Part II of this article dealing with the SEC's and FASB's clarifying of the application of FAS 157, the adoption of the new FASB staff position, FSP FAS 157-3, and sample comment letters sent by the SEC staff will appear in the January issue of The Metropolitan Corporate Counsel.
By the time the third fiscal quarter came to an end, the Securities and Exchange Commission ("SEC") and the Financial Accounting Standards Board ("FASB") had taken positive steps to address serious concerns that application of so-called "fair-value," or "mark-to-market," accounting had artificially depressed corporate balance sheets due to the necessity of using steeply declining market prices to value financial assets. Although several provisions of U.S. GAAP have mandated use of fair-value measurements for some time,1the market-oriented "exit price" valuation and disclosure requirements of FASB Statement No. 157, Fair Value Measurements ("FAS 157"), that came into effect for many companies in the first quarter of 2008, have triggered a firestorm of criticism from preparers of corporate financial statements. In this article, we outline the following steps taken by the SEC and FASB that we believe will be most useful to companies preparing financial statements and the accompanying Management Discussion and Analysis ("MD&A") section of this quarter's Form 10-Q and subsequent periodic reports:
• a joint statement issued by the accounting staffs of the SEC and FASB on September 30, 2008, offered to "clarify" the application of FAS 157 in today's turbulent credit environment;
• the adoption of a new FASB Staff Position - FSP FAS 157-3 - designed to provide additional guidance on issues related to determination under FAS 157 of the fair value of financial assets in inactive markets;
• a sample comment letter sent by the SEC accounting staff in September 2008, to Chief Financial Officers of certain public companies - a "Dear CFO" letter - that offers useful guidelines for analyzing difficult MD&A disclosure questions arising from the application of FAS 157 to measure the value of financial assets and liabilities; and
• another sample "Dear CFO" comment letter from the SEC accounting staff, published in March 2008, which discusses such potential MD&A disclosure topics as management's determination of material unobservable inputs in assigning values to financial instruments, a description of valuation techniques or models used for determining fair value, and the classification (or change of classification) of financial assets (and liabilities) as Level 1, 2, or 3 in the FAS 157 hierarchy.
This recent guidance from the SEC and the FASB staffs should go far toward alleviating companies' concerns that they might be forced to mark down the value of financial assets carried on their balance sheets to "fire-sale" or liquidation prices, despite management's view that these assets eventually could be worth far more when current negative market conditions improve. The trade-off, however, is that both the SEC and the FASB expect much more transparency in companies' MD&A and financial statements with respect to management judgments and assumptions made in marking the value of financial assets (and liabilities) to "model" rather than "market."
Careful review of the latest SEC/FASB guidance will be particularly important to the two senior officials responsible for certifying to the accuracy and completeness of a company's Form 10-Q - the Chief Executive Officer ("CEO") and the Chief Financial Officer ("CFO"). These officials also are responsible for helping their companies design and maintain disclosure controls and procedures that provide reasonable assurance of timely, truthful and reliable disclosure to the investing public of both financial and non-financial information, through periodic reports and other documents filed with or submitted to the SEC. Given the current market uncertainty and the heightened focus by investors and regulators alike on the adequacy of disclosures relating to companies' financial condition and operating performance, along with their future prospects, we recommend that CEOs, CFOs and Disclosure Committees, along with others who assist them in evaluating the effectiveness of their companies' disclosure controls and procedures (as well as their internal control over financial reporting, the effectiveness of which will have to be evaluated as of the end of this fiscal year), consider whether some re-calibration is needed to produce disclosure in their upcoming periodic reports (Form 10-Q and Form 10-K) that meets the expectations of the SEC, the FASB and, last but not least, investors. Going forward, companies should continue to follow these issues because the PCAOB expects to issue a concept release on fair value and the use of valuation specialists by the end of 2008,2and reportedly is considering whether to issue a Practice Alert addressing a number of audit issues related to the credit crisis, which may include matters pertaining to fair value, other-than-temporary impairment, credit derivatives and disclosure.3
Summary Of Recent SEC/FASB Guidance On Fair-Value Issues And Related Developments
On September 30, 2008, the accounting staffs of the SEC and FASB issued a joint statement to "clarify" the application of FAS 157 in today's turbulent credit environment. These clarifications are intended to assist public companies and their auditors with resolution of several knotty fair-value measurement and disclosure issues that have arisen due in major part to the unprecedented immobilization of certain segments of the nation's credit markets and the resultant illiquidity of many financial instruments. The press release containing this relatively new guidance, entitled "SEC Office of the Chief Accountant and FASB Staff Clarifications on Fair Value Accounting" ("September 30 SEC/FASB Statement"), is available at http://www.sec.gov/news/press/ 2008/2008-234.htm.
