Draft on June 17, 2006 (slightly updated where noted)

Fair Value Accounting in the United States

Robert E. Jensen (Trinity University Emeritus Professor)

Send comments to Robert E. Jensen, 190 Sunset Hill Road, Sugar Hill, NH 03586
Email: rjensen@trinity.edu Homepage: http://www.trinity.edu/rjensen/

FAS 157
On September 15, 2006 the FASB released its new standard providing guidance for, especially definitions, for fair value accounting. This is a much watered down standard relative to the original exposure draft that initially proposed the firms have the option of using fair value accounting for virtually all financial instruments that are now accounted for on a historical cost basis under FAS 107 and FAS 115.

FAS 157 can be downloaded free at http://www.fasb.org/st/index.shtml#fas157

The manuscript below was written based upon the original exposure draft that proposed allowing firms the option of extending fair value accounting to virtually all financial instruments. That option was deleted in the final version of FAS 157.

"FASB Enhances Guidance for Measuring Fair Value," AccountingWeb, September 18, 2006 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=102586

The Financial Accounting Standards Board (FASB) has issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements, providing enhanced guidance for using fair value to measure assets and liabilities. More than 40 current accounting standards within generally accepted accounting principles (GAAP) require or permit entities to measure assets and liabilities at fair value. Prior to last week’s issuing of this standard, the methods for measuring fair value were diverse and inconsistent.

“Today’s [sic] Statement establishes a market-based framework for measuring assets and liabilities at fair value if a particular accounting standard calls for it,” Leslie F. Seidman, FASB member, said in a statement announcing the issuing of the Statement. “Moreover, by requiring companies to provide expanded information about the assets and liabilities measured at fair value, investors and other financial statement users will be able to make more informed decisions about the potential effect of those measurements on a entity’s financial performance.”

The standard, which is effective for financial statements issued for fiscal years beginning after November 15, 2007, also responds to investors’ requests for expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. The standard applies whenever other standards require (or permit) assets or liabilities to be measured at fair value. The standard does not expand the use of fair value in any new circumstances.

Under the standard, fair value refers to the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts. The standard clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability. In support of this principle, the standard establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted price in active markets and lowest priority to unobservable data, for example, the reporting entity’s own data. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy.

“The standard clarifies that for items that are not actively traded, such as certain kinds of derivatives, fair value should reflect the price in a transaction with a market participant, not just the company’s mark-to-model value,” said Linda MacDonald, FASB director and fair value measurements project manager. “The standard also requires expanded disclosure of the effect on earnings for items measured using unobservable data.”

The International Accounting Standards Board (IASB) intends to issue this statement to its constituents in the form of a preliminary views document.

October 15, 2006 reply from Bob Jensen

The original 157 Exposure Draft proposed a Fair Value Option (FVO) that would have allowed carrying of virtually any financial asset or liability at fair value rather than just limiting fair value accounting to selected items that are now required to be carried at fair value rather than historical cost. Business firms, and especially banks, generally are against fair value accounting (due to reporting instabilities that arise from fair value adjustments prior to contract settlements). The FASB backed off of the FVO when it issued FAS 157, thereby relegating FAS 157 to a standard that clarifies definitions of fair value in various circumstances. Hence FAS 157 is largely semantic and does not change the present fair value accounting rules.

I asked Paul Pacter (at Deloitte in Hong Kong where he's still very active in helping to set IFRS and FASB standards) for an update on the FVO Project (commenced in 2004) that failed to impact the new FAS 157 standard. His reply is below.

October 31 reply from Paul Pacter (CN - Hong Kong) [paupacter@deloitte.com.hk]

Hi Bob,

Yes, FASB's FV Option (FVO) t is very much active -- an ED on phase 1 was issued in January, and a final FAS is expected before year end.

· Phase 1 addresses creating an FVO for financial assets and financial liabilities.

· Phase 2 addresses creating an FVO for selected nonfinancial items.

Thus phase 2 would go beyond IFRSs, though several IFRSs have FV options for individual types of assets. IAS 16 and IAS 38 allow it for PP&E and intangibles -- though the credit is to surplus, not P&L, no recycling, subsequent depreciation of revalued amounts. IAS 40 gives a FV option for investment property -- FV through P&L. IAS 41 isn't an option, it's a requirement for FV through P&L for agricultural assets.

Phase 2 would commence in 2007.

Re possible amendment to FAS 157, I don't think FASB plans to do that, though I suppose there might be some consequential amendment. But I don't think the FVO will change the definition of fair value that's in FAS 157.

Here's FASB's web page: http://www.fasb.org/project/fv_option.shtml

Warm regards,

Paul

FAS 159 (which greatly affects FAS 157 and FAS 133)
FASB Issues Fair Value Option (but only for financial assets and liabilities)

From SmartPros on February http://accounting.smartpros.com/x56603.xml

The objective is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently.

Generally accepted accounting principles have required different measurement attributes for different assets and liabilities that can create artificial volatility in earnings. The standard aims to help to mitigate accounting-induced volatility by enabling companies to report related assets and liabilities at fair value, which would likely reduce the need for companies to comply with detailed rules for hedge accounting.

"Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities," also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities.

