4. Value Information

As part of its oversight activities, the Oversight Committee of the Financial Accounting Foundation interviewed and requested written comments (collectively, "the interviews") from thought leaders among the FASB's constituencies. There were 107 interviews in total, including 12 with representatives of financial statement users and 17 with regulators (a special class of financial statement users). [FASOversight, p. 1]

While the interviews were not designed to elicit criticisms of financial reporting, in general, or to identify the needs of users of financial information, interviewees did comment on those matters. [FASOversight, p. 1]

Following is a summary of the principal comments received [on the subject] from users and regulators relating to . . . the needs of users. [FASOversight, p. 1]

Disclosure of the impact of changing interest rates on expected future cash flows and asset values would be meaningful. [FASOversight, p. 2]

__________

The APC [Accounting Policy Committee] has considered and expresses below its opinions on a number of specific issues affecting financial accounting standards and financial reports. The APC believes that the following items should be included in the single body of accounting concepts, standards, principles and methods: [RMA90, p. 5]

The fundamental basis of accounting is measurement based on the exchange prices of actual transactions. Thus, assets should initially be recognized at the amount of their historic cost and liabilities at the amount of cash or the fair market value of other assets received in exchange for them. The cost of long-lived assets should be matched periodically to the benefits (revenues) received from their use via systematic amortization procedures. Assets held for sale should continue to be measured at cost until an event permitting realization has occurred. An "event" means a transaction or similar event that establishes with a high degree of certainty both an increase in value of an asset and the enterprise's ability to obtain cash in the amount of that value. [RMA90, p. 5]

By the same token, differences between the initial amount of a long-term liability and the aggregate contractual amounts to repay it in the future establish an historic rate of interest. That interest rate should be used to record interest accruals on the debt regardless of changes in "market" rates. [RMA90, p. 5]

Current market value information is highly esteemed by and frequently requested of borrowers by lenders. However, with the exception of a few well-organized auction markets, its measurement is less precise and more subject to personal bias than is acceptable for financial statements. Until such time as the reliability of current value measurements can be demonstrated, general purpose financial statements should continue to be based on historic cost, and reports that use current value should be presented as supplementary information only. [RMA90, p. 5]

Financial assets and liabilities represent agreements to convey specific amounts of cash from borrowers to lenders at specific future dates. Interest represents the difference between the amount borrowed and the aggregate amount to be repaid. The rate of interest implicit in a financial obligation is established at the inception of the agreement and is called the historic rate. Interest revenue (expense) should be reported periodically on the income statement by applying the historic rate to the unpaid balance of the obligation at the beginning of the period. Interest accrued in excess of a period's payments should be added to the debt; payments in excess of interest accruals should be deducted. [Also included in 5(b)] [RMA90, p. 9]

In cases where the initial borrowing involves consideration other than cash, the historic rate of interest should be estimated by reference to rates of interest on debt instruments of similar duration and risk. In all cases, there should be disclosure of information that allows financial statement users to know or calculate the contractual amounts of cash payments required by the obligation, both periodic ("coupon") and final ("face"). [Also included in 5(b)] [RMA90, p. 9]

__________

[Fifty-eight] percent of the professional [investors] sample said that annual reports all too often fail to present information that reveals the underlying values of a company. [HILL KNOWLTON, p. 12]

__________

Long term productive asset values on the balance sheet are nearly always evaluated at cost [by equity sell-side analysts]. The effect of inflation on such assets rarely is explicitly considered. However, for some companies, a supplemental analysis of assets' market value is conducted. This is undertaken for firms analysts consider to be poorly understood by other analysts and investors, and particularly where latent significant off-balance-sheet or hidden assets may exist. [Also included in 1(b), 1(c), and 5(b)] [PREVITS, p. 17]

[A]nalysts asserted that a cable television company had substantial off-balance-sheet assets in the form of residual payments to be received in the future. They calculated the value of the company using several methods, one being the present value of the anticipated cash flows from these residuals. One analyst stated that "balance sheet recognition of . . . hidden asset values . . . will occur in future years". Other examples include inventory and reserve valuations of extractive industry companies. For instance, in gold mining companies, a market value appraisal is included of the reserve values by ore type. [Also included in 1(b), 1(c), 5(b), and 5(c)] [PREVITS, p. 17]

[Equity sell-side] analysts distinguish between valuations based upon the company's continued existence in its present form: so called fundamental value, and valuations based upon acquisition or breakup of the company. Analysts use several approaches to valuing companies based on fundamentals, most typically in terms of the present value of the company's cash flows, its earnings, or balance sheet valuations. In this approach analysts also distinguish between a company's "Public market value" and "private market value". For example, one analysts measures the fundamental value of a company in terms of:

1) Private market value

2) Price/revenues

3) Price/book value

4) Price/long-term earnings

5) Growth-driven valuation composite

6) Contrarian composite [e.g. Bearish Sentiment Indicators]

7) Earnings momentum composite

8) Technical ranking

9) Beta

[Also included in 1(b) and 1(c)] [PREVITS, p. 19]

Another analyst valued companies in terms of revenue, cash flow multiples, and net income. And yet another analyst valued a cable TV company with purported off-balance-sheet assets on three basis:

1) present value of cash flows,

2) appraised value of assets and

3) the company's liquidation value.

[Also included in 1(a), 1(b) and 1(c)] [PREVITS, p. 19]

Another analyst evaluated the same cable TV company by analyzing each of the many limited partnerships with which the company was related in order to estimate the long-range cash flows of each to the company. [Also included in 1(a), 1(b), and 1(c)] [PREVITS, p. 19]

Analysts label valuations of a company based upon it acquisition or breakup as it "buyout value", "breakup value", "takeover value", "theoretical breakup value", and so forth. Examples of computed break up value include the following:

1) Estimated breakup value = asset values at market price less liabilities.

2) Adjusted breakup value takes the above and adds other "likely" assets.

3) Possible breakup value adds other "possible" assets to all of the above.

[Also included in 1(a), 1(b), and 1(c)] [PREVITS, p. 19]

__________

The second major issue pertaining to financial services is whether "mark-to-market" accounting is the remedy for the deficiencies of historic cost as applied to financial instruments. Some analysts support it wholeheartedly and believe that it should supplant historic cost on the financial statements. Others have reservations about or are opposed to market value accounting. None is opposed to disclosure of market values and most believe that it is vital. Some urge caution to avoid disclosures that are incomplete or that imply that market value disclosure can easily be substituted for the historic valuations that appear on financial statements now. In sum, analysts are agreed that information about market values is important, but differ as to the degree of importance and the extent to which they should be incorporated in financial reports. This topic is discussed at greater length later in this report. [Also included in 19] [AIMR/FAPC92, p. 19]

[Context] The following brief summary of the topic "'Mark-to-Market' Accounting: Value versus Valuation," is from the "Executive Summary" of the report of the AIMR's Financial Accounting Policy Committee (FAPC):

Any imminent change to "mark-to-market" accounting is not welcomed by the majority of financial analysts. They would not be happy to see historic costs removed from the financial statements. They are not convinced that there would be an increase in relevance sufficient to offset the reduction in reliability of the new data. Others disagree and are anxious to see and use market values in their work. In fact, the spectrum of opinion among analysts on the subject is so broad that it cannot be represented succinctly. Furthermore, it varies depending on the extent to which mark-to-market accounting would apply. Some would approve of it for financial instruments or some financial instruments, but not for tangible or other intangible assets. There is agreement, at least within the FAPC, that marketable equity securities should be reported at market and that the disclosures of market values of financial instruments required by Statement of Financial Accounting Standards 107 will provide potentially useful information without any corresponding loss of other data. [AIMR/FAPC92, p. vii and viii]

[Context] It indicates the scope of the discussion of the topic and lists the report's major recommendations, providing an introduction to the following excerpts from the report.

Securities and Exchange Commission Chairman Richard Breeden has been quoted as saying that financial reports should begin with the phrase "Once upon a time..." His statement certainly was made with pejorative intent, given his many public statements in favor of recording financial assets at their market value, so-called "mark-to-market" accounting. In addition to the public advocacy of mark-to-market accounting by Chairman Breeden, there have been other initiatives in that direction both in the United States and abroad. The Financial Accounting Standards Board, in its financial instruments project, has issued one statement [FAS 107] that requires disclosure of the market value of all financial instruments and it also has suggested market values as potentially appropriate measures in its Discussion Memorandum, "Recognition and Measurement of Financial Instruments." Members of the Accounting Standards Board in the United Kingdom also have expressed strong support for using market values in financial reports. [AIMR/FAPC92, p. 24]

AIMR members have different views on market values. All favor disclosure of market values, at least for financial instruments. None believes that disclosure alone could be detrimental to their interests, and all but a few believe that it would be beneficial. Most are opposed to replacing historic cost with market values, but a significant minority would favor such a move. Most would oppose extending mark-to-market accounting from financial assets to real assets, although a small number would not. All agree that if mark-to-market accounting were to be mandated, it should be applied with equanimity to both the left-hand side and the right-hand side of the balance sheet. All agree that it is only assets and liabilities that should be marked to market; determination of the market values of entire firms is the business of financial analysis, not financial reporting. Mark-to-market accounting has many ramifications, discussed in detail below, which have differential persuasive power on individual analysts. [AIMR/FAPC92, p. 24]

Knowing What Market Value Is

It is axiomatic that it is better to know what something is worth now than what it was worth at some moment in the past. However, that is easier said than done. Much has been made of the fact that securities firms and mutual funds mark their balance sheets to market daily. The question is asked why banks and other financial institutions cannot do the same. The answer is that it can be done, but with conceptual and practical difficulties that do not exist for security firms and mutual funds. [AIMR/FAPC92, p. 24]

Balance sheets that are marked to market now are done so on a daily basis. They are never out of date, because they are replaced by a new balance sheet every single business day. Other enterprises issue financial statements less frequently, quarterly and annually. Furthermore, it takes some time after the balance sheet date to prepare and disseminate it. By the time the balance sheet reaches the analyst it already is out of date. Historic cost itself is in reality historic market value, the amount of a past transaction engaged in by the firm. Some argue that if we are to be presented with market values that are bound to be historic by the time they arrive, we are better off with older but transaction-based historic cost. [AIMR/FAPC92,

p. 24]

The counter-arguments to that line of reasoning are two in number. First, many historic costs are seriously out of date. They may have little relation to the current market value of assets, whereas the only-slightly-out-of-date balance sheet market values still will have a good amount of relevance. Second, market value data are comparable. If all enterprises mark their balance sheets to market on the same date, they are all "out-of-date" by the same interval. Historic cost data are never comparable on a firm-to-firm basis because the costs were incurred at different dates by different firms, or even within a single firm. [AIMR/FAPC92, p. 24-25]

There is no financial analyst who would not want to know the market value of individual assets and liabilities. However, there are many who believe that those values are essentially unknowable. [AIMR/FAPC92, p. 25]

Applicability Limited by Measurement Problems

When the term "market value" is used, one is inclined to conjure up a mental picture of the busy trading floors of the New York Stock Exchange or the Chicago Board of Trade, frenzied with the activity of bringing together the effects on supply and demand of innumerable well-informed traders. A variety of equity securities, debt instruments, and commodities have their values continually being revised by frequent trades in well-functioning auction markets. Many other assets, including a myriad of financial instruments, do not trade frequently, and when they do trade the amounts exchanged can deviate considerably over short periods of time. Supply and demand for a large number of financial assets is so thin as to defy determining their market values at any moment with a great deal of precision. [AIMR/FAPC92, p. 25]

