Fair Value in Financial Reporting: Paradigm Shift

July 1, 2006

By William C. Foote, CPA/ABV, CVA

After three years of development, the Financial Accounting Standards Board (FASB) appears set to issue its Statement of Financial Accounting Standards (SFAS) on fair value measurements (the FV Standard).
This standard marks a milestone in FASB's much publicized transformation from rule maker to principles-based standard setter.

The principles-based approach in general, and the FV Standard specifically, will require financial statement preparers and auditors alike to exercise a good deal of professional judgment — in contrast to the checklists and bright line tests to which many CPAs are accustomed.

Numerous existing accounting pronouncements mandate the use of fair value as a measurement attribute (as opposed to historical cost or net realizable value, for example). Those pronouncements apply not only to financial instruments but also to non-financial assets and liabilities. And it seems likely that future pronouncements will require additional fair value measurements.

The FV Standard, currently in working draft form, does not create any new instances where fair value measurements are required. Instead, the Standard aims to improve financial reporting by providing a framework for applying the fair value measurement objective where it is required by Generally Accepted Accounting Principles (GAAP). In other words, the FV Standard will provide guidance on how fair measurements are applied, whereas other existing and future pronouncements will dictate when fair value is the appropriate measurement attribute.

The foundation for this fair value framework is existing guidance, which is currently spread out over a number of different pronouncements. The guidance has evolved over time and has not always been consistent. When the FV Standard is issued, it will serve as a single reference point for preparers, auditors and users of financial information. The FV Standard will promote consistent application of fair value accounting and hopefully make the presentation and disclosure of fair value information in financial statements more decision-useful for investors, analysts and creditors.

History of the Project

In June 2003 FASB added to its agenda a project to improve guidance on fair value measurements. The addition was in part an offshoot of FASB's October 2002 proposal, "Principles-Based Approach to U.S. Standard Setting," — the goal of which was to improve the quality and transparency of financial reporting.

Then in June 2004 FASB published an exposure draft of a proposed SFAS titled Fair Value Measurements (the Exposure Draft). Almost 100 letters from FASB constituents were received by the September 7, 2004 comment deadline.

Building upon the comments received, FASB then posted a working draft (the October 2005 Working Draft) on its Web site. The October 2005 Working Draft reflected decisions reached by FASB staff subsequent to the Exposure Draft. Another working draft (the March 2006 Working Draft) was then posted on FASB's Web site, reflecting decisions reached by FASB staff subsequent to the October 2005 Working Draft.

According to its Web site, FASB intends to issue a final FV Standard by June 30, 2006. FASB Chairman Robert H. Herz, however, recently remarked1 that unsolicited comment letters are still coming in and that the June 30, 2006 target issuance date may not be met. Regardless of the issuance date, the FV Standard will take effect with fiscal years starting after November 15, 2007, unless companies choose to adopt the Standard earlier.

Interestingly, from the time the Exposure Draft was made public in June 2004 several pronouncements that call for fair value measurements have been issued or exposed.2 This is in addition to the 40 pronouncements with fair value measurement requirements that existed at the date of the Exposure Draft.

The Evolution of Fair Value

Fair value is a measurement attribute that has existed for more than 30 years. For example, it is featured prominently in the following pronouncements:

• Accounting Principles Board Opinion No. 29 — Accounting for Nonmonetary Transactions (1973)
• SFAS No. 35 — Accounting and Reporting by Defined Benefit Pension Plans (1980)
• SFAS No. 107 — Disclosures about Fair Value of Financial Instruments (1991)
• SFAS No. 141 — Business Combinations (2001)3

Fair value is not, however, specifically listed as a measurement attribute in FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises. This demonstrates how much the accounting climate has changed since its issuance. Widespread use of fair value in financial reporting has been and continues to be a paradigm shift. It will likely take some time for companies and auditors alike to fully embrace fair value and the requirements of the forthcoming FV Standard.

Fair value is defined in the March 2006 Working Draft as "… the price that would be received for an asset or paid to transfer a liability in a transaction between market participants at the measurement date." The definition of fair value has undergone subtle changes between the Exposure Draft and the March 2006 Working Draft. Table 1 (.PDF) shows the fair value definition contained within the Exposure Draft, the October 2005 Working Draft and the March 2006 Exposure Draft.

But what does fair value really mean? A closer look at three key components of the definition(s), price, transaction and market participants, may add clarity.

Fair value assumes a market-based exchange from the standpoint of the seller. That is to say that the relevant price is an exit price and not an entry price.