The standard requires companies to provide additional information that will help investors and other users of financial statements to more easily understand the effect of the company's choice to use fair value on its earnings. It also requires entities to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet. The new statement does not eliminate disclosure requirements included in other accounting standards, including requirements for disclosures about fair value measurements included in FASB Statements No. 157, Fair Value Measurements, and No. 107, Disclosures about Fair Value of Financial Instruments.

This statement is effective as of the beginning of an entity's first fiscal year beginning after Nov. 15, 2007. Early adoption is permitted as of the beginning of the previous fiscal year provided that the entity makes that choice in the first 120 days of that fiscal year and also elects to apply the provisions of Statement 157.

Jensen Comments

Good News
FAS 159 can simplify some aspects of FAS 133 and IAS 39 accounting since hedging contracts adjusted to fair value and hedged item contracts can both be adjusted to fair values that offset to the extent that hedges are effective. The complicated hedge accounting rules of FAS 133/IAS 39 can, thereby, be avoided in many circumstances.

Bad News
A huge problem is that there will be a whole lot if confusion over inconsistencies over the way any two companies account for a financial contracts. Another problem is that adjustments to fair value more often than not create fiction in financial statements for transactions that never took place.

Other good news and bad news aspects of fair value accounting are discussed by Bob Jensen at http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue

Alternative Concepts for “Valuing” Assets and Liabilities

How a firm reports an asset or liability in a balance sheet typically is rooted in one of the following valuation concepts. GAAP in the United States is historical cost by default, but there are countless instances where departures from historical cost are either allowed or required under certain standards in certain circumstances.

Historical Cost Accounting: Unadjusted for General Price-Level Changes

Advantages of Historical Cost

Survival Concept --- Historical cost accounting has met the Darwin survival test for hundreds of years. One of the most noted books advocating historical cost is called Introduction to Corporate Accounting Standards by William Paton and A.C. Littleton (Sarasota: American Accounting Association, 1940). Probably no single book has ever had so much influence or is more widely cited in accounting literature than this thin book by Paton and Littleton.

Except in hyperinflation nations, unadjusted historical cost is still the primary basis of accounting, although there are numerous exceptions for certain types of assets and liabilities. Most notable among these exceptions are financial instruments assets and liabilities where FAS 115 and FAS 133 spell out highly controversial exceptions.
The Matching Concept --- costs of resources consumed in production should be matched against the revenues of the products and services of the production function. (Assumes costs attach throughout the production process in spite of complicating factors such as joint costs, indirect costs, fungible resources acquired at different costs, changing price-levels, basket purchases such as products and their warranties, changing technologies, and other complications). Profit is the "residuum (as efforts) and revenues (as accomplishments) for individual enterprises." This difference (profit) reflects the effectiveness of management. One overriding concept, however, is conservatism that Paton and Littleton concede must be resorted to as a basis for writing inventories down to market when historical cost exceeds market. This leads to a violation of the matching concept, but it is necessary if investors will be misled into thinking that inventories historical costs are surrogates for value.
The Audit Trail --- historical costs can be traced to real rather than hypothetical market transactions. They leave an audit trail that can be followed by auditors.
Predictive Value --- empirical studies post to reasonably good predictive value of past historical cost earnings on future historical cost earnings. In some cases, historical cost statements are better predictors of bankruptcy than current cost statements.
Accuracy --- Historical cost measurement is more accurate and, relative to its alternatives, is more uniform, consistent, and less prone to measurement error.

Nobody I know holds the mathematical wonderment of double entry and historical cost accounting more in awe than Yuji Ijiri. For example, see Theory of Accounting Measurement, by Yuji Ijiri (Sarasota: American Accounting Association Studies in Accounting Research No. 10, 1975) --- http://accounting.rutgers.edu/raw/aaa/market/studar.htm

Disadvantages of Historical Cost

Does not eliminate or solve such controversial issues as what to include/exclude from balance sheets and does not overcome complex schemes for off-balance-sheet financing (OBSF). It is too simplistic for complex contracting. For example, many derivative financial instruments having current values of millions of dollars (e.g., forward contracts and swaps) have zero or negligible historical costs. For example, a firm may have an interest rate swap obligating it to pay millions of dollars even though the historical cost of that swap is zero. Investors might be easily misled by having such huge liabilities remain unbooked. Historical cost accounting has induced game playing when writing contracts (leases, employee compensation, etc.) in order to avoid having to book what are otherwise assets and liabilities under fair value reporting.
Historical cost mixes apples and oranges such as LIFO inventory dipping that may match costs measured in 1950s purchasing power with inflated dollars in the 21st Century that have much less purchasing power. Historical cost income in periods of rising prices overstates earnings and understates how a firm is maintaining its capital assets. Even historical cost advocates admit that historical cost accounting is useless in economies subject to hyperinflation.
Historical cost accrual accounting assumes a going concern. Under current U.S. GAAP, historical cost is the basis of accounting for going concerns. If the firm is not deemed a going concern, the basis of accounting shifts to exit (liquidation) values. For many firms, however, it is difficult and/or misleading to make a binary designation of going versus non-going. Many firms fall into the gray area on a continuum. Personal financial statements seldom meet the going concern test since they are generally used in estate and divorce settlements. Hence, exit (liquidation) value is required instead of historical cost for personal financial statements.
Historical cost is perpetuated by a myth of objectivity when there are countless underlying subjective estimates of asset economic life, allocation of joint costs, allocation of indirect costs, bad debt reserves, warranty liabilities, pension liabilities, etc.

