Accounting and Taxation

The Trend toward FairValue Accounting

J. Russell Madray, CPA

Background

The requirement to measure someitems at fair value has been in theaccotinting literature for a number ofyears. However, in recent years thenumber of accounting standardsrequiring fair value measurements anddisclosures has increased significantly,and the trend is expected to continue.In many recent pronouncements, theFinancial Accounting Standards Board(FASB) has concluded that fair valueinformation is relevant. At the sametime, however, preparers, auditors, andothers have expressed concerns aboutthe ability to apply a fair value meas-urement principle.

In large part, those concerns resultbecause there is limited application guid-ance for measuring fair value. The guid-ance that currently exists has evolved"piecemeal" over time and is dispersedamong the many pronouncements thatrequire fair value measurements, as wellas FASB Concepts Statement No. 7,Using Cash Flow Information and Pre-

sent Value in Accounting Measurements.

Differences in that guidance have addedto the complexity in generally acceptedaccounting principles (GAAP).

In addition, the FASB's concep-tual framework only contains limitedguidance for addressing measurementissues. For example, FASB ConceptsStatement No. 5, Recognition andMea-

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sûrement in Financial Statements of

Business Fnterprises, which was devel-oped more than 20 years ago, does notidentify fair value as a possible meas-urement attribute. It also does not pro-vide an adequate basis for determininghow the qualitative characteristics ofrelevance and reliability should beapplied in selecting an appropriatemeasurement attribute.

In response to those concerns, theFASB, in June 2003, added a project toits agenda to codify and improve guid-ance for measuring fair value. In Sep-tember 2006, the FASB issued State-ment No. 157, Fair Value Measurements,

which addresses how companies shouldmeasure fair value when they arerequired to use a fair value measure forrecognition or disclosure purposes underCAAP. Statement No. 157 affects morethan 70 different accounting stan-dards—including those used to valuestock options (FASB Statement No.123-R) and derivatives (FASB StatementNo. 133)—but does not expand the useof fair value to any new circumstances.

In February 2007, the FASBissued Statement No. 159, The Fair

Value Option for Financial Assets and

Financial Liabilities, which permitsentities to choose to measure manyfmancial instruments and certain otheritems at fair value. The objective ofStatement No. 159 is to improve fman-cial reporting by providing entitieswith the opportunity to mitigatevolatility in reported earnings causedby measuring related assets and liabili-ties differently without having to applycomplex hedge accounting provisions.This statement is expected to expandthe use of fair value measurement,which is consistent with the FASB's

long-term measurement objectives foraccounting for fmancial instruments.

With the issuance of StatementNos. 157 and 159, some have declared2007 to be the "year of fair value."While the concept of fair value has beenin the accounting literature for a num-ber of years, the trend is certainly accel-erating in that direction. This articlereviews some of the concepts surround-ing fair value, as well as some of thearguments for and against that trend.

What Is "Fair Value"?As a result of FASB Statement No.

157 there is now a common defmitionof fair value to be used throughoutGAAP. The FASB believes that the newstandard will make the measurement offair value more consistent and compa-rable and improve disclosures aboutthose measures. While most account-ing pronouncements that involve fairvalue focus on what to measure at fairvalue. Statement No. 157 focuses onhow to measure fair value. Dispersedthroughout current GAAP are incon-sistent defmitions of fair value and onlylimited guidance on application. State-ment No. 157 remedies the situationby providing "one-stop shopping" forthe defmition of fair value and relatedmeasurement guidance. In otherwords. Statement No. 157 does notintroduce any new requirements man-dating the use of fair value; instead, itunifies the meaning of fair value andadds important disclosures.

Statement No. 157 defines "fairvalue" as: "The price that would bereceived to sell an asset or paid to trans-fer a liability in an orderly transactionbetween market participants at themeasurement dace."

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While the words may have a sim-ilar ring to past definitions, there aresome key differences. First, the defini-tion is based on an exit price (for anasset, the price at which it would besold) rather than an entry price (for anasset, the price at which it would bebought), regardless of whether theentity plans to hold or sell the asset. Asecond key definitional point is thatStatement No. 157 emphasizes that fairvalue is market basedrzxhtr than entityspecific; fair values must rest onassumptions that market participantswould use in pricing the asset or liabil-ity. Thus, the optimism that oftencharacterizes an asset owner must bereplaced with the skepticism that typ-ically characterizes a risk-averse buyer.

The DebateCritics contend that GAAP is seri-

ously flawed. Some in the accountingprofession go so far as to pronouncefinancial statements almost completelyirrelevant to the financial analyst com-munity. The fact that the market valueof publicly traded firms on the NewYork Stock Exchange is an average offive times their asset values serves tohighlight this deficiency. Many reform-ers, including FASB chairman RobertHerz, believe that fair value accountingmust be part of the answer to makingfinancial statements more relevant anduseful.' Advocates of fair valueaccounting say it would give users offinancial statements a far clearer pictureof the economic state of a company.

But switching from historical costto fair value requires enormous eflort.Valuing assets in the absence of activemarkets can be very subjective, makingfinancial statements less reliable. In fact.

disputes can arise over the very defini-tion of certain assets and liabilities.

