fair value: clarifying the issues

Fair value: clarifying the issues*PricewaterhouseCoopers on a key debate in the capital markets

Table of contents

The heart of the matter 1

Key points in the fair value debate

An in-depth discussion 4

Marking to market: How far is far enough?

Overview 5Fair value for financial instruments, while imperfect, 9 is the best available method

Volatility in the financial statements 9Reporting the impact of risks 11Judgments and valuation modeling 13Capital adequacy and regulation 18Procyclicality 19A rational debate 20

Where fair value is an awkward fit 22It is questionable to extend fair value to many assets, 22 particularly most nonfinancial assetsBest not to extend fair value to most other liabilities 23

Niche issues requiring resolution 26

What this means for your business 28

Actions

The path forward: evolving in a dynamic future 29Tasks for the standard setters 29Management explanations: context and consequences 34

An overall perspective 35

September 2008

1The heart of the matter

The heart of the matter

Key points in the fair value debate


Financial reporting is developed with the objective of providing information that will best serve investors, business, and policy makers over the long term. It is intended to communicate a clear and integrated message about a company’s net assets and operating performance. Corporate financial statements, with the notes and narratives surrounding them, are intended to enable investors to predict cash flows, determine returns generated on capital invested, assess the business’ liquidity, and evaluate management’s performance.

Fair value refers to a value derived from a market with willing buyers and sellers (or an estimate thereof). In existing US financial reporting, fair value is applied to certain financial instruments on the premise that knowing today’s value or an estimate of today’s value of those instruments is more important to investors than the cost of them.

Cost is a basis for financial reporting, and it remains relevant in many respects, although in the past 15 years standard setters have reduced its use in areas where cost fails to capture important information. Cost refers to the original value exchanged, adjusted for the economic impact of subsequent events—for example, wear and tear.

Financial instruments, particularly financial assets traded in active markets, derive their value either from contractual cash flows or from residual cash flows.Financial instruments currently reported using fair value includes:

most equity and debt securities held as assets•derivatives•

Loans and certain other assets are special cases, which are discussed in the section on niche issues (see page 26).

Our perspective: Fair value for most financial instruments, while imperfect, is the best available method to reflect market conditions when accompanied by explanations of the context and consequences of reporting fair value.


Most assets and liabilities

While fair value information is generally relevant to investors, it is not always sufficiently reliable or practical to implement by management. These three criteria—relevance, reliability, and practicality—need to be more fully understood prior to any proposed extension of fair value to assets and liabilities where it is not used today.

Assets, particularly nonfinancial assets, generally do not trade separately in active markets, or derive their value from contractual or residual cash flows. They also may be assets whose value derives from their use in the operations of a business, such as:

trade receivables and most bank loans•plant and equipment•inventories used in production •

Liabilities are obligations of a company that generally fall outside the above definition of financial instruments. This category can include:

trade payables•company-issued debt •contingent liabilities•insurance and other non-traded liabilities •other types of obligations•

Our perspective: Standard-setters should refrain from expanding fair value to these assets and liabilities. Both standard setters and capital markets participants need time for reflection, analysis, and debate.

4An in-depth discussion

An in-depth discussion

Marking to market: How far is far enough?


In brief

1. The credit crisis has highlighted the benefits of reporting fair value for financial instruments—and exposed limitations.

2. Reporting fair value, although imperfect, remains the best available method for most financial instruments.

3. The challenges of developing and reporting fair value become even more prominent when applied to many nonfinancial assets and liabilities.

4. The desire to expand the use of fair value needs to be tempered until the method’s limitations are fully understood.

Drastic events in the credit markets have converted what used to be a technical issue in accounting—fair value—into a public debate and a point of bitter contention in the business community. This white paper has two purposes: to summarize the key points of the debate and to articulate a balanced perspective on the issues. In shaping our views, we have weighed the significant benefits and limitations of reporting fair value; both have been forcefully evident in the past year and continue to emerge. On pages 2 and 3, you’ll find key terms and recommendations.

In stable or advancing markets, complaints about fair value are few. Under those conditions, capital markets participants generally recognize that fair value conveys recent values. And unlike traditional cost reporting, fair value measurement doesn’t premise investors’ perceptions of today’s financial performance and condition to values that have in most cases been long since superseded.

Overview


But as all readers of this paper will be aware, credit markets have recently undergone severe difficulty and the market values of many financial instruments have dramatically dropped. Some now ask whether fair value reporting may actually accelerate economic declines, whether it unduly impacts the capital reserves of commercial and investment banks, and, even more fundamentally, whether the measures are reliable.

In our view, fair value, despite its limitations, remains the best available method for most financial instruments, particularly financial assets, as currently applied. Fair value represents the most effective method to reflect the economic realities of market conditions as opposed to cost basis which ignores changes in the market value of financial instruments.

