Peeling away financial reporting issues one layer at a time

FAS 157: Fair Value Has left the Station–But Is It on the Wrong Track?

The CFA Institute recently published a monograph entitled A Comprehensive Business Model: Financial Reporting for Investors, calling for a "…broader, more comprehensive business reporting that provides sufficient information to investors that is needed to understand the wealth-generating [emphasis supplied] activities of a company and the results of those activities."  One of their key recommendations is that fair value measurements be applied to all assets and liabilities, since "fair value information is the most relevant [emphasis supplied] information for financial decision making." 

I have been waiting for the right opportunity to take a poke at FAS 157 — a rules-based standard masquerading as principles-based — and this report by a venerated investor group makes the time right.  My opening is widened further by the following quotation in the report from an FASB publication:

". . . The objectives [of accounting], therefore, focus on matters of wealth. Investors and creditors seek to maximize their wealth (within the parameter of the risks that they are willing to bear). Likewise, business entities also seek to maximize their wealth. It follows, then, that information about the wealth of those entities and the changes in it is relevant to investors and creditors that are seeking to maximize their wealth by investing in or lending to those entities. [As quoted from The FASB Report, No. 263-D (28 December 2004), pp. 1 – 2; emphasis and comments in brackets supplied by yours truly.]

The authors of the monograph are all pretty savvy and clearly share my interest in providing high-quality reports to investors. Yet, I wonder if they realize that fair value, as defined in FAS 157, is not consistent with the objective of measuring wealth and changes in wealth?  The purpose of this post is to describe and illustrate the inconsistency I believe they have missed.

The Economic Principles and a Simple Example to Illustrate Their Proper Application by Accountants

To begin, here are the two basic economic principles I will bring to bear: (1) “Wealth” is command over goods and services; (2) “Income” is the maximum amount of consumption that could take place during a period without changing wealth during the period. 

Imagine a world in which there is only one consumption good — beer. Ignatz Schicker brews beer for his personal consumption and for sale:

  • The accounting period is two days long.
  • Beginning of the period (BOP): Schicker had in his possession 1 keg of beer and $72. He estimated that it would cost him $12 per keg to brew more beer (i.e., ‘replacement cost’ or ‘entry price’), and that he could sell beer (‘fair value’, or ‘exit price’) for $20.
  • Day One: Schicker produces 5 kegs of beer for $12 per keg. He sells 2 kegs and drinks 1 keg.
  • Day Two: The replacement cost and selling prices of beer increase to $16 and $25, respectively.

Applying the basic economic principles, we can straightforwardly calculate Schicker’s economic income for the period as follows:

This is our benchmark ($4.00 of income) against which we can compare the results of applying various approaches that an accountant could take.  There are many approaches to choose from, but these three are sufficient to make my point:

  1. Current GAAP. For our purposes it could be described as historic cost without adjusting for inflation in the cost of beer (so-called ‘nominal dollars’).
  2. The approach endorsed by the CFA Institute, which could be described as ‘Fair Value, Nominal Dollars.’
  3. Economic-principles-based accounting, which is based on replacement costs—adjusted for inflation of the cost of beer (so-called ‘constant units of purchasing power’ [C$]).

My spreadsheet with the underlying calculations displayed below is available here.

And the winner is… replacement cost! That approach is the only one that accurately reports, in accordance with generally accepted economic principles (pun intended), earnings and wealth.

Message to CFA Institute: you are right to push for a comprehensive basis of measurement based on current prices; but, fair value (and FAS 157) is not the answer. Replacement cost is more relevant, more reliable, and even less complex than FAS 157.

Less complex, you ask?  Isn’t that a current focus of the SEC? 

Here are just a couple of examples where replacement cost is much simpler to apply than SFAS 157:

  • Virtually every transaction is burdened by transaction and transportation costs. Both of these costs are a component of an asset’s replacement cost. But under FAS 157, transaction costs are excluded as a component of fair value, thereby creating practical difficulties of having to develop separate estimates. FAS 157 also creates the anomaly of recognizing expenses before the first dollar of benefit from the asset can be realized.
  • Since replacement cost measures economic utility (so says ARB 43, Chapter 4), the unit of account must be the asset grouping that minimizes total replacement costs. Concerns such as the controversy over blockage factors in FAS 157 would not be relevant.
  • The invented concept of ‘principal market’ in FAS 157 would not be relevant. Replacement cost as a measure of economic utility dictates that the least costly way to obtain the asset is reported.
  • Perhaps most important, estimating the present value of future cash flows might only rarely become appropriate for measuring replacement cost. 

Moreover, the concept of replacement cost is not new to the accounting regulators:

  • Inventory impairment (ARB 43, Chapter 4), the familiar lower-of-cost-or-market rule (LOCOM), is based on replacement cost. In essence, the rule provides that inventory should be measured at current replacement cost, if it is less than historic cost. All kinds of complex impairment tests have been promulgated subsequent to the inventory impairment standard; and so much has changed about accounting in the last fifty years that it’s difficult to name many things that have remained the same. LOCOM for inventory is one of the few stalwarts, because there exists no good reason to abandon or modify its replacement-cost-based principles.
  • For a time beginning in the mid-70’s, the SEC required (Accounting Series Release No. 190) disclosures of cost of goods sold, depreciation, inventory and property, plant, and equipment on the basis of replacement cost. SFAS 33, since superseded, required supplemental financial statements prepared on a ‘current cost’ (an attribute that is similar to replacement cost), constant dollar basis.

Wrapping Up

As is my wont, I have used a very simple example to make the points that (1) replacement cost accounting is principles-based and therefore, FAS 157 must be rules-based; and (2) FAS 157 is needlessly complex (a common characteristic of rules-based standards).  But simplicity doesn’t change the fact that the underlying principles of replacement cost accounting are correct, even if, by adding richness to the example, implementation may not be perfect.  Above all, keep in mind that application of FAS 157 cannot result, except by happenstance, in economic measures of wealth or changes in wealth.

Finally, I have to ask myself (and I hope you do this same), why the focus by the FASB is on fair value instead of replacement cost? I think the answer, as usual, has little to do with the informational needs, but the incentives of preparers to influence accounting standards towards new "principles" that permit them to manipulate their income. To see how easy this can be under a full fair value regime, look closely at the operating income numbers in the fair value column. All Ignatz Schicker (or GM for that matter) has to do to generate accounting earnings is to produce beer (or cars). Actual sales to third parties is not directly relevant. Think about it.

3 Comments

  1. Reply nick November 27, 2007

    Great post, much appreciated. Any chance you can use the financial markets in his example for a complex instrument instead of a keg of beer?

  2. Reply StockJockey November 29, 2007

    Interesting.

  3. Reply Jason January 16, 2008

    Where can we find fair market comparables? We used Dow Jones before and just heard of the Private Equity Data Center, but the http://www.pedatacenter.com only tracks venture capital valuations?

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