Proposed Changes to the Mark-to-Market Accounting Rule

Below is the summary of proposed changes by FASB to FASB Statement No. 157, Fair Value Measurements.  This is something that has been widely debated in the blogosphere and is certainly set to have a major impact on the valuations of financial firms if it is passed this coming week on April 2nd.  This proposal is likely part of the tide lifting financial shares recently too.  Some of my earlier comments on mark to market or fair value accounting can be found in earlier posts: Comments on: Study on Mark-to-Market AccountingBattleshipIs capitalism fated to lead to socialism?, IMF Global Financial Stability Report October ‘08

The full content of the proposal is available at FASB here.

PROPOSED MODEL 

10. When evaluating whether it is necessary to make a significant adjustment to quoted prices for identical or similar assets or liabilities in markets that are not active, reporting entities shall apply the following two-step approach (this approach requires significant judgment):

Step 1: Determine whether there are factors present that indicate that the market for the asset is not active at the measurement date. Factors include: 

     a. Few recent transactions (based on volume and level of activity in the market).  Thus, there is not sufficient frequency and volume to provide pricing information on an ongoing basis.     

     b. Price quotations are not based on current information.

     c. Price quotations vary substantially either over time or among market makers (for example, some brokered markets).

     d. Indices that previously were highly correlated with the fair values of the asset are demonstrably uncorrelated with recent fair values.

     e. Abnormal (or significant increases in) liquidity risk premiums or implied yields for quoted prices when compared to reasonable estimates of credit and other nonperformance risk for the asset class.

     f. Significant widening of the bid-ask spread.

     g. Little information is released publicly (for example, a principal-to-principal market).

If after evaluating all the factors the sum of the evidence indicates that the market is not active, the reporting entity shall apply step 2.

Step 2: Evaluate the quoted price (that is, a recent transaction or broker price quotation) to determine whether the quoted price is not associated with a distressed transaction. The reporting entity shall presume that the quoted price is associated with a distressed transaction unless the reporting entity has evidence that indicates that both of the following factors are present for a given quoted price: 

     a. There was a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities (for example, there was not a regulatory requirement to sell).

     b. There were multiple bidders for the asset.

11. If the reporting entity has evidence that both of the factors are present for a given quoted price, then that quoted price is presumed not to be associated with a distressed transaction. In that case, the quoted price may be a relevant observable input that shall be considered in estimating fair value. However, the reporting entity should consider whether any other factors or conditions warrant making an adjustment to the quoted price (see paragraph 29). For example, if a quoted price that is not associated with a distressed transaction is not current or is a consequence of a trade with an insignificant volume relative to the total market for that asset, the reporting entity should consider whether that quoted price is a relevant observable input (that is, whether the quoted price requires adjustment).

12. If the reporting entity does not have evidence that both of these factors are present for a given quoted price (including because there is insufficient information on which to base a conclusion), then the reporting entity shall consider the quoted price to be associated with a distressed transaction and shall use a valuation technique other than one that uses the quoted price without significant adjustment (that is, a significant adjustment is required, resulting in a Level 3 measurement). For example, the reporting entity could use an income approach (that is, a present value technique) to estimate fair value. However, the fair value resulting from the present value technique shall not be derived solely from inputs based on the quoted price associated with a distressed transaction. The inputs should be reflective of an orderly (that is, not distressed or forced) transaction between market participants at the measurement date. An orderly transaction would reflect all risks inherent in the asset, including a reasonable profit margin for bearing uncertainty that would be considered by market participants (that is, willing buyers and willing sellers) in pricing the asset in a non-distressed transaction. 

TRANSITION AND EFFECTIVE DATE

13. The staff proposes prospective transition. Changes in fair value resulting from the application of the FSP are considered changes in estimate and affect results in the period of adoption. The staff believes there are two effective date alternatives: 

     a. Effective for interim and annual periods ending after March 15, 2009.

     b. Effective for interim and annual periods ending after June 15, 2009. Early adoption would be permitted.

14. The staff recommends that a final FSP be effective for interim and annual periods ending after March 15, 2009.

COMMENT PERIOD

 15. The staff recommends a comment period of 15 days ending April 1 so that the Board can finalize the proposed FSP at its Board meeting on April 2.

Sources:
Proposed FSP FAS 157-x, Determining Whether a Market is Not Active and a Transaction is Not Distressed
FASB, March 16, 2009
http://www.fasb.org/board_handouts/03-16-09.pdf

U.S. financial firms want more on mark-to-market
Rachelle Younglai, Reuters, March 24, 2009
http://www.reuters.com/article/ousiv/idUSTRE52N7LW20090324

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3 Responses to Proposed Changes to the Mark-to-Market Accounting Rule

  1. Kimball says:

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  2. Hurd says:

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