Questions of Value

The Next Wave
In fact, wider adoption of fair-value measurements could pick up where recent regulatory efforts leave off. Among the requirements of the Sarbanes-Oxley Act of 2002 is disclosure of whether or not a company has a "financial expert" on audit committees, defined as an individual who understands the application of GAAP to estimates, accruals, and reserves. The legislation was rushed through so quickly, congressional aides say, that the background materials that typically explain the thinking behind such language are limited. But estimates, accruals, and reserves — all basic, interrelated accounting topics — have something else in common: they are all fertile ground for fraud.

"I think Sarbanes-Oxley got it right when it identified these three items," explains the AIMR's McEnally. "They are all noncash accounting entries. And if you want to manipulate your accounting statements, you are forced to deal primarily with the noncash items."

"Estimates are subject to abuse. It is very, very easy to manipulate reserves," agrees John Tonsick, a managing director at the Global Intelligence and Security Division of Citigate, which helps companies assess their compliance with the act. "Congress has recognized that you can define [the accounting] as tightly as you want, but in the end, the only thing that is going to work is oversight and corporate governance."

But what if a wide move to fair value simply eliminated these trouble spots? McEnally thinks fair-value reporting would eliminate reserves, at least. "There would just be fair-value adjustments period to period. If I sold $100 worth of goods, but think I'll receive only $97, then I would record the $97 — not $100 with a $3 [bad debt] reserve."

Historically, restructuring reserves have been particularly prone to earnings management. That's because unlike reserves for taxes or bad debt, there was little ongoing calculation to ensure that the charge a company took matched its actual restructuring costs. Indeed, by subsequently requiring detailed, periodic reporting of restructuring efforts, the SEC's SAB 100 seemed to be groping in the direction of fair-value accounting. But while Congress and the SEC must rely primarily on additional oversight and disclosure, FASB may be moving toward a more fundamental solution.

Standing Up to Greenspan
Of course, how far and how fast Herz can move FASB is still a political question. "Every time we propose changing an accounting rule," he complains, "the lobbyists come out in full force. It's not a particularly warm feature of our system."

However, Herz may be just the right combination of purist and consensus-builder to steer FASB through the occasional political storm. A case in point: FASB's recent exposure draft on special-purpose entities — one of the first major initiatives of his tenure. Anxious to calm investors in Enron's wake, the SEC clamored to make the rule immediately effective. Then, recalls Herz, he heard from officials at the Federal Reserve. Often at odds with the SEC over banking issues, the Fed was fearful that implementing the rule too soon would roil the already rattled credit markets, which rely heavily on such vehicles. "I told them, 'I don't have an office of economic analysis,'" says Herz. "'We believe we have the right [accounting] solution. Why don't you guys walk down the street and talk to each other about the right date to make it effective?'" Remarkably, that's exactly what happened. "Our only public-policy mission is good accounting and good disclosure," he says.

In fact, while Herz jealously guards FASB's independence from government, he regards the Fed as an ideal operating model for his board. "Do we hold large conferences and constant, everyday lobbying efforts to tell the Fed to raise or lower interest rates?" No, he says, because the Fed's management of monetary policy is viewed as a public good. "Well," he says, "good reporting is a public good, too."

Tim Reason is a staff writer at CFO.

Without a Shot Fired

In 1995, the Financial Accounting Standards Board's efforts to require the expensing of stock options brought it to the brink of extinction. But the issue that so bedeviled his predecessors has gone far easier for current FASB chair Robert H. Herz.

To be sure, Herz was at the International Accounting Standards Board in December 2001, when U.S. companies were warning IASB chair Sir David Tweedie of dire consequences if he rekindled the issue on the international stage. But shortly after Herz joined FASB last July, Coca-Cola announced plans to expense options, and a slew of large-cap firms followed suit. Among them was General Electric, whose comptroller, Philip D. Ameen, was a prominent voice in the Financial Executives International's opposition to expensing options. "We saw the light," he says of GE's subsequent decision. "We showed investors the pro forma effects, and they said they wanted them to count."

FASB seems likely to mandate expensing this year, and such experiences (not to mention the IASB's budding ability to run interference for its American cousin) might embolden Herz as he considers broader applications of fair value.

"The Silicon Valley people say we are going to stifle American entrepreneurism. Then the corporate-governance zealots come to me and say [they want a standard that will] make sure there is never, ever a stock option issued in the future," says Herz. "Neither is my perspective. We are just trying to figure out what the [right] reporting is."

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