Ethical Implications of reporting fair value in financial statements.

Abstract

Statement of Financial Accounting Standards No. 157, Fair Value Measurements, issued by the Financial Accounting Standards Board (FASB) on September 15, 2006 provides enhanced guidance for estimating the fair values of assets and liabilities reported in financial statements. Prior to the issuance of this standard, methods for measuring fair value were diverse and inconsistent. The new standard establishes a fair value hierarchy that prioritizes the inputs that should be used when estimating fair value. Level-3 fair value estimates in the hierarchical structure, which involve the highest levels of management judgment and subjectivism, provide the greatest area of ethical concern.

Introduction

On September 15, 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157). This standard provides a single definition of fair value and enhanced guidance for estimating fair values of assets and liabilities to be reported in financial statements. Appendix D in SFAS 157 lists over 60 generally accepted accounting principles (GAAP) that require or permit entities to measure assets and liabilities at fair value. Prior to the issuance of SFAS 157, methods for measuring fair value were diverse and inconsistent, especially for items that were not actively traded. The new standard provides a hierarchical structure for measuring fair value, and also requires expanded disclosure of fair value measurements reported in financial statements, especially for those items measured using unobservable data. This Statement applies under other accounting pronouncements that require or permit fair value measurements; however, it does not require any new fair value measurements [2].

What the standard does do is to establish a fair value hierarchy that prioritizes the inputs (assumptions) that market participants will use when estimating the fair value of an asset or liability. The fair value estimates produced within levels one and two of the hierarchical structure use observable market inputs. However, the Level-3 fair value estimates involve the highest levels of management judgment and subjectivism, so they hold significant potentials for abuse and ethical concern.

Background of the Problem

There has long been resistance to fair value measurement replacement of the historical cost model by accounting professionals. Many professionals believe that historical cost gives the auditor a solid base upon which to form an opinion, thereby reducing the subjectivity in accounting. In contrast, they believe, for example, that the highly subjective pricing of long-term natural gas contracts was an open invitation to unethical, greedy people to manipulate earnings, which led to the great frauds of recent years. It was felt that the larger problem was with the execution of the accounting standards themselves, since they placed more and more pressure on the accountants and auditors to judge values without any solid basis for such an evaluation. This led to a threat of the reliability of accounting information [3].

Eugene H. Flegm, retired CFO of General Motors (GM) and former general auditor of that company, wrote a comment letter in which he outlined the origin of these accounting changes. He states his position on the need for reliable data and stewardship in accounting. Mr. Flegm represents the accounting professional's resistance to fair value measurement in place of a historical cost model. We cite the 1971 Trueblood Committee's conceptual framework for accounting, which proposed two radical shifts in financial accounting:

* The primary purpose of financial statements should be to provide investors and creditors with information to make rational decisions regarding their investments. (The longstanding stewardship function of accounting was relegated to a secondary position.)

* "Earnings" should be determined from an economist's rather than an accountant's view (historical cost model). In this approach, earnings for a given period could best be determined by the discounted change in the values of the beginning and ending balance sheet, ideally. However, determining the rate to be used was open to question. The debate on this has continued to this day, e.g., the radical shift in financial accounting to a balance sheet view of income, which was to lay the groundwork for a move from the historical cost model to a fair value one.

In short, Eugene Flegm believes that the many frauds committed by top management, the largest in history, can be traced not only to the general decline in values in the past 30 years, but also to the steady move to fair value accounting by the FASB. We concur; we believe that subjectivity in accounting must be reduced, and the way to do that is through maintenance of the historical-cost model [3].

An Enhanced Fair Value Framework

Nevertheless, on September 15, 2006, the FASB issued SFAS 157. As mentioned earlier, SFAS 157 provides a new definition of fair value, which is:

* Fair 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.

In addition, SFAS 157:

* Retains the notion that the exchange price is that of an orderly transaction to sell an asset or transfer a liability in its principal or most advantageous market;

* Emphasizes that fair value is a market-based--not entity-specific--measurement, and that a fair value measurement should be based on assumptions market participants would use in pricing an asset or liability;

* Clarifies that assumptions include those about risk and about the effect of a restriction on the sale or use of an asset, and that a fair value measurement for a liability reflects its nonperformance risk;

* Affirms that the fair value of a position in a financial instrument that trades in an active market should be measured as the product of the quoted price for the individual instrument multiplied by the quantity held, with no adjustments for blockage factors;

* Expands disclosures about the use of fair value to measure assets and liabilities in interim and annual periods, subsequent to initial recognition.

SFAS 157 is generally effective for financial statements issued for fiscal years beginning after November 15, 2007, and related interim periods [5].

Fair Value Hierarchy

SFAS 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value estimate should be determined based on the assumptions that market participants would use in pricing an asset or liability. As a basis for considering market participant assumptions in fair value measurements, SFAS 157 establishes a fair value hierarchy that distinguishes between market participant assumptions developed from market data obtained from sources independent of the reporting entity (observable market inputs), and the reporting entity's own assumptions about market participant assumptions developed from the best information available in the circumstances (unobservable inputs).

This fair value hierarchical structure is aimed at increasing the consistency and comparability in fair value measurements, and related disclosures that are reported in financial statements, since it prioritizes the inputs to valuation techniques used to measure fair value into three broad levels, Level-1, Level-2, and Level-3, with Level-1 containing the best and most reliable form of market inputs and Level 3 containing virtually none. Although the availability of market inputs relevant to the asset or liability, and the relative reliability of the inputs, may affect the selection of appropriate valuation techniques, "the hierarchy is intended to convey information about the nature of the inputs (the assumptions, not the valuation techniques) used in creating the reported fair values)." [4].

Market inputs refer to the assumptions that market participants would use in making pricing decisions (that is, in estimating fair values). Market inputs are either observable or unobservable. Observable market inputs refer to inputs developed based on market data obtained from sources independent of the reporting entity. Unobservable market inputs refer to inputs that reflect the reporting entity's assumptions of market inputs.

Level-1 inputs are observable market inputs that reflect quoted prices for identical assets or liabilities in active markets that the reporting entity has the ability to access at the measurement date. An example is a quoted price on the New York Stock Exchange.

Level-2 inputs are inputs other than quoted prices included within Level-1 that are observable for the asset or liability, either directly or indirectly through corroboration with observable market data (market-corroborated inputs).

Level-3 inputs are unobservable inputs for the asset or liability; that is, inputs 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), developed based on the best information available in the circumstances. Assumptions about risk include the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model), and/or the risk inherent in the inputs to the valuation technique [2].

Fair Value Disclosures