SFAS 159: The Fair Value Option
CPAs at a Crossroad?

By James Cataldo and Morris McInnes

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The profession’s limited responsiveness to FASB’s fair value agenda is not entirely accidental. The inattention of the broader profession to accounting policy has allowed FASB and the IASB to advance the fair value agenda largely under the radar of public awareness. In a commendable, though rare, moment of candor, one senior IASB official, speaking at an academic conference, described the highly unusual step of permitting fair value accounting at the preparer’s option as a way to “let in fair value without scaring the horses.” FASB has moved in lockstep with the IASB on this issue, introducing its own “Fair Value Option” (now SFAS 159) exposure draft in January 2006. Because SFAS 159 does not require companies to adopt fair value reporting, those who disagree with it might be led to believe that they can safely ignore the standard. FASB’s statements strongly suggest, however, that, absent a strong message to the contrary from the accounting and financial community, fair value is unlikely to remain “optional” for long.

Many otherwise well informed accounting and finance professionals seem unaware of the radical impact that fair value would have on our financial reporting system. According to the fair value vision, the entire framework of transaction-based accrual accounting would be replaced by a system that measures every asset and liability at an estimate of its current “fair value.” Traditional concepts of revenue, expense, and matching have no place in this vision. What we currently understand as “net income” would be redefined as the change in book equity—that is, the difference between the estimated fair values of assets and liabilities, adjusted for primary capital flows. This system of comprehensive fair value accounting is known as the asset-liability approach.

Europe has a considerable advantage over America in marshalling an effective response to fair value accounting. The European Union’s adoption of International Financial Reporting Standards (IFRS) in 2005 acutely heightened Europeans’ collective awareness of the IASB’s agenda of eventually imposing a full “fair value, representationally faithful” regime on corporate financial accounting. As a result, pressure in Europe has steadily mounted, leading at the beginning of 2006 to the IASB’s agreeing to conduct a full and proper debate of the basics of financial reporting. This action was followed in July 2006 by a further concession from the IASB in the form of a moratorium on the adoption of any new accounting standards before January 2009.

It is far past time that the same awareness is aroused in America, in order to encourage a proper debate on the future of corporate financial accounting and disclosure. Otherwise it is likely that corporate America will simply drift along, relatively unaware of the radical concepts underlying FASB’s fair value agenda. This article is the authors’ attempt to stimulate a vigorous conceptual debate over the future of the fundamentals of our financial reporting system.

First, we provide a brief overview of SFAS 159, arguing that it brings the accounting profession close to a point of no return in the march toward a fair value–based accounting system. Second, we describe several of the key contentions behind the fair value or asset-liability approach to accounting, and point to instances where key weaknesses have been overlooked or simply ignored by its proponents. Third, we describe, and challenge, FASB’s goal and tactics in advancing its fair value agenda. Last, we argue that every CPA should carefully consider fair value’s implications for the profession and the investing public at large.

SFAS 159: A Foot in the Door?

SFAS 159 is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. The standard permits, at the option of the reporting entity, measurement of a wide range of financial assets and liabilities at fair value. In addition to more-conventional financial instruments, the standard extends to warranty and insurance obligations that may be settled by payment to a third party, loan commitments, and unconditional purchase obligations. Items ineligible for fair value election are investments in consolidated subsidiaries and variable-interest entities, pension and postretirement benefit obligations, leases, demand deposits of banks and similar financial institutions, and financial instruments classified as components of shareholders equity. The option of reporting a financial instrument at fair value, once exercised, is irrevocable, and any subsequent net changes to estimated fair value flow directly to the income statement.

SFAS 159 permits election of fair value measurement on a contract-by-contract basis, with the only stipulation being that the election is supported by concurrent documentation or a preexisting documented policy. The reporting entity’s opportunities for fair value election fall into two basic categories:

• At initial adoption of the standard, the entity may reclassify any existing eligible asset or liability to fair value. Any gain or loss resulting from reclassification is reported as a cumulative adjustment to retained earnings.
• Subsequent to initial adoption, the entity may elect fair value at the initial recognition of any eligible financial asset or liability, or upon any event that gives rise to a new accounting basis for that item.

