Summary
The article makes several claims that need a response. First, it declares the principal question that accounting tries to answer is “What is a company really worth?” Second, it states that fair value played a role in the recent “economic meltdown,” because the fair value rules forced “banks to sell their securities in plummeting markets.” Third, it states that historical cost reporting “enabled companies to work their way out of trouble,” by waiting until the market turned around. Fourth, the case is made for fair value measures being unreliable. Finally, it’s noted that International Financial Reporting Standards (IFRS) favor greater use of fair value.
Analysis
First, I was surprised to find I misunderstood the role that accounting plays in our society. I actually thought that accounting was supposed to show an entity’s financial position and results of operations under some rules, like GAAP. If the role of accounting is to find out what a company is worth, it probably would be wiser and certainly easier to consider a company’s market capitalization. That measure is an objective measure of the value of a company. Perhaps for both public and non-public entities, certain industry earnings multiples should be considered or even measures of the present value of estimated future net cash flows.
A company’s real worth might also be approximated by determining its assets minus liabilities measured at fair value. It might be interesting to see if the sum of the parts comes anywhere near the whole as determined for example by a company’s market capitalization.
Currently, reporting assets and liabilities at fair value is not the norm. Rather as most people know, accounting uses a so-called “mixed attribute model” where some assets are measured at fair value, others at historical cost and some at imaginary values like cost minus depreciation or amortized cost.
The argument that fair value measurement caused “banks to sell their securities in plummeting markets,” is simply absurd. Certainly, the sell decision was based on avoiding the possibility of further losses or more simply perhaps, that alternative investments were more attractive.
Accounting’s role in the so-called “economic meltdown” was clearly not the result of the use of fair-value. By the author’s own admission, Fannie Mae’s use of fair-value measures resulted in a 66 percent drop in assets but “had a favorable impact on the company’s results of operations for the quarter.” Accounting, however, did play a role in the mortgage meltdown by not requiring banks to consolidate their so-called qualified special purpose entities. These mortgages in a sense were not on anyone’s books.
Yes, the historical cost model does allow companies to work their way out of (or maybe even into) trouble. Unfortunately for far too many investors and creditors, it also hides the company’s “real worth.”
Under current rules, fair value measurement isn’t even required. For example, under Statement of Financial Accounting Standards (FAS) 159, an entity may “choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value.” FAS 159 applies to financial assets and liabilities and includes for example, cash, evidence of ownership interest in an entity and investments in debt securities. Financial assets also include loans and accounts receivable or in the language of FAS 159 “contracts that convey to one entity a right to receive cash or other financial instrument from another entity.” Presently, financial assets may or may not be stated at fair value because the choice is made instrument by instrument. However, once the choice is made, it is irrevocable.
The bankers associations strongly opposed FAS 159 as it has many other standards. For example, the American Bank Association (ABA) and the International Banking Federation (IBFed) argued that requiring “full fair value” measurement of financial assets and liabilities is not relevant. Apparently for some telling a lie enough times will result in people believing it.
Fortunately, the investment community believes that reporting financial assets at fair value is highly relevant. For example, knowing the fair value of an entity’s investment in securities or the fair value of a bank’s loan portfolio is critical to understanding financial position and results of operations. Currently, some banks are reporting their loan portfolio using fair value and others are not. Hopefully, the marketplace will influence the decision to adopt fair value by seeing fair value statements as being more transparent.
In fairness however, the author’s principal argument is with FAS 157, which entails sorting each fair-value estimate into one of three levels. The fair value for a level one asset is its quoted market price in an active market. When that’s not available, the fair-value estimate could be based on “observable market data,” a level two asset. The third level uses “unobservable inputs” based perhaps on internal models or estimates. Admittedly, it’s this third level that is causing much of the controversy. However, I believe that it is mostly the poster child for eliminating fair-value reporting entirely.
Is there a danger that fair-value measures and especially those based on level three are subject to manipulation? Without question this could be the case. However, earnings today are being manipulated under the current mixed attribute model. Consider, for example, the areas of security investments, receivables and inventories.
A debt security, for example, can be classified into one of three categories based on management’s intent. These categories are trading, held to maturity or available-for-sale. While both trading and available-for-sale securities are shown on the balance sheet at market, the change in unrealized gains or losses from available-for-sale securities is not shown in the income statement. A debt security classified as held-to-maturity will be shown on the balance sheet at amortized cost and changes in its market value are ignored.
Receivables are shown at their gross amounts minus estimates for sales returns, doubtful accounts and sales adjustments. I’ve been frequently fascinated with situations where the gross receivables increase significantly and at the same time the allowance for doubtful accounts decreases. Possible manipulation? You bet.
Inventories almost always involve estimates for simple overstocking or technological obsolescence. To often it seems these reserves decrease in years where meeting the consensus earnings forecast is in jeopardy.
On Friday September 5th, I received a PricewaterhouseCoopers (PWC) report titled “10 Minutes on Fair Value in Financial Reporting.” In it they called for an end to expanding the application of Fair Value beyond today’s requirements. They demanded that standard setters show for any new fair-value regulations that they are relevant, reliable and practical. To say I was surprised would be a huge understatement.
The relevance of fair-value information is undeniable for financial assets. Is fair-value information less reliable than is currently available? Perhaps but remember the estimates involved in producing accounting numbers are so prevalent that to argue that they are reliable is foolish. The difference is we just don’t tell anyone that our measures are not reliable. Also should there not be a tradeoff between relevant information and reliability? For example, what is the relevance of showing so-called identifiable intangible assets such as patents at the difference between the original assigned costs minus an arbitrary amortization amount using the straight-line method?
The world’s largest accounting firms have been till now, great supporters of fair-value. The relevance issue is indisputable. As to practicality, small entities would have difficulty complying with fair-value requirements but what are the chances that they have credit or interest rate swaps on their books? Even in those cases consultants are available with suitable valuation training. Perhaps, PWC needs to invest in personnel with the suitable valuation experience.
Finally, IFRS are far more advanced in the use of fair-value measures. Not only are financial assets shown at fair value but non-financial assets as well. “The only part where fair value comes into a bit more in IFRS is we allow the revaluations of properties. And that is quite useful, because it shows the financial strength of the organization.” [Sir David Tweedie, IASB Chairman, interview published at http://www.cfo.com/article.cfm/11957302?f=search]
While many already claim the use of fair-value leads to higher market volatility with its limited use under GAAP. One would have to say, “you haven’t seen nothing yet – wait till IFRS have to be followed.”
