On April 6, 2007, we issued a white paper discussing Financial Accounting Standards Board Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (FAS 159), and related Financial Accounting Standards Board Statement No. 157, Fair Value Measurements (FAS 157), which is available at http://www.mcgladrey.com/Resource_Center/Audit/Articles/FAS159_FreePassMyth.html. These two standards continue to generate questions related to their early adoption and proper application. Therefore we are providing some additional information received after the issuance of the white paper. This additional information does not change the positions we presented in the white paper.
As a reminder, FAS 159 allows entities to elect to account for eligible assets and liabilities at fair value. It is effective for years beginning after November 15, 2007 with early adoption allowed if it is done within the first 120 days of the fiscal year and certain other conditions are met. If an entity elects to early adopt FAS 159, it must also early adopt FAS 157. FAS 157 establishes a hierarchy for how fair values are determined, establishes that fair values are from a viewpoint of an exit price between market participants and creates substantial new disclosure requirements.
Recap of Recent Intelligence
We continue to have discussions with other CPA firms, the SEC staff and other professionals about the early adoption issues surrounding FAS 159. Recent activities include:
- Discussion at the April 11 meeting of the Professional Practice Executive Committee of the AICPA’s Center for Audit Quality
- Discussions by the AICPA Depository Institutions Expert Panel
- SEC calls with some of the largest accounting firms on April 11(Big 4 firms) and April 13 (second tier firms)
- Individual calls with national offices of our peers
- Receipts of newsletters from the American Banking Association and investment advisors with a variety of mixed messages
- More public companies announcing early-adoption strategies
- Published speech given by SEC Deputy Chief Accountant Jim Kroeker on April 4
http://sec.gov/news/speech/2007/spch040407jlk.htm
- The AICPA Center for Audit Quality issuance of Alert #2007-14 April 17, 2007 with Factors to Consider for Early Adoption of FAS 159
To summarize what we have heard:
- The SEC staff is very concerned about engineered transactions designed to get an accounting result that is not consistent with the objectives of FAS 159. They focus on “good faith” effort to apply FAS 159 and expect that entities would continue to apply fair value accounting to such instruments initially elected on an on-going basis. They are very skeptical of a strategy that lacks substance or that would involve electing the fair value option for a financial asset or liability with an intention of disposing of the asset or settling the liability. In addition, an entity that does not properly adopt FAS 157 is unlikely to get sympathy from anyone. We continue to believe an improper adoption of FAS 157 may result in a conclusion that FAS 159 was not actually early adopted. Most of the strategies being discussed as “opportunities” focus on restructuring investment portfolios and avoiding recording other-than-temporary losses in the income statement. The other major opportunity is electing fair value option for a liability such as trust preferred securities, charging unamortized issuance costs to retained earnings as part of the cumulative effect adjustment then prepaying the obligation. The SEC staff mentioned both of these strategies specifically and cautioned that adoptions of FAS 159 must meet the objectives of FAS 159. The SEC staff has not reviewed any registrant specific fact patterns and come to any conclusions. Any information in promotional literature that asserts the SEC has “approved” or “not objected” to a specific strategy should be viewed with skepticism.
- We don’t believe the FASB will be coming out with any specific guidance or bright lines. The SEC is contemplating a communication to make the views they have shared with the larger firms more broadly available.
- We are unclear if any banking regulators are issuing any formal external guidance.
Minimum Requirements to Support Early Adoption of FAS 159
We believe the documentation of an entity’s decision to early adopt FAS 159 should be thorough. This documentation should be part of the accounting department’s records. This documentation should assist management and the outside auditors in assessing whether a good-faith adoption of FAS 159 has occurred.
The following items are the minimum that should be prepared to support the proposed adoption:
- The entity’s position paper that includes:
a) Description of the proposed strategy;
b) How it meets the objective of FAS 159, as stated in paragraph 1 of the Standard;
c) If the strategy involves sales of securities that are currently valued at less than their cost (or “underwater”), an assessment of how the implementation reconciles to prior assertions made by management regarding their intentions to hold the securities until the securities value was recovered under Financial Accounting Standards Board Statement No.115, Accounting for Certain Investments in Debt and Equity Securities, as amended and interpreted; and
d) A description of how the proposed strategy is consistent with the entity’s Investment Policy and Asset/Liability Management Policy, if applicable and evidence of approval of any exceptions.
e) The Board of Directors and Audit Committee position with respect to the adoption
f) Robust implementation plans for adoption of FAS 157, which is required to be adopted concurrent with FAS 159
g) Draft of the proposed financial statement disclosures as required under paragraphs 17– 22 of
FAS 159
Public Company Adoption of FAS 157 – Effect on First Quarter Procedures Performed by the Independent Auditor
The adoption of any new accounting standard in the first quarter by a public company may require more procedures than a simple inquiry as part of the SAS 100 review procedures. With complex standards such as FAS 123R in 2006 and FAS 157 and 159 when adopted in 2007 or 2008, an entity’s auditors may effectively apply audit procedures during their review of the first quarter Form 10-Q. Therefore the following information is being provided as a summary of FAS 157 provisions and related audit procedures.
FAS 157 establishes requirements for how to measure fair value when it is required under existing GAAP. The provisions of FAS 157 have changed fair value measurement from an “entrance price” approach to an “exit price” approach based on the transactions between market participants. This is a much different concept than what entities have been used to under GAAP in determining fair value. Therefore, these new fair value determinations may result in a more rigorous review process. The principles of FAS 157 apply to recurring measurements of items recorded at fair value (such as available-for-sale or trading securities and lower-of-cost-or-market determinations), nonrecurring measurements such as purchase price allocations, impairment tests and disclosures of fair value such as those required by FAS 107.
Auditors will be referring to Statement on Auditing Standards Codification AU Section 328, Auditing Fair Value Measurements and Disclosures, (AU 328) to determine the scope of their procedures. AU 328’s guidance requires auditors to consider performing certain procedures (with related documentation) when testing the fair value measurements in the interim financial statements. An entity will likely be asked to assist in the preparation of this information. The procedures include:
- Understanding the entity’s process for determining fair value, which includes:
- Controls over the process used to determine fair values
- The expertise and experience of those persons determining the fair value measurements
- The role that information technology has in the process
- The types of accounts or transactions requiring fair value measurement or disclosure
- The extent to which the entity’s process relies on a service organization to provide fair values
- The use of a specialist in determining fair values
- The significant management assumptions used in determining fair value
- The process used to develop and apply management’s assumptions
- The controls over consistency, timeliness and reliability of the data used in valuation models
- Evaluating conformity with FAS 157
- Testing the following:
- Significant assumptions are reasonable and reflect market information
- Fair values were determined using an appropriate valuation model
- Underlying data used was relevant
- Disclosures are in conformity with FAS 157
Conclusion
Interpretations of FAS 159 continue to evolve. We support the concepts in FAS 159 and encourage a thoughtful, robust assessment of a strategy to use the fair value option. We continue to believe that an entity should elect fair value measurements for financial assets and liabilities that are consistent with the objectives of FAS 159: To improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. Implementation strategies employed that only take advantage of FAS 159’s transition provisions are not consistent with that objective. McGladrey & Pullen clients should stay in touch with their service team for new developments.
Statement No. 159 may be found in its entirety on the Financial Accounting Standards Board Web site (www.fasb.org).
 Download PDFof article: FAS 159 status update - April 17, 2007
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