The Securities and Exchange Commission and the Financial Accounting Standards Board jointly issued a release last week to respond to the current crisis in the financial markets.

Contrary to what some seem to believe, the S.E.C./F.A.S.B. release does not do away with or otherwise change the F.A.S.B.'s guidelines for determining fair value in Statement of Financial Accounting Standards No. 157 that went into effect for many companies just this year.

Rather, the S.E.C./F.A.S.B. release affirms the objective of fair value, even when used for illiquid assets, and clarifies how companies should apply the new guidelines when determining the fair value of mortgage-backed securities or other assets in markets that are no longer active.

In particular, the S.E.C./F.A.S.B. release clarifies that when determining fair value, companies should focus on the relevance of the pricing information that is currently available. The new guidelines actually help assess the relevance of pricing information because F.A.S. 157 establishes a hierarchy that puts that information into one of three levels to convey the relative reliability and relevance of the asset fair values. F.A.S. 157 also requires companies to disclose the asset fair values by level in the hierarchy.

Level 1 assets have directly observable market prices in active markets, like stocks traded on major exchanges. Valuing Level 2 assets, including derivatives, isn't as straightforward, but can be done by looking at other observable market information. Level 3 assets are those for which there is no active market; and pricing them can be a more involved process that relies on the holder's forecasts of expected cash flows based on its own market assumptions.

The S.E.C./F.A.S.B. release notes that although these levels were not intended to establish "bright lines" for the valuation, companies must consider all available information in the valuation. Companies cannot, for example, arbitrarily choose to ignore Level 2 pricing information that is available and immediately default to Level 3 pricing information.

But when markets are no longer active, as appears to be the case now for many assets, there might be some circumstances in which Level 3 pricing information is more relevant than the Level 2 pricing information available in those markets and should be used for the valuation.

These circumstances might be indicated when significant adjustments are made to Level 2 pricing information. For example, companies may well need to make significant adjustments to arrive at a reasonable estimate of what a current market price would be for the asset that is being fair-valued when Level 2 pricing information represents prices in disorderly (so-called fire-sale) transactions, broker quotes that are based on models that use information available only to the broker, or other market quotes that are merely indicative bids.

As a follow-up to the S.E.C./F.A.S.B. release, the F.A.S.B. issued for public comment a proposal called "Determining the Fair Value of a Financial Asset in a Market That Is Not Active." The proposal would illustrate how the new guidelines might apply in more specific circumstances.

(The deadline to comment on the proposal is this Thursday, October 9; the F.A.S.B. plans to hold a meeting on Friday to discuss the comments and vote on a final document so it can be used by companies in preparing their third-quarter financial statements.)

At the same time, the Emergency Economic Stabilization Act of 2008—the $700 billion package passed by Congress and signed into law by President Bush on Friday—contains a provision that restates the S.E.C.'s authority to suspend F.A.S. 157 if the S.E.C. determines that "it is necessary or appropriate in the public interest and is consistent with the protection of investors."

Further, amid calls to suspend fair value accounting to put an end to more asset impairments, Representative Spencer Bachus, Republican of Alabama, has asked Barney Frank, chairman of the House Financial Services Committee, to convene hearings on fair-value accounting and the need for reforms to F.A.S. 157.

It is worth noting that F.A.S. 157 is not the reason that in today's markets many assets are impaired. Further, F.A.S. 157 does not require any assets to be recorded at fair value, whether on an ongoing basis (so-called "mark-to-market" accounting) or when impaired.

The fair-value concept was established long before F.A.S. 157 and was referred to in more than 60 of the authoritative pronouncements that were being used by companies when F.A.S. 157 arrived. Many of those pronouncements contained guidelines for determining fair value that were similar to the guidelines in F.A.S. 157 but that were replaced by the new guidelines to improve consistency in application.

With that, conventional wisdom tells us that suspending F.A.S. 157 alone would not do away with fair-value accounting. Fair-value accounting would still be used—but without the new guidelines for determining fair value and without the new disclosures about fair value, which could add to, not reduce, the confusion that currently exists over what fair value is and what fair value means when used in financial reporting today.

The fair-value debate seems certain to continue, having potential implications for the fate of F.A.S. 157. But for now, F.A.S. 157 is holding. So in preparing their financial statements, companies should plan to continue to use the new guidelines (as clarified) for the fair values that are either required or permitted under other authoritative pronouncements.

The views expressed in the article are held by the author and are not necessarily representative of FTI Consulting.

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