The Starting 5
Critical areas of finance most likely to be affected (and soon) by fair-value accounting
1. Liabilities: Compared with financial assets, many of which have long been measured at fair value by corporations, liabilities are unknown territory. Often lacking hard numbers on which to base estimates, companies tasked with putting a current price on loans, insurance contracts, or future environmental-cleanup costs, for example, must rely on hypotheses. “In fair-valuing liabilities,” says Espen Robak, president of Pluris Valuation Advisors, “there is very little in the way of a market there; you’re always going to come to some kind of model, anyway.”
To some critics — Financial Accounting Standards Board chairman Robert Herz is one of them — such modeling is unnecessary when the price of settling a liability is clearly set. Xerox’s chief accounting officer, Gary Kabureck, offers the example of a company that has a long-term debt on which it will pay 7 percent interest at maturity. Even though the company fully intends to hang on to the obligation until it matures, it must report the debt’s fair value in its current financial reporting. If that fair value is 8 percent, the company would have to report bad news to the market for largely hypothetical reasons. “You have to question what is the relevance of liabilities at other than the settlement value,” says Kabureck.
Another aspect of the new rules also seems, to many, to depart from logic. As the risk that companies won’t pay back their debts rises, their reported liabilities actually decrease. That’s because companies estimating the fair value of their own liabilities must factor in the risk that they won’t pay those debts off. That makes the anticipated debt smaller. It also works the other way: if the debtor becomes more creditworthy, the fair value of the debt obligation rises.
The rewards for potential deadbeats can be large, according to a Credit Suisse report on the 380 members of theS&P 500 that began complying with FAS 157 in Q1 2008. For the 25 firms with the biggest amounts of liability measured at fair value, widening credit spreads — an indication of a lack of creditworthiness — spawned first-quarter earnings gains ranging from $11 million to $3.6 billion.
2. Lawsuits: If things proceed according to plan, some companies will have to disclose what corporate lawyers insist can’t be calculated: the future costs of lawsuits.
What will litigation cost? In December 2007, a group of 13 top lawyers employed by Pfizer, General Electric, Viacom, Boeing, McDonald’s, and other prominent companies pronounced any attempt to answer that question an impossible dream. “Litigation is inherently unpredictable,” they wrote to Herz and International Accounting Standards Board chairman Sir David Tweedie.
The lawyers were reacting to what has since blossomed into a FASB proposal to require companies to add more-robust disclosure in their reporting of liabilities that may or may not occur. Under the proposed rule, companies would have to disclose “specific quantitative and qualitative information” about loss contingencies involving legal liabilities as well as such things as environmental-cleanup costs.
FASB’s proposal stops well short of a full fair-value regime for litigation risks, but attorneys fear that may yet come, if not from FASB, then from the IASB. “We do not believe that the fair value of contingent liabilities…can be reliably measured in many cases,” the corporate litigators wrote.
The reason it’s so hard to put a fair value on litigation is that there are so many variables: the laws that apply in a case, the strategies of the lawyers involved, and the mind-sets of the judges, to name a few. “No matter what model is used,” says Larry Levine, director of financial advisory services at RSM McGladrey, “the process is enormously speculative.”
3. Mergers & Acquisitions: The march toward fair-value accounting took a big step in December 2007, when FASB revised its rule on business combinations. The new rule, FAS 141(R), requires companies that acquire assets or assume liabilities in a deal to record the items at their acquisition-date fair values measured according to the new hierarchy setup under FAS 157.
As a result, the fieldwork by acquirers will have to include “a much deeper dive into the financial statements” of potential target companies, says Bank of the West CFO John Wojcik. In the case of banks, specifically, purchasers can no longer accept a purchased company’s estimates of the liability of its loan portfolios. Instead, he adds, the buyer will have to do “a lot more upfront work” to determine the fair value of the loans it stands to absorb.
As it might do with lawsuits, the proposed rule on contingent liabilities could have a significant effect on how companies gauge the worth of a merger, Levine thinks. “What-if” scenarios will be hard to mark to market. “If you buy a company that has $25 million in sales, and you’ll give them another million of payment if they hit $30 million of sales next year, that’s a difficult and somewhat subjective thing to value,” says Levine. The result? Added cost and effort in figuring out what price of a deal to report.
4. Hedging: Trying to simplify FAS 133 — considered by many to be the most notorious example of the complexity of U.S. financial reporting — FASB has proposed sweeping changes in hedge accounting that should expand the use of fair value.
To be sure, the current rules for derivatives and similar risk-management tools involve extensive application of fair value. But with more than 800 pages of rulemaking and guidance needed to make sense of 133, the accounting standard has been something of a black eye for the fair-value concept, and has been in Herz’s gun sights ever since he became FASB chairman in 2002.
One current critique of 133 is that it allows two companies to account for the same transaction in different ways. It also enables a company to mark a hedging instrument at fair value without doing that for the hedged risk. Under the new proposal, all companies would use the same method of hedge accounting and each company would be required to use consistent accounting on both sides of a hedge.
5. Pensions: FASB’s fair-value crusade is plunging deeper into the forests of pensions. In November 2007, with the subprime-mortgage crisis in high gear, the board agreed to get plan sponsors to disclose the fair value of retirement-plan assets more broadly. On current balance sheets, employers lump together plan assets measured at fair value with liabilities that aren’t, yielding a net amount marked to market in mongrelized form.
The result is proposed guidance aimed at improving “the quality of financial reporting by increasing disclosures about the types of assets held in post-retirement benefit plans,” according to a FASB staff position issued in March. The FASB plan would require plan sponsors to disclose separately on their balance sheets the fair value of each “significant” category of plan assets, including cash and cash equivalents; equities; national, state, and local government debt; corporate debt; asset-backed securities; and structured debt.
FASB is also proposing that plan sponsors disclose the fair value of their pensions’ derivatives positions. Employers would have to list the hedging instruments separately rather than in aggregated form and classify them by type. For instance, employers would have to disclose, if significant, a plan’s hedges against such risks as foreign exchange, interest rate, and commodity price. They would also have to provide fair values of pension assets invested in hedge funds, private-equity funds, venture-capital funds, and real estate. To top it off, they would have to disclose facts that enable financial-statement users to assess the valuation methods used to produce the fair-value figures.
Those chores will take heavy lifting — especially for plan sponsors with a multinational presence, notes Kabureck. “If you’ve got a lot of foreign plans, it’s going to be hard to accumulate that information, because trusteed assets in pension funds are independent of the [parent] corporation,” says the Xerox accounting chief. — D.M.K.