The Finer Points of Fair Value

EXECUTIVE SUMMARY

To adopt FASB Statement no. 159, companies must comply with the requirements of Statement no. 157, Fair Value Measurements . Companies and their auditors must consider whether the use of fair value option accounting reflects a “substance over form” decision by management rather than an effort to gain an accounting result. FASB has raised the bar for disclosure required when the fair value option is in play so that financial statement users will be able to clearly understand the extent to which the option is utilized and how changes in fair values are being reflected in the financial statements. Companies are encouraged but not required to present the fair value option disclosures in combination with the fair value disclosures required in other accounting literature. The guidance must be implemented on an instrument-by-instrument basis and is irrevocable. Thomas A. Ratcliffe , CPA, Ph.D., is director of accounting and auditing at Wilson Price in Montgomery, Ala. He is the chairman of the AICPA Accounting and Review Services Committee and is a member of the Private Company Financial Reporting Committee. His e-mail address is tomr@wilsonprice.com .

The first quarter of 2008 is likely to usher in the first significant wave of financial statements from companies that have adopted FASB’s new fair value option for financial assets and liabilities.

FASB released Statement no. 159, The Fair Value Option for Financial Assets and Financial Liabilities , in February. The new standard allows companies to measure certain financial assets and liabilities at “market” or fair value rather than historic or original cost. The option does not require companies to comply with relatively complex hedge accounting requirements spelled out in FASB Statement no. 133, Accounting for Derivative Instruments and Hedging Activities .

The fair value option should allow companies to focus more on electing and complying with the fair value option guidance, rather than on designating and documenting transactions to comply with the Statement no. 133 hedge accounting guidance. The option is effective at the start of the first fiscal year beginning after Nov. 15, 2007. (At press time, FASB was considering a delay, in whole or in part, in the effective date of Statement nos. 157, Fair Value Measurements , and 159.)

This article will explain Statement no. 159’s substantive provisions and provide reporting entities and practitioners some practical guidance for deciding how to report certain assets and liabilities in financial statements. The article also contains some red flags for auditors associated with companies that have elected to use the fair value option.

The overarching objective of the new principles-based guidance is to improve the clarity and consistency of financial reporting by eliminating incidents in which related assets and liabilities are measured differently. FASB’s issuance of Statement no. 159 came on the heels of the release of Statement no. 157, which maps out the hierarchy that provides direction on how fair values are determined.

Statement no. 159 resulted from the first phase of FASB’s fair value option project. In the second phase of the project, FASB is expected to consider expanding the scope of the fair value option to include other items, such as deposit liabilities.

Suitable rationales for adopting the fair value option include a desire for better balance sheet management, the need for alternatives to Statement no. 133 accounting or to better react to changes in interest rates.

IMPLEMENTING THE GUIDANCE
In adopting the Statement no. 159 option, companies must employ the guidance of Statement no. 157.

Statement no. 159 is implemented on an instrument-by-instrument basis. As such, companies can elect the fair value option for certain items and exclude other items within the same or similar category of instruments.

Once the fair value option is elected, the decision is irrevocable. For existing financial assets and liabilities, companies can implement the fair value option when the choice is made to use the guidance in Statement no. 159. In addition, companies can elect to apply the fair value option, after initial adoption, on the date when other eligible items are recognized. As an example, following the initial implementation of the guidance, a company that enters into an eligible commitment can elect to use fair value accounting for that commitment.

Exhibit 1		Early Implementation of FASB Statement no. 159—Public Company Example
	Editor’s Note: This disclosure example was extracted from the Citigroup Inc. first quarter 2007 10-Q filing. Legg Mason convertible preferred equity securities: Prior to the election of fair value option accounting, these shares were classified as available-for-sale securities with the unrealized loss of $232 million as of December 31, 2006, included in accumulated other comprehensive income [loss]. In connection with the Company’s adoption of SFAS No. 159, this unrealized loss was recorded as a reduction of January 1, 2007, retained earnings as part of the cumulative-effect adjustment. We have no intention of selling the Legg shares prior to our previously estimated recovery period. The Legg shares are now included in Trading account assets on Citigroup’s Consolidated Balance Sheet. The decrease in market value for the 2007 first quarter of $7 million pretax was reported with Principal transactions in the Company’s Consolidated Statement of Income. Dividends are included in interest revenue.

FACTORING IN INCREMENTAL DISCLOSURES
FASB has raised the bar for disclosure required when the fair value option is in play so that investors, analysts and other financial statement users will be able to clearly understand the extent to which the option is used and how changes in fair values are reflected in the financial statements.

Companies most likely will elect to use the fair value option for all items within a group of similar items. However, because the guidance can be used on an instrument-by-instrument basis, FASB requires additional disclosures where the fair value option is elected only for certain eligible items within a group of similar eligible items. Companies are required to include in the fair value option disclosures a description of items that are similar to those for which the option was elected, along with the reasons for the partial election.

In developing the disclosures required in Statement no. 159, companies are encouraged, though not required, to present the fair value option disclosures in combination with the fair value disclosures required in other accounting literature. For example, the preferred method of complying would be to combine these disclosures with those presented in compliance with Statement no. 157 and Statement no. 107, Disclosures About Fair Value of Financial Instruments .

