Floyd Norris

Back in the tent -- same game. Party on!

September 30, 2008, 5:17 pm — Updated: 5:24 pm -->
Fair Value Follies 2
The Securities and Exchange Commission and the Financial Accounting Standards Board are out with their guidance on fair value accounting, and it appears to indicate that managements can ignore market values more than most accountants had thought possible.
That may help to satisfy politicians who think the problem is that the banks show their losses when there is hope that the assets will someday regain value, rather than the policies that led them to incur the losses.
You can read the statement here.
In the following excerpts, the italics are mine.
Can management’s internal assumptions (e.g., expected cash flows) be used to measure fair value when relevant market evidence does not exist?
Yes. When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable.
That is not new policy, but it does state it more strongly than it has been stated. More interesting, perhaps, is the question of how you determine a market is not active, or a sale is distressed and can be ignored:
Are transactions that are determined to be disorderly representative of fair value? When is a distressed (disorderly) sale indicative of fair value?
The results of disorderly transactions are not determinative when measuring fair value. The concept of a fair value measurement assumes an orderly transaction between market participants. An orderly transaction is one that involves market participants that are willing to transact and allows for adequate exposure to the market. Distressed or forced liquidation sales are not orderly transactions, and thus the fact that a transaction is distressed or forced should be considered when weighing the available evidence. Determining whether a particular transaction is forced or disorderly requires judgment.
Can transactions in an inactive market affect fair value measurements?
Yes. A quoted market price in an active market for the identical asset is most representative of fair value and thus is required to be used (generally without adjustment). Transactions in inactive markets may be inputs when measuring fair value, but would likely not be determinative. If they are orderly, transactions should be considered in management’s estimate of fair value. However, if prices in an inactive market do not reflect current prices for the same or similar assets, adjustments may be necessary to arrive at fair value.
At first glance, this appears to open the way for companies to ignore more market prices than they had been doing, and to put pressure on auditors to approve such departures. If that is correct, we should see an increase in so-called Tier 3 valuations in the next quarter’s reports.
This is not inconsistent with previous guidance, but the emphasis seems to be placed more on finding exceptions to the rules that require the use of market prices.
One phrase that caught my attention is: “involves market participants that are willing to transact and allows for adequate exposure to the market.”
I wonder if someone will interpret that to say a sale made pursuant to a margin call does not involve participants that were “wiiling to transact,” and thus can be ignored by banks that own the same security, or a similar one. Could the part about “adequate exposure to the market” mean that a private sale — one in which a security is not offered to other possible buyers — is a sale that can be ignored?
A few years from now, long after some bank has failed, there will probably be an S.E.C. enforcement action claiming that fraud was committed when a bank ignored market prices in valuing assets, and the defense will be that the bank used the judgment required by this statement to exclude all the sales that indicated it was overvaluing assets.
If such a case goes to trial, we might find out that the bank was quite happy to rely on prices in inactive markets when the price was rising, but concluded the market was not worthy of attention when the price began to fall.