Fair value accounting (otherwise known as mark-to-market accounting) requires companies to value their financial assets based on current market prices. While relatively straightforward in principle, fair value accounting is often difficult to apply and poorly understood outside of accounting circles.

The recent market turmoil has thrust the implications of fair value accounting into the spotlight as most financial asset prices have fallen considerably and some markets, such as the mortgage-backed securities market, have dried up completely. In these circumstances companies have had to make large write-downs on their assets when applying fair value accounting. In some instances, the current fair value amount may be less than the expected cash flow returns from the assets. Financial institutions have argued that applying fair value accounting in these instances provides a false and misleadingly low valuation of their assets.

"This is the first time fair value accounting has been tested in a volatile market, and we are discovering that its application can be problematic in some cases," says Anna Pinedo, a partner at Morrison & Foerster in New York. "Questions have been raised about how reliable the measurements are, its impact on balance sheets, income statements and capital ratios, and fundamentally, whether fair value accounting is actually accelerating economic decline." Such questions have sparked debate and intervention on both sides of the Atlantic about if and how the application of fair value accounting should be changed.

This article sets out how fair value accounting works under both the US Generally Accepted Accounting Principles (US GAAP) and International Financial Reporting Standards (IFRS) (see box, Accounting standards explained). It also analyses the role of fair value accounting in the current financial crisis, as well as the recent changes and proposals for change to increase flexibility in applying fair value accounting.

Fair value accounting is a method for valuing assets and liabilities, which is broadly based on the amount two unrelated willing parties would transact to buy the asset or assume the liability.

The relevant fair value accounting standards are:

Under both standards the exit (selling) price should be used as evidence of market transactions, rather than the entry (buying) price. Importantly, evidence of market transactions does not include distressed or forced sales. This exception has become significant in the current market conditions (see Distressed sales and inactive markets below).

According to Veronica Poole, a partner at Deloitte LLP in London, "In terms of fair value measurement, the key concepts in US GAAP and IFRS are the same. The words used are different but applying either standard should theoretically bring the same result."

For further background on the implementation of these standards, see box, Accounting standards explained.

Broadly, the purpose of financial reporting is to provide investors (and to a lesser extent business and policy makers) with accurate and clear information on a company's net assets and operating performance. Investors want to be able to predict cash flows and their return on investment, as well as assess the general performance of the company and its management.

The benefit of fair value accounting is that it represents what an asset is worth today, and provides more transparency than historical cost-based calculations (which refer to the original amount exchanged, adjusted to take into consideration the economic effect of subsequent events, such as wear and tear) or future predictions.

The difficulties with fair value accounting arise when markets are inactive or virtually inactive and transactions are distressed, establishing increasingly lower floors for determining the fair value of similar assets. Obtaining an accurate fair value in such circumstances can be difficult and highly subjective (see Distressed sales and inactive markets below). "Inactive markets in the current financial crisis raised many questions: whether we should still use the exit price to determine fair value, whether we should use another method to calculate fair value, or if we should abandon fair value in these circumstances and use a different accounting basis," says Poole. (For further background on the role of fair value accounting in the financial crisis, see Article, Fair value accounting in the credit crisis: don’t shoot the messenger).

Further, changes in fair values of assets can have a material impact on an entity’s income statement and capital ratios (see The impact of write-downs on capital ratios below).

The application of fair value accounting assumes the presence of orderly markets. Generally, fair value is based on quoted market prices where available, and otherwise based on a series of technical requirements.

As there are different ways to determine fair value (see How is fair value determined? above), it is important that investors know what methods were used to calculate the amounts. This has become particularly important in the recent market turmoil, when entities have been relying less on quoted market prices and more on unobservable inputs and various valuation techniques. "In such circumstances, determining fair value can be very subjective," says Stuart Grider, a partner at Freshfields Bruckhaus Deringer LLP in Hong Kong. "Transparency is particularly important since changes in fair value affect not only the company’s balance sheet, but its liquidity position and capital ratios as well. Entities must disclose not only the way fair values were determined, but the potential material affect of any changes in value."

IFRS 7 contains extensive disclosure requirements, and after its most recent amendment it is consistent with FAS 157 on the types of disclosures that need to be provided for instruments carried at fair value.

FAS 157 and IAS 39 apply to all types of financial instruments subject to certain exceptions. Examples of financial instruments covered include:

Both IFRS and US GAAP require financial assets to be classified into specific categories at the time of acquisition, depending on their intention for the asset. These categories determine how a particular financial asset is recognised and measured in the financial statements. FAS 157 sets out three categories:

Assets designated in the first two categories are subject to fair value accounting. Held-to-maturity assets, which are assets that are not intended to be sold in the short term, are accounted for on an amortised cost basis.

IAS 39 sets our four categories:

Under IAS 39, the first two categories are subject to fair value accounting. Loans and receivables and held-to-maturity assets are accounted for on an amortised cost basis.

According to Grider, "The focus in the current crisis is on the first two categories of both accounting standards (trading/financial assets at fair value through profit or loss and available-for-sale) since these are the types of assets that are subject to fair value accounting and have consequently suffered massive write-downs."

In the wake of the recent market turmoil, many financial institutions wanted to reclassify their assets out of the trading and available-for-sale categories into the held-to-maturity category because their intentions for the investments had changed due to the declining markets and they did not want to suffer the write-downs under fair value accounting rules.

