Over the past few years one of the dominant hot topics in investment analysis has been fair value accounting. After the credit crisis, there was a call by some to require fair value accounting for financial instruments. While the Financial Accounting Standards Board (FASB) has yet to reach a final decision on the project, it is fair to state that broad fair value accounting will not be a part of the final standards. And it appears that the FASB final standards will diverge from those passed by the International Accounting Standards Board (IASB).
The issue of the appropriateness of fair value accounting exists in many other industries, including the timber industry. U.S. GAAP is predominately based on historical cost. Most assets are recorded at the amount to acquire or produce, less any depreciation, depletion or impairment. This is the accounting model used by U.S. companies for timber. Although the exact models can differ slightly, the cost to acquire timberlands and to reforest timberlands is capitalized. Companies either capitalize or expense costs to maintain the timberlands, such as fertilization and insecticide treatments. Once the timber matures and is sold, the capitalized cost of the timber is expensed as depletion. Financial statement analysis gets a bit complicated for the analyst when the company acquires existing timberlands. The fair value of the acquired timber at acquisition is capitalized, so likely be recorded at a value higher than if it had been planted by the acquiring company. But this is still in line with historical cost. The historical cost of the acquired timber is its fair value. The post-acquisition depletion expense also becomes a mix of expenses related to originated and acquired timber.
The IASB has a fair value model for agricultural assets. IAS 41, Agriculture, requires that at the end of each period biological assets, such as timber, be recorded at fair value less anticipated selling costs, if fair value can be reliability measure. The change in the fair value is recorded in earnings. Upon cutting of the timber, the recorded asset is either expensed (if sold at that time) or transferred to inventory.
So which model is preferable – historical cost or fair value? Looking at the balance sheet, many believe that for long-lived assets such as timber, historical cost quickly becomes stale and meaningless. This leads to a presumption that fair value is more useful when looking at the asset. But fair value also has its thorns. Valuing timber is not an exact science, and the value can fluctuate from period to period due to factors beyond the company’s control. Therefore, the recorded fair value will likely fluctuate for reasons beyond the maturing of the timber. In addition, there is always concern among investors that companies may have prejudices in determining the value of the timber. Some may want to tout the growth in the assets as a sign of the quality of the management of the company. Others may feel a need to be conservative, perhaps to detract attention from the hidden values of the company, to improve balance sheet ratios or possibly to store unrecorded value until the point of harvest.
This highlights one of the problems with the earnings impact of fair value. Gains (and losses) during the growing of the timber will be recognized in earnings, despite that fact that the timber has not been sold and may not be ready to be sold for some time. Such a model does recognize the earnings over the development period of the value of the timber. But again, valuing timber is not an exact science, and may be impacted by the prejudices of management. The historical cost model, on the other hand, does produce income statement results that match the concept of earnings being recognized upon completion of the earnings process. But it delays the recognition of the value created.
This illustrates some of the issues accounting standard setters in evaluating between historical cost and fair value accounting models. Rarely is either model perfect, especially for assets that fluctuate in value and that will be held over multiple accounting periods. Historical cost tends to give stale, low-quality asset values on the balance sheet. While fair value provides more useful balance sheet information, the fair value at a point in time is rarely definitive, and any imperfections will impact recorded earnings.
Such dilemmas can often result in comprise, which can result in information that serves neither balance sheet valuation needs nor a meaningful recording of earnings flows. Besides highlighting the difficulties in standard setting, it also points to the need of investors to voice their views and make their imprint on future accounting standard setting. It is unlikely there will be any near-term change in U.S. GAAP for timber (absent adoption of IFRS in the U.S., either broadly or through company-by-company election.) But the FASB is currently working on finalizing its standards on accounting for financial instruments. Although the official comment periods have closed, the FASB is always open to input from its constituents. The IASB has proposed changes to the accounting for “bearer plants” – biological assets that are productive for more than one period and not intended to be sold itself – moving them to a historical cost model. The IASB is currently redeliberating the decisions in an exposure draft it issued in 2013.