Fair-Value Revolution

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

Indeed, it’s hard at this juncture for executives to tally up a net gain from fair-value accounting. The new standards, of course, were crafted to benefit shareholders, not corporate management. But if they help boost investor confidence, CFOs may decide that the march to fair value was worth it.

David M. Katz is a deputy editor of CFO.com.

The Starting 5

Critical areas of finance most likely to be affected (and soon) by fair-value accounting

1. Liabilities: Compared with financial assets, many of which have long been measured at fair value by corporations, liabilities are unknown territory. Often lacking hard numbers on which to base estimates, companies tasked with putting a current price on loans, insurance contracts, or future environmental-cleanup costs, for example, must rely on hypotheses. “In fair-valuing liabilities,” says Espen Robak, president of Pluris Valuation Advisors, “there is very little in the way of a market there; you’re always going to come to some kind of model, anyway.”

To some critics — Financial Accounting Standards Board chairman Robert Herz is one of them — such modeling is unnecessary when the price of settling a liability is clearly set. Xerox’s chief accounting officer, Gary Kabureck, offers the example of a company that has a long-term debt on which it will pay 7 percent interest at maturity. Even though the company fully intends to hang on to the obligation until it matures, it must report the debt’s fair value in its current financial reporting. If that fair value is 8 percent, the company would have to report bad news to the market for largely hypothetical reasons. “You have to question what is the relevance of liabilities at other than the settlement value,” says Kabureck.

Another aspect of the new rules also seems, to many, to depart from logic. As the risk that companies won’t pay back their debts rises, their reported liabilities actually decrease. That’s because companies estimating the fair value of their own liabilities must factor in the risk that they won’t pay those debts off. That makes the anticipated debt smaller. It also works the other way: if the debtor becomes more creditworthy, the fair value of the debt obligation rises.

The rewards for potential deadbeats can be large, according to a Credit Suisse report on the 380 members of theS&P 500 that began complying with FAS 157 in Q1 2008. For the 25 firms with the biggest amounts of liability measured at fair value, widening credit spreads — an indication of a lack of creditworthiness — spawned first-quarter earnings gains ranging from $11 million to $3.6 billion.

2. Lawsuits: If things proceed according to plan, some companies will have to disclose what corporate lawyers insist can’t be calculated: the future costs of lawsuits.

What will litigation cost? In December 2007, a group of 13 top lawyers employed by Pfizer, General Electric, Viacom, Boeing, McDonald’s, and other prominent companies pronounced any attempt to answer that question an impossible dream. “Litigation is inherently unpredictable,” they wrote to Herz and International Accounting Standards Board chairman Sir David Tweedie.

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