What's fair? FASB moves closer to fair value consistency and comparability.

CPAs have long been familiar with the term "fair value," a measurement required in accounting for business combinations, goodwill impairment assessments and most financial instruments. But until recently, there were different definitions of fair value, which created inconsistencies in applying generally accepted accounting principles, and limited guidance for applying such definitions.

To remedy the situation, FASB has long considered the need for increased consistency and comparability in fair value measurements and is a step closer to that goal as two of its three most recent standards--FAS 157 and FAS 159--deal with fair value.

FAS 157, "Fair Value Measurements," and FAS 159, "The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115," are effective for fiscal years beginning after Nov. 15, 2007, with early adoption already completed by some 60 companies. Much attention has been given to these principles-based standards by accountants, investment bankers and regulators, but for different reasons.

FAS 157 has been viewed as helpful in clarifying the application of fair value in accounting, while there is concern that FAS 159, also known as the FVO Statement, may be used by some companies in a manner that is inconsistent with the FASB's objective of improving financial reporting.

HIGHLIGHTS OF FAS 157

FAS 157, issued in September and applicable to assets and liabilities permitted or required by GAAP to be measured at fair value, provides a single definition of fair value, a framework for measuring fair value and expands disclosures about fair value measurements.

The provisions of FAS 157 are encompassing, as evidenced by the 28 pronouncements amended or affected, including the long-standing ABP Opinion No. 21, "Interest on Receivables and Payables," and the more recent FAS 156, "Accounting for Servicing of Financial Assets."

Investment companies in particular have paid great attention to FAS 157, as have entities that have goodwill on their financial statements.

FAIR VALUE DEFINED

FAS 157 defines fair value as "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." While this definition sounds familiar enough, FAS 157 further defines every key word or phrase, signaling a precise definition of fair value not seen before.

While retaining the exchange price notion in previous definitions of fair value, FAS 157 clarifies that "price" is the "exit price," which is expected to be different from the "entry price" or the price that would be paid to acquire the asset or received to assume the liability.

The exit price is the result of an "orderly transaction," which is a hypothetical transaction at the measurement date from the perspective of a market participant that holds the asset or owes the liability. An orderly transaction is distinguished from a "forced transaction," such as a forced liquidation or distress sale.

Key to FAS 157 is the emphasis on a market-based measurement, as opposed to an entity-specific measurement, since fair value is based on assumptions that "market participants" would use to price the asset or liability. FAS 157 also states that an orderly transaction "assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities."

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It is possible for the fair value measurement to be different from the price the reporting entity itself would otherwise pay for the asset or receive for the liability at measurement date.

"Market participants" are defined as buyers and sellers in the "principal" or "most advantageous" market for the asset and liability who are knowledgeable about the asset or liability, able and willing to transact for the asset and liability, and not related parties. A fair value measurement assumes the transaction occurs in the principal market, which is the market in which the reporting entity would sell the asset or transfer the liability with the greatest volume and level of activity for the asset or liability.

If there is no principal market for the asset or liability, the most advantageous market setting will be used, which is the market in which the reporting entity would sell the asset or transfer the liability with the price that maximizes the amount that would be received or minimizes the amount that would be paid to transfer the liability. If there is a principal market for the asset or liability, the fair value shall be the price in that market, even if the price in a different market, including the most advantageous market, is potentially more advantageous. The concepts of principal and most advantageous markets are new in GAAP.

VALUATION TECHNIQUES

FAS 157 provides three valuation techniques the reporting entity is to use in arriving at a fair value measurement. Whether one or all of these techniques is used, the entity is to use those that are appropriate in the circumstances and for which there is sufficient data to measure fair value.

Techniques familiar in business valuation, but new to GAAP are the "market approach," "income approach" and "cost approach."

The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. The income approach uses valuation techniques to convert future amounts, such as cash flows or earnings, to a single amount discounted to present value. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset, also known as current replacement cost.

