Mixed Approaches, Mixed Messages, on Financial Reports

The financial crisis has brought corporate accounting to a crossroads: the historical-cost method on one side, fair value on the other.

Financial reporting executives hoping for guidance about which way to proceed might find themselves waiting for a long while.

Financial statements have long relied on historical or amortized costs to tell the story of a company’s fiscal condition, but in recent years more and more items have migrated over to the fair-value realm of reporting. Now, however, fair value has been faulted by critics as contributing to market tailspins—forcing rule makers to reconsider whether they will continue down the fair-value path as investor activists demand.

Expect that debate to last quite a while. Historical cost, for example, has support because it’s a clear-cut approach where numbers are easy to track and verify, but it leaves much to the imagination about assets that have been carried on the books for years.

Hardesty

“Historical cost is like the lampshade joke,” says David Hardesty, a CPA and author for the tax and accounting arm of Thomson Reuters. “You lose your keys and look for them under the lampshade because the light is better. You can see pretty well under the lampshade but what you’re looking for is not there. You can verify cost pretty easily but it doesn’t mean anything.”

Then there’s fair value. The Financial Accounting Standards Board has been on a slow march to steer financial statements toward an increased use of fair value, starting at least with financial assets and liabilities, providing a more current, market-based perspective of an entity’s fiscal condition. But the concept of fair value has taken serious hits in the current market; financial institutions in particular say it forces them into a vicious cycle of writing down asset values and prolonging the recession.

“There was a push among some to move the entire balance sheet to fair value, and the conceptual question is still on the table,” says David Larsen, managing director at advisory firm Duff & Phelps. “But because of current market conditions and all the discussions around fair value, I don’t believe there’s an appetite to move quickly in that direction in the near future.”

Striking a Balance?

Corporate accounting executives stuck in the middle of this uncertainty are left using the “mixed attribute” model to craft their financial statements, piecing line-items together using both accounting methods.

“For some assets and some liabilities, at some times you record the measurement based on historical cost or amortized cost; at other times you require a fresh measurement made at fair value,” says Ed Trott, a former FASB member.

To be sure, much of a company’s balance sheet is still carried at historical or amortized cost or some variation thereof, Trott says. Even in the banking sector—which brims with financial assets and liabilities well suited for fair value accounting—more than 80 percent of a bank’s balance sheet is not carried at fair-value, he says.

Operating companies end up with a mixture of measurement approaches as well, he adds. The typical manufacturing company usually owns some number of marketable equity securities or debt securities carried at fair value if they’re available for sale or held for trading. Pension plans also are reported at fair value, and occasionally assets must be remeasured at fair value if they are deemed impaired.

FCAG COMMENT SUMMARY

Below is a summary of comments received by the Financial Crisis Advisory Group about the state of financial reporting today.

Question 1: From your perspective, where has general purpose financial reporting helped identify issues of concern during the financial crisis? Where has it not helped, or even possibly created unnecessary concerns?

Constituents explained that there is no doubt that society is currently in the middle of a very serious economic crisis. Furthermore, constituents expressed there also is no doubt that mechanisms created to prevent and warn of such problems have failed, and that in many circumstances, urgent, and perhaps radical action is required by those who previously played a role in a well-functioning society. Given the sheer magnitude of the financial crisis, many constituents think that all aspects of the financial regulatory regime should be reviewed to understand what, if any, individual elements contributed to the financial crisis.

A few respondents noted that bank lending, poor risk management, and greed lay at the heart of the financial crisis, not financial reporting. There were comment letters that stated that if the economy is to function properly, accountants must reflect actions made by individuals and entities, even if those actions lead to the demise of an entity. More so, fair values gave early indications and were instrumental in putting a spotlight on the losses that were being realized throughout the economy.

A few constituents mentioned that, in the marketplace, there are views that financial

statements do not provide sufficient transparency. However, other constituents believe that some have confused transparency with the ability to predict a future outcome. Transparent financial reporting permits a user to understand an entity’s financial position at a particular point in time and financial performance over a particular period. While transparent financial reporting can provide information that can help an investor to better understand how an entity may perform financially in the future, it cannot predict that future financial performance.

A comment letter stated that the objectives of general-purpose financial statements are to

provide information about the financial position and its performance and about changes in

the financial position of an entity that is useful to a wide range of users in making economic decisions, with primacy given to the needs of providers of debt and equity capital. As discussed at all FCAG meetings, transparency is the fundamental objective of accounting and financial reporting. However, constituents question the extent that financial reporting has been transparent over the last 18 months.

Mark-to-Market Accounting

There were two clear and distinct views on the relationship of mark-to-market accounting

and the financial crisis. The majority view was that mark-to-market accounting only played a positive role, if any, in bringing the financial crisis to light. The other view was that mark-to-market accounting was/is a causing factor of the financial crisis.

Constituents who believe that mark-to-market accounting only played a positive, if any, role in bringing the financial crisis to light noted the following:

Fair value results can appear harsh when securities prices are declining; yet, for obvious reasons, critics were silent when asset values were rising.

Fair value accounting is the most transparent way to provide information.

