A FAREWELL TO HISTORY
As historical cost accounting gives way to fair value, companies are bracing for turbulent times.
By Justin Wood

When Jeanette Wong presented her company's half-yearly results on July 30 there were beaming smiles all round. As CFO of Singapore's DBS Bank, Wong was thrilled to unveil net earnings that were up by 202 percent over the same period a year earlier.

But when it comes to reporting her interims next year, Wong's smile might not be so wide. That's not because DBS is forecasting any problems. Indeed, the underlying economics of the business have rarely looked sounder. Rather, Wong is concerned that her bank - which has S$168 billion (US$98 billion) of assets under management - could suffer at the hands of a new accounting treatment.

As of 2005, all companies following International Financial Reporting Standards (IFRS) must comply with IAS 39 which requires them to record a range of financial instruments such as derivatives and bonds at fair value on the balance sheet. Any changes in the value of those instruments must then be fed through a company's income statement, or else shown in shareholders' equity depending on the instrument. The impact could be big, particularly given that, up until now, many financial assets and liabilities have been held at historical cost rather than fair value, or else not recorded on the balance sheet at all.

"We're expecting to see greater volatility in our accounts," concedes Wong, although her initial calculations suggest the volatility "won't be major". Nonetheless, as all finance chiefs know, less stable earnings make for a higher beta stock, and that in turn can raise a company's cost of equity and lower its share price.

Just as significantly, the books at DBS are likely to get a lot more complicated. "The main issue I have with IAS 39 is whether investors and analysts will understand the impact of using fair value on our accounts," sighs Wong. "The key for us is making sure they can see what's driving the increased volatility." As she points out, the cash flows of the company won't have changed, just the accounting.

Analysts themselves share Wong's concerns. Tony Raza, who covers banks for Merrill Lynch in Singapore, puts it bluntly: "As an analyst, I don't feel IAS 39 is going to help my understanding of a bank's business. It may even confuse it."

Quite the contrary, counters Paul Pacter, the original author of IAS 39 and now a director at Deloitte in Hong Kong. "IAS 39 is designed to give a more complete picture of a company's financial position," he says. "Any volatility it introduces to a company's earnings is reflective of the risk of the business and should be shown."

All's fair in love and war

Welcome to the highly charged world of fair value - one of the most contentious issues in accounting today. While banks and other financial institutions have found themselves squarely at the center of the fair value debate thanks to IAS 39, other types of companies are likely to feel the growing influence of fair value accounting in the years ahead. The impact on the entire financial reporting "value chain" - from CFOs to auditors to investors and regulators - threatens to be far-reaching.

Traditionally, companies have measured their assets and liabilities at historical cost, depreciating or amortizing them over time. Increasingly, though, accounting standards setters are ditching the use of historical cost in favor of fair value - defined by the International Accounting Standards Board (IASB) as "the price at which an asset or liability could be exchanged in a current transaction between knowledgeable, unrelated, willing parties". The idea is to serve investors better by showing the value of the firm's balance sheet in today's terms rather than yesterday's prices. After all, when asked how much their home is worth people tend to quote current market rates rather than the price they paid many years ago.

Rebecca McEnally, vice president of advocacy at the CFA Institute in the US, which runs the Chartered Financial Analyst qualification, puts it more strongly. "Fair value is the only relevant measurement criterion for financial decision-making," she stresses. "When the management of a company is considering an acquisition, the relevant information is not the historical cost of property, plant, and equipment, but the fair values of the assets and liabilities." And that means all assets and liabilities - including those, such as derivatives and repos, that were often left off balance sheets in the past.

Of course, traces of fair value have been around for years. Companies have long been required to write down bad debts and impaired inventory. But fair-value accounting in its purest form, with assets and liabilities regularly being marked both up and down in response to fluctuating values, and with the resulting gains and losses flowing through the P&L statement, is a relatively new trend, and one that's gathering steam.

The evidence is abundant. Take IFRS. As well as IAS 39 - and its sister standard, IAS 32 - there's the introduction of IAS 40 for investment properties.

Although this standard gives real estate developers the choice of recording their assets at historical cost, in reality it requires them to adopt a fair-value approach, with gains and losses recorded in the income statement or shown in the notes. Then there's IFRS 3 for business combinations that prohibits "pooling of interest" accounting. The rule states that acquiring companies must measure the fair value of all acquired assets, including contingent liabilities, and the fair value of the amount paid, including equity, with the difference recorded as goodwill. IFRS 2 for share-based payments is a further example. The fair value of all employee stock options, for example, must now be determined at the grant date and expensed over the vesting period of the option. And so the list goes on.