Further, the price should exclude transaction costs and should reflect the highest and best use of an asset — the use that will generate the greatest amount of future economic benefits. It is important to note that this highest and best use does not reflect the expectations of the reporting entity, but rather reflects the consensus view of market participants. So a reporting entity's cash flow expectations may differ from the cash flow expectations of market participants.4 For instance, a reporting entity may make better (or worse) use of a particular asset and therefore ultimately realize more (or less) than its fair value, which positively (or negatively) affects earnings.

The transaction is assumed to be an orderly one that reflects market conditions as of the measurement date. It does not, for example, take place under duress. The price of an actual transaction for an asset does not by default determine that asset's fair value. This gets back to the conceptual difference between an entry price and an exit price mentioned above (i.e. they could be different). In many cases, though, the transaction price will in fact represent fair value.

The March 2006 Working Draft describes market participants as "…buyers and sellers in the principal (most advantageous) market for the asset or liability…" It is further specified that market participants are able and willing to transact for the asset or liability, are independent of the reporting entity, and have a reasonable understanding about factors relevant to the asset or liability. The principal market for the asset or liability is generally the market where the lion's share of transactions for the asset or liability occurs. Consistent with the notion of an exchange or exit price (above), it is the market in which the reporting entity would be expected to sell the asset or transfer the liability. In the case of a business combination, for example, market participants might include other known bidders for the target or, if not known, those companies believed to have been bidders. As to liabilities, fair value estimates should assume a transfer to a market participant of comparable credit standing.

CPA valuation specialists will undoubtedly note some similarities between the definition of fair value in the context of financial reporting and the Internal Revenue Service (IRS) definition of fair market value that is commonly cited in valuation engagements. On the interaction between fair value and fair market value, the October 2005 Working Draft acknowledges that "…the measurement objective encompassed within the definition of fair value used for financial reporting purposes is generally consistent with similar definitions of fair market value used for valuation purposes." FASB elected not to simply adopt the IRS fair market value definition since it is accompanied by "…a significant body of interpretive case law…" that may not be relevant for financial reporting purposes.

The Fair Value Hierarchy

Now that we know what fair value means, we need to know how fair value should be determined. Fair value measurements should be made using one or more techniques that are consistent with three broad valuation approaches: the market approach, the income approach or the cost approach [see Table 2 (.PDF)]. There is no bright line offered as to which valuation technique or techniques should be utilized. That decision depends on the circumstances specific to each fair value measurement.

Regardless of the valuation technique used, fair value estimates should reflect as many observable market inputs as possible. Circling back to the discussion of market participants above, market inputs refer to all the assumptions that market participants would make to determine a price for an asset or to transfer a liability.

The FV Standard describes two distinct types of market inputs: observable and unobservable. Observable inputs are based on market data obtained from sources independent of the reporting entity. Unobservable market inputs reflect a reporting entity's own assumptions and therefore cannot be independently verified. The use of unobservable market inputs should be minimized when measuring fair value.

A three-level hierarchy of market inputs is set forth in the FV Standard, with Level 1 inputs being the strongest and Level 3 inputs being the weakest. Certain elements of the fair value hierarchy are consistent with or derive from SFAS No. 107, Disclosures About Fair Value of Financial Instruments.

Level 1 generally consists of quoted prices for identical assets or liabilities in active markets, such as the New York Stock Exchange. No adjustment is permitted to compensate for large blocks of financial instruments that might not be able to be released into the market as of the measurement date due to insufficient trading volume. An adjustment from a quoted price is permitted for restricted securities to reflect the impact of the restriction relative to an otherwise identical unrestricted security. That adjustment, however, is not considered a Level 1 input.

Level 2 inputs include quoted prices for similar assets or liabilities in active markets or quoted prices for identical or similar assets or liabilities in markets that are not active. Also contained within Level 2 are market-corroborated inputs. These are inputs that, although not directly observable, can be substantiated by other market data that is observable.

Level 3 of the fair value hierarchy consists of unobservable market inputs. Level 3 inputs reflect the reporting entity's assumptions of market inputs, developed based on its own data. Level 3 inputs should be adjusted to exclude factors specific to the reporting entity if it is understood that market participants would use different assumptions. In addition, Level 3 fair value measurements should acknowledge the fact that market participants would want to be compensated for the added risk and uncertainty associated with not being able to observe the market input(s). The degree to which Level 3 inputs provide relevant and reliable financial information will naturally vary.

