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| EXECUTIVE SUMMARY
| |
 FASB 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 date.”
The standard does not
require fair values to be used
in any situations not already covered by
GAAP that existed when it was issued.
The “Fair Value
Hierarchy” is the central component
of Statement no. 157. The board
identifies an order of preference (Level
1, Level 2 or Level 3 inputs )
that management must apply in estimating
the fair values of assets or liabilities.
The standard
establishes disclosure requirements
that reveal to financial
statement users how the fair value
estimates were produced because varying
degrees of precision result from using
different kinds of inputs.
Statement no. 157 is
effective for annual statements
for fiscal years beginning after Nov. 15,
2007, and for interim reports prepared in
that initial fiscal year.
Paul B.W. Miller, CPA,
Ph.D., is professor of accounting at the
University of Colorado–Colorado Springs.
Paul R. Bahnson, CPA,
Ph.D., is professor of accounting at Boise
State University. Their e-mail addresses
are
pmiller@uccs.edu and pbahnson@boisestate.edu,
respectively. |
F
ASB issued a standard in fall 2006 with the
understated title Fair Value Measurements
. On one hand, FASB Statement no. 157 appears
to shake the foundation of historical cost
measurement. On the other, it appears innocuous
because it doesn’t compel greater use of fair
values. In fact, the standard does a bit of both.
Either way, CPAs should quickly acquaint
themselves with the new rule, since it becomes
effective for annual statements for fiscal years
beginning after Nov. 15, 2007, and for interim
reports prepared in that initial fiscal year.
Indeed, Statement no. 157 does not require fair
values to be used in any situations not already
covered by GAAP that existed at the time it was
issued. However, it changes the status quo in
three ways:
 It raises the bar for practice by
specifying new factors to consider when measuring
fair values that are already required in GAAP,
such that different (and better) numbers will be
reported in some situations.
It paved the way for FASB Statement
no. 159, The Fair Value Option for Financial
Assets and Financial Liabilities, which
creates the possibility that fair values will be
introduced and used in new ways in financial
statements.
It sets the stage for the new
Conceptual Framework that FASB is developing.
In particular, we believe the board’s 2006
Preliminary Views document, Objective of
Financial Reporting and Qualitative
Characteristics of Decision—Useful Financial
Reporting Information, indicates that fair
value will eventually be the preferred measure for
financial statements. For these reasons, then, it
made sense to issue Statement no. 157 to clean up
and otherwise clarify what fair value means and
how it can and should be measured.
BACKGROUND
Contrary to what
many may think, fair value accounting is not
a theoretical abstraction that might be put
into practice at some indefinite date. Fair values
have actually been introduced into GAAP piecemeal
over many decades in a large number of standards,
including, for example, those dealing with
inventory, investments, financial instruments of
all kinds, business combinations and stock
options. Furthermore, it has also long been
required to write impaired assets down to a fair
value less than their original cost or book value.
FASB developed Statement no. 157 to bring
uniformity and consistency to the literature and,
more importantly, to practice. Among its
contributions is a phenomenal catalog of existing
fair value measurement situations. An appendix to
the standard lists more than 60 pronouncements
where fair values are measured and reported.
As a result, all CPAs should understand this
standard and its implications for practice.
THE BASIC IDEA
The standard
states that “[f]air value is 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 date.” (Statement
no. 157, paragraph 5) Few may comprehend
that this definition is the board’s quiet
resolution of the long-standing controversy of
whether fair value should be based on what the
owner would receive upon selling an asset
(exit value) or what it would pay to
buy a new one (entry value). The
accompanying sidebar, “Entry and Exit Values,”
describes more about this issue and how FASB
worked around the controversy. | |
Entry and Exit
Values The difference
between entry and exit values has
perplexed accounting theoreticians for
more than a half century, dividing even
those who are strongly committed to fair
values over original costs. The classic
example that puzzled many is the case of a
specialized machine that is purchased by
one company at a high price even though it
could only be sold to someone else at a
substantially lower amount. The
outcome of applying exit value accounting
would be an immediate loss to the buyer.
On the other hand, reporting the machine
at its high replacement cost would conceal
the risk inherent in the specialization
strategy. At some point, the dialogue
among theorists bogged down on this
paradox with no further progress.
But the fact remains that differences
between entry and exit values are real.
Indeed, those differences are actually the
source of most income. Specifically, an
actor of some kind acquires an asset in
one market and then uses or sells it in
another, as represented in this diagram:
By selling in the exit market for a
higher price than was paid in the entry
market, profits are achieved. This can
happen only if the actor has relatively
unique access to both markets at the same
time; if just anyone can buy low and sell
high in both markets, the resulting
competition squeezes out the difference.
The diagram at bottom shows the
links between markets and various actors.
