Special issue: fair value in financial reporting, auditing, and tax accounting.

During most of the last century, standard setters emphasized historical cost accounting. Under this traditional accounting model, the income statement, which results from matching an entity's revenues with expenses during a period of time, was considered the primary financial statement conveying useful information about a company's performance and value to shareholders. The balance sheet was considered a by-product of the matching process, since it contained such categories as prepaid expenses, unearned revenues, accrued expenses, and accrued revenues. Financial statements prepared under the historical cost convention were and are still perceived by many today to be reliable, relatively easy to verify, and straightforward to understand.

Historical cost accounting was sufficient as long as a company's assets consisted mostly of identifiable tangible assets. With the increased prominence of intangible assets, such as intellectual capital, human resources, brand names, technology advances, or corporate culture, this accounting model resulted in under-valuing and under-recording assets that contributed significantly to the achievement of a company's strategic goals and objectives. For example, intangible assets that are recorded in the balance sheet--purchased copyrights, patents, and other legal rights--are recorded at historical cost. Other intangible assets, such as brand assets, assets arising from marketing and supplier relationships, and knowledge assets developed from research and development are not recorded at all. Consequently, great disparities between companies' book and market values have been observed, and the users of financial statements have pressed for more relevant fair-value information.

For the past decade, to improve the decision-making relevance of financial statements, the Financial Accounting Standards Board (FASB) has been adding more fair value recognition, measurement, and disclosure standards to the body of U.S. generally accepted accounting principles (U.S. GAAP). The International Accounting Standards Board (IASB) follows a similar approach. As a result, a mixed accounting model has been developed, which is still primarily based on historical cost but with an ever increasing application of fair value accounting. Consequently, a shift has occurred in recent years towards using the balance sheet as the primary financial statement conveying information to shareholders, and the income statement reporting economic income as simply the change in value over a period of time.

Although recent accounting standards reflect increasing acceptance of fair value as a measurement attribute, the shift towards the fair value accounting model has not been without controversies. Fair value accounting information continues to be criticized as being less reliable than historical cost, especially when based on subjective assumptions. Estimation errors introduce distortion not only into the balance sheet, but also into the income statement. Furthermore, unrealized changes in fair values from one period to the next, which must now be reported as gains and losses in financial statements, distort the results of operations, if and when they flow through the income statement each period. And finally, fair value accounting requires proper matching of assets and liabilities, which is even more difficult to implement than the matching of revenues and expenses under a historical cost model.

Existing empirical evidence does not resolve these controversies. Empirical findings suggest that the reliability of fair value estimates varies with the extent to which fair value estimates include publicly observed market-based versus management-produced information. The most consistent evidence regarding the reliability of fair value estimates is found for investment securities traded in active markets. The evidence regarding the reliability of other fair value estimates is rather limited. Furthermore, the empirical research on the reliability of fair value estimates is largely derived from the analysis of banks and other financial institutions for which financial instruments comprise core operating assets and liabilities. Such firms may be fundamentally different from companies holding inventory, property, plant and equipment, and other assets whose value comes from an execution of a business plan rather than fluctuations in market prices. Therefore, a generalization of these research findings to all sectors of the economy can be questioned [1].

This Special Issue of the Review of Business describes the FASB's movement towards fair value accounting and reporting, which reflects a pursuit of one of the most important international accounting convergence objectives the Board shares with the IASB. This theme permeates the articles presented in this journal, which discuss various new accounting pronouncements requiring fair value accounting and reporting, complexities involved in the application of fair value accounting and reporting, as well as problems associated with auditing of the fair-value based financial results.

The majority of this Special Issue focuses on the implications of Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements, issued by the FASB in September 2006. SFAS 157 provides procedural guidance for measuring fair value estimates required by other authoritative accounting pronouncements [2]. This Special Issue also includes articles dealing with other aspects of fair value reporting, such as auditing the fair value of share-based payments, ethical issues associated with the fair value measurements required to be reported in financial statements, and tax accounting applications of the fair value concept.

This issue begins with an interview featuring Theresa P. Ahlstrom, Managing Partner, Long Island Office, KPMG, LLP, who discusses the impact that the Financial Accounting Standards Board's movement toward fair value accounting and reporting is having on the accounting profession. She makes it very clear why there has been an increasing trend toward the use of fair value reporting, especially since this is one of the key international accounting convergence efforts it shares with the IASB. According to Ms. Ahlstrom, there has been considerable dissatisfaction within Corporate America for quite a while that financial statements are irrelevant to financial analysts, in light of the current techniques being used to determine the fair market value of an entity.

The objective of fair value accounting, on the other hand, provides users of financial statements with a clearer picture of the current economic state of a company, making that company's financial statements more useful or "relevant" in the marketplace. Although fair value reporting may clearly be more relevant, Ms. Ahlstrom is not totally convinced of the reliability of financial reporting using more fair value accounting methods. She suggests that the increased subjectivity and estimation process that underpins all aspects of fair value accounting calls the "reliability" of such information into question. for her. However, she believes that fair value has a far better chance of providing more reliable information, in most cases, than the old historical cost model. Finally, she provides a brief explanation of the impact the changes in the financial reporting environment are having on accounting professionals and their education requirements.

