A new FASB Staff Position proposes a 2-step test to determine whether a market is not active. This will hardly satisfy those who think firms shouldn’t have to use fair value accounting for the assets in question in the first place.  But for those who are simply complaining that market prices are ‘fire sale’ prices, it does seem to give enough guidance to allow preparers and auditors to justify using Level 3 inputs (management estimates of discounted cash flows coming from holding the assets) for the mortgage-backed securities that largely triggered the concern.

Any thoughts as to whether this is in time for firms that should be filing 10-Ks imminently.  Can they rely on the unapproved guidance?  Do they already have their market-to-model calculations done, and just needed to be able to justify their use?  In any event, there should be some interesting opportunities for empirical research when the 2008 financials become available in machine-readable form. Any guesses on how much variation we will see in the application of the rule, or (assuming most firms mark to model) in the valuation assumptions themselves?

Read on to see the 2-step test itself.

Step 1 provides factors that indicate that a market is not active. Those factors should not be considered all inclusive because other factors may also indicate that a market is
not active. Factors include:

  • Few recent transactions (based on volume and level of activity in the market).
  • Thus, there is not sufficient frequency and volume to provide pricing information on an ongoing basis.
  • Price quotations are not based on current information.
  • Price quotations vary substantially either over time or among market makers
  • (for example, some brokered markets).
  • Indexes that previously were highly correlated with the fair values of the asset
  • are demonstrably uncorrelated with recent fair values.
  • Abnormal (or significant increases in) liquidity risk premiums or implied yields
  • for quoted prices when compared with reasonable estimates (using realistic
  • assumptions) of credit and other nonperformance risk for the asset class.
  • Abnormally wide bid-ask spread or significant increases in the bid-ask spread.
  • Little information is released publicly (for example, a principal-to-principal
  • market).

12. After evaluating all factors and considering the significance and relevance of each factor, the reporting entity shall use its judgment in determining whether the market is active.
13. If the reporting entity concludes in step 1 that the market for the asset is not active, then the reporting entity will proceed to step 2. In step 2, the reporting entity must presume that a quoted price is associated with a distressed transaction unless the reporting entity has evidence that (a) there was sufficient time before the measurement date to allow for usual and customary marketing activities for the asset and (b) there were multiple bidders for the asset.