In Defense of Fair Value

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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.

Flegm 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.

Historical 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.

For 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.

The 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 overstated. Misleading.

On 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. Misleading.

In 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.

A final 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.

For 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

Flegm, 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.

As 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.

Walter P. Schuetze
Boerne, Texas

Schuetze 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.

The author responds

Schuetze 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.

Since 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.

The 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.

As 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 data. Thus 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.

Certainly 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 this goal.

To 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 write-off.

Schuetze 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.

He 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!

Schuetze 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.

Finally, 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!

Eugene H. Flegm





















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