Refining fair value measurement: FASB 157 upgrades the quality of financial reporting.

Author:Miller, Paul B.W.
 
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FASB 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.

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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.

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...

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