SFAS 157: Mark-to-Market Accounting and the Current Financial Crisis

By Jeff Jinnett, IMDM – Governance, Risk Management & Compliance, Financial Services Group at Microsoft Corporation

Without mark-to-market fair value accounting, this crisis would never have reached this level.” – Real Estate Billionaire Sam Zell, Chairman of Equity Group Investments, September 23, 2008

Sam Zell recently laid much of the blame for the Wall Street financial market melt-down at the feet of Statement of Financial Accounting Standards (”SFAS”) 157, known as the “Fair Value Measurement” or “mark-to-market” rule [*1]. He had company in his attack on SFAS 157 – Martin Sullivan, the former CEO of AIG, testified before the U.S. Congress that the accounting rule created tens of billions of dollars in paper losses for AIG, which resulted in the insurer’s financial crisis and subsequent bailout by the U.S. Treasury.

On the other side, defenders of SFAS 157 argue the financial market requires the transparency created as a result of the accounting rule and that any suspension of the rule would create further financial instability. Financial Accounting Foundation Chairman Robert Denham recently cautioned in a letter to Rep. Barney Frank (D-MA) that “any legislative effort to overturn [SFAS 157] will greatly undermine investor confidence.”

In an attempt to mitigate any negative effects of SFAS 157, the U.S. Securities and Exchange Commission (”SEC”) and the Financial Accounting Standards Board (”FASB”) issued a joint press release [*2] in September of 2008 clarifying the application of SFAS 157 in connection with the measurement of fair value when an active market for a security does not exist. On October 10, 2008, FASB issued Staff Position (”FSP”) 157-3, which further clarified the application of fair value measurements. Despite this guidance, the debate and accusations continued to rage around SFAS 157.

In response to this controversy, Congress mandated as part of the Emergency Economic Stabilization Act of 2008 (”EESA” or the “Act”) that the SEC conduct a study on SFAS 157 in coordination with the Secretary of the U.S. Treasury and the Board of Governors of the Federal Reserve System. The EESA “bail-out” legislation further authorized the SEC to suspend mark-to-market accounting if the SEC deemed such a move “necessary or appropriate in the public interest.” On December 30, the SEC delivered a 211-page report [*3] to Congress containing the SEC’s recommendations as to future implementation of SFAS 157 and needed guidance by FASB (which is subject to SEC oversight).

SEC SFAS 157 Report

After reviewing three years’ worth of financial data for 22 failed banks, The SEC concluded in its report that the current financial crisis was not caused by the application of SFAS 157:

“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…The Staff observes that fair-value accounting did not appear to play a meaningful rule 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.”

The final section of the SEC Report includes eight specific recommendations as to the future implementation of SFAS 157:

1. SFAS 157 should be improved, but not suspended.

2. Existing fair value and mark-to-market requirements should not be suspended.

3. While the Staff does not recommend a suspension of existing fair value standards, additional measures should be taken to improve the application and practice related to existing fair value requirements (particularly as they relate to both Level 2 and Level 3 estimates [*4] ).

4. The accounting for financial asset impairments should be readdressed.

5. Implement further guidance to foster the use of sound judgment.

6. Accounting standards should continue to meet the needs of investors.

7. Additional formal measures to address the operation of existing accounting standards in practice should be established.

8. Address the need to simplify the accounting for investments in financial assets.

As part of the recommendations, the SEC included “Observations” with respect to each recommendation. From an information technology point of view, the “Observations” with respect to Recommendation #3 are the most critical:

• Fair value requirements should be improved through development of application and best practices guidance for determining fair value in illiquid or inactive markets. This includes consideration of additional guidance regarding:

o How to determine when markets become inactive

o How to determine if a transaction or group of transactions is forced or distressed

o How and when illiquidity should be considered in the valuation of an asset or liability, including whether additional disclosure is warranted

o How the impact of a change in credit risk on the value of an asset or liability should be estimated

o When observable market information should be supplemented with and/or reliance placed on unobservable information in the form of management estimates

o How to confirm that assumptions utilized are those that would be used by market participants and not just by a specific entity

• Existing disclosure and presentation requirements related to the effect of fair value in the financial statements should be enhanced

• FASB should assess whether the incorporation of changes in credit risk in the measurement of liabilities provides useful information to investors, including whether sufficient transparency is provided

• Education efforts to reinforce the need for management judgment in the determination of fair value estimates are needed

• FASB should consider implementing changes in its Valuation Resource Group [*5]

Information Technology Implications

The SEC Observations to Recommendation #3 of its SFAS Report suggest that financial institutions seeking to comply with the accounting rule in the future will need to acquire or develop enhanced business intelligence tools in order to meet the recommended “application and best practices guidance”. In a June, 2008 SFAS 157 Survey [*6] , Clearwater Analytics reported on the business intelligence methods employed by 300 surveyed companies. The survey showed that the responding companies followed a wide variety of valuation methodologies, with certain issues posing serious concerns. As Clearwater Analytics commented:

“Determining pricing inputs at the cusip level is a large dilemma for companies implementing FAS 157. Many audit teams have submitted this exercise as a requirement for compliance with FAS 157. However, given fixed income pricing standards and the inability of many industry standard pricing providers to provide input level information, researching each security is often not a practical expedient.”

Companies seeking to comply in the future with SFAS 157 may find it necessary under the new guidance, once issued, to make heightened use of business intelligence tools, collaboration portals and distance learning tools. As noted in a white paper by Confluence, a Microsoft Gold Certified Partner based in Pittsburgh, Pennsylvania which markets automated financial reporting solutions for SFAS 157 compliance [*7] :

“Fund administrators can either tackle the FAS 157 challenge through manual report creation or by leveraging automated financial reporting solutions…Manual processes have the benefit of low initial implementation costs. However, as with most manual processes, there are other not so tangible prices to pay, namely increased risk of error, high production costs, poor service levels and lack of scalability…Automated systems eliminate the time-consuming manual processes that would otherwise be required to collect and cleanse the data, to generate the schedules, sub-schedules and footnotes; and to include the information needed to support the mandatory disclosures for FAS 157 compliance.”

Wall Street & Technology recently noted [*8] that “it is inevitable that at least a few new regulations will hit the Street in 2009, making investment in new compliance tools necessary.” The new IT tools and applications that will be needed to comply with the SEC’s SFAS 157 Report Recommendation #3 and the accompanying “Observations” are an early example of the accuracy of this prediction.

Footnotes:

[1] A general overview of SFAS 157 is beyond the scope of this articel. U.S. Generally Accepted Accounting Principles I”GAAP”) includes a number of accounting rules that require companies to use “fair value” accounting when reporting on their assets, of which “mark-to-market” accounting rules are a subset. SFAS 157 defines “fair value”. For a summary of SFAS 157,

see delivered a 211-page report[1] to Congress containing the SEC’s recommendations as to future implementation of SFAS 157 and needed guidance by FASB (which is subject to SEC oversight).

[3] U.S. Securities and Exchange Commission, Officer of the Chief Accountant, Division of Corporate Finance, “Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting” (2008), located at

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