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

The benefits of the hierarchy can also be assessed by examining improvements in the comparability and consistency of fair value information, since both of these qualities impact the relationship between relevance and reliability [6]. Comparability is enhanced if the hierarchy better enables different companies to measure, report and disclose the fair values of assets and liabilities in a similar manner. Consistency is enhanced if an individual company is better able to measure fair values in a similar manner from period to period. An assessment of the hierarchy in light of these qualitative characteristics follows.

Relevance and Reliability: A Traditional Assessment

Accounting methods, such as some fair value measurement techniques, may increase the relevance of the information produced while simultaneously decreasing its reliability [6]. Though a longstanding debate continues, the FASB has concluded that improvements in relevance generated by the use of fair value information for assets and liabilities is often worth the trade-off of a reduction in the reliability of such information. Fair value better reflects current market conditions, and is more representative of a company's existing financial position than valuations using historical cost, although the latter is usually considered more reliable. A higher degree of usefulness is therefore achievable if fair value information causes better decisions, and thus increased relevance, without undo sacrifice as to its reliability. In an analysis of the trade-offs inherent in using fair value reporting, Ernst & Young [4] suggests that "reliability is a necessary precondition that must be met for information to be relevant."

An assessment of SFAS 157 suggests that financial statement users will be provided with more useful information and insights into the reliability of fair value measurements within the hierarchical structure in the following ways:

* Companies now have better guidance on the considerations in making assumptions for performing Level-2 calculations or, as a last resort, performing Level-3 calculations in those situations where quoted prices in active markets for identical assets or liabilities (Level- 1) are absent.

* Financial statement readers are more aware of the degree to which fair value measurements are derived from observable versus unobservable inputs.

* Disclosing the ranking of inputs provides better transparency and insights into the degree of subjectivity and judgment in a company's reported fair value measurements.

* Formal guidance is now available on the proper ranking when significant inputs are derived from more than one level of the hierarchy (i.e., use the lowest ranking).

* Having an established framework to derive fair values will improve the external auditor's ability to verify a company's fair value measurements, as discussed in more detail in the following section.

On the other hand, the hierarchy does not resolve issues that can potentially erode the reliability of fair value data, and therefore, its relevance for decision-making. Concerns will continue to exist, particularly with respect to the nature of Level-3 inputs, which are used to estimate fair value. By definition, these inputs are unobservable and are derived by company management. They may very well represent inputs based on hypothetical assumptions that would be made by hypothetical third parties (i.e., market participants), and are thus another form of an accounting estimate.

Some critics assert that such measurements may increase the likelihood of manipulation by opportunistic managements and may, in fact, be worse than using less relevant, but more reliable, historical costs. They also fear that this trend "has the potential for widespread deception of investors" [9]. Accordingly, Level-3 inputs will probably continue to be subject to management bias, susceptible to measurement error, and difficult to independently verify. In SFAS 157 (par. C87), the FASB acknowledges that some Level-3 inputs may be of such a hypothetical nature that they "would seem to be of questionable relevance to users of financial statements." However, given the general trend toward fair value reporting, the FASB believes that the hierarchy enhances the overall reliability of those measurements as well as its relevance to decision-makers.

Relevance and Reliability: Another View

Whether a specific trade-off between relevance and reliability is warranted also depends on the relative weights attached to each by a particular financial statement user. Accordingly, another (direct) relationship between relevance and reliability exists among the inputs used to derive fair values. Some believe that "information needs to pass a reliability threshold before it can be considered relevant at all" [4]. In other words, fair value measurements using Level-1 inputs can be viewed as being more reliable and more relevant than those using Level-2 and Level-3 inputs. Though this debate will continue, the FASB expects that the expanded disclosures required in SFAS 157 will enable users to "make more informed judgments" about the reliability of the accounting estimates and the method(s) used to derive them, and to identify fair value measurements that were estimated using "inherently subjective" input data and assumptions, which may not be very reliable (par. C98).

Comparability and Consistency

The fair value hierarchy should also enhance the comparability of information among companies, and improve the consistency from period to period of an entity's reported fair value estimates, because of the following changes in practices:

* All companies must follow the same framework to identify, rank, and then use the best inputs in their valuation techniques.

* Inputs to value specific assets and liabilities should be derived and ranked in a similar way using the new hierarchical structure.

* Pricing inconsistencies in certain Level-1 inputs have been eliminated, particularly with respect to instances when a company has a large holding of a particular asset (e.g., prohibition of blockage discounts) and adjustments to the values of restricted securities.

* Significant events or transactions that impact fair value (e.g., material announcements or large trades) may occur in "after-hours trading" on the measurement date. In such cases, SFAS 157 (par. 26) requires companies to "establish and consistently apply a policy for identifying those events" and how to classify the resultant fair value measurement in the hierarchy.

* Expanded required disclosures ensure a minimum level of clarity and similarity by having valuation information provided in a structured format, which will be more meaningful than existing disclosures.

* Expanded disclosures during interim periods of fair value measurements and related inputs will provide users with more current, and possibly more timely, information than in the past.

However, certain drawbacks to the comparability of fair value information are expected to persist despite the existence of the new hierarchy. This is due to the use of subjective management judgment at various points in the valuation process. For example, fair value measurements for many assets (e.g., intangibles, long-lived assets, etc.) are likely to require the use of present value techniques, and incorporate inputs from both Levels-2 and -3. In such cases, management must determine: (1) the principal (or most advantageous) market for the asset; (2) the underlying assumptions and inputs that market participants would use to value the asset; (3) the valuation technique(s) appropriate in the circumstances; (4) the significance of each input in determining fair value; and (5) the overall classification of the entire measurement within the hierarchy for disclosure purposes.

Accordingly, this degree of subjective judgment can lead to different fair value measurements and disclosures by different companies for substantially identical assets (and liabilities). Overall, however, the guidance and hierarchical structure provided in SFAS 157 will significantly improve the comparability and consistency of fair value measurements provided in financial statements in the future.

Considerations for External Auditors

An external auditor's main objective is to express an opinion on whether a company's financial statements are fairly presented in accordance with generally accepted accounting principles (GAAP). Auditors obtain sufficient appropriate audit evidence to form such an opinion by performing audit procedures. The appropriateness of evidence is measured by its relevance and reliability in determining whether the financial statements are fairly presented [1].

Statement of Auditing Standards No. 101, Auditing Fair Value Measurements and Disclosures (SAS 101), provides a general framework for auditing fair value measurements and disclosures [2]. When auditing values generated from Level-2 or -3 inputs, the process can be viewed as consisting of three steps [10]. First, the auditor must consider the significant management assumptions used to determine fair value, including their supporting documentation, development and application, monitoring of changes, and approval process. Second, the auditor must evaluate whether the valuation method used is appropriate in the circumstances, including whether it is in compliance with GAAP and whether it is appropriate given the client's business, industry, and environment. Lastly, the auditor must perform audit tests on the underlying data used to generate the fair value measurement.