FASB Votes to Issue New Guidance on Key Financial Reporting Topics: Fair Value Accounting; Accounting for Contingencies in Business Combinations; and Other-Than-Temporary Impairments for Debt Securities

April 3, 2009

The Financial Accounting Standards Board ("FASB") voted on April 1 to issue and on April 2 voted to prepare final drafts of additional staff guidance that will modify a number of financial accounting standards relating to:

1.  Fair value accounting – FASB Staff Position ("FSP") FAS 157-e, Determining Whether a Market is Not Active and a Transaction Is Not Distressed. The new guidance will:

• affirm the principle that fair value measurements should be based on prices in "orderly" transactions, not distressed or forced transactions, when markets are not active;
• provide an illustrative list of factors for determining when markets are active and when market activity for particular assets in inactive markets has significantly decreased;
• provide an illustrative list of factors that illustrate when transactions are forced or distressed; and
• apply to all fair value measurements when appropriate.

Effective Date:  The new guidance will become effective prospectively for interim and annual periods ending after June 15, 2009, and although it cannot be applied retrospectively, companies can "early adopt" the guidance and apply it to periods ending after March 15, 2009.

In a related development, FASB also voted to require that fair value measurements and disclosures be included in interim as well as annual financial statements.

2.  Accounting for contingencies in a business combination – FSP FAS 141(R)-1, Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies.  The new guidance will:

• apply to contingent assets and liabilities (as defined in FAS 5, Accounting for Contingencies) acquired in business combinations;
• provide that when the fair value of a contingent asset or liability can be determined as of the acquisition date, it must be reported on the financial statements;
• provide that even when fair value cannot be determined, if it is probable that a contingent asset or liability existed as of the acquisition date and the value can be estimated using existing FAS 5 standards and literature, the estimate must be recorded in the financial statements; and
• provide that where either the existence of a contingent asset or liability is not probable at the acquisition date (or even if probable, the value cannot be estimated), no asset or liability need be recorded in the financial statements.

Effective Date: This guidance will be effective for business combinations in the first annual reporting period beginning after December 15, 2008; in other words, for calendar year companies, for 2009 business combinations.

3.  Measurements and presentation of "other than temporary" impairments – FSP FAS 115-a, FAS 124-a and EITF 99-20-b, Recognition and Presentation of Other-Than-Temporary Impairments. The new guidance will:

• apply to debt securities only;
• change the process for determining when a debt security is "other than temporarily" impaired and how any such impairments are measured and reported;
• amend management’s required assertion that it has the "intent and ability" to hold an impaired debt security until recovery to an assertion that management has no intention to sell the debt security and it is "more likely than not" that it will be able to hold the security to recovery;
• require that impairment losses (in cases where management can make the assertions described above) be divided into two parts: credit related losses that are reported in earnings; and other losses that are reported in other comprehensive income;
• provide guidance that credit losses should be measured on the basis of decreases in expected cash flows; and
• require enhanced disclosures to show more information about the types of securities involved and assumptions used in measuring the impairments.

Effective Date: This guidance will be effective for interim and annual reporting periods ending after June 15, 2009 with early adoption permitted for periods ending after March 15, 2009.

DISCUSSION

Fair Value Accounting — FAS 157

With respect to fair value accounting, on April 2, FASB voted to direct the staff to prepare a final draft of  FSP FAS 157-e, incorporating certain changes approved by the Board. FASB must then vote on the final draft before it can be effective. In the exposure draft FASB had stressed that it did not intend to change the objective of a fair value measurement in the new guidance but recognized that determining fair value in markets where there has been a significant decrease in the volume and level of activity for the asset being valued is "inherently complex, depends on the facts and circumstances and involves significant professional judgment."