Sheltered from the current public debate about fair value measurement for financial instruments is another fair value issue requiring clarification. Should fair value measurement be extended to nonfinancial assets and most liabilities—for example, to manufacturing equipment, brand names, and a company’s own debt?


Critical actions for today and tomorrow

We recommend refraining from expanding fair value beyond where it is applied today. That doesn’t mean that we’re satisfied with the status quo or that we would advise anyone to be satisfied with it. Standard setters and capital markets participants need time for reflection, analysis, and debate, but in the shorter term certain actions are also needed.

How standard setters can help

For the time being, standard setters should refrain from expanding the scope of fair value beyond its current applications, except for potentially certain niche issues (see page 26). As they continue their analysis of fair value and its possible applications across the accounting and reporting model, there needs to be a formal game plan for determining when to use fair value. That game plan should demonstrate the relationship and trade-offs between three primary criteria: the relevance of the information to current and potential capital providers (i.e. investors, lenders and other creditors—collectively “investors”), the reliability of that information, and companies’ ability to implement fair value cost-effectively.

There is a further action for standard setters, and it is already on their agenda. The financial statements should be modified to clearly distinguish the impact on earnings of changes in fair value when that impact is not associated with ordinary business operations. This change would go a long way toward eliminating one of the major complaints about fair value—that the volatility of fair value amounts reported in the income statement can obscure the performance of ordinary business operations. Investors want to be able to make this distinction, and companies want investors to see the distinction.


How management can help

Management can overcome some of the limitations of fair value by explaining the context and consequences of reporting fair value. This does not necessarily mean preparing formal disclosures as footnotes, other than those required, to the financial statements, although management may in some instances choose that option. It does mean conveying to investors when and why fair value is used; how it impacts reported earnings and the financial results of ordinary business operations; and how estimates are developed by means of market data and valuation models. There are also situations in which fair value information would be useful, and management might choose to offer it. For example, investors might find it informative to know the fair value of real property carried at cost because those assets could be used as collateral.


Reporting what most financial instruments can be exchanged for in the market—their fair value—provides valuable insight to investors. Markets determine the economic value of financial instruments such as bonds or common stock. For the most part, such instruments (or derivatives of them) derive their value from contractual or residual cash flows, and the expected cash flows are reflected in their market prices. Even when market prices are difficult to determine, preparers rely on the expected cash flows to develop estimates of fair value.

While fair value yields a relevant measure for most financial instruments, it raises a number of questions, in particular questions surrounding financial statement volatility, reporting the impact of risks, and the judgments required to develop and implement reliable fair value measures. As the credit crisis has persisted and shaken major sectors of the economy, each of these issues has been highlighted. Taken together, these three issues lead to a fourth, also much debated: the impact of fair value on regulatory measures of the capital adequacy of financial institutions.

Volatility in the financial statements

Fair value measurement does not create volatility in the financial statements, any more than a pipeline creates what flows through it. It captures and reports current market values. In both advancing and declining markets, volatility makes it more difficult to forecast earnings and more difficult to distinguish between the financial results of ordinary business operations and the impact of changes in fair value. This is particularly true in the income statement, when gains and losses caused

Fair value for financial instruments, while imperfect, is the best available method


by market movements are reflected in earnings. Identifying core operating results is a critically important exercise for investors; it allows them to assess companies’ sustainable cash flows. The exercise is important to management, as well.

Additionally, as we have observed during declining markets, although investors appreciate the transparency provided by fair value, concerns regarding the reliability of fair value measurement emerge as markets become increasingly dislocated (the relationship between declining market values and reliability is discussed later in the judgments and valuation modeling section beginning on page 13).

The crisis in credit markets across the US economy has focused the issue of volatility in a way that buoyant markets could not. It is true that reporting changes in fair value in the financial statements as currently organized can obscure the ordinary earnings of companies for which changes in fair value are not relevant to key business operations. The standard setters’ task is complex. One of their interests is to define and report earnings from financing and investing activities separately from the company’s ordinary business operations, when doing so is clearly helpful to users, and they will also address where changes in fair value should be presented. Further, they expect to consider other possible revisions to the financial statements, in addition to changes that better accommodate fair value. PricewaterhouseCoopers has already expressed support for segregating changes in fair value measurements.


Reporting the impact of risks

Fair value has been criticized for producing misleading results in the unusual recent market conditions—results, some have argued, that unduly hurt companies in the long run by exaggerating the risks inherent in their portfolios. Critics advance the view that recording massive unrealized losses at fair value signals bad news to investors that ultimately may not occur. In their view, the obligation to recognize unrealized losses paints a misleading picture with negative consequences.

