point of view
A proposal to improve fair
Refining the accounting for impaired bonds may address some
challenges of reporting fair value in illiquid markets
Why change fair value accounting?
The financial crisis has exposed numerous flaws in the
The proposal offers four advantages
for reporting losses on non-trading debt
financial markets—as well as some shortcomings of fair value
accounting for debt securities.
1. Credit and non-credit losses
Critics contend that reporting fair value during illiquid markets
would be reported separately and
prominently in a redesigned income
needlessly creates earnings volatility and destroys bank capital.
statement. This enhances transparency
They have called for its temporary suspension.
by providing more information about
changes in fair value.
Standard setters are addressing the challenges associated
2. Only incurred losses are recorded
with fair value accounting by reevaluating accounting and
in net income. This is consistent with
reporting standards for financial assets. Input from market
accounting for credit losses on loans
participants has been widely solicited and is being considered;
and eliminates an inconsistency in how
incurred losses are reported.
amendments to existing standards have either been issued or
are under consideration.
3. Continues to report debt securities
at fair value.
This proposal offers standard setters a way to address some
4. Reduces effect of temporary market
of the concerns of critics while maintaining the benefits of fair
volatility on net income. Swings in
earnings will be moderated in both
falling and rising markets —essentially
buffering the extremes of bull and
Frozen markets presented a challenge
to fair value accounting
Reassessments follow the crisis
The heart of the debate: Procyclicality
By any measure, America’s current financial
crisis—and the federal government’s
Illiquid markets make it more challenging
response—has been astonishing.
to determine fair value. Moreover, some
Governments and businesses are currently
contend fair value may promote a downward
managing challenges neither the US nor
spiral in asset prices, or procyclicality,
world economy has seen in 70 years.
because potentially temporary losses
Five of the country’s major investment
banks have disappeared via bankruptcy,
During down markets, banks must write
acquisition or conversion to commercial
down assets to reflect current market value.
banks. To date the Federal government has
These write downs reduce regulatory capital.
committed more than $6.5 trillion to stabilize
To increase capital, some banks may sell
the financial markets with more expected
undervalued assets into the depressed
from the Obama administration. The crisis
market. These sales place further downward
has now advanced through the economy
pressure on asset values, which in turn may
exposing systemic vulnerabilities across
trigger further write downs and more sales.
business sectors around the world.
Moreover, during times of severe market
When markets function with
The crisis has spurred scrutiny of nearly
illiquidity, when few or no buyers exist, an
normal liquidity, determining
every corner of the financial services industry, implied market value is estimated. This is
fair value is easy. During
including investment banks, commercial
usually accomplished through valuation
banks, mortgage brokers, hedge funds
models. Models often require significant
illiquid markets, fair value
and rating agencies. The reevaluation also
judgment and estimation, which, critics say,
becomes more difficult to
covers a wide array of financial products,
may make them subjective and unreliable.
establish. It requires making
including mortgage-backed and asset-
significant judgments and
backed securities, credit default swaps
Mending is better than suspending
estimates, which, according
to critics, makes these
Fair value accounting, as the standard
Critics have therefore cal ed for suspension of
for valuing and reporting certain financial
fair value accounting during illiquid markets.
assets, primarily loans and debt securities
They contend these models lead to excessive
held by financial institutions, is also
and punitive write downs. Yet the SEC’s
recent fair value accounting study noted no
linkage between fair value accounting and
Understanding fair value reporting
bank failures. It also asserts that suspending
Under fair value, financial assets are
fair value may reduce the transparency of
reported at current or market value
and confidence in financial reporting.
(commonly referred to as “mark to market”).
Standard setters have responded vigorously
Market value is the price at which buyers
to the challenges associated with fair value
and sellers would be willing to transact for
accounting. They have solicited input from
a particular asset.
a broad range of market participants. Their
When markets function with normal liquidity
efforts have led them to revise some
and robust capital flows, fair value is simple:
standards and consider changing other
the current market price for a particular asset
is the one reported based on transactions
occurring that day.
2 PricewaterhouseCoopers LLP
A few key refinements will better serve
users without diluting fair value’s integrity
During recent forums held on fair value
reverse themselves or result in realized
accounting, the accounting profession
gains or losses.
presented an idea to help address an
inconsistency in how impairment charges
• Changing the income statement format
are recorded for financial assets.
to provide greater visibility for the income
effects of items reported at fair value; and
Impairment for financial assets
include OCI information on the income
Different methods exist to report
statement below net income.
impairments in the value of financial assets.
Many benefits exist
Reporting often depends on legal form—
whether the asset is a loan or bond, such
These refinements offer an improved
as a mortgage-backed or asset-backed
• Provides greater consistency and
Under current practice, loan impairments
comparability in reporting declines in
reflect only credit related losses (those
the fair value of loans and securities
related to a borrower’s inability to make
for financial institutions.
principal and/or interest payments).