Historical Cost Accounting: Price-Level Adjusted (PLA) Historical Cost Accounting

The primary basis of accounting in the U.S. is unadjusted historical cost with numerous exceptions in particular instances. For example, price-level adjustments may be required for operations in hyperinflation nations. The international IASB standards require PLA accounting in hyperinflation nations.

The SEC issued ASR 190 requiring PLA supplemental reports. This was followed by the FASB's 1979 FAS 33 short-lived standard. Follow-up studies did not point to investor enthusiasm over such supplemental reports. Eventually, both ASR 190 and FAS 33 were rescinded, largely from lack of interest on the part of financial analysts and investors due to relatively low inflation rates in the United States. However, PLA adjustments are still required for operations in nations subject to high rates of inflation.

Advantages of PLA Accounting

Attempts to perfect historical cost accounting by converting costs to a common purchasing power unit of measurement.
Has a dramatic impact upon ROI calculations in many industries even in times of very low inflation.
Is essential in periods of hyperinflation.
Uses a readily available and reasonably accurate government-generated consumer price index (usually the CPI for urban households).

Disadvantages of PLA Accounting

There is not general agreement regarding what is the best inflation index to use in the PLA adjustment process. Computing a price index for such purposes is greatly complicated by constantly changing technologies, consumer preferences, etc.
There is no common index across nations, and nations differ greatly with respect to the effort made to derive price indices.
Empirical studies in the U.S. have not shown PLA accounting data to have better predictive powers than historical cost data not adjusted for inflation.

Market Value Accounting: Entry Value (Current Cost, Replacement Cost) Accounting

Entry value is a buyer’s acquisition cost (net of discounts) plus transactions fees and installation expenses. Suppose Company B wants to buy 100 million shares of Company A. Entry value in theory is viewed as the acquisition value of all 100 million shares of Company A in an optimal and practical manner such as buying them in one block, a few blocks, or one share at a time. Buying 100 million shares one share at a time may be impractical and take an unreasonable amount of time. Buying shares in one block may add value to the aggregate of the single share market price due to the added value that 100 million shares may have on controlling Company A. But there might also be blockage discounts to take into account. It may only be practical to buy shares in smaller blocks such as ten purchases of 10 million share blocks.

Current cost accounting by whatever name (e.g., current or replacement cost) entails the historical cost of balance sheet items with current (replacement) costs. Depreciation rates can be re-set based upon current costs rather than historical costs.

Beginning in 1979, FAS 33 required large corporations to provide a supplementary schedule of condensed balance sheets and income statements comparing annual outcomes under three valuation bases --- Unadjusted Historical Cost, PLA-Adjusted historical cost, and Current Cost Entry Value (adjusted for depreciation and amortization). Companies are no longer required to generate FAS 33-type comparisons. The primary basis of accounting in the U.S. is unadjusted historical cost with numerous exceptions in particular instances. For example, price-level adjustments may be required for operations in hyperinflation nations. Exit value accounting is required for firms deemed highly likely to become non-going concerns. Exit value accounting is required for personal financial statements (whether an individual or a personal partnership such as two married people). Economic (discounted cash flow) valuations are required for certain types of assets and liabilities such as pension liabilities. Hence in the United States and virtually every other nation, accounting standards do not require or even allow one single basis of accounting. Beginning in January 2005, all nations in the Eurpean Union adopted the IASB's international standards that have moved closer and closer each year to the FASB/SEC standards of the United States.

Advantages of Entry Value (Current Cost, Replacement Cost) Accounting

Conforms to capital maintenance theory that argues in favor of matching current revenues with what the current costs are of generating those revenues. For example, if historical cost depreciation is $100 and current cost depreciation is $120, current cost theory argues that an excess of $20 may be wrongly classified as profit and distributed as a dividend. When it comes time to replace the asset, the firm may have mistakenly eaten its seed corn.
If the accurate replacement cost is known and can be matched with current selling prices, the problems of finding indices for price level adjustments are avoided.

Disadvantages of Entry Value (Current Cost, Replacement Cost) Accounting

Discovery of accurate replacement costs is virtually impossible in times of changing technologies and newer production alternatives. For example, some companies are using data processing hardware and software that no longer can be purchased or would never be purchased even if it was available due to changes in technology. Some companies are using buildings that may not be necessary as production becomes more outsourced and sales move to the Internet. It is possible to replace used assets with used assets rather than new assets. Must current costs rely only upon prices of new assets?
Discovering current costs is prohibitively costly if firms have to repeatedly find current replacement prices on thousands or millions of items.
Accurate derivation of replacement cost is very difficult for items having high variations in quality. For example, some ten-year old trucks have much higher used prices than other used trucks of the same type and vintage. Comparisons with new trucks is very difficult since new trucks have new features, different expected economic lives, warranties, financing options, and other differences that make comparisons extremely complex and tedious. In many cases, items are bought in basket purchases that cover warranties, insurance, buy-back options, maintenance agreements, etc. Allocating the "cost" to particular components may be quite arbitrary.
Use of "sector" price indices as surrogates compounds the price-index problem of general price-level adjustments. For example, if a "transportation" price index is used to estimate replacement cost, what constitutes a "transportation" price index? Are such indices available and are they meaningful for the purpose at hand? When FAS 33 was rescinded in 1986, one of the major reasons was the cost and confusion of using sector indices as surrogates for actual replacement costs.
Current costs tend to give rise to recognition of holding gains and losses not yet realized.

