January 9, 2009
On December 30, 2008, the Securities and Exchange Commission delivered to Congress a report, mandated by the Emergency Economic Stabilization Act, on mark-to-market accounting standards and their application to financial institutions. The report concludes that fair value accounting standards should not be suspended, but makes eight recommendations to improve their application, including additional guidance for determining fair value in inactive markets. The report finds that investors generally believe fair value accounting increases transparency and facilitates investment decision-making. The report also observes that fair value accounting did not appear to play a meaningful role in the bank failures of 2008, but rather that those failures appeared to be the result of growing probable credit losses, concerns about asset quality and eroding lender and investor confidence.
The Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS No. 157”), in September 2006 with the objective of establishing a single definition of “fair value” and a framework for measuring fair value in generally accepted accounting principles that would increase consistency and comparability in fair value measurements. SFAS No. 157 was intended to expand disclosures about fair value measurements, thereby improving the quality of information provided to users of financial statements, such as investors. SFAS No. 157 defines “fair value” as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” To assist market participants in determining “the price that would be received,” or fair value of an asset or liability, SFAS No. 157 established a three-level hierarchy, called inputs. Generally, Level 1 inputs are current quoted market prices in an active market for the identical asset or liability; Level 2 inputs are quoted current market prices for similar assets or liabilities in an active market; and Level 3 inputs are unobservable, and are used where observable inputs are not available, such as where there is little or no market activity for the asset or liability being valued.
In light of current economic conditions, critics of SFAS No. 157 contend that fair value accounting requires potentially inappropriate write-downs in the value of investments held by financial institutions, particularly those write-downs that are the result of inactive, illiquid, or irrational markets. These write-downs, it is argued, result in values that do not reflect the underlying economics of the securities. Others, particularly investors, maintain that fair value accounting serves to enhance the transparency of financial information provided to the public, and point to poor lending decisions and inadequate risk management as some of the root causes of the current economic crisis.
The Focus of the SEC’s Study on Mark-to-Market Accounting
Congress called for the study on mark-to-market accounting in the wake of the debates as to whether fair value accounting, along with the accompanying guidance on measuring fair value under SFAS No. 157, contributed to instability in the financial markets. For over a year, many financial institutions have contended with the need to measure fair value under SFAS No. 157 for assets, such as mortgage-backed securities and collateralized debt obligations, for which there is no market. Congress mandated that the SEC’s study focus on six key issues facing these institutions:
(1) the effects of such accounting standards on a financial institution’s balance sheet;
(2) the impacts of such accounting on the bank failures of 2008;
(3) the impact of such standards on the quality of financial information available to investors;
(4) the process used by FASB in developing accounting standards;
(5) alternative accounting standards to those provided in SFAS No. 157; and
(6) the advisability and feasibility of modifications to such standards.
The Report’s Results and Recommendations
The most significant conclusion of the SEC’s study on mark-to-market accounting is that the report does not recommend suspension of SFAS No. 157. Indeed, the report states at the outset that the economic crisis was not caused by fair value accounting requirements, but rather resulted from market participants’ efforts to clear significant amounts of debt from their balance sheets coupled with a reduced appetite for risk and eroding confidence of lending counterparties.
Further, the report notes that SFAS No. 157 does not itself require mark-to-market or fair value accounting; it merely provides a definition for “fair value” and establishes a framework for measuring the fair value of assets. According to the report, the requirement of fair value accounting is found in other accounting standards, though mark-to-market accounting is certainly one subset of fair value accounting. The report distinguishes, however, between accounting standards that require changes to fair value to be recognized in the income statement (“marked-to-market”) and those that do not require changes in fair value to be recognized in the income statement unless an impairment has occurred. The study therefore considered the issues associated with fair value accounting in a larger context in addition to addressing specific questions concerning mark-to-market accounting.
1. Effects of Fair Value Accounting Standards on Financial Institutions’ Balance Sheets
In light of concerns that fair value accounting standards may inappropriately affect the balance sheets of financial institutions, the SEC studied the prevalence of assets measured at fair value on each financial institution’s balance sheet and the subset of those assets that were actually marked-to-market through the institution’s income statement. The SEC also examined the level within SFAS No. 157’s three-level hierarchy in which these assets fell.
