Battle Looms Over Fair Value for Financials

Financial firms may be the ones combating the Financial Accounting Standards Board to derail a rule that would require more use of fair-value accounting for derivatives and similar instruments, but many others in Corporate America are cheering them on—fearful that provisions of the rule could lead to more valuation homework, more judgment about items on the balance sheet, and more earnings volatility.

FASB has already received more than 300 letters about its proposal, most of them from financial firms panning the idea. The correspondence comes ahead of an October roundtable on the proposed rule, which would require fair-value accounting for all financial assets and liabilities carried on corporate balance sheets.

Banks are the most at risk as FASB ponders its rule, since they carry so many financial instruments on their balance sheets. But businesses outside the banking sector have a stake in the outcome as well, since the new standard would overhaul hedge accounting rules and require fair-value treatment for some investment securities, debt instruments, and trade receivables that companies routinely use to manage cash and capital on a daily basis.

Greg McGahan, a partner with PricewaterhouseCoopers, says the typical operating company has many financial assets and liabilities on its financial statements that are carried at a cost basis, meaning they are valued at the purchase price, adjusted over time for various factors. The proposed standard would move more of those instruments to fair value, with changes in value recorded in earnings. “Obviously that would be a big change,” he says.

Included in the proposal are instruments such as equity investments in private companies, options to purchase private company shares, mutual funds, and investments in convertible debt instruments. Most investments in common stock would be subject to the fair-value requirement, including those in private companies and some investments currently accounted under the equity method (recognizing a pro rata share of earnings). Even a company’s accounts receivable might need to be recorded at fair value, unless the company plans to hold the receivables for collection.

“Trying to apply fair value to some of these investments will be very difficult,” McGahan says. “It would require a lot more time and effort, and it would change a company’s processes.”

For example, according to McGahan, applying fair value to equity investments in startup companies—a common way to provide capital to develop underlying technology—would be particularly difficult. “These are illiquid private companies that barely get their financial information out the door, and you have to figure out how to fair value them,” he says. “That’s a significant change.”

The Volatility Problem

Kepple

“Trying to apply fair value to some of these investments will be very difficult. It would require a lot more time and effort, and it would change a company’s processes.”

—Greg McGahan,

Partner,

PricewaterhouseCoopers

Paul Kepple, chief accountant at PricewaterhouseCoopers, says most debt securities are already now marked to fair value. But changes in value flow to the “Other Comprehensive Income” category on the income statement, he says, and that only affects equity levels on the balance sheet. “Many of those securities under this proposal would be marked to fair value, but through the income statement—so that will create a lot more earnings volatility for companies,” he says.

Financial executives might not like the news so far, but other elements of FASB’s proposal could actually be welcome improvements for corporate accounting departments. Ken Marshall, financial accounting advisory services leader for Ernst & Young, says the standard would abolish the bright-line, document-intensive analysis of whether a transaction qualifies for preferential hedge accounting treatment; it would be replaced by a more straightforward qualitative analysis. That makes it easier for a transaction to qualify for hedge accounting, but it also introduces judgment and eliminates shortcuts.

Marshall

“It’s simpler accounting, and it more closely resembles the economics of the hedge relationship,” Marshall says. But the elimination of bright lines also means the elimination of the short-cut method, which provided an automatic qualification for hedge accounting treatment, he adds. “Now you would need to reassess all those hedges under the qualitative framework.”

COMMENTS ON FI PROPOSAL

[T]he current model does not provide investors in large, complex

financial institutions with an accurate picture of a company’s financial position and does

not foster sound risk management. This latter point is crucial, as poor risk management

was at the heart of the financial crisis. Firms that do not follow a fair value through net

income (“FV-NI”) model often must evaluate the trade-off between optimal risk

management decisions and the financial statement consequences of their actions. Those

consequences often are negative and can result in poor risk-management decisions. The

consequences of such decisions can have a significant effect on financial stability.

Goldman Sachs has long advocated a FV-NI model for financial assets and trading

liabilities because it provides a clear picture of our financial position and because it

fosters sound risk management which benefits the broader financial system.