Market Value Accounting: Exit Value (Liquidation, Fair Value) Accounting

Exit value is the seller’s liquidation value (net of disposal transaction costs). Whereas entry value is what it will cost to replace an item for a buyer, exit value is the value of disposing of the item. Exit value in theory is viewed as the liquidation value of all 100 million shares of Company A in an optimal and practical manner such as selling them in one block, a few blocks, or one share at a time. Selling 100 million shares one share at a time may be impractical and take an unreasonable amount of time. Selling shares in one block may add value to the aggregate of the single share market price due to the added value that 100 million shares may have on controlling Company A. But there might also be blockage discounts to take into account. It may only be practical to sell shares in smaller blocks.

Exit can even be negative in some instances where costs of clean up and disposal make to exit price negative. Exit value accounting is required under GAAP for personal financial statements (individuals and married couples) and companies that are deemed likely to become non-going concerns. See "Personal Financial Statements," by Anthony Mancuso, The CPA Journal, September 1992 --- http://www.nysscpa.org/cpajournal/old/13606731.htm

Some theorists advocate exit value accounting for going concerns as well as non-going concerns. Both nationally (particularly under FAS 115 and FAS 133) and internationally (under IAS 32 and 39 for), exit value accounting is presently required in some instances for financial instrument assets and liabilities. Both the FASB and the IASB have exposure drafts advocating fair value accounting for all financial instruments.

FASB's Exposure Draft for Fair Value Adjustments to all Financial Instruments
On December 14, 1999 the FASB issued Exposure Draft 204-B entitled Reporting Financial Instruments and Certain Related Assets and Liabilities at Fair Value.

If an item is viewed as a financial instrument rather than inventory, the accounting becomes more complicated under FAS 115. Traders in financial instruments adjust such instruments to fair value with all changes in value passing through current earnings. Business firms who are not deemed to be traders must designate the instrument as either available-for-sale (AFS) or hold-to-maturity (HTM). A HTM instrument is maintained at original cost. An AFS financial instrument must be marked-to-market, but the changes in value pass through OCI rather than current earnings until the instrument is actually sold or otherwise expires. Under international standards, the IASB requires fair value adjustments for most financial instruments. This has led to strong reaction from businesses around the world, especially banks. There are now two major working group debates. In 1999 the Joint Working Group of the Banking Associations sharply rebuffed the IAS 39 fair value accounting in two white papers that can be downloaded from http://www.iasc.org.uk/frame/cen3_112.htm.

· Financial Instruments: Issues Relating to Banks (strongly argues for required fair value adjustments of financial instruments). The issue date is August 31, 1999.

· Accounting for financial Instruments for Banks (concludes that a modified form of historical cost is optimal for bank accounting). The issue date is October 4, 1999.

Advantages of Exit Value (Liquidation, Fair Value) Accounting

In the case of financial assets and liabilities, historical costs may be meaningless relative to current exit values. For example, a forward contract or swap generally has zero historical cost but may be valued at millions at the current time. Failure to require fair value accounting provides all sorts of misleading earnings management opportunities to firms. The above references provide strong arguments in favor of fair value accounting.
Exit value does not require arbitrary cost allocation decisions such as whether to use FIFO or LIFO or what depreciation rate is best for allocating cost over time.
In many instances exit value accounting is easier to compute than entry values. For example, it is easier to estimate what an old computer will bring in the used computer market than to estimate what is the cost of "equivalent" computing power is in the new computer market.

Exit value reporting is not deemed desirable or practical for going concern businesses for a number of reasons that I will not go into in great depth here.

Disadvantages of Exit Value (Liquidation, Fair Value) Accounting

· The exit value is the seller’s liquidation value of a particular asset or liabilities at a particular time and place. It may differ greatly from “valuation-in-use” among a larger set of items in an entire department, division, or company as a whole. For example, liquidation value of a particular asset such as a hotel (land and building) may differ greatly from the economic value of the hotel itself. This is discussed below in the Days Inn illustration. Some items such as financial assets and liabilities have nearly identical liquidation and economic (discounted cash flow) values. The gap between exit and economic value is greater with respect to operating items such as a hotel as a going concern. This is particularly the case for the aggregated exit values of say 200 hotels in a company where the economic value of these hotels in a going concern is generally much higher than the aggregation of local exit values the real estate.

Operating assets are bought to use rather than sell. For example, as long as no consideration is being given to selling or abandoning a manufacturing plant, recording the fluctuating values of the land and buildings creates a misleading fluctuation in earnings and balance sheet volatility. Who cares if the value of the land went up by $1 million in 1994 and down by $2 million in 1998 if the plant that sits on the land has been in operation for 60 years and no consideration is being given to leaving this plant?

· Some assets like software, knowledge databases, and Web servers for e-Commerce cost millions of dollars to develop for the benefit of future revenue growth and future expense savings. These assets may have immense value if the entire firm is sold, but they may have no market as unbundled assets. In fact it may be impossible to unbundle such assets from the firm as a whole. Examples include the Enterprise Planning Model SAP system in firms such as Union Carbide. These systems costing millions of dollars have no exit value in the context of exit value accounting even though they are designed to benefit the companies for many years into the future.

