new guidance on the use of fair value accounting.

The US Financial Accounting Standards Board is working to improve guidance on the application of fair value accounting and disclosure of fair value estimates. Their efforts may help to clarify the valuation of assets in illiquid markets, but could also result in a greatly increased workload for fund managers.

As part of the Emergency Economic Stabilization Act passed last year, the SEC undertook a review of fair value accounting. The study concluded that while mark-to-market accounting should not be suspended, the FASB should issue more guidance on how to apply some of its principles.

“We agree with the SEC and with our Valuation Resource Group that more application guidance to determine fair values is needed in current market conditions,” FASB chairman Robert Herz said in a statement. “Additionally, investors have asked for more information and disclosure about fair value estimates. Therefore, the FASB is immediately embarking on projects that directly address areas that constituents have told us are challenging in the current environment, and which will improve disclosures in financial reports.”

Some areas FASB is looking to improve include determining when a market for an asset or a liability is active or inactive, and determining when a transaction is distressed. The board has previously said managers may use their own judgment to value assets in inactive markets, and that they needn't accept prices arising from distressed transactions as market prices.

Also, the board is examining the application of fair value to stakes in alternative investment funds, such as hedge funds and private equity funds, which could help limited partners.

The board is considering requiring additional disclosures on such matters as sensitivities of measurements to key inputs and transfers of items between the fair value measurement levels. This aspect of the FASB's efforts has the potential to increase the workload on already overburdened CFOs.

The FASB and the SEC released clarifications on mark-to-market accounting in October 2008 concerning how to value illiquid assets in distressed markets. But many in the finance industry said the clarifications weren't sufficient.

The FASB will finish the projects by the end of the second quarter of 2009.

The SEC weighs in
The SEC made eight recommendations in its report on mark-to-market accounting. This is the third of those recommendations, which suggests ways in which the FASB could improve its guidance on fair value accounting.

“recommendation #3:

While the Staff does not recommend a suspension of existing fair value standards, additional measures should be taken to improve the application and practice related to existing fair value requirements (particularly as they relate to both Level 2 and Level 3 estimates.)


•+++ Fair value requirements should be improved through development of application and best practices guidance for determining fair value in illiquid or inactive markets. This includes consideration of additional guidance regarding:

  • How to determine when markets become inactive
  • How to determine if a transaction or group of transactions is forced or distressed
  • How and when illiquidity should be considered in the valuation of an asset or liability, including whether additional disclosure is warranted
  • How the impact of a change in credit risk on the value of an asset or liability should be estimated
  • When observable market information should be supplemented with and / or reliance placed on unobservable information in the form of management estimates
  • How to confirm that assumptions utilized are those that would be used by market participants and not just by a specific entity
  • •Existing disclosure and presentation requirements related to the effect of fair value in the financial statements should be enhanced.

    •FASB should assess whether the incorporation of changes in credit risk in the measurement of liabilities provides useful information to investors, including whether sufficient transparency is provided.

    •Educational efforts to reinforce the need for management judgment in the determination of fair value estimates are needed.

    •FASB should consider implementing changes to its Valuation Resource Group.

    What market heavyweights have said in recent weeks about fair value
    “We endorse mark-to-market accounting … We have told you before that our derivative contracts, subject as they are to mark-to-market accounting, will produce wild swings in the earnings we report. The ups and downs neither cheer nor bother Charlie [Munger] and me. Indeed, the ‘downs’ can be helpful in that they give us an opportunity to expand a position on favorable terms. I hope this explanation of our dealings will lead you to think similarly.”

    “We know that certain banks were not presenting investors with the full picture of their financial health, utilising off-balance sheet vehicles and other accounting methods. This was a disservice to investors as the integrity of the numbers is critical to their making smart investment decisions and to the smooth functioning of our markets. While there are a lot of different views on whether mark-to-market accounting contributed to this crisis, my personal view is that it was not a significant factor.”

    “Accounting standards aren't just another financial rudder to be pulled when the economic ship drifts in the wrong direction … Instead they are the rivets in the hull, and you risk the integrity of the entire economy by removing them.”

    “I think it's wrong to mark-to-market our own private equity investments every quarter [to avoid] good quarters – up, bad quarters – down. We'd just like to tell our shareholders about our investments. If impaired, we should impair them. If worth more, we want to tell you.”

    “If this rigid mark-to-market accounting had been in effect during the banking trouble in the early 1990s, almost every major commercial bank in the US would have collapsed because of shaky Latin American and commercial real estate loans. We would have had a second Great Depression.”