Accounting and Taxation

The Trend toward Fair Value Accounting

J. Russell Madray, CPA

Background
The requirement to measure some items at fair value has been in the accotinting literature for a number of years. However, in recent years the number of accounting standards requiring fair value measurements and disclosures has increased significantly, and the trend is expected to continue. In many recent pronouncements, the Financial Accounting Standards Board (FASB) has concluded that fair value information is relevant. At the same time, however, preparers, auditors, and others have expressed concerns about the ability to apply a fair value measurement principle. In large part, those concerns result because there is limited application guidance for measuring fair value. The guidance that currently exists has evolved "piecemeal" over time and is dispersed among the many pronouncements that require fair value measurements, as well as FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements. Differences in that guidance have added to the complexity in generally accepted accounting principles (GAAP). In addition, the FASB's conceptual framework only contains limited guidance for addressing measurement issues. For example, FASB Concepts Statement No. 5, Recognition andMeaThis issue of the Journal went to press in April 2008. Copyright 2008, Society of Financial Service Professionals.

srement in Financial Statements of Business Fnterprises, which was developed more than 20 years ago, does not identify fair value as a possible measurement attribute. It also does not provide an adequate basis for determining how the qualitative characteristics of relevance and reliability should be applied in selecting an appropriate measurement attribute. In response to those concerns, the FASB, in June 2003, added a project to its agenda to codify and improve guidance for measuring fair value. In September 2006, the FASB issued Statement No. 157, Fair Value Measurements, which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under CAAP. Statement No. 157 affects more than 70 different accounting standardsincluding those used to value stock options (FASB Statement No. 123-R) and derivatives (FASB Statement No. 133)but does not expand the use of fair value to any new circumstances. In February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, which permits entities to choose to measure many fmancial instruments and certain other items at fair value. The objective of Statement No. 159 is to improve fmancial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This statement is expected to expand the use of fair value measurement, which is consistent with the FASB's

long-term measurement objectives for accounting for fmancial instruments. With the issuance of Statement Nos. 157 and 159, some have declared 2007 to be the "year of fair value." While the concept of fair value has been in the accounting literature for a number of years, the trend is certainly accelerating in that direction. This article reviews some of the concepts surrounding fair value, as well as some of the arguments for and against that trend.

What Is "Fair Value"?

As a result of FASB Statement No. 157 there is now a common defmition of fair value to be used throughout GAAP. The FASB believes that the new standard will make the measurement of fair value more consistent and comparable and improve disclosures about those measures. While most accounting pronouncements that involve fair value focus on what to measure at fair value. Statement No. 157 focuses on how to measure fair value. Dispersed throughout current GAAP are inconsistent defmitions of fair value and only limited guidance on application. Statement No. 157 remedies the situation by providing "one-stop shopping" for the defmition of fair value and related measurement guidance. In other words. Statement No. 157 does not introduce any new requirements mandating the use of fair value; instead, it unifies the meaning of fair value and adds important disclosures. Statement No. 157 defines "fair value" as: "The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement dace."

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While the words may have a similar ring to past definitions, there are some key differences. First, the definition is based on an exit price (for an asset, the price at which it would be sold) rather than an entry price (for an asset, the price at which it would be bought), regardless of whether the entity plans to hold or sell the asset. A second key definitional point is that Statement No. 157 emphasizes that fair value is market basedrzxhtr than entity specific; fair values must rest on assumptions that market participants would use in pricing the asset or liability. Thus, the optimism that often characterizes an asset owner must be replaced with the skepticism that typically characterizes a risk-averse buyer.

disputes can arise over the very definition of certain assets and liabilities. The crux of the fair value debate is this: Each side agrees that relevance and reliability are important, but fair value advocates emphasize relevance, while historical cost advocates place greater weight on reliability.

