Another Fair Value Antidote?

After spending a day on the congressional hot seat, FASB chairman Robert Herz and the FASB have proposed expedited guidance on fair value for a 15-day comment period. The proposal guides companies on how to determine whether an asset's market can be considered not active, and whether a transaction being used to estimate an asset's value is not distressed.

Under FAS 157, which provides a measurement framework for fair-value accounting, financial instruments' fair values cannot be based on distressed sales. Fair-value accounting has been in existence for years, but has recently been criticized for worsening the financial crisis and leading to massive write-downs in the financial-services sector. (Of course, if you ask me, blaming fair value accounting for the financial crisis is kind of like placing the blame for a burning building on the smoke alarm! Maybe we should, instead, be looking for the bank execs who are holding the matches!)

Critics imply that the current rules require banks to unduly write down their asset values, even though they believe those assets are actually worth more than the amounts they feel mandated to report. The truth in FASB's view, however, is more complex: To avoid second-guessing by auditors, firms are tending to use any price they can find when estimating the fair values of their assets — even prices that are basically unreliable and too low to truly reflect an asset's current worth, because the prices resulted from a so-called forced transaction. Those types of transactions are not representative of an asset's fair value, according to FASB.

FAS 157 calls on companies to use a three-step hierarchy when estimating the current worth of their financial assets and liabilities. The evaluations must be based on prices that have been used in orderly transactions, not those that are considered forced or distressed.

Level 3 requires the most judgment, as it is designated for thinly traded or untraded assets that have a value derived from "unobservable inputs." For that reason, there has been a stigma attached to Level-3 numbers. So financial-statement preparers have tended to reference Level 2-type prices, although they shouldn't always do so.

Firms may have been wary of exploring Level-3 pricing because those inputs do require more judgment — which can result in more scrutiny from auditors and more work on the part of their internal staff and the need for outside help, such as valuation experts. Only 9 percent of financial instruments subject to fair value were classified under Level 3 since FAS 157 was implemented, compared to 76 percent of those instruments that fell under Level 1, according to a Securities and Exchange Commission study of financial institutions' use of fair value issued late last year.

To be sure, FASB board members acknowledged, these days it seems like nearly every financial instrument's market is inactive, and nearly every transaction is distressed, making the job of accountants that much harder. If a company determines, under the new proposal, that a price cannot be relied upon, then it needs to use another valuation technique, which falls under Level 3. As it is, many (including this blogger) believe, issuers were not taking the extra steps necessary to figure out the fair value of an asset that is not actively being traded.

If approved, companies will follow a two-step approach to determine whether they're justified in straying from observable prices because those valuations aren't truly representative of an asset or liability's current fair value. First, they will consider the signs that could indicate a market is inactive, such as there being too few transactions on which to judge pricing on an ongoing basis, or that price quotations are derived from outdated information.

Then, if all the evidence indicates the market is not active, companies will evaluate whether the price they are referencing was made under a distressed transaction. If it was not, then the price can be used for estimating fair value. But if it was, companies must use alternative valuation techniques.

FASB will vote on the proposal on April 2, one day after the public-comment period ends. FASB expects companies to use “significant judgment," which Herz acknowledges could result in different companies reporting different values of the same type of asset.

New FASB Proposal: A Balance Sheet That Doesn't Balance!

A balance sheet that doesn't balance? Financing and operating classifications that depend on your company type? A cash-basis income statement?

Well, not quite. But accounting standards-setters are online and on the road urging investors and companies to weigh in now on a proposal to radically alter financial statements. And while accrual accounting isn't going away, accountants might be surprised to find that the above descriptions do accurately describe the look and feel that financial statements might have just two years from now.

Issued as a discussion paper in October by both the FASB and the International Accounting Standards Board, the goal of the redesign is to address investor complaints that items on each of the financial statements are not linked across the three statements, and that dissimilar items are often aggregated.

Among the notable features: all three statements — balance sheet, income statement, and cash-flow statement — will be divided into two major sections: business and financing.
The "business" section — which is subdivided into operating and investing categories — will focus on what a company does to produce goods and provide services. The operating category will include its primary or "core" revenue and expense-generating activities, and the investing category will include activities that generate a return but are not "core."

The "financing" section will include those activities that fund a company's business activities. For nonfinancial institutions, that would primarily include cash, bank loans, bonds, and other items that arise from general capital-raising activities.

One effect of the new format is that the balance sheet won't balance the way we expect it to. That is, assets won't equal liabilities and equity because assets and liabilities will be in each category.

Another feature guaranteed to generate some controversy is that management will decide whether items in the financial statements are related to operations or to financing. That means different companies might account for the same item differently. A manufacturer might record proceeds from mortgage-backed securities as investment earnings, while a bank might record identical proceeds as operating earnings.

Although the new statement categories may resemble those used on current cash-flow statements, they won't actually be handled the same way. For example, under SFAS No. 95, if you've invested in property, plant, and equipment, you would call that an investing activity. But under the FASB's new proposal, capital expenditures may well end up in the operating category (property, plant, and equipment used to develop your inventory is an operating asset).
Another big change for preparers: using the direct method to generate a cash-flow statement. Though companies have the option to do so under current accounting, that option is almost universally ignored in favor of the indirect method.

Although this is only in the “discussion stage” at this point, one thing’s for sure: huge changes are coming to financial statement presentations.