An alternate approach is to determine the market rate of interest at which to discount a given stream of cash flows expected to emanate from a particular financial instrument or portfolio of similar instruments. This might work with financial instruments that are securities, such as bonds, where the rates at which more popular issues trade could be applied to less frequently traded issues of the same credit quality. However, even there one could infer that the rate on the marketable issue probably would be lower than that of a bond which is harder to liquidate. We also encounter the problem of determining the market rate of interest for financial instruments that do not trade, eg. portfolios of consumer or business loans. How could we assure comparability among a vast number of country banks choosing to measure with the same interest rate, even though they may have different costs of funds and local or regional variations in business conditions and credit risk? [AIMR/FAPC92, p. 25]

Although our experience in the securities industry indicates to us that mark-to-market measures lack a good amount of reliability, one exception is marketable equity securities. As they are defined by Statementf Financial Accounting Standards No. 12, "Accounting for Certain Martable Securities," they have market values that are relatively easily determined by frequent trades in markets of sizable breadt€h and depth. All but one member of AIMR's Accounting Policy Committee agree that those securities should be reported at market value. In fact, the FAPC recommends that market value replace the lower-of-cost-or-market method currently mandated for those securities. The FAPC's view is based also on the unique characteristic of equity securities that they provide no contractually-specified future cash payments5. Therefore, in their case, expected or hoped-for changes in market value are much if not all of the reason for investing in them. [Also included in 8(d)] [AIMR/FAPC92,

p. 25-26]

Debt securities present a different situation. Many investors in these securities have little interest in the day-to-day changes in their quoted prices. They hold such securities primarily in anticipation of collecting their future cash proceeds. The vast majority of debt security holders are financial institutions that seek to match streams of cash inflows from investments to their obligations payable in cash outflows. A basic principle of managing a financial intermediary is to minimize interest rate risk by linking financial asset investments to financial instrument liabilities. The process is best characterized as being one step short of hedging. Until methods are available to determine with reliability the market values of all the related financial liabilities we cannot support a unilateral marking to market of the assets alone. [AIMR/FAPC92, p. 26]

We are very aware of the fact that some institutions, in particular certain failed savings associations, have engaged in gains trading ("cherry-picking" to some) in their bond investment portfolio. That leaves a portfolio primarily constituted of bonds whose market price is less than cost; the portfolio is said to be "under water." This objectionable practice would be eliminated by mark-to-market accounting under which gains and losses would be recognized as they occur, rather than as the effect of an exchange. Furthermore, whether investments in bonds are accounted for at cost, at market, or otherwise, the reported amounts of gains and losses should be separated from other revenues and expenses on the income statement so that financial analysts and others can both detect and evaluate them. If that procedure were to be followed, then under current GAAP gains trading should be evident to an astute analyst who looks closely both at the institution's sources of earnings and at its disclosures of the market values of portfolios being carried at cost. We also believe that it is unjust to mandate a costly change in accounting for well-managed institutions to atone for the misconduct of others. [AIMR/FAPC92, p. 26]

How to Implement Mark-to-Market Accounting

What would be the scope of mark-to-market accounting if it should be employed? Will it apply to all assets or only some? Both assets and liabilities? All assets and some liabilities? Will it apply to all industries or only to some? Will it apply differently to different types of companies? These are the several broad questions that at least have to be considered before we plunge into the unknown. [AIMR/FAPC92, p. 26]

We start by considering a recent and current problem: how to value the bond portfolio(s) of financial intermediaries. At the urging of the SEC, the problem was deliberated at length by the Accounting Standards Executive Committee (AcSEC) of the AICPA, which issued several exposure drafts of position papers. When those efforts proved unsuccessful, the problem was passed on to the FASB. Many observers note that marking to market only the bond investment portfolio introduces to reported earnings a volatility that does not really exist because it is in effect canceled by unrecognized changes in counterpart liabilities. However, counterparts cannot be identified that specifically relate to a bond portfolio. Thus, one is led to conclude that mark-to-market could only work if it were applied to all assets and liabilities. In financial institutions, that entails all the measurement difficulties discussed above. [AIMR/FAPC92, p. 26-27]

It also forces consideration of the valuation of core deposits. Theoretically, there is no way in which a liability that must be paid at face amount on demand should have a market different from its nominal amount. But sometimes it can. This has been borne out by prices paid to acquire financial intermediaries. Even more dramatic evidence has come via recent "sales" of core deposits alone. The "sale" involves the acquiring institution accepting core deposit liabilities of a certain stated amount in exchange for receiving assets of a lesser amount. The valuation of core deposits is extremely controversial and it appears unlikely that recognition of their market value would be allowed, either directly or through recognition of a core deposit intangible asset. Even if recognition were permitted, how would the value of core deposits that are not traded be measured? [AIMR/FAPC92, p. 27]

For non-financial enterprises, how should mark-to-market accounting be applied, or should it? If financial services enterprises are required to mark their financial instruments to market, should not all firms that hold or issue financial instruments also be required to record them at market value? For some such enterprises that hold large and stable interests in other enterprises, doing so would introduce a volatility into reported earnings that seems unrelated to the economic accomplishment of the period. However, most assets of such firms are non-financial, either tangible such as inventory and plant, or intangibles of various sorts. Marking these to market would require solutions to different measurement problems, the pursuit of which unfortunately ceased when the FASB issued FAS 896 The concept of measuring the current cost (or some other current market value) of tangible assets is relatively straightforward, but its application may encounter practical difficulties and often produces less-than-precise measurements. Answers with respect to intangible assets are not so obvious and we devote a separate section of this report below to their consideration. [AIMR/FAPC92, p. 27]

Effect of Market Value Changes on Trend Analysis

Many financial analysts oppose mark-to-market accounting because of its potential effects on their analysis of trends. Much current analysis of financial intermediaries focuses on changes in balance sheet items stated at historic cost. Trend analysis, in particular, requires comparable numbers period by period. Historic costs allow analysts to assess changes in a financial intermediary's financial position without having first to remove the confounding effects on that position of exogenous economic events. For example, analytic disaggregation of a loan portfolio by geographic area, purpose of loan (commercial real estate, consumer credit, etc.), and otherwise is essential to understanding the risks and exposures of a financial institution. Many analysts seek data that reveal the changes in the intermediary's portfolio resulting from transactions, excluding the effect of changes imposed by the market. In addition, they wish to compare historic yields on investments in securities and other financial instruments with the institution's overall and regional cost of funds. Those analysts feel that important data would be irretrievably lost if historic costs were supplanted in the financial statements themselves by mark-to-market accounting. [AIMR/FAPC92, p. 27-28]

Effect of Market Value Changes on Income

No matter how well mark-to-market accounting could be implemented and applied judiciously to matched assets and liabilities, it still would increase significantly the volatility of reported earnings. Some argue that the volatility exists and that a primary benefit of mark-to-market accounting is that real volatility would be revealed. Even if we concede that point, the question becomes one of how business enterprises and the capital markets are to deal with it. [Also included in 5(a)] [AIMR/FAPC92, p. 28]

As financial reporting is practiced today, financial managers have much discretion over the recognition of changes in value by astute timing of exchange transactions and by the adoption of artful allocation procedures. Mark-to-market accounting would take away much of that discretion. Even where the relative influence of market value changes is small overall, at the margin it has the propensity to make earnings exceedingly unpredictable, a disconcerting fact for enterprises trying to minimize their capital costs by reporting smooth and growing earnings. [Also included in 5(a)] [AIMR/FAPC92, p. 28]

Some analysts are quite willing to accept the increases in reported income volatility that would be produced under mark-to-market accounting. Many of them even would welcome it. They feel that the effects on a particular enterprise of general economic conditions and financial market movements are relevant and to some degree vital to their assessments of its economic status and progress over time. They may not yet be ready to do away with historic cost entirely, but they look forward to the opportunity of integrating FAS 107 data into their evaluations and forecasts as soon as they become generally available. [Also included in 5(a)] [AIMR/FAPC92, p. 28]

One method for dealing with changing market values and their effect on income would be for the FASB to generate accounting standards that put into practice the concept of comprehensive income that appears in Concepts Statement No. 6. As defined in Paragraphs 73-77 of that statement, comprehensive income would encompass all changes in owners' equity exclusive of transactions with owners themselves. It would also be disaggregated into a variety of basic components and intermediate components. Thus the effect of exogenous events such as market value changes would be separated from the effect of endogenous productive activities. If market value changes were reported separately and clearly, their effect isolated, then their unpredictability would assume a lesser importance as it was assessed separately from productive activities. [Also included in 5(a)] [AIMR/FAPC92, p. 28]

Prognosis for Mark-to-Market Accounting

A few financial analysts and investment managers are unequivocally opposed to and a few unalterably in favor of mark-to-market accounting. But most have adopted a wait-and-see attitude. It is difficult to forsake historic cost when it is uncertain that its replacement will accomplish what its advocates promise. FAS 107, which takes effect for fiscal periods ending after December 15, 1992, requires disclosure of the market value of all financial instrument assets but only some of the related liabilities. We anticipate that many of the problems set forth in the preceding discussion will be encountered in its application. We welcome the opportunity to deal with them in a realistic setting without having to make a total commitment and changeover to mark-to-market accounting. We also expect that at least some of the experience gained from applying FAS 107 to financial instruments may be transferable later to nonfinancial assets and liabilities. [AIMR/FAPC92, p. 28-29]

Finally, we note that mark-to-market accounting is intended to apply to individual assets and/or liabilities, either singly or in portfolios of homogeneous components. Despite our overall opposition to its imminent adoption, we consider it to be appropriately within the domain of the accounting function. On the other hand, when it comes to the valuation of business enterprises, either singly, in groups, or by components, we rightfully regard that as the province of financial analysis and a matter beyond the scope of financial reporting. [Also included in 1(c)] [AIMR/FAPC92, p. 29]

[Context] The AIMR report's introduction to the section entitled "Summary of Important Positions and Guide to Future Actions" begins and ends as follows:

Much of this report relates to the present state of the art and implications for future developments in financial reporting. Righfully, so do most of the positions stated in this section . . . [T]hey all build on positions taken by AIMR in the past . . . [Also included in 1(b), 1(d), 3(d), 5(a), 8(c), 11(a), 12, 18(a), 18(c) and 18(d)] [AIMR/FAPC92, p. 59]

We expect the positions set forth below to build on the precedents of the past. That does not prevent them from breaking new ground, but they do not introduce significant inconsistencies with previous AIMR positions. To the extent that they do establish new stances those are largely the result of the changing world that we describe earlier in this report. [Also included in 1(b), 1(d), 3(d), 5(a), 8(c), 11(a), 12, 18(a), 18(c) and 18(d)] [AIMR/FAPC92, p. 60]

Those two paragraphs introduce the following summary of a position taken by the Committee.