The report concludes that fair value measurements were used to measure a minority of assets (45%) and liabilities (15%) included in the financial institutions’ balance sheets. While the percentage of assets for which fair value affected income was only 25%, the report notes that these fair value measurements did significantly affect reported income for the financial institutions sampled.
2. Impact of Fair Value Accounting on Bank Failures in 2008
The SEC examined possible correlations between fair value accounting and the bank failures that occurred during 2008. The report concludes that the bank failures resulted from growing probable credit losses, concerns about asset quality, and eroding lender and investor confidence as opposed to fair value accounting. The report further states that, even for failed banks that did recognize sizeable fair value losses, it did not appear that the reporting of those losses was the reason for the failure.
3. Impact of Fair Value Accounting on the Quality of Financial Information Available to Investors
To evaluate assertions that fair value accounting enhanced the transparency of financial information provided to investors, the SEC examined how fair value accounting and fair value measurements are used by investors. Using information from a variety of sources, including comment letters received by the SEC on the issue of fair value accounting, the report concludes that investors generally view fair value accounting as providing more transparent financial information, which facilitates better investment decision-making and more efficient capital allocation amongst firms. However, investors also expressed a need for improvement to: impairment requirements; application in practice of SFAS No. 157; fair value measurement of liabilities; and presentation and disclosure requirements of fair value measures.
4. Process Used by FASB in Developing Accounting Standards
The SEC undertook to study the process by which accounting standards are developed and promulgated in connection with evaluating the viability and feasibility of modifying the accounting standards that require fair value accounting. The report concludes that while FASB, as an independent accounting standard-setter, was best suited to develop unbiased accounting guidance, there were certain areas for improvement that would enhance the timeliness and transparency of the FASB’s process. Such improvements would include: the creation of a financial reporting forum; increasing the transparency and consistency of fieldwork during the development of accounting standards; conducting post-adoption reviews of major standards to identify unintended consequences or other issues; and periodically assessing existing standards for continued relevance and acceptable cost-benefit profiles in light of changing economic conditions.
5. Alternatives to Fair Value Accounting Standards
The SEC examined the consequences associated with suspending the guidance in SFAS No. 157 or, in the alternative, suspending fair value accounting itself. The report concludes that suspending the guidance in SFAS No. 157 would remove the standardized measurement and disclosure requirement but would not change fair value accounting requirements. Suspending SFAS No. 157 would likely result, therefore, in inconsistent and sometimes conflicting advice on fair value measurements, with issuers returning to practices that existed prior to the issuance of the standard.
The report also concludes that suspending fair value accounting itself, with a return to historical cost-based measures or other alternative measures, would likely increase investor uncertainty. Instead, the report recommends that additional actions be taken to improve the challenges encountered with respect to implementing fair value accounting, such as addressing the need for additional guidance to determine fair value in inactive markets. The report also recommends readdressing existing impairment standards in order to improve the utility of information available to investors.
6. Advisability and Feasibility of Modifications to Fair Value Accounting Standards
Drawing from the results of its conclusions with respect to issues 1-5 above, the report makes the following eight recommendations regarding modifications to fair value accounting standards:
The full report can be found at
 The difficulties facing such institutions has not gone unnoticed by the SEC or FASB. On September 30, 2008, the SEC and FASB issued a joint clarification regarding the implementation of mark-to-market accounting in cases where a market is disorderly or inactive. On October 10, 2008, FASB finalized the new FASB Staff Position 157-3, which clarified the application of SFAS No. 157 to a financial asset for which the market is inactive.
 For purposes of its study, the SEC adopted a more limited definition of “financial institutions” than that provided in Section 3(5) of the EESA due to the time constraints associated with completing the study within the Congressionally-imposed deadline of ninety days. In examining the effects of fair value accounting standards on financial institutions’ balance sheets, the SEC limited the study sample to public companies, establishments primarily engaged in providing loans to individuals (“credit institutions”), and government-sponsored enterprises that primarily provide federally guaranteed loans and similar entities.
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