Historical cost accounting is fading as Corporate America marches into a new era.

What is a company really worth? That is the central question that accounting attempts to answer, and it is no easy exercise.Every answer invites debate, and that debate has now intensified, thanks to “fair value” accounting.

Under fair value, a company values its assets and liabilities based on what they would fetch today, rather than what they originally cost. The concept is not new — accounting has long operated under a “mixed attribute” model, which records many items at historical cost while requiring that companies mark to market certain asset classes (such as securities, derivatives, and intangible assets obtained in a merger). But a host of factors have suddenly propelled the calculation of fair value from a secondary concern to a dominant theme of corporate accounting, and many companies are just beginning to understand the ramifications. If fair value takes full hold, as some have suggested it should, company results may look far different than they do today.

In stark contrast to most other accounting concepts, fair value has already achieved the improbable feat of making front-page news, thanks to its alleged role in the subprime-mortgage crisis. Mired in the real estate mess, such financial-services giants as Merrill Lynch, Citigroup, and UBS suffered staggering losses in the first half of 2008. At the same time, new fair-value measurement requirements were taking hold, forcing the banks to determine how to value securities based on the prices they would fetch in markets that had all but dried up. The question has been: Has fair-value accounting played a role in the economic meltdown? As bankers claimed that the new standards prompted them to dump the securities at fire-sale prices, large investors contended that mark-to-market accounting reflected an economic volatility that was already there.

Fair value’s tipping point lies in the innocuously titled Fair Value Measurements, a standard issued in September 2006 by the Financial Accounting Standards Board. Better known as FAS 157 and effective for fiscal years beginning after November 15, 2007, the standard spells out how companies should determine the valuations of the assets and liabilities they mark to market. But it is far more than a how-to guide. Because it affects abroad array of core activities, including contingent liabilities, mergers and acquisitions, intangible assets, pensions, hedges, environmental-cleanup obligations, and loans, its effect will be profound. Indeed, FAS 157, which already includes a three-page list of opinions and statements that are affected by fair-value accounting, seems likely to influence standard-setting far into the future. “Assuming it stays where it is right now,” says Gary Kabureck, chief accounting officer at Xerox Corp., the rule “is going to be, over time, one of the most important standards” that FASB has ever written.

What’s more, if, as is widely expected, the generally accepted accounting principles that have long governed U.S. companies give way to adoption of international financial reporting standards, fair value may get a further boost. That’s because IFRS appears to favor even greater use of it.

The ultimate intent of fair value is to give investors better visibility into how companies value their assets, and few deny that it achieves that aim. But at what cost to companies, both in terms of internal compliance demands and the impact that greater transparency has on their share prices, will such benefits come? While recent events on Wall Street provide only an imperfect proxy for fair value’s impact, those who claim that it will increase volatility have plenty of evidence on their side.

Missing Markets

The initial challenge in meeting the requirements of FAS 157 entails sorting each fair-value estimate into one of three levels, or “buckets,” as Paul Farr, CFO of PPL Corp., calls them. Since the fall of 2007, the finance and technology departments of PPL, an Allentown, Pennsylvania-based diversified energy company, have been hard at work filling those buckets with information about how the company gauges the fair value of the derivatives it buys and sells. “We’ve had a 157 project under way for nine months,” Farr said in May. “The last six months have been the most intense, as we were ‘bucketizing’ the various transactions.”

In bucket 1, the value of an asset or liability stems from a quoted price in an active market; in bucket 2, it is based on “observable market data” other than a quoted market price; and in bucket 3, fair value can be determined only through “unobservable inputs” and prices that could be based on internal models or estimates. It’s that third bucket that critics say has some serious holes.

Even FASB has struggled with how to place a market value on a transaction for which there is no market. Complicating the issue is that the board defines fair value as an “exit” price — “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date,” as the standard says.

The need to conjure up an exit price can force corporate borrowers to try to figure out, for example, what they would pay someone to take on debt no one is likely to buy. Not for nothing did an exasperated Robert Herz, chairman of FASB, declare in an April meeting that by requiring companies to estimate the fair value of such liabilities, “we’re forcing people to do mental gyrations in parallel universes.”

In the throes of the subprime crisis, some financial-services firms found themselves ill-equipped to perform such acrobatics. Finance executives in the sector complained that the fair-value rules were “pro-cyclical” — that they were a self-fulfilling prophecy forcing banks to sell their securities in plummeting markets.

Under FAS 157, FASB calls on companies to price an asset or liability as would market players “willing” to buy or sell the asset or liability but who aren’t “forced or otherwise compelled to do so,” noted Bob Traficanti, head of accounting policy and deputy controller of Citigroup, at a conference held by Standard and Poor’s last spring. Calling on FASB to test the 157 valuation hierarchy in light of companies’ first-quarter experience, Traficanti asserted that some of the prices Citigroup had to come up with had indeed felt coerced.

