Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting OFFICE OF THE CHIEF ACCOUNTANT DIVISION OF CORPORATION FINANCE UNITED STATES SECURITIES AND EXCHANGE COMMISSION This is a report by the Staff of the U.S. Securities and Exchange Commission. The Commission has expressed no view regarding the analysis, findings, or conclusions contained herein. i TABLE OF CONTENTS Commonly-Used Abbreviations viii Executive Summary 1 I. Introduction 11 A. How this Study Fulfills the Statutory Mandate 11 1. Statutory Mandate 11 2. Context for this Study 11 3. Approach to this Study 12 4. Structure of this Study 14 B. The Financial Reporting Framework 15 1. Balance Sheet 16 2. Income Statement 17 3. Other Basic Financial Statements 18 4. Notes to the Financial Statements, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Other Disclosures 19 C. Other Considerations 20 1. Role of Accounting in Prudential Oversight 20 2. International Considerations 20 D. Background Information on Fair Value Accounting 22 1. Definition of Fair Value 22 a. U.S. GAAP 22 b. IFRS 23 2. Application of Fair Value Accounting 24 a. How Fair Value Impacts Accounting for Financial Instruments 25 i. U.S. GAAP 25 ii. IFRS 31 b. How Fair Value Impacts Accounting for Non-Financial Instruments 32 i. U.S. GAAP 32 ii. IFRS 33 3. Historical Context for Fair Value Accounting 34 4. Other Measurement Bases 38 a. Description of Other Measurement Bases 38 b. Consideration of Measurement Attributes 40 ii II. Effects of Fair Value Accounting Standards on Financial Institutions’ Balance Sheets 43 A. Methodology for Studying Effects of Fair Value Accounting Standards 43 B. Empirical Findings from this Study on Effects of Fair Value Accounting Standards 45 1. Assets 46 a. Significance of Assets Measured at Fair Value 46 i. Percentage of Assets Measured at Fair Value 46 ii. Percentage of Assets Measured at Fair Value through Income 49 iii. Distribution of Issuers by Percentage of Assets Measured at Fair Value 52 iv. Use of Fair Value Option 54 v. Comparison of Percentage of Assets Measured at Fair Value Before and After Adoption of SFAS No. 157 and SFAS No. 159 57 b. Nature of Assets Measured at Fair Value on a Recurring Basis 58 c. Classification of Assets in Fair Value Hierarchy 60 i. Fair Value Hierarchy Classification over Time 61 ii. Distribution of Issuers by Percentage of Assets Classified as Level 3 63 2. Liabilities 65 a. Significance of Liabilities Measured at Fair Value 65 i. Percentage of Liabilities Measured at Fair Value 65 ii. Distribution of Issuers by Percentage of Liabilities Measured at Fair Value 68 iii. Use of Fair Value Option 70 iv. Comparison of Percentage of Liabilities Measured at Fair Value Before and After Adoption of SFAS No. 157 and SFAS No. 159 72 b. Nature of Liabilities Measured at Fair Value on a Recurring Basis 74 c. Classification of Liabilities in Fair Value Hierarchy 75 i. Fair Value Hierarchy Classification over Time 75 ii. Distribution of Issuers by Percentage of Liabilities Classified as Level 3 78 3. Equity 79 a. SFAS No. 157 Adoption 79 b. SFAS No. 159 Adoption 82 c. Accumulated Other Comprehensive Income 84 iii 4. Income Statement 86 a. Recurring Fair Value Measurements 87 i. Recurring Mark-to-Market Adjustments 87 ii. Level 3 Fair Value Measurements 89 iii. Impact of Changes in Creditworthiness in Measuring Liabilities 91 b. Non-Recurring Fair Value Measurements (Impairments) 92 i. All Impairments 92 ii. Other-than-Temporary Impairments on Securities 93 iii. Goodwill Impairment 94 c. Key Income Statement Drivers Unrelated to Fair Value Measurements 94 d. Conclusions 95 III. Impact of Fair Value Accounting on Bank Failures in 2008 97 A. Methodology for Studying Bank Failures 97 B. Regulatory Framework Governing Bank Failures 99 1. Capital Adequacy Guidelines 99 2. Reported Capital Status for 2008 Failed Banks 101 C. How Fair Value Accounting Affects Reporting under U.S. GAAP for Banks 104 1. Aggregate Failed Banks < $1 Billion of Total Assets 105 2. Aggregate Failed Banks > $1 Billion, but < $10 Billion of Total Assets 107 3. Failed Banks > $10 Billion of Total Assets 109 a. Washington