Based on the foregoing, non-financial assets and liabilities are more likely to fall into Levels 2 and 3 of the fair value hierarchy. Conversely, financial instruments and readily tradable commodities likely stand a better chance at classification in Levels 1 and 2 of the hierarchy, given the observable market inputs that may apply.

Where a particular fair value measurement falls within the fair value hierarchy (i.e. Level 1, Level 2 or Level 3) depends on the lowest level significant input, which obviously involves some judgment. Categorizing fair value measurements as such will be necessary to meet disclosure requirements called for by the FV Standard. For instance, Level 3 fair value measurements will likely require additional disclosures, such as a reconciliation of beginning and ending balances.

Resistance

Some FASB constituents will welcome the FV Standard with open arms. Some are opposed to it. Others believe FASB is moving too fast and that, since the March 2006 Working Draft is in places significantly different than the Exposure Draft, it should be re-exposed. Check out the comment letters at www.fasb.org/ocl/fasb-selectproject.php.

There are those who believe issuing the FV Standard at this time is akin to putting the cart before the horse, insofar as it will come ahead of the completion of the joint conceptual framework project that FASB and International Accounting Standards Board (IASB) added to their respective agendas in October 2004. Phase C of that project, which addresses initial and subsequent measurement, was still in the planning and research phase as of May 16, 2006, with no time frame set for an initial document.5 In addition, IASB is expected to issue its own exposure document on the fair value issue. Some FASB constituents think it should wait to see the results of the IASB effort.

Then there are those who believe application of the FV Standard will be expensive and burdensome due to the changes in accounting processes that may be necessary, and the additional education or staff commitment required for companies (especially small privately held companies) and their auditors. For instance, with respect to the use of valuation techniques, the most appropriate technique or techniques should be utilized regardless of the cost and effort involved.

Still others feel that there should be separate fair value measurement guidance for financial instruments and for non-financial assets and liabilities.

In summing up some of the positive and negative feedback on the forthcoming FV Standard, FASB Chairman Herz said in a December 6, 2005 speech:

"Many proposed solutions and ideas have been suggested to reduce complexity and increase transparency within our reporting system. For example, some see fair value accounting as a way to simplify accounting standards and to improve the relevance and transparency of financial statements. But, of course, others view fair value accounting very differently, believing it introduces unacceptable subjectivity, misleading volatility and significant additional complexity into financial reporting."

Conclusion

Like it or not, fair value accounting is a reality. Future pronouncements will dictate if and to what extent the use of fair value in financial statements is expanded (or contracted). CPAs across the U.S. (including but not limited to CFOs, auditors and valuation specialists) need to become educated on the topic of fair value and perhaps change their mindsets.

The strength of the impending FV Standard may ultimately lie with the quality and quantity of implementation guidance made available to CPAs, whether as an appendix to the standard itself or in other separate guidance. To that end, FASB Chairman Robert H. Herz recently remarked1 that FASB may in the future consider the need for interpretations or best practices documents concerning fair value measurements.

If all goes as planned, when the FV Standard takes effect, investors, analysts, creditors and other users of financial statements will increasingly be rewarded with fair value measurements that are reliable, relevant and consistent.

1. "Fair Value Measurements in Financial Reporting ― Where Are We? Where Are We Going?" ― Presentation by Robert H. Herz, National Association of Certified Valuation Analysts Annual Conference, June 2, 2006.
2. Notably, SFAS No. 123 (revised 2004) ― Share-Based Payment will be outside of the FV Standard's scope, on the basis that measurements under that standard are only fair value-like.
3. On June 30, 2005 an exposure draft of a proposed SFAS, Business Combinations — A Replacement of FASB Statement No. 141, was published.
4. See, for example, FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements (2000), paragraphs 25 to 38.
5. For additional information on the conceptual framework project, refer to Halsey G. Bullen, FASB Senior Project Editor and Kimberley Crook, IASB Senior Project Manager, Revisiting the Concepts: A New Conceptual Framework Project, May 2005, and www.fasb.org/project/conceptual_framework.shtml.
6. Remarks of Robert H. Herz, Chairman, FASB. 2005 AICPA National Conference on Current SEC and PCAOB Reporting Developments, December 6, 2005.

William C. Foote, CPA/ABV, CVA is a member of the expert services group at Aronson & Company, a nationally ranked top 50 accounting and consulting firm. He is a graduate of James Madison University and also a member of the VSCPA Editorial Task Force.