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A recent FASB proposal allowing fair value measurement is too complicated, say critics who normally support such measures.
Marie Leone, CFO.com | US
April 26, 2006
In an exchange that highlights some of the challenges facing the Financial Accounting Standards Board's drive to reduce accounting complexity, experts from Standard and Poor's have said one of FASB's latest proposals is likely to create more confusion.
In January, FASB proposed giving companies the choice of using fair value accounting when booking certain financial assets and liabilities, rather than historic cost accounting or other methods. The proposal, an expansive amendment of FAS 115 (Accounting for Certain Investments in Debt and Equity Securities), would, in many cases, allow companies to avoid using the complex and often cumbersome hedge accounting provisions of FAS 133. It would also reduce earnings volatility caused by instruments that don't qualify for FAS 133 treatment.
Under current accounting, financial instruments purchased as hedges often are reported at their historic cost, even as companies report the hedged item at fair value. The resulting mismatch in values can cause earnings to fluctuate over the life of the hedge, even if the hedge ultimately proves effective. But if the fair value of both the financial instrument and the item it is intended to hedge are reported on the balance sheet and any changes in both flow through income, as FASB proposes, the two items would offset each other. And the more effective the hedge, the smaller the resulting impact on earnings would be.
That proposal would seem to be representative of FASB Chairman Robert Herz's public push to reduce complexity in financial accounting. Not only would it simplify, or eliminate, hedge accounting in many cases, it would also move U.S. generally accepted accounting principles (GAAP) closer to International Accounting Standards (which already provide such an option). The proposal's reliance on fair value measurements is also a hallmark of Herz's anti-complexity effort.
But the first phase of the two-step proposal doesn't go far enough, says Neri Bukspan, chief accountant for S&P. Bukspan, and his colleague, Joyce Joseph-Bell, who co-authored S&P's 11-page comment letter, support the use of fair value accounting. Like other proponents of fair value —including FASB itself — Bukspan says fair value offers a better gauge of true market value than historic cost. Yet Bukspan and Joseph-Bell raise several thorny issues related to the practical application of FASB's proposal.
For example, S&P argues against the proposal's "mixed attribute" framework, which increases the potential for unexplained balance sheet mismatches between connected assets and liabilities.
Bukspan offers a hypothetical example to illustrate the potential mismatch. Under the pending rule, an oil company has the choice of recording a debt obligation (a financial liability) using either cost- or fair-value accounting, but is limited to using cost accounting to record a new oil reserve discovery (a non-financial asset). If the company is inconsistent regarding which accounting treatment it uses to book the reserves' effect on the debt obligation, analysts would be left scratching their heads, hunting for a balance sheet match between the asset and liability, says Bukspan.
The pending rule also potentially diminishes the usefulness of financial statements, says S&P. Since the choice is theirs, companies could decide to account for Yen-denominated debt using cost accounting, and dollar-denominated debt using the fair value option. "The vast discretion — with no guidance — is a significant concern to us," writes Bukspan and Joseph-Bell.
Moreover, argues Bukspan, the proposed rule could create an opening for "accounting arbitrage" abuse. The arbitrage would compound accounting mismatches if companies use the rule's flexibility to paint financial statements in a more favorable light, while ignoring such guidelines as corporate risk management or internal measurement practices.
Indeed, other commentators who support fair value expressed similar concerns. Jack Ciesielski, publisher of the Analyst's Accounting Observer newsletter, said the ability of companies to choose which approach they use "makes for a cherry-picking opportunity for financial statement preparers." Wrote Ciesielski: "I think the Board is risking a possible fair value backlash."
One way to counter the negative effects of mixed attributes or inconsistent accounting treatments is for the rule to mandate "robust disclosures," adds S&P's Bukspan. FASB's draft does note that it "would require certain financial statement presentations and disclosures to compensate for the lack of comparability that will arise from the alternative measurement treatment permitted by [the proposal]." But that assurance wasn't sufficient for S&P, which said the proposal "does not provide sufficient guidance for consistent disclosures." Without clear explanations of how values are derived, S&P's commentators worry, comparisons become pointless, and "income statements likely will lose their informational value. . . [because] periodic changes in fair values will be condensed to a single line item."
S&P also urged that FASB issue its fair value measurement statement (a separate project now underway at FASB) concurrently, or earlier, than the proposed amendment to FAS 115. That, say S&P experts, would provide guidance on what measurement basis to use, especially regarding financial assets and liabilities for which a liquid market does not yet exist.
Such comments, of course, are actively solicited by FASB in advance of new accounting treatment, and it's common for exposure drafts like this one to be criticized. However, the fact that proponents of fair value measures have taken issue with the current draft illustrate some of the difficulties FASB is likely faces as it shifts accounting from historic cost to fair value measures.