Study with the several resources on Docsity
Earn points by helping other students or get them with a premium plan
Prepare for your exams
Study with the several resources on Docsity
Earn points to download
Earn points by helping other students or get them with a premium plan
Community
Ask the community for help and clear up your study doubts
Discover the best universities in your country according to Docsity users
Free resources
Download our free guides on studying techniques, anxiety management strategies, and thesis advice from Docsity tutors
An in-depth analysis of fair value accounting, its definition, application, historical context, and comparison with other measurement bases. It also discusses investor and user views, recommendations from advisory committees, and the reliability of fair value accounting. essential for accounting students and professionals seeking a comprehensive understanding of fair value accounting.
What you will learn
Typology: Lecture notes
1 / 259
This page cannot be seen from the preview
Don't miss anything!
This is a report by the Staff of the U.S. Securities and Exchange Commission. The Commission has expressed no view regarding the analysis, findings, or conclusions contained herein.
ii
II. Effects of Fair Value Accounting Standards on Financial Institutions’ Balance Sheets 43 A. Methodology for Studying Effects of Fair Value Accounting Standards 43
B. Empirical Findings from this Study on Effects of Fair Value Accounting Standards 45
b. Nature of Assets Measured at Fair Value on a Recurring Basis 58
c. Classification of Assets in Fair Value Hierarchy 60 i. Fair Value Hierarchy Classification over Time 61 ii. Distribution of Issuers by Percentage of Assets Classified as Level 3 63
b. Nature of Liabilities Measured at Fair Value on a Recurring Basis 74
c. Classification of Liabilities in Fair Value Hierarchy 75 i. Fair Value Hierarchy Classification over Time 75 ii. Distribution of Issuers by Percentage of Liabilities Classified as Level 3 78
v
vi
viii
Act Emergency Economic Stabilization Act of 2008 AFS Available-for-Sale Agency Appropriate Federal Banking Agency Boards FASB and IASB CIFiR SEC Advisory Committee on Improvements to Financial Reporting Commission United States Securities and Exchange Commission EESA Emergency Economic Stabilization Act of 2008 EITF Emerging Issues Task Force FASB Financial Accounting Standards Board FDIC Federal Deposit Insurance Corporation FDICIA Federal Deposit Insurance Corporation Improvement Act of 1991 Federal Reserve Board of Governors of the Federal Reserve System FVO Fair Value Option FSP FASB Staff Position GAAP Generally Accepted Accounting Principles GSE Government Sponsored Enterprise and Similar Entities HFI Held-for-Investment HFS Held-for-Sale HTM Held-to-Maturity IAS International Accounting Standard IASB International Accounting Standards Board IFRS International Financial Reporting Standard(s) MD&A Management’s Discussion and Analysis of Financial Condition and Results of Operations MSR Mortgage Servicing Right OCC Office of the Comptroller of the Currency OCI Other Comprehensive Income OTS Office of Thrift Supervision OTTI Other-than-Temporary Impairment PCA Prompt Corrective Action PCAOB Public Company Accounting Oversight Board Sarbanes-Oxley Act The Sarbanes-Oxley Act of 2002 SEC United States Securities and Exchange Commission SFAC Statement of Financial Accounting Concepts SFAS Statement of Financial Accounting Standards SOP Statement of Position Staff Staff of the United States Securities and Exchange Commission TFR Thrift Financial Report Treasury Committee The Department of the Treasury’s Advisory Committee on the Auditing Profession
On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (“EESA” or the “Act”) was signed into law.^1 Section 133 of the Act mandates that the U.S. Securities and Exchange Commission (the “SEC” or “Commission”) conduct, in consultation with the Board of Governors of the Federal Reserve System (“Federal Reserve”) and the Secretary of the Treasury, a study on mark-to-market accounting standards as provided by Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value Measurements (“SFAS No. 157”).^2
As discussed further in this study, SFAS No. 157 does not itself require mark-to-market or fair value accounting. Rather, other accounting standards in various ways require what is more broadly known as “fair value” accounting, of which mark-to-market accounting is a subset. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in U.S. generally accepted accounting principles (“GAAP”), and requires expanded disclosures about fair value measurements. However, to ensure that this study was responsive to the policy debate discussed below, for purposes of this study the SEC Staff (the “Staff”) considered the issue of fair value accounting in this larger context, including both mark-to-market accounting and SFAS No. 157.
