Additional Briefing Document Regarding 4/2/09 FASB’s Fair Value and OTTI FSP’s

FASB Reaffirms Original Principles of Fair Value (aka Mark-to-Market) Accounting and Requires More Disclosures.  Board Calls for Changes in Accounting for Impairments

The FASB considered three proposals yesterday.  Two of the proposals were related to fair value (mark-to-market) accounting, and one was associated with accounting for impaired securities, such as mortgage-backed securities.

The first proposal (on FAS 157) relates to how to figure out fair values when there is no active market or where the price inputs being used really represent distressed sales. After considering all of the feedback we received on our original proposal issued two weeks ago, the FASB yesterday reaffirmed that the objective of measuring fair value has always been and continues to be the same since FAS 157 was published.  The objective is to reflect how much an asset would be sold for in an orderly transaction (as opposed to a distressed or forced transaction) at the date of the financial statements. Specifically, yesterday's vote said that companies should look at factors and use judgment to ascertain if a formerly active market has become inactive.

Once a company has made that determination, more work will be required to estimate the fair value. In trying to estimate fair value in an inactive market, the company must see if the observed prices or broker quotes obtained represent "distressed transactions". Other techniques such as a management estimate of the expected cash flows might also be appropriate in that circumstance.  However, even if a company analysis is used, it must meet the objective of estimating the orderly selling price of the asset under current market conditions. Some financial institutions have made public statements that they do not expect this proposal to significantly impact their financial statements.

The second proposal relates to fair value disclosures for any financial instruments that are not currently reflected on the balance sheet of companies at fair value. The current rule is that fair values for these assets and liabilities are only disclosed once a year. The Board voted yesterday that these disclosures should be required on a quarterly basis, providing qualitative and quantitative information about fair value estimates for all those financial instruments not measured on the balance sheet at fair value. For commercial banks, one financial asset impacted by this is loans, which will now have disclosures about their fair value every quarter.

The third proposal deals with other-than-temporary impairment (OTTI). The proposal could change when an impairment write down is recorded in earnings.  Also it could change where in the financial statements the impairment is reported. Under the current rules, unless the severity and duration of a drop in fair value is too great, if a company can assert that it intends and is able to hold a security until the fair value recovers, it need not record an impairment charge on the income statement. The new proposal the Board approved indicates that no impairment charge is required if there is both no current intention to sell and, it is more likely than not, that it will not be required to sell prior to the fair value recovering.* However, if management expects at the financial statement date that all of the cash flows won't be 100% collected, an impairment must be recorded in the statement of income.

In certain situations, the proposal changes the presentation of the impairment charge, splitting it up into two pieces. First, the amount of the impairment related to just the credit losses will be reflected on the income statement and will reduce net income. Second, the amount of the impairment related to all other factors will be shown in other comprehensive income in the equity section of the balance sheet. There will be a "gross" presentation of this on the income statement, one which will clearly display the total reduction in fair value below cost, the amount offsetting it that is being charged to other comprehensive income, and the net amount that is being recorded through net income.

Many balance sheet metrics used to analyze banks, such as Tangible Common Equity, should be relatively unaffected by this proposal, though earnings, other comprehensive income and retained earnings would be impacted. The Board did add significant new disclosures as part of this proposal as well.

Generally, these new proposals will be effective for the second quarter, though companies may elect to adopt them for the first quarter. However, we indicated that if a company wants to adopt the impairment proposal in the first quarter, it must also adopt the FAS 157 fair value in inactive markets proposal.

These proposals should be considered in the context of the larger ongoing joint project with the International Accounting Standards Board (IASB) to reconsider accounting for financial instruments. A proposal on this project is expected to be issued later this year.

*This sentence may be true for a HTM security but it is not true for an AFS security.  For an AFS security an impairment charge is required anytime the security’s fair value is below cost since the measurement attribute for AFS securities is fair value—it just maybe that the charge would go into OCI—instead of earnings if it is determined to be not other than temporary.