Bailing out the balance sheet

Of all the pieces of the Emergency Economic Stabilization Act of 2008 that US lawmakers found objectionable, Section 132 didn’t come up often. But it gives the Securities and Exchange Commission a sweeping new power: to suspend mark-to-market accounting any time it sees fit.
The section reads in part: “The Securities and Exchange Commission shall have the authority under the securities laws … to suspend, by rule, regulation, or order, the application of Statement Number 157 of the Financial Accounting Standards Board for any issuer … or with respect to any class or category of transaction if the Commission determines that is necessary or appropriate in the public interest and is consistent with the protection of investors.”
Section 133 went on to authorise the SEC, led by Christopher Cox, to conduct a study on mark-to-market accounting to determine its impact on a firm’s balance sheet as well as its role in the current financial crisis. The SEC is also charged with exploring “alternative accounting standards to those provided in such Statement Number 157”. The SEC will have 90 days from the enactment of the bill to conduct the study, after which it must submit a report detailing its findings to Congress.
The Center for Audit Quality, the Council of Institutional Investors and the CFA Institute quickly came out against any suspension of fair value accounting. Suspending fair value would be “unnecessary and counterproductive”, they said, and would deprive investors of critical financial information when it is needed most.
“Fair value is only a means of communicating information that is important to investors and other market stakeholders; it is not the underlying cause of the current economic crisis,” the organisations said in a statement.
Plenty of finance professionals disagree, notably The Blackstone Group’s Stephen Schwarzman, who has on numerous occasions publicly stated that mark-to-market accounting is partly the cause of our current problems.
But as much as the market might welcome a reprieve from the endless
write-downs, it doesn’t look likely that Congress will nix markto-market accounting entirely.
“I do not believe the SEC will use this authority, which will in essence override the FASB’s authority to implement this guidance,” says Jay Beam, senior vice president of finance at alternative investment firm American Capital. “A better course of action would be continued clarification of fair value standards which may ease some of the rigor or ‘rules’ as being interpreted by audit firms in the implementation FAS 157.”
The SEC and the FASB have done so. Before the bailout bill even passed, the two bodies jointly issued several clarifications on FAS 157.
Overall, the clarifications stress that mark-to-market accounting is fundamentally a principle-based standard, rather than a rule-based standard.
“I think the overarching premise of this is allowing greater judgment in what determines fair value and what inputs are more relevant in determining fair value,” Beam says. “I think most audit firms initially took a very narrow view, very rules-based approach; this is going to move them a little bit more towards center.”
The clarifications don’t shed much light on valuing traditional private equity holdings, but for larger private equity firms that have invested in structured products, they will prove useful. In particular, the clarifications state that management’s internal assumptions can be used to measure fair value when relevant market evidence does not exist. Market quotes such as broker quotes or information from a pricing service may be an input in determining fair value, but are not necessarily determinative if an active market does not exist for the security in question; and disorderly transactions are not determinative of fair value.
The move away from broker quotes is a good one, Beam says. Under current conditions, the quotes aren’t based on actual transactions in the marketplace, because those markets are often very inactive, and what transactions do take place are often distressed or forced.
Nonetheless, the SEC and the FASB could have done more, he says.
“Most people were a little bit disappointed that it wasn’t as enlightening as it should have been. But I think additional judgment added to the fair value process will be favorably viewed. I think we’re getting there. Hopefully additional releases and guidance will continue to move in that direction.”