FAS 157 Blows

File the newly enacted FAS 157 under “stupid accounting tricks”. In addition to making investments and representing Foundry Group on the boards of companies we’ve invested in, my partner Jason Mendelson also runs our back office and is responsible for overseeing our audits and financial reporting to our investors. Jason is knee-deep in audit season right now, and he has a great and detailed rant up at Venture Beat about the stupidity of FAS 157.

FAS 157 is theoretically designed to make the valuation of our portfolio more transparent to our investors by requiring us to value our investments at “fair market value”. Sounds like motherhood and apple pie, right? Who could have a problem with this? Well it turns out that valuing early stage private companies like the ones we invest in is more art than science and valuations are open to interpretation (and discretion), thus opening the whole system to valuation related liability and false comfort from false precision. In the good old days of VC, one basically (with a few exceptions) set the valuation of a company to the price of the last round of financing. While there were situations in which this could produce misleading valuations (particularly when the market was going down), it worked pretty well and in my opinion, and didn’t create busy work that leads false precision around company valuations.

While FAS157 arguably makes sense when valuing public companies (and perhaps formerly public companies that were taken private and have the scale for public market comps to make sense), for the early stage venture world, it creates a process that wastes resources and money and helps no one but the accounting firms — and perhaps law firms down the line when valuation lawsuits start inevitably springing up.

I am constantly amazed by the the creativity and initiative the accounting industry has shown in the wake of scandals like Enron and Worldcom. While they were complicit in these frauds, they somehow came out the other side as beneficiaries when laws like Sarbanes-Oxley and rules like 409A were enacted, essentially creating entirely new lines of business and mandatory employment for themselves. And now they’ve come up with FAS 157, finding yet another way to bill ever more hours to produce an end result that has little meaning and helps no one. At least not in my corner of the universe, the early-stage VC world.

  • I would have to say my laugh out loud moment came when I was reading through the reasoning behind this:

    “In developing this Statement, the Board considered the need for increased consistency and comparability in fair value measurements and for expanded disclosures about fair value measurements.”

    It is best put that this is one more why to ping us and fatten up their wallets. What a 'professionally' written load of [email protected]

    Auditor: “We aren’t valuation people. We can’t tell you that.” – can't wait to see what comes about next…

    Thank you for this article!

  • James_Egan

    To say that FAS 157 was designed for the sole purpose of increasing your firm's accounting payables is somewhat obtuse. Thankfully you don't fully commit to this direction of thinking.

    While I do agree that accountants and lawyers have serious conflict of interest when designing standards and/or regulations, this rule does have its merits. I am of the camp that fair value accounting does its job very well for assets in liquid markets. This cuts down on accounting valuation bills somewhat and provides more transparency than historical costs.

    However, I think you'll agree that the more illiquid an asset becomes, the more fair market value accounting fails to achieve it's designed purpose (assuming that purpose is unbiased transparency of asset value and not more hours billed).

    Luckily, a think tank composed of nearly all of the incoming President's economic cabinet members has recently come forth with a paper mentioning desired changes to fair value rules.

    Check out recommendation #12 from the Group of 30's most recent publication:

    http://www.group30.org/pubs/recommendations.pdf

    • James, thanks for your comment. No, I am not saying that FAS157 is nothing more than a vehicle to boost accounting firms' revenues. But I am saying that while it might make more sense in the context of liquid public securities (though I have little personal experience to make a definitive claim here), it is being force-fit to the early stage VC world and doesn't really achieve the goal of increased transparency — it just trades one set of potential problems for another, and likely will lead to less consistency in early valuations. even for the same company that might be in multiple VC funds portfolios that have different accounting firms, and it does so at an increase in costs, both in accounting fees and an internal management time within my own firm.

      And don't get me started on something like Sarbox, which has created an annual ~$3m cost in accounting fees for compliance for public companies. This has been a definite contributor to the lack of IPOs in recent years, particularly for small growth companies, since being able to burn $3m of net income and remain a profitable company implies/requires a certain scale of revenues that has caused many companies that might have previously been IPO candidates to exit via M&A due to the very real perception that it is just not worth the cost and liability to be a public company. This is a certainly a long-term issue for the VC business.

  • James_Egan

    I totally agree with Sox, it’s been abused by accountants to a ridiculous level. Also FAS 157 isn't perfect. I agree with you that this 'force-fitting' is probably not what the originators of the standard had in mind when creating it. I'm not in the VC industry, but it seems accountants abuse it like they abuse Sox.

    I wonder if IFRS has a different approach or method for fair value accounting when referring to the types of assets you deal with.