The events leading up to the Congressional call for this study illustrated the need for identifying and understanding the linkages that exist between fair value accounting standards and the usefulness of information provided by financial institutions. In the months preceding passage of the Act, some asserted that fair value accounting, along with the accompanying guidance on measuring fair value under SFAS No. 157, contributed to instability in our financial markets. According to these critics, fair value accounting did so by requiring what some believed were potentially inappropriate write-downs in the value of investments held by financial institutions, most notably due to concerns that such write-downs were the result of inactive, illiquid, or irrational markets that resulted in values that did not reflect the underlying economics of the securities. These voices pointed out the correlation between U.S. GAAP reporting and the regulatory capital requirements of financial institutions, highlighting that this correlation could lead to the failure of long-standing financial institutions if sufficient additional capital is unavailable to offset investment write-downs. Further, they believed the need to raise additional capital, the effect of failures, and the reporting of large write-downs would have broader negative impact on markets and prices, leading to further write-downs and financial instability.
Just as vocal were other market participants, particularly investors, who stated that fair value accounting serves to enhance the transparency of financial information provided to the public. These participants indicated that fair value information is vital in times of stress, and a suspension of this information would weaken investor confidence and result in further instability in the markets. These participants pointed to what they believe are the root causes of the crisis, namely poor lending decisions and inadequate risk management, combined with shortcomings in the current approach to supervision and regulation, rather than accounting. Suspending the use
(^1) Pub. L. No. 110-343, Division A.
(^2) See Section 133(a) of the Act.
It is also important, as noted above, to clearly demarcate the difference between the accounting standards that require measurement of financial instruments at fair value and SFAS No. 157, which only provides guidance on how to estimate fair value. This demarcation is important when considering the focus of this study as well as its recommendations.
Although not mandated for study by the Act, the Staff believes that it is important to recognize what many believe to be the larger problem in the financial crisis that led to the financial distress at financial institutions other than banks, including The Bear Stearns Companies, Inc. (“Bear Stearns”), Lehman Brothers Holdings Inc. (“Lehman”), and Merrill Lynch & Co., Inc. (“Merrill Lynch”). Rather than a crisis precipitated by fair value accounting, the crisis was a “run on the bank” at certain institutions, manifesting itself in counterparties reducing or eliminating the various credit and other risk exposures they had to each firm. This was, in part, the result of the massive de-leveraging of balance sheets by market participants and reduced appetite for risk as margin calls increased, putting enormous pressure on asset prices and creating a “self-reinforcing downward spiral of higher haircuts, forced sales, lower prices, higher volatility, and still lower prices.”^5 The trust and confidence that counterparties require in one another in order to lend, trade, or engage in similar risk-based transactions evaporated to varying degrees for each firm very quickly. What would have been more than sufficient in previous stressful periods was insufficient in more extreme times.
A. The Organization of this Study
As mandated by the Act, this study addresses six key issues in separate sections. Issues were studied using a combination of techniques, which are described in each of the respective sections. Where practicable under the time constraints of this study, data was analyzed empirically and obtained from a broad-based population that included a cross-section of financial institutions.
For issues that did not lend themselves to empirical analysis, alternative methods were undertaken, including Staff research of public records, analysis of public comment letters received regarding this study, and the hosting of three public roundtables to obtain a wide range of views and perspectives from all parties. Careful attention was given to maximize the opportunities for both proponents and opponents of fair value measurements to be heard.
This study is organized into seven sections, beginning with an introductory section that outlines in greater detail the mandate for this study under the Act and background information intended to provide readers with a common base of knowledge. Each of the remaining six sections addresses one of the issues mandated for study. The following highlights each of these six sections.
(^5) Testimony of Timothy F. Geithner, President and Chief Executive Officer, Federal Reserve Bank of New York,
before the Committee on Banking, Housing and Urban Affairs of the United States Senate on Actions by the Federal Reserve Bank of New York in Response to Liquidity Pressures in Financial Markets (April 3, 2008).
1. Effects of Fair Value Accounting Standards on Financial Institutions’ Balance Sheets
This section explores the effects of fair value accounting standards on financial institutions’ balance sheets. In the debate concerning fair value accounting, some assert that accounting standards that require fair value accounting may inappropriately affect the balance sheets of financial institutions. This section studies those concerns by analyzing a sample of fifty financial institutions that were selected from a broad-based population of financial institutions in our markets.
The effects of fair value accounting standards on each financial institution was studied to gauge the prevalence of assets measured at fair value on the balance sheet and the subset of those assets that are also marked-to-market through the income statement. This study also evaluated, among other items, the level within SFAS No. 157’s fair value hierarchy in which assets fell.^6 Information was analyzed by type of financial institution to draw out common characteristics and dissimilarities that may exist within each industry type.
From the sample of financial institutions studied in this section of the study, the Staff observed that fair value measurements were used to measure a minority of the assets (45%) and liabilities (15%) included in financial institutions’ balance sheets. The percentage of assets for which changes in fair value affected income was significantly less (25%), reflecting the mark-to-market requirements for trading and derivative investments. However, for those same financial institutions, the Staff observed that fair value measurements did significantly affect financial institutions’ reported income.
