Ask the Expert: Fair value accounting and the FASB
By Susan Campbell
All's fair in love, war and financial accounting, right? Not quite. With today's unpredictable market conditions, investors need to know what an asset is currently worth, rather than what is was worth when it was acquired. As a result, the Financial Accounting Standards Board (FASB) increasingly requires U.S. corporations to mark more balance sheet items to their "fair value." But what exactly does fair value mean and what are its implications?
Under GAAP, the fair value of an asset is the amount at which that asset could be bought or sold in a current transaction between willing parties, other than in a liquidation. On the other side of the balance sheet, the fair value of a liability is the amount at which that liability could be incurred or settled in a current transaction between willing parties, other than in a liquidation. Quoted market price in an active market is the best evidence of fair value and is used as the basis for measurement. Many times quoted market prices for an asset are often unavailable, so an estimate of fair value can be used. As a result, difficulties can occur when making estimates of fair value.
But unlike the more static economic environment of the 1970s when the FASB first developed many of the principles guiding current financial reporting, today's rapid price changes and shorter technology cycles can more dramatically shock the economic system. Does this changed environment require fair value-based reporting across the board? Although fair value can provide more transparency than historical cost based measurements, many claim that fair value reporting may make financial statements more subjective, too volatile and increasingly difficult for comparing companies for investment.
The Financial Journalist asked an expert, Tony Sondhi, Ph.D, of A. C. Sondhi & Associates in Maplewood, N.J., to comment on this debate and evaluate the implications of fair value reporting for analysts and investors. Sondhi is founder and president of the firm, which develops and markets analytical tools and databases to institutional and individual clients for investment and financial reporting purposes.
On Subjectivity...
In the real world, hard assets such as plant facilities, land or illiquid securities are typically reported at historical purchase prices. In recent years, standard setters, including the FASB, have asked companies to more accurately reflect changes in the value of assets and liabilities using comparable transactions in the marketplace and management's best understanding of the fair values.
"All non-market- based fair values are subjective because they are based on and sensitive to the estimates, assumptions and measurement methods management uses to determine fair value," says Sondhi. "However, subjectivity need not be a deterrent to using fair value accounting. Whether we like to admit it or not, estimated fair values are the basis of our economic decisions. Just as when you lease a car, or turn it in, you want the best estimate of the car's current fair value, regardless of its original price. This movement by the FASB reinforces the relevance of fair values to effective decision making."
On Volatility...
Many fear that fair value will bring a level of volatility to financial statements that will make it more difficult for investors to make sense of them. In Sondhi's opinion, historical cost isn't the solution, it's the problem. "I think that historical cost hides a significant amount of actual volatility in the marketplace," said Sondhi. "There is more market volatility today, and fair value reporting will better reflect this actual volatility."
On Comparability...
"Historical costs are never comparable," he said. "If an investor is looking at two paper companies, each with a paper mill, but one company bought its mill years ago and the other just completed construction, the prices on the balance sheet are not comparable. As a result, financial ratios, other investment metrics and inputs for valuation models are confounded. The FASB move to fair value will significantly increase comparability."
While the FASB has required companies to report fair value for certain items such as derivatives and other securities on the balance sheet, other related assets and liabilities are reported at historical cost or some mix of historical costs and fair value. Sondhi cites the example of a company using derivatives to hedge foreign currency exposures of investments in foreign operations. "Unlike derivatives, these investments are reported at the current exchange rate times the historical cost of the investment; it is unlikely that such a measure reflects the company's actual economic exposure to currency movements."
"Inconsistent measures of derivatives and the related assets or liabilities often obscure the extent to which the company has effectively hedged its economic exposure and make it harder to compare investments."
Inadequate disclosures present additional problems. According to Sondhi, the best way to fully explain balance sheet items is to report fair values accompanied by substantive footnote disclosures that explain the procedures that management used to arrive at their best estimates, as well as the sensitivity of those estimates to assumptions underlying the computation.
Although there is much debate today about what fair values are, and many obstacles to overcome as people get used to looking at financial statements in a different way, Sondhi believes that debate is very healthy for the economic system. Long term, the movement towards a consensus on how to better measure fair value, combined with better disclosure, will ultimately help investors make more informed decisions.
Susan Campbell has more than 20 years of experience implementing creative solutions to financial services marketing communications problems.
Issue 16, The Financial Journalist - February 2004
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