(The article featured below is a selection from Federal Securities Law Reporter, which is available to subscribers of that publication.)

SEC, FASB Issue Clarifications on Fair Value Accounting

The SEC's Office of the Chief Accountant and the Financial Accounting Standards Board staff have issued guidance to assist in the determination of fair value in the current market environment. FASB plans to propose additional interpretive guidance soon, according to the SEC's news release, but the staff concluded that preparers and auditors needed immediate clarifications on FASB's fair value measure guidance in FASB Statement No. 157. The clarifications respond to questions that have arisen in the current market environment.

The guidance advises that management's internal assumptions, such as expected cash flows, can be used to measure fair value when relevant market evidence does not exist. The use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable, according to the guidance. The staff noted that, in some cases, it may be more appropriate to use unobservable inputs than observable inputs. For example, when significant adjustments are required for observable inputs, it may be appropriate to use an estimate based primarily on unobservable inputs.

Multiple inputs from different sources, when taken together, may provide the best evidence of fair value, according to the staff. Expected cash flows may be considered along with other relevant information.

The staff advised that broker quotes may be an input when measuring fair value, but may not be determinative if an active market for a security does not exist. When markets are less active, brokers may rely more on models with inputs based on information that is only available to the broker, the staff explained. One should place less reliance on quotes that do not reflect the result of market transactions. The nature of the quote should be considered when weighing the available evidence.

The concept of a fair value measurement assumes an orderly transaction between market participants. The results of disorderly transactions, such as distressed or forced liquidation sales, are not determinative when measuring fair value. A transaction that is distressed or forced should be considered when weighing the available evidence. The guidance reminds market participants that the determination of whether a transaction is forced or disorderly requires judgment.

The staff explained that a quoted market price in an active market for the identical asset is the most representative of fair value and is required to be used. Transactions in inactive markets may be considered when measuring fair value but are not determinative. Orderly transactions should be considered in estimating fair value. If the prices in an inactive market do not reflect current prices for the same or similar assets, adjustments may be necessary to determine fair value.

Among the indicators that should be considered in determining whether a market is inactive is a significant increase in the spread between the amount the sellers are "asking" and the price that buyers are "bidding." Another indicator is the presence of a small number of bidding parties. The determination of whether a market is active or inactive requires judgment.

The guidance also covers the factors to be considered when determining whether an investment is other-than-temporarily impaired. This determination often requires the exercise of reasonable judgment based on the particular facts and circumstances of each investment, according to the staff. There are no bright line tests or safe harbors for judging other-than-temporary impairments, but the staff advised that "rules of thumb" may be useful.

The guidance lists certain factors that may be considered to determine whether an other-than-temporary impairment exists, including the length of time and the extent to which the market value has been less than cost. Another factor is the financial condition and near-term prospects of the issuer. Management and auditors may also consider the intent and the ability of the holder to retain its investment in the issuer for a period of time that is sufficient to allow for a recovery in market value. All available information should be considered when estimating an anticipated recovery period, according to the staff.

The staff advised that clear and transparent disclosure is critical to provide investors with an understanding of the judgments made by management. The SEC staff and the FASB staff continue to consult with market participants on the issues that have arisen in applying fair value measurements in the current market environment.