The new fair value hierarchy: key provisions, implications, and effect on information usefulness.

Abstract

Statement of Financial Accounting Standards No. 157, Fair Value Measurements, introduces a fair value hierarchy that prioritizes the data companies use for such measurements. The new hierarchy, together with additional footnote disclosures, is expected to improve existing practices concerning fair value reporting. This paper examines the key provisions of the fair value hierarchy and assesses its impact on the usefulness of reported financial information. The hierarchy's influence on the external auditor's role is also discussed.

Introduction

Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157), standardizes existing practices companies use to measure assets and liabilities at fair value [5]. Appendix D to the Standard lists over 60 accounting pronouncements that refer to various aspects of fair value reporting, but many contain conflicting or limited implementation guidance. The volume of pronouncements mentioning fair value is evidence of the gradual, but relentless, shift away from the long-standing historical cost (or transaction-based) system [7].

The shift results from increased emphasis by standards setters on the relevance of information provided to financial statement users, over its reliability. The standard introduces a three-level fair value hierarchy that prioritizes the quality and reliability of information used to develop such measurements, and expands disclosure of specific fair value information by level within this hierarchy. These requirements should help financial statement users better assess the reliability of reported fair value information, determine the consistency of its application, and improve comparability with other companies.

This paper provides a brief overview of the major fair value measurement principles in SFAS 157, followed by an examination of the fair value hierarchy and its impact on financial reporting. The benefits and criticisms of the hierarchy are discussed, and its impact on the usefulness of fair value information for decision-making is assessed. Finally, the hierarchy's likely influence on the external auditor's role is also examined.

Overview of Fair Value Measurements in SFAS 157

SFAS 157 clarifies existing approaches to fair value measurements currently dispersed throughout the accounting literature. The new guidance has three main components, the goal of which is to standardize the measurement and disclosure of the fair values of existing assets and liabilities.

* First, SFAS 157 (par. 5) defines fair value as the price that a company would receive to sell an existing asset or pay to transfer a liability (i.e., an exit price) in an orderly transaction between third parties (i.e., marketplace participants). In other words, fair value measurements reflect assumptions that knowledgeable, independent market participants would make to hypothetically price the asset or liability, as opposed to relying on management's internal or entity-specific assumptions.

* Second, SFAS 157 establishes a framework for companies to follow when measuring assets and liabilities at fair value. This framework includes the techniques or models companies use to compute fair value. The three primary valuation techniques discussed in the standard are: (1) the market approach, which generally uses quoted prices that are readily available (e.g. the New York Stock Exchange); (2) the income approach, which generally uses present value techniques to discount future cash flows, or certain option-pricing models, and (3) the cost approach, which generally represents current replacement cost. Although SFAS 157 does not specify when a particular valuation technique should be used, it does require that the technique(s) be appropriate in the circumstances and applied on a consistent basis.

The accuracy and reasonableness of fair value measurements largely depend upon the reliability of the data and assumptions used in these techniques. Accordingly, SFAS 157 introduces a fair value hierarchy that prioritizes these inputs into three levels. Highest priority (Level-1) is given to observable unadjusted quoted prices in active markets for identical assets or liabilities. Intermediate priority (Level-2) is given to all other observable information. Lowest priority (Level-3) is given to unobservable information. As explained in paragraph 30 of SFAS 157, Level-3 inputs are unobservable inputs for an asset or liability (e.g., future cash flows and discount rates) that reflect the reporting entity's own assumptions about the assumptions market participants would use in pricing the asset or liability (including assumptions about risk), if such information is available without undue cost and effort.

* Finally, SFAS 157 expands interim and annual disclosures about fair value measurements. These disclosures include tables containing the fair values of major categories of assets and liabilities, the level within the hierarchy from which the measurements were derived, and gains and losses recognized during the period. For valuations involving Level-3 inputs, additional disclosures are required relative to the other two levels in order to partially compensate for their weaker reliability, as highlighted in the hierarchy below.

The Fair Value Hierarchy of Measurement Inputs

Information used to measure fair value can be derived from many sources and varies as to the level of reliability. Reliability relates to the degree of assurance capable of being obtained through verification that information faithfully represents what it purports to represent. Accounting methods and techniques used to measure information contribute to its degree of reliability [6].

It is essential that fair value measurements be derived from data and assumptions from the viewpoint of market participants. To highlight differences in reliability and enhance the consistency and comparability of fair value measurements, SFAS 157 establishes a hierarchy that prioritizes the information (inputs) to fair value measurements. Inputs are first categorized as either observable or unobservable. Observable inputs reflect assumptions that market participants would make, based upon market-based information from sources independent of the company. Sources of observable inputs include the following:

1. Exchange Markets such as the New York Stock Exchange (NYSE);

2. Dealer Markets such as NASDAQ or other Over-the-Counter (OTC) markets;

3. Brokered Markets such as real estate; and

4. Principal-to-principal market transactions which are privately negotiated with little public information available.

Oftentimes, situations exist where little, if any, market activity for the asset or liability exists at the measurement date. In such cases, the use of unobservable inputs is permitted. However, management must examine and consider assumptions that market participants would make to price the asset or liability. These assumptions should be based on the best information available in the circumstances, including a company's internal data. For example, information to ascertain the fair value of a specific operating division of a company is generally not readily available in an active market. In this type of situation, the fair value computation will likely require management to: (1) derive assumptions concerning future cash flows from an external viewpoint and (2) employ one or more valuation techniques. Such measurements are less reliable than identifiable information or quoted prices in established markets. In general, companies should "maximize the use of observable inputs and minimize the use of unobservable inputs" to their valuation models [5: par. 21].

The fair value hierarchy prioritizes these observable and unobservable inputs into three categories, or levels, based on their degree of reliability. The components of the hierarchy are summarized below:

The Hierarchy and the Usefulness of Fair Value Information

Information Usefulness

The benefits of the fair value hierarchy to users of financial information can be assessed from different perspectives. In general, financial information is considered to be useful if it enhances one's ability to make investment and credit decisions [6]. Furthermore, such information is considered "better" (i.e., more useful) primarily if it has more relevance and reliability. Relevance refers to the capacity of information to "make a difference" in the decision-making process. While useful information must have both relevance and reliability to a minimum degree, neither is the paramount characteristic of accounting information [8].

Given the extent and complexity of existing fair value guidance, the benefits of the hierarchy should be evaluated by assessing whether it improves current theory and practice. Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Financial Information (CON 2), provides guidance helpful in making this assessment. First, the hierarchy should enhance the relevance and reliability of fair value information for users. Relevance is enhanced if the hierarchy improves a user's ability to make a decision involving fair values compared to existing practice. In other words, the information should help users to better assess a company's future outcomes, confirm the results of prior expectations, and be available on a timely basis. On the other hand, reliability is enhanced if users are provided with fair value measurements that are more verifiable, faithfully represented, and unbiased than they are under existing practices.