· Exit value accounting records anticipated profits well in advance of transactions. For example, a large home building company with 200 completed houses in inventory would record the profits of these homes long before the company even had any buyers for those homes. Even though exit value accounting is billed as a conservative approach, there are instances where it is far from conservative.

· Value of a subsystem of items differs from the sum of the value of its parts. Investors may be lulled into thinking that the sum of all subsystem net assets valued at liquidation prices is the value of the system of these net assets. Values may differ depending upon how the subsystems are diced and sliced in a sale.

· Appraisals of exit values are both to expensive to obtain for each accounting report date and are highly subjective and subject to enormous variations of opinion. The U.S. Savings and Loan scandals of the 1980s demonstrated how reliance upon appraisals is an invitation for massive frauds. Experiments by some, mostly real estate companies, to use exit value-based accounting died on the vine, including well-known attempts decades ago by TRC, Rouse, and Days Inn.

· Exit values are affected by how something is sold. If quick cash is needed, the best price may only be half of what the price can be by waiting for the right time and the right buyer.

· Financial contracts that for one reason or another are deemed as to be "held-to-maturity" items may cause misleading increases and decreases in reported values that will never be realized. A good example is the market value of a fixed-rate bond that may go up and down with interest rates but will always pay its face value at maturity no matter what happens to interest rates.

Exit value markets are often thin and inefficient markets.

Economic Value (Discounted Cash Flow, Present Value) Accounting

There are over 100 instances where present GAAP requires that historical cost accounting be abandoned in favor of discounted cash flow accounting (e.g., when valuing pension liabilities and computing fair values of derivative financial instruments). These apply in situations where future cash inflows and outflows can be reliably estimated and are attributable to the particular asset or liability being valued on a discounted cash flow basis.

Advantages of Economic Value (Discounted Cash Flow, Present Value) Accounting

Economic value is based upon management's intended use for the item in question rather than upon some other use such as disposal (Exit Value) or replacement (Entry Value).
Economic value conforms to the economic theory of the firm.

Disadvantages of Economic Value (Discounted Cash Flow, Present Value) Accounting

How does one allocate a portion of the cash flows of General Motors to a single welding machine in Tennessee? Or how does one allocate the portion of the sales price of a single car to the robot that welded a single hinge on one of the doors? How does one allocate the price of a bond to the basic obligation, the attached warrants, the call option in the fine print, and other possible embedded derivatives in the contract? The problem lies in the arbitrary nature of deciding what system of assets and liabilities to value as a system rather than individual components. Then what happens when the system is changed in some way? In order to see how complex this can become, note the complicated valuation assumptions in a paper entitled "Implementation of an Option Pricing-Based Bond Valuation Model for Corporate Debt and Its Components," by M.E. Barth, W.R. Landsman, and R.J. Rendleman, Jr., Accounting Horizons, December 2000, pp. 455-480.
Cash flows are virtually impossible to estimate except when they are contractually specified. How can Amazon.com accurately estimate the millions and millions of dollars it has invested in online software?
Even when cash flows can be reliably estimated, there are endless disputes regarding the appropriate discount rates.
Endless disputes arise as to assumptions underlying economic valuations.

Fair Value Accounting

The term “fair value” is more ambiguous than the above valuation concepts. The default assumption is that it is an exit (liquidation) value with some departures from the exit value definition above. Suppose that a firm has 100 million shares of A Company common stock. Exit value is defined as the liquidation value of all 100 million shares in an optimal manner such as selling them in one block versus multiple blocks. Fair value under FASB definitions is the aggregation of the current exit value of one share and ignores added blockage values or discounts for block sales. Also in many instances the FASB requires fair value to be something other than exit value such as when economic discounted cash flow is required for pension obligations.

Fair value accounting departs from historical transaction cost. There are numerous instances where it is required under present U.S. GAAP, especially when historical cost is either zero or highly misleading. Such is the case for derivative financial instruments that often have zero cost at the date contracts become effective. This is why FAS 133 requires fair value accounting for all derivative instrument contracts but not all financial instrument contracts in general since financial instruments other than derivative contracts have meaningful historical costs and immediate transfers of risk at the time of the original transaction.

Fair value is the estimated best disposal (exit, liquidation) value in any sale other than a forced sale. It is defined as follows in Paragraph 540 of FAS 133:

The amount at which an asset (liability) could be bought (incurred) or sold (settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and should be used as the basis for the measurement, if available. If a quoted market price is available, the fair value is the product of the number of trading units times that market price. If a quoted market price is not available, the estimate of fair value should be based on the best information available in the circumstances. The estimate of fair value should consider prices for similar assets or similar liabilities and the results of valuation techniques to the extent available in the circumstances. Examples of valuation techniques include the present value of estimated expected future cash flows using discount rates commensurate with the risks involved, option- pricing models, matrix pricing, option-adjusted spread models, and fundamental analysis. Valuation techniques for measuring assets and liabilities should be consistent with the objective of measuring fair value. Those techniques should incorporate assumptions that market participants would use in their estimates of values, future revenues, and future expenses, including assumptions about interest rates, default, prepayment, and volatility. In measuring forward contracts, such as foreign currency forward contracts, at fair value by discounting estimated future cash flows, an entity should base the estimate of future cash flows on the changes in the forward rate (rather than the spot rate). In measuring financial liabilities and nonfinancial derivatives that are liabilities at fair value by discounting estimated future cash flows (or equivalent outflows of other assets), an objective is to use discount rates at which those liabilities could be settled in an arm's-length transaction.

