What's fair? FASB moves closer to fair value consistency and comparability.

Six months after FASB issued a unifying definition of fair value, it issued FAS 159, "The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115," in February.

Also known as the FVO standard, public feedback on FAS 159 so far reflects much debate on the standard's intended benefits and potential for abuse during transition, and some general concern about the outside auditors' ability to audit the implementation, specifically, the reasonableness of the inputs used by the audit clients in arriving at the fair value measurements.

FAS 159, which applies to measurements for stocks, bonds, loans, warranty obligations and interest rate hedges, provides entities the option (but not the requirement) to measure at fair value such financial instruments and certain other items that are not currently required to be measured at fair value.

Current accounting measurement for such instruments may be historical cost, amortized historical cost or lower of cost or market. The stated objective of FAS 159 is "to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets (such as loans held for sale) and liabilities (such as forward sales commitments) differently without having to apply complex hedge accounting provisions," found in FAS 133.

Although FAS 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value, it expands the use of fair value measurement.

The fair value option may be applied instrument by instrument (with a few exceptions); is irrevocable (to minimize potential for abuse, unless a new election date occurs as described by FAS 159); and is applied only to entire instruments and not to portions of instruments.

Upon taking the option to measure an eligible financial asset or liability at fair value, a for-profit entity is required to report in earnings unrealized gains and losses on items for which the fair value option has been elected at each subsequent reporting date.

For eligible items existing at the effective date of FAS 159, the entity shall report the effect of the first "remeasurement" to fair value as a cumulative-effect adjustment to the opening balance of retained earnings.

As discussed later, this provision has been viewed as a potential source of accounting abuse. In amending FAS 115, "Accounting for Certain Investments in Debt and Equity Securities," FAS 159 permits held-to-maturity securities (HTM), previously required to be measured at amortized cost, to be measured at fair value.

If the fair value option is elected for available-for-sale or HTM securities, cumulative unrealized gains and losses at the option date shall be included in the cumulative-effect adjustments, and specific disclosures are required. Modifications in the requirements are provided for not-for-profit entities.

Required disclosures include, among others:

* A schedule presenting the pre-tax portion of the cumulative-effect adjustment to retained earnings;

* The fair value at the effective date of eligible items for which fair value option is elected and the carrying amount of those same items immediately before electing the fair value option;

* Management's reasons for electing fair value option for each existing eligible item;

* Reasons for partial election within a group of similar eligible items; and

* The amount of valuation allowances removed from the balance sheet because they were related to items for which the fair value option was elected.

TRANSITION ISSUES RELATING TO FAS 159

Upon first remeasurement to fair value for existing eligible financial instruments, a cumulative-effect adjustment to beginning retained earnings of the reporting entity is to be recorded. There has been concern expressed by accounting and regulatory observers that this one-time non-earnings impact provides a potential for abuse intended to achieve an accounting result, specifically when unrealized losses are involved.

A common example has been described as follows: a company identifies losing players in its portfolio (such as underwater HTM securities), elects to fair value such items and records the loss directly in retained earnings. The company then sells the same instruments, only to purchase replacement instruments and value them at historical cost all over again, apparently retreating from fair value going forward for those instruments.

Both the SEC and the AICPA's Center for Audit Quality (CAQ) have expressed clear warnings about the example above.

In an April 4, 2007, speech by SEC Deputy Accountant James Kroeker, "Regardless of whether these engineered transactions achieve your accounting goal ... you can expect the SEC to have a continued interest in this topic." And an April 17, 2007, letter from the CAQ warns, "If an entity proposes to adopt the fair value option merely to achieve an accounting result that is contrary to the principles and objectives in FAS 159 ... the auditor should reach a conclusion that the entity's proposed accounting departs from generally accepted accounting principles."

Also, Lynn Turner, former SEC chief accountant, has expressed concern in a recent speech that FAS 159 opens the door for companies to pick and choose fair value measurement for securities, thus allowing them to hide losses in their portfolio and manage earnings.

And in June, the PCAOB expressed some concern, primarily about the challenge auditors will likely face with the adoption of FAS 159. As described above, fair value measurement uses various assumptions and valuation techniques.

PCAOB Chair Mark Olson stated that fair value accounting, "while presenting the promise of greater relevance, represents an area of potential audit risk." Olson cited factors such as the training required in valuation, and that many auditors may not have extensive training in valuation techniques.

He further stated that auditors "should be mindful" about the possibility of client bias in fair value assessments, and that internal controls surrounding fair value measurements may be different from those over typical business transactions.

GOING FORWARD

Interestingly, FAS 159 represents just Phase 1 of FASB's fair value project. Phase 2 is intended to address the FVO for certain nonfinancial assets and nonfinancial liabilities and the deposit liabilities of depository institutions.

Phase 2 deliberations are scheduled for the third quarter of 2007 and the exposure document for public comment could be available as early as the first quarter of 2008. In the meantime, financial statement preparers, auditors and users of those financial statements impacted by the new fair value standards have plenty to deal with.

A. Christine Davis, CPA is a director in the Litigation and Forensic Consulting Services Group in the San Francisco office of Hemming Morse, Inc. You can reach her at davisc@hemming.com.

BY A. CHRISTINE DAVIS, CPA

RELATED ARTICLE: Need more fair value info?

FAS 157

Summary: www.fasb.org/st/summary/stsum157.shtml

Guidance: www.fasb.org/pdf/fas157.pdf

FAS 159

Summary: www.fasb.org/st/summary/stsum159.shtml

Guidance: www.fasb.org/pdf/fas159.pdf