Recording unrealized losses during the recent unusual market conditions when management’s view of an instrument’s risk differs from the markets’ is an illustration of one of the imperfections of fair value. Whether any fair value measurement accurately reflects or distorts the expected cash payments at a particular point can only be decided in the long term. Fair value provides insight into some of the financial risks associated with a company’s financial instruments—particularly the downside risk. Management can explain its view of risks and values relative to the markets’ view, in order to provide investors with management’s judgments that underlie the reported fair values.

The crisis in the credit markets has underscored the importance of identifying and explaining significant risks. Where financial institutions took risks and markets turned against them, that reality has been transparently evident in their financial reporting. The situation is different in a historical cost model, where the risks to which management has exposed the business remain unstated, or delayed, until the assets mature or management decides to sell them. For example, the economic values of derivative instruments that increase or decrease with the market should be reported at fair value despite the fact that their cost basis is typically zero. Cost measures can create artificial (albeit temporary) stability in the financial statements by ignoring changes in market value.


Auction-rate securities

The dilemma of auction-rate securities is one of the clearer examples of how distressed credit markets have affected industrial, technology and service businesses, not just financial institutions. It also reflects one of the limitations of fair value: without appropriate explanations from management, a securities’ inherent risks may not be transparent to a company’s investors.

Auction-rate securities are investments held by certain companies where the interest rate paid on the investment is reset through an auction at stated intervals, typically 30 or 60 days. These securities have been used as investments as

if they were money market funds for which the principal could be redeemed at the stated auction dates. Many companies held these instruments as short-term investments and redeemed them as needed to fund their operations. When credit markets froze, the ability to redeem these securities disappeared; there were no longer any willing buyers. Because companies could no longer redeem them, the cash tied up in them was unavailable, and some other investment or source of financing had to be found to fund operations. This caused difficulty for some companies because their financing alternatives were limited.


Judgments and valuation modeling

Fair value measures require (a) applying market prices regardless of how erratic the market may be (referred to as Level 1 values), or (b) referring to prices of similar securities (referred to as Level 2 values). When neither of those alternatives exists, companies employ models to determine fair value (referred to as Level 3 values). Turmoil in the credit markets has spotlighted the latter scenario. But at what point should companies turn from market prices to models? There is no clear-cut answer, and judgment is required to make that call. The difficulties do not end there. Once the decision to use models has been made, management—and investors interested in understanding management’s perspective—must grapple with the complexities and range of judgments inherent in using models. Valuation models require preparers to make significant assumptions and judgments which are intended to reflect how the markets are expected to behave. In a stable market environment the assumptions and judgments may be more straight-forward and fall within a relatively narrow band, which may engender a greater sense of confidence in the result. In times of market turbulence, the range of judgments is wider typically leading to a wider range of outputs.

Investors are naturally concerned about the appropriateness and transparency of management’s assumptions and judgments. And management looks to do the best possible job of estimating fair values in order to provide investors with objective and reliable information, while recognizing the realities of marketplace second guessing and the litigation environment.

Valuation models: Are they sufficiently reliable?

Estimates based on modeling are far from new. All estimates in the financial statements are based on some form of modeling and are inherent in accrual accounting. Most companies have long since learned


to institutionalize the development of estimates for a variety of purposes in financial reporting—for example, valuations of bad debt, warranty reserves, and a wide variety of asset valuations and impairments. Modeling may be a fairly simple exercise when the elements that comprise the nature of the item being measured are relatively straight-forward. Conversely, when market conditions are unusual or the elements that comprise the nature of the item being measured are numerous and the relationships between them are extensive and dynamic, the modeling exercise becomes more complicated. Despite the complexity of a model, recent past and current market data may be used to validate model outputs. The development of financial models is generally a function of:

the identification of relevant elements and their interdependencies to •develop the characteristics of the model,

the reliability and availability of information necessary to populate the •model, and

the competence and objectivity of the individuals preparing, applying •and reviewing the inputs and results of the model.

When appropriate, predicting outcomes using models provides management’s best estimate of the value of financial instruments, despite being subject to a wide range of judgments. And to increase the usefulness of the modeling results, the estimate should be accompanied by explanations of the key context and consequences of the modeling process and its results. In fact, the SEC acknowledges the reality of using models and has encouraged companies to explain the characteristics of models used, the types of inputs used in models and their impact on the results, the sensitivity of the results to alternative inputs and how the model’s results are validated.

No silver bullet exists—there is subjectivity that cannot be eliminated from modeling that increases with the complexity of the model and the level of uncertainty in the market in which an instrument trades. We


anticipate that models will continue to evolve and develop as they have in the past, taking into account more variables and interrelationships.

Should fair value be suspended in times of crisis?

Recent market conditions have brought forward critics who argue for suspending fair value reporting when markets are severely distressed. In their view, under those conditions market data to develop fair values are not reliable, and therefore not relevant.

