For a rare, brief moment in financial-reporting time, companies will have some new latitude to cherry pick fair-value accounting treatments–reporting this liability at fair value but that one at historical cost–in a way that might cast a blinding spotlight on a picture of fiscal health.
But will they do so with only appearances in mind? The market is cautiously optimistic–betting, or at least hoping—they won’t.
When the Financial Accounting Standards Board adopted Statement No. 159 Fair Value Option, it gave companies a choice: You can report certain of your financial assets and liabilities at fair value–or not. You get to choose.
The standard allows companies to adopt fair-value treatment selectively so they can report assets and liabilities that are related to one another using the same method, said FASB when it issued the standard. Previously, companies suffered accounting-induced volatility in earnings because they were required to report such related assets and liabilities using different measurement methods.
LaMonte
The intention, says Mark LaMonte, vice president and senior credit analyst for Moody’s, is to enable derivative-like accounting treatment without the complexities of derivative accounting rules, which have proven difficult to apply and have led to a significant number of restatements in recent years.
“If you have a portfolio of fixed-income securities that are marked to market, and then you have debt that is theoretically hedging those assets, you have interest-rate-sensitive assets and an interest-rate-sensitive obligation, being debt,” he says. “By fair valuing the debt while at the same time having to record assets at fair value, you get to record the hedge effect without having to go through the exercise of Statement No. 133. The fair value option is useful in circumstances where it’s being used because a hedging relationship exists.”
But the newly adopted fair-value option standard doesn’t say companies can only use it where hedge-like transactions are in place. In principles-based fashion, the standard lets companies decide for themselves where to apply fair value treatment. That creates the worrisome opportunity for companies to use the rule to “dress up their balance sheet, especially at transition,” says LaMonte.
Hepp
John Hepp, senior manager for Grant Thornton, describes how misuse of the rule in the early stages of adoption might skew a company’s debt obligations or apparent credit worthiness.
“Assume a company issues credit, then the credit rating goes down,” Hepp says. “That means the value of the debt goes down.” The importance of fair value may mean different things to the entity that issued the debt compared to the entity who owed the debt, he says. “If I bought the debt, I’d certainly carry it at fair value on my books because it’s the amount I could sell it for,” he notes. “To the one who issues the debt, just because the market price has gone up or down, it may not mean they can settle the debt at that amount. Would I actually incur a loss if the fair value went up? If the fair value went down could I realized a gain?”
SUMMARY
The excerpt below is from Statement of Financial Accounting Standards No. 159, The Fair Value Option For Financial Assets And Financial Liabilities, published February 2007 by the Financial Accounting Standards Board:
Why Is The FASB Issuing This Statement?
This Statement permits entities to choose to measure many financial instruments and
certain other items at fair value. The objective is to improve financial reporting by
providing entities with the opportunity to mitigate volatility in reported earnings caused
by measuring related assets and liabilities differently without having to apply complex
hedge accounting provisions. This Statement is expected to expand the use of fair value
measurement, which is consistent with the Board’s long-term measurement objectives
for accounting for financial instruments.
How Will This Statement Change Current Accounting Practices?
The fair value option established by this Statement permits all entities to choose to
measure eligible items at fair value at specified election dates. A business entity shall
report unrealized gains and losses on items for which the fair value option has been
elected in earnings (or another performance indicator if the business entity does not
report earnings) at each subsequent reporting date. A not-for-profit organization shall
report unrealized gains and losses in its statement of activities or similar statement.
The fair value option:
May be applied instrument by instrument, with a few exceptions, such as
investments otherwise accounted for by the equity method
Is irrevocable (unless a new election date occurs)
Is applied only to entire instruments and not to portions of instruments.
What Is the Effective Date of This Statement?
This Statement is effective as of the beginning of an entity’s first fiscal year that
begins after November 15, 2007. Early adoption is permitted as of the beginning of a
fiscal year that begins on or before November 15, 2007, provided the entity also elects
to apply the provisions of FASB Statement No. 157, Fair Value Measurements.
No entity is permitted to apply this Statement retrospectively to fiscal years
preceding the effective date unless the entity chooses early adoption. The choice to
adopt early should be made after issuance of this Statement but within 120 days of the
beginning of the fiscal year of adoption, provided the entity has not yet issued financial
statements, including required notes to those financial statements, for any interim
period of the fiscal year of adoption.
