Will Fair Value Fly?

Editor's Note: On Friday, The Financial Accounting Standards Board issued additional guidance to help corporations and accounting firms measure assets and liabilities using the fair value method of accounting. The new rule, known as FAS No. 157, affects over 40 existing accounting standards—including those used to value stock options (FAS 123) and derivatives (FAS 133)—but does not expand the use of fair value to any new circumstances, said FASB in a press statement.

Two weeks ago, deputy editor Ron Fink published a story in CFO magazine that anticipated the issuance of FAS 157, provided practical analysis of the subject, and included a discussion of whether standards, and a standards-setting body, is now needed in the asset valuation industry. Here's the full text of that story.

Much has changed in financial reporting since Andrew Fastow and Scott Sullivan, the finance chiefs of Enron and WorldCom, respectively, brought disgrace upon themselves, their employers, and, to a degree, their profession. Regulators and investors have pressed companies to be more open and forthcoming about their results — and companies have responded. According to a new CFO magazine survey, 82 percent of public-company finance executives disclose more information in their financial statements today then they did three years ago. But that positive finding won't quell calls for further accounting reform.

The U.S. reporting system "faces a number of important and difficult challenges," Robert Herz, chairman of the Financial Accounting Standards Board, told the annual conference of the American Institute of Certified Public Accountants in Washington, D.C., last December. Chief among those, said Herz, is "the need to reduce complexity and improve the transparency and overall usefulness" of information reported to investors.

Critics contend that generally accepted accounting principles (GAAP) remain seriously flawed, even as companies have beefed up internal controls to comply with the Sarbanes-Oxley Act. "We've done very little but play defense for the last five to six years," charges J. Michael Cook, chairman and CEO emeritus of Deloitte & Touche LLP. "It's time to play offense."

Cook, a respected elder statesman in the accounting community, goes so far as to pronounce financial statements almost completely irrelevant to financial analysis as currently conducted. "The analyst community does workarounds based on numbers that have very little to do with the financial statements," says Cook. "Net income is a virtually useless number."

How can financial statements become more relevant and useful? Many reformers, including Herz, believe that fair-value accounting must be part of the answer. In this approach, which FASB increasingly favors, assets and liabilities are marked to market rather than recorded on balance sheets at historical cost. Fair-value accounting, say its advocates, would give users of financial statements a far clearer picture of the economic state of a company.

"I know what an asset is. I can see one, I can touch one, or I can see representations of one. I also know what liabilities are," says Thomas Linsmeier, a Michigan State University accounting professor who joined FASB in June. On the other hand, "I believe that revenues, expenses, gains, and losses are accounting constructs," he adds. "I can't say that I see a revenue going down the street. And so for me to have an accounting model that captures economic reality, I think the starting point has to be assets and liabilities."

More than any other regulatory change, fair value promises to end the practice of earnings management. That's because a company's earnings would depend more on what happens on its balance sheet than on its income statement (see "The End of Earnings Management?" at the end of this article).

But switching from historical cost would require enormous effort from overworked finance departments. Valuing assets in the absence of active markets could be overly subjective, making financial statements less reliable. Linsmeier's confidence notwithstanding, disputes could arise over the very definition of certain assets and liabilities. And using fair value could even distort a company's approach to deal-making and capital structure.

A Familiar Concept
Fair value is by no means unfamiliar to corporate-finance executives, as current accounting rules for such items as derivatives (FAS 133 and 155), securitizations (FAS 156), and employee stock option grants (FAS 123R) use it to varying degrees when recording assets and liabilities. So does a proposal issued last January for another rule, this one for accounting for all financial instruments. FASB's more recent proposals to include pensions and leases on balance sheets also embrace fair-value measurement (see "Be Careful What You Wish For" at the end of this article).

While both Herz and Linsmeier are careful to note that they don't necessarily favor the application of fair value to assets and liabilities that lack a ready market, they clearly advocate its application where there's sufficient reason to believe the valuations are reliable. Corporate accounting, Herz says, is the only major reporting system that doesn't use fair value as its basis, and he points to the Federal Reserve's use of it in tracking the U.S. economy as sufficient reason for companies to adopt it.

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