The Role of Current Values in Financial Reports

A great controversy has arisen recently over "mark-to-market" accounting. Feelings are strong both in favor of it and against it with a spectrum of opinion in between. Financial analysts also have diverse views, even though they are not as extreme as others may be. No financial analyst is opposed to the disclosure of current values, in fact most would welcome it. On the other hand, no analyst is at this time prepared to abandon totally the historic-cost-based but eclectic system of valuation used in accounting today. In fact, most financial analysts are going to require much persuasion before they will be willing to accept expansion of the role of current value in financial statements themselves. [Also included in 1(d)] [AIMR/FAPC92, p. 61]

Much of the unwillingness of financial analysts to accept immediately a greater use of market values in financial statements stems from a perceived need for utmost reliability in the numbers provided to them. They feel that even though historic costs are subject to certain manipulation, the situation could be worse with respect to numbers that are not verifiable by reference to a transaction in which the enterprise participated. Some analysts are concerned also about partial measures. They feel, for example, that marking the securities portfolio and (perhaps) other assets of a bank to market is misleading if that institution's liabilities are not revalued also. Their concern is the one expressed in the preceding section, that the financial report on the business will not reflect the manner in which it is managed. [Also included in 1(d)] [AIMR/FAPC92, p. 61-62]

The process of learning to understand and use new and unfamiliar financial information is longer and more arduous than anyone might expect. In FAS 33, we were provided with information that, although imprecise, was a godsend to those financial analysts who understood it and were able to use it in their work. Unfortunately, the FASB's five-year experiment came to an end before more than a modicum of financial analysts were able to take the necessary time from the press of their day-to-day duties to study and grasp the significance of inflation-adjusted data. That experience also was undermined by the incessant claims of individual business enterprises that the disclosures required by FAS 33 were worthless, and by the rapid decline in the rate of inflation during that five-year period. [Also included in 1(d)] [AIMR/FAPC92, p. 62]

Our position is that we would like current value reporting to be given a chance. We need to be able to assess the extent to which volatility really exists even though the financial statements themselves may, as a political matter, need to be shielded from it. As long as current values are not seen, financial analysts cannot use them. However, the vehicle of disclosure should be used so as to offer financial analysts the opportunity to use current values. They should not be coerced into it by a sudden and unilateral removal from financial statements of the historic costs and other amounts which are familiar and useful to so many financial analysts. [Also included in 1(d)] [AIMR/FAPC92, p. 62]

__________

[Context] Meeting of the Investor Discussion Group on December 9, 1992. Part of the meeting was devoted to the topic of measurement uncertainties. During the discussion, one investor made reference to value information.

Participant I-9

I don't think you can ask the companies to do this. This prejudices their negotiating of settlement of claims. A company can't put a number in there that they would be happy to settle for without costing the shareholders value over time because that's a blank check. The two areas in which I find information would be most helpful on are real estate (fair value that could be realized in an orderly liquidation over time) and the health care benefits assumptions. On the latter, companies like [names deleted] are not using numbers that are relevant to past history because if they did they would be insolvent. We want the accounting profession to at least put us on notice that the inflation rate in health care that they're using doesn't bear any relationship to what's going on over the last 20 years. We can't do that ourselves. [Also included in 9] [TI 12/9, p. 65-66]

[Context] Meeting of the Investor Discussion Group on January 13, 1993. Part of the meeting was devoted to the topic of value information.

Committee/Staff/Observer

Although not plentiful, the Special Committee has located several sources that discuss users' interest in fair value information. Based on the materials that we have reviewed to date, we understand that investors are interested in fair value information if it is provided in addition to the historical-cost-based-measurements currently used in financial statements, but not in lieu of that information. [TI 1/13, p. 2]

Our question is: Do you agree with our understanding? If so, why do you want information based on both kinds of measurements? That is, what does one kind of measurement tell you that the other kind does not? [TI 1/13, p. 2]

Participant I-12

I cover financial companies and this is a very important issue. I think the current market value disclosures for publicly traded instruments makes perfect sense to me and I'm happy with the current disclosures. But if you're going to a full market value accounting model, you're in essence looking at liquidation value accounting and that is in conflict with the going concern principle. So I don't really find much value-added with the direction that accounting is moving on this issue; in fact, I think it could provide disinformation. Another troubling issue is where do you make the adjustment between cost and fair value; in the income statement (introducing a lot of volatility in earnings) or in equity (running the risk that a company might be closed down simply because of the mark-to-market)? In some circumstances, the latter scenario might be appropriate, but we all lived over the past 10-15 years through instances where that might not be appropriate. [TI 1/13, p. 2]

Participant I-15

I agree with [participant I-12] on many things, but if you look, for example, at the bankruptcy of [names deleted], if the assets had been marked to market, you would have realized that the company wasn't a going concern, because the assets were obsolete and vastly overstated on the books. I follow the airline industry, and you haven't had a transaction on a used piece of equipment in three years; it's an example of where fair value for assets would be very helpful and it should be disclosed. [TI 1/13, p. 3]

Participant I-7

In terms of manufacturing companies, I find fair value for the most part of relatively limited interest. However, to the extent that some of my companies have moved off to the financial service arena, and the ground rules have been changed on those businesses, then I absolutely would want to have fair value information in at least a notational form for financial assets. [TI 1/13, p. 3]

Committee/Staff/Observer

[Participant I-12] for question 1(a), please try to get the volatility aspect out of the equation; we will get to that. [TI 1/13, p. 3]

Participant I-11

I'm not sure you can get away from that because I think it addresses a broader issue. I think, when talking about fair value, you have to distinguish between financial assets and nonfinancial assets, particularly between highly-liquid, publicly-traded assets, and others. On the sell-side, we have been living in a mark-to-market world all our life, so that's no strange animal to us. But I don't think it makes a lot of sense for nonfinancial assets because who determines the market? What is fair value? As anybody who has been involved with appraisals or merger negotiations knows, there can be wide honest differences of opinions about what constitutes fair value. [TI 1/13, p. 3]

As I said, there is a broader issue here. I use historical financial statements as one of the benchmarks that is helpful to me in making forecasts of future performance. What I need is to be confident that the benchmark I'm using stays the same, and I think that historical financial statements provide that sort of stable reference point. I'm not sure that it is the accountant's job to determine that [name deleted's] assets were worth less than historical cost; I think that's the analyst's job. What I get from the historical statements is a determination of how management allocated assets and the subsequent outcome of those decisions; I think that gives me some guidance on the future. But if every time I open a set of financial statements of a company and it's different than the one I looked at the previous quarter or previous year, I'm at sea. So let's get away from arbitrary adjustments to financial statements to solve some imputed or imagined or perhaps real abuse we think we see, because it's probably going to create new ones. [Also included in 1(c)] [TI 1/13, p. 3-4]

Committee/Staff/Observer

With respect to fair value, would you feel the same way if we were in an inflationary environment? [TI 1/13, p. 4]

Participant I-11

Yes. I may make inflation adjustments myself in my analytical work, but I'll do it based on my assessment. If I'm just presented with management's assessment of what it is, how do I know that I agree with that? [TI 1/13, p. 4]

Participant I-7

One of the beauties of our business is recognizing dramatic structural change. For example, just on the tax, we had to deal with going from APB 11 to FASB 109. To the extent that we have to live with change that is outside of our control, for example the changes that occurred in the financial services industry over the past 3 years, there is no way for me to get any idea of what the situation is for a company without getting fair value disclosure of its financial assets (for example for its HLTs). [TI 1/13, p. 4]

Committee/Staff/Observer

So you say "make the attempt to provide fair value"? [TI 1/13, p. 4]

Participant I-7

Yes, in notes. [TI 1/13, p. 4]

Participant I-8

I concern myself with real assets, not financial assets. Are you talking about having changes in fair value from year to year affect the income statement? [TI 1/13, p. 5]

Committee/Staff/Observer

We don't know yet. [TI 1/13, p. 5]

Participant I-8

I have a strong opinion on that. If you let that affect the income statement, I think it's wrong. There is just too much fluctuation. [TI 1/13, p. 5]

Committee/Staff/Observer

I would be interested in either [participant I-11] or [participant I-7]'s definition of financial assets. How do assets held for sale fall into the notion of financial assets that might be treated differently or the same as assets that are part of the normal operations? [TI 1/13, p. 5]

Participant I-7

Going back to the financial institutions, in the 50s, 60s, and 70s, we went through periods of volatility in terms of the real estate or the corporate finance marketplace. If there was volatility on the downside, the asset was put on the book at original cost; it was just set aside. My sense today is that there are much more requirements because of external demands for more marking-to-market. For example, [name deleted] had $5 billion of write-offs inside of two years over three different time periods. After the second write-off, you normally assume that there is a third one coming; but the first was a shock, the second was a surprise. [TI 1/13, p. 5]

Committee/Staff/Observer

I'd like to follow up on a point made by [participant I-12]. I'd like to ask other members if you all think that fair value equates liquidation value. The reason I'm asking this is because fair value is defined a number of times in the accounting literature and it's always defined as some kind of value other than a liquidation value. For example, one acceptable way of estimating fair value for loans of a financial institution would be to take loans made last year at 9% and discount them using an 8% discount rate which corresponds to the current rate at which you would make that loan today. Would that still be a liquidation value? [TI 1/13, p. 6]

Participant I-12

Yes, because the underlying implication is that you could sell that loan at a rate that would equal the 8% return. [TI 1/13, p. 6]

Participant I-10

You're suggesting that the underlying creditworthiness has not changed. [TI 1/13, p. 6]

Committee/Staff/Observer

In my example, that hasn't changed. If it had changed, you would have to change your rate. [TI 1/13, p. 6]

Participant I-12

A critical point that [participant I-11] made is the reliability of the statements and whose judgment is applied to the statements, and what are the premises behind the statements. For example, in the real estate debacle of the last 5 years, an appraiser would go to a property in Massachusetts and would assign a certain value to the property. For my analytical purposes, I was looking at what is the ultimate write-off on bad real estate loans. I was taking the real estate loan portfolio and marking them down 30% for my own purposes. Now, do I want an appraiser coming every quarter and make that markdown? So I think there is an issue of whose judgment is being applied and the consistency of that judgment. It's an issue of reliability and of uneven application of principles. [TI 1/13, p. 6]

Also, how do you determine fair value for an instrument where there isn't even a market? I've securities people tell me they mark to market every day; why didn't [name deleted] mark down some of their loans long before they had to take big hits, if indeed they were marking to market? [TI 1/13, p. 7]

Participant I-14

Covering a broad range of industries over a long period of time, I would agree with [participant I-11] more than anyone I heard around here. I think you need a sense of stability somewhere. I think notational comments about fair value would be helpful but it can't eliminate the analyst's judgment. Fair value changes often enough. One of my favorites is lease accounting; I started when leases were a liability, and in the 1980s I was told they were assets, now they seem to be liabilities. Comments by management in footnotes would be helpful. [Also included in 8(c)] [TI 1/13, p. 7]

Participant I-8

My comments are based only on real assets. I've never analyzed financial companies, only companies that are in the manufacturing sector. Does it matter that a factory is worth half what it was 5 years ago in terms of its contribution to the manufacturing process? I don't think it's material. I would not want to see changes in fair value injected in the income statement. [TI 1/13, p. 7]

Participant I-12

Another example. If you're a bank, assume you make a loan to the local grocery store on December 31, 1991 at prime + 2 points. The grocery store keeps paying the loan back but suddenly the loan would be reflected at a different fair value because of a change in market interest rates. The economic value of that loan is unchanged because it's going to vary with the level of interest rate. But I can see cases where the balance sheet value of that loan might be changed because there is no market for that type of loan. [TI 1/13, p. 7]

Participant I-8

Can I ask a question? Let's say I own a million acres of land in Florida, I sell one acre for $100,000; can I take that transaction and say that's the value for a million acres? Or how else do I decide what the million acres is worth? Somebody's subjective judgment will be involved and you're are not going to come up with a number that even three people around this table would agree with. [TI 1/13, p. 8]

Committee/Staff/Observer

That suggests to me that your real concern is whether you can get believable information. What would you say if you had a million dollars of U.S. Treasury Notes? [TI 1/13, p. 8]

Participant I-8

I'll accept that there is a market value for that type of asset where there is an active market. I would accept marking that asset to market. [TI 1/13, p. 8]

Participant I-12

What if you had a million dollars in a private placement that has different pricing clauses in different environments and where there is no public market for it? [TI 1/13, p. 8]

Committee/Staff/Observer

I would ask you: if you could only have one number in the balance sheet for U.S. Treasury bonds, which one would you want in the balance sheet? [TI 1/13, p. 8]

