The impact of the accounting profession's movement toward fair value reporting in financial statements: an interview with Theresa Ahlstrom, Long Island Office Managing Partner, KPMG LLP.

KPMG LLP, the audit, tax and advisory firm, turns knowledge into value for the benefit of its clients, people, communities and the capital markets. Its professionals work together to provide clients access to global support, industry insights, and a multidisciplinary range of services. KPMG LLP (www.us.kpmg.com) is the U.S. member firm of KPMG International. In 1993, KPMG International was the first multidisciplinary professional services organization to establish itself along industry-specific lines of business. This enabled KPMG to tailor services and strategies to the needs of clients across a range of global industry markets. KPMG International's member firms have 103,000 professionals, including 6,700 partners, in 144 countries.

Theresa P. Ahlstrom is KPMG's Long Island Office Managing Partner and the Northeast Audit Quality Support Partner, supporting the Northeast Audit Area Risk Management Partner, and playing a key role in the development and execution of the area's quality enhancement initiatives. She started her career at KPMG, LLP, in 1982 as a pre-professional in the firm's National Department of Professional Practice (DPP), and joined the audit professional staff of the Long Island office in 1983. In 1993, after a two-year rotation in DPP and the Office of General Counsel, she was admitted into the partnership.

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Ms. Ahlstrom has served as lead engagement partner for numerous clients in the healthcare, biotech, consumer and industrial market, and non-profit industries. Because of her technical experience and client service record, she was designated an SEC Reviewing Partner, Professional Practice Partner, Employee Benefit Resource Partner, Primary Campus Recruiter, and National Training Instructor.

Graduating summa cum laude with a B.S. degree in accounting from St. John's University in 1983, she was inducted into the YWCA Academy of Women Achievers in 1998 and the Long Island's Top 50 Women Hall of Fame in 2000, 2001 and 2003. Ms. Ahlstrom is also very active in numerous community activities and professional associations, and received the 2003 Long Island Fund for Women and Girls Achievers Award. She resides in South Huntington, New York, with her husband Bob and their two young sons.

Q: How do you think fair value affects the reliability and relevancy of the financial statements?

A: There have been grumbles within Corporate America for well over a decade that financial statements are irrelevant to financial analysts, in light of the current techniques analysts use to value the health and projected financial performance 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 a company's financial statements more useful or "relevant" in the marketplace. Clearly, historical cost accounting, while perhaps easier to follow and "bookkeep," has seen its day and more than outlived its usefulness. So I think most preparers and users of financial statements are sold on the enhanced relevancy point. However, I am not convinced on the topic of reliability of financial reporting using more fair value accounting methods. The increased subjectivity and estimation process that underpins all aspects of fair value accounting calls the "reliability" of such information into question for me. Having said that, I do believe that fair value has a far better chance of providing more reliable information in most cases than the old historical cost model.

Look at the last four Statements on Financial Accounting Standards (SFAS) issued by the Financial Accounting Standards Board (FASB), which all require some form of fair value reporting (i. e., SFAS 155, Accounting for Certain Hybrid Financial Instruments, SFAS 156, Accounting for Servicing of Financial Assets, SFAS 157, Fair Value Measurements, and SFAS 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R), and SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities, Including an amendment of FASB Statement No. 115). It is very clear from these standards that the "fair value train" has left the station, has accelerated quickly, and in my view will not to return anytime soon.

Q: Similarly, what is your view on whether employing fair value accounting measures increases or decreases the complexity and "quality" of financial reporting?

A: While I, and probably most other practitioners, think that today's accounting couldn't possibly get more complex, I believe the trend to recording more assets, liabilities, and the associated transactions at fair value will prove us wrong. Fair value accounting does not ensure, in my eyes, enhanced "quality" in financial reporting. As has always been the case, the quality of the financial statements still hinges on the soundness of internal controls over financial reporting and the thoroughness and technical competency of the preparers. I have heard many proponents of fair value accounting tout that it is the end of earnings management (and, therefore, improved quality of earnings) because there would be more of a focus on the assets and liabilities on the balance sheet than on the income statement. I would suggest that the inherent subjectivity and complexity of fair value valuation techniques makes it ripe for manipulation, if that is the objective. Of course, the astute reader of the financial statements could detect some cases of manipulation if there is robust disclosure of the assumptions underlying the valuations.

