Will Fair Value Fly?

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

Fair value’s defenders say such concerns are misplaced. The possibility that a contingent consideration won’t materialize, for starters, is already reflected in an acquirer’s bid, says Patricia McConnell, a Bear Stearns senior managing director who chairs the corporate-disclosure policy council of the CFA Institute, a group for financial analysts. “It’s in the price,” she says.

As for intangibles that are acquired and then extinguished, the analyst says a write-off would not in fact be required under fair value if the transaction strengthens the acquirer’s market position. That position would presumably be reflected in the value of the assets associated with those intangibles as recorded on the balance sheet under fair-value treatment.

“It may be in buying a brand to gain monopolistic position that you don’t have an expense,” McConnell explains, “but rather you have the extinguishment of one asset and the creation of another.” Yet McConnell, among others, admits that accounting for intangibles is an area that would need improvement even if FASB adopted fair value.

Deceptive Debt?

Another area of concern involves capital structure, with Barge suggesting that fair value may make it more difficult to finance growth with debt. He contends that marking a company’s debt to market could make a company look more highly exposed to interest-rate risk than it really is, noting during the May conference that Time Warner’s debt was totally hedged.

Barge also cited as problematic the hypothetical case of a company whose creditworthiness is downgraded by the rating agencies. By marking down the debt’s value on its balance sheet, the company would realize more income, a scenario Barge called “nonsensical.” He warned of a host of such effects arising under fair value when a company changes its capital structure.

Proponents find at least some of the complaints about fair value and corporate debt to be misplaced. Herz notes fair value would require the company to mark the hedge as well as the debt to market, so that if a company is hedging interest-rate risk effectively, its balance sheet should accurately reflect its lack of any exposure.

What’s more, fair value could also improve balance sheets in some cases. When, for instance, a company owns an interest in another whose results it need not consolidate, the equity holder’s proportion of the other company’s assets and liabilities is currently carried at historical cost. If, however, the other company’s assets have gained value and were marked to market, the equity holder’s own leverage might decrease.

A real-life case in point: If the chemical company Valhi marked to market its 39 percent stake in Titanium Metals, Valhi’s own ratio of long-term debt to equity would fall from 90 percent (at the end of 2005) to 56 percent, according to Jack T. Ciesielski, publisher of The Analyst’s Accounting Observer newsletter.

Still, even some fair-value proponents share Barge’s concern about credit downgrades. As Ciesielski, a member of FASB’s Emerging Issues Task Force, wrote last April in a report on the board’s proposal for the use of fair value for financial instruments, it is “awfully counterintuitive” for a company to show rising earnings when its debt-repayment capacity is declining.

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