Defense of Fair Value
FEBRUARY 2006 - In
“Accounting at a Crossroad” (December 2005), Eugene
H. Flegm blames FASB and its standards on fair-value accounting
for enabling Enron and other contemporaneous frauds such as
Qwest, Global Crossing, and Parmalat. That’s like blaming
fires on the inventor of matches.
has two major recommendations: 1) eliminate FASB and have
the SEC set the accounting rules; and 2) abandon fair-value
accounting (except as to lower of cost or market for inventory
and when stock is issued in a merger) and revert to historical
cost accounting and the matching concept.
cost accounting, and FASB’s grotesque impairment standard
(SFAS 144) that looks at undiscounted cash flows to determine
whether cost of an asset is impaired, produce financial
statements that in many cases are misleading.
example, look at the financial statements of U.S. auto companies
(Flegm worked at GM for several decades). Overcapacity in
the auto industry, and attendant reduced or nonexistent
margins, have been known facts for many years, but the U.S.
auto industry has not responded by writing down plant costs.
Balance sheets have been hugely overstated. Misleading.
U.S. commercial airline industry had too many aircraft and
too many seats. September 11 dramatically worsened the situation.
Aircraft are parked in the desert, but owners of commercial
aircraft as well as airline companies and their equipment
lessors have been very slow to write down aircraft costs,
if they have done so at all. Balance sheets have been hugely
the other side of the coin, consider the oil and gas industry.
With oil at more than $50 a barrel and natural gas at more
than $10 per thousand cubic feet (MCF), the financial statements
of oil and gas companies based on historical cost, either
successful efforts or full cost, are hugely understated.
the real estate industry, the cost of real estate owned
by REITs is in many cases vastly less than fair value of
the real estate. Misleading.
example. Dozens, probably hundreds, and maybe thousands
of companies own valuable, highly salable intangible assets
such as brands and patents, which are nowhere to be found
on their balance sheets because those assets have no recorded
historical cost. Misleading.
balance sheets to have relevance to investors and creditors
and rating agencies, historical cost of assets and historical
proceeds of liabilities need to be replaced with fair value.
I encourage CPA Journal readers to read the October
2005 submission by the Chartered Financial Analysts to FASB,
in which the CFAs recommend fair-value accounting for all
assets and liabilities. (See “A Comprehensive Business
Reporting Model: Financial Reporting for Investors,”
CFA Centre for Financial Reporting, October 24, 2005, at
along with other commentators, complains that Enron abused
fair-value accounting by overstating assets. Enron exemplifies
why auditors should not accept auditee companies’
estimates of fair value of their assets (and liabilities).
Had Arthur Andersen, Enron’s auditor, required that
Enron back up its estimates of the fair value of assets
with written opinions from outside, independent valuation
experts, these results could have been cited in Andersen’s
audit opinion and included in Enron’s registration
statements and Forms 10-K; Enron’s abuse of fair value
would not have happened and Arthur Andersen would still
exist today. (CPAs are neither qualified nor competent to
judge fair-value amounts ascribed to noncash assets and
liabilities, thus the need for outside, independent valuation
experts.) I was chief accountant at the SEC from January
1992 through March 1995. I wish that I had required Enron
to get those opinions from outside, independent valuation
experts and to include those opinions in its registration
statements and 10-Ks; in such a case, the Enron debacle
might not have happened.
of this writing, FASB is expected to issue soon a standard
on fair-value measurements. I recommend that FASB, with
help from the SEC and from federal and state banking and
insurance regulators, proceed to require fair-value measurements
in all balance sheets for all assets and liabilities as
soon as possible. When that happens, FASB will be able to
dissolve, for we no longer will need accounting rules, much
less a mountain of complex accounting rules such as we have
today, and there will be no need for FASB.
is a former chief accountant of the SEC and has written
and spoken extensively about fair-value accounting. He co-authored
(with P.W. Wolnizer) Mark-to-Market Accounting, “True
North” in Financial Reporting, which was published
by Routledge in 2004.
found it “incredible” that I blamed FASB for
enabling the frauds at Enron, Qwest, Global Crossing, and
Parmalat through their application of fair-value measurements
required by FASB standards, comparing it to blaming fires
on the inventor of matches. I believe a better analogy would
be that they furnished matches to arsonists. Former
CPA Journal editor-in-chief Robert H. Colson best illustrated
this effect in his July 2005 editorial, where he tells of
attending the documentary “Enron: The Smartest Guys
in the Room.” He noted two scenes that accountants
should take to heart. In one, when Enron’s management
announced to assembled employees that the SEC had granted
the company the right to account for trades at “mark-to-market,”
the employees erupted in cheers and danced on their chairs.
