Peeling away financial reporting issues one layer at a time

Replacement Cost Rebound

In the public FASB meeting on Tuesday, one of the topics was revenue recognition under circumstances where the consideration received is other than cash.  The Board discussed how to value the consideration received, and I am told that a majority of the Board favored fair (exit) value.

HOWEVER, Chair Bob Herz made a "strong case" for replacement cost. I don't know anything yet about the substance of Bob's comments, but following on the publication of the SEC's study of mark-to-market accounting, this is the first ray of hope that a full-blown reconsideration of fair value could occur.

Another reason I am writing so soon again is to provide those of you who happened to read yesterday's epistle via email with a link to Walter Schuetze's speech, which I inadvertently omitted.  I also want to take this opportunity to address some of the concerns that some readers have already expressed about the positions I have taken. An investor named Andy and an experienced appraiser, Alfred King, have provided representative comments.

The Preferences of "Investor Andy"

Andy wrote that he prefers historic cost "about 80% of the time" because of its objectivity; for the other 20%, mainly marketable securities and loans, he prefers fair value. He is "…most concerned with what an asset cost, because that represents the initial investment, and will allow me to calculate a return on investment."

As to the claim that historic cost is objective, in yesterday's post I spoke primarily about the balance sheet, yet nothing makes my point better than an historic cost income statement.  There is nothing objective about allocations to the income statement for depreciation, bad debt expense, warranty costs, and much more. 

But, the comment I really want to respond to concerns how to go about measuring return on investment.

Consider the oil and gas industry. The value of a producing field has nothing to do with what it cost to develop perhaps twenty years ago, or even how much it has produced to date.  Valuation has everything to do with all sorts of things ignored by historic cost accounting: current oil prices, the current amount of reserves, and the current capability of the current owner to operate and manage the field to maximize its remaining economic returns.

If the current operator cannot generate an adequate return based on the current value of the field, then management should consider selling it to an operator that can achieve a return commensurate with that current value. Historic cost cannot provide me with the information I need to judge whether the current operator is making an adequate return. I have consulted in the oil and gas industry, and the company I worked for adjusted its goals for field managers every year; those goals had absolutely nothing to do with the sunk costs that were reported on the balance sheet by historic cost accounting; and I am positive that investors take the same approach as management.

In summary, Andy, I want the managers of my investment to maximize profit, not simply to generate a satisfactory return based on the amount invested some arbitrary time ago.

Andy also accused me of having a "double standard" when comparing fair value to replacement cost:

"… You eviscerate fair-value accounting, not theoretically, but how it was put into application. Alternatively, you do not consider how replacement value could be taken advantage of preferring instead to think about it theoretically."

I plead "not guilty." I stated that fair value has problems in both principle and its application. But, to be clearer, I should have stated that SFAS 157 is a failed application because it begins with a flawed principle: the flaw being that wealth is command over goods and services. There are two parts to this. First, goods and services are not cash, and fair value measures the potential for cash. Second, and much more important, you can't command anyone to buy your asset. However, every seller does have a 'reservation' price; therefore, you can command goods and services by bidding high enough. In that sense, Andy, replacement cost, as its name implies is actually nearer in concept to historic cost than fair value.

The Appraiser, Alfred King

I have had a series of interesting exchanges over the last few months with Alfred King, author of Executive's Guide to Fair Value. I haven't read the entire book, but I generally agree with his critique of FAS 157.

After today's post, Alfred King wrote, in part:

"I spent about two years of my life working with replacement cost and price level accounting [when that information was required by GAAP].  With the best will in the world, and with some clients no limit on the resources that could be applied, we still could not come up with satisfactory information. …. Nobody in their right mind would replace an inefficient factory building that had been added to five times over 25 years at the same site.  You could build a new modern building with 20% less square feet, and much lower utility costs if you really would replace it.  But of course buildings go on for many many years." [emphasis in original]

"This was one, but not the only, reason the supplemental information died a natural death within three years.  I remember it so well because for about six months we in the valuation business thought it was going to be our equivalent of what the 1933 and 1934 Acts did for Public Accountants.  It wasn't, and we were soon back to our old type of valuations."

I will admit that I haven't read FAS 33 in years, and don't have much recollection as to the details of the requirements. Although Mr. King's critique may have been an important consideration when FAS 33 was in effect, I don't relate it to my vision of what replacement cost accounting should now be.