On October 10, 2008, the FASB issued a new FASB Staff Position - FSP FAS 157-3 - which provides additional guidance on issues related to determination of the fair value of financial assets in inactive markets under FAS 157, available at www.fasb.org. The FSP is consistent with and "amplifies" the September 30 SEC/FASB Statement, and provides an illustrative example. As discussed below, the final FSP has been revised from its proposed form (FSP FAS 157-d) to clarify that the existence of a disorderly market does not automatically compel a conclusion that all such transactions necessarily are distressed or disorderly - the analysis should be performed at the transaction level (rather than at the market level) and may require significant judgment. The FSP became effective upon issuance, and applies to prior periods for which financial statements have not been issued - in other words, calendar year-end reporting companies would apply the new guidance in preparing the financial statements required to be filed as part of their third-quarter Form 10-Qs.
The Emergency Economic Stabilization Act of 2008 ("EESA"),4which was signed into law by the President on October 3, 2008, contains two provisions dealing with FAS 157. One provision (Section 132 of EESA) re-affirms the SEC's existing authority to suspend "mark-to-market" accounting as prescribed by FAS 157.5The other provision (Section 133 of EESA) directs the agency - in consultation with the Federal Reserve Board and the U.S. Treasury - to conduct a study on mark-to-market accounting as it applies to commercial banks and other financial institutions. The study, which must be completed and submitted to Congress by January 2, 2009, must cover a number of topics, including the impact of FAS 157 on the balance sheets of financial institutions, this standard's role in the bank failures of 2008, and the quality of financial information provided to investors. The SEC has already commenced the study ( see SEC press release at http://www.sec.gov/news/ press/2008/2008-242.htm), and has created a webpage dedicated to the study and related materials - http://www.sec.gov/spotlight/ fairvalue.htm. On October 29, 2008, the SEC hosted a roundtable on mark-to-market accounting to explore its impact on financial reporting by financial institutions, any potential impact on market behavior, usefulness to investors and ways to improve upon these accounting standards.6The SEC will host its next roundtable on November 21, 2008.7Of more immediate relevance may be the decisions of responsible officials at the Treasury Department and elsewhere within the federal government regarding what prices to pay for distressed financial assets that will be purchased from firms participating in the newly authorized financial rescue program.
In mid-September 2008, the SEC accounting staff published a sample comment letter that offers useful guidelines for analyzing the difficult MD&A disclosure questions preparers are facing this quarter as they weigh the materiality of credit risk and its role in their companies' fair-value measurements. While the letter was sent primarily to CFOs of financial institutions, the staff has indicated informally that the guidance it furnishes would be relevant to all companies that report in their financial statements a significant amount of asset-backed securities, credit-based derivative assets and liabilities, and loans carried at fair value or the lower of cost or market. The September 2008 "Dear CFO" letter, available at http://www.sec. gov/divisions/corpfin/guidance/fairvalueltr0908.htm, supplements a prior "Dear CFO" letter issued by the staff in March 2008, to help companies resolve fair-value measurement disclosure issues in the first quarter 10-Q's MD&A upon initial adoption of FAS 157. This March 2008 letter is available at http://www.sec.gov/divisions/ corpfin/guidance/fairvalueltr0308.htm.
