FAS 157: Let the Tweaking Begin

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Includes: BAC, C, GE, GS, JPM, MS, WFC, XLF
by: Gary Townsend

Well, someone was listening.

In recent Congressional testimony, Ben Bernanke, Sheila Bair, Tim Geithner, Mary Schapiro, and other regulators have all taken reasonably constructive positions on reforming FAS 157 and Fair Value accounting, also known as Mark-to-Market. While they all say they see great conceptual value in mark-to-market accounting (for its “transparency” and “clarity”) and wouldn’t support a rescission or suspension of FAS 157 per se, they support “tweaking” it, or changing to reduce its “pro-cyclicality,” or allowing greater management judgment in determining marks and preparing associated disclosures. And we now know that the Financial Accounting Standards Board plans to issue a new disclosure draft for public comment on proposed changes within weeks.

Can anyone spare a fig leaf?

The truth is that any one of these “tweaks” implies fundamental changes to FAS 157--changes that will leave the rule largely unrecognizable.

To be clear, Fair Value accounting must be reformed, in my opinion. It is fundamentally flawed and at war with FASB’s own conceptual framework for financial reporting. But in the interest of “transparency and clarity,” the FASB would do the public a great favor if, when it issues its new rule, it also provides its own full disclosure and explains what an utter and miserable failure FAS 157 has been. Here are some proposed topics it might touch on (and I invite readers to add to my list):

  • The importance of professional judgment to the valuation process. FAS 157 took judgment to the vanishing point. The new rule should explain why professional judgment is essential to the valuation process.

  • The deficiencies of the “Fair Value.” FAS 157 eliminated “market” from the definition of “fair value”. It’s time to put “market” back in. But FASB should also discuss the conceptual deficiencies of the “fair value” definition. Interested readers can find my critique here.
  • When are mark-to-market disclosures misleading? If the objective of FASB’s conceptual framework is to provide information to help “assess the amounts, timing, and uncertainty” of cash flows, users of financial statements may be misled if losses are recorded based on the market’s perception (or misperception) of an asset’s value. Here’s the real-life experience of Bank of New York Mellon when it disclosed the “fair market” value of its Alt-A mortgage portfolio along with the portfolio’s estimated cash-flow value. The difference? Only $1 billion.

The new definition of Fair Value accounting must look first to the purpose of the assets or liabilities being valued, rather than their value in liquidation. One of the great ironies of FAS 157 was that it has undercut the public’s confidence in financial statements prepared in accordance with Generally Accepted Accounting Principles. For instance, banks typically mark only a small proportion of their assets and liabilities to market for purposes of their financial statement presentation. However, all are required to disclose in footnotes the “fair value” of their financial assets and liabilities. Though MTM results can bear little relevance to the intrinsic value of a loan or security that the holder plans to hold to maturity, the disclosures became the perceived reality. The math is easy. Many banks that are well-capitalized and solvent in accordance with GAAP are simultaneously insolvent when GAAP results are adjusted to “fair value”. Here’s what happened to Capital One: the company’s tangible book value per share of $28.24 according to GAAP became minus-$1.21 after adjusted for disclosed FV marks. Such absurd contradictions are extremely harmful to public confidence.

Washington, D.C. hasn’t done much to boost investor confidence lately. That needs to change. It’s time that the SEC, FASB, Treasury, and bank regulators embark on a full-court public relations press to affirm GAAP financial results, while detailing the conceptual problems and doubtful accuracy of “fair value” in such a highly stressed and illiquid economy as the current one.