What's so Fair about Fair Value?
Referred to colloquially as “fair value accounting,” the new rules issued by the Financial Accounting Standards Board (FASB) are intended to force corporate income statements and balance sheets to reflect current value rather than historical cost for assets and liabilities. The thinking is that by providing an item’s current or fair value, anyone analyzing the financial statement will have a better understanding of how the company is actually doing.
Only problem is, calculating the value of certain items can be difficult at best. Valuing a marketable security is pretty straightforward, but how do you value an intangible like a corporate brand? Sceptics fear companies will find ways to manipulate fair value estimates. And because subjectivity will enter into the equation, the process of transforming to new valuation methods may be anything but fair. Furthermore, the FASB has received so many comment letters that there is speculation that the effective date, set to apply for statements issued for fiscal years beginning after June 15, 2005, might be moved. In short, the fairness of fair value is being questioned.
Fair value accounting as a concept is entirely not new. Most people are familiar with its use in the accounting of inventory, for example, which is recorded at cost and then adjusted down to the lower of cost or market value, and for accounts receivable or marketable investments, which are also adjusted down for uncollectible accounts.
It’s the subjectivity of fair value accounting that’s relatively new as a concept. Historically, balance sheets represented the accumulation of assets less depreciation or amortization, based on the actual cost, which was a known number. Debts represented obligations minus any payments already made. The income statement was designed to capture historical profit or loss for a certain time period, based on objective data.
But then the thinking about what the income statement ought to represent began to change. In 1984, the FASB first introduced some flexibility in its Statement of Financial Accounting Concepts No. 5, which stated that “financial statements are to be measured by different attributes such as historical cost, current replacement costs, current market value, net realizable value, or present value of future cash flows.”
The debate about whether to use historical cost or market value really heated up in response to the savings and loan fiasco of the 80s. People began to question whether flawed accounting by our financial institutions had in some way contributed to the crisis.
At a November, 1991 SEC conference in Washington, DC, a consensus formed around the idea that historical cost accounting was losing relevancy and that it should be replaced with mark-to-market valuation. Mark to market was born. As a result, the FASB began to require companies to supplement their historical cost information with disclosures about the fair value of financial instruments reported on the financial statements – but only in the notes. Nevertheless, the transition to fair value accounting had begun to roll.
Other standards followed, including valuation accounting by creditors for loan impairments, and for impairment of long-lived assets. Further standards required valuation accounting of derivatives, business purchases, as well as goodwill and other intangibles. With valuation accounting extended to much of the balance sheet, it was only a matter of time before the FASB would issue guidelines on how accounts should be valued.
In June, the FASB issued a new exposure draft on fair value measurements providing guidance on how to measure both financial and non-financial assets and liabilities, and expanding disclosure requirements. Under the new standard, fair value should be determined using multiple valuation techniques consistent with market approach, income approach and cost approach. All three approaches should be considered, though not necessarily used, according to the FASB.
The FASB identified three levels of valuation, each progressively harder to measure and therefore requiring more professional judgment:
Level One assumes that current market data is available, such as for marketable securities that are actively traded.
Level Two assumes that no market information is available but that comparable information exists, as is the case when a particular security doesn’t trade but where a comparable security does. Valuation would then be based upon the market value of the similar security, with some adjustments.
Level Three assumes that no market information exists, even for similar assets or liabilities, as is the case for certain intangibles such as intellectual property. The valuation would then require a computation of the anticipated earnings or cash flow which would be generated – discounting the expected future cash flow. This number could swing wildly based upon the professional opinion of the evaluator, and that’s what isn’t fair about fair value. At level three, no one really knows what the true value is.
If a company’s fair value calculation for a Level Three item requires a computation of the anticipated cash flow, then under the income approach, the company should estimate present value of expected future cash flow or earnings that could be generated from the asset. What makes this hard is that you first have to strip the cash flow from other assets, requiring access to historical data and sometimes sophisticated cash flow models. The other difficulty is predicting the cash flow life cycle of the asset.
With the treasurer’s role expanding to include fiduciary responsibility over assets and liabilities and anticipated cash receipts or disbursements, then even if the treasurer isn’t personally responsible for the valuation, he will be called to provide the data necessary to compute the value. Any cash flow guidance the treasurer provides will have a significant impact on valuation results.
Asset valuations for Level Three assets will depend primarily on the bifurcated earnings or cash flow allocation generated by each Level Three valuation. This will need to be carefully calculated taking into consideration all facts and circumstances related to that particular asset. At the same time, company earnings and cash flow attributed to tangible assets, unrecorded intangible assets, or other investments should be excluded from the computation.
One thing financial professionals need to be aware of is that documentation will become critical to the process. After all, Level Three valuations will be based largely upon a professional person’s opinion about what he thinks is going to happen, so there will have to be justification for his estimates. These estimates will be used to arrive at the net cash flow estimates, which are dependent upon the estimated future revenue less the estimated future costs associated with the asset. The treasurer must understand which balance sheet values are subject to professional interpretation and be prepared to support and document a reasonable value, without unduly influencing the third party making the valuation.
There are likely to be increased requirements for financial professionals with custodial responsibility over balance sheet assets and liabilities to establish monitoring processes.
|
Moving to fair value, there’s an increased risk of financial statement volatility that could result in unexpected changes in corporate balance sheets, skewing the financial ratios commonly used by lenders, credit agencies and investors to determine the financial health of a company. While a company might be enjoying healthy cash flow activity, a sudden change in circumstances related to an asset held on the books of the company could result in a sudden reduction of both assets and equity triggering a violation of debt covenants. It may also place the company in a new and higher risk category with credit rating agencies. A sudden impairment adjustment could increase the cost of company capital due to a credit change from the agencies.
In this risk-adverse environment, there’s also a danger that during the company audit, audit procedures might be more focused on protecting the auditor than on fairly presenting a company’s financial condition. Since opinions often differ among professionals, the use of professional estimates is likely to lead to an overly conservative valuation, to the detriment of the issuer.
Nowhere are estimates more difficult than where they involve events in the future. The use of professional judgment of unknown future events raises the risk of error or material miscalculation. And if investors suffer damages after relying on subjective estimates, the results are sure to be lawsuits, which could become messy. Just imagine what will happen as each side produces its own experts with their own valuations.
Though fair value accounting is supposed to provide more relevant financial information to the reader, when certain types of information aren’t readily available, computing fair value certainly can involve a high degree of estimation. And for that reason, some people are going to say it isn’t fair.
Even the accounting standards board acknowledges that there is a tradeoff between reliable values and relevant (fair value) values, but they’re willing to accept the tradeoff. For those who grew up using historical cost accounting, it’s a bit like substituting subjective values for objective values on the balance sheet. Under the old view there was at least a known figure, based on something concrete, rather than on an individual’s professional opinion.
Fair value accounting is changing the way we record and report corporate financial activity. The rules themselves will continue to change, as international accounting rules converge.
For certain items, until a valuation is challenged by regulators, investors, or through litigation, or until the asset is really sold or disposed of, a concrete number can’t be known. Whether or not the subjectivity introduced by fair value accounting proves fair to companies and investors, in the near term it’s likely to be slippery.