From our perspective, suspension is unworkable. It would amount to reducing the flow of information just when investors are most anxious and in greatest need of information. That doesn’t square with the purpose of financial reporting. From a technical standpoint, suspension creates formidable complexities such as when and how to suspend or reinstate fair value, and what to measure during the suspension period.

Fair value, accompanied by appropriate explanations, increases the transparency of the impact of market forces on financial reporting. If fair value were replaced with some other measure, investors would be left to their own devices to estimate the expected cash flows of most financial instruments. Because of the practical limitations on investors’ inability to obtain detailed transactional information about the instruments, their estimates would likely be less reliable than those provided by management.

There is a related issue. Some critics object to using what they describe as “liquidation” or “forced sale” values to estimate fair value (which is specifically addressed in US GAAP), rather than values obtained through fully voluntary transactions between market participants. While the point is understandable, this represents another example of where judgment is required, and there will likely be differences of view as to what constitutes a forced sale or liquidation.


Other issues

Consideration is warranted regarding a further challenge associated with valuation models from the investor perspective: ease of comparability. When models are used, comparing results across companies and industries can be a challenge because companies may employ different judgments and assumptions. While not a comprehensive solution, comparability can be enhanced through explanations by management regarding its use of models and assumptions as described above. Furthermore, over time, investors may compare prior management estimates to actual results to test the validity of models and modeling techniques on a company-by-company basis.

Additionally, the level of uncertainty in the markets has increased management’s concerns about second-guessing of their judgments and litigation, particularly when using models. These concerns may drive preparers to take what they regard as an excessively conservative approach to valuing financial instruments.


The IASB on fair value and complexity for financial instruments

The International Accounting Standards Board (IASB), based in London, is responsible for developing and issuing IFRS. As a matter of policy, the US standard setter works in close cooperation with the IASB, in the interest of writing converged standards. In response to the widely held view that existing reporting requirements for financial instruments are difficult to understand, interpret, and apply, the IASB recently released for public comment a discussion paper, Reducing Complexity in Reporting Financial Instruments.

In this paper, the Board analyzes the main causes of complexity in reporting financial instruments and proposes possible approaches to address those complexities. The Board recognizes that issues will have to be addressed before fair value is expanded beyond its current applications to financial instruments. The Board also acknowledges that resolving those issues could be a long process.

The Board proposes interim approaches that would reduce the number of categories of measurement bases and simplify hedge accounting requirements and models. Further, it examines arguments for and against a possible long-term approach that would use a single measurement method (i.e., fair value) for all types of financial instruments.

We appreciate the Board’s continuing work on this set of important issues. While there is too much content in the discussion paper for comment here, one observation is needed. It may seem simple and reasonable to require only one measurement attribute for all financial instruments, but such a radical solution would result in significant changes for all capital markets participants. Any such change will need full acceptance from the financial reporting community and this can only be obtained after a properly structured debate of the issues. Consequently, we recommend that the Board not, at this stage, pre-empt that debate by assuming that the long-term solution is a single measurement attribute or by requiring greater use of fair values.


Capital adequacy and regulation

During the course of this recent financial crisis some major financial institutions recognized billions of dollars in losses as the fair value of certain securities fell off sharply. Those institutions have had to scramble to shore up their capital resources to meet regulatory standards. Major financial institutions have a role in maintaining the safety and soundness of the financial system. Strain on capital levels, particularly at these institutions, adds fuel to the debate about fair value. Is fair value measurement, which promptly reflects these losses, in some way at fault? Or is banking regulation in some way at fault? Have banking institutions been unduly stressed by the overall situation? Or are they simply paying for errors of judgment in risk management?

Regulators use GAAP numbers, in part, as a starting point to evaluate and define the inputs to capital requirements of financial institutions. Among the indicators of capital adequacy, regulators consider certain financial ratios, including total assets to adjusted equity, both of which generally reflect the impact of fair value changes, particularly to the extent that these changes are recognized through income.

Since the introduction of risk-based capital measures in the late 1980s, banking regulators have responded to financial sector developments and the requests of financial institutions and other constituencies for more dynamic and “economically aligned” risk sensitive measures. They have done this by focusing their efforts on resolving the challenges of adjusting financial assets and certain liabilities included in the capital measures in response to risks inherent in those instruments. So far, there has been limited modification of the equity definition in the measures.

The regulatory capital developments may have seemed a technical matter of no great concern to the investing public until the current crisis, when the composition of capital and the measures’ possible disposition to


pro-cyclicality drew attention particularly as the capital levels of regulated financial institutions (and their non-regulated counterparties) came under pressure with distressed earnings and volatile carrying values. Further, existing regulation has prompted regulators to require some financial institutions to raise capital, sell assets, and/or restrict lending in order to maintain their capital ratios, and address safety and soundness considerations. These responses have, in turn, apparently impacted the access to credit for some borrowers and contributed to declining business and consumer confidence in the larger economy.

