Fair-Value Revolution

What is a company really worth? That is the central question that accounting attempts to answer, and it is no easy exercise. Every answer invites debate, and that debate has now intensified, thanks to "fair value" accounting.

Under fair value, a company values its assets and liabilities based on what they would fetch today, rather than what they originally cost. The concept is not new — accounting has long operated under a "mixed attribute" model, which records many items at historical cost while requiring that companies mark to market certain asset classes (such as securities, derivatives, and intangible assets obtained in a merger). But a host of factors have suddenly propelled the calculation of fair value from a secondary concern to a dominant theme of corporate accounting, and many companies are just beginning to understand the ramifications. If fair value takes full hold, as some have suggested it should, company results may look far different than they do today.

In stark contrast to most other accounting concepts, fair value has already achieved the improbable feat of making front-page news, thanks to its alleged role in the subprime-mortgage crisis. Mired in the real estate mess, such financial-services giants as Merrill Lynch, Citigroup, and UBS suffered staggering losses in the first half of 2008. At the same time, new fair-value measurement requirements were taking hold, forcing the banks to determine how to value securities based on the prices they would fetch in markets that had all but dried up. The question has been: Has fair-value accounting played a role in the economic meltdown? As bankers claimed that the new standards prompted them to dump the securities at fire-sale prices, large investors contended that mark-to-market accounting reflected an economic volatility that was already there.

Fair value's tipping point lies in the innocuously titled Fair Value Measurements, a standard issued in September 2006 by the Financial Accounting Standards Board. Better known as FAS 157 and effective for fiscal years beginning after November 15, 2007, the standard spells out how companies should determine the valuations of the assets and liabilities they mark to market. But it is far more than a how-to guide. Because it affects abroad array of core activities, including contingent liabilities, mergers and acquisitions, intangible assets, pensions, hedges, environmental-cleanup obligations, and loans, its effect will be profound. Indeed, FAS 157, which already includes a three-page list of opinions and statements that are affected by fair-value accounting, seems likely to influence standard-setting far into the future. "Assuming it stays where it is right now," says Gary Kabureck, chief accounting officer at Xerox Corp., the rule "is going to be, over time, one of the most important standards" that FASB has ever written.

What's more, if, as is widely expected, the generally accepted accounting principles that have long governed U.S. companies give way to adoption of international financial reporting standards, fair value may get a further boost. That's because IFRS appears to favor even greater use of it.

The ultimate intent of fair value is to give investors better visibility into how companies value their assets, and few deny that it achieves that aim. But at what cost to companies, both in terms of internal compliance demands and the impact that greater transparency has on their share prices, will such benefits come? While recent events on Wall Street provide only an imperfect proxy for fair value's impact, those who claim that it will increase volatility have plenty of evidence on their side.

Missing Markets
The initial challenge in meeting the requirements of FAS 157 entails sorting each fair-value estimate into one of three levels, or "buckets," as Paul Farr, CFO of PPL Corp., calls them. Since the fall of 2007, the finance and technology departments of PPL, an Allentown, Pennsylvania-based diversified energy company, have been hard at work filling those buckets with information about how the company gauges the fair value of the derivatives it buys and sells. "We've had a 157 project under way for nine months," Farr said in May. "The last six months have been the most intense, as we were 'bucketizing' the various transactions."

In bucket 1, the value of an asset or liability stems from a quoted price in an active market; in bucket 2, it is based on "observable market data" other than a quoted market price; and in bucket 3, fair value can be determined only through "unobservable inputs" and prices that could be based on internal models or estimates. It's that third bucket that critics say has some serious holes.

Even FASB has struggled with how to place a market value on a transaction for which there is no market. Complicating the issue is that the board defines fair value as an "exit" price — "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date," as the standard says.

The need to conjure up an exit price can force corporate borrowers to try to figure out, for example, what they would pay someone to take on debt no one is likely to buy. Not for nothing did an exasperated Robert Herz, chairman of FASB, declare in an April meeting that by requiring companies to estimate the fair value of such liabilities, "we're forcing people to do mental gyrations in parallel universes."

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