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As historical cost accounting gives way to fair value, Europe's CFOs are bracing for turbulent times.
Justin Wood, CFO Europe Magazine
November 29, 2004
The countdown is on. The deadline for all EU-listed companies to adopt International Financial Reporting Standards (IFRS) — including controversial IAS 39 — is just around the corner. For the investor community seeking comparability of financial reports, that's good news. But for many CFOs that will mean grappling with one of the most contentious issues in accounting today — fair value.
Of course, banks and other financial institutions have found themselves squarely at the centre of the fair value debate thanks to IAS 39, which requires them to record a range of financial instruments such as derivatives and bonds at fair value on the balance sheet. Any changes in the value of those instruments must then be fed through a company's income statement, or else shown in shareholders' equity, depending on the instrument. The impact could be big, particularly given that, up until now, many financial assets and liabilities have been held at historical cost rather than fair value, or else not recorded on the balance sheet at all.
But other types of companies besides banks are likely to feel the growing influence of fair-value accounting in the years ahead. Take IAS 40 for investment properties. Although this standard gives real-estate developers the choice of recording their assets at historical cost, in reality it requires them to adopt a fair-value approach, with gains and losses recorded in the income statement or shown in the notes. Then there's IFRS 3 for business combinations, which prohibits "pooling of interest" accounting. The rule states that acquiring companies must measure the fair value of all acquired assets, including contingent liabilities, and the fair value of the amount paid, including equity, with the difference recorded as goodwill. IFRS 2 for share-based payments is a further example. The fair value of all employee stock options, for example, must now be determined at the grant date and expensed over the vesting period of the option. And so the list goes on. (See "Blast the Past" at the end of this article.) Indeed, the impact on the entire financial reporting "value chain" — from CFOs to auditors to investors and regulators — threatens to be far-reaching.
Martin Cubbon, group finance director of Hong Kong-based Swire Pacific, notes: "Fair value isn't just creeping into accounting, it's marching headlong. It seems to be the avowed intent of the IASB to pretty much standardise on fair value."
At Swire, a HK$17.6 billion ($2.26 billion) conglomerate that owns a large real-estate business, as well as 46 percent of Cathay Pacific Airways and other businesses, the introduction of IAS 40 for investment properties is set to have a major impact. With Hong Kong having adopted the standard effective in 2005, any changes in the value of the company's property portfolio will impact the profits of the whole group. In the past decade, annual swings in the value of the company's investment properties have been as high as HK$9 billion, a figure that would wipe out profits entirely in some years, while doubling them in others.
"As an old-fashioned 25-year qualified accountant, I think the move to greater fair value is very dangerous," says Cubbon. For one, he doesn't believe the volatility that fair-value accounting introduces to earnings is useful. But more than that, he worries that fair-value accounting is too subjective. Where liquid markets exist, determining the fair value of an asset or liability is simple enough. But when companies must make their own assessments of fair value using a discounted cash flow model or similar technique, then room for error, or even abuse, opens up.
"Historical cost accounting may be flawed, but at least it's objective; you know what you're getting," he observes. "With fair value, on the other hand, you're bringing in a great deal of assumptions and judgements about the future." As an example, Cubbon points to the flexibility managers have in setting the discount rate used in valuing a fixed asset. "These are highly judgmental areas," he sniffs.
Others share Cubbon's view. "Logically, all assets should go on the balance sheet," notes Robert Kirk, a professor of financial reporting at the University of Ulster in Ireland, "but assigning a value to assets that aren't bought or sold regularly — such as intellectual property — can't be an exact science."
Yet Rebecca McEnally, vice president of advocacy at the CFA Institute in Virginia, counters that accountants have been using estimates — such as guessing the useful life of a building — and models like straight-line depreciation for years. What's more, she points to a deeper issue. "If management finds such difficulty in determining the values of its assets, then what sort of decisions are they making in the absence of such relevant and useful information?" she asks.
How Fair Is Fair?
For their part, accounting standards setters acknowledge the increased use of fair value in recent years, but deny they're obsessed with it. "People have assumed that we're fanatics about fair value, but we're not," states David Tweedie, chairman of the London-based IASB.
It's well known that his organisation has been locked in a rancorous dispute with the European Commission over whether the EU will adopt IAS 39 when its 25 member states start using IFRS next year. Officials at the commission believe the standard will bring too much volatility into the accounts of banks and affect issues such as capital adequacy. They charge that the IASB is being too ideological in its pursuit of fair value.
Tweedie denies this. "We try to be pragmatic rather than dogmatic," he states. "When is it worthwhile using a fair-value approach? When does it benefit investors? Nobody's interested in the fair value of old machinery, but they probably do want to know the fair value of a company's city-centre headquarters."
Leslie Seidman, a board member at the U.S.'s Financial Accounting Standards Board (FASB), reckons the approach in America is equally secular. "The important issue to consider is the trade-off between relevance and reliability," she explains. "Fair value is often considered a more relevant measurement attribute for an asset or liability, but we'll only require it if it's reliable."
