Will Fair Value Fly?

Fair-value accounting could change the very basis of corporate finance.

More than any other regulatory change, fair value promises to end the practice of earnings management. That’s because a company’s earnings would depend more on what happens on its balance sheet than on its income statement (see “The End of Earnings Management?” at the end of this article).

But switching from historical cost would require enormous effort from overworked finance departments. Valuing assets in the absence of active markets could be overly subjective, making financial statements less reliable. Linsmeier’s confidence notwithstanding, disputes could arise over the very definition of certain assets and liabilities. And using fair value could even distort a company’s approach to deal-making and capital structure.

A Familiar Concept

Fair value is by no means unfamiliar to corporate-finance executives, as current accounting rules for such items as derivatives (FAS 133 and 155), securitizations (FAS 156), and employee stock option grants (FAS 123R) use it to varying degrees when recording assets and liabilities. So does a proposal issued last January for another rule, this one for accounting for all financial instruments. FASB’s more recent proposals to include pensions and leases on balance sheets also embrace fair-value measurement (see “Be Careful What You Wish For” at the end of this article).

While both Herz and Linsmeier are careful to note that they don’t necessarily favor the application of fair value to assets and liabilities that lack a ready market, they clearly advocate its application where there’s sufficient reason to believe the valuations are reliable. Corporate accounting, Herz says, is the only major reporting system that doesn’t use fair value as its basis, and he points to the Federal Reserve’s use of it in tracking the U.S. economy as sufficient reason for companies to adopt it.

The corporate world, however, must grapple with its own complexities. For one, fair value could make it even more difficult to realize value from acquisitions. Take the question of contingent considerations, wherein the amount that acquirers pay for assets ultimately depends on their return. Under current GAAP, the balance-sheet value of assets that are transferred through such earnouts may reflect only the amount exchanged at the time the deal is completed, because the acquirer has considerable leeway in treating subsequent payments as expenses.

Under fair value, the acquirer would also include on its balance sheet the present value of those contingent payments based on their likelihood of materializing. Since the money may never materialize, some finance executives contend those estimates could be unreliable and misleading. “I disagree with [this application of fair value] on principle,” James Barge, senior vice president and controller for Time Warner, said during a conference on financial reporting last May.

Barge cites the acquisition of intangible assets that a company does not intend to use as a further example of fair value’s potentially worrisome effects. Under current GAAP, their value is included in goodwill and subject to annual impairment testing for possible write-off. But if, as FASB is contemplating, the value of those assets would be recorded on the balance sheet along with that of the associated tangible assets that were acquired, Barge worries that an immediate write-off would then be required — even though it would not reflect the acquiring company’s economics.

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