Highlights of the joint SEC and FASB staff guidance from September 30, 2008, the FSP FAS 157-3 issued by FASB on October 10, 2008, and the SEC accounting staff's two "Dear CFO" letters addressing the application of fair-value accounting and related MD&A disclosures, are outlined in Part IIof this article, together with some practice tips that we hope will be useful to companies in preparing this quarter's Form 10-Q or the annual report on Form 10-K. As previously noted, careful consideration of the implications of this guidance for periodic reports is important not only to the CEOs and CFOs who will be called upon to certify to the accuracy and completeness of the financial statements and explanatory MD&A, but also to those who assist these officials in meeting their obligations to evaluate the effectiveness of their companies' disclosure controls and procedures as of the end of the most recently completed fiscal quarter.
1 FASB Statement No. 133 , Accounting for Derivative Instruments and Hedging Activities ("FAS 133") is a notable example of a U.S. GAAP accounting standard that involves the use of fair-value measurements when accounting for credit derivatives.
2See PCAOB Standing Advisory Group Meeting: Standards-Setting Accomplishments and Priorities as of October 23, 2008, available at http://www.pcaobus.com/Standards/Standing_Advisory_Group/Meetings/2008/10-22/2009_Proposed_Activities_Remarks.pdf .
3See Financial Executives International ("FEI") Financial Reporting Blog dated October 24, 2008, available at www.fei.org.
4 Emergency Economic Stabilization Act if 2008, Pub. L. No. 110-343 (2008).
5 The American Bankers Association sent a letter (dated October 13, 2008) to SEC Chairman Christopher Cox requesting the SEC to override FASB's new FSP FAS 157-3, available at http://www. aba.com/aba/documents/press/ChrmnCoxLtr.101308.pdf. In contrast, the Center for Audit Quality, the CFA Institute, the Council of Institutional Investors and the Consumers Federation of America sent a joint letter to Chairman Cox expressing concern that a decision to suspend fair value accounting would adversely impact investor confidence among other things, available at http://www.sec. gov/comments/4-573/4573-65.pdf. More recently, Robert E. Denham, the Chairman of the Financial Accounting Foundation which oversees the FASB, sent a letter to Chairman Cox urging the SEC to resist calls for suspension or overriding of FASB accounting standards, available at http://www.sec. gov/comments/4-573/4573-83.pdf. On October 2, 2008, Mr. Denham sent a letter expressing similar concerns to the Chairman of the Committee on Financial Services of the U.S. House of Representatives, Representative Barney Frank, available at http://www.fasb.org/DenhamLetter_10-2-08.PDF. Another joint letter requested the SEC to provide guidance on the use of judgment when making fair-value determinations in the context of an inactive market under FAS 157. See Letter from the U.S. Chamber of Commerce, the Financial Services Roundtable, Property Casual Insurers Association of America, American Council of Life Insurers, Mortgage Bankers Association, and American Insurance Association to SEC Chairman Christopher Cox (October 23, 2008), available at http://www. sec.gov/comments/4-573/4573-61.pdf.
6 Some of the panelists appearing at the SEC's Roundtable on Mark-to-Market Accounting, held October 29, 2008, expressed the view that fair-value accounting did not cause the credit crisis, and asked the SEC to expand the scope of its study to consider "root causes" of the crisis. Other panelists disagreed, noting in particular the strong views of William Isaac, former Chairman of the FDIC, who argued that fair-value accounting was "destroying" capital for banks. He also said that while he was at the FDIC, the agency had studied mark-to-market accounting for more than one year and decided not to pursue that method for three reasons - a) it would yield misleading results, b) interfere with the ability of banks to accept short-term deposits and convert them to long-term loans (one of their primary functions), and c) pro-cyclicality. An archived version of the Roundtable on Mark-to-Market Accounting held on October 29, 2008, and related materials, are available at http://www.sec.gov/spotlight/fair-value.htm .
7 Previously the SEC hosted a roundtable on Fair Value Accounting Standards on July 9, 2008, archived version available at http://www.sec. gov/spotlight/fairvalue.htm
Catherine T. Dixon is a Partner in the Washington, DC office of Weil, Gotshal & Manges LLP and Theresa Hyatte is a consulting attorney at Weil Gotshal.