The crux of the fair value debate isthis: Each side agrees that relevanceand reliability are important, but fairvalue advocates emphasize relevance,while historical cost advocates placegreater weight on reliability.

Relevance versus ReliabilityThe pertinent conceptual guid-

ance for making trade-offs between rel-evance and reliability is provided byFASB Concepts Statement No. 2,Qualitative Characteristics of Accounting

Information. It provides guidance formaking standard-setting decisionsaimed at producing information usefulto investors and creditors. ConceptsStatement No. 2 states:

The qualities that distinguish"better" (more usefiil) informa-tion from "inferior" (less useful)information are primarily thequalities of relevance and reliabil-ity.... The objective of accountingpolicy decisions is to produceaccounting information that isrelevant to the purposes to beserved and is reliable.Critics of fair value generally believe

that reliability should be the dominant

characteristic of financial statementmeasures. But the FASB has requiredgreater use of fair value measurements infinancial statements because it perceivesthat information as more relevant toinvestors and creditors than historicalcost information. In that regard, theFASB has not accepted the view thatreliability should outweigh relevance forfinancial statement measures.

Some critics also interpret relia-bility as having a meaning that differsin at least certain respects from howthat term is defined in the FASB'sConceptual Framework. Some criticsequate reliability with precision, andothers view it principally in terms ofverifiability. However, Concepts State-ment No. 2 defines reliability as "thequality of information that assuresthat information is reasonably freefrom error or bias and faithfully repre-sents what it purports to represent."With respect to measures, it states that"[t]he reliability of a measure rests onthe faithfulness with which it repre-sents what it purports to represent,coupled with an assurance for theuser, which comes through verifica-tion, that it has that representationalquality." Thus, the principal compo-nents of reliability are representational

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ACCOUNTING AND TAXATION

faithfulness and verifiability.

Although there are reliability con-cerns associated with fair value meas-ures, particularly when such measuresmay not be able to be observed inactive markets and greater reliancemust be placed on estimates of thosemeasures, present-day fmancial state-ments are replete with estimates thatare viewed as being sufficiently reliable.Indeed, present-day measures of manyassets and liabilities (and changes inthem) are based on estimates, forexample, the collectibility of receiv-

ables, salability of inventories, usefullives of equipment, amounts and tim-ing of future cash flows from invest-ments, or likelihood of loss in tort orenvironmental litigation.

Even though the precision of cal-culated measures such as those indepreciation accounting is not open toquestion since they can be calculateddown to the penny, the reliability ofthose measures is open to question.Precision, therefore, is not a compo-nent of reliability under ConceptsStatement No. 2. In fact. Concepts

Major Accounting Standards that Refer to Fair Value

APB Opinion No. 18, T/ie Equity Method of Accounting for Investments inCommon StockFASB Statement No. 13, Accounting for LeasesFASB Statement No. 28, Accounting for Sales with LeasebacksFASB Statement No. 66, Accounting for Saies of Reai EstateFASB Statement No. 68, Research and Development ArrangementsFASB Statement No. 87, Employers' Accounting for PensionsFASB Statement No. 106, Employers' Accounting for Postretirement Bene-fits Other Than PensionsFASB Statement No. 115, Accounting for Certain Investments in Debt andEquity SecuritiesFASB Statement No. 133, Accounting for Derivative Instruments and Hedg-ing ActivitiesFASB Statement No. 141 (Revised 2007), Business CombinationsFASB Statement No. 142, Goodwili and Other intangible AssetsFASB Statement 150, Accounting for Certain Financial Instruments withCharacteristics of both Liabiiities and EquityFASB Interpretation No. 45, Guarantor's Accounting and Disclosure Require-ments for Guarantees, including indirect Guarantees of Indebtedness of OthersFASB Interpretation No. 46-R, Consolidation of Variable Interest EntitiesFASB Staff Position No. FAS 143-1, Accounting for Electronic EquipmentWaste Obligations

Statement No. 2 expressly states that

reliability does not imply certainty or

precision, and adds that any preten-

sion to those qualities if they do not

exist is a negation of reliability.

ConclusionAlthough the debate continues

about what is "fair," and there are

many obstacles to overcome, the

debate is healthy. One of the require-

ments of Statement No. 157 is to fully

explain the use of fair value through

substantive footnote disclosures that

explain the procedures that manage-

ment used to arrive at their estimates,

as well as the reliability of the assump-

tions underlying the estimates. Long

term, the movement toward a consen-

sus on how to better measure fair value,

combined with better disclosure,

should ultimately help investors make

more informed decisions. B

J. Rüssel Madray, CPA, is president ofThe Madray Group, Inc., which helpsbusinesses, accounting firms, and otherorganizations understand and implementtechnical accounting and auditing issues.He also serves as a senior lecturer atClemson University's School of Accoun-tancy and Legal Studies. In addition tobeing a CPA, he is also a certified man-agement accountant and a certified finan-cial manager. He may be reached atmj@clemson.edu.

(1) Robert H. Herz's remarks to the Financial

Executives International Current Financial

Reporting Issues Conference, New York Hilton

Hotel, November 4, 2002.

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