In another scene, Enron CEO Jeffrey Skilling explained how
“mark-to-market” would work to enrich Enron’s
traders and management.
FASB issued its conceptual framework concepts in which the
accounting world was turned upside down from the matching
of costs and revenues and emphasis on the income statement
to the valuation of the balance sheet, we have seen a steady
decline in the control aspect of accounting, culminating
in the major frauds of the l990s and early 2000s.
work of New York Attorney General Eliot Spitzer in particular
points out how deep the problem of top management fraud
has become. For example, he succeeded in imposing $1.4 billion
in civil fines (under threat of criminal action) on the
top 10 banks in the U.S for hyping the sales of stocks during
the dot-com “bubble” period.
I stated in the new foreword to the republication of my
book, Accounting: How to Meet the Challenges of Relevance
and Regulation (Elsevier Ltd., 2004; reviewed in The
CPA Journal in October 2005), “[I]n the real
world we are dealing with human beings who can (and will)
be pressured and often tempted to manipulate accounting
what continues to be needed is an objective, transaction-based
model with … historical cost as a control point.”
Accountants should not attempt to provide financial statements
to meet the presumed needs of the short-term speculator,
but instead should seek to meet the needs of the long-term
shareholder and investor with reliable reports based on
transactions, not guesses about values.
the primary cause of the problems of the past 30 years has
been the decline in ethics in general. This decline, however,
was exacerbated by the move to a value-based accounting
report and, sadly, by the loss of integrity in public accounting.
In my presentation that The CPA Journal published,
I focused on the problems facing every person entering the
profession and business. All must cope with the desire to
be considered “a team player” while doing the
right thing, because those goals will not always coincide.
We need to build a control system that will reduce the subjectivity
(and thus controversy) of accounting. We also need to build
a “heat shield” that will make the work of the
public accountants and business accountants easier. The
IRS has such a system with its “advance rulings”
procedure. Our primary goal should be to stop top management
fraud and it will take procedures such as this to accomplish
support his position, Schuetze also comments on other matters
that I find puzzling. He notes that I worked for GM for
several decades (actually 28 years) and implies that we
never dealt with the issue of overcapacity. In fact, the
subject was debated continuously as we tried to balance
the need for capacity in an “up” year versus
a permanent decline. (The best illustration of the problem
occurred at Ford, which in the early 1980s reduced its capacity
as sales declined only to find itself short of capacity
when the Taurus model became a hit in the late l980s.) Reviewing
GM’s annual reports from l986 (when we first recognized
the problem of overcapacity as market share began to decline)
through 2004 would show that we wrote off about $18.4 billion
in that period. In 2005 GM announced another $2.5 billion
goes on to mention the real estate industry, where he finds
the costs recorded by REITs misleading because they must
be less than the fair value of the real estate. I think
that anyone who remembers the savings-and-loan fiascos of
the l980s would never mention the application of fair value
to real estate.
also discusses the failure of the auditors at Enron to acknowledge
that too much was taken for granted by everyone, including
the time he was the SEC’s chief accountant. Surprisingly,
he comments that “CPAs are neither qualified nor competent
to judge fair-value amounts ascribed to noncash assets and
liabilities, thus the need for outside, independent valuation
experts,” apparently believing they would be more
trustworthy than public accountants. He is suggesting, however,
that public accountants should rely on another set of “experts”
in forming an opinion on the financial statements!
also complains that “probably hundreds, and maybe
thousands of companies own valuable, highly salable intangible
assets such as brands and patents, which are nowhere to
be found on their balance sheets.” Certainly the Coca-Cola
brand name is worth billions, but I doubt that anyone would
include its value in estimates of operating income should
the company put the value on its balance sheet. Accounting
is (or should be) closely tied to cash flows, and, barring
a sale of the Coca-Cola company, no cash would be forthcoming.
he closes with the astounding conclusion that fair-value
measurements in all balance sheets for all assets and liabilities
should be put into effect as soon as possible. “When
that happens, FASB will be able to dissolve, for we will
no longer need accounting rules … and there will be
no need for FASB.” Now that is incredible!