The main problem of fair value adjustment is that many (most?) of the adjustments cause enormous fluctuations in earnings, assets, and liabilities that are washed out over time and never realized. The main advantage is that interim impacts that “might be” realized are booked. It’s a war between “might be” versus “might never be.” The war has been waging for over a century with respect to booked assets and two decades with respect to unbooked derivative instruments, contingencies, and intangibles.

Chartered Financial Analysts group favors full fair value reporting
The CFA Centre for Financial Market Integrity – a part of the CFA Institute – has published a new financial reporting model that, they believe, would greatly enhance the ability of financial analysts and investors to evaluate companies in making investment decisions. The Comprehensive Business Reporting Model proposes 12 principles to ensure that financial statements are relevant, clear, accurate, understandable, and comprehensive (See below).
"Analysts' group favours full fair value reporting," IAS Plus, October 31, 2005 --- http://www.iasplus.com/index.htm

CFA Institute Centre for Financial Market Integrity
Comprehensive Business Reporting Model – Principles

1. The company must be viewed from the perspective of a current investor in the company's common equity.
2. Fair value information is the only information relevant for financial decision making.
3. Recognition and disclosure must be determined by the relevance of the information to investment decision making and not based upon measurement reliability alone.
4. All economic transactions and events should be completely and accurately recognized as they occur in the financial statements.
5. Investors' wealth assessments must determine the materiality threshold.
6. Financial reporting must be neutral.
7. All changes in net assets must be recorded in a single financial statement, the Statement of Changes in Net Assets Available to Common Shareowners.
8. The Statement of Changes in Net Assets Available to Common Shareowners should include timely recognition of all changes in fair values of assets and liabilities.
9. The Cash Flow Statement provides information essential to the analysis of a company and should be prepared using the direct method only.
10. Changes affecting each of the financial statements must be reported and explained on a disaggregated basis.
11. Individual line items should be reported based upon the nature of the items rather than the function for which they are used.
12. Disclosures must provide all the additional information investors require to understand the items recognized in the financial statements, their measurement properties, and risk exposures.

This pits financial analysts against bankers and corporate preparers of financial statements who contend that fair value too often requires estimation subject to enormous measurement error and subjectivity. Even when there is zero estimation error there are controversial problems of how to offset changes in fair value in a double entry bookkeeping system. The balance sheet may be more informative at the expense of the income statement if changes in fair value are offset by changes in current earnings. A basic problem is that gains and losses from incurred transactions become confounded with gains and losses of hypothetical transactions that never took place when fair value adjustments are made for financial assets and liabilities that are still on the books.

On January 25, 2006, the Financial Accounting Standards Board issued Exposure Draft (ED) No. 1250-001 providing investors and creditors with a Fair Value Option (FVO) to report certain financial assets and liabilities at fair values. This extends fair value reporting beyond those items such as derivative financial instruments, trading securities, and available-for-sale instruments that are already required under other standards to be reported at fair values. The accompanying news release reads as follows at http://www.fasb.org/news/nr012506.shtml

The Financial Accounting Standards Board (FASB) today issued an Exposure Draft that would provide companies with the option to report selected financial assets and liabilities at fair value. Under the option, any changes in fair value would be included in earnings. The proposed Standard seeks to reduce both complexity in accounting and volatility in earnings caused by differences in the existing accounting rules.

Current GAAP uses different measurement attributes for different assets and liabilities, which can lead to earnings volatility. The proposed Standard helps to mitigate this type of accounting-induced volatility by enabling companies to achieve a more consistent accounting for changes in the fair value of related assets and liabilities without having to apply complex hedge accounting provisions.

Under this proposal, entities would be able to measure at fair value financial assets and liabilities selected on a contract-by-contract basis. They would be required to display those values separately from those measured under different attributes on the face of the balance sheet. Furthermore, the proposal would require companies to provide additional information that would help investors and other users of financial statements to more easily understand the effect on earnings.

“The option to measure related financial instruments at fair value should simplify accounting and encourage the display of more relevant and understandable information for investors and other users of financial statements,” said Leslie F. Seidman, FASB member and Board collaborator on the project. “Today’s proposal also helps achieve further convergence with the International Accounting Standards Board, which has previously adopted a fair value option for financial instruments.”

In September 2006 the FASB issued FAS 157 that actually eliminated, for now, the FVO that was originally proposed in initial exposure draft. The following paper was written before the FVO was eliminated.

On May 11, 2006 the FASB provided updates prior to issuing the new standard at http://www.fasb.org/project/fv_measurement.shtml . The FASB intends to stick with its plan to issue the new standard before June 30, 2006.