Exhibit 2		Key Accounting and Reporting Issues
	Some of the issues that must be addressed by reporting entities when electing the fair value option are as follows: The guidance needs to be implemented with the objective of improving financial reporting rather than to achieve a particular accounting result. The guidance needs to be implemented only after reporting entities have communicated the intent to use the guidance with those in organizational governance. The guidance should be implemented at initial adoption by recognizing the cumulative effect of using the fair value option as an adjustment to beginning retained earnings. The guidance may be elected only for certain eligible items. The guidance must be implemented on a permanent basis. The guidance in Statement no. 157 related to fair value measurements must be implemented simultaneously with implementing the guidance related to the fair value option. The guidance needs to be implemented on an instrument-by-instrument basis. The guidance includes incremental disclosures that must be in the notes to the financial statements when the election to use the fair value option is made. The guidance includes even more disclosures when the fair value option only is partially adopted for certain financial instruments and not for other similar instruments. The guidance can be implemented for existing financial assets and liabilities at the point the election is made to utilize the guidance. The guidance can be used subsequent to initial adoption on the date where other eligible items are recognized in the financial statements. The guidance is expected to be utilized extensively by many reporting entities and on a limited basis [if at all] by other entities. The guidance includes enhanced disclosures that should be helpful to users in efforts to compare financial statements that incorporate the fair value option with statements where reporting entities did not elect to utilize that option. Note: When reporting entities initially adopt and subsequently utilize the accounting guidance in FASB Statement no. 159, many accounting and reporting issues must be addressed, including disclosures in the notes to the financial statements. Only some of those issues are noted in this exhibit.

The expanded disclosure requirements are expected to help financial statement users understand management’s rationale for implementing the fair value option. In addition, the disclosures should reveal how changes in fair value of financial instruments affect earnings reported during the period. And the information should highlight the differences between fair values and contractual cash flows for certain items.

One of the high-profile issues that emerged during the early implementation period relates to how reporting entities are electing the option for available-for-sale (AFS) and held-to-maturity (HTM) securities that are accounted for using the provisions of Statement no. 115, Accounting for Certain Investments in Debt and Equity Securities . Using the guidance within Statement no. 115, trading securities already are marked-to-market with gains and losses included in reporting earnings. However, while AFS securities are marked-to-market at each financial statement date, gains and losses on those securities bypass income and are reported in equity as an adjustment to other comprehensive income. HTM securities are not marked-to-market; rather, unless there is an other-than-temporary impairment in value of those securities, they are reflected in the financial statements at amortized cost.

Many companies have been weighing the risks and rewards of using the irrevocable fair value option to reclassify securities from the available-for-sale and held-to-maturity categories securities that are accounted for using the provisions of Statement no. 115.

By doing so, companies could elect the fair value option for “underwater” investments in certain securities, transfer those securities from the available-for-sale and held-to-maturity categories into the trading category and report the unrealized losses as an integral part of the cumulative-effect adjustment that is used in implementing this guidance.

Because the cumulative-effect adjustment is taken directly to retained earnings, any losses on the securities would not be reflected in income, even if the securities subsequently are sold. Once the one-time application of Statement no. 159 has passed, changes in fair value going forward are reported in earnings.

With such a move comes the risk of riling regulators. The SEC staff, in an April 2007 conference call for auditors of public companies, issued a warning about structured transactions that are designed to trigger a particular accounting result.

Research by Jack Ciesielski, owner of the investment research firm R.G. Associates Inc., showed that 60 companies adopted Statement no. 159 in the first quarter under the early adoption provisions. Another 12 adopted Statement no. 159 only to rescind the decision in full or in part.

Seacoast Banking Corp. of Florida was among the dozen companies that reversed course. Under the transition provisions of Statement no. 159, Seacoast, a Stuart, Fla.-based holding company for Seacoast National Bank, opted to report at fair value, beginning Jan. 1, 2007, approximately $251 million of investment securities. The effect of the change to fair value was reflected as a cumulative-effect adjustment to the opening balance of retained earnings and the changes to fair value after that date as a component of current earnings reflected in the income statement.

The cumulative-effect adjustment reduced opening retained earnings by $3.7 million. “The elective use of fair value accounting for financial instruments enables us to better align the financial results of those items with their economic value and allows for more active management of our balance sheet,” Seacoast CEO Dennis S. Hudson III said in a press release issued April 25, detailing the company’s first quarter performance.

On May 11, Seacoast announced that it would revise its decision. “Additional interpretations of the requirements for early adoption of FAS 159 including general comments made more recently by the Securities and Exchange Commission and further analysis by the accounting industry have caused the Company to conclude that it should record the entire transition adjustment as a charge to earnings for the first quarter of 2007 rather than a charge to beginning retained earnings,” the company announced. “This revision is expected to reduce GAAP earnings for the first quarter by approximately $3.7 million or $0.20 diluted earnings per share.”

Ciesielski predicts that the cherry-picking of financial instruments for fair value accounting in order to achieve a particular accounting result is largely a historical footnote now that regulators and investors are on alert for the activity. But he says that earnings might still be manipulated by companies that tinker with Level 3 inputs—the part of the fair value hierarchy spelled out in Statement no. 157 that allows companies to base their valuations on unobservable inputs rather than quoted prices for similar or identical assets or liabilities. “That’s where the arguable judgments might be,” Ciesielski says.

A key for auditors in evaluating the appropriateness of fair value option decisions is to ensure that the guidance is implemented in a manner that is consistent with the underlying objectives of Statement no. 159 and reflects substance over form. Auditors need to exercise the appropriate level of professional skepticism when evaluating facts and circumstances related to using the fair value option. A heightened degree of awareness might be necessary to ensure that businesses are using the option to reflect economic reality, rather than attempting to achieve a particular accounting result.

AICPA RESOURCES JofA article “ Refining Fair Value Measurement,” Nov. 07, page 30. Workshop Fair Value Measurement Workshop, Feb. 28–29, New York City. CPE Fair Value Accounting: A Critical New Skill for All CPAs , a CPE self-study course (#733300) For more information or to make a purchase, go to www.cpa2biz.com or call the Institute at 888-777-7077.