US GAAP permits reclassification out of the trading category in rare circumstances, which the Financial Accounting Standards Board (FASB) has confirmed includes the present credit squeeze. However reclassification was not permitted under IFRS. To rectify this, in a controversial move the International Accounting Standards Board (IASB) issued a revision to permit reclassification under IAS 39 in the same circumstances as are available under FAS 157 (13 October 2008). "Many commentators felt that this swift rule change was a capitulation to pressure from affected financial institutions, and the result would be decreased transparency in the market" says Grider. "But it has undeniably provided some relief to financial institutions under stress."

IFRS 7 Financial Instruments: Disclosures was also amended to require entities to make additional disclosures relating to any assets that are reclassified under the new rule.

Many financial institutions have reportedly taken advantage of the reclassification rule change to reclassify certain assets into the held-to-maturity category (or loans and receivables category under IFRS) to avoid marking-to-market and therefore suffering large write-downs.

According to Grider, "It's a tough situation because on the one hand it is damaging for specific financial institutions and the market generally if assets are written down to values that may be misleadingly low, but on the other hand, if large volumes of assets are reclassified into the held-to-maturity or loans and receivables categories, a black hole is created and there is even less price critical information reaching the market, which does nothing to increase investor confidence and get the markets moving again."

Poole says that in any event reclassification is only a partial solution: "There are still a lot of assets on the books of financial institutions that are carried at fair values because some assets are clearly not loans and receivables, and other assets will not fall into the held-to-maturity category because the intention of the financial institution for that asset has not changed – they are just waiting for the market to improve before selling."

As fair value under US GAAP and IFRS assumes the presence of orderly markets, if a market is inactive and a transaction is distressed, quoted market prices should not be used to calculate fair value. However, in the recent market turmoil there has been uncertainty as to the application of this principle. "It was unclear how broadly the exception could be interpreted," says Pinedo. "Some auditors believed that if there were one or two sales within a market an active market existed and assets therefore needed to be written down to reflect the prices at which the securities were bought and sold. Financial institutions often disagreed, believing that there was still value in their assets and that current market prices were indicative of distressed sales."

The US Securities Exchange Commission (SEC) was mandated by Section 133 of the Emergency Economic Stabilization Act of 2008 to conduct a study into fair value accounting. Its final report noted the ambiguity in the exception and requested guidance from the FASB, which oversees US GAAP, on how to determine when markets are inactive and if a transaction is forced or distressed. In response, on 17 March 2009, FASB issued draft proposals to improve guidance on fair value measurements. The final guidance issued on 2 April 2008 (FASB Staff Position (FSP) FAS 157-4) affirmed that regardless of the level of activity in the market, the objective of fair value accounting remains the same. Fair value in an inactive market should be based on the value of an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions (that is, in the inactive market).

The guidance also provides, among other things, a list of factors to consider when determining whether a market is not active. If the reporting entity determines, on the weight of the evidence, that there has been significant decrease in market volume or activity, then transactions or quoted prices may not be determinative of fair value and further analysis of the transactions or quoted prices is needed, and a significant adjustment may be necessary to estimate fair value.

The guidance does not specify how the price should be adjusted, but suggests that using multiple valuation methodologies may be appropriate. When weighting indications of fair value resulting from the use of multiple valuation techniques, the reporting entity should consider the reasonableness of the range of fair value estimates. The objective is to determine the point within that range that is most representative of fair value under current market conditions.

FSP FAS 157-4 also states that determining the price at which willing market participants would transact if there has been a significant decrease in the volume and level of activity for the asset or liability depends on the facts and circumstances and requires the use of significant judgment. The objectives and principles in FSP FAS 157-4 are the same that are currently used under IFRS (though the wording used is different). In practice, this new application guidance may not result in significant differences between IFRS and US GAAP.

Pinedo notes that while the guidance is helpful, it may not go far enough: "The valuation is still very subjective, so it may not give auditors sufficient comfort to use unobservable inputs if there is quoted market data available."

For further details of the proposals, see box, FSP FAS 157-4: when is a market inactive and a transaction distressed?

Under IFRS and US GAAP, a gain or loss arising from a change in the fair value of a financial asset or liability is recognised as follows:

Under capital adequacy regulations, financial institutions are required to maintain a certain amount of capital in comparison to their assets. If their assets fall in value, the amount of capital required to be maintained by the ratio should ensure that a bank has sufficient capital to absorb such losses and still repay its creditors and depositors. (For further background on capital adequacy requirements, see Practice note, Basel II: an overview).

Changes in fair value amounts where those gains or losses flow through the income statement are recognised in regulatory capital calculations. This is because assets in these categories are held with the intent to trade or sell them within a relatively short time period, at which time changes in their value will be realised as a gain or loss. Therefore, using their fair values in regulatory capital calculations is considered an accurate reflection of their effect on a bank's current financial position.

When the market value of an asset drops, this will affect the entity's capital adequacy ratio, and it may be required to sell off assets to meet regulatory capital requirements, or raise new capital, which is costly in the current environment.

"The interplay between fair value accounting and capital regulatory requirements is very sensitive," says Grider. "When the markets declined rapidly and fair values plunged, financial institutions were forced to sell assets to shore up their capital. This led to lower prices in the market, which then had the knock-on effect of decreasing the fair value of similar assets. This continuing downward pressure on pricing has led to the argument that fair value accounting in the current economic climate is procyclical – making a bad situation even worse."

According to Poole, fair value accounting is here to stay. "Fair value accounting did not cause the financial crisis, but it is clear that changes need to be made to financial instruments accounting. At the moment we have a lot of different government organisations and institutions investigating fair value accounting and there is a lot of political pressure to ease the strain that financial institutions are under. It's important not to buckle under that pressure, but rather take a long-term and measured approach to changes."