Conclusions and Outlook
Annex 2.1. The World According to GAAP
Note: Kenneth Sullivan prepared this annex.
The International Accounting Standards Board promulgates the IFRS and the Financial Accounting Standards Board promulgates the U.S. GAAP. IFRS applies to all European Union/
European Economic Area companies with listed securities, while U.S. GAAP, combined with SEC regulations, governs all U.S. companies.28 This annex will focus on accounting standards for valuing structured fi nance products and for the treatment of OBSEs. In both cases, the U.S.
GAAP and IFRS treatments are substantially the same, but there are some subtle differences. The standards FAS 157 and IFRS 7, which elaborate the disclosures for fi nancial instruments, are new to their respective frameworks and at the end of 2007 disclosures under these standards were only made by early adopters that included most major fi nancial entities.
FAS 157 defi nes fair value as “…the price that would be received to sell an asset or paid
28A number of countries rely on their respective national accounting standards, which may differ from both IFRS and U.S. GAAP. These are not considered in this chapter.
to transfer a liability in an orderly transaction between market participants at the measure- ment date.”29 FAS 157 recognizes fair value as an exit value from a sale, while currently IFRS is less prescriptive.
In determining fair value, both IFRS and U.S. GAAP prescribe a hierarchy of fair value methodologies starting with observable prices in active markets and moving to a mark-to- model in which some of the material inputs are unobservable. However, only FAS 157 requires disclosure of a formal three-level classifi cation of all fi nancial instruments in the fi nancial state- ments. “Level-one” valuation requires observable prices for the same instrument in liquid mar- kets. When observable prices are unavailable for the valuation date, “level-two” valuation allows the use of prices on nearby dates, or the use of arbitrage-type valuation models that use the observable prices of other fi nancial instruments.
For example, such a model might value a CDO tranche on the basis of credit spreads or implied correlations of similar CDO tranches. For instruments for which level-one and level-two valuations inputs are not available, “level three”
allows the use of theoretical valuation models that use as inputs various relevant fundamental parameters. For example, an MBS valuation might be based on estimated or market-implied delinquency and foreclosure rates, and loss severities. This makes valuation of level-three assets highly dependent on, and sensitive to, the model’s assumptions. FAS 157 requires disclo- sures of information concerning changes to the levels of and valuation methodologies for level- three assets. These include:
• A reconciliation of opening and closing balances with a disclosure of total gains and losses and where they are reported in earn- ings (income statement or other comprehen- sive income), along with all changes in stocks, including transfers in and out from other levels.
• For the annual statements, the disclosure of valuation techniques used to measure fair
29FAS 157, paragraph 5, “Defi nition of Fair Value.”
ANNEX 2.1. THE WORLD ACCORDING TO GAAP
value and any changes in techniques in the period.
While IFRS require disclosure of valuation assumptions, they do not have a classifi cation framework like FAS 157.
Neither U.S. GAAP nor IFRS prevent a fi rm from changing the method for calculating an asset’s fair value over its life. Changes in market conditions may move assets from a level two to three classifi cation, or vice versa, as fi rms assess the availability and integrity of market data with regard to the valuation of their assets.
While the market-to-model valuation tech- nique accepts the use of unobservable inputs, it still requires the use of those valuation assump- tions commonly used by “market participants”
in determining an exit price for the instrument.
This means using information regarding market participant assumptions that is reasonably avail- able without undue effort and cost. In cases where an active market no longer operates, entities must take account of any information that provides evidence of fair value, whether it be liquidity premia or credit spreads. For example, if the liquidity spreads are deemed to be so extreme as to not represent an orderly transaction, entities may still gain measures of credit risk on their structured products through reference to the prices of similar instruments such as ABX indices to value MBS. This provides a means of estimating the appropriateness of an asset’s valuation. While the index is imprecise, it may be a better measure of the underlying creditworthiness of an instrument, as it is less affected by the liquidity risks priced into traded instruments. As discussed in the body of the main text, the major audit fi rms have reached a general consensus for determining an “orderly transaction” under current market conditions.
IFRS and U.S. GAAP both require disclosures of risk management issues relating to fi nancial instruments, but IFRS 7 requires more extensive disclosures relating to liquidity risks and sensitiv- ity analysis. SEC regulations prescribe additional disclosures outside of U.S. GAAP as part of statu- tory periodic reporting, resulting in differences in the overall disclosure frameworks.
Both frameworks differ in their account- ing for the treatment of securitization-related OBSEs such as asset-backed commercial paper conduits and SIVs. Both require balance sheet consolidation on the basis of control or if the sponsoring entity absorbs the majority of the expected risks and benefi ts, including provision of liquidity support. U.S. GAAP defi ne control as more than 50 percent of rights, while IFRS have a test of effective control that can be less than 50 percent. U.S. GAAP describe variable interest entities, which are open-ended OBSEs, and qualifying special-purpose entities, which have a defi ned termination. IFRS defi ne special- purpose entities. Each framework provides tests to determine the level of control or balance of risks and rewards that will trigger consolidation.
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