SEC Acting Chief Accountant James Kroeker supports FASB’s recent proposed guidance on mark-to-market accounting as crucial to the swift action that must be taken to address the accounting for investment impairments and to improve the measurement guidance for illiquid assets for first quarter 2009 reporting. In testimony before the House Financial Services Committee, James Kroeker said that FASB acted diligently and responsively to use its expertise as an independent standard-setter and expose amendments to the measurement of securities in inactive markets and the recognition of other-than-temporary security impairments.
More broadly, the SEC official believes that FASB must be responsive to the needs of capital market participants. The Commission has broad authority to prescribe accounting standards, he noted, but it has long relied on FASB as a private standard-setter and recognized the importance of the Board's independence. For its part, FASB is obliged to keep accounting standards current in order to reflect emerging issues and changing business practices.
Responding to intense congressional pressure, FASB proposed the guidance on March 17, with an abbreviated comment period ending on April 1. According to the Chief Accountant, FASB's plans to finalize the proposed amendments by the first week of April in time for first quarter 2009 reporting. In his view, first quarter 2009 reporting would represent a timely response to the recommendations contained in the SEC’s recent study of fair value accounting, and the Commission is encouraged that FASB has taken advantage of this earliest opportunity to act.
FASB's proposed amendments seek to directly address two of the recommendations of the SEC study on mark-to-market accounting. First, they provide additional guidance on determining whether a market for a financial asset is not active and a transaction is not distressed for fair value measurements. Generally, if the market is not active, then a valuation technique other than one that uses the quoted price must be used. For example, the reporting entity could use an income approach, such as a present value technique based on estimated cash flows, to estimate fair value based on an orderly transaction between willing market participants. This amended ability to use cash flows to measure securities in inactive markets addresses concerns about using distressed, forced or disorderly sales as the basis for estimating fair value.
Second, the FASB proposals provide a clearer benchmark for when an other-than-temporary impairment exists and needs to be recorded on securities held outside of a company's trading book, and to transparently disclose the amount of the impairment directly associated with probable cash flow declines. The changes would provide greater clarity than exists today about the nature of losses. Under these proposals, the probable losses in cash flow would be recorded in earnings, and the loss attributable to all other factors, such as liquidity and changes in interest rates, would be transparently reported as a component of other comprehensive income. The SEC official clarified that securities available for sale would continue to be reported at fair value on the balance sheet.
To illustrate how the FASB proposals would improve the accounting for other-than-temporary impairments, the official asked the Committee to consider their application to a mortgage-backed security comprised entirely of a large portfolio of residential mortgage loans. Under existing guidance for other-than-temporary impairments, if it becomes probable that an investor in a mortgage-backed security will suffer even a minor loss of expected cash flow, instead of recording the minor loss in earnings, the loss is based upon the security’s current fair value. The FASB proposals would provide additional information to the investor by reporting the minor loss of expected cash flow in earnings with other changes in value recognized in equity until a decision to sell the security, and realize the loss, was made. That is, explained Mr. Kroeker, such a model would appear to help bridge the gap between the current fair value and the value expected from holding investment positions until markets return to normal liquidity levels.