From the May 2009 issue of Treasury & Risk magazine

Fair Value Twist

In a hotly debated and controversial move, the Financial Accounting Standards Board (FASB) voted 3 to 2 in favor of new guidelines for all public companies to follow in accounting for impaired securities, such as mortgage-backed securities. The new guidelines on reporting on what are called "other than temporarily impaired" (OTTI) securities, came in the wake of threats by the House Finance Committee to pass legislation ordering the change, and after intense lobbying by many banks. The requirements were adopted in conjunction with two other guidelines, which essentially reaffirmed the FASB's original principles of fair value or market-to-market accounting in FAS 157, and increased the frequency for reporting on the fair value of financial instruments from annually to quarterly.

According to FASB, the new guidelines, which go into effect June 15, but can be applied effective March 15 on a voluntary basis, do not affect when a company recognizes impairment, but could change where in the financial statements an impairment is reported. "Under the current rules," the board explains, "unless the severity and duration of a drop in fair value is too great, if a company can assert that it intends and is able to hold a security until the fair value recovers, it need not record an impairment charge on the income statement. The new proposal the Board approved indicates that no impairment charge is required if there is both no current intention to sell and, it is more likely than not, that it will not be required to sell prior to the fair value recovering."

In general, under the new guidelines, the portion of impairment related to just credit losses would be reflected on a company's income statement, reducing net income, while the impairment related to all other factors would be shown in the other comprehensive income line in the equity section of a company's balance sheet.

Patrick Finnegan, director of the financial reporting policy group of the CFA Institute's Centre for Financial Market Integrity, says his organization is pleased with the board's actions in largely sticking with the mark-to-market principle for valuing a company's assets, but he expresses concern about the OTTI change. "The bottom line," he says, "is that the board is giving much more discretion to management--with a lower hurdle to meet--to determine whether an asset is temporarily impaired or not." He adds: "Under the old rule, management had to prove intent to hold a security to maturity. Now they can just say they intend to do that."

Finnegan warns that the change in accounting for OTTI securities could become an issue for non-financial companies "like a big pharmaceutical firm or a tech company with a huge cash balance." Such firms, he explains, are more likely to have invested those funds in assets that are now permanently impaired. He also warns that if it makes investors less confident about the transparency and reliability of financial statements, it could end up increasing the cost of capital. In addition, "treasurers need to know the creditworthiness of their banks, for example when they have a committed line of credit, and with this change, it's much harder to establish that," he says.

While only a few of the many comment letters to the FASB on the OTTI change relating to FSP 115 and FSP 124 come from non-financial companies, the majority of those that did were critical. Charles Miller, vice president and controller at Texas Instruments, writes that the company opposed the change, saying it would "greatly burden companies in a period of constrained resources."

Rue Jenkins, assistant treasurer of Costco Wholesale Corp., notes that his firm has two investment portfolios that would be subject to the new guidelines. "Both hold asset and mortgage backed securities, some of which have been other than temporarily impaired," he writes. He argues the new requirement that firms separate OTTI securities--between a credit loss and non-credit component--"does not provide useful information" to investors, and adds that the new rule does not "provide sufficient guidance for the investor to assess and value the bifurcated components" of the securities in question.

Salome Tinker, director of accounting and financial reporting at the Association for Financial Professionals (AFP), says that AFP is generally in favor of all three of the FASB guideline decisions. Regarding the controversial OTTI guideline, she says, "Now companies have to break out liquidity risk and interest risk, which can stay on a balance sheet. Only credit risk has to go into earnings. That's a positive."

At the same time, Tinker notes that the new guidelines introduce more judgments into valuation and into management intentions relating to the intended disposition of distressed assets. "And when you introduce judgments, they are judgments," she says, adding, "Sure there will be abuses. You just have to hope the auditors will catch them."

Brian Kalish, director of finance at AFP, says, "This OTTI change is definitely a plus for banks, but the magnitude of the benefit is debatable. Arguably, banks will be more able to cover up problems."

The April 2 vote on the OTTI guideline change was unusually divisive for the accounting standards board. Speaking in advance of the vote, board member Marc Siegel, one of the two dissenters, said, "I'm afraid that this change will result in fewer impairments being recognized, and I don't think that will help the investor confidence in the balance sheet."

Thomas Linsmeier, the second dissenter on the board, accused his colleagues of making changes in the accounting rules to address regulatory capital concerns. "I find one of the most unfortunate parts of this to be the fact that we're continuing to take the responsibility on, rather than having the regulators take this on," he said.

In a joint written dissent, Linsmeier and Siegel observed that most of the investors and investor organizations that had commented on the guidance changes during an abbreviated comment period had objected to them. They said they believed that "accounting standards should be focused on serving the needs of investors, who did not request this urgent change."

Rick Martin, a technical accounting expert at Pluris Valuation Advisors, says, "All the FASB did by allowing companies to split off credit from non-credit-related losses was push back a day of reckoning." He says it was akin to "looking at a hurricane-damaged house and trying to separate wind from water damage."

Meanwhile, AFP's Tinker says, "The accounting rules before these changes weren't showing the real value of OTTI assets. The new rules get us closer, but they aren't perfect, and I suspect they'll be rewritten again."

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