Q: During September 2006, the FASB issued SFAS 157, "Fair Value Measurements." Please comment on what impact this will have on the current accounting standards that require fair value measurements. Does this standard add to the complexity? Does it enhance the consistency of fair value reporting?

A: In my view SFAS 157 was long overdue. With numerous existing accounting standards requiring varying degrees of fair value estimates, SFAS 157 clearly provides some consistent "how to" requirements for calculating fair value. However, it is likely to add some complexity in financial reporting, as well as audit risk, associated with such reporting and disclosures.

Moreover, based upon the assumptions within the "inputs" used to make the fair value calculations, the Financial Accounting Standards Board established a hierarchy of fair value measurements for financial disclosure, referred to as Levels 1, 2 and 3. This hierarchy, which is explained thoroughly in some of the articles presented in this journal issue, is intended to convey information about the nature of the inputs, with Level 1 being the "most reliable, "which includes inputs that are only quoted prices in active markets, versus Level 3, which consists of unobservable inputs [that may reflect the Company's own assumptions].

Of course, this new standard will require that entities expend more effort than in the past, as they are forced to use more complex valuation models and calculations that are claimed to produce more reliable valuation estimates. Who is to make the final decision as to what valuation technique is most appropriate in each situation, especially when economists have been arguing about these issues for years? I also foresee many instances where there will be a lively debate about what the most appropriate "hierarchical level" a particular valuation estimate should be classified as, as Level 3 valuation requires more detailed and costly reconciliations and roll-forward disclosures for all activities that occurred during the period. Nonetheless, this debate is healthy as it should improve the transparency of fair value estimates to the astute reader and analyzer of the financial statements.

The benefit of having one set of guidelines for calculating fair value measures codified within one accounting standard will hopefully improve consistency and transparency which may outweigh the costs associated with the complexity of the calculations. The disclosures within the financial statements should be a good step in allowing investors to understand the inputs and assumptions used by a Company to determine fair value and in turn, make their own judgments on the reliability and relevance of the information within the financial statements.

Q: How does the greater use of fair value accounting measurements affect the audit procedures of the independent auditor?

A: The impact on the independent audit has been relatively extensive, particularly in auditing the more complex fair value calculations using valuation models, for example as required by SFAS 123(R), Share-Based Payment, or in situations (which are becoming more and more common) where a company uses third-party specialists to determine a fair value measurement. In short, in these situations the subjectivity and complexity has had a direct impact on audit risk and the cost of the audit.

At KPMG, timely, extensive and on-going training programs for its professionals worldwide are developed and delivered on each new accounting and audit standard. Additionally, our engagement teams are typically armed with a list of procedures and steps they use to effectively and efficiently audit complex accounting areas, such as fair value measures, referred to as audit program guides. Our firm also specifically trains experienced audit and advisory professionals to assist engagement teams in working through more difficult accounting standards, such as SFAS 157.

More often than not, our core audit engagement teams are assisted by valuation specialists, actuaries, financial derivative resources or share-based payment specialists. These professionals, most of whom are specially-trained audit partners and senior managers, principally assist the auditors in assessing the qualifications of third-party specialists engaged by a client to calculate fair value measurements and disclosures and determining the reasonableness of the assumptions and methodologies used in such measurements. Of course, where valuations and estimates are used to determine fair values, there are numerous other audit procedures that are employed. These include documentation and testing of management's process over calculating fair value measures, including assumption development, as well as testing completeness, accuracy, and relevancy of the underlying data used in the valuations and other calculations.

Q. How could accounting programs appropriately prepare students for the fair value accounting measurements they will inevitably deal with when they enter the business world?

A. There is no doubt that the movement toward the increased use of fair value accounting and estimation methods requires additional skill sets in accountants, auditors, analysts and financial reporting specialists, than were previously required. I would argue that the enhanced fair value requirements may significantly increase the workloads of these individuals, given the complexity and the need for more continuous updating of fair values estimates than before. Unfortunately, this comes at a time of already stretched resources of both corporate accounting and financial reporting staffs and external auditors.

Accounting programs are going to have to ensure that there is a focus on teaching the next generation of CPAs valuation techniques and in-depth financial statement analysis tools. Additionally, higher education institutions may need to consider providing more opportunities for students to specialize in areas of economics, finance, and statistics [in addition to accounting degrees], to ensure that today's students are adequately prepared to tackle tomorrow's challenges.

Interviewed by Patrick A. Casabona, The Peter J. Tobin College of Business, St. John's University (This interview took place on January 29, 2007.)