You’ll Need a Fair Value “Mindset”

The chief accountant at Xerox debates why corporates may not be ready to use fair value on non-financial assets.
Marie LeoneJuly 10, 2008

It will take more than a change in rules to make companies comfortable with the move to fair value accounting. It will take a change in “mindset,” predicts Gary Kabureck, the chief accountant and corporate vice president at Xerox Corp.

Kabureck was one of eight experts invited by the Securities and Exchange Commission to participate in a roundtable session on fair value accounting this week. Representing the perspective of financial statement preparers, the chief accountant debated several key points with fellow panelist during the half-day meeting that was aimed at fleshing out thorny issues related to the switch from historical cost accounting to the fair value method.

“Fair value accounting is a very different issue for commercial companies than [it is] for financial services companies,” asserted Kabureck, mainly because the composition of a commercial company’s balance sheet is different, as is the basic business model. Indeed, since the SEC and U.S. and international accounting standard-setters have pushed for the expanded use of fair value accounting — an effort codified by the release last year of FAS 157 Fair Value Measurement — critics have complained that the methodology is not suitable for the non-financial assets. The reason: For assets and liabilities that are not based around short-term trading, or are held to maturity — such as loans, deposits, and receivables — fair-value measurement leads to income statement volatility, such as understatements and overstatements.

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While Kabureck supported the idea of measuring financial assets and liabilities using fair value, he said that the idea of using the methodology to value non-financial items needs more scrutiny by regulators and standard-setters. Companies “have lived with a mixed attribute model for a long time,” and will continue to deal with those models even after fair value accounting is resolved, said the Xerox executive, referring to a financial statement model that uses both fair value and historical cost calculations.

Kabureck explained that using fair value accounting on non-financial assets and liabilities is “difficult” because those items do not have contractual cash flows or available markets which act as a starting point for value estimates. In fact, Kabureck said some fair value estimates puzzle him in general because he still cannot figure out what has caused the “mega adjustments” or huge subprime-related writedowns that have been reported by companies such as Citigroup, UBS, Merrill Lynch and others. He posited: Were the writedowns caused by mark-to-market accounting, impairment charges, or off-balance sheet items that came back on the balance sheet?

Despite saying that the focus on fair value is “more important today than ever before,” Kabureck wondered whether “we have gone too far in trying to apply fair value in too many places . . . and arguably producing misleading results.”

To make the switch, he said finance executives would have to change their mindset with regards to how they view their businesse if fair value measurement is mandated for non-financial assets. For instance, FAS 157 says that if the principle market for an asset is deep and active, then an input from that market should be used to derive a fair value — even though the principle market may not be the most advantageous market. Such a concept would be difficult for operational managers to consider because they tend to “work [their] most advantageous market,” says Kabureck.

What’s more, FAS 157 instructs preparers to look at hypothetical transactions to value assets and liabilities if an active market does not exist. In essence, managers will have to train themselves to think like market participants rather than operations experts, something that Kabureck says will be a challenge.

He sees longer-term problems on the education front in terms of accounting curriculum at colleges and universities. “To some extent, business schools are still in the industrial economy,” with respect to accounting programs. Kabureck says that so far, schools have not put enough emphasis accounting for “21st Century economies,” because they lack a focus on fair value measurement, valuation techniques, and present valuing derivatives.

He also worries the increased volume and complexity of fair value measurement will force many companies to bring in outside specialists, which presents a set of problems in itself. Those snags include: finding the right valuation team; scheduling their work to coincide with relatively short timeframes when companies have to close their books and produce regulatory filings; and vetting the outside firm’s internal controls and procedures. He suspects there also will be a bit of “opinion shopping” among companies that hire outside specialists, as each valuation firm base their estimates on different theories and approaches.

By Kabureck’s lights, there is a “need for a path forward on non-financial assets and liabilities, or at least a further deferral of FAS 157 for them.”