When the history of accounting in the U.S. is written, March 10, 2010, will go down as one of the key dates. While little noticed, a Financial Accounting Standards Board announcement portends perhaps the greatest change in GAAP since FASB itself was formed. The following quote from the FASB Web site hardly hinted at what was to come:
"The FASB chairman announced [March 10, 2010] that he added the following projects to the board's agenda:
"1. Investment properties. The board will consider whether entities should be given the option (or be required) to measure an investment property at fair value through earnings. Existing International Financial Reporting Standard (IAS 40, Investment Properties) provides such an option. This project also will consider how an entity should consider a lease when measuring the fair value of a leased investment property."
The full significance of this announcement probably was not immediately clear to readers. As will be shown below, this announcement from FASB, in terms of changing GAAP as we know it, will be hard to overestimate. It looks as though far-reaching change is about to happen - and perhaps not the kind of change discussed in the last presidential election.
Those of us who studied accounting way back in the dark ages learned at least three salient truths:
* Be conservative;
* Recognize all losses at once; and,
* Do not recognize income or gains until a transaction has been completed.
These "truths" obviously are not laws of nature; rather, they are simply man-made rules for accounting under GAAP in the United States. What man can create, man can also change.
If FASB truly "converges" GAAP with IFRS, by incorporating the essential elements of the International Financial Reporting Standard on Investment Properties (IAS 40) into U. S. GAAP, this will probably be the first time the above three truths will have been changed.
We disregard the short-term changes now required for accounting in financial instruments. For financial instruments, where there are active markets, most observers feel that reporting current values provides better information to users. The reason is simple. It is assumed that these financial instruments can be turned into cash, both quickly and with little expense - i.e., a narrow spread between bid and asked prices. Thus, such instruments are "near cash" and readers of financial statements are not being served if these assets continue to be carried at original or historical cost.
But with the addition of the "investment properties" accounting to the FASB agenda, we are taking the first real step toward fair value accounting. Remember that when SFAS 157 on fair value measurements was issued, the board made crystal clear that it was not moving toward FV accounting, only providing a standard for how to determine FV, as and when it would be used.
Well, the other shoe has now dropped. Adoption of full convergence with IAS 40 will introduce true fair value accounting to users of U. S. GAAP. Are we ready for this? Do we need it? Do we want it?
First, a word of disclosure. As will be seen below, adoption in the U. S. of IAS 40 will start to do for the valuation profession what the 1933 and 1934 acts did for public accounting. It will for the first time require the use of valuation specialists as part of normal quarterly and annual financial reporting.
But what may be profitable for this writer and his colleagues is not the same thing as what is in the country's best interest. For over 30 years I have been arguing against FV accounting, even though it was not here in real-world terms. I consistently argued against any adoption of required FV disclosures where changes would flow through the financial statements. In a sense, I was arguing only against a straw man. Now, what I feared, and anticipated, is about to happen; my predictions of trouble are not changing.
Adopting FV accounting, even a small first step, is going to change the ways in which companies manage their business. Focus will be on investment results, rather than on operations. I have used the analogy of football. If field goals scored six points, and a touchdown scored only three points, wouldn't the total strategy of the game change? Of course it would, because you do what you have to do to win under the existing scoring rules. Give companies, in the future, credit for changes in value of assets, and it does not take Nostradamus to predict how they will react.
At this point, let's look at exactly what FASB is considering adopting. Investment properties are defined in IAS 40 as: "Property (land or a building - or part of a building - or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for: (a) use in the production or supply of goods or services or for administrative purposes; or (b) sale in the ordinary course of business."
The key distinction is between passive property, capable of generating cash flows independently of other assets held by the entity, and actively managed property such as plant assets, the use of which is integrated with the rest of the entity's operations. Under IAS 40, investment property can be reported at fair value, but it does not have to be. But once a company starts reporting a property at fair value, it must periodically revalue - either up or down. This is to ensure that someone would not choose to recognize only gains, write an asset up and then disregard it in the future.
As written in IFRS, initial valuation at fair value is strictly at the option of the holder; it is not, in other words, mandatory. Whether this "choice" will be retained in the U.S. is undoubtedly one of the open questions to be decided by FASB.
What is critical for this analysis, however, is the artificial distinction between an investment building and an identical "active" building. Imagine a 100,000-square-foot warehouse owned by a company, but rented out to someone else. That would make it investment property. If the owner used it itself for warehousing, the building would not be considered investment property. Same building, different owner or user, different values reported to investors and creditors.
We make an assumption that companies sitting on investment properties with significant built-in gains, not yet reflected on the financial statements, will be motivated to opt for fair value treatment. Conversely, companies sitting on assets that have not risen in value will have zero incentive to go to fair value treatment. Interestingly, land for the first time, if treated as an investment, can also be written up (or down) to fair value.
If there is one conclusion to be drawn from 37 years of FASB rule-making, it is that the board actively dislikes choices of different accounting in otherwise similar circumstances.
How long will it be before analysts and journalists start to complain about companies "managing" their earnings by how they classify a specific structure? As written, IAS 40 begs for such disparate treatment, so I would predict some modification by FASB of the "free choice" aspect, as well as the disparate accounting for otherwise identical structures. Any such modification, however, can only go in the direction of more, not less, use of fair value treatment of structures. Once FASB adopts IAS 40 - in the interest, of course, solely of convergence - I predict that there will be increasing pressure for expanding the role of fair value to many more assets and asset categories.
I could write another article about all the things that are wrong with fair value accounting, but close this piece with discussing but one problem area. Valuation is not an exact science; in fact, it is not a science at all. Two equally competent valuation specialists should come within 10 percent of each other for a specific asset. They will not come any closer than 10 percent, other than by chance.
A 10 percent range, plus or minus, may not seem significant, but my experience with impairment testing leads me to the belief that companies often are interested in the effect of accounting and valuation choices that impact EPS by literally a cent per share. A 10 percent range in valuation of material assets has the potential to swamp results of operations for a period. I am not asserting that managements would ever manage earnings through the valuation process. But, trust me, the potential exists.
The FASB decision to consider adoption of IAS 40, as part of a convergence effort, may seem to be a minor blip in the course of recent development in GAAP. To the contrary, in this writer's opinion it is the start of a truly major revolution in financial reporting.
Alfred King is vice chairman of Marshall & Stevens Inc., a valuation consulting firm. Reach him at aking@marshall-stevens.com.