Participant I-12

I'd go for the historical cost because I can always make the adjustment for any interest rate environment. I can pick the Wall Street Journal and look at the average balance sheet and the yield on those notes and then also adjust the liabilities. [TI 1/13, p. 9]

Committee/Staff/Observer

Then, what does the million dollars of Treasury bonds in the balance sheet tell you? [TI 1/13, p. 9]

Participant I-12

It tells me there is an asset of $1 million that's earning an average rate of 10% and the company is generating that dollar amount of interest revenue. Because I'm looking at the interest revenue and the interest expense. There's an awful lot of judgment that goes into estimating fair value; I'd rather use my judgment and apply it consistently. [TI 1/13, p. 9]

Committee/Staff/Observer

[Participant I-12] if one of the companies that you follow had two lines of business and it made a decision to get out of the retail side of the business and it was anticipated that the sale of that business was significantly higher than the book value of those assets and liabilities, would you still opt for historical-cost-basis financial statements in connection with those assets and liabilities or for an estimated fair value for the business? [TI 1/13, p. 9]

Participant I-12

I believe we have an accounting principle that companies use for discontinued operations. [TI 1/13, p. 9]

Committee/Staff/Observer

But they don't anticipate the gains. [TI 1/13, p. 9]

Participant I-12

I can tell you a number of instances where a sale of a business has taken place at a third of the price the company said it would sell it for. [TI 1/13, p. 9]

Committee/Staff/Observer

So again your concern is reliability. [TI 1/13, p. 10]

Participant I-12

An issue you have brought up that has gotten a lot of attention is this notion of "held for sale". There is a fundamental operating principle in the world of banking or any lending operation. That is, there are times when there's a lot of investments you want to buy or a lot of loans you want to make. There are also times when nobody wants to borrow. Historically, in the world of banking, treasury securities have been used as a liquidity reserve. In some cases, they will hold those for long periods of time, in other cases they won't because they don't know when the economic environment is going to change. It seems to me that the emphasis on held for sale might be somewhat misplaced. [TI 1/13, p. 10]

Committee/Staff/Observer

Let me give you a second part of question 1. Right now, in the accounting standards, fair value information creeps into the financial statements. A basic example is when companies report investment in marketable equity securities at market value when that value is below cost. In some cases, even though some items may be measured at historical cost, companies disclose fair value in the notes. For example, FASB 107 on fair value of financial instruments. Another example is under the old FASB 33 with inflation accounting. Our question is; despite seemingly negative opinions about fair value accounting, do you use fair value information in your work? If so, when and how? Some examples would be helpful. [TI 1/13, p. 10]

Participant I-12

The primary fair value item that financial analysts look at is cost vs market in the investment portfolio. I look at that periodically to see if a company has gains or losses, and then I look at what cash flows those assets are generating. I don't use it very much. I typically will look at a company and make adjustments depending on the environment. For that, I use average balance sheets; that's what is useful to me. Fair value disclosure is really not of that much use. [Also included in 1(b)] [TI 1/13, p. 10]

Participant I-8

The problem I have is you want to address the question of fair value across all types of companies and types of operations, and I think you're not going to get anywhere with that. [TI 1/13, p. 11]

Committee/Staff/Observer

That's the next question. This question is how do you use fair value information that is available now? Or if you had more, how would you use it? For example, if you're looking at a company that paid $4 an acre for real estate, and you know that they sold one acre for $100,000, would you use that information? [Also included in 1(b)] [TI 1/13, p. 11]

Participant I-8

I would try to in a security analysis sense, not in an accounting sense. [Also included in 1(b)] [TI 1/13, p. 11]

Participant I-7

For most of my manufacturing companies, I'm depending on the accounting profession now to look at what I consider fair value. I'm assuming that the accountants, in conjunction with management, are looking at receivable accounts and at inventory and they're giving me a measurement of fair value to some extent through a reserve account. I may get that information only once a year but I use that information. I can look at that reserve account through a number of years. But my problem is not necessarily in the manufacturing arena, it's in the financial arena. [TI 1/13, p. 11]

Participant I-14

I think we all make the mental adjustment and use fair value a lot more than we're willing to admit. That's part of our job because what we're trying to do is determine earning power, fair value of a whole company, as compared to the price of its paper. How many times do you look at the current price for a semiconductor and you look at a balance sheet and there is $50 million of inventory that you know has just gone down; you make that adjustment. This is ongoing and we do it all the time. I would opt for fair value on a notational basis. [Also included in 1(b)] [TI 1/13, p. 11]

Participant I-8

You are in some sense already using fair value when you accept the depreciation life that the management of the company is giving for the manufacturing assets. [Also included in 1(b)] [TI 1/13, p. 12]

Committee/Staff/Observer

That's an impairment concept. It's the lower of cost or market concept as opposed to fair value. I agree with what [participant I-7] said, that we do make reserves to make sure that the values are at least realizable. But on the upside, taking the example of the semiconductor, we don't, even notationally, talk right now about the increase in value of that inventory. [Also included in 1(b)] [TI 1/13, p. 12]

Participant I-8

But it gets into what is the value added by the enterprise you're looking at and the accounting has to be appropriate to that. If the company is speculating in semiconductors and doesn't do anything else, then fair value is appropriate. If I'm converting raw silicone, and there are big margins because of value added, should the accounting be the same as the guy whose not adding any value? [TI 1/13, p. 12]

Committee/Staff/Observer

Our accounting model today is a mixed attribute model. It's not purely historical cost; in some circumstances, we do make value adjustments in financial statements. Based on what you've said, one might argue that we should change that and go to a purely historical cost system, and eliminate any value adjustment that we have today and reflect those in the footnotes. Is that a logical conclusion? [TI 1/13, p. 12]

Participant I-12

I could go for that. I thought depreciation represented a decline in economic value because of the wearing out of the assets. I don't know if that's the same as the fair market value that we're talking about here. [TI 1/13, p. 12]

Committee/Staff/Observer

Let's go back to the example that [participant I-14] gave of the inventory. Under present accounting rules, if market value is lower than cost, the company would write the inventory down and report that in the financial statements. Alternatively, we could propose that it continues to report the cost and explain by footnote that the cost is in excess of market value at that date. That would be a pure cost system; you would know that every number on the balance sheet is cost and only cost. [TI 1/13, p. 12-13]

Participant I-12

I would be happy with that. [TI 1/13, p. 13]

Participant I-5

We are using fair value accounting on the down side but not on the upside. And all of us would agree that we should mark to market as quickly as possible on the downside. The logical extension is that if you mark to market every asset, then presumably it should represent the value of the business. Therefore, if we just mark the equity on the balance sheet to market, which is the stock price, we're done. We just divide up the total equity value between the company's assets. [TI 1/13, p. 13]

Committee/Staff/Observer

It won't add up. [TI 1/13, p. 13]

Participant I-5

Then there are some assets that you're not ascribing a value to. [TI 1/13, p. 13]

Committee/Staff/Observer

Goodwill. [TI 1/13, p. 13]

Participant I-5

Put it on there. [TI 1/13, p. 13]

Committee/Staff/Observer

At one extreme, we could propose a model whereby each item in the financial statements is measured at some type of value. At the other extreme, we could propose a model whereby each item is measured at cost. Or we could adopt some kind of hybrid method where items would be measured at cost whenever value information is not important, and at value when value is most relevant to your work, depending on certain conditions. This conditional approach is the subject of the next part of the discussion. The first part of our question is: under what circumstances would you prefer to have fair value information recorded in the financial statements? That is, where fair value becomes the primary measurement basis. [TI 1/13, p. 13-14]

Participant I-7

When it happens today, that is, when the transaction takes place. In that case, I get fair value. So I don't have to ask you to do anything for me, from a manufacturing point of view. [TI 1/13, p. 14]

Participant I-8

I don't think fair value has any place in the financial statements where the value added is not related to the assets that are there. [TI 1/13, p. 14]

Committee/Staff/Observer

In the manufacturing arena, if a company you follow has some nonoperating assets, would your preference be historical cost or fair value for those? [TI 1/13, p. 14]

Participant I-8

I can accept fair value there, and in fact, you usually get that when a company discontinues an operation; it attempts to put a fair value on that discontinued operation. You should go back and see how close those numbers are to the price that they actually realize subsequently when they dispose of the operation; my guess is that it's not very close (not even plus or minus 10%). [TI 1/13, p. 14]

Participant I-11

What we're really talking about here is a continuum of assets. A T-Bill is easy because that's like a dollar bill. 100,000 shares of IBM is pretty easy. 100,000 shares of some of the stock I follow is less easy and so on down on the continuum. My position is that the starting point for the financial statements ought to be historical cost. And there ought to be some very persuasive reasons to do anything but that historical cost. I think you can make a strong argument for marking to market on marketable securities. I think you can make a weaker argument on securities that don't have public markets. And as you go down the continuum, the argument gets weaker and weaker. But the more I think about it, I think that we should really double check and triple check before we get away from historical cost. That's the benchmark. It seems to me that the role of the accounting profession is to take the books of the company and presents them to users in some understandable form. The role of the financial analyst is to take those statements and manipulate them for some purpose; equity analysis, credit analysis, or whatever it may be. I think we have a tendency to want to ask the accounting profession to do our job. My last comment is that I don't have any problem with that time-honored principle of recognizing losses and deferring gains. [TI 1/13, p. 14-15]

Committee/Staff/Observer

I don't think we should think about this subject in terms of impinging on the analyst's job. If what you do with the historical cost financial statements is an automatic adjustment to make them better, shouldn't we do the something better first, if it's so obvious? [TI 1/13, p. 15]

Participant I-12A key underlying accounting assumption is that a company has an economic value or purpose. It seems to me that historical cost adjusted for economic events that affect a company is a valid approach. In some respects, if you adopt a market value accounting approach, you're impinging on the analyst's job because people have different opinions and judgment about the fair value of assets. [TI 1/13, p. 15]

Participant I-5

One place fair value is used now is for liquidating banks; that should remain. Although different people have different opinions about the right number for fair value, even if you're off by 10%, it's better than the variations you get when you look at old historical costs. I don't know how much sense the time-honored tradition of recognizing losses and deferring gains make. [TI 1/13, p. 15]

Participant I-11

The one time you really know what the fair value is when the transaction occurs. That's why I say let's stay with the historical cost because we have a transactional model. [TI 1/13, p. 16]

Participant I-7

Is there a concern on the part of the accounting profession that if market value is disclosed in footnotes, that if the information turns out subsequently not to be correct, that it could be used against the people who make the fair value adjustments? [Also included in 18(b)] [TI 1/13, p. 16]

Committee/Staff/Observer

That's the second part of the question, which deals with fair values being disclosed rather than being recognized in the financial statements. In that case, let's not talk about the liability issue. [TI 1/13, p. 16]

Participant I-7

I want historical cost information in the financial statements, and notational disclosure of fair values. [TI 1/13, p. 16]

Committee/Staff/Observer

[Participant I-12] said that part of determining fair value depends on what your expectations are as to how you are ultimately going to realize the asset or settle a liability. Even if you want to adjust the information you receive, why wouldn't you want to know what management's expectations are with respect to fair value? [Also included in 2(b)] [TI 1/13, p. 16-17]

Participant I-12

Management lies all the time. [Also included in 2(b)] [TI 1/13, p. 17]

Committee/Staff/Observer

So it's a reliability issue? [Also included in 2(b)] [TI 1/, p. 17]

Participant I-12

Yes. [Also included in 2(b)] [TI 1/13, p. 17]Participant I-10Have you ever seen a management who thought that their stock was overvalued? With fair value, you're giving them a platform to induce people to believe that there is an enormous gap between what the market price is and what they believe the business is worth. I think that plenty of room would be given for deception. Not everyone is a professional investor; there are millions of people who believe what th€ey read! It's somewhat dangerous. [Also included in 2(b)] [TI 1/13, p. 17]

