What to do with fair value accounting

There's a lot of opinion out there on the quality of "fair value" accounting, which has been all over the news as of late. Some argue FAS 157 should be suspended immediately, as a way of granting relief to all those trouble banks out there. Newt Gingrich recently issued such a call in Forbes. He quotes some economists that suggest 70 percent of the "real crisis" has been caused by "mark-to-market accounting in an illiquid market." He would also repeal Sarbanes-Oxley, by the way. On the other hand,  the New York Times quotes JPMorgan Chase analysts who wrote recently that blaming mark-to-market accounting "is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick."  

The reality is that the rule, like all others, requires interpretation. And if Sarbox did anything, it made audit firms much more conservative in the way they apply the rules. Fortunately, the SEC just issued new guidance that aims to make the rule a bit less onerous when it comes to illiquid securities.

The guidance essentially acknowledges the big lurking issue--the potential to really sock it to banks' capital ratios at the worst time--and makes clear that it's okay for companies to use internal models and assumptions to determine the fair value of financial assets when there is no market for the securities. Recently, companies, no doubt influenced by their audit firms, seemed to give undue weight "to the last observable selling price of their securities before the markets froze completely," notes CFO.com in this article. This was happening even though an analysis of the underlying securities might suggest a higher value.  

Under the new guidance, companies and auditors now have wider leeway and can consider a range of inputs. That raises some issues, and judgment will be required. Still, for some companies, this new guidance will make a difference. They may not have to write down as much. We could see muted losses as early as the third quarter. It may not represent the solution to the crisis. But we may hear fewer calls to get rid of the rule completely.  - Jim