Implications for analysis

ADS Because of the profound effect that fair value accounting will have on the financial statements, it will influence the manner in which financial statement analysis is conducted. We note some of the important issues that will need consideration when analyzing financial statements prepared under the fair value model:

Focus on the balance sheet
Currently, the income statement is arguably the most important statement for analysis. In particular, equity analysts tend to pay scant attention to the balance sheet. Part of the reason for ignoring the balance sheet is that it is not particularly informative under the historical cost model. This  will change with the advent of fair value accounting. The balance sheet will become an important if not the most important statement for analysis. In contrast, the income statement will lose some of its importance because bottom-line income will merely measure net changes in assets and liabilities. Accordingly, the focus of financial statement analysis will need to shift toward the balance sheet.

Restating income 
Analyzing and restating income will become an even more crucial task for the analyst. The bottom-line income under the fair value accounting model merely measures the net change in the fair values of assets and liabilities. This income measure is conceptually closer to economic income and is therefore less useful for analyzing current period’s profitability or forecasting future earnings. An analyst needs to carefully analyze income to separate the effect of current operations from unrealized gains and losses arising from changes in fair values of assets and liabilities.

Analyzing use of inputs
 As noted earlier, Level 3 inputs are less reliable and more susceptible to manipulation. Therefore, a major task in financial statement analysis when using fair value accounting information is analyzing the levels of inputs that have been used in determining asset and liability values. In particular, it is important to identify and quantify the extent to which Level 3 inputs have been used in determining fair values. The widespread use of Level 3 inputs is an important indicator of the quality or lack thereof of the financial statements. Fortunately, companies are required to provide detailed footnote disclosure regarding the assumptions underlying their fair value estimates, including the type of inputs used. This information will be crucial for evaluating the quality of the financial statement information.

Analyzing financial liabilities
  Fair values of debt securities decline with a decrease in the creditworthiness of the borrower. This creates a counterintuitive situation with respect to the valuation of a business’s financial liabilities (e.g., debt obligations). A decreasein the business’s creditworthiness will result in a decrease in the fair value of the debt obligation. The decrease in fair value of the debt obligation will result in recognizing an unrealized gain, which will artificially inflate income during the period. Therationale for this accounting treatment is that when the entire balance sheet is prepared on a fair value basis, a reduction in fair value of debt is unlikely to occur without a corresponding (and probably greater) decrease in the fair value of assets. Therefore, when taken together there is unlikely to be an artificial increase in equity.

While the explanation is logical, there is still an issue with how this accounting treatment will affect the debt equity ratio. When determining the debt equity ratio, we recommend that the face value of the outstanding debt should be used, rather  than its fair value. This will provide a better indication of the ability of a business to meet its fixed commitments. ADS