Although banking regulators— the global network of agencies—have been aware for some time of the need to rethink the equity component of capital regulation; the credit crisis caught up with them. This has prompted calls for standard setters to retract or modify the use of fair value in the banking industry. In our view, these are separate issues that should be addressed separately. Banking regulation needs to respond more realistically to the impact of fair value measures on equity. Fair value should not be modified or suspended because it impacts regulatory capital measures. Any perceived deficiencies in capital adequacy regulations should not be resolved by changing financial reporting.

Procyclicality

Some observers suggest that fair value promotes a downward spiral in prices and investor confidence. As financial institutions take write-downs when prices drop, they may be forced to sell off assets to maintain compliance with regulatory capital requirements. The result is continuing downward pressure on pricing. This sequence of cause and effect clearly exists in economics—and faithfully reflecting these changes in fair value is fundamental to transparent financial reporting.

Pragmatically, what is the solution? It is in the marketplace itself. Market forces can be expected to act in their own time. As prices continue to


decline, buyers will eventually swoop in to take advantage of low prices and begin pushing prices back up. The phenomenon also exists when markets are on the rise—although with fewer complaints.

A rational debate

The severity of the credit crisis has triggered powerful emotional responses. It’s not just that many billions of dollars have been lost, credit markets dislocated, and the broader economy harmed, although those would be reason enough. All the world is now a stage on which financial and business events are closely followed. Companies in difficulty are brutally exposed to publicity. Their leaders are closely questioned and in some instances dismissed. As well, the crisis is intimately linked with major social issues in the United States, home ownership and upward mobility. And there is an embarrassment factor: innovations in large-scale financial management that once seemed brilliant devices for risk-sharing now seem to many observers to have been irresponsible.

Despite the criticisms that have surfaced in the course of the credit crisis, fair value measurement continues to be the best available method for reporting most financial instruments. In good times, it helps companies show the immediate impact of earnings growth and value creation. In hard times, it is the best means available to keep investors informed. Reporting fair value can and should be improved. The challenges introduced by earnings volatility, for example, can be reduced by revising the presentation of such information in the financial statements (see page 33). As well, the preparer and user communities need to become more comfortable with valuation models, and preparers need to effectively implement and employ valuation techniques and modeling.


Fair value has a history

For many years, standard setters have grappled with the complexities of accounting for financial instruments. Decisions regarding what measurement attributes to apply have been difficult and sometimes controversial. In 1994, Financial Accounting Standard (FAS) 115 was introduced in US GAAP as a partial solution. It required fair value accounting for many debt and equity securities. In 2000, FAS 133 was introduced to improve the accounting model for derivative securities (both assets and liabilities) by requiring fair value measurement. FAS 157, issued in 2006, established a common definition of fair value. In 2008, FAS 159 expanded the ability of companies to elect fair value as their measurement basis for certain financial assets and liabilities.

There is a perception among some market participants that FAS 157, issued in 2006, has actually caused the recent flood of write-downs. We disagree. FAS 157 does not require more fair value measurement, although it does define fair value and requires a more structured approach to developing fair values, which some believe has been a contributing factor to the extent of the write-downs.


Where fair value is an awkward fit

As the credit crisis and broader difficulty in the US economy continue to play out, attention has been drawn, back to the long-term trend of using fair value in financial reporting. The imperfections of fair value for financial instruments, as highlighted during the recent financial market crisis have pointed out the challenges that exist in using fair value when markets are not sufficiently liquid to help establish fair values. For nonfinancial assets and liabilities, those challenges are exacerbated, calling into question whether the capital markets are ready for fair value for these assets and liabilities.

It is questionable to extend fair value to many assets, particularly most nonfinancial assets

The debate should focus on the three criteria cited at the beginning of this paper: the relevance of information to investors, the reliability of that information, and companies’ ability to implement fair value cost-effectively (i.e., the practicality of doing so). In particular, the thresholds of relevance and practicality are revealing litmus tests in the effort to assess whether fair value measurement should be extended beyond its existing applications.

The relevance and practicality issues are exemplified by the issues associated with use of the assets in business operations and lack of primary markets. Standard setters need to temper their apparent desire to expand fair value to assets beyond where it is used today in order to provide the time necessary to reflect on and debate a reasonable path forward. In addition, the debate and standard setting process needs to provide time for the capital markets to understand the consequences of changing from the methods used today to report these assets.

