With a proposal that would let companies opt to report selected financial instruments at fair value, the Financial Accounting Standards Board has opened the possibility of a significant move toward more fair value measurement.The board has issued the proposal as an exposure draft in hopes that comments will support it as a reduction in the complexity of accounting and in volatility in earnings.
"This will provide a real simplification for entities that have related assets and liabilities that are affected by similar changes in the environment, such as changes in interest rate, but under current accounting standards might be required to be accounted for differently," said FASB member Leslie F. Seidman.
The mismatched measurements, Seidman said, can lead to "accounting volatility," the phenomenon of changes in companies' financial reports caused not by changes in economic factors, but simply by the way assets and liabilities are accounted for.
The ED proposes allowing companies to measure at fair value financial instruments that they can select on a contract-by-contract basis. They would have to display these values separately from instruments measured under other attributes on the face of the balance sheet, and would have to provide disclosures that would help the users of financial statements to more easily understand the effect on earnings.
Seidman said that the proposed standard is also relevant for companies entering into hedging transactions. FASB Statement 133, Accounting for Derivatives and Hedging Activities, allows for hedge accounting only for derivatives, not cash positions. The transaction also has to meet significant qualifying criteria.
Under the proposal, the derivative must still be measured at fair value, but the company would have the option of also marking the hedged item at fair value, thus achieving symmetry in accounting.
The change could simplify accounting for securities that are required to be carried at fair value - for example, in a trading account that is being funded by liabilities that, under current generally accepted accounting principles, have to be carried at cost.
Under the proposed principle, the securities and the related liabilities could both be reported at fair value.
The proposed standard would bring U.S. accounting closer to the standards of the International Accounting Standards Board, and thus represents another step in FASB's move to converge U.S. and international standards as much as possible.
King and McEnally have questions
Alfred King, vice chairman of the valuation company Marshall and Stevens and noted accounting commentator, asked whether the IASB is now driving U.S. GAAP. However, Seidman reiterated that convergence is only one of the reasons FASB is moving in this direction. Accounting simplicity and mitigating the effects of the mixed attribute model, she said, were primary considerations.
"The proposal isn't precisely the same as the international standard, but it is a step toward convergence, in that if a company is following international standards, they would be able to elect a fair value option under the U.S. standard and get a more converged set of financial statements," Seidman said.
The differences between the two standards are specified in the FASB document.
King also questioned whether the option to measure most financial instruments at fair value - the proposal specifies a few exceptions - may lead to a loss of comparability among financial reports.
"Comparability among companies is going to be difficult if some companies adopt the fair value option and others don't," King said. "Suppose, for example, two companies each have a 25 percent equity interest in another company, and each now consolidates on the equity method. Under the new proposal, one company can continue to use the equity method, while the other firm would start showing on its books 25 percent of the fair value of the other business, not just its proportionate share of the current period's earnings. You will certainly get different results from the two approaches. Perhaps instead of making this an option, if FASB really believes in it they should mandate it for all."
Seidman said that the option will lead to more consistency within the financial statement of a given company, because related assets and liabilities would be accounted for similarly, reducing related accounting volatility by showing the real economic exposure in earnings.
"To that extent that companies make different elections, we admit that there is potential for a decrease in comparability between companies, but to try to address that, we are proposing some disclosure requirements so the difference will be readily apparent to the user of the financial statement and hopefully allow them to bridge that gap," Seidman explained.
The required disclosures would state that the company had elected fair value reporting, and then report the difference between the fair value amount and the amount expected to be paid. The proposal sets a principle that relies on judgment, that the preparer "provide information sufficient to allow users to understand the effect on earnings."
Rebecca McEnally, vice president of advocacy of the CFA Institute, asked a similar question: "Why not simply value all financial instruments at fair value, as the CFA Institute has long been advocating?"
Seidman agreed with the idea, but noted that it cannot be immediately implemented.
"We have recently reaffirmed our goal of reporting all financial instruments at fair value," Seidman said. "We do have ongoing research efforts to resolve some of the underlying issues that would be necessary for us to implement that in a broader way. This proposal is a step forward in that direction. It's an interim way to reduce the complexity and mitigate accounting volatility until we can get there."
The proposal is limited to financial instruments, but it suggests a second phase that would apply to non-financial instruments. Seidman described the second phase as a "potential exploration of whether similar accounting differences exist in the realm of non-financial items." The board has not begun that effort yet, but the current exposure draft requests suggestions of types of non-financial instruments that should be included in the scope of that phase.
Discussions are expected to begin in the first quarter of 2006.
The scope of the proposal excludes investments that would otherwise be consolidated and liabilities recognized under lease contracts. It also excludes financial obligations for pension and other post-retirement benefits, employee stock option and stock purchase plans, and other forms of deferred compensation arrangements.
The board excluded these kinds of assets and liabilities, because any modifications should be part of a reconsideration of those areas, and should not be affected by the fair value options.
The exposure draft proposes adoption for fiscal years beginning after Dec. 15, 2006, with earlier adoption permitted, but not retrospective adoption. Comments are requested by April 10, 2006. The draft is available at www.fasb.org.
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