2. Impact of Fair Value Accounting on Bank Failures in 2008
This section analyzes possible linkages between fair value accounting and bank failures occurring during 2008. Some have asserted that fair value accounting contributed to the failure of one, or more, financial institutions during 2008.
For purposes of studying this issue, banks were grouped based on asset size. Within each group, this study evaluated banks’ use of fair value measurements over time by analyzing data over a period of three years. The Staff also analyzed the key drivers of regulatory capital to evaluate the impact of fair value measurements on capital adequacy relative to other factors, such as incurred losses on loans.
The Staff observes that fair value accounting did not appear to play a meaningful role in bank failures occurring during 2008. Rather, bank failures in the U.S. appeared to be the result of growing probable credit losses, concerns about asset quality, and, in certain cases, eroding lender and investor confidence. For the failed banks that did recognize sizable fair value losses, it does not appear that the reporting of these losses was the reason the bank failed.
(^6) SFAS No. 157’s fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into
three broad levels. The fair value hierarchy gives the highest priority to unadjusted quoted prices in active markets (Level 1) and the lowest priority to unobservable inputs (Level 3).
5. Alternatives to Fair Value Accounting Standards
This section examines the potential alternatives to fair value measurements. During the recent debate leading to the mandate for this study, some have considered the feasibility of suspending SFAS No. 157. This section first addresses the specific consequences of suspending the guidance in SFAS No. 157, which would not itself change fair value accounting requirements, but rather remove the currently operative guidance for implementation. This section also discusses whether it would be prudent to modify the guidance on fair value measurements that currently exists.
This section also examines consideration of a suspension of fair value accounting itself, including the positives and negatives of available alternatives, such as historical cost-based measures. Valuable insights and thoughts for this section were obtained through review of academic research, comment letters received on this study, and also from the perspectives of participants at the three public roundtables hosted by the Commission.
Through its study of this issue, the Staff found that suspending SFAS No. 157 itself would only lead to a reversion of practice, resulting in inconsistent and sometimes conflicting guidance on fair value measurements. As to alternatives to fair value accounting, while such alternative measurement bases exist, each alternative exhibits strengths and weaknesses, as well as implementation issues. Considering evidence regarding the usefulness of fair value information to investors, the suspension of fair value accounting to return to historical cost-based measures would likely increase investor uncertainty. However, given the significant challenges encountered in practice related to implementing existing standards, additional actions to improve the application and understanding of fair value requirements are advisable. Such additional measures to improve the application should include addressing the need for additional guidance for determining fair value in inactive markets (including examining the impact of illiquidity), assessing whether the incorporation of credit risk in fair value measurement of liabilities provides useful information to investors, and enhancing existing presentation and disclosure requirements.
One of the most significant concerns expressed regarding existing fair value standards is the current state of accounting for impairments. Currently there are multiple different models applied in practice for determining when to record an impairment for investments in securities. Additionally, existing impairment guidelines for securities are not consistent with the reporting guidelines for impairment charges for other non-securitized investments (e.g., direct investments in loans). Accordingly, investors are provided information that is not recognized, calculated, or reported on a comparable basis. Further, under existing presentation requirements, investors are often not provided sufficient information to fully assess whether declines in value are related to changes in liquidity or whether declines relate to probable credit losses. In addition, subsequent increases in value generally are not reflected in income until the security is sold. The Staff believes that the existing impairment standards should be readdressed with the goal of improving the utility of information available to investors.
6. Advisability and Feasibility of Modifications to Fair Value Accounting Standards
This final section summarizes steps taken and underway to improve upon current accounting requirements. This section also provides recommendations on the advisability and feasibility of modifications to existing accounting standards and related financial reporting requirements, which are discussed below.
B. Recommendations
The recommendations, and the observations leading to the related recommendations, are described in detail in the final section of this study. For ease of reference, the following table provides an executive summary of the recommendations based upon the observations of this study. To facilitate an understanding for how each recommendation was developed, each recommendation below is associated with relevant observations that indicated a need for action or improvement.
Recommendation #
SFAS No. 157 should be improved, but not suspended.
Observations
Recommendation #
Existing fair value and mark-to- market requirements should not be suspended.
Observations
Recommendation #
The accounting for financial asset impairments should be readdressed.
Observations
Recommendation #
Implement further guidance to foster the use of sound judgment.
Observations
Recommendation #
Accounting standards should continue to be established to meet the needs of investors.
Observations
utility to others, such as for prudential oversight.
Recommendation #
Additional formal measures to address the operation of existing accounting standards in practice should be established.
Observations
Recommendation #
Address the need to simplify the accounting for investments in financial assets.
Observations