The practicality and relevance of how nonfinancial assets are used in business operations

At the core of this debate are the challenges of developing fair values relevant to as broad of an investor base as reasonably possible. Deep, liquid, primary markets may be limited or may not exist for many assets,


particularly most nonfinancial assets (such as manufacturing facilities, distribution networks and customer lists, etc.), making it challenging to determine fair values. Also, nonfinancial assets, employed to produce and deliver products and services, generate economic value and cash flows principally through their ongoing use in business operations, not through changes in their market value. Fair values for these assets need to be developed reflecting this customized use (e.g., geographic location; interdependencies with other assets of the business, such as intellectual property, distribution networks, etc.; and obsolescence factors such as age and technology).

Given that market information is in short supply for these assets, companies are required to employ many judgments in the valuation exercise. Key judgments, among others, in developing fair value for these assets are (i) how the assets should be aggregated when determining fair value, and (ii) how management uses those assets in tandem with each other to generate cash flow. There’s no clear cut answer as to how to resolve these matters. Companies rely on judgment to make that call. Moreover, once those decisions are made, management—and investors interested in understanding management’s judgment—must grapple with the host of other complexi¬ties inherent in determining the fair values of these assets.

Although we acknowledge that valuations of these assets are determined in business combinations, they are not determined on a periodic basis in the normal course of financial reporting. The complexities of developing fair values for these assets increase the cost both in effort and time. It is questionable whether the benefits outweigh the costs, given that investors’ primary focus is on understanding and assessing cash flows.

Best not to extend fair value to most other liabilities

The concept of marking to market an issuer’s obligations raises a thorny valuation issue. Current US GAAP defines the fair value of a liability as the price that would be paid to transfer the liability to another market participant. However, in reality most liabilities are directly settled between


the counterparties and they are usually not legally transferable. For purposes of cash flow analysis, information about the resources required to settle those obligations is critical.

For example, when a company’s credit rating declines, its debt decreases in value to market participants. This decrease also occurs when market returns increase relative to the rate of return on the debt instrument (e.g., a fixed-rate obligation). The change is reported under fair value accounting. Here is how it works: to reduce the debt to fair value on the balance sheet, a company records a decrease in the liability and a corresponding gain in the income statement. But recording this gain indicates that income was generated as a result of a decline in the credit standing of the company or changes in interest rates. This result is counter-intuitive and also fails to report the resources still required to fulfill the obligation, which hasn’t changed.

Yet fair value may have legitimate uses in reporting some liabilities. For this reason, we advocate limited applications of fair value to liabilities—as and where appropriate. For example, when a liability offsets an asset reported at fair value, the liability should also be reported at fair value to reflect the underlying economics of the transaction. In such cases, a limited option to use fair value makes sense because it allows management the flexibility to select a measurement attribute that best presents investors with management’s understanding of the underlying economics.

Unfortunately, this approach decreases comparability across companies, but the financial reporting is more informative than it would otherwise be—an acceptable trade-off. Every accounting and reporting model involves trade-offs; none is or can be perfect. Taking guidance from the overriding objective of financial reporting—to communicate a clear and integrated message about a company’s net assets and operating performance—standard setters work toward the least imperfect solutions that can effectively serve this purpose.


Contingent liabilities: a test case

New fair value requirements will soon be effective for one type of liability: contingencies in mergers and acquisitions. This is an instance where the relevance, reliability, and practicality of developing and reporting a single numerical estimate of fair value are questionable.

The new mergers and acquisition standard (FAS 141R) requires that certain acquired contingencies be recognized at fair value at the acquisition date. In subsequent periods, those contingent liabilities will be measured at the higher of their acquisition-date fair value or the amount determined under the existing guidance for non-acquired contingencies (FAS 5 requires loss contingencies to be accrued when the loss is probable and estimable).

In circumstances where active markets do not exist, the fair value of a contingency could be the price that a third party would charge to fully assume the risk. However, there is often no such third party and no market information, as contingencies tend to be both company-specific and subject to a wide range of outcomes.

As an illustration, a generally used approach to determining a best estimate of the fair value of a contingency for accounting purposes is to apply estimates of the likelihood of each outcome occurring. An amount developed in this way may not be useful when the range of possible outcomes is wide and highly uncertain or, in fact, binary (as in a win or lose lawsuit). Reporting a single amount can imply a level of precision that may not exist and obscure the risks associated with this contingent obligation.


Niche issues requiring resolution

A number of issues on the margin of the fair value debate, while highly important to particular companies or industries, should be dealt with on a case-by-case basis. Debate and decisions on these issues do not change the critical action steps for today and tomorrow. In every case, the appropriate measurement approach may or may not be fair value. Here is a representative list of niche issues:

Assets held for sale. • Should management’s intended use of the asset and its business model make a difference to the measurement attribute selected?

Real estate.• Because secondary markets for real estate exist, should real property be marked to fair value even when used not as an investment vehicle, but rather in conjunction with other assets, to generate a return on capital?

Biological assets.• Should agricultural companies reflect the value of their crops when sold into the markets or during the growing season?