Even strong proponents of fair value acknowledge the potential operational difficulties and room for abuse in implementing a fair-value approach for items without active markets. Michel Baise, general manager of group finance at Fortis, a Belgian bancassurer with €523 billion ($643 billion) in assets under management, cites other concerns. For instance, Baise isn't convinced that fair-value accounting — particularly IAS 39 — does a good job of representing economic reality. As he explains, banks have their own internal risk management frameworks based on value-at-risk principles. However, he notes, IAS 32 and IAS 39 provide a very different perspective on risk in the company.
"If reporting standards are showing volatility that doesn't match our risk management framework, how should we react? How should investors react?" he asks. "We believe our internal models best reflect economic reality, but investors will see IAS 39."
He goes on to warn that: "The great danger is that decisions will be made to modify the risk profile of the company based on the volatility derived from fair value. The accounting could start to drive economic decision-making."
In the United States, where FAS 133 — the U.S. GAAP equivalent of IAS 39 — has been in place for several years now, some observers believe this is already happening. Robert Pickel, CEO of the International Swaps and Derivatives Association in New York, says: "We have come across instances of people choosing to avoid transactions that make economic sense because the accounting treatment is unfavourable."
He also questions how useful fair-value accounts are to investors. "Mark-to-market gives a real-time picture of a firm's exposures, but the average company releases its financial statements several weeks after the reporting date," he argues. "There are question marks over how meaningful that real-time information is to investors when it merely provides a snapshot of a firm's position in markets that can change quickly."
At Swire Pacific, Cubbon is another who questions whether fair value serves shareholder needs. "I've asked investors whether they support greater fair value and they don't seem that interested," he reveals. "Most of them are looking to strip out extraordinary and exceptional numbers and concentrate on what the free cash flows are." He believes that most investors would prefer to see moves that would strengthen their confidence in the auditing process, whereas "fair value will make the auditing process even tougher".
Up and Down
Paul Pacter, the original author of IAS 39 and now a director at Deloitte in Hong Kong, reckons some of the criticisms levelled against fair-value accounting are self-serving on the part of CFOs. For example, because fair value recognises gains and losses on an ongoing basis, it reduces the ability of managers to smooth out their earnings. "They can no longer decide when to book a gain or loss by selling an asset," he notes.
That said, Pacter does have sympathy in two key areas. First, he agrees that questions of reliability remain, although ever-improving sources of information and more powerful IT should help to make fair-value calculations easier. More importantly, he sympathises with CFO concerns over how investors will react to greater earnings volatility.
"Unfortunately, the world is obsessed with a single bottom-line number, the net income figure used to calculate earnings-per-share," he states. "If investors took a broader view, perhaps managers wouldn't worry quite so much about flowing value changes through their P&L."
The solution, says Pacter, is to redesign the income statement, and this is exactly what the IASB and FASB are currently doing. In a joint project, the two standards setters have teamed up with the Accounting Standards Board in the U.K. to create a new way of presenting earnings information. Although the project is still several years from completion, initial reports have suggested a three-column income statement designed to break earnings down into ongoing or underlying income, exceptional items, and then unrealised gains and losses resulting from changes to fair value on the balance sheet.
The initiative "has been a critical need in IFRS for a long time," observes Pacter. "Until they resolve this issue, the IASB is going to encounter fierce resistance to greater use of fair value."
But a new income statement is just the beginning. If fair value continues its onward march, then CFOs can expect a great deal more change to their accounts, says Pearl Tan, an accounting professor at Nanyang Business School in Singapore. "If full fair-value accounting is ever to take place, then there must be a complete overhaul of reporting," she argues.
Tan calls for more prospectus-style reporting detailing the estimates and assumptions used to calculate fair values, and also for greater use of range reporting rather than single-point estimates, along with sensitivity and scenario analysis.
It all adds up to a greater burden for CFOs and finance teams, not to mention the extra burden on auditors, who will have to assess reams of new data. Some CFOs reckon their annual report could double in size over the next few years. But that might not be such a bad thing, says Kirk of the University of Ulster. "Management has a perfect opportunity to use the narrative sections of their reports to discuss the value of brands and so on. Most have tended not to want to give away what they think is competitive information." In the end, he adds, it's the shareholders who lose out.
With additional reporting by Janet Kersnar.
How Far Can Fair-Value Accounting Go?
While many in the financial community complain that fair-value accounting is progressing too far too fast, others can't get enough of it. Pearl Tan, an accounting professor at Nanyang Business School in Singapore, is just such an advocate.
Indeed, Tan would like to see a world where all of a company's assets and liabilities are regularly measured at fair value on the balance sheet. And that includes internally generated intangibles such as patents and research projects-provided, of course, that robust corporate governance and market discipline mechanisms are in place to check opportunistic reporting.
"For a long time there have been pervasive criticisms against accounting that a company's most valuable assets are not being recognised on the balance sheet," she notes. "The issue is significant now more than ever given the growing importance of intellectual capital and brands."