In the normal course of commerce,
profits are earned by manufacturers and
dealers because of their ability to
simultaneously access different markets
such that their entry values are less than
their exit values. However, at the last
stage, a consumer can typically sell an
asset only in a market that will not pay
as much as the purchase price. It is on
this paradox that theorists have
foundered.
FASB’s Workaround
By specifying in Statement no. 157
(and thus in 60 other pronouncements) that
fair value is the reporting company’s exit
value, FASB risked the possibility that
some would be forced to show losses when
acquiring assets for use that could be
sold only for less than the purchase
price. To deal with this potentially
confusing outcome, the standard requires
owners to value their assets under the
presumption of selling them to a buyer who
will apply them to the “highest and best
use of the asset by market participants,
considering the use of the asset that is
physically possible, legally permissible,
and financially feasible at the
measurement date” (paragraph 12). The
board explains further: “In broad terms,
highest and best use refers to the use of
an asset by market participants that would
maximize the value of the asset or the
group of assets within which the asset
would be used. Highest and best use is
determined based on the use of the asset
by market participants, even if the
intended use of the asset by the reporting
entity is different.” Regarding the
specialized machinery example, the highest
and best use will often be the same as the
plans of the existing owner. Thus, the
exit valuation in this context will
converge on the entry value. This
substitution of an expected replacement
cost for a true exit value may create some
initial head scratching. But, however it
turns out, we applaud the board for
finding a good practical way to cope with
the issue that has for so long vexed
theorists.
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THE HIERARCHY
The central
component of Statement no. 157 is its description
of the “Fair Value Hierarchy” (paragraphs 22–31).
The board identifies priorities that management
must follow in estimating the fair values of
assets or liabilities. The hierarchy describes
inputs to measurement models without actually
specifying which models should be used. The
relationships among the three levels of inputs are
described by the flowchart in Exhibit 1.
Level 1. The preferred inputs to
valuation efforts are “quoted prices in active
markets for identical assets or liabilities,” with
the caveat that the reporting entity must have
access to that market (paragraph 24). Information at
this level is based on direct observations of
transactions involving the same assets and
liabilities, not assumptions, and thus offers
superior reliability. However, relatively few items,
especially physical assets, actually trade in active
markets.
Level 2. FASB acknowledged
that active markets for identical assets and
liabilities are relatively uncommon and, even when
they do exist, they may be too thin to provide
reliable information. To deal with this shortage
of direct data, the board provided a second level
of inputs that can be applied in three situations.
The first involves less-active markets for
identical assets and liabilities; this category is
ranked lower because the market consensus about
value may not be strong. The second arises when
the owned assets and owed liabilities are similar
to, but not the same as, those traded in a market.
In this case, the reporting company has to make
some assumptions about what the fair value of the
reported items might be in a market. The third
situation exists when no active or less-active
markets exist for similar assets and liabilities,
but some observable market data is sufficiently
applicable to the reported items to allow the fair
values to be estimated. Specifically for
financial assets and liabilities involving
fixed-dollar flows, a suitable Level 2 input to a
valuation model may be the apparent discount rate
for similar assets and liabilities implied by
their market value and future cash flows. For
example, a company may estimate the value of its
untraded liabilities by finding the discount rate
that the markets seem to be applying to its traded
debt securities. Notably, FASB indicates that
assumptions enter into models that use Level 2
inputs, a condition that reduces the precision of
the outputs (estimated fair values), but
nonetheless produces reliable numbers that are
representationally faithful, verifiable and
neutral.
Level 3. If inputs from levels
1 and 2 are not available, FASB acknowledges that
fair value measures of many assets and liabilities
are less precise. The board describes Level 3
inputs as “unobservable,” and limits their use by
saying they “shall be used to measure fair value
to the extent that observable inputs are not
available.” This category allows “for situations
in which there is little, if any, market activity
for the asset or liability at the measurement
date” (paragraph 30). Earlier in the standard
(paragraph 21), FASB explains that “observable
inputs” are gathered from sources other than the
reporting company and that they are expected to
reflect assumptions made by market participants.
In contrast, “unobservable inputs” are not
based on independent sources but on “the reporting
entity’s own assumptions about the assumptions
market participants would use.” To clarify that
this category excludes fabricated numbers, the
board requires them to “be based on the best
information available in the circumstances.”
Despite being “assumptions about assumptions,”
Level 3 inputs can provide useful information
about fair values (and thus future cash flows)
when they are generated legitimately and with best
efforts, without any attempt to bias users’
decisions.
