The more we consider what the Financial Accounting Standards Board accomplished with SFAS 159, the more we're warming up to the sea change it represents. This standard, titled "The Fair Value Option for Financial Assets and Financial Liabilities," permits without requiring managers to account for financial assets and liabilities using their fair values, with unrealized gains and losses flowing through the income statement. Some have disparaged SFAS 159 for not mandating full fair-value reporting, while others have criticized its "optionality."We see it quite differently. For years we have endorsed the Quality Financial Reporting paradigm that calls managers to step out on their own and try to meet the needs of the capital markets for useful information. In effect, SFAS 159 provides a nudge in this direction by allowing, even encouraging, innovative managers to jump into QFR by applying fair value without waiting for everyone else to get into the pool. We've often said that the biggest rewards will go to those who start providing better financial statements, so we're gratified that FASB seems to have seen it our way.
The topic for this column is the equity method, which we subjected to blistering criticism a few years ago for its abject failure to produce results that help statement users project future cash flows. Now that management can actually toss the equity method overboard, we thought it would be good to reprise our thoughts from April 2001 and perhaps stimulate some to take the plunge.
In our ongoing evaluation of opportunities for improving generally accepted accounting principles, we now turn to the equity method. This method is applied to investments where the investor has influence over the investee (by rule of thumb, 20 percent to 50 percent, although past FASB action has reduced the lower limit and possible future action could reduce the upper limit). The method also applies to joint ventures in which the investor does not have a controlling interest.
In our view, the equity method is an anachronistic artifact that no longer makes sense, if it ever did. Despite drastic improvements in the general understanding of capital markets since this method was prescribed 30 years ago, it is still required. Beyond a doubt, financial reporting would be greatly improved if the method was abandoned and the investments accounted for at market value. Although this recommendation won't surprise our regular readers, we want to explain how we arrive at this position.
A BIT OF HISTORY
When the Accounting Principles Board issued Opinion 18 back in 1971, adopting the equity method may have made more sense than it does today, because it was perceived to be an improvement over the cost method. At the time, the APB identified two weaknesses of the cost method.
First, the board members acknowledged that the cost method describes investing success only by reporting income from dividends and disposal gains or losses. They observed that frequent lags between the investee's earnings and its dividends make these signals ineffective. Further, success signals don't get through at all if the investees pay no dividends or only small stable amounts. Of course, disposal gains and losses aren't reported until the investor is no longer invested.
Thus, the APB concluded that cost provides poor interim feedback between the purchase and sale of the stock. In this context, they saw the equity method as a safe alternative that would provide somewhat more timely information.
The APB also thought the equity method avoided a second problem created by the investor's influence over the size and timing of the investee's dividends. This complication further eroded confidence that dividend income could be a useful indicator of performance.
In effect, the board decided that the best interim success measure is the earnings achieved by the investee under the investor's influence. While their hearts might have been right, they ignored the method's limited ability to provide information that is anywhere as useful as market values.
IN THE BLIND SPOT
From our 21st-Century perspective, one could wonder why the equity method's glaring limitations didn't compel the APB to adopt mark-to-market in 1971. For various reasons, we all have blind spots that make us slow to embrace an obviously better solution. As an analogy, everyone pretty well acknowledges today that comfort and health considerations justify banning smoking from all airline flights. Nonetheless, that industry went for years without any smoking restrictions at all, and made only a halfway move toward relief by setting up nonsmoking sections, instead of leaping all the way to the best solution.
In the same sense, the profession's mindset in the early 1970s was not yet ready to accept the market method, even though it clearly solves the timeliness problem more completely, reliably and easily than the equity method.
Now, let's fast-forward through 20 years and a conceptual framework to consider FASB's deliberations leading up to SFAS 115 that finally required the market-value method for some investments. Despite increasing sophistication and the by-now-obvious limitations of measuring income with the investee's modified GAAP earnings, the board did not even consider overturning Opinion 18. In fact, it just ducked that issue with the crafted comment that it "decided to limit the scope of the project because of its desire to expedite resolution of the [gains trading] problems with the current accounting and reporting practices for investment securities."
In other words, more pressing political issues demanded a solution and the equity method was left unchallenged, even though the superiority of market value was clear.
Next, when we fast-forward to today, we see that FASB has refused to reconsider the equity method. Thus, Opinion 18 remains in the same blind spot after 30 years, still rationalized by the anachronistic position that the equity method is better than cost. Ironically, even the APB admitted in Opinion 18 that market value meets "most closely the objective of reporting the economic consequences of holding the investment." However, moving all the way to market value was a huge step that they could not take in 1971. With the market-value method now firmly in place for other investments, dumping the equity method would be a small step. Nothing but indifference allows FASB to continue the half-hearted solution embodied in the equity method, instead of putting feet to this 30-year-old observation.
IT'S ALL ABOUT CASH FLOW
As always, some will oppose any change. In this case, they will assert that market-value measures of large holdings lack reliability. A more precise statement would be that the measures have less verifiability than original cost. However, one has to be very myopic to believe there is any verifiability in a book value based on original cost plus a fraction of the investee's adjusted earnings less dividends.
In fact, the real question is whether some measure of market value more reliably describes the current cash-flow potential of the investment than the equity-method book value. When the issue is framed that way, the answer is obviously in favor of change.
As we suggested, regular readers of our columns won't be surprised by our call for reporting market values for all investments. Our view is based on the taproot idea that change in current market value is the most useful measure of investment performance in general, whether or not that change is realized.
Even if market values can only be approximated, they should be reported because they are more informative than the equity-method book value, which is nothing more than a flow-through of a garbled cost basis from the investee's GAAP account balances. This measure lacks both relevance and reliability.
Accordingly, it's way past time for FASB to jettison this outdated method. Nothing but market value provides stockholders and the public with useful information, while holding managers accountable for all their actions. The equity method accomplishes neither result, and that outcome is inexcusable.
There is no small satisfaction in seeing that today's FASB has responded to these arguments by at least making fair value an acceptable alternative. Will many make the change? Frankly, we don't think so, simply because of practitioners' reluctance to try new things. We hesitate to call the pace of innovation "glacial" because, after all, glaciers actually move ... .
Nonetheless, company managers should look at Toyota, for example, which took the plunge into hybrid vehicles without waiting for others, and now enjoys a huge lead. We think the same effect will occur for those who toss the equity method and start reporting the truth, the whole truth, and nothing but. AT
Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors' views are not necessarily those of their institutions.
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