This Statement permits application to eligible items existing at the effective date (or
early adoption date).
Source
SFAS No. 159: Fair Value Option For Financial Assets And Liabilities (Financial Accounting Standards Board; February 2007)
While in certain circumstances it may be possible, Hepp says the reporting of debt at fair value seems counterintuitive. “If you carry it through to its logical conclusion, a company with a negative credit rating could realize a profit through fair value reporting,” he adds.
Related Disclosures
Moody’s raises another significant concern about making the use of fair value optional, instrument by instrument, as the standard allows. “Comparability is one of our biggest concerns,” says LaMonte. “The fair value option can be elected on a contract-by-contract basis,” he notes. “We’ll have some companies accounting for things at fair value, and we’ll have companies accounting for the same transactions within a company, some at fair value, some not. It creates the potential for all kinds of comparability problems when something is completely optional.”
Wilkins
FASB’s answer to both concerns, raised and deliberated during the standard-setting process, is a healthy dose of disclosure requirements. “There are detailed disclosures that we believe will provide information to help people better understand the extent to which the fair value option has been elected and what the impact would be both on the balance sheet and the income statement,” says Robert Wilkins, the senior project manager at FASB who oversaw the development of the fair-value option standard.
To the concern about reporting debt at fair value, Wilkins says disclosure requirements specify companies must address changes to the instrument-specific credit risk, not the general credit risk. “The standard requires people to say not only what amounts attribute to that, but how gains and losses attributable to instrument-specific credit risk were developed,” he notes. “How did you determine those numbers? We don’t provide detailed guidance about how to do it, but there is a requirement that you make those disclosures.”
Wilkins emphasizes the importance of collateral to the reporting of debt levels. “Keep in mind if you have a liability of an entity that is over-collateralized, even though credit worthiness of the debtor decreases, there really may not be much impact on the fair value of the liability because creditors are relying on availability of collateral to provide resources for repayment,” he says. “They are not that concerned simply by deterioration of the creditworthiness of the debtor itself.”
Albert King, vice chairman of Marshall & Stevens and a member of the Financial Reporting Committee for the Institute of Management Accountants, says he thinks it’s a stretch that companies could manipulate the option in the new rules to achieve any kind of meaningful reporting gain.
King
“I don’t think it would be possible for a company to account its way out of real financial difficulty,” he says. “The markets are pretty efficient and people are pretty smart. This is a bookkeeping entry that has nothing to do with what a company needs to settle this debt. Writing down the value of a debt doesn’t alter the debt. The only way you reduce a debt in real terms is to go through bankruptcy courts.”
King says if companies get overly selective about how they apply the option to report assets and liabilities at fair value the market will notice and regulators will act. “If they adopt a pick-and-choose basis just to see where it will make things look better, the FASB and the Securities and Exchange Commission will step back in and make it not a fair value option but mandatory,” he notes. “The board has said publicly they want all financial assets and financial liabilities at fair value.”
King and other experts also emphasize that the standard does not allow companies to rethink their elections later. Once they elect fair value, they can’t reverse course and return to historical cost in a future reporting period.
That, says Moody’s LaMonte, makes the new standard a little easier to accept. He acknowledges the disclosure requirements will provide the necessary information to assess and compare companies, but it will involve a long monitoring period as companies transition to fair-value elections through early adoption and under normal timing. “Once we get past the transition period, relative to a company’s own debt, it would be rare for companies to elect to use the fair value option if they didn’t have a legitimate hedging purpose for doing so,” LaMonte says.
Miller
Paul B.W. Miller, accounting professor at the University of Colorado at Colorado Springs and a former FASB staffer, says the fair-value option represents a big step toward principles-based accounting, giving companies parameters within which to make sound accounting judgments.
“This standard represents a whole new approach to regulation by creating choices that can be used for good or bad,” Miller says. “Too often, bad accounting has been imposed on everyone to keep anyone from using really bad accounting. The loss is that good accounting hasn't been allowed.”
Miller adds that FASB may well be betting that the forces of good accounting will prevail over bad accounting. “FASB is apparently hoping that the benefits of opening up superior accounting to intelligent managers will outweigh the costs of the fruitless efforts by some managers to make themselves look better than they really are,” he says. “The long term goal has to be that the benefits reaped by the first group will make others want to do the same thing.”
Related standards and coverage can be found in the box above, right.
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