Financial Reporting Alert 07-4: Key Accounting Issues and the Current Credit Environment
September 27, 2007
|Editor’s Note: On October 3, 2007, the CAQ issued the three white papers summarized in this alert as final.|
On September 22, 2007, the Center for Audit Quality (CAQ), with input from the eight largest public accounting firms and various professional organizations, 1 submitted to the staffs of the SEC, FASB, PCAOB, and various banking regulatorsthree draft white papers addressing key accounting issues resulting from the current turbulent conditions in the credit markets. 2 The CAQ is looking to these parties for comments on the white papers and hopes to make the documents’ guidance available to preparers and auditors expeditiously.
If reviews of the draft white papers produce significant changes, look for a follow-up Financial Reporting Alert.
|Editor’s Note: According to the CAQ, impacted entities may include, but are not limited to, commercial and investment banks, insurance companies, investment companies such as mutual funds and hedge funds, pension and employee benefit plans, and university endowment funds.|
The white papers, discussed in more detail and reprinted below, focus on three issues:
- Measurement of fair value in illiquid (or less liquid) markets — Are currently observed market prices representative of and consistent with the definition of fair value in FASB Statement No. 157, Fair Value Measurements? This issue is relevant not only in the accounting for assets measured at fair value, such as trading and held-for-sale portfolios, but also in measuring and reporting asset impairment and for making disclosures about fair value.
- Accounting for underwriting and loan commitments — Commitments to fund loans or underwrite securities may be adversely affected by the deteriorating conditions in the credit market, and their value may decline as a result of increases in commitments credit spreads, increasing probabilities of borrower default, or decreases in the prices the entity could expect to obtain from selling the resulting loans or securities.
- Consolidation of commercial paper conduits — In light of current conditions, a variable interest holder might, as a consequence of reconsidering the identity of the primary beneficiary, conclude that it now absorbs a majority of the entity’s expected losses and is the primary beneficiary of the conduit.
While the summaries below highlight certain key points, the draft white papers should be read in their entirety.
1. Fair Value Measurements Impacted by Illiquidity (refer to the draft white paper)
Subprime mortgage loans are experiencing an increase in delinquencies and defaults caused by rising interest rates and declining values in real estate. As a result, investments in securities backed by subprime mortgage loans have been downgraded by rating agencies. Not only have investors backed away from subprime mortgage-backed securities, demand has sharply fallen for a wide variety of asset-backed securities, commercial paper, and commercial loans, resulting in what some have termed a liquidity crisis.
A key issue is whether currently observed market prices are representative of and consistent with the definition of fair value in Statement 157, or whether, in this environment, observed market prices could be considered distressed sales.
The white paper notes that it is important to distinguish between (1) an imbalance between supply and demand (e.g., fewer buyers than sellers, thereby forcing prices down) and (2) a “forced” or “distressed” transaction. Because persuasive evidence is required in establishing that an observable transaction is forced or distressed, it is not appropriate to assume that all transactions in a relatively illiquid market are forced or distressed.
The SEC, in a 2004 accounting and auditing enforcement release, determined that using a definition of fair value that assumed supply and demand were in reasonable balance was a violation of GAAP and that the registrant should have considered the current market environment, such as imbalances of supply and demand, in the determination of the then-current market value. Further, the SEC objected to the practice of taking a long-term view of the market while ignoring prices quoted by external sources.
Other key points from the draft white paper include the following:
- A decline in a market’s transaction volume does not necessarily mean that the market is not active. A market is still considered active if transactions are occurring frequently enough on an ongoing basis to obtain reliable pricing information. When an active market exists, a quoted price provides the best evidence of fair value (Level 1 per Statement 157).
- In the absence of an active market for the identical asset, entities often use valuation models. Entities may not ignore available market information or market participant assumptions that are reasonably available without undue cost and effort. Valuation models that use historical default data, or an entity’s own default assumptions, rather than assumptions that marketplace participants would use, are not appropriately using current market participants’ assumptions, even if the default assumptions are “stressed.”
- Statement 157 contains disclosure requirements regarding fair value measurements that apply to entities that have adopted Statement 157. Entities that have not yet adopted Statement 157 should consider disclosures required by existing pronouncements (for example, AICPA Statement of Position No. 94-6, Disclosure of Certain Significant Risks and Uncertainties) in situations in which fair value measurements have a significant effect on the financial statements. When an entity that has not adopted Statement 157 measures fair value using significant unobservable inputs, the white paper suggests that the entity may wish to consider disclosures similar to those found in Statement 157.
