Fair-Value Revolution

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

The lawyers were reacting to what has since blossomed into a FASB proposal to require companies to add more-robust disclosure in their reporting of liabilities that may or may not occur. Under the proposed rule, companies would have to disclose “specific quantitative and qualitative information” about loss contingencies involving legal liabilities as well as such things as environmental-cleanup costs.

FASB’s proposal stops well short of a full fair-value regime for litigation risks, but attorneys fear that may yet come, if not from FASB, then from the IASB. “We do not believe that the fair value of contingent liabilities…can be reliably measured in many cases,” the corporate litigators wrote.

The reason it’s so hard to put a fair value on litigation is that there are so many variables: the laws that apply in a case, the strategies of the lawyers involved, and the mind-sets of the judges, to name a few. “No matter what model is used,” says Larry Levine, director of financial advisory services at RSM McGladrey, “the process is enormously speculative.”

3. Mergers & Acquisitions: The march toward fair-value accounting took a big step in December 2007, when FASB revised its rule on business combinations. The new rule, FAS 141(R), requires companies that acquire assets or assume liabilities in a deal to record the items at their acquisition-date fair values measured according to the new hierarchy setup under FAS 157.

As a result, the fieldwork by acquirers will have to include “a much deeper dive into the financial statements” of potential target companies, says Bank of the West CFO John Wojcik. In the case of banks, specifically, purchasers can no longer accept a purchased company’s estimates of the liability of its loan portfolios. Instead, he adds, the buyer will have to do “a lot more upfront work” to determine the fair value of the loans it stands to absorb.

As it might do with lawsuits, the proposed rule on contingent liabilities could have a significant effect on how companies gauge the worth of a merger, Levine thinks. “What-if” scenarios will be hard to mark to market. “If you buy a company that has $25 million in sales, and you’ll give them another million of payment if they hit $30 million of sales next year, that’s a difficult and somewhat subjective thing to value,” says Levine. The result? Added cost and effort in figuring out what price of a deal to report.

4. Hedging: Trying to simplify FAS 133 — considered by many to be the most notorious example of the complexity of U.S. financial reporting — FASB has proposed sweeping changes in hedge accounting that should expand the use of fair value.

To be sure, the current rules for derivatives and similar risk-management tools involve extensive application of fair value. But with more than 800 pages of rulemaking and guidance needed to make sense of 133, the accounting standard has been something of a black eye for the fair-value concept, and has been in Herz’s gun sights ever since he became FASB chairman in 2002.

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