Adjustments. With the
exception of traded securities, it generally will
not be possible to find identical assets and
liabilities traded in active markets. In these
situations, the observed values are adjusted to
allow for differences between the reported items
and the substitutes that are measurable. These
adjustments may reflect different physical
conditions and locations as well as other
constraints on marketability.
| | FASB 157
Hierarchy of Inputs to Valuation
Models |  | | | |
| |
DISCLOSURES
Because varying degrees of precision result
from using different kinds of inputs, Statement
no. 157 establishes disclosure requirements that
reveal to financial statement users how the fair
value estimates were produced. First of all,
managers must provide separate disclosures about
assets and liabilities whose fair values are
measured repeatedly from those whose values are
measured only once or occasionally. For example,
fair values of investments and many financial
instruments are estimated at every reporting date.
Others, such as impaired assets and those acquired
in a purchase combination, are not revalued at
every date. For recurring situations, a
schedule must reveal how much of the reported fair
value was developed using each level of input for
each category of asset and liability. Exhibit 2 is
taken from Appendix A of the standard as an
illustration of this table for assets. This
information is relevant because it allows users to
assign varying degrees of precision to different
categories. For example, a user might consider the
Level 1 measures to be precise at +/–1%; Level 2
at +/–5%; and Level 3 at +/–20%. If so, the total
market value in Exhibit 2 would likely fall in the
interval between $251,000 and $269,000. The $9,000
variation from the reported $260,000 consists of
the sum of 1% of the $205,000 at Level 1, 5% of
the $25,000 at Level 2, and 20% of the $30,000 at
Level 3. The variation would be greater, of
course, if more assets are valued with Level 3
inputs, or if greater imprecision is assumed for
each category. While imprecision and uncertainty
can never be eliminated, users can reduce them by
using this tabulation to quantify the potential
variability. To assist users in situations
with more significant reliance on Level 3 inputs,
Statement no. 157 requires management to provide
additional information about changes in these
estimated fair values as a reconciliation of the
beginning and ending values. The table must also
indicate whether the resulting gains and losses
appear in the income statement or other
comprehensive income on the balance sheet.
For nonrecurring situations, managers will
provide more complete disclosures similar to those
for recurring measures. Again, the purpose is to
provide users with sufficient analytical
ammunition to deal with the uncertainty produced
by these estimates. | | Example
Disclosures About Recurring Fair Value
Measures | | | | |
| ($
in thousands) | Fair Value
Measurements at Reporting Date
Using: |
| |
| Description
| 12/31/XX
| Quoted
Prices in Active Markets for
Identical Assets
(Level 1)
| Significant
Other Observable Inputs
(Level
2) | Significant
Unobservable Inputs
(Level 3)
|
| Trading
securities | $115
| $105
| $10
|
|
| Available-for-sale
securities | 75
| 75
|
|
|
| Derivatives
| 60
| 25
| 15
| $20
|
| Venture
capital investments | 10
|
|
| 10
|
| Total
| $260
| $205
| $25
| $30
| | |
WHAT DOES FASB 157 ACCOMPLISH?
The main contribution of Statement no. 157
is to bring many other accounting standards into
the 21st century by creating more rigor for
estimates of fair value. An appendix not only
identifies each affected pronouncement but also
shows words that are deleted and added by the new
standard. For example, paragraph 5(c) of FASB
Statement no. 13 on leases is amended by Statement
no. 157 (strikethrough indicates deletion and
underlining addition):
Fair value of the leased property. The
price for which the property could be sold in an
arm’s length transaction between unrelated
parties. The price that would be received to
sell the property in an orderly transaction
between market participants at the measurement
date. Market participants are buyers and sellers
that are independent of the reporting entity,
that is, they are not related parties at the
measurement date. As this excerpt
shows, Statement no. 157 is designed to clarify
existing standards, not create new uses of fair
value.
SETTING THE STAGE
Any
discussion of Statement no. 157 would be
incomplete without addressing its second purpose
of providing a launch pad for bringing additional
usefulness into statements through later new fair
value standards and a new conceptual framework
that we predict will call for fair value
measurements in more situations, either in
supplemental disclosures or in the body of the
financial statements themselves. This
purpose has already been fulfilled in FASB
Statement no. 159, which was issued in early 2007,
only six months after Statement no. 157. The
details of this standard will be described in a
forthcoming issue of the JofA. What
should be noted here is that the statement would
have been much harder to compose, pass and
implement if the groundwork in Statement no. 157
had not been completed. We are satisfied
with the direction taken in Statement no. 159
because it will allow innovative managers to
voluntarily bring greater quantities of more
useful information to the capital markets through
their financial statements. Of course, the risk is
that some managers will try to use the flexibility
to produce misleading representations of some but
not all of their assets and liabilities. These
efforts would be both unethical and pointless
because the capital markets will sooner or later
extract a penalty through lower stock prices and
higher capital costs. Looking well ahead, we
expect traditional cost-based financial reporting
to fade while value-based reporting grows more
prominent. This process has actually been under
way in one form or another for decades, so it
should not come as a surprise. We don’t think
statements no. 157 and no. 159 will disrupt this
gradual trend.  |
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