By Joseph Neu
What if companies could forget about hedge accounting and simply mark to market (or fair value) all hedges and underlyings (see story)? What if they could recognize the declining value of their debt in earnings? And what if companies could forget about trading, available for sale (AFS), and held to maturity (HTM) classifications—and related impairment considerations—and simply recognize offsetting gains and losses across an investment portfolio?
If the FASB has its way, such “what-ifs” will soon become a reality. Next month (and in the wake of a June public roundtable) the Board will redeliberate an Exposure Draft that it released in January, which covered the first phase of a such an option.
The proposed Statement would allow an entity “to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and financial liabilities on a contract-by-contract basis, with changes in fair value recognized in earnings as those changes occur.” A second phase will consider additional, including some nonfinancial, assets and liabilities.
Such a radical departure from current accounting guidelines however, is more than many firms can imagine. The project was sparked by a convergence project with IAS 39. Which offers a similar alternative. But as was the case with IAS 39, the Fair Value Option is meeting considerable resistance.
A laundry list of cons
There are several concerns about moving to Fair Value, according to the FASB Staff’s analysis of the comment letters on the Exposure Draft:
• It will impair comparability, enabling economically similar transactions to be accounted for differently;
• It does not provide a reliability threshold, such as limiting to reliably measurable fair values or verifiable fair values, to curb abuse (This is the subject of another, concurrent project the FASB is undertaking to bolster fair value measurement guidance in order to avoid Enron like mark-to-model abuse);
• It should not be issued until the proposed FASB Statement on fair value measurement is finalized;
• It might result in the entity recognizing gains or losses in earnings for changes in its own credit worthiness. This is a particular sore point for rating agencies like Moody’s, which noted: “Distressed companies may be motivated to measure their debt at fair value at transition so as to appear more solvent and less leveraged, and to avoid triggering debt covenants.”
• It will increase volatility in earnings;
• It would be better reported as a disclosure item rather than on the face of the financial statements;
• It will be costly to implement;
• It will require burdensome recordkeeping, tracking, etc.;
• It will create transition issues, such as an opportunity to “bury” previously unrecognized losses in a cumulative catch-up adjustment;
• It indicates that the Board is placing undue weight on convergence with international standards;
• It should be a requirement, thus avoiding comparability problems; and
• It should not be issued until the conceptual framework project reconsiders whether cost basis or FV is more relevant.
So why support it?
According to the FASB, a third of respondents to its ED expressed “general support” for the proposed Statement. Just over another third supported the proposal, but requested substantive modifications.
Many of the supporters would actually prefer that the FASB relax hedge-accounting standards (and this includes most corporates) as opposed to introducing the FV option. This suggests that a major reason to support the fair value option is in reaction to the increasing difficulty to get hedge accounting on a growing number of transactions (e.g., in response to stricter interpretations of which hedges qualify for the short-cut method; see p. 1).
However, a more compelling reason to get behind the fair value option may be that it offers firms a means to transition on an elective, contract-by-contract basis into the world of fair value accounting; which is, after all, where the accounting standard setters are heading anyway.
By electing the fair value option as part of a controlled transition plan, firms can learn for themselves how fair value accounting could alter their financial and risk management practices in various areas and gauge the market responses to these changes.
In this respect, by offering this option, the FASB is simply seeking an acceptable way to move the world forward.