Coming to terms with fair value accounting

Implications: This article is the best summary to date of the FASB's new standard on fair value accounting.  FAS 157 is an important standard.  First, it allows (but doesn't require) companies to abandon historical cost for a broad range of financial assets and liabilities.   It also reflects a change in the FASB's philosophical approach towards a more balance-sheet oriented approach to standards setting, in contrast to the earnings measurement approach that used to dominate.  Also of interest is the principles-based nature of the standards.  In both of these ways, FAS 157 is close to what one might expect from the IFRS.  This standard is just one more step on the road to GAAP-IFRS congruence.  The article is also useful in pointing out the key issues that analysts need to understand to avoid being blindsided by reporting entities.

Analysis: Fair value accounting offers both opportunity and risk for analysts.  On the plus side, it offers more relevant information than historical cost figures.  For example, company risk exposures and asset coverage can be better understood. 

On the downside, however,  FAS 157 doesn't mandate  fair value accounting, but simply allows it for assets and liabilities that previously were valued using historical cost.  What's more, companies can elect to use fair value for some assets and liabilities, but not use it for like items.  They will have to disclose this fact, and why fair value was not chosen.  But the fact that some items will be valued using fair value and other similar items won't be presents a complication for the analyst.  Another potential problem is that many of the asset and liabilities covered by the standard are not traded on public exchanges, and therefore do not have readily observable market prices.  Companies must therefore resort to some form of DCF model, with all of the dangers that this implies.  Slight tweaks in assumptions can lead to huge changes in value. 

The article also points out a potential avenue for manipulation that analysts should be aware of.  Unrealized holding losses on securities available for sale can be reclassified as trading securities upon implementation of FAS 157, with the losses becoming part of a cumulative-effect adjustment that goes straight to retained earnings.  Even if the instruments are later sold for a loss, the resulting loss won't appear in earnings.  Just one more fair value trap that analysts will have to look out for.