Relevance versus Reliability

The pertinent conceptual guidance for making trade-offs between relevance and reliability is provided by FASB Concepts Statement No. 2,
Qualitative Characteristics of Accounting

characteristic of financial statement measures. But the FASB has required greater use of fair value measurements in financial statements because it perceives that information as more relevant to investors and creditors than historical cost information. In that regard, the FASB has not accepted the view that reliability should outweigh relevance for financial statement measures. Some critics also interpret reliability as having a meaning that differs in at least certain respects from how that term is defined in the FASB's Conceptual Framework. Some critics equate reliability with precision, and others view it principally in terms of verifiability. However, Concepts Statement No. 2 defines reliability as "the quality of information that assures that information is reasonably free from error or bias and faithfully represents what it purports to represent." With respect to measures, it states that "[t]he reliability of a measure rests on the faithfulness with which it represents what it purports to represent, coupled with an assurance for the user, which comes through verification, that it has that representational quality." Thus, the principal components of reliability are representational

Information. It provides guidance for making standard-setting decisions aimed at producing information useful to investors and creditors. Concepts Statement No. 2 states: The qualities that distinguish "better" (more usefiil) information from "inferior" (less useful) information are primarily the qualities of relevance and reliability.... The objective of accounting policy decisions is to produce accounting information that is relevant to the purposes to be served and is reliable. Critics of fair value generally believe that reliability should be the dominant

The Debate
Critics contend that GAAP is seriously flawed. Some in the accounting profession go so far as to pronounce financial statements almost completely irrelevant to the financial analyst community. The fact that the market value of publicly traded firms on the New York Stock Exchange is an average of five times their asset values serves to highlight this deficiency. Many reformers, including FASB chairman Robert Herz, believe that fair value accounting must be part of the answer to making financial statements more relevant and useful.' Advocates of fair value accounting say it would give users of financial statements a far clearer picture of the economic state of a company. But switching from historical cost to fair value requires enormous eflort. Valuing assets in the absence of active markets can be very subjective, making financial statements less reliable. In fact.

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ACCOUNTING AND TAXATION

faithfulness and verifiability. Although there are reliability concerns associated with fair value measures, particularly when such measures may not be able to be observed in active markets and greater reliance must be placed on estimates of those measures, present-day fmancial statements are replete with estimates that are viewed as being sufficiently reliable. Indeed, present-day measures of many assets and liabilities (and changes in them) are based on estimates, for example, the collectibility of receiv-

ables, salability of inventories, useful lives of equipment, amounts and timing of future cash flows from investments, or likelihood of loss in tort or environmental litigation. Even though the precision of calculated measures such as those in depreciation accounting is not open to question since they can be calculated down to the penny, the reliability of those measures is open to question. Precision, therefore, is not a component of reliability under Concepts Statement No. 2. In fact. Concepts

Statement No. 2 expressly states that reliability does not imply certainty or precision, and adds that any pretension to those qualities if they do not exist is a negation of reliability.

Conclusion
Although the debate continues about what is "fair," and there are many obstacles to overcome, the debate is healthy. One of the requirements of Statement No. 157 is to fully explain the use of fair value through substantive footnote disclosures that explain the procedures that management used to arrive at their estimates, as well as the reliability of the assumptions underlying the estimates. Long term, the movement toward a consensus on how to better measure fair value, combined with better disclosure, should ultimately help investors make more informed decisions. B
J. Rssel Madray, CPA, is president of The Madray Group, Inc., which helps businesses, accounting firms, and other organizations understand and implement technical accounting and auditing issues. He also serves as a senior lecturer at Clemson University's School of Accountancy and Legal Studies. In addition to being a CPA, he is also a certified management accountant and a certified financial manager. He may be reached at mj@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.

Major Accounting Standards that Refer to Fair Value

APB Opinion No. 18, T/ie Equity Method of Accounting for Investments in Common Stock FASB Statement No. 13, Accounting for Leases FASB Statement No. 28, Accounting for Sales with Leasebacks FASB Statement No. 66, Accounting for Saies of Reai Estate FASB Statement No. 68, Research and Development Arrangements FASB Statement No. 87, Employers' Accounting for Pensions FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities FASB Statement No. 141 (Revised 2007), Business Combinations FASB Statement No. 142, Goodwili and Other intangible Assets FASB Statement 150, Accounting for Certain Financial Instruments with Characteristics of both Liabiiities and Equity FASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, including indirect Guarantees of Indebtedness of Others FASB Interpretation No. 46-R, Consolidation of Variable Interest Entities FASB Staff Position No. FAS 143-1, Accounting for Electronic Equipment Waste Obligations

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