Special issue: fair value in financial reporting,
auditing, and tax accounting.
by Casabona, Patrick A.^Gornik-Tomaszewski, Sylwia
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
COPYRIGHT 2007 St. John's University, College
of Business Administration Reproduced with permission of the copyright holder. Further reproduction or distribution is prohibited without permission.
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NOTE: All illustrations and photos have been removed from this article.