Trends & Developments in FAS 157

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP


The FAS 157 controversy continues to evoke emotion and incite heated debates among many in the financial and accounting communities. While some feel strongly that the mark-to-market accounting rules caused the current financial meltdown, others are of the opinion that it makes the market more transparent and efficient.

In this week's Buzz article, VC Experts founder, Joseph Bartlett, entertains and enlightens us with some interesting perspectives from opposing experts on the FAS 157 subject. Joe then comes up with a very creative and compelling solution to this accounting dilemma. Joe's novel proposal is in step with the wisdom of Marvin Bower, who is widely credited with being the founder of professional management consulting. Bower once said, "Decisions should be based on facts, objectively considered."

The controversy on the value and wisdom of FAS 157 has recently heightened in intensity with an article in The Deal by William Isaac,[1] attacking the current concept of mark-to-market accounting as unsound, at least as applied to financial institutions such as commercial banks. Isaac speaks with significant authority since he was chairman of the Federal Deposit Insurance Corporation during one of several periods in which problems with financial institutions had a ripple effect on the economy; in fact, Isaac is probably the best known FDIC chair in my professional career. Herewith excerpts from Isaac's short but hard hitting piece:

"Mark-to-market accounting has destroyed hundreds of billions of dollars on capital during the past two years and has depleted lending capacity by 10 times that amount..

".[m]ark-to-market accounting has produced terribly misleading disclosures by valuing assets well below their true economic value. It is transparently bad accounting.

"If the SEC suspends FAS 157, banks and their regulators will value the affected assets the same way they value all the other assets on banks' books. They will consider the cash flow on the assets, the likelihood of defaults and the probable losses. Valuations and disclosures will be improved, not obscured.

"Historical cost accounting, the cornerstone of generally accepted accounting principles is vastly superior.

"Historical cost accounting does not run market depreciation through the income statement and does not deplete bank capital (unless the decline in value is considered permanent). This system provides a more accurate financial picture of a bank than the FAS 157 rules and does not destroy bank lending capacity."

There is, of course, another side to the debate; I will cite on that score a presentation Bob Swieringa gave at a Cornell Business School/PWC seminar in October, at which I (a Courtesy Professor at Cornell) also presented.

Bob is a heavyweight . a member of the accounting faculty at the Stanford Graduate School of Business and at Cornell before serving as a member of FASB from 1986 to 1996. He was a professor in the practice of accounting at the Yale School of Management before returning to Cornell in 1997 as the Dean from 1997 to 2007 and continues as a professor of accounting, Bob's points include the following:

"References to fair value in accounting pronouncement date back to 1953 and in accounting literature date back to 1903;

"Fair value is 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 [it] does not require an actual transaction; does not require that a market exist; is based on information as of the measurement date; and it is not intended to reflect the ultimate settlement amount;

"Fair value measurements do not extend the use of fair value measures; the objective is to increase the consistency and compatibility of fair value measurements and require disclosures about how fair value measurements have been determined, the levels of inputs used to measure fair value."

It would be, of course, uncharacteristic for me not to provide the solution to the dramatically opposed learned opinions. The solution, as is often the case, is to be found (at least in my view) by stating the problem correctly, the problem that FAS 157 was designed to overcome.

To recapitulate, in focusing on so-called Level 3 assets (illiquid securities for which no market had ever existed or if one had it is no longer functional) the "conservative," meaning beyond criticism, rule of thumb was to follow the basic principle of cost accounting, as Isaac points out, and value the asset at cost unless some intervening event made it clear that value had depreciated. The failure of the market either to continue, or to ever have existed in the first place, was not, generally speaking, a dominant criterion for valuing assets which were not held for sale into a market.

The principal value of a rule of thumb which focused on cost (depreciated cost in the appropriate instance) is that it was simple to apply and, accordingly, deemed unlikely to expose the parties in charge to an allegation that they had somehow "cooked the books." The problem, however, as Bob points out, is that rule of thumb accounting, if you will, doesn't necessarily tell the market place about the fair value of the asset as of the date in question.[2] It is, arguably, a lazy man's way of valuing illiquid assets and, accordingly, produces the kind of unreliable result one would expect once you accept the premise that it is the product of the "lazy man." As supporters of FAS 157 have pointed out, cost accounting is misleading if the value of an asset has been impaired. Historical cost accounting is conditioned on the ability to recover the recorded amount. Once it is determined that the recorded amount cannot be recovered, the asset (e.g. a loan) needs to be re-measured. There is no such thing as unconditional use of historical cost accounting.

On the other side of the coin, of course, Isaac's criticisms, which are better articulated, on the negative side, than any I have seen so far, speak for themselves.

Now, turning back to the statement of the problem, it is "transparency," . i.e.. how to give the most reliable information to the marketplace, given that any method (at least any method suggested so far) runs into quite valid criticisms that, in particular cases, it can be misleading and reflect valuations that may well be long out of date.

Given the conundrum, I like to use the Man from Mars device . a keen observer who lands on our shores and, as he steps out of the spaceship, is presented with the issue. His take? "Well, if you're trying to give the maximum amount of information to the marketplace, why don't you state the valuation both ways, and explain, in each case, how you got there? Interested parties, assuming a minimum level of sophistication, can then apply their own judgment; the point is that they have the raw material which enables them to do so, to their satisfaction.

As the phrase is coined, or at least repeated by Prof. Sharp in the materials to which I have provided a link,[3] this is "multi-dimensional" accounting. Indeed, as Bob Swieringa said to me informally in a humorous aside (but nonetheless with a logic behind the remark), one could present the balance sheet numbers in both red and green, depending on which formula and methodology one applied to the valuation calculation.

Obviously, in order to preserve consistency so that the marketplace can compare apples to apples, it doesn't make sense to authorize the pursuit of more than, say, two competing valuation protocols. That said, if the Financial Accounting Standards Board would allow multidimensional presentations under FAS 157, it seems to me such guidance could do the trick. It can be argued that the Levels 1-3 required by FAS 157 do some of this. FASB could (and should) indicate how both methods are to be presented . which comes first, for example, and how each presentation must be made so as to minimize confusion. FASB should also insist that the conventions employed be outlined in detail, perhaps in the footnotes, so that the market can understand whether those in charge had faithfully and consistently applied each of the alternatives. Finally, there is no rule that says that an audit client must deploy both systems. I am arguing simply that the possibility be opened to the board of the audit client and its accountants.

[1] Isaac, "Down for the Count," The Deal, Dec. 2008, p. 37.

[2] Quoting Bob again (in turn quoting from PEIGG):

"Historically, the private equity industry used cost or the value of the latest round of financing as an approximation of fair value, often without taking into account other facts and circumstances. Such an approach is incompatible with FAS 157. At each valuation date, a manager must make a determination of fair value for each investment. However, a manager may conclude that the best indicator of fair value is provided by cost or the value of the latest round of financing."

[3] See Bartlett, "FAS 157 - Fair Value Measurements Adopted by the FASB."

Joseph W. Bartlett, Special Counsel,

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