Consequently, this would be our first choice in developing a new accounting model for

financial instruments. We recognize, however, that this is a minority view that also is not

achievable at the current time. Faced with these realities, we are supportive of the [Accounting Standards Update]

and believe it is a good compromise for the banking book because the balance sheet

would reflect fair values and impairments would be recognized sooner than the current

incurred loss model. Additionally, investors, regulators and other financial statement

users would have the information necessary to understand the balance sheet and income

statement impacts of the changes in value of the banking book assets.

—Matthew Schroeder

Managing Director, Global Head of Accounting Policy

Goldman Sachs

FASB’s proposal and IASB’s guidance contain fundamental differences, such as

when financial assets would be measured at fair value with changes in fair value recorded

in net income or in other comprehensive income (OCI) or at amortized cost, when

financial liabilities would be measured at amortized cost, fair value, or a mixture of the

two, and how financial assets would be evaluated for impairment. We believe that the

FASB and IASB will miss a significant opportunity to demonstrate their commitment to

convergence if there is divergence on such a fundamental aspect of financial reporting as

the accounting for financial instruments and hedging activities. In addition to the

difficulties in understanding and comparability that divergence causes for financial

statement users, members of the FASB/IASB Expert Advisory Panel (EAP) have noted

that implementation of different FASB and IASB impairment proposals simultaneously

by entities that have operations that apply GAAP and IFRSs would be a significant

operational challenge. We believe that it is important for the FASB and IASB to work

together in order to achieve high-quality, converged solutions.

—KPMG

The CCMC supports FASB’s objective to simplify and improve financial reporting for financial instruments. However, the CCMC believes the Proposal establishes a path contrary to that objective by adding complexity and confusion in financial reporting because:

The Proposal fails to achieve convergence because of serious, potentially irreconcilable fundamental differences between FASB and IASB;

The Proposal creates classification and measurement systems that fail to accurately reflect an entity’s business model;

The Proposal produces unnecessary complexity in the measurement and reporting of core deposits;

While the hedging proposal has improvements over current accounting practices, the scope of potential economic activity itself remains unsettled;

The current system of equity method accounting should be maintained; and

The Proposal fails to provide an adequate cost benefit analysis.

—Tom Quaadman

Vice President

Center for Capital Markets Competitiveness

Source

Comments on FASB’s Financial Instruments Proposal

But the standard would also eliminate the flexibility to designate something as a hedge at the start of a transaction then “un-designate” it as a hedge later. “Once a hedge, always a hedge,” Marshall warns, “so you have to be pretty comfortable with the hedge relationship well into the future.”

Arcy

Jerry Arcy, managing director at Duff & Phelps, says companies outside the financial services sector have been a bit unaware of what’s coming at them. “Non-financial services entities should be interested in this, but I’m not sensing that they’re participating very broadly in [the discussion],” he says. “There are some tactical areas in this that are going to come to roost and hit companies much stronger than they realize.”

Arcy says companies should study the proposal and offer their views on it to assure FASB hears from a broad range of filers—not just those in financial services—that would be required to apply it.

Scoles

Mark Scoles, a partner with Grant Thornton, says it’s too soon for companies to change their accounting systems in preparation for the new standard—but it’s not too soon to study how the standard might change your accounting policies and practices. He also encourages companies to write to FASB even if only to express a few specific points of concern.

Accounting experts watching the standard closely say this one is ripe for change before it becomes final, especially since the exposure draft was approved by only a 3-2 vote. Chairman Robert Herz cast the deciding affirmative vote.

Herz

Herz is leaving FASB Oct. 1, and will be replaced by FASB member Leslie Seidman. She dissented from the majority in publishing the draft in its current form. Seidman contends that companies should have more latitude to set values based on long-term plans to hold instruments and draw in the cash flows they are expected to produce.

Even further, FASB’s overseer, the Financial Accounting Foundation, also announced last month that it would expand FASB from five seats back to seven upon Herz’s departure. (The FAF eliminated those two seats only a few years ago.) That means three new votes will be introduced just as FASB decides the standard’s final fate, which opens the door to significant changes, Scoles says.

Arcy calls it an “opportunity” to drive the standard in a new direction. “This could change the whole momentum,” he says.