• While reflecting only incurred losses in
Impairment charges for debt securities
net income, would disclose all changes
“Any fundamental change to
reflect both credit and non-credit
in the fair value of debt securities on the
fair value reporting runs the
face of the income statement.
risk of reducing confidence
In normally functioning markets, this
• Provides more information about the
among investors … [But]
inconsistency went unnoticed. However,
causes of changes in fair value, including
several areas [refinements
with severe market illiquidity, impairment
both credit and non-credit factors.
charges for many debt securities contained
in reporting and disclosures]
a significant illiquidity or non-credit
• Removes liquidity and other transitory
could be evaluated in
component—in some cases the majority
charges from the net income of
regard to reporting periodic
of the impairment was non-credit related.
institutions with a “buy and hold”
changes in fair value without
This inconsistency, together with its impact
compromising the core
on the financial markets, is now at the
forefront of the fair value debate in financial,
regulatory, and public policy circles.
The proposal is not intended to be a
panacea that addresses all fair value
Advancing a proposal to refine fair
Vincent P. Colman
concerns. The suggested refinements
represent one method to address an
Managing Partner, Assurance
To address this issue and more clearly
inconsistency in impairment accounting
report the nature of impairment of debt
and further the effort to improve fair value
securities, the idea proposes:
accounting for financial assets.
SEC Roundtable on
• Separating impairment charges into two
This method has been discussed at
components: losses related to declines
roundtables sponsored by FASB, IASB,
in expected cash flows (or incurred credit
and the SEC. Favorable comments
losses) and all other changes in fair value.
have been received from the accounting
October 29, 2008
profession, bank regulators and preparers.
• Reporting incurred credit losses in net
Investor feedback received has been
income and all other impairment losses
mixed, tending toward skeptical, as some
in other comprehensive income (OCI).
expressed concern about the possibility
OCI is a holding account for temporary
of reduced transparency for impairment
unrealized changes in fair value of various charges. These concerns are discussed
financial assets and liabilities until they
in the following Q&A.
point of view 3
Key questions are raised by critics
of the proposal...
Q: Won’t this plan reduce fair value
Q: Doesn’t the proposal suggest a level
information flowing through the income
of precision in measuring credit and non-
statement thus reducing transparency?
credit losses that simply does not exist
and may be misleading to users?
A: The proposal provides transparency
while maintaining the integrity of fair
A: Estimating losses will always be
value accounting. Fair value changes and
subjective and imprecise. This enhanced
impairments are disclosed fully on the
measurement and reporting of credit and
balance sheet and income statement. New
non-credit losses, while imperfect, will be
information about any impairment charge
more directionally accurate and useful than
(credit versus noncredit) is disclosed on the
face of the income statement.
Q: Won’t this idea allow institutions
The proposal also provides more
to hide losses or massage earnings
consistency. Credit-related changes are
to create more favorable results?
reflected in net income and all non-credit-
A: The proposal increases transparency
related changes in fair value (holding
by providing more information about the
gains and losses) are reflected in OCI.
causes of changes in fair value—both credit
Here is our perspective.
This approach is consistent with existing
and non-credit factors. Removing liquidity
treatment of holding gains and losses for
and other transitory charges from the net
available for sale securities contained in
income of institutions with a “buy and hold”
business model may reduce distortion from
Q: How will this proposal affect
excessive market pessimism in distressed
markets and excessive market optimism
in euphoric markets.
A: The proposal does not diminish or
reduce the information currently provided
Q: How does this proposal address
to regulators for use in regulatory capital
the inherent inconsistency in the current
evaluation. However, it acknowledges the
“mixed attribute” model used in fair
interplay between financial and regulatory
value accounting—assets are marked
reporting, which serve different purposes
to market but most liabilities are not?
— informing investors versus safety and
A: The proposal is an effort to begin
soundness of an institution. Regulators
to address some—but not all—of the
have and will continue to use financial
shortcomings of fair value accounting.
reporting information in a manner that
Resolving other issues, such as the mixed-
best serves their regulatory mandate.
attribute model, will require extensive
That being said, as a byproduct, the
debate involving many constituencies
proposal would indeed, under current
and both the FASB and the IASB as they
regulatory rules, reduce stress on regulatory
all continue their efforts to improve fair
capital during times of market illiquidity.
© 2009 PricewaterhouseCoopers LLP. All rights reserved.
Vincent P. Colman
“PricewaterhouseCoopers” refers to PricewaterhouseCoopers
Managing Partner, Assurance
LLP or, as the context requires, the PricewaterhouseCoopers
To have a deeper discussion about how
global network or other member firms of the network,
this proposal might affect your business,
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PricewaterhouseCoopers LLP (US). NY-09-0906-A
Russell B. Mallett III
Financial Services Practice Technical Leader