The Bucket List

Herz and the board, however, seem unlikely to budge on FAS 157. What’s more, finance executives outside the banking sector haven’t griped all that much about the measure, with some saying that it doesn’t change their companies’ underlying accounting at all.

“Our reporting, as in ‘disclosure,’ has changed significantly, but our reporting of actual amounts recorded has not changed,” says Ted R. French, executive vice president and CFO of Textron, a $13.2 billion industrial conglomerate. “This particular standard did not require us to fair-value any new assets or liabilities that weren’t already required to be recorded at fair value.”

But it is unclear to what degree other companies can take heart from that, since compliance varies widely from one company to the next. Determining which bucket a given transaction resides in poses not only an intellectual exercise, but a bureaucratic one as well. While there were disclosure requirements to categorize deals into three buckets prior to FAS 157 — under the nongovernmental Financial Industry Regulatory Authority’s Management Discussion and Analysis strictures, for instance — “it was still a significant effort to recategorize all of our transactions according to the FAS 157 requirements and systematize the process for future reporting periods,” says Farr. Thus, PPL’s accounting and technology staff had to go back and “force” its computer system to plug in “literally thousands of energy transactions in a given year” into one of the three buckets, he says.

For other companies, the changes in fair-value disclosure may coincide with other, more sweeping developments. Caught in the downdraft from the subprime turmoil, troubled mortgage guarantor Fannie Mae saw mixed results from the introduction of FAS 157 at the start of 2008. On the one hand, fair value underlined the company’s perilous position; given the 66 percent first-quarter drop in Fannie Mae’s assets, many feared a government bailout was in the cards. For its part, however, Fannie Mae reported that applying FAS 157 to the measurement of its financial guarantees “had a favorable impact on the company’s results of operations for the quarter.”

Flawed Estimates

For those not as well acquainted with marking credit swaps and interest-rate derivatives to market, the demands of the new regime can represent radical change. Companies may not find it easy to estimate what was formerly thought inestimable. Only last year, FASB began requiring plan sponsors to report the adequacy of pension funding on their balance sheets rather than merely in the footnotes of their financial statements; now they must come up with the fair value of those amounts. In another example, companies with pending lawsuits may soon have to estimate what such litigation, which often spreads out years into the future, will ultimately cost.

Fair value’s critics have, in fact, cited the reliance on estimates — and the ability to thereby manage earnings — as a major flaw. “There’s a concern that it gives far too much latitude,” says Ken Becker, CFO of privately held Portland Nursery, in Portland, Oregon. “You don’t have the objectivity of a [historical] cost figure to base your numbers on.”

Another concern is that fair-value reporting will pressure companies to act precipitously — and against their long-term interests. Wesley Walton, vice president of finance at CBC Federal Credit Union, points out that historical-cost reporting enabled companies to “work their way out of trouble” by holding on to fading securities until the market turned around, since they had to show only what they had originally paid for them.

Indeed, it’s hard at this juncture for executives to tally up a net gain from fair-value accounting. The new standards, of course, were crafted to benefit shareholders, not corporate management. But if they help boost investor confidence, CFOs may decide that the march to fair value was worth it.

David M. Katz is a deputy editor of CFO.com.

The Starting 5

Critical areas of finance most likely to be affected (and soon) by fair-value accounting

1. Liabilities: Compared with financial assets, many of which have long been measured at fair value by corporations, liabilities are unknown territory. Often lacking hard numbers on which to base estimates, companies tasked with putting a current price on loans, insurance contracts, or future environmental-cleanup costs, for example, must rely on hypotheses. “In fair-valuing liabilities,” says Espen Robak, president of Pluris Valuation Advisors, “there is very little in the way of a market there; you’re always going to come to some kind of model, anyway.”

To some critics — Financial Accounting Standards Board chairman Robert Herz is one of them — such modeling is unnecessary when the price of settling a liability is clearly set. Xerox’s chief accounting officer, Gary Kabureck, offers the example of a company that has a long-term debt on which it will pay 7 percent interest at maturity. Even though the company fully intends to hang on to the obligation until it matures, it must report the debt’s fair value in its current financial reporting. If that fair value is 8 percent, the company would have to report bad news to the market for largely hypothetical reasons. “You have to question what is the relevance of liabilities at other than the settlement value,” says Kabureck.

Another aspect of the new rules also seems, to many, to depart from logic. As the risk that companies won’t pay back their debts rises, their reported liabilities actually decrease. That’s because companies estimating the fair value of their own liabilities must factor in the risk that they won’t pay those debts off. That makes the anticipated debt smaller. It also works the other way: if the debtor becomes more creditworthy, the fair value of the debt obligation rises.

The rewards for potential deadbeats can be large, according to a Credit Suisse report on the 380 members of theS&P 500 that began complying with FAS 157 in Q1 2008. For the 25 firms with the biggest amounts of liability measured at fair value, widening credit spreads — an indication of a lack of creditworthiness — spawned first-quarter earnings gains ranging from $11 million to $3.6 billion.

