No Unintended Consequences? Really?

Harsh light shines on FAF’s Post-Implementation Review of FASB’s Fair Value Standard.


Last week, FASB’s overseers (the FAF) released a post-mortem report on FAS 157, the Fair Value Measurement (or ‘mark-to-market’) accounting standard that was alternately hailed and reviled during the 2008-10 economic crisis. FAF’s Post-Implementation Review (PIR) report, in brief, concluded FAS 157: (1) met its objectives in producing a single methodology for fair value measurement, (2) did not produce any unintended consequences, (3) was not overly costly in general, although simplifications in disclosures could be researched by FASB, particularly for private companies and not-for-profits, and (4) FASB should improve its process for documenting its consideration of cost-benefit and outreach with constituents.

Earlier this week, the FASB released its response  to FAF’s PIR report. The crux of FASB’s response was a page of bullets outlining how FASB will document cost-benefit considerations and user outreach, and conduct research on disclosure simplification with an emphasis on employee benefit plan financial statements, private companies and not-for-profits.

FAS 157: The Good, The Bad, and the Ugly

FAS 157 was hailed in its heyday by investor organizations for increasing ‘transparency’ through its requirements for measuring the fair value of certain illiquid assets. Investor organizations wanted financial institutions to avoid overvaluing those assets, and wanted institutions to write down the values of underwater assets closer to what the market would bear. (For the investor point of view, see, e.g. the Nov. 14, 2008 joint comment letter sent to the SEC by the Center for Audit Quality, CFA Institute, Council of Institutional Investors, Consumer Federation of America, and Investment Management Association.)

At the same time, FASB’s fair value standard was reviled during the onset of the economic crisis, particularly within banking organizations, financial institutions, and among some current and former banking regulators. Some alleged the accounting standard’s requirement for an ‘exit value’ or an ‘arms-length transaction’ value was feeding ‘procyclicality’ of the economic downturn. See, e.g. the Oct. 13, 2008 comment letter sent to the SEC by American Bankers Association President Ed Yingling. For those of us who lived through the world of developing, interpreting, applying, or reporting on accounting standards during the economic crisis, the first two paragraphs of the ABA president’s letter will bring back memories of tense times.

 My Two Cents

Cent One: Could Better Use Have Been Made of Comment Letters?

I personally agree with much of what Ed Yingling said in his 2008 comment letter to the SEC about some of the ‘fixes’ to FAS 157 that coulda’, shoulda’, taken place when early FASB Staff Positions like FSP FAS 157-3 were issued.  Although, in my view, if more far-reaching fixes had been made to address – call them ‘unintended consequences’ or the real-world results of interpretations made by the masses  (and/or their auditors) of the technical language included in FAS 157, perhaps some people would not have felt the need, as Yingling did then, and Congress about six months later, to ask FASB to act, or for the SEC to override FASB.

Could FASB have done more, given the comment letters it received on the Exposure Draft before issuing the standard that became FAS 157?

Troublingly, the FAF’s PIR report notes certain constituent information and records from the development of FAS 157 are no longer available and thus could not be considered as part of the PIR review. A resulting recommendation of the FAF’s PIR team was for FASB to maintain better records of outreach with constituents.

FAS 157, in my view, is the ‘poster child’ for opportunity lost, in terms of comments that were made by constituents during the formal comment letter process, but not taken up in a final standard or the series of FSPs that followed. Did economic harm result?

There are two schools of thought: one school suggests accounting is neutral and does not influence economic results. Another school of thought, to which I have always belonged, believes reported accounting results, including the methodology required for how those results are so reported, can have a feedback effect on economic activity, which in turn will have an impact on reported results.

I believe the lack of taking up some of the early comments may have triggered the groundswell of concern that ultimately swept up to the level of elected officials, ending with Congressional hearings that prodded the FASB to act swiftly in issuing FSPs to clarify certain matters relating to fair value measurement and other-than temporary impairment.

Opportunities lost that may have led to opportunity cost, (at least in terms of the interim six month period until further fixes were provided by FASB after Congressional hearings took place) may be seen in some of the forks in the road not taken in comments provided by constituents, such as the  comment letter filed by FEI’s Committee on Corporate Reporting (CCR) on the draft FASB Staff Position (FSP) which became FSP FAS 157-3, which, like the ABA, voiced concern about the potential inconsistency between the direction the draft was taking and room for apparent conflict with the SEC’s earlier guidance, or perhaps some of the other  Close to 100 Comment Letters filed on FASB FV Proposal.

Following FASB’s action in October of 2008, constituents believed further action was still necessary to stem what they saw as issues with the implementation of FAS 157. See, e.g. the joint comment letter that FEI’s CCR filed together with the U.S. Chamber of Commerce’s Committee on Capital Markets Competitiveness.

 Cent Two: Procyclicality, Congressional Hearings, and More: And Yet, No ‘Unintended Consequences’?
Continued concern with Fair Value Accounting found its way into the Emergency Economic Stability Act of 2008 (EESA), which included two provisions relating to fair value: (1) a requirement calling for an SEC study on fair value (mark-to-market) accounting, and (2) formal reiteration of the SEC’s authority to suspend FAS 157, FASB’s Fair Value Accounting standard.