Rebecca McEnally, vice president of advocacy at the CFA Institute in Virginia, agrees. "We strongly believe that internally generated goodwill should be recorded at fair value with revaluation. Intangible assets are the major drivers of the global economy but largely ignored currently in our basic accounting."
Both Tan and McEnally concede that accounting standards are unlikely to require the fair value of such intangibles in the near future; nonetheless, Tan sees signs of change. Most important, in her view, are the recent amendments to IAS 36, whereby companies can no longer amortise their acquired goodwill and must carry out regular impairment tests on it. "Although IAS 36 only requires downward recognition of losses, the valuation mechanisms have to be available to determine goodwill impairment," she explains. With those valuation tools in place, it's only a short leap to being able to value internally generated goodwill too, with companies showing revaluations both up and down.
Critics, of course, point to the fact that markets do a good job of valuing a company's intangible assets through changes in its share price. Further, they point to the enormous subjectivity required to value such complex items on the balance sheet, not to mention the risk of fraud.
But Tan counters that nobody knows a company and the drivers of a business as well as its managers. "Markets would benefit from seeing the opinions and assumptions of managers about the future," she says. "If those assumptions were unrealistic, the markets would quickly discipline the firm."
Blast the Past
Some of the key areas where fair value applies in International Financial Reporting Standards.
IFRS 2: Share-Based Payments. Covers the issuance of shares, or rights to shares, in return for services and goods, including employee stock options. The fair value of the share-based payment, determined at the grant date, should be expensed over the vesting period.
IFRS 3: Business Combinations. Companies must account for all mergers and acquisitions using the purchase methods. The pooling of interest methods is prohibited. Acquiring companies must measure the fair value of all acquired assets, including contingent liabilities, and the fair value of the amount paid, including equity, with the difference recorded as goodwill.
IAS 2: Inventories. Producers of agricultural and mineral products, and commodity brokers and traders are permitted to measure their inventories at fair value less costs to sell.
IAS 16: Property, Plant and Equipment. Companies have the option to carry property, plant and equipment at cost, less depreciation and impairment, or to carry them at fair value with regular remeasurement. Remeasurements go directly to equity, not through the income statement.
IAS 32: Financial Instruments: Disclosure and Presentation. Requires companies to explain the significance of financial instruments on their financial position, performance and cash flows, including information about the fair values of all financial instruments, even if measured at cost in the balance sheet.
IAS 36: Impairment of Assets. Requires companies to carry assets at no more than their recoverable amount. Recoverable amount is essentially a fair value measurement. Significantly, recent amendments mean that goodwill can no longer be amortised. Rather, the fair value of a company's goodwill must be regularly measured and only marked down if impaired.
IAS 38: Intangible Assets. Companies have the option of carrying certain intangible assets at fair value if an active market exists for those assets, such as milk quotas, stock exchange seats or taxi licences.
IAS 39: Financial Instruments: Recognition and Measurement. Companies are required to measure at fair value all investments in equity securities, some debt securities, all derivatives, and any financial asset held for trading, with regular remeasurement. Also, companies can choose, at the time of acquisition or issuance, any financial asset or financial liability to be carried at fair value. Changes in value go through the P&L or to shareholders' equity, depending on the instrument.
IAS 40: Investment Property. Companies have the option to carry investments in real estate at cost, less depreciation and impairment, or to carry them at fair value with regular remeasurement and gains and losses going through the P&L.
IAS 41: Agriculture. Animals, forests, crops and produce are recorded at fair value, with regular remeasurement and gains and losses going through the P&L.
IASB Project: Reporting Comprehensive Income. The IASB is carrying out this project in conjunction with the U.S.'s FASB and the U.K.'s Accounting Standards Board in order to redesign the income statement. The idea is to show in separate lines — or possibly columns — the profitability of a firm's underlying operations, any exceptional and extraordinary items, and any unrealised gains and losses that result from changes in the fair value of assets and liabilities.
IASB Project: Insurance Contracts. IFRS 4 on insurance contracts lays the groundwork for IASB's approach to accounting for insurance contracts. A second project is under way to build on this foundation and it's likely that insurance companies will be required to measure assets and obligations arising from insurance contracts at fair value.
IASB Project: Intangible Assets. The IASB is working with the Australian Accounting Standards Board to look at how companies might be able to recognise a broader range of internally generated intangible assets, such as newspaper mastheads, using a fair value methodology.
IASB Project: Measurement. The IASB and the Canadian Accounting Standards Board are examining the aims and methodologies used to make measurements in financial accounting. The project will analyse how and when certain measurement techniques, including fair value, can and should be used.
FASB Exposure Draft: Fair Value Measurements. Although this will lead to a U.S. GAAP accounting standard, the IASB is paying close attention and could well adopt much of its content. The proposed standard aims to clarify and provide guidance on how companies should carry out fair-value measurements as and when required under US GAAP.
Sources: www.iasplus.com; IASB; FASB