Subject to only a few exceptions, fair value election is permitted on a contract-by- contract basis and at the sole discretion of the entity. Paragraph 12 of the standard states that fair value “may be elected for a single eligible item without electing it for other identical items.” Portions of financial holdings currently accounted for as held to maturity or available for sale may be reclassified to fair value at the initial adoption date without jeopardizing the historical-cost classification of the remaining assets.

The standard’s disclosure requirements may provide some deterrence against obvious abuses of “a la carte” fair value elections. For example, SFAS 159 requires explanation of management rationale where fair value is elected for only part of a group of similar eligible instruments. Nonetheless, the standard’s broad discretionary latitude poses a clear challenge to the comparability and consistency of financial statements. At initial adoption, virtually identical entities may make widely divergent decisions for classification of existing assets and liabilities. These decisions will be far from neutral; they must inevitably be influenced by powerful incentives, such as the impact on retained earnings, statutory capital, and the earnings volatility.

Most companies will be hesitant to reclassify large portions of their existing positions at initial adoption. The ongoing effects of fair value accounting on a company’s net income patterns and volatility may introduce unwelcome sources of uncertainty to the company’s financial reporting. Classification decisions will likely strain the analytical capabilities and corporate decision-making processes of even the most sophisticated entities. Many may choose incremental adoption for newly acquired financial instruments as analytic resources and corporate policy catch up with the opportunities presented by fair value reporting.

The application of SFAS 159 will likely be strongly influenced by differences in reporting incentives, analytic resources, and management disposition. The authors believe it is difficult to imagine a standard more at odds with the essential accounting attributes of comparability and consistency. So why aren’t more people complaining?

It’s an Option … What’s Not To Like?

Being offered what seems a rare gift of discretionary flexibility from FASB, it’s no surprise that relatively few reporting companies have raised objections to the fair value option. With the standard seeming to pose little threat to companies’ immediate interests, reactions to SFAS 159 from the financial and accounting sectors focus mainly on technical issues and are largely silent with respect to the broader fair value agenda.

Beware, however, of future mandates from FASB, advanced in the seemingly reasonable goal of greater comparability. FASB acknowledges that discretionary application of fair value will adversely impact the comparability of financial statements between otherwise similar companies. We think FASB’s “answer” to the comparability and consistency problems introduced by SFAS 159 will be an even more extensive, eventually mandatory, application of fair value reporting. At its September 6, 2006, meeting, FASB debated whether to retain the standard’s optional features. FASB reaffirmed optional application, but it is clear that mandatory fair value measurement was being considered even before the standard was issued. Significantly, the only two dissenting opinions registered from the board in the final standard were from members objecting to optional application.

The fast-track treatment of SFAS 159 seems to be evidence of FASB’s determination to advance the fair value agenda. As it stated in the exposure draft: “The Board agrees that the provisions of this proposed Statement may impair comparability and consistency across entities, but it supports the provisions of this proposed Statement to enable greater use of fair value.” Why is FASB so intent on this course? In the following sections, we attempt to provide insight into the views underlying the fair value agenda.

Fair Value: A Foregone Conclusion?

To our minds, the most alarming aspect of the controversy is the degree to which fair value proponents regard the superiority of an essentially untested approach as a foregone conclusion. This attitude is well represented in the financial press. As one CPA Journal article contended: “Perhaps the strongest argument for a move to fair value accounting is that historical cost financial statements do not provide information that is relevant to investors” (Rebecca Toppe Shortridge, Amanda Schroeder, and Erin Wagoner, “Fair-Value Accounting: Analyzing the Changing Environment,” April 2006). This contention seems to contradict all the contemporary research on the informativeness of financial statements, which clearly indicates that financial reporting has become more, not less, informative over the years. Recent research suggesting incremental benefits from fair value measures in no way establishes the irrelevance of current U.S. GAAP, or indeed, vice versa. For example, a recent article in the Accounting Review, while supportive of “full fair value” income measures, also finds strong affirmation for the efficacy of traditional measures: “[Conventional] net income volatility exhibits the most consistent and robust correlations across the risk factors we examine” (Leslie Hodder, Patrick Hopkins, and James Wahlen, “Risk Relevance of Fair Value Income Measures for Commercial Banks,” March 2006).