Under FAS 157 (Fair Value Measurements), fair value measurement assumed that an asset or liability is exchanged in an orderly market and not in a forced transaction. In the face of the severe market disruptions starting in the fall of 2008, FASB issued FSP FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for that Asset Is Not Active, that provided additional guidance and stressed the importance of management judgment. The latest guidance is being issued in response to concerns expressed by some that neither FAS 157 nor FSP FAS 157-3 provided sufficient guidance on how to determine whether a market for a financial asset that historically was active is not active and whether an observed transaction in an inactive market is or is not distressed. FASB has indicated the goal of the new guidance is to re-emphasize that prices in orderly transactions are still the benchmark for fair value measurements and that distressed transactions in inactive markets are not reflective of fair values.

Under the new standard, a two step test is imposed. First, in determining fair values of its assets and liabilities, a reporting entity must evaluate whether the relevant market for those assets and liabilities is active or inactive. Relevant factors include:

• the volume of recent transactions;
• price quotations that are not based on current information;
• price quotations that vary substantially over time or among market makers;
• indexes that previously were highly correlated with fair values are demonstrably uncorrelated with recent fair values;
• abnormal liquidity premiums or implied yields for quoted prices when compared with reasonable estimates of credit and other nonperformance risks;
• abnormally wide bid-ask spreads; and
• situations where little information is released publicly.

Using such factors, the reporting entity must determine whether the market is active or inactive. If it determines that the market is not active, a second determination must be made: whether the observable transactions were orderly. The final FSP drops the presumption, present in the proposal, that all transactions in inactive markets are distressed or disorderly unless proven otherwise. Under the final FSP, reporting entities must consider whether there are circumstances that indicate that an observed transaction in an inactive market is not "orderly". Circumstances could include:

• the seller was in or near bankruptcy and was required to sell to meet regulatory requirements;
• the was a usual and customary marketing period but the seller sold the asset to a single market participant; or
• the transaction price was an outlier relative to prices for similar transactions.

The reporting entity must then determine whether the transaction was orderly based on the weight of the evidence. Quoted prices that do not represent orderly transactions are not determinative of fair value nor are they determinative of market participant risk premiums. FASB’s staff has also stressed that reporting entities should not have to incur undue cost and effort to make these determinations.

If the reporting entity determines both that the market is inactive and the observed transaction is a distressed transaction, the observed values may not be reflective of fair market value and the entity may look to other evidence, such as management’s judgments about projected cash flows or other relevant evidence to determine fair values. In other words, depending on the circumstances, FASB’s new guidance appears to say that the reporting entity is not required to rely for its fair value determinations on any extrinsic observable evidence, regardless of the characteristics of the market or the transaction itself that are being considered. Rather, the character of both the market and the observed transaction should be examined to determine whether they provide reliable evidence for purposes of determining fair values.

Accounting for Contingencies in Business Combinations – FAS 141(R)

FAS 141(R) was issued in December 2007 and is effective for business combinations occurring in the first annual reporting period beginning on or after December 15, 2008. As issued, the statement required that all contractual contingencies and all non-contractual contingencies that are more likely than not to give rise to an asset or liability (as defined in FAS 6, Elements of Financial Statements) be recognized at their acquisition date fair value. Following issuance of the statement, concerns were expressed about the application of FAS 141(R) to litigation related contingencies. Specifically, objections were raised because determining fair values for such contingencies was not only extremely difficult and prone to error, but could risk violating attorney-client privileges, could result in potentially prejudicial disclosures in the financial statements, and could disrupt or make more difficult resolution and settlement of pending litigation.[1] There was also concern that the requirements would undermine the long established "treaty" between the American Bar Association and the American Institute of Certified Public Accountants that governs lawyers responses to auditor’s inquiries.[2]

In response, in October 2008 FASB added a project to reconsider the requirements of FAS 141(R). On April 1, FASB voted to approve further staff guidance in the form of FSP FAS 141(R)-1, which provides that an acquirer shall recognize at fair value, at the acquisition date, a contingent asset or liability acquired in a business combination if the acquisition date fair value of that asset can be determined during the measurement period. If the acquisition date fair value cannot be determined, an asset or liability still shall be recognized at the acquisition date if two criteria are met:

• information available at the end of the measurement period indicates that it was probable that an asset or liability existed at the acquisition date; and
• the amount of the asset or liability can be reasonably estimated.