Committee/Staff/Observer

Certain fair value information can be influenced by management, but historical cost information is the result of management's decisions. The one number that is not affected by management is market price. So why shouldn't we want to get market price rather than either historical cost or some estimate of fair value? [TI 1/13, p. 17]

Participant I-7

Because market price might not be reflective of future prices, depending on how fast realization will take place. When you can get market price every day at the end of the day, you do it. But what happens if you have assets where there is no market price? [TI 1/13, p. 17]

Committee/Staff/Observer

But there are market prices for a lot of assets that we do not now mark to market, such as automobiles. [TI 1/13, p. 18]

Participant I-15

Going back to management's perceptions. When you look at some of the opportunities that companies take, when they realize a large gain, to do these restructuring charges and write-off assets, it shows you that management is often shortsighted and unreliable. You can't believe what management tells you many times. [Also included in 2(b)] [TI 1/13, p. 18]

Participant I-12

Going back to the question of why don't we just use market value? The market is nothing more than a value at a point in time. All the market is collective judgments as to the fair market value at a point in time. I'm saying that those judgments have a lot of unreliability in them. Is Citicorp really worth $8.50, the price it closed at the end of 1991, or is it worth $21.50? Those differing prices simply reflect the collective decision-making of analysts. I'm not convinced that that's an appropriate benchmark that gives us the kind of reliability and stability that we need to make our own judgments about what the market might do. We're getting into some circular logic here that bothers me a lot. [Also included in 2(b)] [TI 1/13, p. 18]

Committee/Staff/Observer

Is the last transaction price, if readily available in the market, a good surrogate fair value for what might be the next transaction? I think you may get a different answer on a government bond versus a sale of real estate in Houston when there is 50 properties available and there is only one sale. Some people on the regulatory side would say take that one sale and use it as fair value. Others would say you can't do that because it's a distressed value, not a reflection of future value. [TI 1/13, p. 18]

Committee/Staff/Observer

Same example. I'm the accountant for the 51st property, the one who bought at 9 times the current market. He paid the highest price ever paid in Houston for the building. I'm producing the financial statements for that company. You know, I know, everyone at this table knows that financial statement is overstated and wrong. To me, there is got to be a mechanism for marking down that misleading financial statement. [TI 1/13, p. 19]

Participant I-11

I have no problem with doing that notationally. But that is not wrong. The fact is that the client did pay a high price for the building and that's the fact; a transaction occurred. So it's not wrong to say that this is the transaction that occurred. Is it the present value of that property? No, clearly it's not. What is the present value? That's where we get into the subjectivity. We get back to the question of how you determine fair value? A T-Bill is pretty easy, but even for marketable securities you can get into some issues about the extent to which the market price is representative of the obtainable price for the block you're dealing with. [TI 1/13, p. 19]

Participant I-12

Going back to the example of the 51st property in Houston. The question is who is the buyer? Is it Exxon Corporation making the property its headquarters and they intend to occupy it permanently? Or is it O&Y and they're speculating? You get a different result on what is the economic value of the building depending on the identity of the buyer and the purpose of the purchase. [TI 1/13, p. 20]

Participant I-8

In that example, what number are you going to record in the financial statements as the fair value of that 51st property? [TI 1/13, p. 20]

Committee/Staff/Observer

The answer is there is no one number, but it's clearly something less than the excessive price paid. [TI 1/13, p. 20]

Participant I-8

If you put an intelligent estimate of fair value in the financial statements, it will get dignified to an extent greater than it should. Whereas if you have notational presentation and you're able to describe the subjectivity involved, it doesn't get dignified to the same extent. [TI 1/13, p. 20]

Participant I-7

Still on that example, the question is whether it is fair to ask the accounting profession to make an assessment of what the fair value of that property is and will be in the future. [TI 1/13, p. 20]

Committee/Staff/Observer

[Participant I-12], I believe you said that what's important is economic value. Would you describe what you mean by economic value? [TI 1/13, p. 21]

Participant I-12

It has to do with the going concern value. In the manufacturing sector, for example, you have a plant that make widgets. The economic value of that plant is the discounted value of cash flows generated by all the widgets they make. [TI 1/13, p. 21]

Committee/Staff/Observer

What would be the economic value of a long-term bond? [TI 1/13, p. 21]

Participant I-12

Let's look at a financial company whose purpose is to intermediate funds. For example, a bank receives a deposit placed in a 5-year CD (at 5%) and buys a 5-year Treasury note at 7%; the maturities are matched. If interest rates go up, the value of the bond goes down but the value of the deposit goes up, so the two are a wash. [TI 1/13, p. 21]

Committee/Staff/Observer

So, even though the economic value is more important than the cost, you would still say that the cost should be reported in the financial statements? [TI 1/13, p. 21]

Participant I-12

Yes. In the particular example I use, you assume that a decline in the fair value of the asset is offset by the decline in value of the liability, so the two are a wash theoretically. [TI 1/13, p. 21]

Committee/Staff/Observer

Two questions addressed to [participant I-7] in the context of a manufacturing company. You mentioned that even though we may not recognize and measure fair values on the balance sheet, you would still encourage them to be in the footnotes. Was that meant to be directed to financial assets and liabilities only or to operating assets and liabilities as well? [TI 1/13, p. 21]

Participant I-7

I'd like to see operating asset values as well. [TI 1/13, p. 22]

Committee/Staff/Observer

My second question is whether you would agree that fair value measurement is more relevant when an operating asset becomes an asset held for sale? [TI 1/13, p. 22]

Participant I-7

Yes, in that particular situation. Are you putting it under APB 30 rules? [TI 1/13, p. 22]

Committee/Staff/Observer

Yes.

Participant I-8

I thought you already were trying to measure those at realizable values. [TI 1/13, p. 22]

Committee/Staff/Observer

Yes, but that's different from fair value. [TI 1/13, p. 22]

Committee/Staff/Observer

We can couch that question not in terms of assets held for sale, but in terms of nonoperating assets, which might include assets held for sale but also investments of the manufacturing entity. How would you like to see nonoperating assets treated in financial statements? [TI 1/13, p. 22]

Participant I-7

To the extent that management feels that there is a major downside risk, I want it noted. [TI 1/13, p. 22]

Committee/Staff/Observer

Last question on fair value, which deals with the volatility or "noise" issue in reported earnings. First, do you agree that fair values in financial statements would introduce unhelpful noise in reported earnings? Anybody think it will not introduce unhelpful noise? The answer seems to be no. Next question: would your answer to this question differ depending on how the impact of fair value measurements is reported in the income statement? [Also included in 2(b)] [TI 1/13, p. 22-23]

Participant I-7

And reliable? [Also included in 2(b)] [TI 1/13, p. 23]

Committee/Staff/Observer

Take the reliability issue off the table. [Also included in 2(b)] [TI 1/13, p. 23]

Participant I-11

I don't think you can separate those issues. My complaint is this notional fair value is fundamentally an unreliable number. What is the fair value of the [large commercial office building]? [Also included in 2(b)] [TI 1/13, p. 23]

Participant I-8

If I am not mistaken, there is already a distinction made in the income statement in the way in which accounting is done for earnings of foreign companies depending on whether the currency is considered to be stable or the "banana republic" type thing. The accounting profession is saying that in the latter case, the accounting will be done a specific way because the currency fluctuations should stay within a specific band. [Also included in 2(b)] [TI 1/13, p. 23]

Committee/Staff/Observer

There is no interest for running value changes through the income statement. I'm wondering what your reaction is to the accounting in the pension arena when value changes are in effect spread to eliminate volatility. That's kind of a compromise in the market value arena; is that good or bad? [Also included in 2(b) and 9] [TI 1/13, p. 23]

Participant I-7

You're not in the business of putting businesses out of business. In some instances, if you didn't spread, you would really create a problem. [Also included in 2(b)] [TI 1/13, p. 23]

Participant I-8

I think it's good; it reflects the realities of the world and to that extent it's good. The real question is whether the actuarial assumptions are valid or not, not the interim fluctuations in the assets that happen to be held at that moment. [Also included in 2(b) and 9] [TI 1/13, p. 24]

Participant I-12

I have a problem with the actuarial assumptions. We all know of companies that are still using 7-10% accumulation rates. This comes back to the notion of reliability. I don't have a problem in trying to reflect in some manner the cost of employee health care benefits; on the other hand, what happens if we socialize medicine and get deflation? [Also included in 2(b) and 9] [TI 1/13, p. 24]

Participant I-5

The question of reliability is fine and good, but the fact is the present historical book value that is recorded is significantly less reliable than someone's best guess of fair value today in 95% of the cases. For example, Rockfeller center gets an appraisal every year; $1.8 billion 4 years ago, then $1.7 billion, then $1.6 billion. Meanwhile, the bond is trading as if it's worth maybe $700 million. If the company shows it in the balance sheet at historical cost of $600 million and didn't tell you about the $1.8, $1.7, and $1.6 billion, what is the best measure? I think the best guess of what someone says it's worth today is valuable to have relative to what the cost was in 1936. [Also included in 2(b)] [TI 1/13, p. 24]

Committee/Staff/Observer

It seems that what I'm hearing is that historical cost information is important not for the dollar amount that is attached to the cost but for the other information that comes along with it. You know about what the asset is, how it is being used, and its terms. You're not using the dollars that are attached to it, but you want the information so you have the information necessary to you to apply your own judgment as to value. You don't want the fair value information in the financial statements even though it might be more relevant than the historical cost dollars because of concerns about reliability. [TI 1/13, p. 24]

Participant I-7

Therefore, why would we change historical values? [TI 1/13, p. 25]

Committee/Staff/Observer

If you're looking at two companies, one bought a plant in 1992, the other in 1980, so there is a significant difference in costs of acquisition. They both sell the same products to the same customers. How would your analysis be affected, if at all, because the cost structures of the companies would be different? [Also included in 2(c)] [TI 1/13, p. 25]

Participant I-12

Theoretically, on an economic value basis, the two companies selling the same products at the same price ought to be worth the same amount of money. Although there might be some difference in efficiency or deficiency. [Also included in 2(c)] [TI 1/13, p. 25]

Participant I-7

The real market is not going to reflect that; it's looking at the bottom line. [Also included in 2(c)] [TI 1/13, p. 25]

Participant I-5

The financial statements of those two companies are going to look radically different, but you're telling me that they should be valued the same. The only way I'm going to find out that they should be valued the same is to go back and figure out what years the companies bought their plants. I'm going to look at cash flow from operations and required capex to keep you at the same level. It's a much more convoluted process than it would be if the statements were identical. [Also included in 2(c)] [TI 1/13, p. 25]

Participant I-12

If you're looking at cash flow, the only impact that transaction has on the income statement is the depreciation and the interest expense. [Also included in 2(c)] [TI 1/13, p. 25]

Participant I-14

On the manufacturing company, I find it very hard to believe that the building that was put up in 1980 has not had substantial modifications to produce a product that would be sold in 1992 and that would be reflected in the equipment account. Where something like this would be more appropriate is in the retail field where there are always changes. Also, since retailers predominantly lease, the cost of the leases has an enormous impact on the bottom line. So I think that the more realistic question would relate to retailing rather than manufacturing. [Also included in 2(c)] [TI 1/13, p. 25-26]

Committee/Staff/Observer

If you want a last word on fair value accounting, speak up now. [TI 1/13, p. 26]

Participant I-11

Don't do it. [TI 1/13, p. 26]

Participant I-12

Yes, don't do it. [TI 1/13, p. 26]

[Context] Meeting of the Investor Discussion Group on March 17, 1993. Part of the meeting was devoted to the topic of conservatism, volatility, reliability, and neutrality. During the discussion, comments were made on the volatility of value information.