Differences between U.S. GAAP book equity and market capitalization based on traded share prices are often cited as compelling evidence of deficiencies in the traditional accounting framework. To quote again from Shortridge, Schroeder, and Wagoner: “The fact that the market value of publicly traded firms on the New York Stock Exchange is five times their asset value serves to highlight this deficiency.” This amounts to criticizing U.S. GAAP for failing to represent something that it was never intended to measure. Regrettably, the notion of balance sheet “irrelevance” seems to have established credibility through repetition.

Differences between market value and book value are an acknowledged aspect of informed financial statement analysis. Financial professionals deal with such distinctions as a matter of course; indeed, as a matter of their livelihood. Any informed financial statement analysis is conducted in reference to relevant industry peer groups. The ratio between market and book value is only one of many financial reporting outcomes whose significance and interpretation depends on industry or individual company context. No system of financial reporting—certainly not fair value—would eliminate the need for integrity and nuanced judgment in both preparation and interpretation. The simple presumption of fair value’s superiority underestimates the sophistication of U.S. GAAP and its usefulness when properly prepared and competently interpreted.

Is GAAP Irrelevant in the ‘New Economy’?

Proponents of radical change to the accounting framework would also have us believe that ideas drive value in an unprecedented manner and have ushered in a new era. But do recent events really depart so radically from past history? Value has long been created in fundamentally intangible ways: by building a franchise in the market through strong brands, superior technology, patents, dominance in the channels of distribution—and then defending the franchise from rivals by creating barriers to entry. For example, in the early 1980s, Home Depot created a market capitalization many times the book value of its equity by means of a novel distribution and marketing strategy and excellent execution. In the early 1990s, the Gap and Wal-Mart did likewise. Some start-ups have exploited radically new technologies to create value, witness eBay and Google. A hundred years ago, the new tecphnologies were the railroads and the automobile; 60 years ago it was television; 35 years ago it was the mainframe computer.

The conservatism and professional skepticism of the accounting profession may be needed more, not less, in the modern economy. The structural limitations of traditional accrual accounting are well understood by sophisticated financial statement users, and, far from being irrelevant, have served well over a prolonged period of economic dynamism and value creation. Pfizer’s commentary on the SFAS 157 exposure draft provides a succinct statement on the limitations of externally reported financial information: “We wish to stress our belief that investors are best served when the standards-setters recognize the limits of the accounting model. The accounting model works best when it measures, records, and summarizes past transactions and events. It becomes increasingly inadequate when it departs further and further from this baseline.” Pfizer, like other thoroughly modern corporations such as Microsoft and Lockheed-Martin, seemed puzzled at the rush to abandon the current system.

The How and Why of Fair Value

Many concerns about the practicality and reliability of fair value measurement under SFAS 157, Fair Value Measurements, have emerged both before and since its enactment in September 2006. An excellent account of SFAS 157 and its broader ramifications recently appeared in these pages (Robert G. Haldeman, Jr., “Fact, Fiction, and Fair Value Accounting at Enron,” The CPA Journal, November 2006).

Though SFAS 157 raises significant unresolved issues for the “how” of valuation, the gaps in the “why” of FASB’s fair value measurement are perhaps even more striking. SFAS 157’s preamble seems to take pains to disassociate it from anything beyond improving measurement methods:

This Statement applies under other accounting pronouncements that require fair value measurements, the Board having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements.

Fair value proponents, the authors are certain, consider further codification of fair value practices as essential to the transition to a full fair-value accounting system. But without a more forthright description of policy goals, how can one assess how well SFAS 157 furthers these objectives? By refusing explicitly to link the how of fair value measurement and the why of the fair value accounting vision, the standards setters evade a needed debate.

The missing “why” in SFAS 157 has not gone unnoticed by industry observers. As Pfizer noted in its comment letter: “Generally we think the ED [exposure draft] should not have been issued until the creation of a Concepts Statement regarding using fair value. … We are concerned that separating the ‘how’ [of] fair value in the ED from the ‘why’ of fair value unnecessarily constrains the improvement of old and the development of new accounting standards.”

The usefulness and validity of income based on fair value hinge upon capturing all significant sources of enterprise value. But is this possible in any system of accounting measurement? SFAS 157 explicitly excludes measurement of value elements arising from the enterprises’ creative marshalling of productive resources—perhaps the most significant component of value in the modern enterprise. As the introductory summary to SFAS 157 declares: “This Statement emphasizes that fair value is a market measurement; it is not an entity-specific measurement.” This again raises the critical question of why: The basic valuation perspective of SFAS 157—arm’s-length estimates of distinct and separate assets and liabilities—is ill suited for measuring the value of the entity as a whole.