In determining whether these two criteria are met, acquirers can use the guidance in existing FAS 5, Accounting for Contingencies and FASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss. This means that existing standards and practices for determining whether a contingent asset or liability, particularly a contingent legal asset or liability, needs to be recognized and valued should continue to be applicable. It also means that the "treaty" governing lawyers responses to auditor’s inquiries should also continue to be applicable. 

What is noteworthy about this new guidance is that it modifies the requirement of FAS 141(R) that a fair value estimate must be included for every contingent asset or liability acquired in a business combination and restores the role of existing FAS 5 in valuing and reporting such contingencies, including the provision that contingencies do not have to be valued if their value cannot be determined or estimated. This is particularly important for contingent assets and liabilities such as legal claims that are extremely difficult to value.

Other-Than-Temporary Impairments for Debt Securities – FAS 115, FAS 124 and EITF Issue No. 99-20.

On April 2, 2009, in a 3-2 vote, FASB voted to direct the staff to prepare a final draft of guidance that will involve changes to FAS 115, Accounting for Certain Investments in Debt and Equity Securities, FAS 124, Accounting for Certain Investments Held by Not-for-Profit Organizations, and EITF Issue No. 99-20, "Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets." The new staff guidance, FSP FAS 115-a, FAS 124-a and EITF 99-20-b, makes two important changes to present accounting standards with respect to debt securities.[3]

Under the previous standard, when considering whether an asset was impaired, management had to first determine whether any impairment was "other than temporary." In order to avoid classifying an impairment as "other than temporary" management had to be able to assert that it had both the intent and the ability to hold the asset for a sufficient period of time to allow for any anticipated recovery in value. If no recovery in value was anticipated regardless of management’s intent and ability, an impairment charge was required. 

The new guidance changes management’s required assertion. Management must now assert that (1) it does not intend to sell the security, and (2) it is more likely than not that it will not have to sell the asset before the recovery period. Arguably, this is a considerably more flexible standard than the old one because it only requires a "more likely than not" determination as to the ability to hold.

The second major change included in the guidance is that any impairment losses that must be recognized are now divided into two components: the part of the loss that is related to credit losses, and the part of the loss that is related to other factors. Determination of credit losses could be based on management’s estimates of decreases in cash flows or amount of impairment deriving from credit deterioration or other relevant factors. Credit losses must be included in earnings and non-credit losses are reported in other comprehensive income. When presenting this information, however, the reporting entity is required to present separately the total amount of the impairment in the statement of earnings and the amount recognized in other comprehensive income as a deduction from or offset to the total impairment.

In addition to this bifurcation of loss, the standard requires separate presentation of losses related to held-to-maturity and available-for-sale securities in the financial statement sections describing the components of other comprehensive income. The guidance also requires significant additional disclosures concerning:

• disaggregated information based on the nature and risks of the various types of securities being valued;
• cost bases for available-for-sale and held-to-maturity debt securities by major security types;
• information by major security types about the methodology and key inputs used to measure the credit loss portion of the measurement;
• information of key inputs used in these determinations such as performance indicators of the underlying securities, loan to collateral value ratios, third party guarantees, levels of subordination and vintage; and
• a roll-forward of amounts recognized in earnings for  debt securities for which an other-than-temporary impairment has been recognized and the non-credit portion of the other-than-temporary impairment that has been recognized in other comprehensive income.

Non-credit losses on held-to-maturity securities reported in other comprehensive income will have to be amortized over the life of the securities in a prospective manner by offsetting the recorded value of the asset unless the securities are sold or there are additional credit losses.

When adopting the new guidance, reporting entities will also be required to record a cumulative-effect adjustment as of the beginning of the period of adoption to reclassify the noncredit component of an impairment loss from retained earnings to other comprehensive income if the reporting entity meets the "intent and more likely than not" tests.

The guidance also requires that this information be provided for interim periods.

This guidance will impose significant new measurement requirements on reporting entities for their debt securities, as they will need to attempt to segregate the credit and non-credit portions of impairment losses and deal with both initial and subsequent reporting and valuation of such assets, particularly held-to-maturity debt securities.