Will Fair Value Fly?

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

Editor’s Note:

On Friday, The Financial Accounting Standards Board issued additional guidance to help corporations and accounting firms measure assets and liabilities using the fair value method of accounting. The new rule, known as FAS No. 157, affects over 40 existing accounting standards—including those used to value stock options (FAS 123) and derivatives (FAS 133)—but does not expand the use of fair value to any new circumstances, said FASB in a press statement.

Two weeks ago, deputy editor Ron Fink published a story in CFO magazine that anticipated the issuance of FAS 157, provided practical analysis of the subject, and included a discussion of whether standards, and a standards-setting body, is now needed in the asset valuation industry. Here’s the full text of that story.

Much has changed in financial reporting since Andrew Fastow and Scott Sullivan, the finance chiefs of Enron and WorldCom, respectively, brought disgrace upon themselves, their employers, and, to a degree, their profession. Regulators and investors have pressed companies to be more open and forthcoming about their results — and companies have responded. According to a new CFO magazine survey, 82 percent of public-company finance executives disclose more information in their financial statements today then they did three years ago. But that positive finding won’t quell calls for further accounting reform.

The U.S. reporting system “faces a number of important and difficult challenges,” Robert Herz, chairman of the Financial Accounting Standards Board, told the annual conference of the American Institute of Certified Public Accountants in Washington, D.C., last December. Chief among those, said Herz, is “the need to reduce complexity and improve the transparency and overall usefulness” of information reported to investors.

Critics contend that generally accepted accounting principles (GAAP) remain seriously flawed, even as companies have beefed up internal controls to comply with the Sarbanes-Oxley Act. “We’ve done very little but play defense for the last five to six years,” charges J. Michael Cook, chairman and CEO emeritus of Deloitte & Touche LLP. “It’s time to play offense.”

Cook, a respected elder statesman in the accounting community, goes so far as to pronounce financial statements almost completely irrelevant to financial analysis as currently conducted. “The analyst community does workarounds based on numbers that have very little to do with the financial statements,” says Cook. “Net income is a virtually useless number.”

How can financial statements become more relevant and useful? Many reformers, including Herz, believe that fair-value accounting must be part of the answer. In this approach, which FASB increasingly favors, assets and liabilities are marked to market rather than recorded on balance sheets at historical cost. Fair-value accounting, say its advocates, would give users of financial statements a far clearer picture of the economic state of a company.

“I know what an asset is. I can see one, I can touch one, or I can see representations of one. I also know what liabilities are,” says Thomas Linsmeier, a Michigan State University accounting professor who joined FASB in June. On the other hand, “I believe that revenues, expenses, gains, and losses are accounting constructs,” he adds. “I can’t say that I see a revenue going down the street. And so for me to have an accounting model that captures economic reality, I think the starting point has to be assets and liabilities.”

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.

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.

Herz and other fair-value proponents disagree, noting that the income accrues to the benefit of the shareholders, not to bondholders. “It’s not at all counterintuitive,” asserts Rebecca McEnally, director for capital-markets policy of the CFA Institute Centre for Financial Market Integrity, citing the fact that the item is classified under GAAP as “income from forgiveness of indebtedness.” But Ciesielski says investors are unlikely to understand that, and that fair value, in this case at least, may not produce useful results.

Resolving the Issues

Even some of FASB’s critics agree, however, that the current system needs improvement, and that fair value can help provide it. “Fair value in general is more relevant than historical cost and can lead to reduced complexity and greater transparency,” Barge admits, though he has noted that the use of fair value may also lead to “soft” results that “you can’t audit.”

For much the same reason, Colleen Cunningham, president and CEO of Financial Executives International (FEI), expressed concern in testimony before Congress last March that “overly theoretical and complex standards can result in financial reporting of questionable accuracy and can create a significant cost burden, with little benefit to investors.” In an interview, she explains that her biggest concern is that FASB is pushing ahead with fair-value-based rules without sufficient input from preparers. “Let’s resolve the issues” before proceeding, she insists.

Herz concedes that numerous issues surrounding fair value need to be addressed. But important users of financial statements are pressing him to move forward on fair value without delay. As a comment letter that the CFA Institute sent to FASB put it: “All financial decision-making should be based on fair value, the only relevant measurement for assets, liabilities, revenues, and expenses.”

Meanwhile, Herz isn’t waiting for the conceptual framework to be completed before enacting new rules that embrace fair value. “In the end, we’re not going to get everybody agreeing,” Herz says. “So we have to make decisions” despite lingering disagreement.

Ironically, one fair-value-based proposal that FASB issued recently may have created an artful means of defusing opposition. The Board’s proposal for financial instruments gives preparers of financial reports the choice of using historical cost or fair value in recording the instruments on their balance sheets. That worries some people, who say giving companies a choice of methods will make it harder to compare their results, even when they’re in the same industry.

By providing such an option, however, Herz may have, unwittingly or not, come up with an effective means of short-circuiting opponents’ attacks. What, after all, can be their gripe about the use of fair value if FASB lets them opt out of such rules? “I think this actually might be a good way for FASB to get things done,” says Ciesielski. “If they were going to mandate that all use it, there’d be stalling forever. Offering companies the option will give those that look good under it an incentive to do it — and the others might have to get on the stick.”

