FASB may kill fair value accounting by permitting it

I have long argued that the alternative to fair value accounting is unfair value accounting and so I should normally be cheering the proposal by the Financial Accounting Standards Board (FASB) to permit fair value accounting for financial assets and liabilities. But actually, I am not happy at all.

The FASB’s Exposure Draft entitled The Fair Value Option for Financial Assets and Financial Liabilities “would create a fair value option under which an entity may irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and financial liabilities on a contract-by-contract basis, with changes in fair value recognized in earnings as those changes occur.” There are two problems with this exposure draft. First is that the fair value option can be exercised on a contract by contract basis allowing the company to chery pick profitable contracts to show on fair value basis while showing the loss making contracts on historical cost basis. The requirement that the fair value election is irrevocable provides only partial protection against this. The second problem that aggravates the cherry picking danger is that there are no safeguards at all on how this option can be exercised. Comparing its proposal with International Accounting Standard 39 (IAS 39), the FASB states:

This Statement has no eligibility criteria for financial assets and financial liabilities, whereas IAS 39 (as revised in 2005) indicates that, for other than hybrid instruments, the fair value option can be applied only when doing so results in more relevant information either because it eliminates or significantly reduces a measurement or recognition inconsistency (that is, an accounting mismatch) that would otherwise arise from measuring assets or liabilities or recognizing the gains and losses on them on different bases, or because a group of financial assets, financial liabilities, or both is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the entity’s key management personnel.

The FASB proposal thus threatens to make fair value accounting very attractive to the scoundrels. The market recognizing this would penalize any entity that exercises this option. Thus fair value accounting would be killed by a proposal that professes to permit it.

I think fair value accounting should be the default method for all financial assets and liabilities. Companies should be allowed to irrevocably elect historical cost accounting (on an asset class by asset class basis) if they can show that this is more relevant and reliable because (a) market prices are not readily available and (b) fair values estimates have too much subjectivity.

Posted at 4:54 pm IST on Mon, 30 Jan 2006         permanent link

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