Fair despair

Martin Cubbon, group finance director of Hong Kong-based Swire Pacific, notes: "Fair value isn't just creeping into accounting, it's marching headlong. It seems to be the avowed intent of the IASB to pretty much standardize on fair value."

At Swire, a HK$17.6 billion-a-year (US$2.3 billion) conglomerate that owns a large real estate business, as well as 46 percent of Cathay Pacific Airways and other businesses, IAS 40 is set to have a major impact. With Hong Kong having adopted the standard effective in 2005, any changes in the value of the company's property portfolio will impact the profits of the whole group. In the past decade, annual swings in the value of the company's investment properties have been as high as HK$9 billion, a figure that would wipe out profits entirely in some years, while doubling them in others.

"As an old-fashioned 25-year qualified accountant, I think the move to greater fair value is very dangerous," says Cubbon. For one, he doesn't believe the volatility that fair value accounting introduces to earnings is useful. But more than that, he worries that fair value accounting is too subjective. Where liquid markets exist, determining the fair value of an asset or liability is simple enough. But when companies must make their own assessments of fair value using a discounted cash flow model or similar technique, then room for error, or even abuse, opens up.

"Historical cost accounting may be flawed, but at least it's objective; you know what you're getting," he observes. "With fair value, on the other hand, you're bringing in a great deal of assumptions and judgements about the future." As an example, Cubbon points to the flexibility managers have in setting the discount rate used in valuing a fixed asset. "These are highly judgmental areas," he sniffs.

But McEnally at the CFA Institute retorts that accountants have been using estimates - such as guessing the useful life of a building - and models like straight-line depreciation for years. What's more, she points to a deeper issue. "If management finds such difficulty in determining the values of its assets, then what sort of decisions are they making in the absence of such relevant and useful information?" she asks.

How fair is fair?

For their part, accounting standards setters acknowledge the increased use of fair value in recent years, but deny they're obsessed with it. "People have assumed that we're fanatics about fair value, but we're not," states David Tweedie, chairman of the London-based IASB.

It's well known that his organization has been locked in a rancorous dispute with the European Commission over whether the EU will adopt IAS 39 when its 25 member states start using IFRS next year. Officials at the Commission believe the standard will bring too much volatility into the accounts of banks and affect issues such as capital adequacy. They charge that the IASB is being too ideological in its pursuit of fair value.

Tweedie denies this. "We try to be pragmatic rather than dogmatic," he states. "When is it worthwhile using a fair-value approach? When does it benefit investors? Nobody's interested in the fair value of old machinery, but they probably do want to know the fair value of a company's city-center headquarters."

Leslie Seidman, a board member at America's Financial Accounting Standards Board (FASB), reckons the approach in the US is equally secular. "The important issue to consider is the trade-off between relevance and reliability," she explains. "Fair value is often considered a more relevant measurement attribute for an asset or liability, but we'll only require it if it's reliable."

Robert Herz, chairman of the FASB, echoed those views in a speech in late 2002. "It's hard to argue with the conceptual merits of fair value É Certainly, to those who say that accounting should better reflect true economic substance, fair value, rather than historical cost, would generally seem to be the better measure," he said. However, he added: "We are also very cognizant of the potential operational difficulties, reliability concerns, and room for abuse in implementing a fair value approach for items for which there are not active markets."

Michel Baise, general manager of group finance at Fortis, a Belgian bancassurer with E523 billion (US$647 billion) in assets under management, shares those concerns. And he has others too. For instance, Baise isn't convinced that fair value accounting - particularly IAS 39 - does a good job of representing economic reality. As he explains, most banks have their own internal risk management frameworks based on value-at-risk principles. However, he notes, IAS 32 and IAS 39 provide a very different perspective on risk in the company. "If reporting standards are showing volatility that doesn't match our risk management framework, how should we react? How should investors react?" he asks. "We believe our internal models best reflect economic reality, but investors will see IAS 39."

He goes on to warn that: "The great danger is that decisions will be made to modify the risk profile of the company based on the volatility derived from fair value. The accounting could start to drive economic decision-making."