The problem goes beyond the purely technical challenges raised by SFAS 157. SFAS 157 does allow companies to estimate value based on the hypothetical price of groups of assets and liabilities to prospective buyers. However, the guidelines for applying such an approach are unclear, and the standard’s fair value hierarchy clearly favors valuation of individual items in traded markets. If reporting entities apply the principle of “highest and best use” or best market price, the most valuable grouping of assets and liabilities is likely to be the entire business franchise. Should an estimate of a company’s hypothetical sales price be the aim of financial accounting? Does this contribute useful information when direct, market-based measures (e.g., share price) are available?

Rather than allow needed debate, SFAS 157 seems to have been rushed into introduction in service of FASB’s broader fair value ambitions. The Financial Executives International (FEI) Committee on Corporate Reporting, among the most engaged and assertive of participants in the U.S. accounting policy debate, in a letter dated March 16, 2006, called on FASB to re-expose the proposed standard. This came on the heels of a thoughtful and essentially critical assessment of the exposure draft by the AAA Financial Accounting Standards Committee (Accounting Horizons, July 2005). Previous to that, several companies submitted letters to FASB questioning and challenging most of the tenets of the exposure draft (e.g., Pfizer, Microsoft, Lockheed-Martin). Despite this criticism, FASB issued SFAS 157 on September 15, 2006, posting its completed version on September 20. Some initial criticism of the exposure draft of SFAS 159 focused on the absence of authoritative guidance on how to measure fair value. It seems likely that FASB’s haste in issuing SFAS 157 was a response to this criticism, aimed at removing it as a source of resistance to the fair value option and, ultimately, the fair value agenda.

FASB and Its Skeptics

While its proponents in accounting policy circles evidently regard the superiority of the asset-liability view as an established fact, some of the foremost exemplars of value creation in the modern economy take strenuous exception to the assumptions of this approach. To quote Microsoft’s’ response to the SFAS 157 exposure draft:

[W]e do not believe there is any compelling evidence that supports the claim of increased reliability and comparability with respect to the resulting fair value measurements. In fact, we believe a further move to fair value measurement could result in less reliable financial statements … In addition to our concerns regarding reliability, we are not convinced that a further move to fair value measurements will result in more relevant financial reporting.

Lockheed-Martin expressed similar sentiments:

[W]e do not believe that a convincing case has been made for the superiority of a fair value balance sheet, particularly concerning the reliability of reported information and its susceptibility to manipulation. The potential marginalization of the income statement under a fair value approach is especially troubling, and we do not believe the further commingling of realized and unrealized gains improves financial reporting.

Such comments should give pause to anyone tempted to regard fair value as the presumptively superior basis for modern financial statement reporting.

Comment letters from industry also expressed considerable frustration with FASB’s apparent disregard of dissenting views on the desirability of further moves toward fair value reporting. Noting the strong reservations expressed in response to previous FASB reports on fair value, Microsoft goes on to say:

We hope you can understand our frustration when the basis for conclusions … indicates that “Users of financial statements generally have agreed that fair value information is relevant,” but provides no evidence to support that statement, does not discuss whether fair value information is more relevant, or provides any kind of explanation for the qualifier “generally.”

FASB’s dismissive attitude toward fair value skeptics is clearly on display in several of its articles and essays. For example, a joint FASB-IASB publication notes: “The FASB rejected what we currently understand to be the basis for financial accounting in favor of the ‘Asset-Liability View’ more than 20 years ago” (Halsey Bullen and Kimberley Crook, “Revisiting the Concepts: A New Conceptual Framework Project,” May 2005). The authors assert that the U.S. GAAP framework is intellectually indefensible because it relies in part on “subjective” judgments. Referring to the FASB discussions occurring in 1976, they state: “Critics of the asset-liability view who favored the revenue and expense view were challenged to define revenue and expense without reference to assets or liabilities or recourse to highly subjective terminology such as proper matching. Some tried, in letters, articles, and public meetings with the FASB, but none could meet the challenge.”

