Fair Values Good, Historical Costs Bad - Essay Example

Fair Values Good, Historical Costs Bad In the novel Animal Farm (Orwell, p. 50), one of the first mantras of the animals after taking over the farm was “Four legs good, two legs bad!” as a way to commit to the memory of the victorious four-footed rebels the first two commandments of the new regime: that men (two-legs) are bad and animals (four legs) are good. Accountants, not known for devising convenient mnemonics beyond “Debit Left, Credit Right”, have in the last two years or so found a reason to devise a new one as in our title. Why so? Are accountants finally rising up in arms against the wave of bad publicity generated by the recent scandals of the profession? Have the bean-counters tired of numbers? What in the balance sheet’s name is happening? The simple reason for the new mantra is that the accounting profession has decided on a new set of standards for the valuation of assets. Perhaps never before in accounting history has an issue generated such controversy as the debate between fair value and historical cost, which is reaching mythic proportions as a battle between good and evil. Accounting and Modern Business The accounting profession is one of the pillars of capitalism, a great invention of the modern era because it allows for transparency, fairness, and trust in the conduct of business (Johnson, 1975). Without accounting standards, it would have been impossible for the world of business to have gone as far as it has, simply because we would not have many of the aspects of business that we now take for granted. Valuation of corporate shares, borrowing and lending of funds, capitalisation of assets, and even pricing of products and services would have been problematic, as it was in the early days of business when the words caveat emptor (Buyer Beware!) was the norm. In addition, it is easier to calculate profit and loss and to price risk because accountants have agreed on generally accepted accounting practice. Investors are better informed, owners of corporations can sleep better at night, and millions of workers can get instant feedback on their collective performance thanks to the accounting standards that help establish share prices, cash flows, and liquidity, giving each stakeholder a clearer picture of its position. Accounting reports have come a long way in the last hundred years as to report the true position of a company’s accounts, but as recent events have made clear, notably the scandals associated with formerly high-flying companies Enron and WorldCom in the U.S., accounting standards need to be continuously and carefully defined and updated to temper every company’s considerable discretion in calculating profits and deciding what to show on the balance sheet (Brealey and Myers, 1998, p. 776). Two organisations have been instrumental in performing the painstaking work of coordinating the development of accounting standards that apply to most companies doing business all over the world: the Financial Accounting Standards Board (FASB) of the U.S. and the International Accounting Standards Board (IASB) of the U.K. Their missions are similar, which is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information (FASB, 2006). Since 1984, the IASB has been working on the issue of valuation of financial instruments such as options and derivatives, but it was only in 2001, shortly after the collapse of some companies and the dot-com crash, when a new accounting standard called IAS 39 was approved, subsequently adopted by FASB, and became part of the International Financial Reporting Standards (IFRS) for implementation in January 2005 (Deloitte, 2006). Dawn of a New Era Traditionally, companies measure their assets and liabilities at historical cost, depreciating or amortising them over their useful lives. The historical cost is the amount paid when the asset was purchased or the liability incurred. Accountants would estimate the useful life of the asset and depreciate it using standard formulas. At the end of each year, accountants would have an estimate of the value of the asset or liability, and this would go into the balance sheet for reporting purposes. However, financial innovations in the last two decades have led the IASB and FASB to use the fair value instead of historical cost in valuing assets and liabilities. The fair value is defined by FASB through SFAS 157 as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” It is therefore the price at which an asset or liability could be exchanged between knowledgeable, unrelated, and willing parties. The intention is to serve investors by showing the value of the firm’s balance sheet in today’s rather than yesterday’s prices. In January 2001, IASB adopted IAS 39 on the recognition and measurement of financial instruments. The new standard covers the valuation of a financial instrument, which is a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. A financial asset is any asset – cash, equity instruments, derivative and non-derivative contracts – that is recognised as such. A financial liability is any liability that is a contractual obligation to deliver a financial asset to another entity; or to exchange financial assets or financial liabilities with another; or a contract that will or may be settled in the entitys own equity instruments. Excluded are some instruments, such as leases, covered by other standards (Deloitte, 2006). IAS 39 continues being modified, with FASB’s help, from being a mixed (combined fair value and historical cost) to a pure fair value rule. Points of Controversy: Good or Bad? Along each side of the IAS 39 divide are lined arguments of Orwellian proportions. Like the animals that tasted firsthand the costs and benefits of the pig-led rebellion at Manor Farm, academics and practitioners, auditors and accountants, CEOs and CFOs, managements and Boards, and governments and firms are sounding their views on the new standards. Before going into the details of the debate, this is how it works: IAS 39 requires companies to record a range of financial instruments at fair value on the balance sheet. Any changes in the value of those instruments must then be reflected in the income statement, or else shown in shareholders’ equity depending on the instrument. The potential impact of this simple change in accounting procedures is tremendous, particularly since many financial assets and liabilities have been held at historical cost rather than fair