Mutual 109 b. IndyMac 111 c. Downey Savings and Loan 113 D. Interaction Between Regulatory Capital and U.S. GAAP 114 E. Analysis of Causes of Declines in Failed Bank Capital 117 1. Aggregate Failed Banks < $1 Billion of Total Assets 118 2. Aggregate Failed Banks > $1 Billion, but < $10 Billion of Total Assets 119 3. Failed Banks > $10 Billion of Total Assets 120 a. Washington Mutual 121 iv b. IndyMac 123 c. Downey Savings and Loan 125 F. Evaluation of the Circumstances Surrounding Each Bank Failure 125 1. Failed Banks < $1 Billion of Total Assets 126 2. Failed Banks > $1 Billion, but < $10 Billion of Total Assets 128 3. Failed Banks > $10 Billion of Total Assets 130 a. Washington Mutual 133 b. IndyMac 134 c. Downey Savings and Loan 135 G. Impact of Fair Value Accounting on Other Distressed Financial Institutions 136 IV. Impact of Fair Value Accounting on the Quality of Financial Information Available to Investors 139 A. Investor and User Views About the Use of Fair Value Measurements 139 1. Comment Letters and Other Public Statements 139 a. Representative Survey of Comment Letters 140 b. Other Public Statements 143 c. Observations 144 2. Common Themes in Individual Analyst Reports on Fair Value Measurements 145 B. Views Presented by Participants at Recent SEC Fair Value Roundtables 146 1. July 9 Roundtable 146 a. Usefulness of Fair Value and Related Disclosures in Current Market Conditions 146 b. Application of Fair Value Accounting 147 c. Market Behavior Effects of Fair Value Accounting 147 d. Impact of Non-Performance Risk on Fair Value of Liabilities 148 2. October 29 Roundtable 148 a. Usefulness of Fair Value Accounting 148 b. Market Behavior Effects of Fair Value Accounting 149 c. Application of Fair Value Accounting 149 d. Interaction with Regulatory Capital Requirements 149 e. Potential Changes to Financial Statement Presentation 150 3. November 21 Roundtable 150 a. Usefulness of Fair Value Information 150 b. Asset Impairment Guidance and Estimates of Fair Value 150 c. Financial Statement Presentation 151 d. Additional Disclosures 151 v C. Recent Advisory Committee Recommendations Related to Fair Value Measurements 151 D. Prior Published Staff Views on Fair Value Accounting 153 E. Abstract of Available Academic Studies Addressing the Impact of Fair Value Accounting on the Quality of Information Available to Investors 154 V. Process Used by the FASB in Developing Accounting Standards 157 A. Background and Mission 157 B. Governance and Structure 158 C. Standard-Setting Process 159 1. How Topics Are Added to the FASB’s Technical Agenda and Developed 160 2. Accessibility of Meetings 162 3. Public Exposure of Standards 162 4. Further Deliberation by the FASB 162 5. Statements of Financial Accounting Standards 163 6. Additional Due Process 163 a. Resource Groups 163 b. Other Due Process 163 7. Statements of Financial Accounting Concepts 164 8. Other Documents 164 9. Emerging Issues Task Force 165 10. Public Record 165 D. Recent Activities with Respect to FASB Governance and Process 165 E. FASB’s Interaction with the IASB 168 VI. Alternatives to Fair Value Accounting Standards 169 A. Impact of a Suspension of SFAS No. 157 169 B. Recent Proposals Regarding Measurement Attributes 172 vi 1. Broader Issues Related to Identifying Appropriate Measurement Bases 173 a. Past versus Current Values 175 b. Measurement Methods Within Past or Current Values 177 2. Concepts and Themes Underlying Recent Proposals 178 a. Theme 1 – Modify Fair Value (For Example, Return to Historical Cost) 179 b. Theme 2 – Modify What is Considered to be a Current Value Measure 186 C. Auditing Standards 188 VII. Advisability and Feasibility of Modifications to Fair Value Accounting Standards 191 A. Financial Reporting Responses to Global Economic Crisis 192 1. SEC Division of Corporation Finance “Dear CFO” Letters 192 2. SEC / FASB Staff Clarifications on Fair Value Measurements 192 3. IASB Expert Advisory Panel 192 4. IASB Fair Value Disclosures 193 5. IASB Amendments to IAS 39 and IFRS 7 193 6. Other-than-Temporary Impairment 193 7. Advisory Group on Financial Reporting Issues Arising from Global Economic