Committee/Staff/ObserverThe last question about volatility is: what problems related to volatility do you have with the information you receive from external financial reporting? The meeting materials on page 11 identified 4 possibilities. [Also included in 2(b)] [TI 3/17, p. 33]

Participant I-12

Fair value accounting. Running changes in the value of a bond portfolio through the income statement is going to make that statement incredibly volatile, and it may be a faked volatility because those quarterly gains or losses may or may not be realized. For example, anybody who sold their stocks November 1, 1987 probably realized substantial losses; anybody who waited 6 months probably made out just fine. So the realization of gains and losses is vastly different from the paper effect. Fair value accounting would just make the volatility of earnings that much worse. [Also included in 2(b)] [TI 3/17, p. 33]

Participant I-16

Does that make it worse or does that just recognize the reality? [Also included in 2(b)] [TI 3/17, p. 33]

Participant I-12

What's reality? [Also included in 2(b)] [TI 3/17, p. 34]

Committee/Staff/Observer

I don't want to get into an argument but I could argue that the November 1 person holding the securities as opposed to the person who sold those securities is not presenting a very correct balance sheet. I'm not talking about how to handle that in the income statement, that's a different issue. [Also included in 2(b)] [TI 3/17, p. 34]

Participant I-12

But in terms of volatility, that would introduce volatility in the income statement that wasn't there before. [Also included in 2(b)] [TI 3/17, p. 34]

Committee/Staff/Observer

Assuming you put the unrealized November 1 loss in the income statement. [Also included in 2(b)] [TI 3/17, p. 34]

[Context] Meeting of the Creditor Discussion Group on December 8, 1992. Part of the meeting was devoted to the topic of creditors' objectives and approaches. During the discussion, comments were made on value information.

Participant C-5

The dilemma that's being expressed is that price and value are the same at any point in time, but price and value are different. I don't believe the markets have actually woken up to that. There is continually this dilemma of trying to chase price and claiming that's value. I think the accounting profession has to be careful because they're following, and they're getting into this same chase. [Also included in 1(a)] [TC 12/8, p. 5-6]

Committee/Staff/Observer

Can you identify some of the accounting that you think is chasing that incorrectly? [Also included in 1(a)] [TC 12/8, p. 6]

Participant C-5

Well, mark to market obviously. [Also included in 1(a)] [TC 12/8, p. 6]

Committee/Staff/Observer

[Participant C-5], are the implications of that the same whether it's a debt instrument or whether it's an equity instrument? [Also included in 1(a)] [TC 12/8, p. 6]

Participant C-5

Yes. We see this particularly in real estate, more so right now than even in commercial credit. I think some sanity has returned to the commercial markets, but right now we are claiming that real estate value is in fact real estate price, and we are particularly troubled because we can see a tremendous disequilibrium. Risk of decline has been removed from that market, the discounts required in that market are still substantial. We basically are selling properties at 12 times cash on cash, or 12% cap rates, or eight times cash on cash yields with a relatively locked in income stream. We can see the disequilibrium, and we just don't know when the balance will come back, but that's the whole game of investing debt or equity. [Also included in 1(a)] [TC 12/8, p. 6]

Committee/Staff/Observer

I would have thought the significance of that might vary whether you're talking about real estate, whether you're talking about an equity instrument, or whether you're talking about a debt instrument, depending on where it sits in a liquidation priority. [Also included in 1(a)] [TC 12/8, p. 6]

Participant C-5

Well, that's true. As you come closer to the question of customer viability, then liquidation and price risk becomes particularly relevant. But as you move away from that, it becomes less relevant. The lower you get on the debt structure, the more you look like equity, and so the closer you are, the more it becomes important. [Also included in 1(a)] [TC 12/8, p. 7]

__________

Participant C-11

I'd also say . . . that there is something missing, which is more balance sheet related items. I happen to be more emphasizing in my own work on analysis of financial intermediaries, and an extremely important thing that you analyze is the trend of various loans or investments or deposits, or whatever the items may be. This seems to be missing from all of the elements here. Your trend analysis of various balance sheet items is just as important as the trend analysis of revenues or costs. The emphasis on balance sheet items also gets me into a discussion of mark to market in the sense that if you mark to market your financial statements, number one, you lose all those trends, but also you are departing from cash in the sense that your loans and investments after all do end up getting paid at a stated amount at some maturity date. And so for several reasons I think that the accrual and cash accounting tables and analysis are both important, and then secondly I think the balance sheet has to be brought into a lot more focus on these bullets. [Also included in 1(a) and 1(c)] [TC 12/8, p. 9]

__________

Participant C-6

Just to pick up a little bit on what [participant C-9] said, but from a different point of view, looking at, again, privately-held companies, which is what we deal with. We look at granting credit in a very traditional way, looking at historical information. We don't place a lot of faith on projections, and we look at a very traditional aspect of cash flow: profitability. As far as asset value, we place a fair amount of emphasis on asset value, meaning the primary assets of the companies that we deal with (accounts receivable and inventory) and knowing what those assets comprise of, and what the quality of those assets are, which is of utmost importance to us. [Also included in 1(a) and 1(b)] [TC 12/8, p. 11-12]

__________

Participant C-3

When you look at a large financial institution, the biggest question that pops up is whether the accounting model that we're using is right. That focuses on the mark-to-market issue. The investment portfolio discussions that have gone on is really just the tip of the iceberg. In looking at some of the companies that I look at, segments become the secondary issue; how you determine earnings is the number one issue, or what are the earnings of a company. [Also included in 5(a) and 15] [TC 12/8, p. 28-29]

[Context] Meeting of the Creditor Discussion Group on February 2, 1993. Part of the meeting was devoted to the topic of value information.

Committee/Staff/Observer

I would like to address the first set of topics which has to do with fair values and market values at the beginning of page 4 of your meeting materials. Looking at the bottom of page 4 [of the meeting materials], I'd like to call your attention to make sure we're focusing on the same definition. Fair value is the Financial Accounting Standards Board's definition of fair value, which is the amount at which the asset--or you could substitute liability if you wish--could be exchanged in a current transaction between willing parties other than in a forced or liquidation sale. Therefore, where there is a market, market value and fair value are deemed to be the same. As a creditor, do you consider fair values? And if so, do you consider fair value for all assets and liabilities? And if you do, what are the sources, that is, where do you get that information, even if it's only for some selected assets and liabilities and for what purpose do you use that information? [TC 2/2, p. 1]

Participant C-13

I would accept the definition of fair value that you've given as a reasonable definition of fair value. But, from the point of view of the fixed-income investor, there would also be a consideration of what the value could be in a forced liquidation setting. [TC 2/2, p. 1]

Participant C-2

Generally, I think particularly for major assets or selected assets, you would consider a range of values of which liquidation value might be at the bottom and book value is going to be in there somewhere, and also fair value. You compare those values and use them in your analytical work, certainly. But looking at liquidation values is important to me. [TC 2/2, p. 1-2]

Participant C-7

From a banking standpoint, our focus is on that which we've taken for collateral, generally fairly specific tangible assets as opposed to trying to value the intrinsic value of a business. We really don't get concerned with value until we are in liquidation. [Also included in 1(a)] [TC 2/2, p. 2]

Committee/Staff/Observer

Are you saying that ability to recover amounts otherwise uncollectible are where you're coming from? [Also included in 1(a)] [TC 2/2, p. 2]

Participant C-7

Yes. [Also included in 1(a)] [TC 2/2, p. 2]

Participant C-11

Before we talk about valuation of a specific loan or whatever it might be, I think we have to recognize, from the beginning, that we're dealing with a business, the business of financial intermediaries, where 90% or whatever of the assets and liabilities are financial instruments. For a bank or an insurance company, you're using the assets and liabilities to keep track of factors such as the amount of growth in the business and the interest rate sensitivity risk. In other words, you look at whether the assets and liability are reasonably well balanced in terms of what might happen if interest rates go up and down and all that. In my mind, those are reasons why the historical cost model should be retained as opposed to moving to a fair value model. The historical cost framework is very important in knowing what's going on. So there's more to this than just valuation of specific balance sheet items. There's a whole business that we're dealing with, and what are the risks and what are the rewards in that business. And the content of historical cost numbers, to my mind, are critical to that. [TC 2/2, p. 2]

Participant C-2

I wouldn't be advocating use of fair value as recognition in the financial statements. I think it's important additional information that I consider, but I very much support the continued use of historical cost as the model and the framework. [TC 2/2, p. 2]

Participant C-4

We rely on the consistency and comparability of historical cost analysis. I don't think that the information we'll be getting from an auditor on fair market value is information that would not otherwise be available to us. We feel that historical cost consistency is much more important in our analysis than fair market value. [Also included in 2(c)] [TC 2/2, p. 3]

Participant C-15

Maybe it's helpful to view assets in two classes--financial assets and fixed assets. For fixed assets, you're interested in return on assets rather than what do we get in liquidation or an orderly sale. For financial assets, we would tend to look at the difference between the book and market value. [TC 2/2, p. 3]

Participant C-17

One of the difficulties with fair market values is they're so volatile. As additional information, it's helpful, because it gives you a reference point. Knowing what the spread is and getting some sense of fair market versus historical is important. I don't base my decisions solely on it. The thought that comes to me is sometimes, if I'm trying to choose between a secured and unsecured debt, for example, I may want to factor in how much capital support is really there. And I may be swayed to some extent by the reliability of the values that I see. You use fair values with a certain amount of prudence. [Also included in 2(b)] [TC 2/2, p. 3]

Participant C-14

I would agree with [Participant C-15] comment on fixed assets; our approach is that fair market value of fixed assets will be reflected in profitability As an example, McDonald's have enormous undervalued real estate holdings, which provide a creditor with a great deal of comfort of the secured basis. But, in theory those undervalued real estate holdings should show up in the firm's profitability. [TC 2/2, p. 3]

Committee/Staff/Observer

In this group and in discussions with other, we've heard a lot about two sets of market value and fair value information. One of the things that I personally as a committee member have tried to sort through is how all of you use supplemental information versus primary information and which is more important in different circumstances. In what circumstances do you become much more interested in market value information versus historical cost? [TC 2/2, p. 3]

Participant C-17

I get real interested in what assets are worth or what the fair market value is the more I rely on security or also as a way to try to evaluate an extra strategy if the company fails. But in the normal course of business, I'm going to be looking to the ability of the company to pay, I don't want to liquidate the company in order to get repaid. I'm looking at that more as a backstop. I look also at market value to make the decision as to whether or not and what type of collateral I need. [Also included in 1(a)] [TC 2/2, p. 4]

Participant C-4

As the more distressed the situation becomes, we start focusing our attention on the liquidation values, and at that point, we may not necessarily be relying on what a CPA audit tells us. We may actually go to an expert and get some appraisals ourselves, which would be beyond the scope of the normal audit. To have fair market value information included in an audit is not something that is of great benefit to us normally. It's nice to have as an additional disclosure. [Also included in 17(b)] [TC 2/2, p. 4]

Participant C-17

The thing that concerns me is that we start talking about trying to throw into the normal reporting process fair market values. What that generally means is you're going to have a whole lot of adjustments on an annual basis through the income statement, or either directly in equity. That means that I've got to spend more time trying to figure out what's the real cash flow. I've never really liked that, never really felt comfortable when that kind of thing has occurred. I don't want it to interfere with my ability to try to determine that the company is an ongoing enterprise and how well or poorly it's doing. [TC 2/2, p. 4]