The interview is followed by seven articles dealing with various aspects of fair value accounting, reporting, and auditing:

* Patrick A. Casabona and Victoria Shoaf illustrate the FASB's movement toward fair value accounting by providing a broad overview of recent major standards requiring fair value accounting and reporting in financial statements. They then summarize and evaluate the formal guidance for measuring fair value estimates provided in the FASB's SFAS 157, Fair Value Measurements. The authors explain how SFAS 157 increases consistency and comparability in fair value measurements by providing a single definition of fair value, establishing a framework for measuring fair value, and expanding required disclosures about fair value measurements. Although SFAS 157 does not require any new fair value measurements, the application of this Statement might change current practice for some entities.

* Omar Esquivel and Sylwia Gornik-Tomaszewski examine how fair value reporting is used in GAAP, and provide further clarification of the guidance provided in SFAS 157. They also explain how the new standard affects the fair-value-based impairment testing models for tangible and intangible assets, and provide a numerical illustration and evaluation of its application to impairment testing under SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets.

* On June 30, 2005, the FASB and the IASB each issued a number of exposure drafts dealing with both business combinations and consolidation procedures. These exposure drafts are considered a major joint project on business combinations leading towards continued convergence of U.S. GAAP and International Financial Reporting Standards (IFRS). The article by Ibrahim M. Badawi and Nina T. Dorata discusses the significant accounting changes proposed in these exposure drafts, which include the application of the acquisition method, recognition of full fair value of goodwill in partial business combinations, and use of fair value measurements.

* SFAS 157 introduces fair value hierarchy, which prioritizes inputs into valuation techniques used to measure fair value. In the next article, James M. Fornaro and Anthony T Barbera discuss the key provisions of SFAS 157's fair value hierarchy, and assess whether the fair value information assists users in making more informed business decisions. They also discuss the influence of the fair value hierarchy on the role of external auditors.

* SFAS 157's fair value measurement guidance applies broadly to financial and nonfinancial assets and liabilities, and there are only a few scope exceptions to this Statement. Although SFAS 123(R), Share-Based Payment, is scoped out of SFAS 157, it requires that share-based payments provided to employees by companies be measured at the fair value of the awards at the date of grant. Because employee stock option arrangements are not publicly traded instruments, the fair value of such options must be estimated using option-pricing models and such measurements are difficult to audit by accounting professionals. Benjamin R. Silliman and Adrian P. Fitzsimons examine the Public Company Accounting Oversight Board's (PCAOB) audit guidance provided in the Staff's questions and answers (Q & A), issued in October 2006. These Q's and A's provide detailed guidance to CPAs who audit the fair value estimates involved in employee share-based payment arrangements. This article discusses some of the difficulties and complexities in auditing the fair value of stock option transactions.

* The article written by Teresa M. Danile and Irene N. McCarthy deals with ethical implications in reporting fair value. Prior to the issuance of SFAS 157, use of diverse and inconsistent methods for measuring fair value promoted abuses. The authors examine whether the enhanced fair value framework and fair value hierarchy established in SFAS 157 improve financial reporting. They conclude that although better consistency and comparability are achieved, serious ethical concerns remain, especially regarding the Level-3 inputs in SFAS 157's hierarchical framework. These are unobservable inputs based on the reporting entity's own assumptions about the assumptions that market participants would use to estimate the fair values of certain assets and liabilities, when observable market data is not available. Level-3 estimates require considerable judgment in terms of both the selection and application of valuation techniques, and therefore require effective controls and competent independent auditors and other corporate governance mechanisms to thwart potential abuses. This article also discusses the implications of SFAS 157 for academic programs.

* The final article in this Special Issue deals with a tax accounting application of the fair value measurement concept. Richard Lai and Laura Lee Mannino review the rules for determining the amount of a deduction for a charitable contribution of a vehicle, as recently amended by the American Jobs Creation Act of 2004. Although charitable contributions of property are generally based on fair market value, the new rules limit the amount of the deduction to the gross sales proceeds from the subsequent sale of the vehicle by the charity.

This volume would not have been possible without the support and collaboration of numerous individuals. First of all, as the guest editors of this special issue, we would like to express our sincere appreciation to Brenda Massetti, Editor of the Review of Business, for her support during the publication process. In addition, we would like to thank all the reviewers for their insightful comments. All manuscripts were reviewed by academics and technical experts in the area of fair value accounting. Each manuscript was revised at least twice before final acceptance.

Endnotes

1. American Accounting Association (AAA), Financial Accounting Standards Committee (FASC). "Response to the FASB's Exposure Draft on Fair Value Measurements," Accounting Horizons, Vol. 19, No. 3, September 2005, 187-196.

2. The IASB has also been working on a similar fair value measurement project. This project forms part of the Memorandum of Understanding between the IASB and the FASB, which sets out a Roadmap of Convergence between International Financial Reporting Standards (IFRS) and U.S. GAAP 2006-2008. The IASB published a discussion paper in November 2006, which indicates the Board's preliminary view of the provisions of FASB's SFAS 157 and its differences to existing fair value measurement guidance in IFRS. The Board invites respondents to comment on its preliminary views, as well as the provisions of SFAS 157, by April 2, 2007. These comments will be considered in conjunction with the development of an IASB exposure draft on fair value measurements, which the Board aims to issue in early 2008.

Patrick A. Casabona, The Peter J. Tobin College of Business, St. John's University

Sylwia Gornik-Tomaszewski, The Peter J. Tobin College of Business, St. John's University