Apart from its reliance on an obscure meeting occurring more than 30 years ago, the argument for rejection of our current accounting system in favor of an untested fair value approach seems strikingly presumptuous. Why must revenue and expense concepts be divorced from assets and liabilities? Revenue creates monetary assets—this is the essence of dual-entry accounting, an enactment of the market exchange process that is the very essence of commerce. Resources are acquired, used up, and accounted for as expenses; and resources are mainly accounted for as assets. Credit is used to acquire resources, giving rise to liabilities.

Proper matching, though clearly involving the exercise of professional judgment, is not merely a subjective exercise. Rather, matching and accrual accounting are the product of a highly evolved, widely understood body of principles-based standards and practices. Dissenting views on the benefits of fair value do not stem from ignorance or lack of sophistication. By failing to speak up for the merits of the traditional framework, CPAs are permitting their profession to be defined by its abuses.

The Exclusive Choice Trap

Much discussion of fair value versus traditional U.S. GAAP casts complex issues of measurement and reporting into a “for or against” framework. For example, a recent FASB report (L. Todd Johnson, “Understanding the Conceptual Framework,” December 28, 2004) invokes the notion of “conceptual primacy” to assert that sound financial reporting requires the selection of a single, exclusive unifying principle. According to this view, acceptance of the asset-liability approach (i.e., the full fair-value approach) demands that we discard the supposedly obsolete framework built around the revenue-generation process and related transaction-based principles. Any other approach, it asserted, would lack intellectual respectability.

This “either-or” approach is also invoked in the 2003 SEC study on the adoption of a principles-based accounting system [“Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System”]: “Since we believe that the FASB should maintain the asset/liability view in continuing its move to an objectives-oriented standard setting regime, we also believe that the FASB should eliminate the inconsistency by removing the need to assess the earnings process in the determination of revenue recognition.”

Insisting on the “conceptual primacy” of a single approach to measuring economic performance and risk seems both unnecessary and misguided. The emerging challenges of modern financial reporting suggest instead that several measurement and reporting perspectives are needed to present a full picture of the modern enterprise.

The Choice Is Ours

In Enron’s aftermath, it is natural to look to radical, seemingly elegant alternatives like fair value to improve our profession’s intellectual image and to put the difficulties of the past behind us. Fair value and the asset-liability approach can trace their roots directly to Nobel Prize–winning mid-20th-century economist John R. Hicks’ elegant theoretical concepts about capital and income. But is a fair value accounting system really a good thing for our profession and for investors?

Accounting has served for years as an essential counterweight to the inherent exuberance and all-too-frequent deceptions of corporate management. A fair value–based system would detach accounting from its proven moorings in the verification and stewardship of enterprise transactions and place it squarely in the realm of economic and financial analysis. Here, the accountant, already at a huge disadvantage in specific business knowledge and information access, will be playing on management’s turf. Fair value accounting may increase audit fees and appear to elevate the profession’s status in the short run. In the contest with management over the presentation of financial results, however, accountants will be more outmatched than ever. Large accounting firms have generally supported fair value, perhaps anticipating greater demand for their services in the ensuing audit of complex fair value estimates. Nevertheless, corporations and the audit firms that serve them will ultimately feel the pain of any changes that hurt their investors.

Despite the institutional weight currently behind the fair value agenda, other powerful participants in financial policy making seem unwilling to consign traditional U.S. GAAP to obsolescence. As the Federal Reserve Board warned in its comments on the Fair Value Measurement exposure draft: “The relationship of fair value accounting with longstanding revenue recognition principles needs further consideration, to ensure that revenue that is not yet earned is not ‘up-fronted’ though a fair value regime.” Indeed, recent scholarship finds Enron’s collapse was considerably abetted by just the kind of “up-fronting” feared by the Federal Reserve Board (George J. Benston, “Fair-Value Accounting: A Cautionary Tale from Enron,” Journal of Accounting and Public Policy, July/August 2006).

SFAS 159, in our view, brings the profession close to the point of no return on the march to a full fair-value accounting system. Rather than wait for FASB’s next pronouncement, we should seek to influence the crucial decisions now being made over the future direction of our financial reporting system. Broader professional involvement, we believe, will show that the cumulative knowledge and experience embodied in current U.S. GAAP cannot be readily dismissed. Instead of discarding our current system, we hope that the profession will find new, effective methods for communicating value-relevant information while preserving the integrity and consistency of the transaction-based accounting model—and, along with it, our unique contribution as professional accountants.

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