Commodities (trading inventories)• . Should companies engaged in mining and extracting commodities mark their inventory to fair value and, if so, when should the marks begin?

Loans receivable• . Should loans receivable be recognized at historical cost or fair value, given that some banks hold and service loans for their duration while other institutions bundle and sell them? Should a bank’s business model make a difference in how loans are measured in the financial statements?


Navigating current differences between US GAAP and IFRS

Today, US GAAP has limited provisions for the application of fair value to nonfinancial assets, while international financial reporting standards (IFRS) provide for greater use. For example, IFRS requires agricultural products (e.g., living plants and animals) to be measured at fair value. In addition, intangible assets, property, plant and equipment, and investment property can be revalued each period at fair value if management elects to do so and the assets can be reliably measured.

We advocate leaving both IFRS and US GAAP where they are today. Existing differences will need to be worked out and tend to be issues for specific industries rather than broadly structural issues (see the discussion of niche issues on page 26). As always, we favor converged solutions rather than “agreements to disagree.” In light of the challenges and costs of developing and reporting fair value

for nonfinancial assets, standard setters globally must assess the relevance, reliability, and practicality of fair value in any further applications to nonfinancial assets. In our view, the right solution is to refrain from expanding the use of fair value, to continue reflecting, and to complete important related standard-setting projects before reopening this topic.

28What this means for your business

What this means for your business

Actions


In earlier pages we have wrestled with various problems that come to light in the effort to understand where fair value generally makes sense and where it is awkward. On balance, the current approach is a reasonable place to pause and reflect on what we’ve learned and where we should go in the future.

It’s too early to predict where new fair value requirements will emerge, if anywhere. The path forward will depend on investors and their evolving needs, on new developments in modeling, on legal and regulatory influences, developments in the capital markets and much else. No GPS device maps far into the future of accounting and reporting. The future will go where it will and must, but some guiding principles should be marked on every compass.

As the capital markets march forward, it is important to keep front and center the purpose of financial reporting. As noted at the outset of this paper, financial reporting aims to communicate a clear and integrated message about a company’s net assets and operating performance. Corporate financial statements, with the notes and narratives surrounding them, should enable investors to determine returns generated on capital invested, assess the solvency of the business, predict future cash flows, and evaluate management’s performance. If and when the use of fair value is expanded, we should make certain that it upholds this overriding purpose.

Tasks for the standard setters

Since 1994, a number of accounting and reporting standards with fair value requirements have been issued without a comprehensive framework for deciding when fair value should be used. Standard setters have been able to achieve a great deal in terms of introducing fair value without broaching the larger issue of framework development. However, their case-by-case, pragmatic approach has fostered the perception in

The path forward: evolving in a dynamic future


the capital markets that they automatically choose fair value, without considering how it will interact with the larger financial reporting system.

Two major needs are to reorganize the income statement and to complete a clear and consistent framework.

Revising the accounting and reporting framework

The accounting world at large and the standard setters recognize the need for a revised framework, researched and written jointly by the standard setters. That effort is under way and its results should demonstrate the relationships and trade-offs between relevance to investors, reliability of the information, and a company’s ability to implement. We are confident in the revision process and, therefore, prefer to postpone any further applications of fair value (except in limited circumstances) in either US GAAP or IFRS until the framework is prepared, publicly debated, refined, and adopted, all of which will and must take time.

What criteria should the standard setters consider as they continue to explore the basis for fair value measurement? The three broad criteria of relevance, reliability, and practicality, and how they interact to enhance or diminish each other, should be consistently kept in mind. In addition, we believe that four areas of focus should be fundamental to the debate. They are the following:

Management’s ability to monetize assets or settle liabilities.• The availability of market information should be a strong consideration in determining whether fair value should be used. Many financial instruments (for example, debt and equity securities) can be monetized; they are typically traded in highly active markets.

Nature of the asset or liability.• As noted earlier, reporting at fair value provides relevant information about most financial instruments


The SEC’s Advisory Committee on Improvements to Financial Reporting

In July 2007, the SEC chartered the committee with an assigned objective to make recommendations toward increasing the usefulness of financial information for investors while reducing the complexity of the financial reporting system for investors, companies, and auditors. Its final report of recommendations has been issued to the SEC.

The Committee’s report recommends that, as part of the conceptual framework project, the FASB develop a decision framework for systematically

determining which measurement attribute is most appropriate for certain activities or assets and liabilities, based on the trade-off between relevance and reliability. The Committee also recommends that the FASB refrain from issuing new standards or interpretations that require fair value until the decision framework has been completed.


because there are underlying contractual or residual cash flows and generally, management’s buy, hold, or sell decisions are based on fair values.