Crisis 194 8. G-20 Summit on Financial Markets and the World Economy 194 9. FASB / IASB Roundtables on Global Financial Crisis 195 10. Proposed FASB Staff Position on Amendments to EITF Issue No. 99-20 195 11. Project on Disclosures for Certain Financial Instruments 195 12. FASB Project on Recoveries of Other-than-Temporary Impairments (Reversals) 196 B. Current Projects 196 1. Conceptual Framework Project 196 2. Financial Statement Presentation Project 197 a. Segregation of Activities 198 b. Reconciliation of Cash Flow to Comprehensive Income 198 c. Disaggregation of Assets / Liabilities Measured on Different Bases 198 3. Reducing Complexity in Reporting Financial Instruments 199 4. Insurance Contracts Project 199 5. IASB’s Fair Value Measurement Project 200 vii C. Recommendations and Related Key Findings 200 1. Recommendation – SFAS No. 157 Should Be Improved, but Not Suspended 200 2. Recommendation – Existing Fair Value and Mark-to-Market Requirements Should Not Be Suspended 201 3. Recommendation – Additional Measures Should Be Taken to Improve the Application of Existing Fair Value Requirements 202 4. Recommendation – The Accounting for Financial Asset Impairments Should be Readdressed 204 5. Recommendation – Implement Further Guidance to Foster the Use of Sound Judgment 205 6. Recommendation – Accounting Standards Should Continue to Be Established to Meet the Needs of Investors 206 7. Recommendation – Additional Formal Measures to Address the Operation of Existing Accounting Standards in Practice Should Be Established 206 8. Recommendation – Address the Need to Simplify the Accounting for Investments in Financial Assets 208 Appendices 211 A. Summary of Comment Letters Received as Input to this Study B. Participants in SEC Roundtables on Fair Value Accounting C. Illustration of Revised Financial Statement Presentation to Segregate Amounts by Measurement Attributes, as Proposed by CIFiR D. FASB and FAF Members (2008) viii Commonly-Used Abbreviations Act Emergency Economic Stabilization Act of 2008 AFS Available-for-Sale Agency Appropriate Federal Banking Agency Boards FASB and IASB CIFiR SEC Advisory Committee on Improvements to Financial Reporting Commission United States Securities and Exchange Commission EESA Emergency Economic Stabilization Act of 2008 EITF Emerging Issues Task Force FASB Financial Accounting Standards Board FDIC Federal Deposit Insurance Corporation FDICIA Federal Deposit Insurance Corporation Improvement Act of 1991 Federal Reserve Board of Governors of the Federal Reserve System FVO Fair Value Option FSP FASB Staff Position GAAP Generally Accepted Accounting Principles GSE Government Sponsored Enterprise and Similar Entities HFI Held-for-Investment HFS Held-for-Sale HTM Held-to-Maturity IAS International Accounting Standard IASB International Accounting Standards Board IFRS International Financial Reporting Standard(s) MD&A Management’s Discussion and Analysis of Financial Condition and Results of Operations MSR Mortgage Servicing Right OCC Office of the Comptroller of the Currency OCI Other Comprehensive Income OTS Office of Thrift Supervision OTTI Other-than-Temporary Impairment PCA Prompt Corrective Action PCAOB Public Company Accounting Oversight Board Sarbanes-Oxley Act The Sarbanes-Oxley Act of 2002 SEC United States Securities and Exchange Commission SFAC Statement of Financial Accounting Concepts SFAS Statement of Financial Accounting Standards SOP Statement of Position Staff Staff of the United States Securities and Exchange Commission TFR Thrift Financial Report Treasury Committee The Department of the Treasury’s Advisory Committee on the Auditing Profession [...]... 10 I Introduction A How this Study Fulfills the Statutory Mandate 1 Statutory Mandate The mandate for this study comes from the Emergency Economic Stabilization Act of 2008, which was signed into law on October 3, 2008 Section 133 of the Act mandates that the SEC conduct, in consultation with the Federal Reserve and the Secretary of the Treasury, a study on mark -to- market accounting standards as provided... Summary On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (“EESA” or the Act ) was signed into law.1 Section 133 of the Act mandates that the U.S Securities and Exchange Commission (the “SEC” or “Commission”) conduct, in consultation with the Board of Governors of the Federal Reserve System (“Federal Reserve”) and the Secretary of the Treasury, a study on mark -to- market accounting standards... http://www.sec.gov/spotlight/fairvalue.htm.) 14 value accounting and whether fair value accounting contributed significantly to their failures This section also discusses the impact of fair value accounting on other distressed financial institutions • Section IV of this study is “Impact of Fair Value Accounting on the Quality of Financial Information Available to Investors.” This section discusses the views of investors and other financial... standards Further, this section draws upon the analysis and findings of the previous sections of this study and develops a list of recommendations of additional measures to improve fair value accounting and the accounting for financial asset impairments B The Financial Reporting Framework21 The objective of financial reporting is to provide information useful to investors and creditors in their decision-making... before the end of the 90-day period beginning on the date of the enactment of this Act containing the findings and determinations of the Commission, including such administrative and legislative recommendations as the Commission determines appropriate.8 2 Context for this Study Over the last 12 to 18 months, the world economy has experienced economic conditions that have affected financial and non-financial... order of the sections in the legislative mandate, with one exception to facilitate organization: the section describing “Alternatives to Fair Value Accounting Standards” appears before the section describing “Advisability and Feasibility of Modifications to Fair Value Accounting Standards.” Specifically: • Section II of this study is “Effects of Fair Value Accounting Standards on Financial Institutions’... information available to investors; (4) the process used by the Financial Accounting Standards Board in developing accounting standards; (5) the advisability and feasibility of modifications to such standards; and (6) alternative accounting standards to those provided in such Statement Number 157.7 Section 133 of the Act also mandated that the Commission shall submit to Congress a report of such study. .. Value Accounting Standards This final section summarizes steps taken and underway to improve upon current accounting requirements This section also provides recommendations on the advisability and feasibility of modifications to existing accounting standards and related financial reporting requirements, which are discussed below B Recommendations The recommendations, and the observations leading to the. .. generally not contemplated in the remainder of this study The methodologies used by the Staff to gather and analyze data for Sections II - VII of this study are described in each of those sections Broadly, the Staff gathered information for this study through: (1) a review of publicly available financial and other information, (2) consultations with 14 Specifically, Section 3(5) of the Act defines “financial... information intended to provide readers with a common base of knowledge Each of the remaining six sections addresses one of the issues mandated for study The following highlights each of these six sections 5 Testimony of Timothy F Geithner, President and Chief Executive Officer, Federal Reserve Bank of New York, before the Committee on Banking, Housing and Urban Affairs of the United States Senate on Actions . Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark -To- Market Accounting OFFICE OF THE CHIEF. the Act ) was signed into law. 1 Section 133 of the Act mandates that the U.S. Securities and Exchange Commission (the “SEC” or “Commission”) conduct, in consultation with the Board of Governors. Committee The Department of the Treasury’s Advisory Committee on the Auditing Profession 1 Executive Summary On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (“EESA” or the