New requirements for measuring and reporting fair value in GAAP.

Abstract

Statement of Financial Accounting Standards No. 157, Fair Value Measurements, which was finally issued in September 2006, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. The standard gives guidance on how to measure fair value where it is permitted or required under more than 60 other accounting pronouncements. This paper provides a broad overview of recent major accounting standards requiring fair value accounting and reporting, and then focuses on the new formal guidance on fair value measurements.

Background

The controversy over fair value measurement and reporting is partly founded in the trade-off of reliability for relevance. Historical cost has been the preferred measure with accountants because it is reliable, and it is normally relatively easy for the auditor to verify and for users to understand. However, historical cost does not provide a good representation of the current economic value of the assets and liabilities of an entity, and the users of financial reports have pressed for more relevant information.

Increasingly, the business community has become more and more interested in the cash flows that potentially could be derived from an entity's net assets and the value of those net assets. Their needs have impelled the Financial Accounting Standards Board's (FASB) movement toward fair value reporting, which has also been enhanced in recent years because of its convergence efforts with the International Accounting Standards Board (IASB). Preparers have expressed concerns about their ability to implement fair value measurement in financial statements prepared using generally accepted accounting principles (GAAP), partly because there has been limited guidance for applying fair value measurement techniques due to their evolution over time in a piecemeal fashion among many standards.

Given the pervasive use of fair value measurements within existing financial statements, and the prospect for more fair value measurements in the future, the Board felt that there was a need for more guidance on measuring fair value and disclosing both how fair value is determined and the impact that fair value measurements have on the financial statements.

This paper provides a summary and evaluation of Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157), which explains how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP. This new standard also provides a common definition of fair value, to be used where applicable in GAAP, and enumerates the existing standards that utilize fair value in various ways, which will be affected by the new standard. The FASB believes that the new standard will make the measurement of fair value more consistent and comparable, and improve disclosures about fair value measures. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 (e.g., in 2008 for calendar year-end companies).

Fair Value Accounting and Reporting--An Overview

The reporting of fair values of assets and liabilities in financial statements has been required for a number of years, especially for financial instruments, although the presentation varies according to the GAAP applicable in each situation. Currently, the fair values of only certain financial instruments must be recorded on the balance sheet and/or disclosed in the footnotes, and the changes in fair value may be reported in the income statement or other comprehensive income. The following is a summary of the most significant FASB standards issued since 1975 (listed in Appendix D of SFAS 157) that currently require fair value measurements to be reported in financial statements.

* SFAS 13, Accounting for Leases (as amended), issued in 1976, establishes standards of financial accounting and reporting for leases by lessees and lessors. In considering whether a lease is a financing transaction, called a capital lease, one of the criteria is whether the present value of the minimum lease payments exceeds 90% of the fair value of the asset. Another criterion is whether the buyout is significantly lower than the fair value of the asset at the lease termination. In any case, the capitalization amount is less than or equal to the fair value of the asset leased. (Note that there are a number of other standards dealing with leases that are explained in Appendix D of SFAS 157, which are not specifically discussed in this paper.)

* SFAS 87, Employers' Accounting for Pensions (subsequently amended by SFAS 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)), was issued in 1985 and requires extensive use of present value techniques in estimating the current value of pension benefits earned each period, and the employer's liability for benefits accrued. It requires the disclosure of the fair value of plan assets.

* SFAS 88, Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, as amended, was issued in 1985 and establishes standards for an employer's accounting for settlement of defined benefit pension obligations, for curtailment of a defined benefit pension plan, and for termination benefits.

* SFAS 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, as amended by SFAS 158, was issued in 1990. It applies the same present value techniques as SFAS 87 to determine current compensation expense and postretirement benefit liability; it also requires the disclosure of the fair value of plan assets.

* SFAS 107, Disclosures About Fair Value of Financial Instruments, issued in 1991, provides the definition of a financial instrument, defines its fair value, and explains how its fair value should be disclosed in the financial statements. It also provides some guidance on how the fair values of financial instruments could be obtained.

* SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, issued in 1993, requires that certain investments in debt and equity securities classified as trading and available-for-sale be recorded on the balance sheet at their fair values, and the unrealized gains and losses be recognized in the income statement for securities classified as trading, or in other comprehensive income for available-for-sale securities.

* SFAS 123(R), Share-Based Payment, issued in 2004 to replace SFAS 123, Stock-Based Compensation (1995), and to supersede Accounting Principles Board (APB) Opinion No. 25 (1972), Accounting for Stock Issued to Employees, is not within the scope of SFAS 157. However, it requires the use of option-pricing modeling to measure the fair value of share-based payment awards granted to employees at the grant date, with compensation expense allocated over the award's required service period. SFAS 123(R) also addresses transactions with outsiders in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity's equity instruments, or that may be settled by the issuance of those equity instruments.

* SFAS 133, Accounting for Derivative Instruments and Hedging Activities, as amended, was issued in 1998. This standard requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position, and measure those instruments at fair value. It also provides that a derivative may be specifically designated as: a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment; a hedge of the exposure to uncertain cash flows of a forecasted transaction (such as the future issuance of a bond); or a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency-denominated forecasted transaction.

* SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (as amended), issued in 2000, provides accounting and reporting requirements for a transfer and servicing of a financial asset and the extinguishment of a liability, as well as the definition of the fair value of an asset (or liability). It defined fair value as the amount at which the asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale. After a transfer of financial assets, an entity must recognize the financial and servicing assets it controls and the liabilities it has incurred, and derecognize financial assets when control has been surrendered and liabilities when they are extinguished.