value, or else not recorded on the balance sheet at all. IAS 39 requires that these instruments be brought out of the reporting closet and displayed in the income statement or balance sheet from now on. Supporters of “fair values good, historical costs bad” claim that the new standard is more realistic, comprehensive, relevant and reliable, up-to-date, and makes earnings management or window dressing more difficult. Critics raised several arguments against IAS 39. On top of their list is the perception that using fair value is more subjective and would result in less stable earnings, a higher beta stock, a higher company’s cost of equity, and lowering share prices. This may not be true, because analysts base their share price valuations on free cash flows and not accounting profits and losses. IAS 39 only changes the company’s accounting, not the cash flows. Critics also gripe about the paperwork, as changes in valuation (and fair value may lead to dramatic changes year-on-year depending on the behaviour of the macro-economy) need assumptions and explanations to be better understood. Investors would then need to be more discerning and knowledgeable of what goes into each financial report, certainly good news for analysts and CFO teams, which would increase in numbers as they hire more staff to write down and explain the numbers, clarify the reporting systems, and understand the voluminous pages of supporting notes, calculations, and assumptions (Wood, 2004). All these could make financial reporting confusing, but on the other hand, IAS 39 was designed precisely to give a more complete picture of a company’s financial position. Any volatility in earnings would, therefore, merely reflect the inherent business risk and help potential investors make better decisions. After all, as Black (1980) argued, the true object of accounting rules is to produce earnings proportional to value, not changes in value. IAS 39 conforms to this criterion, as fair value by definition comes closest to reflecting real earnings, and hence, real value, and would seem to be the more relevant measurement criterion for financial decision-making (Economist, 2004). Fair value has been around for years, as companies wrote down bad debts and impaired inventory, but critics still find fair value accounting dangerous. The subjectivity of valuation may be easy if the markets are liquid, but if not, the room for error and abuse goes up when companies assess fair value using discounted cash flow models. Historical cost accounting may be flawed, but at least it is objective. Companies know what they get. Fair value, on the other hand, relies on too many assumptions and forward-looking statements. But then again, this is not new. Accountants have used estimates – such as guessing the useful life of an asset – and models like straight-line depreciation in the past. Besides, if managements complain that calculating fair value is difficult in the absence of relevant and useful information, one need only be reminded that management is nothing else but the ability to make decisions in the face of the unknown (Drucker, 1986). The real issue, as with other accounting standards, is the trade-off between relevance and reliability. As accounting should reflect true economic substance, fair value as a more relevant measurement attribute for an asset or liability would be useful only if it is reliable. More powerful information technology systems, everyone hopes, would improve data and reporting reliability. Another danger is that accounting could start driving economic decision-making, as management is pressured to modify its risk profile based on perceived volatility. As short-termism in management is driven by pressure from financial analysts, new standards such as IAS 39 might begin to influence the quality of strategic decisions. One solution is redesigning the income statement, breaking earnings into ongoing or underlying income, exceptional items, and then unrealised gains and losses resulting from changes to fair value on the balance sheet (Wood, 2004). This is hard work, but it brings down the level of risk. What Next? The arguments are endless, but all boils down to how reports are presented, how investors are educated, and how the latter understand these reports. If information is clearly defined, the wild swings in value can be understood and factored into the valuation process. Thicker reports require deeper study, but good accounting, corporate governance, and disciplinary mechanisms would cope with this, even if opportunistic reporting risks remain. The main advantage is that fair value reporting makes even more transparent the managers’ assumptions of the company’s future. Markets would be able to better judge the information made available, and the public’s perception of management thinking would somehow find its way into the share price efficiently (Fama, 1970) or not (Shiller, 1990). Towards the end of Orwell’s novel (p. 132), the mantra became “four legs good, two legs better”, which reminds us that, perhaps, the battle between fair value and historical cost is not between good and evil in the world of financial reporting standards, but rather a progression from something good into something better. Historical cost accounting may have been good for a bygone era, but the time has come to move on to (better) fair values. Reference List Black, F. (1980). The magic in earnings: Economic earnings versus accounting earnings. Financial Analysts Journal, 36, 6, 3-8. Brealey, R.A. and Myers, S.C. (2003). Principles of corporate finance, 7th ed. New York: McGraw-Hill. Deloitte Touche Tomatsu (2006). Standards: IAS 39. Retrieved 5 December 2006, from: . Drucker, P. F. (1986). The Frontiers of Management. New York: Truman Talley. Economist (2005, July 28). The ones that get away. The Economist, 380, 83. Fama, E. (1970). Efficient capital markets: A review of theory and empirical work. Journal of Finance, 25, 383-417. Financial Accounting Standards Board (FASB) (2006). Home page. Retrieved 4 December 2006, from: . Johnson, H.T. (1975). The role of accounting history in the study of modern business enterprise. Accounting Review, 50, 3, 444-450. Orwell, G. (1945/2004). Animal farm. Reprint of the 50th anniversary edition, 6 January 2004. New York: New American Library. Shiller, R. (1990). Market volatility and investor behaviour. American Economic Review, 80, 2, 58–62. Wood, J. (2004, September). Farewell to history. CFO, 7, 27-30. Read More