Fair-Value Revolution

Historical cost accounting is fading as Corporate America marches into a new era.

“Our reporting, as in ‘disclosure,’ has changed significantly, but our reporting of actual amounts recorded has not changed,” says Ted R. French, executive vice president and CFO of Textron, a $13.2 billion industrial conglomerate. “This particular standard did not require us to fair-value any new assets or liabilities that weren’t already required to be recorded at fair value.”

But it is unclear to what degree other companies can take heart from that, since compliance varies widely from one company to the next. Determining which bucket a given transaction resides in poses not only an intellectual exercise, but a bureaucratic one as well. While there were disclosure requirements to categorize deals into three buckets prior to FAS 157 — under the nongovernmental Financial Industry Regulatory Authority’s Management Discussion and Analysis strictures, for instance — “it was still a significant effort to recategorize all of our transactions according to the FAS 157 requirements and systematize the process for future reporting periods,” says Farr. Thus, PPL’s accounting and technology staff had to go back and “force” its computer system to plug in “literally thousands of energy transactions in a given year” into one of the three buckets, he says.

For other companies, the changes in fair-value disclosure may coincide with other, more sweeping developments. Caught in the downdraft from the subprime turmoil, troubled mortgage guarantor Fannie Mae saw mixed results from the introduction of FAS 157 at the start of 2008. On the one hand, fair value underlined the company’s perilous position; given the 66 percent first-quarter drop in Fannie Mae’s assets, many feared a government bailout was in the cards. For its part, however, Fannie Mae reported that applying FAS 157 to the measurement of its financial guarantees “had a favorable impact on the company’s results of operations for the quarter.”

Flawed Estimates

For those not as well acquainted with marking credit swaps and interest-rate derivatives to market, the demands of the new regime can represent radical change. Companies may not find it easy to estimate what was formerly thought inestimable. Only last year, FASB began requiring plan sponsors to report the adequacy of pension funding on their balance sheets rather than merely in the footnotes of their financial statements; now they must come up with the fair value of those amounts. In another example, companies with pending lawsuits may soon have to estimate what such litigation, which often spreads out years into the future, will ultimately cost.

Fair value’s critics have, in fact, cited the reliance on estimates — and the ability to thereby manage earnings — as a major flaw. “There’s a concern that it gives far too much latitude,” says Ken Becker, CFO of privately held Portland Nursery, in Portland, Oregon. “You don’t have the objectivity of a [historical] cost figure to base your numbers on.”

Another concern is that fair-value reporting will pressure companies to act precipitously — and against their long-term interests. Wesley Walton, vice president of finance at CBC Federal Credit Union, points out that historical-cost reporting enabled companies to “work their way out of trouble” by holding on to fading securities until the market turned around, since they had to show only what they had originally paid for them.

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