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 As demonstrated by three recent Statements of Financial Accounting Standards, SFAS 157, Fair Value Measurements, SFAS 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, and SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities, the FASB's fair value train moves inexorably forward. Dare I say that I do not believe that it will be the financial reporting panacea that many financial statement readers expect?
It is not the fundamental concept of fair value that I quibble with. What's not to like about fair value? Historical cost, revenue recognition and matching all seem so, well, twentieth century. Some would say even nineteenth century, but their origins were really in the twentieth. Fair value accounting just feels so timely, so correct - the right way to measure the balance sheet and report income.
In his classic work, Value and Capital (1939), the British economist J.R. Hicks defined a person's income as, ". . . the maximum that he can consume during a week, and still expect to be as well off at the end of the week as he was at the beginning." Hicks saw income as a matter of wealth creation and defined the first as the growth in the second (and losses as the reverse) during a given period. Chairman Robert Herz studied Hicks' theory while attaining a degree in economics from the University of Manchester and has cited it in support of fair value-based accounting standards.
Indeed, fair value accounting is consistent with such a measure of income. In this view, the opening and closing balance sheets - all assets and liabilities - are valued at fair value. Their change from one period to the next is that period's measure of income. As this reasoning goes, by fully adopting fair value accounting, we would be better able to embrace a principles-based approach to financial reporting, allowing us to sidestep so many of the bright-line rules that presently plague financial statements. Moreover, we would be able to focus on what is really important - measuring value and value creation. Such a position certainly presents an attractive proposition.
Most who question the FASB's embrace of fair value accounting do so from the view that extensive estimates and assumptions are needed in its full application. Introducing such subjectivity into financial statements makes them that much less useful and much more prone to the whims of overly optimistic and opportunistic managers bent on misleading investors. Recall that it was this very problem that helped to make the Enron fraud possible. The fair value disclosure requirements of SFAS 157 are a step in the right direction, but still leave plenty of room for unscrupulous managers to play the financial numbers game.
Fair value's use of estimates and assumptions will certainly be a difficult problem to overcome. However, my main concern with a full application of fair value accounting is in how it is limited in its ability to divide wealth creation, that is, the generation of income, into what I'll term active versus passive components.
When a company reports income, investors want to know how much of it relates directly to management's effort. Active income, or wealth creation derived from management effort, can be reproduced again and again. Today we might term such wealth creation as sustainable earnings or sustainable cash flow. Investors are willing to pay a multiple of such income. Investors are less sanguine about passive income, or income derived from the action of markets. They will pay much less for such income because it cannot be reproduced so readily. A gain derived from the increase in the value of an investment is added wealth and can be spent. But it cannot be reproduced readily, certainly not through the efforts of management.
Consider a simple merchandising firm. There is active wealth creation between the time that inventory is purchased and when a receivable is collected for its sale. However, fair value accounting, without the age-old principles of revenue recognition and matching, cannot give us a valid measure of that income and the proper time periods during which it was created.
In his book, More Than a Numbers Game: A Brief History of Accounting (2006), Thomas King shows how accounting first developed as a stewardship function with a primary focus on the balance sheet. Income measurement was a secondary consideration. It was only later that the focus moved to income measurement. As it did, the balance sheet took on less importance. Fair value accounting moves us back toward a balance sheet orientation, giving it primary emphasis.
Measuring effort and its rewards, or active income generation, and assigning it to reporting periods requires application of the principles and rules of revenue and expense measurement. If we are to keep this important component of modern financial reporting, we must be prepared to continue applying these rules and not be so quick to discard them like yesterday's fashion. The FASB's project on financial statement presentation, where income and cash flow are segregated into operations and other sources, indicates that the standard-setting body is aware of the need to maintain some of these more basic principles. Let's hope they don't become dissuaded. Moreover, accountants have reason to embrace them, lest they be relegated to little more than appraisers focused on assigning values to the assets and liabilities of the balance sheet.
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