In any case, the fair value measurement of an asset assumes the "highest and best use" of the asset by market participants, even if the intended use of the asset by the reporting entity is different. The fair value of a liability shall reflect the "nonperformance risk" relating to the liability, which is the risk that the obligation will not be fulfilled. Appendix A of FAS 157 provides implementation guidance using simplified examples that illustrate the application of the new standard.

Whichever valuation technique is used, FAS 157 defines "inputs" to be used in the technique as either "observable" or "unobservable," with the provision that the valuation technique used shall maximize the use of observable inputs and minimize the use of unobservable inputs. That is because observable inputs reflect assumptions market participants would use in pricing the asset or liability and are developed based on market data obtained from sources independent of the reporting entity.

Unobservable inputs reflect the reporting entity's own assumptions about the assumptions market participants would use in pricing the asset or liability.

FAIR VALUE 'HIERARCHY'

One of the most important developments in the FASB's fair value project, as reflected in FAS 157, is the fair value "hierarchy." The hierarchy is meant to increase consistency and comparability in fair value measurements and related disclosures by ranking the quality and reliability of information used as inputs for the valuation techniques.

The hierarchy, which sets forth Level 1, Level 2 and Level 3 inputs, gives the highest priority to quoted prices in active markets (Level 1), and lowest to unobservable inputs (Level 3).

Level 1 uses observable, identical and "active market" data for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. FAS 157 defines an "active market" as one in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis.

Level 2 inputs are generally also observable quoted prices, but relate to similar, as opposed to identical, assets or liabilities in "less active market" or divergent on dates for transactional data.

Level 3 uses any data for the asset or liability that does not fall into the first two categories, which may include information that is observable, but dissimilar. There is no auction market or the market is many years old for the transactional data. The company's own data (unobservable) may be used if it is the best economic modeling data available.

FAS 157 is clear that Level 1 must be used first, then Level 2. Level 3 can only be used if no information exists in Level 1 or Level 2. For most assets and liabilities, Level 1 and Level 2 information is available. Level 3 assets are usually new intangibles.

FAS 157 also requires specific disclosures, depending on whether the fair value measurement is recurring (such as for trading securities) or nonrecurring (such as for impaired assets). In either case, FAS 157 sets forth specific disclosures for "information that enables users of its financial statements to assess the inputs used to develop those measurements."

FASB expects FAS 157 to result in increased consistency and comparability in fair value measurements, but cautions that entities will need to make systems and other process changes to comply with the new requirements. For example, it seems inevitable that proper application of the valuation techniques would require having the appropriate resources and personnel, which translates to additional costs.

HIGHLIGHTS OF FAS 159

Six months after FASB issued a unifying definition of fair value, it issued FAS 159, "The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115," in February.

Also known as the FVO standard, public feedback on FAS 159 so far reflects much debate on the standard's intended benefits and potential for abuse during transition, and some general concern about the outside auditors' ability to audit the implementation, specifically, the reasonableness of the inputs used by the audit clients in arriving at the fair value measurements.

FAS 159, which applies to measurements for stocks, bonds, loans, warranty obligations and interest rate hedges, provides entities the option (but not the requirement) to measure at fair value such financial instruments and certain other items that are not currently required to be measured at fair value.

Current accounting measurement for such instruments may be historical cost, amortized historical cost or lower of cost or market. The stated objective of FAS 159 is "to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets (such as loans held for sale) and liabilities (such as forward sales commitments) differently without having to apply complex hedge accounting provisions," found in FAS 133.

Although FAS 159 does not affect any existing accounting literature that requires certain assets and liabilities to be carried at fair value, it expands the use of fair value measurement.

The fair value option may be applied instrument by instrument (with a few exceptions); is irrevocable (to minimize potential for abuse, unless a new election date occurs as described by FAS 159); and is applied only to entire instruments and not to portions of instruments.

Upon taking the option to measure an eligible financial asset or liability at fair value, a for-profit entity is required to report in earnings unrealized gains and losses on items for which the fair value option has been elected at each subsequent reporting date.

For eligible items existing at the effective date of FAS 159, the entity shall report the effect of the first "remeasurement" to fair value as a cumulative-effect adjustment to the opening balance of retained earnings.