The most straightforward way to determine replacement cost to meet the wealth measurement objective is to ask oneself what would be the least amount one would have to pay for an asset (or a similar asset that provided the same utility), if one did not actually already own it. It seems to me that real estate appraisers make estimates for specific properties on that basis as a matter of course. Often, their best estimate is the result of making somewhat objective adjustments to 'comparables' for age, floor space and even location.

Having said that, I would allow for any number of approaches to approximating replacement cost, so long as they adequately answered the question I posed in the previous paragraph.  Like FAS 157, the greater the subjectivity in the estimates, the more detailed would be the disclosures.  However, in all cases, I would require reconciliations of the changes in balance sheet accounts in sufficient detail to make all assumptions, and changes in assumptions, transparent.

To be sure, there must be many implementation hurdles to overcome in broadly applying replacement cost accounting, but for goodness sake, consider the alternatives. Sorry, Andy, but I think historic cost has become a bucket of offal, and fair value is falling flat on its face.

4 Comments

  1. Reply Andy Alexander April 2, 2009

    Hey Tom, Andy again.
    Are you planning on starting a new career as an appraiser? Because the adoption of replacement cost accounting would place some major new administrative burdens on companies. Appraisers would be in high demand.

  2. Reply Michael April 2, 2009

    I’ve seen you espouse replacement cost on multiple occasions but am having trouble determining what the real difference is between exit price under FAS 157 and your view of replacement cost. If I try to determine what the exit price would be for a given asset, am I not implying what the entry price for a buyer of that asset would be?…i.e. one’s exit price is another’s entry price, which I would view to be the replacement cost. For an untraded mortgage backed security, I can’t look to quoted prices to determine what the asset would cost me to replace it today, so I estimate the cash flows and apply a discount rate using a market participant’s persepctive. This is how a purchaser would determine what the asset would cost them today, but it’s also the principles that a holder of the asset would think about as well under FAS 157.

  3. Reply Tom Selling April 2, 2009

    Hi, Michael:
    That’s a fair question you ask. For financial assets, the difference between exit value and entry/replacement cost is captured conceptually by the bid-ask spread. ‘Ask’ is replacement cost, and replacement cost will also ‘capitalize’ whatever additional acquisition costs you may have to incur.
    For non-financial assets, the replacement cost may be a ask price, or it may be a combination of asking prices for various components that when you add them up is less than yjr asking price for the whole thing from a dealer or another manufacturer. The example I think about most is inventory for resale. A manufacturer’s lowest replacement cost would be its out-of-pocket costs to manufacture a new one.
    I am not claiming that replacement cost would solve the lack of an active market problem for all financial assets. I agree with you that for debt securities that don’t trade at all, you may still be able to apply some kind of DCF model, but a mid-market price is not the answer. I think the model should take into account bid-ask spreads of roughly similar securities that do trade, and these could be very large.
    What I am claiming, however, is that replacement cost measurement should be the stated objective, even if some measures of replacement cost are more reliable than others. I want to measure all assets on the same basis (because it is simply wrong to add apples and oranges), and the only common basis that works for both financial and non-financial assets is replacement cost.
    Thanks for writing, and I hope this helps.
    Best,
    Tom

  4. Reply Kathryn P. O'Mara April 5, 2009

    Getting back to the topic of financial assets, I’m not sure that ask prices (replacement cost) are any more objective than bid prices, even in active markets. In an active market, a bid-ask spread reflects the dealer profit margin, but that margin also includes the risk premium that the asset will deteriorate in the time that it takes the dealer to sell the asset. I think that’s where IFRS’ insistence of a bid price for assets and and ask price for liabilities was a bit more fundamentally sound. However, since bid-ask spreads are usually tight in active markets, the whole fair value vs. replacement cost is mostly academic at that point.
    Returning to the inactive markets, I’m even less convinced that “replacement cost” is a sound objective. Aren’t the revisions to FAS 157 essentially allowing banks to write assets to their “ask” prices (“intrinsic” value taking only credit losses to the P&L)?
    Maybe the issue isn’t that fair value is fundamentally unsound. Perhaps people just don’t like the answers that fair value gives them. If “everyone” is convinced that their own “toxic assets” are undervalued, then why isn’t anyone buying them? Perhaps the banks are a bit more objective when looking at others’ portfolios than they are when looking at their own?

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