Management’s intended use.• The value of an asset may vary depending on how management intends to use it—assets may be used in conjunction with other assets to produce a product and earn a return, or the asset may be individually held for sale. For this reason, management’s intent can be an important variable in determining value, but paying attention to it introduces subjectivity and potentially reduces comparability. There may be no acceptable way to assign a fair value that takes intent into account, but the issue bears exploration in the context of revising the framework.

Role of financial statements in valuing the business and •demonstrating stewardship. Financial statements are designed to assist investors in valuing the business and determining how well management executes stewardship by generating cash flows. Decisions about how to measure assets should reflect these overriding purposes.

Reorganizing the income statement

As noted in earlier pages, reporting changes in fair value in the income statement as currently organized can obscure the earnings of companies for which changes in fair value are irrelevant to their ordinary business operations. As part of their larger project on financial statement presentation, the standard setters are slated to reorganize the income statement. Their efforts should bring much-needed clarification.


Financial Statement Presentation

The FASB and IASB through their joint financial statement presentation project, have been working towards a proposal to revise and restructure the format of the basic financial statements for the past few years. The status of the project suggests that activities in each of the financial statements—the statements of financial position, comprehensive income and cash flows—be presented in the categories of business activities (operating and investing) and financing activities. An entity’s management would decide how to classify items into the sections and categories, and management would describe its classification in its disclosure of accounting policies. To the extent practical, and entity would disaggregate, label and total items similarly in each statement. The objective is to classify assets and liabilities and changes in those assets and liabilities in the same categories in the balance sheet and the income statement.

The notes to the financial statements would present a schedule that reconciles the statement of comprehensive income with the statement of cash flows. In doing so, this reconciliation is intended to disaggregate the elements of income into its cash and accrual components. Further, it would segregate the accrual components into those attributable to changes in prices and estimates (i.e. changes in fair values) and those that are not.

To date, the standard setters have yet to release these proposals for public comment and debate, although we currently expect that to occur during the latter half of calendar 2008.


Management explanations: context and consequences

A critical aspect of making fair value work is for management to mitigate its limitations by providing the context and consequences of fair value. Management’s perspective on the issues associated with its use of fair value—such as reported fair value versus intrinsic value, volatility, judgments, and the use of valuation techniques—needs to be explained to investors. The substance of the explanation should be largely left to management’s discretion and to market forces that will tend over time to set a de facto standard.

Management carries some responsibility for helping investors become more comfortable with fair value and modeling techniques. Fair value is sometimes determined using an estimation technique, and in these circumstances the user must understand the model and the assumptions underlying it. Effective, understandable explanations will tend to move investors toward a deeper appreciation of the valuation process that generates estimates. In reality, informed parties would most likely come up with a range of values but for financial statement purposes a single numerical amount has to be used. A deeper appreciation needs to be encouraged, not to divert attention from specific measurements but to set them in a more holistic context.


An overall perspective

There is unmistakably a journey in progress, and we are all engaged in it. It began with the introduction of fair value in 1994, it continued with expansions and refinements of fair value, and it is taking us now through rough terrain. The credit crisis and turmoil in the broader economy are teaching lessons—more than enough—about large-scale financing patterns and regulatory oversight, about risk management, about the interdependence of markets, about private and public finance, and more still. One of those lessons concerns the tensions generated by fair value reporting of financial instruments under severely adverse market conditions. The test is new; nothing of quite this kind has occurred before. Some observers would prefer to turn back the clock and eliminate fair value. Others would prefer all assets and liabilities to be measured at fair value, with cost data relegated to notes or no longer provided. PricewaterhouseCoopers sees nothing in the dynamics of the situation that argues for discontinuing fair value measurement—or for expanding its use. Instead, now is the time to pause, reflect on lessons learned, and evaluate whether it makes sense to expand fair value beyond where it is applied today.

Where is this journey headed? We don’t know, and we’re quite sure that no one today can predict its course. There are too many variables, some evident now, others certain to emerge over time. The challenges are multidimensional, and sound solutions will win consensus through a highly interactive, long-term process of reflection, analysis, and debate. We are committed to developing points of view as key issues surface in the debate and to sharing those points of view widely. We are no less committed to objectivity: we will advocate what makes sense in light of the many dimensions and stakeholders in issues under discussion.

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© 2008 PricewaterhouseCoopers LLP. All rights reserved. “PricewaterhouseCoopers” refers to PricewaterhouseCoopers LLP or, as the context requires, the PricewaterhouseCoopers global network or other member firms of the network, each of which is a separate and independent legal entity. *connectedthinking is a trademark of PricewaterhouseCoopers LLP (US). NY-ST-08-0739-A.TP

To have a deeper conversation about how this subject may affect your business, please contact:

Raymond Beier Strategic Analysis Group LeaderPricewaterhouseCoopersPhone: 973 236 7440Email: [email protected]

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fair value: clarifying the issues

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