As discussed later, this provision has been viewed as a potential source of accounting abuse. In amending FAS 115, "Accounting for Certain Investments in Debt and Equity Securities," FAS 159 permits held-to-maturity securities (HTM), previously required to be measured at amortized cost, to be measured at fair value.

If the fair value option is elected for available-for-sale or HTM securities, cumulative unrealized gains and losses at the option date shall be included in the cumulative-effect adjustments, and specific disclosures are required. Modifications in the requirements are provided for not-for-profit entities.

Required disclosures include, among others:

* A schedule presenting the pre-tax portion of the cumulative-effect adjustment to retained earnings;

* The fair value at the effective date of eligible items for which fair value option is elected and the carrying amount of those same items immediately before electing the fair value option;

* Management's reasons for electing fair value option for each existing eligible item;

* Reasons for partial election within a group of similar eligible items; and

* The amount of valuation allowances removed from the balance sheet because they were related to items for which the fair value option was elected.

TRANSITION ISSUES RELATING TO FAS 159

Upon first remeasurement to fair value for existing eligible financial instruments, a cumulative-effect adjustment to beginning retained earnings of the reporting entity is to be recorded. There has been concern expressed by accounting and regulatory observers that this one-time non-earnings impact provides a potential for abuse intended to achieve an accounting result, specifically when unrealized losses are involved.

A common example has been described as follows: a company identifies losing players in its portfolio (such as underwater HTM securities), elects to fair value such items and records the loss directly in retained earnings. The company then sells the same instruments, only to purchase replacement instruments and value them at historical cost all over again, apparently retreating from fair value going forward for those instruments.

Both the SEC and the AICPA's Center for Audit Quality (CAQ) have expressed clear warnings about the example above.

In an April 4, 2007, speech by SEC Deputy Accountant James Kroeker, "Regardless of whether these engineered transactions achieve your accounting goal ... you can expect the SEC to have a continued interest in this topic." And an April 17, 2007, letter from the CAQ warns, "If an entity proposes to adopt the fair value option merely to achieve an accounting result that is contrary to the principles and objectives in FAS 159 ... the auditor should reach a conclusion that the entity's proposed accounting departs from generally accepted accounting principles."

Also, Lynn Turner, former SEC chief accountant, has expressed concern in a recent speech that FAS 159 opens the door for companies to pick and choose fair value measurement for securities, thus allowing them to hide losses in their portfolio and manage earnings.

And in June, the PCAOB expressed some concern, primarily about the challenge auditors will likely face with the adoption of FAS 159. As described above, fair value measurement uses various assumptions and valuation techniques.

PCAOB Chair Mark Olson stated that fair value accounting, "while presenting the promise of greater relevance, represents an area of potential audit risk." Olson cited factors such as the training required in valuation, and that many auditors may not have extensive training in valuation techniques.

He further stated that auditors "should be mindful" about the possibility of client bias in fair value assessments, and that internal controls surrounding fair value measurements may be different from those over typical business transactions.

GOING FORWARD

Interestingly, FAS 159 represents just Phase 1 of FASB's fair value project. Phase 2 is intended to address the FVO for certain nonfinancial assets and nonfinancial liabilities and the deposit liabilities of depository institutions.

Phase 2 deliberations are scheduled for the third quarter of 2007 and the exposure document for public comment could be available as early as the first quarter of 2008. In the meantime, financial statement preparers, auditors and users of those financial statements impacted by the new fair value standards have plenty to deal with.

A. Christine Davis, CPA is a director in the Litigation and Forensic Consulting Services Group in the San Francisco office of Hemming Morse, Inc. You can reach her at davisc@hemming.com.

BY A. CHRISTINE DAVIS, CPA

RELATED ARTICLE: Need more fair value info?

FAS 157

Summary: www.fasb.org/st/summary/stsum157.shtml

Guidance: www.fasb.org/pdf/fas157.pdf

FAS 159

Summary: www.fasb.org/st/summary/stsum159.shtml

Guidance: www.fasb.org/pdf/fas159.pdf