This is the next step in an ongoing effort of the FASB to require fair value reporting of all financial items apart from operating items used in mainline operations such as manufacturing and service operations. But the FVO standard for now would be optional and exclude some financial items. Page 3 of the FVO reads as follows:

Issue 1: The scope of this proposed Statement includes the following financial assets and financial liabilities that some may not have considered as being included:

a. An investment being accounted for under the equity method

b. Investments in equity securities that do not have readily determinable fair values, as described in paragraph 3 of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities

c. Insurance and reinsurance contracts that are financial instruments, as discussed in FASB Statements No. 60, Accounting and Reporting by Insurance Enterprises, No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration

Contracts and for Realized Gains and Losses from the Sale of Investments, and No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts

d. Warranty obligations that are financial liabilities and warranty rights that are

financial assets

e. Unconditional purchase obligations that are recorded as financial liabilities on the purchaser’s statement of financial position as discussed in paragraph 10 of FASB Statement No. 47, Disclosure of Long-Term Obligations.

Additionally, Paragraph A6 reads as follows:

The Board decided to exclude from the scope of this Statement the following financial assets and financial liabilities for the reasons indicated:

a. An investment (principally an investment in a subsidiary) that would otherwise be consolidated. The Board believes the fair value option project should not be used to make significant changes to consolidation practices.

b. Employers’ and plans’ financial obligations for pension benefits, other postretirement benefits (including health care and life insurance benefits), postemployment benefits, employee stock option and stock purchase plans, and other forms of deferred compensation arrangements as defined in Statements 35, 87, 106, 112, 123 (revised December 2004), 43, and 146, and Opinion 12. The Board believes that any modifications should be part of a reconsideration of those individual areas.

c. Financial liabilities recognized under lease contracts as defined in Statement 13. (This exclusion does not include a contingent obligation arising out of a cancelled lease and a guarantee of a third-party lease obligation.) The Board wanted to avoid undermining the lease accounting provisions of Statement 13 (as amended), which requires measuring the lessee’s obligation for a capital lease at an amount that may not be the fair value of that liability. The Board believes those lease accounting provisions should not be changed by the fair value option project without a comprehensive reconsideration of the accounting for lease contracts. The Board believes also that no scope exception is needed for the assets recognized by lessors under sales-type leases, direct financing leases, or leveraged leases because those assets are not purely financial assets and, thus, are not included in the scope of this Statement.

d. Written loan commitments that are not accounted for as derivatives under Statement 133. The Board will include such written loan commitments in the deliberations of Phase 2 because nonfinancial components affect the determination of the fair value of those written loan commitments.

e. Financial liabilities for demand deposit accounts. The Board will include the liability for demand deposit accounts in the deliberations of Phase 2 because nonfinancial components affect the determination of the fair value of those demand deposit accounts.

The Board also affirmed that the election of the fair value option is not permitted for current or deferred income tax assets or liabilities because such assets and liabilities are not contractual and, thus, are not financial assets or financial liabilities.

The FVO also excludes written loan commitments and financial liabilities for demand deposits.

Disclosure requirements are as follows in Paragraph 12 of the FVO proposal:

An entity shall disclose the following with respect to financial assets and financial

liabilities for which the fair value option has been elected:

a. The difference between the carrying amount of any financial liabilities reported at fair value due to election of the fair value option and the aggregate principal amount the entity would be contractually required to pay to the holders of the obligations at maturity (or through the maturity date for any debts whose principal amounts are

payable in installments), if any

b. Information sufficient to allow users of financial statements to understand the effect on earnings (or other performance indicators for entities that do not report earnings) of changes in the fair values of the financial assets and financial liabilities subsequently measured at fair value as a result of a fair value election

c. Quantitative information by line item indicating where in the income statement gains

and losses are reported that arise from changes in the fair value of financial assets

and financial liabilities for which the fair value option has been elected

d. A description indicating how interest and dividends are measured and reported in the income statement.

The fact that this extension of fair value accounting is optional creates inconsistencies in financial reporting between otherwise similar companies. Not making it optional, however, is politically explosive at this point in time with heavy resistance coming from various sectors of the economy, particularly banks and other firms that are heavily into financial assets and liabilities apart from derivative financial instruments.

A major component of the FVO is the option to book a firm commitment. Under present standards firm commitments are not booked even when hedged. For example, if a bank agrees to loan a customer $10 million in 60 days it is a forecasted transaction that is not booked until the loan transpires. If an “underlying” interest rate such as 10% is specified, the forecasted transaction becomes a firm commitment under FAS 133 definitions. Neither forecasted transactions (at forward prices) nor firm commitments (at contracted prices) are booked even though both types of commitments may be hedged. The ED gives a company the option of booking its firm commitments and recognizing changes in value to current earnings. If the firm commitment is hedged with respect to fair value, the change in the hedge contract value may offset the change in the firm commitment fair value. Failure to book firm commitments, under existing rules, creates very confusing hedge accounting treatments under current FAS 133 rules that would be greatly simplified if firm commitments could be booked and carried at fair value at all times.

The FVO standard does not change rules for accounting for investments under the equity method (APB 18) and investments requiring consolidated financial statements. The equity method adjusts historical cost for proportionate changes in the earnings of the company that is owned with 20% or more of the voting shares.

The FVO proposal pushes U.S. GAAP closer to the fair value provisions in the International Accounting Standards Board IAS 39. At present the FASB’s FAS 133 involves very complex hedge accounting rules that would be greatly simplified in certain hedging situations where a company elects the FVO.

There is also a very important statement of intent for future standards. The FVO proposal explicitly states that if the fair value accounting option for financial items becomes a standard, the FASB will next propose extending the option to certain types of non-financial items.

