Choosing the Fair Value Option

Earnings volatility and accounting complexity are two targets of a new proposal from FASB. Who is likely to take advantage of the proposed option?
Helen ShawJanuary 30, 2006

The Financial Accounting Standards Board’s proposal of a fair value option for financial assets and liabilities will have the broadest applicability among financial institutions and companies with financial arms, according to FASB board member Leslie Seidman.

Observers agree. “The real advantage is for banks in managing their interest-rate risk for their financial assets and liabilities,” says Jeffrey Wallace, managing partner at Naperville, Illinois-based Greenwich Treasury Advisors.

The option to report financial assets and liabilities at fair value, on a contract-by-contract basis, aims to reduce earnings volatility and accounting complexity. At present, under generally accepted accounting principles, different assets and liabilities fall under different measurement attributes, which can result in earnings volatility. The proposal would allow for changes in value to be recognized consistently.

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For example, explains Seidman, in the financial statements of a firm with a bond-trading portfolio funded by repurchase agreements, assets may be marked to market through earnings, but liabilities may be carried at cost. The proposal would allow a company to choose, irrevocably, to measure any financial instrument at fair value on the first day of the transaction. If the firm also chose to measure its liabilities at fair value, the effect of changes in interest rates on assets and liabilities would be shown at the same time, allowing real-time recognition of all the gains and losses.

“The earnings will show the extent to which they are economically hedged,” explains Seidman. “The result is like hedge accounting, but it should be much simpler to comply with the requirements.” She observes that in order to qualify for special provisions to match gains and losses under FAS 133, Accounting for Derivative Instruments and Hedging Activities, extensive documentation and qualifying criteria are required.

Wallace believes that few companies will take advantage of FASB’s proposed option. Most companies have more debt than equity, he explains, and taking the fair value option would introduce profit-and-loss volatility — a nemesis of chief financial officers.

FASB, on the other hand, expects that the proposal could apply to all companies that invest in financial instruments. For entities that elect to use fair value, says Seidman, “we think it will enable them to simplify their accounting.”

The proposal could also mark one more step toward the day when FASB may require all liabilities to be measured at fair value, speculates Wallace. “We are seeing convergence — it is an example of the International Accounting Standards Board leading the way and the FASB following,” he said. Indeed, in its announcement last week, FASB noted that the proposal achieves further convergence with IASB, which has already adopted a fair value option for financial instruments.

The deadline for filing public comments on FASB’s proposal is April 10.