Financial Accounting Standard 157 is the new accounting rule that applies to corporations, investment managers, private equity managers and banks. In a nutshell, FAS 157 requires assets held on the balance sheet for investment or trading purposes to be marked to market value and the changes in the asset value to be charged against or added to current earnings. Adopted in 2007 by the Financial Accounting Standards Board, it applies to all companies with a fiscal year of 2008. It will also apply to the fair value of corporate pension plan assets under FAS 132(r) for corporate fiscal years beginning after Dec. 15, 2009.
However, in April, the FASB decided to add a little accounting alchemy of its own when it changed the rules of FAS 157 primarily to help out the banking industry. In short, the FASB altered the application of FAS 157 to lessen the need for banks to take an earnings hit when toxic assets on their balance sheet run into trouble.
The key change revolves around the language other than temporarily impaired. If an asset gets that designation, it triggers a write-down that must be charged to the income statement of the bank. However to avoid this classification, all that bank management now has to do is to assert that (1) the bank does not have the intent to sell the security; and (2) it is more likely than not that the bank will not have to sell the security before recovery of its cost basis. This allows recognition of the potential losses associated with toxic assets to be delayed.
As the wording above indicates, the FASB gave banks considerable judgment as to when they decide to write down the value of some of their toxic assets. The FASB also created a second out for banks and other companies. Banks can also ignore market prices in the valuation of their balance sheet securities when the observed market transactions are not orderly.
A disorderly market is one where the market is not active, and where the market price results from a distressed transaction. With respect to the level of market activity, the FASB leaves this to the judgment of the reporting entity to determine whether a market is active. Furthermore, in an inactive market, the FASB allows the presumption that any transaction is distressed. To overcome this presumption, bank managers, who have an incentive not to disclose bad news, would have to make the extra effort to generate additional information regarding the circumstances of the transaction to prove that it was not distressed to be able to use the information in valuing their own securities. This is not likely to happen.
Why did the FASB make these changes? It came under pressure from U.S. lawmakers, who threatened to enact legislation if the board did not comply with their wishes.