Statement of Financial Accounting Standard Number 157, Fair Value Measurements (“SFAS No. 157”) was issued by the Financial Accounting Standards Board (“FASB”) in September 2006. SFAS No. 157 became effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. SFAS No. 157 does not require any new fair value measurements. Rather, it provides additional guidance to assist with the determination of fair value measurements when fair value measurement is required under various other accounting pronouncements. SFAS No. 157 provides a definition of fair value to be applied to all fair value measurements, guidance for acceptable valuation methods and enhanced disclosure requirements regarding the valuation methods used and the inputs to those valuation models.

A Call for Review of Mark-to-Market

The Emergency Economic Stabilization Act of 2008 obligated the Securities and Exchange Commission (“SEC”) to conduct a study on the mark-to-market requirements of SFAS No. 157, particularly focused on the impacts to financial institutions. At a minimum, the SEC was required to consider the following six topics:

1. the effects of such accounting standards on a financial institution's balance sheet;

2. the impacts of such accounting on bank failures in 2008;

3. the impact of such standards on the quality of financial information available to investors;

4. the process used by the Financial Accounting Standards Board in developing accounting standards;

5. the advisability and feasibility of modifications to such standards; and

6. alternative accounting standards to those provided in SFAS No. 157.

The ultimate cause for the mandated study is presumably to revisit the definition of fair value and acceptable valuation methods as defined by SFAS No. 157.

Fair value is defined under SFAS No. 157 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.” This definition has come under scrutiny because it only considers the price that would be received in a sale and does not allow for the price that would have to be paid to acquire a comparable asset. Thus, only bid prices can be considered, while ask prices have to be ignored. Many have argued that some midpoint between the bid price and ask price of any particular asset would result in the best approximation of fair value, especially in instances where there is a large spread between the two prices in situations where potential purchasers would demand a steep discount in current market conditions due to liquidity issues.

Acceptable valuation methods under SFAS No. 157 are the market approach, the income approach, and the cost approach. The market approach utilizes market multiples or matrix pricing using the quoted prices of benchmark securities to determine the fair value. The income approach uses discounted future amounts, for example, cash flows or earnings, to determine fair value. The cost approach uses the replacement cost, from the perspective of the seller, with an allowance for obsolescence, to determine fair value. All three valuation methods are restricted to current market expectations. Many opponents have argued that the inability to incorporate future market expectations into their valuation models unfairly distorts valuations due to temporary market swings, thereby increasing volatility in their financial statements. This becomes more significant during sharp swings in the economy as valuations cannot look past the current swing and incorporate stabilized conditions in the future. Opponents argue that this is unfair and irrelevant in situations where current market conditions result in significant fair value swings in periods where the holder of the asset or liability does not intend to dispose of the position in the short-term. Furthermore, opponents argue that in cases where current market conditions require a revaluation and an accompanying write-down due to impairment, entities are not entitled to write-up the fair value of the asset or liability if fair value recovers in the future. This will result in irrational gains on the income statement as the fair value begins to rise, further increasing volatility due to swings in market conditions. These effects are pro-cyclical because it can actually increase the overall swing in the economy.

The SEC's Initial Findings

While the SEC is scheduled to begin their formal study early in 2009, they have hosted three roundtable meetings to discuss mark-to-market accounting under SFAS No. 157 through December 8, 2008. The primary recurring comments focus on the fact that SFAS No. 157 does not require any new fair value measurements and only aims to enhance the transparency of financial reporting as it pertains to fair value measurements. Participants have also stressed the fact that the FASB is overseen by the Financial Accounting Federation (“FAF”), and independent, private-sector organization. There is a strong consensus among the participants that a repeal of SFAS No. 157 would deteriorate investor confidence in the markets by reducing the transparency of financial statement disclosures and undermine the independence of the FAF. While some expressed some concern for the new standard, particularly regarding the volatility issues, none of the roundtable participants have expressed a desire for an outright repeal of SFAS No. 157.

The FAF's Initial Response

On October 27, 2008, the FAF issued a letter to Christopher Cox, Chairman of the SEC. In this letter, the FAF stressed the importance of maintaining an independent accounting standards setting process. They stressed the fact that standards are established through due process with consideration given to responses from the public as well as consultation with the SEC. Furthermore, it was stated that the FAF believes that a repeal of SFAS No. 157 would lead to an erosion of investor confidence and the FAF requested the SEC to reject appeals to overturn any accounting standard.

What Does All of This Mean?

The SEC appears at this point to remain committed to maintaining an independent accounting standard setting body. However, the SEC does maintain ultimate oversight over the FASB. Considering that the SEC has not received credible feedback requesting a repeal of SFAS No. 157, it is unlikely that they will do so, especially considering the possibility that such a move may in fact erode investor confidence at a time when that confidence level is already quite low. However, the SEC is receiving a considerable amount of constructive feedback regarding some of the exact mechanics of SFAS No. 157, particularly as it pertains to the stated definition of fair value and the acceptable valuation methods. It is entirely possible that the SEC may decide to alter the definition of fair value in such a way to include both the price that would received to sell an asset and the price that would be paid to purchase an asset, and/or modifying the acceptable valuation methods to allow for enhanced discretion in the methods to be utilized. Modifications to the acceptable valuation methods could come in the form of the allowance for the incorporation of expectations of future market conditions and/or a moving average of historic valuations. Finally, it is plausible that rules regarding impairment could be altered to change the manner in which subsequent recoveries in fair value are accounted for.