The SEC issued its report in Dec. 2008  (and did not suspend fair value accounting), constituents were still not satisfied that enough relief had been provided from what some viewed as either procyclical downward effects arising from FAS 157, or other unintended consequences of FAS 157. As a result, Congressional hearings were convened on March 12, 2009, after which still further guidance from the FASB was published in early April.

Meanwhile, on the other side of the pond, Hans Hoogervorst, Chairman of the International Accounting Standards Board, remarked on the role of accounting standards in meeting calls for transparency during the financial crisis in a speech he delivered on March 8, 2014 in New Delhi, India entitled, Closing the Accounting Chapter of the Financial Crisis.
Referencing the Financial Crisis Advisory Group, a joint advisory group of the FASB and IASB that he had co-chaired with former SEC Commissioner (now IFRS Foundation Trustee) Harvey Goldschmid, Hoogervorst said:
"One of the key findings of the FCAG was to emphasize the role of financial reporting in providing unbiased, transparent and relevant information. However, the FCAG also recognized that only so much can be expected of accounting. Yes, accounting standards could contribute to financial stability by providing transparency. But, no, we should not expect accounting standards to provide a veneer of stability by ignoring volatility when it is really there."

Although it is true FAS 157 did not bring on any new requirements to fair value or mark-to-market securities that were not previously required to be fair valued (MTM), the change in methodology for determining fair value that came about under FAS 157 sometimes left asset holders with nothing but a “fire sale” price as the only third-party reference rate available.

My understanding, and again, I could be wrong and welcome being corrected, is that there was an underlying presumption when FAS 157 was developed and voted out by the FASB board – and that indeed, for FAS 157 to ‘work,’ it necessitated “efficient markets.”

Given the lessons learned from the credit crisis, including whether behavior follows “efficient markets” vs. a “herd mentality” – whether in a downward spiral or upward “irrational exuberance” – I believe the high pressure of the economic downturn in particular caused many of those old bubbles and related beliefs to burst.

Further, I believe you will find economists who will swear up and down that FAS 157 feeds procyclicality, and perhaps just as many economists who will take an oath that a neutral accounting standard can in no way impact economic transactions on a micro- or macro-economic level.

Some studies on this subject include: Procyclicality and Fair Value Accounting (IMF Working Paper-2009), (study favored procyclical impact); Fair Value Accounting: Villain or Innocent Victim: Exploring the Links Between Fair Value Accounting, Bank Regulatory Capital, and the Recent Financial Crisis (BostonFed, 2010, no linkage to procyclicality); Did Fair Value Accounting Contribute to the Financial Crisis (Christian Laux and Christian Leux, 2010, FV did not contribute to financial crisis); The Role of Valuation and Leverage in Procyclicality (Joint Report of the Financial Stability Forum (FSF)-Committee on the Global Financial System (CGFS) (2010) (acknowledges procyclicality in rising markets and downturns);. The Turner Review  (which spoke of ‘hard wired procyclicality) and Comments on FASB’s Fair Value Amendment Reflect FAS 157 Distress – The Schulzke Brief ) See our post from the November, 2008 for additional comments on procyclicality attributed to FAS 157.

Be that as it may, even if one denies a direct causative factor between FAS 157 and ‘procyclicality’ – I personally cannot buy off on the FAF PIR’s conclusion that there were ‘no unintended consequences’ from a standard that was blamed by some – even if wrongfully -- for triggering the economic crisis.

In at least one public roundtable on the subject of disclosure, I remember hearing a panelist reference the famous saying that is used as frequently used to justify ‘enhanced’ disclosure: “Sunlight is the best disinfectant.” This particular panelist noted that, “Too much sunshine can also burn.”

I applaud the FAF PIR’s conclusions about conducting further outreach on potentially simplifying FAS 157 for private companies, not-for-profits, and potentially expanding any learnings from those efforts to all of FASB’s constituents. Most importantly, FASB and the FAF deserve applause for undertaking a PIR in the first place, when current standard-setting projects are calling for attention and PIR must be challenging, something akin to a ‘peer review’ in the world of auditing, particularly pre-PCAOB in the public company realm.

However, I am at a loss as to the FAF PIR’s conclusion as to ‘no unintended consequences.’ The economic tailspin that took place in 2007-2010 was certainly ‘unintended’ and unforeseen in 2004, 2005 and the period in which FAS 157 was under development. There is no ‘shame’ in the word ‘unintended’ in and of itself, especially for a once-in-a-generation (hopefully) recession. I would not view it as a ‘negative’ admission for anyone, the FAF’s PIR team included, to issue a declaration that there were, indeed, some ‘unintended consequences’ arising from a standard like FAS 157.

Indeed, understanding how such unintended consequences arose, and whether any could have been headed off sooner through the comment letter process (specifically, through the handling of comment letters) would be constructive feedback that gets to the heart of FAF’s PIR process, and I think FASB board and staff members, and FASB’s constituents should  agree that PIR results are meant to move forward, not backward, and to be used as a basis for improvement. Oh, well.  Maybe next time.

Tomorrow’s installment will address the FAF PIR report’s statements regarding the cost of implementing FAS 157 with respect to the accounting standard vs. the SEC, PCAOB and preparers and auditors behaviors related thereto.

DISCLAIMER: Unless specifically noted, the views posted in this column do not necessarily represent the views of FEI, its officers, directors, agents, employees or members.