Differences Between U.S. and International Fair Value Accounting

Paragraphs A21-A23 of the FVO proposal read as follows:

A21. The IASB has included a fair value option for financial instruments in IAS 39. Its provisions are similar to those in this Statement insofar as the fair value options in both pronouncements require that the election:

a. Be made at the initial recognition of the financial asset or financial liability

b. Is irrevocable

A22. The differences between the provisions in this Statement and international standards pertain principally to disclosures, scope exceptions, and whether certain eligibility criteria must be met to elect the fair value option.

a. IAS 32, Financial Instruments: Disclosure and Presentation (as revised in 2005), requires disclosure of the amount of change during the period and cumulatively in the fair value of the financial instrument that is attributable to changes in credit risk for loans, receivables, and financial liabilities for which the fair value option has been elected. This Statement does not require any disclosures related solely to the portion of a change in fair value attributable to changes in credit risk, although it does require a qualitative disclosure of reasons for significant changes in fair value

of financial liabilities.

b. This Statement includes a scope exception for financial liabilities for demand deposit accounts, whereas IAS 39 does not. However, IAS 39 stipulates in paragraph 49 that “The fair value of a financial liability with a demand feature (eg a demand deposit) is not less than the amount payable on demand, discounted from the first date that the amount could be required to be paid.” The Board will reconsider this scope exception as part of Phase 2 of the fair value option project.

c. This Statement includes a scope exception for written loan commitments that are not accounted for as derivative instruments under Statement 133, whereas IAS 39 does not. The Board will reconsider this scope exception as part of Phase 2 of the fair value option project.

d. This Statement has no eligibility criteria for financial assets and financial liabilities, whereas IAS 39 (as revised in 2005) indicates that, for other than hybrid instruments, the fair value option can be applied only when doing so results in more relevant information either because it eliminates or significantly reduces a measurement or recognition inconsistency (that is, an accounting mismatch) that would otherwise arise from measuring assets or liabilities or recognizing the gains and losses on them on different bases, or because a group of financial assets,

financial liabilities, or both is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the entity’s key management personnel.

A23. The inability to elect the fair value option for financial liabilities for demand deposit accounts under this Statement would likely not result in a significantly different reporting outcome than election of the fair value option for thos liabilities under IAS 39. The extent of the other differences between the FASB and IASB standards related to eligibility criteria will depend on the circumstances and the extent to which entities desiring to elect the fair value option under IAS 39 will be able to meet those criteria.

Comprehensive Income versus Current Income

As mentioned above, a huge controversy surrounding fair value accounting entails where to put double entry offset when an asset or liability is adjusted to fair value. These offsets are hypothetical in the sense that the gains and losses are unrealized and in many instances will never be realized. It may be known that they will never be realized in the case of items intended to be “held-to-maturity.” For example, FAS 133 requires that a commodity derivative contract be continuously adjusted to fair value with offsets going to current earnings. Periodic fluctuations in income (earnings) before its expiration date are strictly unrealized and hypothetical. Quite often it is known in advance that they will totally offset one another over time such that the ultimate effect is zero impact on retained earnings even though the earnings has fluctuated up and down for fair value adjustments prior to contract expiration.

FAS 130 created a special Comprehensive Income (OCI) equity account mainly for fair value adjustment offsets that are temporary until the ultimate gain or loss is realized. The existence of such a “special equity account” arose prior to the formal definition of “comprehensive income” in FAS 130 in 1997. For example, FAS 115 in 1993 requires that financial instruments be classified as “trading” versus “available for sale (AFS) versus held to maturity (HTM). Trading securities must be continuously adjusted to fair value with offsets going to current earnings, thereby creating hypothetical fluctuations in earnings. HTM securities must be carried at cost and are not adjusted for fair value. AFS securities are adjusted to fair value with offsets going to a “special equity account” which after 1997 became known as Other Comprehensive Income in the United States.

FAS 133 requires all derivative financial instruments to be adjusted to fair value. Speculative contract changes in fair value are charged to current earnings. Contracts that qualify for special FAS 133 hedge accounting relief require fair value adjustment in a manner that does not impact upon current earnings to the extent that the hedges are deemed effective. Fair value changes of cash flow and foreign currency hedges are offset by entries to OCI that do not impact current earnings. Fair value changes in fair value hedges are offset in other ways, including possible change of accounting for the hedged item from historical cost to fair value accounting during the hedging period.

Originally the FASB wanted all fair value changes in derivative financial instruments to be charged to current earnings whether they were hedges or speculations. Preparers of financial statements, especially banks, heatedly objected to having earnings fluctuate hypothetically in the case where hedges were entered into to guarantee cash flow outcomes (in the case of cash flow hedges) or lock in value (in the case of fair value hedges). FAS 133 subsequently became the most complicated of all FASB standards because of the complexity of trying to keep current earnings from fluctuating in thousands of different types of very complicated hedging contracts.

A hybrid instrument is a structured instrument that contains combinations of one or more embedded derivatives. In September 2006

Draft on June 17, 2006 (slightly updated where noted)

CFA Institute Centre for Financial Market Integrity Comprehensive Business Reporting Model – Principles

CFA Institute Centre for Financial Market Integrity
Comprehensive Business Reporting Model – Principles