Cash Flow

The Shaq Attack on Fair Value

An accountant invokes the world of hoops to disparage fair-value purchase accounting.
Marie LeoneMarch 4, 2008

Time has not quashed the backlash over fair value accounting. It’s been 18 months since the Financial Accounting Standards Board issued FAS 157, Fair Value Measurement, to set the stage for using market pricing to value corporate transactions. But opponents of the concept continue to complain about the difficulties of its practical application.

To be sure, fair-value advocates, including FASB members, tout the concept’s main benefit: that it provides investors with added transparency by forcing companies to mark to market assets and liabilities. But critics argue that fair-value accounting does the opposite. Instead of providing investors with a better picture of economic reality, fair-value accounting distorts market realties by leaving too much room for management’s discretion and potential abuse, they contend.

Early on, corporate accountants blasted the idea of introducing fair value into purchase accounting. For example, in one 2005 comment letter filed with FASB, PepsiCo senior vice president and controller Peter Bridgman declared: “We have never used anything other than a discounted cash flows analysis to evaluate and value a business combination transaction . . . We believe that the fair-value is established by the buyer and seller as a result of the business combination transaction and not as a result of a hypothetical transaction among market participants.”

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Attitudes haven’t changed much. Last week, another corporate accountant, currently working on a deal, disparagingly described fair-value accounting as akin to a misguided sports fan’s assessment of pro basketball’s Shaquille O’Neal. “Fair value accounting would have us valuing Shaq’s game total at 35 points, when the scoreboard only recorded 15 for him,” said the executive who asked not to be identified. He explained that while O’Neal may be capable of scoring 35 points on any given night — and some sports analysts may figure that potential into his overall value — the reality is reflected on the scoreboard, where the true accounting takes place.

What’s more, this summer two academics blamed fair-value methodology for contributing to the credit crisis — lumping the accounting concept in with such culprits as reckless lending and inaccurate credit ratings of securitized debt. In the opinion piece they prepared for the Financial Times, Stella Fearnley of the U.K.’s Bournemouth University and Shyam Sunder of Yale School of Management, stressed the “circularity” of fair value.

By their lights, fair value assumes that markets have “good information” culled from financial results and credit-rating reports. But if rating agencies and investors get their data from corporate financials — “which are themselves based on prices inflated by a market bubble, the accounting numbers support the bubble,” the scholars argue. They continue: “So instead of informing markets through prudent valuation and controlling management excess, ‘fair’ values feed the prices back to the market.”

Other critics contend that purchase-accounting abuses could be worsened by the use of the fair value. Just last month, RiskMetrics Group, a research and consulting outfit, issued a report contending that while FAS 141(R)— the revised business-combination rule that mandates the use of fair value — tightens some purchase accounting loopholes, it widens others.

The study, “Acquisition Accounting: New Rules & Shenanigans,” for example, notes on the one hand that FAS 141(R) will make it harder for buyers to manage earnings because the rule restricts the use of restructuring reserves and in-process research-and-development write-offs. At the same time, FAS 141(R) leaves “plenty of room for management discretion and potential abuse,” the report authors write.

What’s more, co-author Dan Mahoney says, fair-value accounting leaves the door open for companies to understate assets and overstate liabilities because the assumptions are subjective.

Manipulating fair-value assumptions during the so-called “stub” period is one way companies will abuse the new purchase-accounting rules, Mahoney told The stub period is the gap between the last time a target company reports interim results and the acquisition closing date.

Under 141(R), which takes effect for fiscal years beginning on or after December 15, companies are required to value the target company’s assets and liabilities, identifiable intangible assets, and some previously unrecognized contingencies at fair-market value at the time of the sale. As a result, an overly aggressive company could manipulate assumptions to understate acquired inventory, then turn around and sell the inventory and record revenue with an understated cost of sales, for example.

By doing that, a company would see a boost in gross margins and earnings when they sold the inventory at the proper market rates. Similarly, if the company uses fair-value assumptions to understate accounts receivable, it will receive a boost to earnings when the outstanding bills are eventually paid and recognized.

Mahoney also warns investors to scrutinize acquisition price adjustments in light of fair-value calculations. He explains that under U.S. generally accepted accounting principles, buyers have up to one year after a deal closes to make adjustments to the purchase price allocation for assets and liabilities of the target company. Accordingly, the same earnings-boosting games can be played during the post-acquisition period that are played during the stub period.

Organic growth, a non-GAAP metric, will also be ripe for gamesmanship in purchase accounting, says Mahoney. Generally, organic growth is defined as corporate growth minus benefits attributed to acquisitions. “However, companies have come up with their own definitions of organic growth than can be misleading,” write the authors.

The study cites a situation in which an acquiring company reports an “internal” growth revenue number that includes a portion of the target company’s annual revenue, rather than removing all of it—as the acquirer should do. That accounting treatment could allow buyers to acquire targets that have just signed large deals and then later label that growth as internal, contend the authors.

Where should investors look to unearth such non-GAAP shenanigans? In the Management’s Discussion and Analysis of the company’s annual report or in earnings releases where other non-GAAP measures are discussed, says Mahoney.