Critics note that such tactics wouldn’t be necessary if there were more demand for the use of fair value from users of financial statements. The CFA Institute’s passionate support notwithstanding, FEI’s Cunningham contends “there isn’t a lot of demand for [fair value] among working analysts.” Herz disputes that, noting that FASB’s user group, a committee of analysts and investors, has thrown its full support behind fair value. But Cunningham says there may be less to that than meets the eye, since analysts tend to view their ferreting out of such information from footnotes and off-balance-sheet activities as a competitive advantage. Who would need analysts if financial results were as simple and transparent as Herz wants?

The debate is likely to come down to whether the costs involved in applying fair value are worth the benefits. Here again, corporate-finance executives sharply disagree with the CFA Institute. Time Warner’s Barge, for one, warns that, “for complex multinational companies like Time Warner, ExxonMobil, or GE, the practicality of providing all of the assumptions may not be cost beneficial.”

Dismissing those objections, the CFA Institute’s McEnally notes that such disclosure would involve virtually no work that financial managers don’t already do for internal purposes. “Managers make assumptions every day for their assets,” she says.

Tellingly, FASB’s rule for expensing stock-option grants requires just those types of disclosures. And Ciesielski says he expects other new rules embracing fair value to impose similar requirements on management. “The only assurance that investors have that estimated fair values are honest is if the disclosures are robust — and actually exist.”

Ronald Fink is a deputy editor of CFO.

The End of Earnings Management?

Although fair-value accounting has been heralded as a cure for earnings management, even its supporters acknowledge that the technique is not immune to manipulation.

In a report last April, accounting expert Jack Ciesielski cited “the boundless opportunities for meeting earnings targets” based on fair-value measurement of just four types of financial instruments—equity securities without trading markets, insurance and reinsurance contracts, warranty obligations and rights, and unconditional purchase obligations. Ciesielski, publisher of The Analyst’s Accounting Observer newsletter, also noted in a cover letter accompanying the report: “Fair value was one of the ingredients in the witches’ brew that Enron’s managers concocted.”

Others point out, however, that manipulation of fair-value estimates should be easy to detect if the assumptions that managers use are disclosed. Indeed, Patricia McConnell, a managing director of Bear Stearns, conditions her support for fair value on regulatory requirements that mandate such disclosure.

Meanwhile, Robert Herz, chairman of the Financial Accounting Standards Board, says that valuation practices need to be standardized in the same way accounting rules are. With that in mind, Herz has been making presentations to conferences of valuation experts. — R.F.

Be Careful What You Wish For

While there is almost total consensus in the world of corporate finance that the current reporting system is in dire need of improvement, disagreement abounds as to how such improvement should be achieved. Fair-value measurement, for instance, is generally seen as the most reliable basis for financial accounting, but critics say it can have numerous unintended and unwelcome consequences.

Debate is also starting to rage over whether certain items that aren’t currently on corporate balance sheets belong there. For example, do pensions or leases belong on the balance sheet? If so, how should they be counted?

Consider disclosures for leases, the latest item the Financial Accounting Standards Board wants companies to report on their balance sheets instead of relegating to footnotes. Even the industry’s chief lobbying group, the Equipment Leasing Association, agrees that many, if not most, leases should be recorded as liabilities on the balance sheet, because they amount to financing. Yet the ELA argues that an exception should be carved out for small, short-term leases for such items as copiers and PCs, because they represent annual operating expenses rather than capital investments. In that case, asks leasing consultant William Bosco, “is capitalization really what you want? We submit no.”

Can an exception for those deals be made, however, without replicating the type of bright-line test that even Bosco admits leads to unwelcome complexity — as well as the kind of check-the-box approach that adheres to the letter of GAAP but violates its spirit? Theoretically, a principles-based rule might be developed with that in mind. But the Securities and Exchange Commission’s deputy chief accountant, Scott Taub, suggests an alternative: apply the idea of materiality to the question instead. In other words, if the leases are as insignificant as Bosco and the ELA insist, then the items needn’t be reported in the first place, says Taub.

Of course, if anything is in the eye of the beholder these days, it’s materiality. So CFOs who take Taub’s advice may be playing with restatement fire.

Leasing is just the latest of FASB’s controversial proposals for rules for recording assets and liabilities on balance sheets at fair value. The chart below lists other rules that have been enacted or proposed in the past few years that have yielded untoward consequences — or threaten to do so — in at least some cases. As such, the box may serve as a scorecard for what is shaping up to be an ongoing battle over “improvements” to GAAP. — R.F.

Recent FASB Pronouncements That Embrace Fair Value
Item FAS Issue Year Potential Impact
Derivatives 133 Hedging 1999 More earnings volatility
Stock options 123R Expensing 2005 Higher compensation costs
Hybrid financial instruments 155 Embedded derivatives 2006 Less earnings volatility
Securitization 156 Servicing rights 2006 More earnings volatility
Pensions NA Liabilities NA Lower shareholders’ equity
Leases NA Financing NA Higher leverage
Sources: The Analyst’s Accounting Observer, FASB

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