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Fair Value Option: One Small Step

Jan 26

Written by: Jack Ciesielski
1/26/2006 7:22 AM

Yesterday, the FASB issued an exposure draft entitled "The Fair Value Option for Financial Assets and Financial Liabilities" available for your downloading delight right here.

It's got nothing to do with employee stock options, folks, even though that's the only thing conjured up by the word "option" these days. What this proposal does is something pretty worthwhile, I think: if enacted, it will allow firms to report certain assets and liabilities at their fair value, instead of historical cost.

That's not a bad thing at all. A balance sheet tells its story about an entity's rights and obligations much more clearly when they're stated at what they're worth at the balance sheet date - not what they were worth three months, or one year, or three years ago. At the same time, it's true that what constitutes a "fair value" is going to have its problems too.

The proposal put some limits on what can be "fair valued" in the balance sheet. Barred from the option:

An investment that would be consolidated. (Like a subsidiary.)

Pension and other postretirement benefit plans.

Employee stock option and stock purchase plans, and deferred compensation arrangements

Lease liabilities

Written loan commitments not treated as derivatives

Financial liabilities for demand deposits

Maybe that sounds like a lot of exclusions, but there's still plenty of balance sheet territory where this could be applied. One possible upside to this proposal: if firms are allowed to apply fair value measurement to financial instruments they'd normally hedge, applying fair value to both hedged item and hedging instrument could create a "natural" hedging relationship in the balance sheet. That means there could less need for Statement 133 accounting, with all of its attendant headaches and opaque results.

The downside (apart from measurement difficulties): it's an option, not a requirement. That insures comparability problems between companies.

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Pension & Other Benefit Plans: A Look Ahead

Investors in firms with defined benefit pension plans always face the risk of suddenly being pushed farther back in line when it comes to being served their returns. Variability in plan assets and variability in benefit plan obligations are the reason: poor asset returns coupled with sinking interest rates always spell tough times for defined benefit plan funding. In that regard, this year’s asset returns combined with the Fed’s “Operation Twist” add up to “Operation Agony” for defined benefit pension plans. If trends continue along their current path, firms that may have anticipated moving to more realistic pension accounting - like Honeywell, AT&T and Verizon already have done - might forego that decision. It could be just too painful.

Pensions aren’t the only kind of benefit plan affected by Operation Twist. Other postemployment benefit (OPEB) plans share much the same accounting model as pensions, including the calculation of a projected benefit obligation that similarly incorporates a discount rate - one that will also be affected by Operation Twist. The net OPEB obligations were slightly less than pension obligations at the end of 2010, but also promise to grow in 2011. Investors perceive them as less threatening than pension obligations because they don’t require funding. Strangely, there are a number of firms that are recognizing income from these benefit plans - without ever creating a dime of cash for investors.

A recent edition of The Analyst’s Accounting Observer dissects these issues, and is available only to paid subscribers. A condensed version is available for free upon request. To receive it, send an e-mail to Brenda Rappold at brappold@accountingobserver.com, with “PENSIONS” in the subject line.

For information about subscribing to The Analyst’s Accounting Observer, click here.