Committee/Staff/Observer

[Participant C-4], I thought I heard you say that when the situation gets more distressed, you're looking at the liquidation value. So comparing that to the page 4 definition, simply you bypass that type of fair value, "a willing buyer seller other than forced sale or liquidation basis". Is that not of interest? If we gave you that information, do you do anything with that information or do you want that information? [TC 2/2, p. 4]

Participant C-4

In most cases, liquidation value would probably be less than the fair value notion you use. But we would use this information as an aside, yes. We feel there is some value to it. [TC 2/2, p. 4]

Participant C-17

When you're a lender, you never sell at fair market value. You're basically at an auction, or you're dealing with a "workout specialist" who's basically trying to shepherd the company from bankruptcy. So your notion of fair value is a reference point, but we would never expect to get that value. But it is a good reference point. [TC 2/2, p. 5]

Participant C-4

I think it's easier to determine what the fair value is as opposed to the liquidation value. In that respect, since that information is readily available we prefer to use it. [TC 2/2, p. 5]

Participant C-2

I think the fair value compared to book value becomes useful if you know management intends to sell the assets or is preparing the business for sale. [TC 2/2, p. 5]

Participant C-13

The historical cost model seems to suit our requirements the best. But fair value information, providing you can satisfy yourself as to reliability, is important, particularly if there's a large disparity between fair and book value. The McDonald's example is a good one on one side. The life insurance industry in the 1980's is a good example on the other side, where the much lower market values book indicated some pressures and strains on the industry. [Also included in 2(b)] [TC 2/2, p. 5]

Participant C-14

To answer the question as to whether fair value is useful, I'd say it is in cases of material upgrading of assets or when a possible sale is a potential source of liquidity. [TC 2/2, p. 5]

Participant C-15

The footnote type of disclosure would be more useful to creditors and sophisticated financial analysts rather than having the values on the balance sheet bounce all over the place. For example, a number of years ago when interest rates were high and a lot of banks' government bond portfolios were under water, if you'd marked bank's assets to market you'd basically wiped off their government securities portfolio and their net worth. And a year later, interest rates declined and those asset values increased. [TC 2/2, p. 5]

Committee/Staff/Observer

Something I thought I saw in S & P's green guide said that a company's ability to service its debt is not affected by its market value. [TC 2/2, p. 6]

Participant C-15

I would think it would. Looking at McDonald's again as an example: they have a very high debt to equity ratio because they're carrying their assets at historical cost. We would mark those assets to market. [TC 2/2, p. 6]

Participant C-5

Historical cost may be one reference to what actual value is. Current price is your supposed fair market value in a non-distressed situation. In making decisions, you have to understand the likelihood that market value will return to some reference point. One of the problems with market value is many markets are inefficient--the real estate property market being the most inefficient, just because of the way it's driven by tax incentives and the like. It takes a while for these markets to find equilibrium but we have to understand that underlying all that, there is a real value. As a lender, it is true we don't take into account market value, not just because we don't necessarily believe the approach that's been used, but also because we don't get the detail of all the assumptions that went into the estimates. Without knowing all those assumptions, and you could never give us all those assumptions in a set of disclosures, we would have to go in and make our own set of assumptions and revisit the estimates anyway. Large corporations, particularly, is the one area where we would advance funds without knowing market values. And in secured lending situations, non-investment grade, it really adds no value to us. [Also included in 9] [TC 2/2, p. 6]

Committee/Staff/Observer

[Participant C-5], one of the arguments you hear for fair value is the relevance argument. That is, fair value is always more relevant than historical cost. I think what I heard you say is it may or may not be in your situation. Because of not knowing the assumptions that go into it, and the timeliness of it, that may not be any more relevant than other information you have. [Also included in 2(a)] [TC 2/2, p. 6]

Participant C-5

For example, you could have given me a perfect real estate fair value in 1988. And knowing that the land had flipped three times in the course of the last three years, a good lender would have been smart enough to figure out it wasn't worth $500,000 then $1 million, and then a million and a half. And each time an accountant had good comparable sales, analysis and so forth, it could have given you a number showing significant increases. Realizing that this thing was getting into a disequilibrium, a lender knowing historical costs would have been smarter to focus on that than on fair value. Fair value can be misleading. . . . [T]imeliness is so critical. Even trade receivables. You could give me year-end balances but then I need to know what today's are. We advance on a weekly and a daily basis on trade receivables. [Also included in 2(a)] [TC 2/2, p. 6-7]

Participant C-7

I guess we rely on historical cost because of consistency and the relative objectivity. I think fair value becomes an issue whenever you think that there's a variance; the degree of variance somehow correlates to your interest in fair values. It's when you see a major variance that you become interested. You want to abandon the historical cost concept, and then get into current value. [Also included in 2(b)] [TC 2/2, p. 7]

Participant C-11

I would agree with all of these comments. I think that if we're talking about going concerns, the need for fair value information and its reliability and usefulness, in terms of knowing how well the business is doing, is lot less and definitely that puts it into supplemental status. I think we have a great problem in general as to knowing when a company is in distress, and when we have to take a different accounting approach. So far, all the comments have been focused on revaluing at market values specific types of assets. Nobody's mentioned liabilities. But I think we can't forget that. I want to make a comment that in an increasingly distressed situation, a company doesn't have to, necessarily, sell one particular type of loan or securities or whatever. There is often an option of selling part of its business. And so when you're talking about what is the fair or market value of an entity, it isn't necessarily just individual assets. It can be a business component. And the way you value the component of the company's business is going to be a lot different then. And it may be even more successful a way to take care of a distress situation than just selling its individual loans. I think if you're thinking about market value, you have to think in a more complex way and not just value the specific individual assets and liabilities and think you've done the job. I feel strongly about that. I'd also make just a general comment about supplemental information. I don't ascribe more importance to something because it's in a footnote, as opposed to being in a supplemental schedule of some sort. We have all kinds of supplemental schedules that are required and that's where you can get some of your best data. As a user, I don't have a phobia about needing to have it on the balance sheet or a footnote, per se. [Also included in 2(a), 2(b), and 5(d)] [TC 2/2, p. 7-8]

Committee/Staff/Observer

I would just be curious to know if having audited versus not audited financial statements would make a difference in any of your answers? If you didn't have audited statements, those who would like to see the fair value indicated somewhere, if there was no attestation, does that make a difference? [Also included in 17(a)] [TC 2/2,

p. 8]

Participant C-17

I'm not going to have some guy (management) come and tell me this is what he thinks his business is worth, without any kind of independent verification. [Also included in 17(a)] [TC 2/2, p. 8]

Participant C-13

Wasn't what [participant C-11] was saying run in contrast to that? Because supplementary disclosure are not necessarily verified. [Also included in 17(a)] [TC 2/2, p. 8]

Committee/Staff/Observer

I thought that what I was hearing was that [participant C-11] was saying that they would be benchmarked however to some audited statements somewhere. Did I misunderstand? [Also included in 17(a)] [TC 2/2, p. 8]

Participant C-11

They could be. In the current data framework that we have, there's certain supplemental data that's just as important as anything in the financials. I think that this is an awkward subject to talk about. But I think that many users don't necessarily have enormous confidence in the integrity of the statements that have been reported on over the past decade. I don't think that I would necessarily say that just because it's audited by a huge firm, it would mean that I would take them at face value. [Also included in 17(a)] [TC 2/2, p. 9]

Committee/Staff/Observer

At the bottom of page 4 of the meeting materials, there's a position put on the table that I haven't heard talked about yet. It says that if you used fair value, rather than historical cost, as the measurement basis of financial statements, you might get different measurements of income that might make cuts you don't currently see. The typical example is that inflation will allow companies to look like they're growing because historical cost makes no discrimination about the size of the dollar that's in the balance sheet or the income statement. Where dollar or standard dollar value financial statements or current cost statements or any other varieties that have been proposed over the years would separate out holding (inflation) gains from real gains. So, for example, ABC Company sells 100 widgets every year. And the 5% inflation every year makes it look like the sale of those same 100 widgets is revenue growth. And ABC Company has about the same profit every year. So, from the point of view of what's really happening, ABC Company is really losing against inflation, and perhaps even doing some self liquidating. Is that issue important to you to get an alternative measurement of earnings that somehow makes that cut? And if so, how do we do it, if at all? [Also included in 5(a)] [TC 2/2, p. 9]

Participant C-13

In the example you cite, the very first question you ask management about revenues is what's the price impact; that's the simple answer to that question. [Also included in 5(a)] [TC 2/2, p. 9]

Committee/Staff/Observer

And you're telling me that is part of what you do? [Also included in 5(a)] [TC 2/2,

p. 9]

Participant C-13

Yes. You're identifying the price impact on revenues directly for that particular enterprise as opposed to being on a generalized basis. So you're getting to the heart of the problem as it relates to that specific enterprise rise relative to inflation. [Also included in 5(a)] [TC 2/2, p. 10]

Committee/Staff/Observer

If you start at the top, then, and you say, okay, I now am going to identify the price per unit effects here, do you do any analysis down from there? And, if so, what? [Also included in 5(a)] [TC 2/2, p. 10]

Participant C-13

Let's take a soft drink company such as Coca-Cola. The domestic unit growth is low. But the overseas unit growth continues to be very satisfactory. So, you disaggregate. Then you need to disaggregate the price impacts, domestically and also in major overseas markets. So the next stage is disaggregation of aggregate information. [Also included in 5(a)] [TC 2/2, p. 10]

Participant C-4

In construction, all of the contractors typically lock at prices at the beginning of a contract so the gains that occur are on completion of projects. So this information to us is not that crucial. [Also included in 5(a)] [TC 2/2, p. 10]

Participant C-2

I think we are accustomed to dealing with these issues of how comfortable we can get with this notion of inflation gains through the analytical process. I think we address the issues. We don't necessarily need to have them screened out for us. [Also included in 5(a)] [TC 2/2, p. 10]

Participant C-4

You do run the risk of information overload here, too, at times. You've got to remember that the typical analyst has to get into separating those two elements out. We have some significant borrowers who have been pretty effective in locking in costs by hedging commodity prices or whatever. And that's part of what we would consider operating management. Is that truly manufacturing efficiency that allows you to take that commodity and turn it into a product at a low cost? Or is it your effectiveness of your hedging strategy such that you lock in early commodity prices? We look at it as one big operating process and the quality of management is all a part of that activity. We're pretty good at analyzing numbers but I could get into information overload if you gave me too much. [Also included in 5(a) and 19] [TC 2/2, p. 10-11]

Participant C-2

The point is the cost of determining that in light of that information. And I think for many credit granters we're working with financial statements of small businesses. I think if cost to develop that information becomes more onerous than it presently is, we're going to drive those businesses away from audited financial statements to our detriment. [Also included in 5(a) and 17(a)] [TC 2/2, p. 11]

Participant C-17

As lenders, you tend to know customers. So as these issues come up, because of increasing inflation, half the time they're telling you about it or you're asking about it, and whatever. So I think sometimes you can get to the point where it becomes overload. [Also included in 5(a)] [TC 2/2, p. 11]

Committee/Staff/Observer

One of the things we're thinking about in terms of the future is: are we heading towards the database or are we heading towards more sophisticated analysis of results? And that's part of the puzzle that we're trying to deal with; on the one hand, we'd like to have both sets of information (fair value and historical cost), on the other hand, that's pretty costly. And if you're not going to use it anyway, why should we provide it? [Also included in 16(a)] [TC 2/2, p. 11]

Participant C-17

I think [participant C-2] made a real good point: the small guy, he can't afford it. So you have to balance it. Larger companies tend to be so scrutinized that there are a lot of different sources. It's the little guy who slips in the cracks. And the quality of what you're seeing gets poorer because they simply can't afford it. [TC 2/2, p. 11]

Participant C-5

I'll make this comment about the database thinking. The database is a facility that clearly does allow you to make some cuts in data. [Participant C-11] mentioned earlier about all the footnote disclosures. We don't get those footnotes in databases. And so I would hope that even if they are supplemental or footnote type disclosures, that there's at least enough structure that those can continually be databased in such a way that whether it's unrealized gains, they will be included. So there is value to database. I want to say that there is also this individual analysis. And that's where the world is still going to be at. [Also included in 5(d) and 16(a)] [TC 2/2, p. 11]

[Context] Meeting of the Creditor Discussion Group on February 2, 1993. Part of the meeting was devoted to the topic of alternative accounting procedures. During the discussion on business combinations, comments were made on value information.

