Simplifying Accounting Is No Simple Task

A recent FASB proposal allowing fair value measurement is too complicated, say critics who normally support such measures.

In an exchange that highlights some of the challenges facing the Financial Accounting Standards Board’s drive to reduce accounting complexity, experts from Standard and Poor’s have said one of FASB’s latest proposals is likely to create more confusion.

In January, FASB proposed giving companies the choice of using fair value accounting when booking certain financial assets and liabilities, rather than historic cost accounting or other methods. The proposal, an expansive amendment of FAS 115 (Accounting for Certain Investments in Debt and Equity Securities), would, in many cases, allow companies to avoid using the complex and often cumbersome hedge accounting provisions of FAS 133. It would also reduce earnings volatility caused by instruments that don’t qualify for FAS 133 treatment.

Under current accounting, financial instruments purchased as hedges often are reported at their historic cost, even as companies report the hedged item at fair value. The resulting mismatch in values can cause earnings to fluctuate over the life of the hedge, even if the hedge ultimately proves effective. But if the fair value of both the financial instrument and the item it is intended to hedge are reported on the balance sheet and any changes in both flow through income, as FASB proposes, the two items would offset each other. And the more effective the hedge, the smaller the resulting impact on earnings would be.

That proposal would seem to be representative of FASB Chairman Robert Herz’s public push to reduce complexity in financial accounting. Not only would it simplify, or eliminate, hedge accounting in many cases, it would also move U.S. generally accepted accounting principles (GAAP) closer to International Accounting Standards (which already provide such an option). The proposal’s reliance on fair value measurements is also a hallmark of Herz’s anti-complexity effort.

But the first phase of the two-step proposal doesn’t go far enough, says Neri Bukspan, chief accountant for S&P. Bukspan, and his colleague, Joyce Joseph-Bell, who co-authored S&P’s 11-page comment letter, support the use of fair value accounting. Like other proponents of fair value —including FASB itself — Bukspan says fair value offers a better gauge of true market value than historic cost. Yet Bukspan and Joseph-Bell raise several thorny issues related to the practical application of FASB’s proposal.

For example, S&P argues against the proposal’s “mixed attribute” framework, which increases the potential for unexplained balance sheet mismatches between connected assets and liabilities.

Bukspan offers a hypothetical example to illustrate the potential mismatch. Under the pending rule, an oil company has the choice of recording a debt obligation (a financial liability) using either cost- or fair-value accounting, but is limited to using cost accounting to record a new oil reserve discovery (a non-financial asset). If the company is inconsistent regarding which accounting treatment it uses to book the reserves’ effect on the debt obligation, analysts would be left scratching their heads, hunting for a balance sheet match between the asset and liability, says Bukspan.

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