Once one gets below current assets and current liabilities on the balance sheet, fair-value accounting (FVA) is the greatest hoax since one-size-fits-all. Start with the fact that FVA is highly judgmental because there are seldom active markets for long-lived assets. (Seldom, but not never.) So, invariably it's a Level 3 measurement (something just this side of pure fiction, no matter how 'precise' it may appear). That goes in spades for intangible assets.
Besides that, two other aspects of fair-value accounting trouble me. The first is that the people being asked to compute fair values on long-lived assets tend to be accountants. Value is prospective. Accounting looks backwards. And, frankly, other than an annual budget, ne'er the twain shall meet for accountants. If my CPA and non-CPA colleagues wanted to deal with the kind of ambiguity that we who do work under ASC 805 routinely embrace, they would have never become accountants. And, unfortunately, based on my anecdotal inquiries of professors around the country, accounting education on the college campus seriously lags what those of us reading this blog often have to confront.
Exercising the kind of judgment that is required to make Level 3 calls in the fair-value hierarchy will give most accountants migraines. Embracing the lack of precision and the softness of 'fair-value rules' is not why most of my colleagues became bean-counters. (I'm an extreme outlier in the distribution, which, I trust, is obvious.)
The second and arguably more troubling aspect of fair value is the incentives it creates: because fair value is an "exit price"--what it might be worth, rather than what was paid for a long-lived asset--the incentive is to trade assets ("The bazaar [bizarre?] is open!"), NOT to create unique capabilities that generate annuity streams of free cash flows that create real value for companies through returns that far exceed a company's cost of equity capital. Except in an article I wrote for the August 2008 edition of the IMA's "Strategic Finance" magazine ("The Fatal Flaw in SFAS 157"), I've not seen any substantive discussion of incentives in the context of FVA. I also argued strongly against FVA's assumption of homogeneity among both long-lived assets and the values thereof.
Along with that is the truly bizarre implementation of FVA: If a company gets a downgrade in the creditworthiness of long-term debt, well, that debit to funded debt has to have an offsetting credit somewhere--it really is helpful to understand the debits-and-credits side of accounting, folks. Under fair-value, that offsetting credit juices up the bottom line of the P&L. So, get a credit downgrade, and boost the bottom line. Terrific.
Bear Stearns did that in Q2 of 2007. They even managed to keep from laughing hysterically about it when they discussed it during the earnings call. Of course, less than year later, they were out of business. But writing down debt and pumping up the P&L is stark-raving nuts.
But then, so is fair-value, IMHO. Accrual accounting based on historical costs is far from perfect, but it has the rigor of real transactions, as one of our colleagues already observed, standing behind it. That alone makes it a helluva lot better than anything related to FVA applied to long-lived assets and liablities. As a former CFO, too, I cannot imagine having to sign off personally on Qs every quarter. I'd sooner take up cordless bungee-jumping.
FWIW, I believe that, with 'big GAAP', the FASB is trying to move towards balance sheets that reflect the market value of invested capital. It's not just a futile idea. It's a horrific idea because value is subjective. It always has been, and it always will be.
Fair-value accounting is a textbook case of the dreadful things that can happen when 65 really, really smart people--this particular group is in Norwalk, Conn., but they could be anywhere--have far too much time on their hands. They don't understand the wisdom of the old adage, "Don't just do something. STAND THERE!"
Thanks, Jason.