2. Accounting for Underwriting and Loan Commitments (refer to the draft white paper)
In the current market environment, commitments to fund loans or underwrite securities may decline in value as a result of increases in credit spreads, increasing probabilities of borrower default or decreases in the prices the entity could expect to obtain from selling the resulting loans or securities.
The white paper contains the following observations:
- Forward contracts that are derivatives under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, should be recognized at fair value as either an asset or liability with changes in fair value recorded in earnings as they occur.
- EITF Issue No. 96-11, “Accounting for Forward Contracts and Purchased Options to Acquire Securities Covered by FASB Statement No. 115,” 4 requires that nonderivative forward contracts to purchase securities to be accounted for under Statement 115 should be designated as either held-to-maturity, available-for-sale, or trading at the inception of the commitment and accounted for consistently with the accounting classification under Statement 115.
- Loan commitments that relate to mortgage loans that will be held for sale should be accounted for by the issuer as derivatives under Statement 133.
Two acceptable alternatives exist for loan commitments that (1) relate to loans that the company intends to hold for sale and (2) are not commitments that are accounted for at fair value under Statement 133, FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, or industry-specific accounting guidance:
Alternative A:Such loan commitments would be carried at the lower of cost or market by analogy to Issue 96-11
Alternative B: Contingent losses or loan commitments would be recognized, in accordance with FASB Statement No. 5, Accounting for Contingencies, if the loss is probable and reasonably estimable.
- Loan commitments that (1) relate to loans to be held for investment and (2) are not commitments that are accounted for at fair value under Statement 133, Statement 159, or industry-specific accounting guidance should be evaluated for credit impairment under Statement 5 and other relevant guidance.
- Commitments to acquire loans to be held only until the market improves cannot be considered commitments to acquire loans held for investment.
- At the date an entity changes its intent from holding a loan for sale to holding a loan for investment, the accounting in Alternative A or Alternative B above should be used, with no previously recognized losses reversed. The lower of cost or fair value, on the date intent changes, becomes the new cost basis of the loan.
3. Consolidation of Asset-Backed Commercial Paper (ABCP) Conduits (refer to the draft white paper)
ABCP conduits are typically variable interest entities (VIEs) under FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities. Under the guidance in FASB Staff Position (FSP) No. FIN 46(R)-6, “Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R),” the sponsor of an ABCP must examine the design of the conduit to determine (1) what risks are present within the conduit and (2) the purpose of the entity’s creation. ABCP entity sponsors and other variable interest holders such as liquidity backstop providers are required to determine which party (if any) absorbs the majority of an ABCP program’s expected losseswhen the party first becomes involved with the entity.
The determination of the conduit’s primary beneficiary (any primary beneficiary must consolidate the entity) is reevaluated on the occurrence of certain events. These events include (but are not limited to) (1) the conduit acquiring new assets or new risks, (2) a variable interest holder acquiring or disposing of its variable interests, or (3) a combination of these events. In addition, the reduction in the conduit’s assets along with changes in contractual arrangements among variable interest holders (e.g., rollovers of ABCP) may result in a reconsideration event. Because reconsideration events may occur frequently, sponsors should typically reevaluate their model assumptions periodically to ensure that conduit consolidation is not required.
The white paper notes that sponsors and other variable interest holders of ABCP programs should ensure that the assumptions used in calculating expected losses reflect recent marketplace activity. In light of current conditions, a variable interest holder might, as a consequence of reconsidering the primary beneficiary, conclude that it now absorbs a majority of the entity’s expected losses and is the primary beneficiary of the conduit.
The white paper also notes the following:
- An ABCP conduit sponsor may not dismiss recent events as an anomaly and must give consideration to their possible reoccurrence in modeling future conduit cash flows.
- Sponsoring banks must use market default assumptions at the date of reconsideration, even if the sponsor believes those assumptions are incorrect.
- If a sponsoring bank goes beyond contractual commitments to support an ABCP conduit, those actions should be carefully evaluated under the guidance in FASB Staff Position No. FIN 46(R)-5, “Implicit Variable Interest Under FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities,” which discusses factors to consider when determining whether an implicit variable interest exists.
2 Deloitte & Touche LLP professionals were alerted to these developments in a September 18 internal publication. The technical content of this Financial Reporting Alert, while very similar in most respects, supersedes the technical content of the internal publication.
3 Statement 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.” For entities that have not yet adopted the provisions of Statement 157, similar principles would apply as the statement did not conceptually change the definition of fair value.
4 FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities.