Securities and Fair-Value Accounting
Tim Krumwiede, Ryan M. Scadding, and Craig D. Stevens
MAY 2008 - Many
entities are in the process of implementing FASB’s recently
issued guidance on fair value, SFAS 157, Fair Value Measurements,
and SFAS 159, The Fair Value Option for Financial Assets and
Financial Liabilities—Including an Amendment of FASB Statement
No. 115. Proper implementation can require CPAs to exercise
professional judgment. This professional judgment is being put to
the test in the measurement of fair value for mortgage-backed securities
(MBS) because of significant declines in values and reduced levels
of trades resulting from the recent credit market crises. This article
illustrates the application of this professional judgment to MBSs
as well as a discussion on other-than-temporary impairments of MBSs
under SFAS 115, Accounting for Certain Investments in Debt and
Equity Securities. In addition to providing a primer on the
accounting treatment of MBSs, the discussion of SFAS 157 and SFAS
159 is expanded to help CPAs apply these standards in other situations.
of Federal Housing Enterprise Oversight (OFHEO), an independent
entity within the U.S. Department of Housing and Urban Development,
defines an MBS as “a security that represents an undivided
interest in a group of mortgages.” (See “Portfolio
Caps and Conforming Loan Limits,” Mortgage Market Note 07-1,
OFHEO, September 6, 2007.) Investors in these securities have
the right to receive future mortgage payments (interest and/or
principal). Payments on some MBSs are guaranteed by one of three
agencies: the Government National Mortgage Association (Ginnie
Mae), the Federal National Mortgage Association (Fannie Mae),
or the Federal Home Loan Mortgage Corporation (Freddie Mac). Ginnie
Mae is associated with the federal government and its guarantee
is backed by the full faith and credit of the government. Thus,
an MBS guaranteed by Ginnie Mae is considered a low credit risk.
(Although Fannie Mae and Freddie Mac were established by the federal
government, they are not government-funded.) MBSs backed by the
guarantee of Fannie Mae and Freddie Mac are generally considered
to be low risk.
MBSs are issued by private entities and are not guaranteed by
Fannie Mae, Freddie Mac, or Ginnie Mae. Accordingly, these MBSs
generally carry a greater credit risk than an MBS that has an
agency guarantee. In recent years, the issuance of non-agency
MBSs grew rapidly. For example, OFHEO estimates indicate that
non-agency MBSs issued comprised 19.7% of all MBSs issued in 2001
and 55.9% in 2006 (table 1 in the aforementioned article “Portfolio
Caps and Conforming Loan Limits”). In 2007, the trend started
to reverse; in the second quarter of 2007, non-agency MBSs issued
were 47.2% of the total MBSs issued.
common type of MBS is a pass-through security in which mortgages
with similar characteristics are pooled together and each investor
receives a pro- rata share of principal and interest. Other variations
of MBSs include a collateralized mortgage obligation (CMO), which
is formed when payments from a pool of mortgages are divided into
different bond classes known as tranches. The distinguishing feature
between the tranches is that each one represents a different maturity.
For example, if a security has four tranches, payments are made
to the bond class (tranche) with the shortest maturity. Once the
entire principal is paid on this tranche, payments are made to
the bond class with the next shortest maturity. The process continues
until all tranches are paid.
MBSs are a special variation of a CMO. With a strip, the claim
to the future principal and interest payments are separated into
two classes. Owners of the interest-only strip have claims to
the interest from the mortgage payments. Owners of the principal-only
strip have claims to the principal from the mortgage payments.
Interest paid on the interest-only strip is based on outstanding
principal. Accordingly, interest-only strips have a greater prepayment
risk than do other MBSs.
bonds, the price of an interest-only strip has a positive correlation
to interest rates. As interest rates decrease, prepayments will
increase, which in turn will reduce the interest payments and
the value of an interest-only strip. An interest-only strip can
act as a hedge against traditional bonds, whose prices are inversely
related to interest rates.
have seen non-agency institutions offer an increasing number of
MBSs that are collateralized by subprime mortgage loans. Subprime
loans are loans issued to borrowers with various suboptimal credit-risk
characteristics. Many of these loans were issued with a high loan-to-value
ratio (i.e., greater than 90%), were poorly collateralized, or
were issued with initial “teaser” interest rates that
eventually adjust to higher interest rates. Interest-rate adjustments
and other factors have resulted in delinquent mortgage payments
and subsequent foreclosures on homes. Continued construction of
new homes, foreclosed homes being placed on the market, and reduced
housing demand have resulted in a larger-than-normal number of
single-family homes for sale. In turn, property values in a number
of markets have started to decline, and many believe values will
continue to decline into the foreseeable future. All of these
factors have contributed to a decline in the value of many MBSs.
and housing problems have unfolded, so has the need to address
various subjective accounting provisions. First, because of the
dynamic credit-market environment, the illiquidity of many MBSs
backed by subprime loans has created another element of fair value
that needs consideration. Second, under the provisions of SFAS
115, it has become necessary to exercise judgment in determining
if the decline in value of certain MBSs is other-than-temporary.
Before addressing these two important issues, the authors will
discuss SFAS 159 and its relationship to SFAS 115.
115, MBSs are classified into one of three categories: trading
securities, held-to-maturity securities, or available-for-sale
securities. Pursuant to paragraph 14 of SFAS 140, Accounting
for Transfers and Servicing of Financial Assets and Extinguishment
of Liabilities, certain MBSs that are subject to substantial
prepayment risk, such as interest-only strips, cannot be classified
as held-to-maturity securities. Trading securities and available-for-sale
securities are reported at fair value on the balance sheet. Held-to-maturity
securities are reported at amortized cost. Unrealized holding
gains or losses are reported in net income for trading securities.
On the other hand, unrealized gains and losses on available-for-sale
securities are not included in the determination of net income;
instead, the gains or losses are recorded as a component of other
comprehensive income. An important exception exists for available-for-sale
and held-to-maturity securities that have experienced an other-than-temporary
decline in value. The exception, discussed below, requires that
the unrealized loss be reported in the determination of net income
rather than as a component of other comprehensive income.
option for financial assets provided for in SFAS 159 modifies
the rules of SFAS 115. If the election is made for a security
that would otherwise be classified under SFAS 115 as available-for-sale
or held-to-maturity, the security will be reported at fair value,
and unrealized gains and losses will be reported in net income.
Therefore, determination as to whether a decline in value is other-than-temporary
is not relevant where the SFAS 159 election is made.
election of SFAS 159 can be made for all securities, for a group
of identical securities, or on a security-by-security basis. The
election is made on the election date and is irrevocable unless
another election date occurs. Most important, an entity can make
the election on the adoption of SFAS 159 for financial assets
and liabilities owned or issued before that date (e.g., on January
1, 2008, for calendar year–end companies). Additionally,
the election can be made on a security when the security is purchased.
Paragraph 9 of SFAS 159 includes a complete list of triggers allowing
for an election. Once SFAS 159 is effective for an entity, the
effect of the first remeasurement to fair value will be reported
as a cumulative-effect adjustment to the opening balance of retained
earnings (para. 25).
is a concepts-based standard and its application should be consistent
with its underlying objective. Application of the standard to
“dress up” financial statements or obtain a desired
accounting result that is inconsistent with the standard’s
intent could easily draw the attention of the SEC and other regulators.
The objective of SFAS 159 (according to para. 1) is “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.”
by the AICPA’s Center for Audit Quality, auditors should
exercise appropriate professional skepticism for entities that
may attempt to apply the standard in a manner inconsistent with
its objective (“SFAS 159 Early Adoption Date Approaching—Factors
to Consider,” www.thecaq.org/newsroom/pdfs/CAQPressRelease_041807a.pdf,
April 17, 2007). For example, assume an entity holds MBSs that
are underwater and are classified as available-for-sale or held-to-maturity.
In the period adopted, the entity elects the fair-value option
for the MBSs, records the loss as a cumulative-effect adjustment
to the beginning balance of retained earnings, and in a later
period sells the MBSs. After the sale of the MBSs, the entity
reinvests the proceeds in other investments but does not elect
the fair-value option for these new investments. The totality
of these transactions could be construed as an attempt to avoid
loss recognition in the determination of net income and, accordingly,
be inconsistent with the objective of SFAS 159.
requirements may discourage entities from violating the intent
of the fair-value election. An entity must disclose its reasons
for electing the fair-value option. If a partial election is made,
an entity must disclose the reasons for the partial election.
recorded as available-for-sale or held-to-maturity, where the
fair-value option is not elected, the entity must perform an analysis
at each reporting period to determine whether a decline in fair
value below the amortized cost basis is other-than-temporary.
that are not of high credit quality, the first step is to analyze
the securities for impairment in accordance with EITF 99-20, “Recognition
of Interest Income and Impairment on Purchased Beneficial Interests
and Beneficial Interests That Continue to Be Held by a Transferor
in Securitized Financial Assets.” That guidance provides
that an other-than-temporary impairment should be considered to
have occurred if the “present value of the original cash
flows estimated at the initial transaction date (or the last date
previously revised) is greater than the present value of the current
estimated cash flows” (para. 12). If, as a result of this
analysis, an other-than-temporary impairment has been determined
to have occurred, then the security must be written down to fair
value with the resulting loss reported in the determination of
If an other-than-temporary
impairment has not been indicated as a result of this analysis
(i.e., EITF 99-20), the investor should still determine whether
the investment is other-than-temporarily impaired under other
relevant guidance (i.e., SFAS 115). This second step is more qualitative
than the analysis under EITF 99-20 and may require significant
management judgment. The impairment analysis described in SFAS
115 applies to all debt and equity securities that are within
the scope of that guidance, even if highly rated. SFAS 115 does
not provide a definition of “other-than-temporary”
impairment, but explains that the cost basis of the individual
security shall be written down to fair value when one has occurred.
The one example provided in SFAS 115 (para. 16) states, “If
it is probable that the investor will be unable to collect all
amounts due according to the contractual terms of a debt security
not impaired at acquisition, an other-than-temporary impairment
shall be considered to have occurred.”
Position (FSP) 115-1/124-1, “The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments,”
provides further guidance in analyzing an investment for other-than-temporary
impairment by breaking the analysis down into specific steps.
Nevertheless, no bright-line tests are available to help determine
whether an other-than-temporary impairment exists, and all available
facts and circumstances should be considered. The most specific
guidance comes from SEC Staff Accounting Bulletin (SAB) Topic
5.M, “Other Than Temporary Impairment of Certain Investments
in Debt and Equity Securities.” That guidance provides a
few examples of factors that indicate a decline is other-than-temporary:
length of the time and the extent to which the market value
has been less than cost;
b. The financial condition and near-term prospects of the issuer,
including any specific events which may influence the operations
of the issuer such as changes in technology that may impair
the earnings potential of the investment or the discontinuance
of a segment of the business that may affect the future earnings
c. The intent and ability of the holder to retain its investment
in the issuer for a period of time sufficient to allow for any
anticipated recovery in market value.
on Auditing Standards (SAS) 92 (AU section 332, para. 47) provides
further guidance on factors to consider, including:
value is significantly below cost and—
decline is attributable to adverse conditions specifically
related to the security or to specific conditions in an
industry or in a geographic area;
decline has existed for an extended period of time; and
does not possess both the intent and the ability to hold
the security for a period of time sufficient to allow for
any anticipated recovery in fair value.
security has been downgraded by a rating agency.
financial condition of the issuer has deteriorated.
have been reduced or eliminated, or scheduled interest payments
have not been made.
entity recorded losses from the security subsequent to the
end of the reporting period.
of guidance is geared toward providing indicators as to when a
write-down could be necessary. In contrast, SAB Topic 5.M, point
(c), focuses on when a write-down may not be needed. An enterprise
could claim that an investment is not other-than-temporarily impaired
if it represents it has the intent and ability to retain the investment
for a period of time sufficient for a recovery in market value.
The current tumultuous economic environment has led many companies
to use this justification as a way to avoid write-downs on some
MBSs. Managements are generally expected to document this intention
and their ability at the time the security is first determined
to be impaired, and to update that documentation on each reporting
date to ensure that their representations are still valid.
subprime crisis has resulted in the fair value of many securities
declining below their amortized cost. In certain cases, this might
be a result of temporary illiquidity in the markets rather than
an indication of a permanent decline in fair value. An investor
may have to analyze the severity and duration of these declines
to determine whether an impairment is other-than-temporary. Additionally,
other factors previously discussed, such as the intent and ability
of the investor to hold the securities for an extended period
of time in anticipation of a sufficient recovery in fair value,
should be considered.
understanding of the fair-value measurement and disclosure requirements
will be necessary for most investments in MBSs. Investment companies
measure fair value for all MBSs. Other companies measure and report
the fair value of an MBS held as an investment unless the MBS
is classified as held-to-maturity and the fair-value option of
SFAS 159 is not elected. SFAS 157 provides guidance in measuring
fair value and appropriate disclosures.
is effective for fiscal years beginning after November 15, 2007,
if not adopted early. Although FASB considered delaying the effective
date of this standard, on November 14, 2007, it issued a news
release rejecting any deferral of SFAS 157 for financial assets
and liabilities, although under FSP 157-2 a one-year deferral
would be provided for nonfinancial assets and liabilities as long
as these assets and liabilities are not reported at fair value
on a recurring basis.
of SFAS 157 is to provide a consistent framework for fair-value
measurement. Accordingly, the following discussion focuses on
the provisions of SFAS 157. For MBSs, fair-value measurements
under SFAS 157 will generally be similar to measurements of fair
value prior to the issuance of SFAS 157. Expanded fair value disclosures
are also required under SFAS 157. Entities that have not yet adopted
SFAS 157 are technically exempt from these disclosure requirements
until the standard is adopted and implemented. In its whitepaper
providing additional guidance on fair-value measurement for MBSs
and other assets, however, the CAQ suggests that entities using
unobservable inputs may wish to consider using disclosures similar
to those required in SFAS 157 [“Measurements of Fair Value
in Illiquid (or Less Liquid) Markets,” www.aicpa.org
October 3, 2007].
of Fair Value
(para. 5) defines fair value as “the price that would be
received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement
date.” This definition assumes an orderly transaction between
market participants. It further points out (para. 7) that “an
orderly transaction is a transaction that assumes exposure to
the market for a period prior to the measurement date …
it is not a forced transaction (for example, a forced liquidation
or distressed sale).”
uncertainty and decline in value of MBSs collateralized with subprime
mortgages, the question arises as to whether recent market prices
(when available) represent a true fair value, or a distressed
sale. For example, an investment company may be allowed to hold
only those debt securities that have a minimum credit rating.
Recently, the credit ratings for many MBSs have been downgraded
and, as a result, some investment companies may have been forced
to sell a security that was downgraded. If such a sale is made
into a market without significant liquidity, will the transaction
price represent fair value? Was the sale a distressed sale?
The CAQ whitepaper
addresses potential distressed sales at several points. First,
it is noted that a significant decrease in transaction volume
is not necessarily indicative of distressed sales. If transactions
are occurring, even at a reduced level, they are still market
transactions and “persuasive evidence is required to establish
that an observable transaction is a forced or distressed transaction”
(page 4). Because fair value is determined on the measurement
date, current market prices are the relevant prices even if volume
is thinner than normal.
of fair value assumes a transaction between market participants.
According to SFAS 157 (para. 10), market participants should be
independent of the reporting entity, knowledgeable, able to transact
for the asset or liability, and willing to transact in that they
are motivated but not forced to sell. Although the CAQ whitepaper
provides information on market participants, it does not explicitly
address how to distinguish between sellers who are forced to sell
and sellers who are not forced to sell.
of the fair-value definition is that an appropriate market must
be identified. SFAS 157 (para. 8) states that “the measurement
assumes that the transaction to sell the asset … occurs
in the principal market for the asset … or, in the absence
of a principal market, the most advantageous market.” Important
to note is that the principal market is not necessarily the most
advantageous market. Additionally, the principal market for one
entity could be different from the principal market for another
Related to Auditing Fair Value Measurements of Financial Instruments
and the Use of Specialists” (Staff Audit Practice Alert
2, December 10, 2007, www.pcaobus.org), which appears motivated
by factors related to MBSs, the Public Company Accounting Oversight
Board (PCAOB) emphasizes the importance of determining an entity’s
principal market when pricing services are used for fair-value
measurements The alert states that “a pricing service might
provide an amount for which a large financial institution could
sell the financial instrument. However, a company that owns that
financial instrument might not be able to transact in the same
market as a large financial institution. If the price available
to a large financial institution would not be available to the
company, then that price may not be an appropriate measure of
fair value under SFAS 157.”
(para. 18) provides three valuation techniques: the market approach,
the income approach, and the cost approach. One or more of these
approaches can be used for a single asset. The market approach
and the income approach are the most likely approaches to be used
for MBSs. With the market approach, prices and information from
market transactions for similar or identical assets are used (the
use of matrix pricing is a market approach). The income approach
uses present-value techniques to convert future amounts (cash
flows or earnings) to a single present value.
If one valuation
technique is better than another in estimating fair value, then
that should be the technique of choice. Additionally, if inputs
are more readily observed for one technique, then that should
be the technique given priority. However, multiple valuation techniques
can be combined to value an asset. Once a valuation technique
is chosen, it should be applied on a consistent basis among similar
assets and across reporting periods. If a change in technique
or mix of techniques is warranted because it becomes apparent
that a change will result in a better measure of fair value, then
the change is allowable. For example, assume a certain type of
MBS has typically been valued using a market approach, but the
liquidity of the market has decreased. A change in the valuation
technique may then be warranted. The change may simply be that
a decreased emphasis is placed on the market approach and an increased
emphasis is placed on the income approach. However, when observable
market transactions are available, they should at least be considered
in the valuation process. Whether the change is from one technique
to another, or is a change in the weighting placed on a technique,
the change should be accounted for as a change in accounting estimate
under SFAS 154 (SFAS 157, para. 20).
into Fair-Value Measurements
identifies the following hierarchy of inputs to be used in measuring
1 inputs are quoted prices (unadjusted) in active markets for
identical assets or liabilities. An active market for the asset
or liability is a market in which transactions for the asset
or liability occur with sufficient frequency and volume to provide
pricing information on an ongoing basis (para. 24).
2 are inputs other than quoted prices included within Level
1 that are observable for the asset or liability, either directly
or indirectly (para. 28).
3 are unobservable inputs for the asset or liability. Unobservable
inputs shall be used to measure fair value to the extent that
observable inputs are not available, thereby allowing for situations
in which there is little, if any, market activity for the asset
or liability at the measurement date (para. 30).
should be given to Level 1 inputs. If Level 1 inputs are not available,
preference should be given to other observable inputs (Level 2)
over unobservable inputs (Level 3). Even when market activity
for an MBS is at a reduced volume, if price quotes and observable
transactions by market participants are available for identical
MBSs, then Level 1 inputs should be used. For some MBSs, however,
quoted prices from an active market may not be available. In this
case, Level 2 or Level 3 inputs may be necessary.
Level 2 inputs
would include quoted prices for similar assets in active markets
or quoted prices for identical or similar assets traded in markets
that are not active. For example, the uncertainty surrounding
default rates and real estate values may result in a situation
where identical or similar MBS pricing information is not current
or is highly volatile. In such a situation, observed prices could
be Level 2 inputs or possibly Level 3 inputs. The CAQ whitepaper
(page 5) provides another example of the use of an observable
input suggesting that “the pricing indicated by the ABX
credit derivative index for subprime mortgage bonds may be a Level
2 input when used as an input to the valuation of a security backed
by subprime mortgage loans.”
The use of
Level 3 inputs is necessary when observable inputs are not available.
For MBSs, this could happen when very little or no market activity
is observed for identical or similar assets at the measurement
date. In using Level 3 inputs, SFAS 157 (para. 30) indicates that
“the fair-value measurement objective remains the same,
that is, an exit price from the perspective of a market participant
that holds the asset.” Assumptions
in a model used to measure fair value should take into account
assumptions that market participants would make in pricing an
asset if the information can be obtained without undue cost and
environment of foreclosures, defaults, and uncertain real estate
values suggests increased risk and uncertainty of future cash
flows for investors holding MBSs. Accordingly, measuring risk
for some MBSs may have become more difficult. FASB’s Concepts
Statement 7 (para. 62) suggests that a fair-value measurement
should include a risk premium if the risk adjustment is identifiable,
measurable, and significant. However, SFAS 157 clarified that
a risk premium should be incorporated into fair-value estimates
if a market participant would include one, even if the measurement
of risk is difficult. Accordingly,
an appropriate risk premium should be incorporated into models
used to measure the fair value of MBSs.
in a model to measure the fair value of subprime-related MBSs
could include estimated default rates, prepayment rates, and discount
rates. The fair value of an MBS would be more accurate to the
extent that some of these inputs can be observed in market transactions.
The CAQ whitepaper (page 7) suggests that a model could be tested
by applying it to similar securities for which pricing information
is available. If the model reflects current assumptions of market
participants, it should approximate the market price.
fair-value measurements based on the use of unobservable inputs
(Level 3) requires the exercise of significant professional judgment.
Consistent with the subjectivity of these measurements, extensive
disclosures are required by SFAS 157 (see paras. 32–35).
Among other disclosures, entities must disclose the levels (1,
2, or 3) in which inputs to fair-value measurements fall. Because
Level 3 inputs are the most subjective, the additional information
disclosed about Level 3 inputs must enable the reader of the financial
statements to assess how the inputs affect the fair-value measurement.
The disclosures should provide users of financial statements with
the ability to assess the reliability of fair-value measurements.
Krumwiede, PhD, CPA, is an associate professor of accounting
and Ryan M. Scadding is a graduate student, both
at Bryant University, Smithfield, R.I.
Craig D. Stevens, CPA, is a senior manager in regulatory
and capital markets consulting at Deloitte & Touche LLP.