Special issue: fair value in financial reporting, auditing, and tax accounting.(from the editors)

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.