In the US, where FAS 133 - the US GAAP equivalent of IAS 39 - has been in place for several years now, some observers believe this is already happening. Robert Pickel, CEO of the International Swaps and Derivatives Association, says: "We have come across instances of people choosing to avoid transactions that make economic sense because the accounting treatment is unfavorable."

He also questions how useful fair-value accounts are to investors. "Mark-to-market gives a real-time picture of a firm's exposures, but the average company releases its financial statements several weeks after the reporting date," he argues. "There are question marks over how meaningful that real-time information is to investors when it merely provides a snapshot of a firm's position in markets that can change quickly."

At Swire Pacific, Cubbon is another who questions whether fair value serves shareholder needs. "I've asked investors whether they support greater fair value and they don't seem that interested," he reveals. "Most of them are looking to strip out extraordinary and exceptional numbers and concentrate on what the free cash flows are." He believes that most investors would prefer to see moves that would strengthen their confidence in the auditing process, whereas "fair value will make the auditing process even tougher".

Fair and square

At Deloitte, Pacter reckons some of the criticisms levelled against fair-value accounting are self-serving on the part of CFOs. For example, because fair value recognizes gains and losses on an ongoing basis, it reduces the ability of managers to smooth out their earnings.

"They can no longer decide when to book a gain or loss by selling an asset," he notes. That said, Pacter does have sympathy in two key areas. First, he agrees that questions of reliability remain, although ever-improving sources of information and more powerful IT should help to make fair value calculations easier. More importantly, he sympathises with CFO concerns over how investors will react to greater earnings volatility.

"Unfortunately, the world is obsessed with a single bottom-line number, the net income figure used to calculate earnings-per-share," he states. "If investors took a broader view, perhaps managers wouldn't worry quite so much about flowing value changes through their P&L."

The solution, says Pacter, is to redesign the income statement, and this is exactly what both the IASB and FASB are currently doing. In a joint project variously titled "Performance Reporting" and "Comprehensive Income" the two standards setters have teamed up with the Accounting Standards Board in the UK to create a new way of presenting earnings information. Although the project is still several years from completion, initial reports have suggested a three-column income statement designed to break earnings down into ongoing or underlying income, exceptional items, and then unrealized gains and losses resulting from changes to fair value on the balance sheet.

"The Performance Reporting initiative has been a critical need in IFRS for a long time," observes Pacter. "Until they resolve this issue, the IASB is going to encounter fierce resistance to greater use of fair value.""

Fair enough

Norman Lyle, CFO of US$8.5 billion-a-year Jardine Matheson in Hong Kong, couldn't agree more. The group has a range of interests, from supermarkets to insurance broking to car retailing, but also has a 42 percent stake in Hongkong Land. For several years now, this listed real estate developer has been reporting the fair value of its investment properties and putting the resulting gains and losses through its P&L - with massive volatility as a result. In 2003, for example, a US$824 million decrease in the value of its property portfolio helped turn an operating profit of US$256 million into a loss of US$559 million. And in the first half of this year, an increase in the value of those same properties boosted an operating profit of US$145 million up to US$944.8 million.

Nonetheless, says Lyle, "We've found that if you present this properly to analysts and investors, then they can understand the accounts quite clearly." To that end, Hongkong Land shows an underlying profit figure on its income statement, then a separate line for fair value changes, and finally a net profit figure.

"It's a presentational issue," Lyle maintains. "We explain the ongoing profitability of the business, and then show the changes in fair value, which are largely non-cash items." But a new income statement is just the beginning. If fair value continues its onward march, then CFOs can expect a great deal more change to their accounts, says Pearl Tan, an accounting professor at Nanyang Business School in Singapore. "If full fair-value accounting is ever to take place, then there must be a complete overhaul of reporting," she argues.

For example, Tan highlights the need for more prospectus-style reporting detailing the estimates and assumptions used to calculate fair values. And she calls for greater use of range reporting rather than single-point estimates for the value of assets and liabilities, along with sensitivity and scenario analysis in place of a single balance sheet presentation.

It all adds up to a much greater burden for CFOs and their finance teams, not to mention their auditors who will need to verify the reams of assumptions and calculations that companies have made. At Fortis, Baise reckons his annual report could double in size over the next few years. At DBS, Wong too acknowledges the huge demands of producing fair-value accounts. It's yet another reason for her smile to turn to a frown next year.

Justin Wood is managing editor of CFO Asia, based in Singapore