Ethical Implications of reporting fair value in financial statements.

SFAS 157 (paragraphs 32-35) requires disclosures about the fair value of assets and liabilities recognized in the statement of financial position in periods subsequent to initial recognition, whether the measurements are made on a recurring basis or on a nonrecurring basis. Quantitative disclosures using a tabular format are required in all periods (interim and annual). Qualitative (narrative) disclosures about the valuation techniques used to measure fair value are required in all annual periods.

Ethical Implications of Level-3's Fair Value Measurements and Audit Considerations

The Level-3 fair value estimates in the hierarchical structure are estimated with the most unreliable valuation inputs (assumptions), and therefore involve the most uncertainty and highest levels of management judgment and subjectivism. This is because market prices and other market inputs that would first be used to estimate their fair values are not available. Thus, management can employ their own assumptions about the inputs necessary to calculate fair values (such as future estimated cash flows and discount rates). Therefore, it is with the Level-3 fair value estimates reported in financial statements that the ethical problems will be the greatest, as managers try to over- or underestimate fair values to accommodate their own objectives.

It is noted, however, that SFAS 157 requires the most detailed disclosures for the Level-3 fair value estimates reported in financial statements, to apprise readers of financial statements of managements' assumptions, and the reliability (or unreliability) of their fair value estimates. These requirements, combined with the expanded guidance of Statement on Auditing Standard No. 101, Auditing Fair Value Measurements and Disclosures (SAS 101), provide stakeholders with greater assurance about the reliability of the estimates. Specifically, SAS 101 provides a general framework for auditing fair value measurements and disclosure--providing guidance on understanding management's process for developing fair value estimates and evaluating whether the measurement conforms to GAAP.

The new guidance in SFAS 157 and the additional information reported in financial statements must also be considered during periodic audits. For example, the auditor must understand the new GAAP requirements for each type of fair value estimate and disclosure. The new GAAP does not specify methods or processes that should be used for measuring assets and liabilities at fair value. If observable market inputs are not available (i.e., a Level-3 valuation measurement), management techniques for estimating fair value should incorporate assumptions that individuals in the marketplace would use. If that information is not available without excessive cost and effort, then GAAP permits an entity to use its own assumptions as long as there is no indication that marketplace participants would use different assumptions [6].

Specifically, the auditor must evaluate the significant input assumptions, consider the appropriateness of the valuation model used, and test the underlying data and valuation estimates. The auditor does this even when management uses a valuation specialist to prepare the estimate. When management uses a qualified and objective specialist for the fair value measurement it uses for financial reporting purposes, it is still management that is responsible for the data that form the basis for the measurement, as well as the approach, methods, and assumptions the specialist used in arriving at the fair value of an item [6].

Implications for Academia and Corporate Governance

It has been suggested that investors and accountants will have to broaden their knowledge of fair value measurement methodologies, since there are already a large number of standards that require fair value estimates, and that academic programs at universities should provide joint accounting and finance programs that include courses on valuation techniques in financial reporting. There still remains the problem of greedy CEOs, CFOs, and challenged accounting professionals. Various approaches to address ethical lapses have been suggested. The Sarbanes-Oxley Act has been a boon. Business education could be a remedy. To improve corporate governance and mindful accounting professionals, it has been recommended that business schools focus on integrity at the individual, company and societal levels--that is, on business in society, not just business in economy [7].

In addition, it has been suggested that the principal problem that financial accounting should deal with is top management's fraud. Some authors have suggested that a cultural audit would provide a means for assessing the tone at the top and the attitude toward internal controls and ethical decision making recommended by the Treadway Commission almost two decades ago. A cultural audit would be a tool for creating ethical companies suggested by the authors Castellano and Lightle [1]. They propose that the board of directors, through the audit committee, retain an outside firm to conduct a cultural audit every three years. The authors cite three issues that need to be addressed:

* The degree to which preoccupation with meeting the analyst's expectations permeates the organizational climate;

* The degree of fear and pressure associated with meeting numerical goals and targets; and

* The compensation and incentive plans that may encourage unacceptable, unethical, and illegal forms of earnings management.

This means of assessment recognizes the critical role of internal controls over financial reporting for creating and maintaining ethical companies.

References

1. Castellano, J. and S. Lightle. "Using Cultural Audits to Access Tone at the Top," The CPA Journal, February, 2005. http://www.nysscpa.org/printversions/cpaj/2005/205/p.6.htm

2. Financial Accounting Standards Board. "Fair Value Measurements," Statement of Financial Accounting Standards. No. 157. Norwalk, CT: FASB, September 2006.

3. Flegm, Eugene H. "On Solving the Problem, Not Being It," The CPA Journal, February 2005, 12-14.

4. Haldeman, Jr., R.G. "Fact, Fiction, and Fair Value Accounting at Enron," The CPA Journal, November 2006, 14-31.

5. Highlights, The CPA Journal, November 2006, 10.

6. Menelaides, S.L., L.E. Graham and G. Fischbach. "The Auditor's Approach to Fair Value," Journal of Accountancy, June 2003, 73-76.

7. Waddock, S. "Hollow Men and Women at the Helm ... Hollow Accounting Ethics?" Issues in Accounting Education, 20 (2), 2005, 145-150.

Teresa M. Danile, The Peter J. Tobin College of Business, St. John's University

Irene N. McCarthy, The Peter J. Tobin College of Business, St. John's University