Challenges in Asset Valuation

A newly enhanced focus on processing financial information to ensure data transparency that allows users to get more accurate asset valuations.

In a letter to Russell Golden, technical director of the Financial Accounting Standards Board, a nonprofit created to serve investors, public company auditors and capital markets, the Center for Audit Quality expressed its support for FASB efforts to improve illiquid asset valuations through a set of proposals.

FASB has proposed recognition and presentation of other-than-temporary impairments and determining whether a market is not active and a transaction is not distressed, or FSP FAS 115-a and FAS 157-e.

Both CAQ and FASB support industry efforts to respond to one of the most significant consequences of the current economic crisis: difficulties when estimating the fair value of illiquid assets, including mortgage-backed securities. In the letter - sent to the secretary of the Treasury, the chairmen of the Federal Reserve and Securities and Exchange Commission, among others - CAQ stresses how critical it is to ensure "that any improvements made to financial reporting address the issues at hand by enhancing the relevance and transparency of financial information that is critical to properly functioning capital markets."

CAQ supports an "appropriately modified" FSP FAS 115-a noting that it will achieve the objectives of providing preparers appropriate relief from the impact of fair value measurements in the current market environment" without significantly damaging the transparency that investors and other users of financial statements seek.

By contrast, CAQ says, the proposed FSP 157-e, which proposes an exception to the definition of fair value, would reduce data transparency and would have unintended consequences.

Furthermore, CAQ stresses the importance of independent, unbiased accounting standards. "An independent standard setter is fundamental to investor confidence" and key to high-quality financial reporting. If the current economic crisis increases the urgent need for accounting guidance, there also is a need for balance. It is just as critical that accounting standards are "promulgated to promote financial transparency and address investor information needs.

Another benefit is that those who regulate and set capital standards for banks have the ability to obtain information outside of the financial statements and to make changes or adjustments to such standards "without having to make changes to the fundamental accounting determinations and resulting investor information."

CAQ also suggests more further clarification on when it is necessary to state that a market is not active and a transaction is distressed. Since "the proposed model of establishing a presumption that all transactions in inactive markets are distressed is flawed," CAQ said, as that concept "forces preparers to ignore relevant market transactions and moves away from the exit price objective, which is the cornerstone of measuring the fair value of an asset."

In addition, CAQ notes, the departure from an exit price in the current market that is proposed in FSP FAS 157-e is very broad and may have significant unintended consequences, including the potential increase in day one gains, delay of losses recorded on debt securities which the holder intends to sell, and inflating net asset values used by investment companies for transactional purposes.

One revision should be that of limiting the scope to certain illiquid debt securities, which seem to be the focus of undertaking the project.

In addition, unless appropriate guidance is applied the proposed FSP will be operationally difficult to implement and will reduce active markets and expand what are considered to be inactive markets. That may result in less objective measurements, CAQ says, as well as in entities not willing to sell financial assets because they may realize a loss, and wait for a higher "mark-to-model" value.

CAQ recognizes, however, that it supports the issuance of FSP FAS 115-a if it is improved.

Currently problems include unclear information about application of guidance particularly for equity securities.

Signed by CAQ executive director Cynthia Fornelli, the letter states, "We do not support the proposed requirement that, for held-to-maturity securities, the difference between the security's fair value and the security's amortized cost less the credit impairment recorded in earnings is recognized in other comprehensive income upon recognition of the other-than-temporary impairment and subsequently amortized through other comprehensive income."

In summary, CAQ votes against FSP FAS 157-e, which "does not serve the best interest of the public," but notes that a properly modified FSP FAS 115-a is the best option because it "is meritorious but warrants modification prior to finalization."