The only way to fix what has happened is to have Congress or regulators fix the market infrastructure, and not call for accounting rules to change because accounting rules only indirectly provide guidance on what should be done. Accounting should not be an escape goat for failures in other areas.

Fair value accounting and its required disclosures help investors understand the risks an entity has undertaken.

Constituents who believe that mark-to-market accounting is a causing factor of the financial crisis base their opinion on the following issues:

Current market prices reflect speculation; something most companies do not do.

Assuming fair value accounting was created in response to the savings and loans crisis in the late 1980’s, are accountants too often asking how to fair value something and not whether to fair value it?

Though fair values helped identify problems in active markets, it made inactive pricing more difficult and forced individuals to write down inactive instruments because it was assumed that the inactive market followed the active market.

Accounting has real-world effects. For example, despite no change in the economics of the business and because of the overemphasis on earnings statements by banks, credit

markets can be impacted by accounting changes as companies can be in violation of bank

covenants simply because of accounting changes.

In addition to the fair value debate, constituents also noted a few other accounting topics that may have played a role in the financial crisis. For example:

Entities hide the nature and risks associated with off-balance-sheet vehicles through consolidation procedures. Going forward, items should not be off-balance-sheet if there are economic recourses or liabilities associated with them.

Hedge accounting must be re-examined with easier hedge effectiveness testing and

documentation.

The incurred loss model to impair securities motivates an increase in lending during a

growth period, and a decrease during a downturn, thus contributing to the overexuberance

at the top of the cycle and an excessive decline at the bottom.

Any new disclosures for special-purpose entities and similar items should be developed as part of a holistic review of the existing disclosure requirements. Simply adding to the

already voluminous disclosures is likely to overburden users with disjointed and unfocused information.

Source

Financial Crisis Advisory Group Summary of Comments (April 14, 2009).

If all that sounds complicated, you’re not alone. In its 2005 study on off-balance-sheet activity, the Securities and Exchange Commission said the mixed-attribute model creates incentives to pursue “accounting-motivated transaction structures.” Last year the SEC’s Advisory Committee on Improvements to Financial Reporting called the mixed-attribute model “avoidable complexity.”

Still, solutions are years away, and increasingly controversial.

Investor advocates repeatedly call for more use of fair value, with improved disclosures and reporting to help investors better understand those reported values; they say fair value is the most relevant measure to portray economic reality. “It provides an early warning system and is the only accounting regime that can facilitate the timely correction from previous bad decisions,” the CFA Institute said in a communiqué last fall to the U.S. Treasury.

The financial sector, on the other hand, says more fair value would lead to more controversy, more volatility, and more “pro-cyclicality,” the buzzword to describe the spiraling effect as market activity and market pricing chase one another. Banks say if they’re increasingly judged based on short-term, ever-changing fair values, they’ll need to operate on a fair-value basis. That would mean more adjustable rates and fewer fixed-rate products.

Forging Ahead, With Difficulty

Chuck Mulford, accounting professor at Georgia Tech, says the economic crisis has put a spotlight on the problems with measuring the entire balance sheet—or even just all financial instruments—at fair value.

Mulford

“The subjectivity of fair value is very much a problem,” he says. “We’ve grown up with financial statements that are supposed to be objective and verifiable, and now we’re replacing it with something much more subjective.”

Mulford is referring to the judgment that must be applied in establishing values for instruments, especially when there aren’t good market indices to serve as benchmarks or when market activity doesn’t provide a good benchmark. That would be times like now—which is why so many financial reporting executives are frustrated, and fair-value accounting is provoking such fierce debate.

“Do I have an actual market price?” Mulford asks. “Is it one that arises from a market that is active or inactive? If it’s active, is it a distressed price? If I can’t use the price do I go to my own estimation?”

If the current recessionary environment leads to inflation (something a fair number of economists predict), that may make fair value more palatable, he says. “It’s very possible we will see inflation again, and that would be a big game-changer,” he warns. “Historical-cost numbers become meaningless when you have heavy inflation.” Mulford said.

Trott

Trott says FASB and the International Accounting Standards Board have stated their goal that all financial instruments be carried at fair value, and he believes it still will happen eventually. First the boards must finalize their plans to establish a new method of presenting financial statements, he says, because it will provide a better method for explaining and reporting uses of fair value.

In addition, the boards must tread lightly through political landmines, where lawmakers are muscling in on the standard-setting process. Both FASB and IASB have modified accounting rules in the midst of the economic crisis to satisfy political bodies threatening to take action of their own.

“You have a very strong banking establishment that does not want to see more use of fair value, especially for their loan portfolio,” Trott says.

Hardesty says he believes the tension over fair value will ease over the next few years as practice develops around how to measure fair value. After all, Financial Accounting Statement No. 157, Fair Value Measurements, didn’t require any new use for fair value; it only ushered in a new way of measuring that value, leaning heavily on judgment when market prices are not available.

“The people who get involved with these things, primarily CPAs, are not really well-trained in this,” he says. “Their training is in hard-and-fast mechanical rules with bright lines. They’re trained in principles, and making judgments is difficult.”