Pro-fair value crowd makes its case

For a while, it seemed as though the anti-fair value crowd was winning the day. The many critics of FAS 157 were being heard well above the din. Some were openly calling for the rule to be abolished, but now the audit community is fighting back.  

The biggest knock on the rule is that it has been "pro-cyclical," that is, it exacerbated an already bad banking situation by forcing banks to take bigger losses on troubled assets. This destruction of capital damaged bank capital ratios and forced them into a frenzy of capital raising. In this view, the rule forces mark-to-market values onto securities, even though that value may not reflect the true value of securities.  

Bill Isaac, who chaired the Federal Deposit Insurance Corp. in the 1980s, has championed this view. He says that if fair-value accounting had been in place during the S&L crisis, the banking and thrift industries each would have suffered a combined additional loss of $100 billion.

But audit groups say that it would be really counterproductive if companies were not required to value their assets at something approximating current value. How else can investors and others make rational decisions. The Center for Audit Quality recently sent a letter in support of FAS 157 to the SEC, says the "movement toward greater relevance, usefulness and transparency in financial reporting that has taken place over the last thirty years."    

Investors and FAS 157 supporters think the flip side of the coin has been ignored: Capital requirements. If the drawback of a severe decline in asset values is that it pushes companies toward capital ratio deficiencies, why not adjust the capital requirements. Regulators have "considerable leeway in evaluating assets to determine whether a financial institution meets capital requirements." This applies mainly to level two assets. Indeed, regulators recently changed, for some troubled banks, the way certain preferred shares are accounted for.  

What remains to be seen is whether the recent guidance will make a difference. Under the new guidance, companies and auditors now have wider leeway and can consider a range of inputs, beyond just "the last observable selling price," when valuing illiquid securities.   We certainly haven't seen the end of this issue. The PCAOB is considering issuing additional guidance on fair value accounting, and the Financial Accounting Standards Board plans to issue new disclosure requirements. What's more, the SEC has scheduled another roundtable on FAS 157 for later this month; it aims to issue a report on possible changes in January. - Jim