Questions of Value

Fair-value proponents, by contrast, believe volatility may be the price of investor confidence. "Where feasible, fair value provides the best information to investors," insists Rebecca McEnally, vice president of advocacy for the Association for Investment Management and Research (AIMR). "Obviously, this can involve assumptions if there are not fair-market prices [available.] But if all the assumptions are disclosed, that brings a good deal of sunlight to the process."

McEnally also counters criticism of fair value's reliability by noting that historic cost numbers "are reliable and relevant only on the day they are recorded." This is the crux of the fair-value debate: each side agrees both qualities are important, but fair-value advocates emphasize relevance, while historical-cost advocates place greater weight on reliability. "Reliability is infinitely greater when we are not marking everything in the statements to market," responds Ameen. For example, he says, annually valuing a simple asset like a desktop computer is a nearly impossible exercise, while amortizing its original cost "is a simple mechanical process" involving only the assertion of its known original cost and its life.

Still, Ameen says Herz's speech was not a surprise — FASB has long indicated a preference for fair-value measurements, which have been making inroads into accounting standards for the past 15 years. The simplest and least-controversial application is to use fair value for the initial recognition of assets and liabilities. FAS 141 and 142, for example, dealt with mergers and the purchase of intangibles by requiring the use of fair value at a far more granular level and for many more items than previous standards.

Since Herz came on board, FASB also has issued Interpretation 45. Written partially in response to Enron's illegal side agreements to back supposedly independent financial deals, it requires that companies issuing guarantees recognize an initial liability for the fair value of the obligation, and disclose quarterly the current carrying amount of the liability and maximum potential amount of future payments. And, of course, this year the board is expected to revisit FAS 123, whose preferred treatment of expensing stock options at fair value is finally gaining grudging acceptance.

To Mark It, to Mark It
Fair value's first use in U.S. accounting, however, was not initial recognition, which for simple assets is often the same as historical cost. Instead, it was first used to mark to market financial instruments on an ongoing basis. That remains a vastly more complex and controversial exercise. "Even for traded securities," notes Ameen, "the relevance of fair value, let alone the reliability, is a challenge. When you get into derivative positions such as those that Enron held, the reliability is very suspect."

Indeed, far from improving investor confidence, fair-value accounting was abused by energy and telecom companies when they recognized enormous phantom gains from trading hedges and capacity swaps. "I am happy to see some recent events curb some of the enthusiasm for fair value," says Ameen. "Those who believe in fair value seem to believe it is universally appropriate and solves every [problem]."

Yet Jackson M. Day, the Securities and Exchange Commission's acting chief accountant, suggests public perception of earnings quality suffers from inconsistencies in the way earnings and net assets are measured. "Unfortunately," he said in a December speech before the American Institute of Certified Public Accountants, "we still have a mixed-attribute model that can be arbitraged, and not much has been done yet about providing measurement guidance, especially related to providing valuation guidance when estimating fair value." Does that potential for arbitrage mean Day favors a wholesale move to fair value? "Well, we have to do something," he told CFO.

Such a move was certainly favored by Edmund L. Jenkins, Herz's predecessor. "We now fair-value some financial [instruments] and not others," he told CFO in the wake of the Enron scandal. As a result, companies had to take the extra step of recording changes to fair value for cash-flow hedges under FAS 133 under comprehensive income. "If we had fair value for all financial instruments," said Jenkins, "we would have a better presentation in the financial statements."

Herz says FASB is "very cognizant" of the potential for abuse when active markets don't exist. FASB, he told the FEI in a recent speech, will "make sure that our promulgation of standards that require fair-value measurements doesn't outstrip the ability of people in the real world to properly implement the concept." He has also announced plans to create Valuation Advisory Groups to help preparers of financial statements.

As for FAS 133 — at 800 pages the Moby Dick of accounting standards and arguably an equally large black mark for fair-value accounting — Herz shrugs. "Any standard that raises 200 implementation issues is not a good standard," he says.

Revisiting FAS 133 in depth, however, is not likely to be on FASB's immediate agenda, which is jammed with potentially massive undertakings that include redesigning the income statement and evaluating a shift away from detailed accounting standards to principles-based accounting. Both projects are likely to include substantial debate about the broader application of fair value.

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