Even though fair-value accounting has been around for decades, it began spreading into nearly every cranny of corporate finance only just lately, courtesy of Financial Accounting Standards Board Statement No. 157, Fair Value Measurements, and other strictures. What’s more, the ongoing subprime crisis has brought the burgeoning system into the spotlight, as almost daily reports of earnings losses are worsened by the fact that they now must be marked to market.
With companies just starting to comply with the new rules, senior finance executives must explain fair value to employees, peers, and directors—not to mention themselves. Following is a thumbnail account of the pitfalls of the transformation, from the CFO’s point of view.
The theory of fair value is that a company’s financial statements are most useful to investors if the company’s assets and liabilities are constantly reported at market value. Traditionally, companies reported their assets and liabilities at historic cost—that is, what they paid for them.
For a simple analogy, consider your personal finances:
•Under historic cost accounting, your earnings would consist of your salary.
•Under fair value accounting, your earnings consist of your salary, plus the increase (or decrease) in the value of your house and other assets. During the housing boom, you were richer because your house was worth more, even though you didn’t plan to sell it. When the housing market crashed, you became poorer.
In general then, it’s easy to see why finance executives would dislike the concept, particularly in an economic downturn. But there are more specific reasons for their distaste.
1) CFOs generally hate fair value because it makes their companies’ bottom line numbers move up and down in ways they can’t control. They are already spending a lot of time explaining to investors that their financial results are moving up and down not because of the company’s performance, but because of the fair value of different assets and liabilities within their company.
2) Fair value already affects dozens of accounting areas, and the folks who write accounting standards are adding new ones all the time. Major areas affected already include accounting for: pensions, mergers, stock options, environmental liabilities, hedging and derivatives, and uncollected debts. Some of these — for example, the value of the stock in a company’s pension portfolio — can have a huge impact on a company’s financial results.
3) The fair value of items that can’t easily be priced on the open market is hard to determine. CFOs will need to hire valuation firms and prove that the fair value estimates they report to investors were made in good faith . . . or risk charges of fraud.
4) CFOs will need to make sure their treasurers are up to speed on fair value — for example, in the recent credit crisis, a type of instrument known as an auction-rate security, which treasurers usually considered to be the equivalent of cash, suddenly became illiquid. Because the ARS’s couldn’t be sold in the market, fair-value rules forced CFOs to actually write down (reduce) the amount of cash they were telling investors the company had — even though, from a long-term perspective, the securities were worth their face value.
5) CFOs will need to rely heavily on accounting firms to help them with valuation methodology and will also probably spend a lot of time explaining to, and wrangling with, their auditors over the fair-value methods they have chosen. Advisers to the Public Company Accounting Oversight Board, which regulates auditors themselves, say the auditing profession is woefully unprepared to evaluate the fair-value estimates provided by companies — suggesting that fair value may well be the next Section 404 (that is, an expensive and painful multi-year dispute between companies and auditors).