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Questions of Value

Is fair-value accounting the best way to measure a company? The debate heats up.
Tim Reason, CFO Magazine
February 1, 2003

Despite 29 years as an accountant in the United States and abroad, Robert H. Herz still considers himself an economist by training and disposition. "I got into accounting to get a job, basically," he says.

Which, as casual career plans go, worked out pretty well. Last July, Herz became chairman of the Financial Accounting Standards Board. That puts him in charge of setting the generally accepted accounting principles used in the United States — standards whose perceived global superiority has been called sharply into question by a year of accounting scandals and market turmoil. What's more, Herz came to FASB from the International Accounting Standards Board (IASB), and is now in a position to exert powerful influence on the efforts by both those bodies to massage U.S. GAAP and international accounting standards as they coalesce into a worldwide standard.

Although highly regarded among his peers for his knowledge and proficiency as an accountant, it is the economist in Herz that should make CFOs sit up and take notice. He has strong opinions about what's wrong with accounting and financial reporting in the United States. "Accounting has historically not defined income as change in wealth, or change in net worth or value," he explains. "It has defined it by thousands and thousands of conventions that measure allocations of historical costs." In other words, accounting hasn't really defined income.

These "pure accounting fantasies," Herz declares, have helped create "a basic schism in U.S. industry" between company management and investors. He believes CFOs and CEOs — and current accounting methods — focus on meeting annual budgets and reporting those financial metrics that they control (and for which they are held accountable).

What's wrong with that? "Unfortunately for people who invest in companies," he says, "that's a very incomplete exercise. Investors also want to know what the impacts of external events on enterprise value are."

CFOs may bemoan the fact that this view deemphasizes their own role in creating value, but given the fragile state of the capital markets, they may have ample cause to welcome Herz's focus. "If I can achieve anything good" as FASB's chair, he says, it will be to improve management's and investors' understanding of their different perspectives. After all, absent investor confidence, the most strenuous efforts to create value can't amount to much.

To be sure, the concept of fair value is far from problem-free. And while FASB has long believed in fair value, years will pass before that belief fully becomes practice. But in Herz, the board has a strong proponent of fair value at its helm, and he thinks it's high time the process was accelerated.

Fair Use
Herz's views reflect his education at England's University of Manchester, cradle of Hicksian economics, a branch that focuses on changes in overall economic value when measuring economic growth and productivity. For Herz, in practical terms that generally means reporting the fair value of — or marking to market — assets and liabilities whenever it can be reliably determined.

"I think it's hard to argue with the conceptual merits of fair value as the most relevant measurement attribute," Herz told a conference of Financial Executives International (FEI) in November. "Certainly, to those who say that accounting should better reflect true economic substance, fair value, rather than historical cost, would generally seem to be the better measure."

Corporate finance executives agree, up to a point. "The relevance of fair value — if you can define it in a meaningful fashion — is easy to support," concedes General Electric comptroller Philip D. Ameen. But as former chair of the FEI's Committee on Corporate Reporting, Ameen has long argued that determining the relevance and reliability of fair-value measures is often fraught with difficulty for publicly traded corporations. Moreover, he says, for some companies, wholesale use of fair value would require disclosure of hundreds, if not thousands, of valuation assumptions and how they were derived.

"I understand the whole attraction of market-value accounting," says Charles W. Mulford, professor of accounting at the DuPree College of Management at Georgia Institute of Technology, adding that many balance-sheet items already are carried at fair value, and some, such as property, plant, and equipment, probably should be. But while reluctant to criticize fair value itself, Mulford is troubled by the possibility of emphasizing total company value at the expense of measuring management performance. "What amount of value creation can be assigned to the efforts of management for a particular time period? That is the essence of accounting," he says. "Otherwise, it's simply an appraisal process."

The other, often unspoken, argument against fair value is that regularly measuring the effect of market movements on a company's assets and liabilities can introduce enormous volatility into financial statements. Fear that volatility will spook investors is the reason companies manage earnings in the first place. It's even the driving force behind some existing accounting standards, such as smoothing of pension gains and losses, says Mulford, since income numbers can otherwise become so volatile as to be meaningless.


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.


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."


But there's the rub. Under FAS 123, fair value is measured at the grant date; subsequent adjustments are not generally allowed. Yet even this relatively simple fair-value application is challenging.

Coca-Cola, for example, won praise for its plan to value options by averaging bids solicited from investment banks. But some observers suspect those bids will simply represent an outsourcing of the Black-Scholes calculation, not executable market transactions. Real market prices would include discounts for unique features of stock-options such as nontransferability. (FAS 123 does not allow such discounts for companies applying valuation techniques internally.)

Coke's 2001 estimate of its stock-options expense would have cut its earnings that year by $202 million. But John Finnerty, of Analysis Group/Economics, says if a market existed, the actual expense might be as little as half that amount, simply because Black-Scholes ignores the illiquidity of the grants.

"I actually believe a market could be created in hedging of stock options," says Herz. Finnerty agrees, noting that there's more than enough profit potential tied up in stock options to interest investment banks. He believes a developed market for stock option instruments is only a matter of time. "There are smart guys in these investment banks who have solved similar problems in the past," he says. —T.R.

Rule, Britannia?

While the Financial Accounting Standards Board's published agenda is already loaded with complex and controversial issues, chairman Robert H. Herz has suggested in recent speeches that the board revisit pension accounting.

International accounting standards offer little clue about what this may mean for pension smoothing — IAS differ from U.S. generally accepted accounting principles only in the technical detail of application. But before he was chair of the International Accounting Standards Board, Sir David Tweedie oversaw the development of FRS 17 in UK GAAP — a virtually unsmoothed pension technique that requires measuring the liabilities and assets of pension funds and recording the year-over-year change as income or expense.

Herz would seem sympathetic to that approach: In addition to being a CPA, he is a UK-chartered accountant and unapologetic Anglophile who considers Tweedie an ally in the struggle to improve accounting standards. In fact, when interviewed by CFO during his IASB tenure, Herz suggested hypothetically that one way of circumventing the technical differences between the IAS and U.S. GAAP pension accounting was to simply eliminate pension smoothing.

So is this an area of convergence where the UK's answer would trump both GAAP and IAS?

"Clearly, that is a concern," says General Electric comptroller Philip D. Ameen, former chair of the Financial Executives International's Committee on Corporate Reporting. "FEI would not care for that. We think that pensions have to be viewed with a very long-term horizon, [and are concerned about] the extreme volatility we could see in short-term operating results."

Ameen can take some comfort in Herz's thoughts on FRS 17. "I'm not quite there," says Herz of eliminating smoothing entirely. Because measuring the liability is an actuarial exercise, he believes some smoothing should be preserved. "But on the asset side, I would eliminate expected return and just record value of the assets."

Herz is quick to point out that his personal opinion isn't necessarily shared by FASB's six other members, so that approach is far from a foregone conclusion. But whatever the outcome, it's clear Herz is serious about addressing pensions. "As a citizen, beyond my standards-setting capacity, this is a very important issue with regard to the whole retirement structure of our nation. My concern is that we have constructed accounting methods that prompt strange behavior. It's like stock options — if accounting prompts strange behavior solely because of the accounting, that's not a good answer." —T.R.

Where Fair Is Fair

Accounting standards in which fair value plays a prominent role for initial recognition or ongoing valuation.

FAS #Subject
FAS 115Valuing equity investments
FAS 123Stock-option accounting
FAS 133Hedging derivatives
FAS 141Business combinations
FAS 142Purchased intangibles
FAS 143Asset retirement obligations
Interpretation 45 (affects
FAS 5, 57, and 107)
Guarantees



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