Participant C-4

If you went to mark to market accounting [it could possibly solve problems related to business combinations]. [Also included in 8(b)] [TC 2/2, p. 42]

Participant C-11

People are not asking for mark to market accounting now for manufacturing and service companies; only perhaps for financial companies. [Also included in 8(b)] [TC 2/2, p. 42]

[Context] Responses to the postmeeting questionnaire to the February 2, 1993 Creditor Discussion Group meeting.

QUESTION 1

a. At the February 2, 1993 meeting, participants agreed that, as a general rule, they did not support increased use of fair-value-based measurements in the financial statements. Participants offered several reasons for their preferences for current practice and their concerns about recording assets and liabilities at fair values.

Please indicate your agreement or disagreement with each viewpoint below:

SA Strongly Agree

A Agree

N Neutral

D Disagree

SD Strongly Disagree

Current practice, which is largely based on

historical costs, provides a stable

benchmark from one reporting period

to the next, which analysts need to

analyze performance. SA -7 A -7 N D SD

Estimates of fair value for many assets are

not sufficiently reliable because of

thin or nonexistent markets. SA-5 A-7 N-2 D SD

Estimates of fair value for many assets are

not sufficiently reliable because management

could introduce bias into the estimates of values

whenever judgment is required. SA- 5 A-6 N-2 D-1 SD

Participant C-3: Provide disclosures of discount rates.

Fair values would result in unhelpful volatility or "noise"

in the income statement. SA-3 A-8 N-2 D-1 SD

Fair value is not liquidation value. SA-11 A-3 N D SD

Fair values of individual assets and liabilities are not as relevant

as fair values of component businesses when looking at

potential sales to improve liquidity. SA-1 A-7 N-3 D-1 SD-1

Participant C-3: I agree with the statement but the issue is whether fair value is more relevant than historic cost in identifying the impact of potential sales.

Participant C-18: Neither is relevant!

Participant C-2: This depends on size of company.

Fair values in financial statements would be stale by the time

users received the reports containing them. SA-2 A-6 N-4 D-1 SD-1

Participant C-3: Is historical cost any better?

Costs to estimate certain fair values exceed the information

benefits that users would gain. SA-1 A-1 N D SD

Participant C-17: Generally, the information is helpful as one of the many measures of capital support (considered) in the effort to determine the need for collateral (should I lend unsecured?) or additional collateral. However, secured lenders will normally look to the value of their assets and will retain independent appraisals to determine same.

Participant C-13: Mixing fair values and historical cost values in the same set of statements is unhelpful and potentially misleading.

Participant C-3: The arguments the committee has made clearly indicate their desire/preference for "reliability" over "relevance." I'm not sure this is right, particularly in an industry where balance sheets have become so liquid!

Participant C-5: Timeliness, accuracy, implied liquidity, and bias already addressed.

Participant C-4: If we are relying on the fair value of underlying assets to extend credit, we would make our own estimates of the fair value using specialists familiar with the market for a particular asset. CPAs don't need to do their own analysis of fair value, leave it to the experts.

Participant C-7: Potential variation in methodologies.

Participant C-14: Fair value information is only relevant to credit analysis for those assets which can be sold to provide liquidity without changing the nature of the company's operation.

Participant C-11: Some data is better as supplemental disclosure or in the management discussion context.

Participant C-15: Lack of ability to make meaningful comparisons due to different valuation methods. Distinguish between financial assets for which there is a secondary market.

b. Some fair value information is already available in financial statements, either disclosed in notes or recorded on the face of the statements (for example, for marketable debt and equity securities). Do you use that information:

5 _ All the time?

Participant C-2: I do use this information in thinking about a range of values for a specific asset or group of assets. Liquidation value (or estimated) establishes the bottom of the range. Other values I might obtain or ponder are: fair, present (DCF), replacement, etc. I then compare those to book value and make appropriate judgments.

8 _ Occasionally, but not always?

_ Rarely?

_ Never?

[PMQC 2/2, p. 1-3]

__________

QUESTION 2

Some participants mentioned that the usefulness of fair value information varies. Listed below are different circumstances that may or may not affect your views about the usefulness of fair value information. Please mark each circumstance U, N, X as defined below:

U The circumstance tends to render fair value information useful in my work

N The circumstance tends to render fair value information not useful in my work

X The circumstance has no effect on my view about the usefulness of fair value information in my work

Participant C-5: Not comfortable with answer choices U, N, X - confusion may impact answers. N-Alternative sources more current and effective.

Type of Asset or Liability

____U-4,N-6,X-2 Receivables

____U-8,N-1,X-3 Inventories

____U-7,N-0,X-4 Other current assets that are financial instruments

____U-0,N-4,X-6,U/X-1 Other current assets that are not financial instruments

____U-7,N-3,X-2 Property, plant and equipment

Participant C-11: Values uncertain.

____U-4,N-3,X-5 Identified intangible assets

Participant C-11: Not as specific numbers, however, I do think about changes in conditions that could produce impairment.

____U-3,N-2,X-7 Purchased goodwill

Participant C-11: Same as above.

____U-10,N-0,X-2 Other long-term assets that are financial instruments

____U-2,N-4,X-5,U/X-1 Other long-term assets that are not financial instruments

____U-3,N-4,X-5 Short-term liabilities

____U-5,N-4,X-4 Long-term debt

Participant C-17: Public debt as a measure of IPO or refinance.

Participant C-11: The term "long term" is misused when applied to a financial intermediary.

____U-1,N-3,X-7 Other long-term liabilities that are not financial instruments, such as deferred taxes

____U-8,N-0,X-3,U/X-1 Off-balance-sheet items, such as forward purchase contracts

Participant C-17: Any adjusted value suspect.

Participant C-11: When related to balance sheet items valued at market.

____ Some other asset or liability (please identify)

__________________________

Participant C-18: Question is not clear. These are not "circumstances," they are b/s categories. Don't know what you are asking here.

Participant C-4: Construction contract entries u/b or o/b.

Intended Usage of the Assets or Liabilities

____U-11,N-2,X-1 Assets held for sale

Participant C-17: Would look to bids or expression of interest by buyers instead.

____U-10,N-0,X-3,U/X-1 Assets held for investment

____U-3,N-5,X-4 Assets used in the business

____U-2,N-8,X-3 Liabilities that will be held to maturity

____U-7,N-1,X-4 Liabilities that will be settled in the near term, perhaps before maturity

____ Some other type of usage (please identify)

___________________________

Degree of Reliability and Source of Fair Value Information

____U-11,N-0,X-2 Quoted market price from active secondary market

____U-5,N-1,X-5,N/X-1 Quoted market price from thin secondary market

____U-10,N-0,X-2 Quoted market price from dealer

Participant C-17: Only if taken from a statistically significant population.

Participant C-11: Can be good or bad data from all sources - no one is better per se.

____U-9,N-0,X-3 Quoted market price from broker

Participant C-17: (same as above)

Participant C-11: (same as above)

____U-9,N-2,X-2 Independent appraisal only

Participant C-11: Not always reliable.

____U-5,N-3,X-4 Management's estimate only (using pricing models, discounting method, or other valuation techniques)

Participant C-3: If it's being used as a "performance system" to compensate management,

then why isn't it good enough for financial reporting?

____U-1 Some other source of fair values (please identify)

_______________________

Participant C-2: If values seem reasonable and assumptions are appropriate. Analyst estimates using market approximations gained for general knowledge or publications.

Participant C-4: Our internal analysis.

Company Situation

____U-6,N-1,X-5 Company is a going concern

____U-8,N-2,X-3 Company is in a distressed situation

Participant C-17: Values change about every 5 seconds depending on the perceived leverage of the different parties.

Participant C-2: Best-worst case scenarios.

____U-5,N-2,X-6 Company is in bankruptcy

Participant C-17: (same as above)

____U-10,N-0,X-3 Company will liquidate

____X-1 Some other company situation (please identify)

Participant C-11: Data can be useful, but the kind of data must relate to specific circumstances and can vary from firm to firm.

[PMQC 2/2, p. 3-6]

__________

QUESTION 3

Some advocates point out that fair value financial reporting can estimate the impact of changing price on earnings-distinguishing "holding" gains from "real" gains. Participants did not appear in favor of using fair values for this purpose. The following were suggested as reasons why users do not believe fair value reporting is helpful in dealing with changing prices.

Please indicate your agreement or disagreement with each viewpoint below:

SA Strongly Agree

A Agree

N Neutral

D Disagree

SD Strongly Disagree

Users prefer analysis of price-volume trends on revenues

as a basis for evaluating the effects of price changes rather

than changes in fair value. SA A N D SD

4 8 1 1

Users believe the importance of changing prices is dependent

on the industry and individual company; it should not be the

basis for making a universal change in the basis of measurement. SA A N D SD

2 12

Users already feel accustomed to making adjustments in

their analyses for changing prices without changing accounting

rules. SA A N D SD

2 9 2 1

Users are less concerned with the effects of changing prices

on earnings than they are in understanding how companies are

managing finances when changing prices are important

concerns. SA A N D SD

3 8 2 1

[PMQC 2/2, p. 6-7]

[Context] Meeting of the Creditor Discussion Group on March 11, 1993. Part of the meeting was devoted to the topic of conservatism, volatility, reliability, and neutrality. During the discussion, comments were made on value information.

Participant C-1

The way you phrased the question, it's an equity question. Because for me, a lot of the write-offs and reserves that are done are more to justify a bad year; let's dump everything we possibly can into it so that our earnings on a net income basis will improve next year whereas from my standpoint cash flow is more important. So I've got to go back and adjust for these reserves that were set up in 1992 for plant closings that are not going to happen till 1993. The other part is that conservatism relates to this concept of hidden assets on the balance sheet where you've got inventories and receivables that are based on cost and maybe should be also based a little bit more on market. Market value might be lower but, at the same time, the market value of fixed assets also based on cost could be dramatically higher. There's no way to really tell whether assets and/or liabilities have any type of reality to the true market value of the company. [Also included in 2(b)] [TC 3/11, p. 41]

__________

Committee/Staff/Observer

Let me give you an example that was given to me so I can test your feel for conservatism. Real estate market in Europe is apparently weakening. Realistically, perhaps the collateral is salable now at the value of the loans on the books. However, conservatism might tell you that you believe that the trend will be down. So a very conservative approach would be to project what the real estate market will be three years hence and write the loans that are collateralized down to that level now. Is that appropriate use of conservatism? [Also included in 2(b)] [TC 3/11, p. 42]

Participant C-17

No, the move to write the banks' assets down on their performing assets to collateral value would be pretty strenuously objected to. Conservatism may create some real hardships in terms of their ability to lend or their willingness to lend. To just simply do it because it appears to be the most conservative approach is not a good idea. [Also included in 2(b)] [TC 3/11, p. 42-43]

[Context] Meeting of the Creditor Discussion Group on March 11, 1993. Part of the meeting was devoted to the topic of priority of improvements needed i