2. Lawsuits: If things proceed according to plan, some companies will have to disclose what corporate lawyers insist can’t be calculated: the future costs of lawsuits.

What will litigation cost? In December 2007, a group of 13 top lawyers employed by Pfizer, General Electric, Viacom, Boeing, McDonald’s, and other prominent companies pronounced any attempt to answer that question an impossible dream. “Litigation is inherently unpredictable,” they wrote to Herz and International Accounting Standards Board chairman Sir David Tweedie.

The lawyers were reacting to what has since blossomed into a FASB proposal to require companies to add more-robust disclosure in their reporting of liabilities that may or may not occur. Under the proposed rule, companies would have to disclose “specific quantitative and qualitative information” about loss contingencies involving legal liabilities as well as such things as environmental-cleanup costs.

FASB’s proposal stops well short of a full fair-value regime for litigation risks, but attorneys fear that may yet come, if not from FASB, then from the IASB. “We do not believe that the fair value of contingent liabilities…can be reliably measured in many cases,” the corporate litigators wrote.

The reason it’s so hard to put a fair value on litigation is that there are so many variables: the laws that apply in a case, the strategies of the lawyers involved, and the mind-sets of the judges, to name a few. “No matter what model is used,” says Larry Levine, director of financial advisory services at RSM McGladrey, “the process is enormously speculative.”

3. Mergers & Acquisitions: The march toward fair-value accounting took a big step in December 2007, when FASB revised its rule on business combinations. The new rule, FAS 141(R), requires companies that acquire assets or assume liabilities in a deal to record the items at their acquisition-date fair values measured according to the new hierarchy setup under FAS 157.

As a result, the fieldwork by acquirers will have to include “a much deeper dive into the financial statements” of potential target companies, says Bank of the West CFO John Wojcik. In the case of banks, specifically, purchasers can no longer accept a purchased company’s estimates of the liability of its loan portfolios. Instead, he adds, the buyer will have to do “a lot more upfront work” to determine the fair value of the loans it stands to absorb.

As it might do with lawsuits, the proposed rule on contingent liabilities could have a significant effect on how companies gauge the worth of a merger, Levine thinks. “What-if” scenarios will be hard to mark to market. “If you buy a company that has $25 million in sales, and you’ll give them another million of payment if they hit $30 million of sales next year, that’s a difficult and somewhat subjective thing to value,” says Levine. The result? Added cost and effort in figuring out what price of a deal to report.

4. Hedging: Trying to simplify FAS 133 — considered by many to be the most notorious example of the complexity of U.S. financial reporting — FASB has proposed sweeping changes in hedge accounting that should expand the use of fair value.

To be sure, the current rules for derivatives and similar risk-management tools involve extensive application of fair value. But with more than 800 pages of rulemaking and guidance needed to make sense of 133, the accounting standard has been something of a black eye for the fair-value concept, and has been in Herz’s gun sights ever since he became FASB chairman in 2002.

One current critique of 133 is that it allows two companies to account for the same transaction in different ways. It also enables a company to mark a hedging instrument at fair value without doing that for the hedged risk. Under the new proposal, all companies would use the same method of hedge accounting and each company would be required to use consistent accounting on both sides of a hedge.

5. Pensions: FASB’s fair-value crusade is plunging deeper into the forests of pensions. In November 2007, with the subprime-mortgage crisis in high gear, the board agreed to get plan sponsors to disclose the fair value of retirement-plan assets more broadly. On current balance sheets, employers lump together plan assets measured at fair value with liabilities that aren’t, yielding a net amount marked to market in mongrelized form.

The result is proposed guidance aimed at improving “the quality of financial reporting by increasing disclosures about the types of assets held in post-retirement benefit plans,” according to a FASB staff position issued in March. The FASB plan would require plan sponsors to disclose separately on their balance sheets the fair value of each “significant” category of plan assets, including cash and cash equivalents; equities; national, state, and local government debt; corporate debt; asset-backed securities; and structured debt.

FASB is also proposing that plan sponsors disclose the fair value of their pensions’ derivatives positions. Employers would have to list the hedging instruments separately rather than in aggregated form and classify them by type. For instance, employers would have to disclose, if significant, a plan’s hedges against such risks as foreign exchange, interest rate, and commodity price. They would also have to provide fair values of pension assets invested in hedge funds, private-equity funds, venture-capital funds, and real estate. To top it off, they would have to disclose facts that enable financial-statement users to assess the valuation methods used to produce the fair-value figures.

Those chores will take heavy lifting — especially for plan sponsors with a multinational presence, notes Kabureck. “If you’ve got a lot of foreign plans, it’s going to be hard to accumulate that information, because trusteed assets in pension funds are independent of the [parent] corporation,” says the Xerox accounting chief. — D.M.K.