The new fair value hierarchy: key provisions, implications, and effect on information usefulness.

Abstract

Statement of Financial Accounting Standards No. 157, Fair Value Measurements, introduces a fair value hierarchy that prioritizes the data companies use for such measurements. The new hierarchy, together with additional footnote disclosures, is expected to improve existing practices concerning fair value reporting. This paper examines the key provisions of the fair value hierarchy and assesses its impact on the usefulness of reported financial information. The hierarchy's influence on the external auditor's role is also discussed.

Introduction

Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157), standardizes existing practices companies use to measure assets and liabilities at fair value [5]. Appendix D to the Standard lists over 60 accounting pronouncements that refer to various aspects of fair value reporting, but many contain conflicting or limited implementation guidance. The volume of pronouncements mentioning fair value is evidence of the gradual, but relentless, shift away from the long-standing historical cost (or transaction-based) system [7].

The shift results from increased emphasis by standards setters on the relevance of information provided to financial statement users, over its reliability. The standard introduces a three-level fair value hierarchy that prioritizes the quality and reliability of information used to develop such measurements, and expands disclosure of specific fair value information by level within this hierarchy. These requirements should help financial statement users better assess the reliability of reported fair value information, determine the consistency of its application, and improve comparability with other companies.

This paper provides a brief overview of the major fair value measurement principles in SFAS 157, followed by an examination of the fair value hierarchy and its impact on financial reporting. The benefits and criticisms of the hierarchy are discussed, and its impact on the usefulness of fair value information for decision-making is assessed. Finally, the hierarchy's likely influence on the external auditor's role is also examined.

Overview of Fair Value Measurements in SFAS 157

SFAS 157 clarifies existing approaches to fair value measurements currently dispersed throughout the accounting literature. The new guidance has three main components, the goal of which is to standardize the measurement and disclosure of the fair values of existing assets and liabilities.

* First, SFAS 157 (par. 5) defines fair value as the price that a company would receive to sell an existing asset or pay to transfer a liability (i.e., an exit price) in an orderly transaction between third parties (i.e., marketplace participants). In other words, fair value measurements reflect assumptions that knowledgeable, independent market participants would make to hypothetically price the asset or liability, as opposed to relying on management's internal or entity-specific assumptions.

* Second, SFAS 157 establishes a framework for companies to follow when measuring assets and liabilities at fair value. This framework includes the techniques or models companies use to compute fair value. The three primary valuation techniques discussed in the standard are: (1) the market approach, which generally uses quoted prices that are readily available (e.g. the New York Stock Exchange); (2) the income approach, which generally uses present value techniques to discount future cash flows, or certain option-pricing models, and (3) the cost approach, which generally represents current replacement cost. Although SFAS 157 does not specify when a particular valuation technique should be used, it does require that the technique(s) be appropriate in the circumstances and applied on a consistent basis.

The accuracy and reasonableness of fair value measurements largely depend upon the reliability of the data and assumptions used in these techniques. Accordingly, SFAS 157 introduces a fair value hierarchy that prioritizes these inputs into three levels. Highest priority (Level-1) is given to observable unadjusted quoted prices in active markets for identical assets or liabilities. Intermediate priority (Level-2) is given to all other observable information. Lowest priority (Level-3) is given to unobservable information. As explained in paragraph 30 of SFAS 157, Level-3 inputs are unobservable inputs for an asset or liability (e.g., future cash flows and discount rates) that reflect the reporting entity's own assumptions about the assumptions market participants would use in pricing the asset or liability (including assumptions about risk), if such information is available without undue cost and effort.

* Finally, SFAS 157 expands interim and annual disclosures about fair value measurements. These disclosures include tables containing the fair values of major categories of assets and liabilities, the level within the hierarchy from which the measurements were derived, and gains and losses recognized during the period. For valuations involving Level-3 inputs, additional disclosures are required relative to the other two levels in order to partially compensate for their weaker reliability, as highlighted in the hierarchy below.

The Fair Value Hierarchy of Measurement Inputs

Information used to measure fair value can be derived from many sources and varies as to the level of reliability. Reliability relates to the degree of assurance capable of being obtained through verification that information faithfully represents what it purports to represent. Accounting methods and techniques used to measure information contribute to its degree of reliability [6].

It is essential that fair value measurements be derived from data and assumptions from the viewpoint of market participants. To highlight differences in reliability and enhance the consistency and comparability of fair value measurements, SFAS 157 establishes a hierarchy that prioritizes the information (inputs) to fair value measurements. Inputs are first categorized as either observable or unobservable. Observable inputs reflect assumptions that market participants would make, based upon market-based information from sources independent of the company. Sources of observable inputs include the following:

1. Exchange Markets such as the New York Stock Exchange (NYSE);

2. Dealer Markets such as NASDAQ or other Over-the-Counter (OTC) markets;

3. Brokered Markets such as real estate; and

4. Principal-to-principal market transactions which are privately negotiated with little public information available.

Oftentimes, situations exist where little, if any, market activity for the asset or liability exists at the measurement date. In such cases, the use of unobservable inputs is permitted. However, management must examine and consider assumptions that market participants would make to price the asset or liability. These assumptions should be based on the best information available in the circumstances, including a company's internal data. For example, information to ascertain the fair value of a specific operating division of a company is generally not readily available in an active market. In this type of situation, the fair value computation will likely require management to: (1) derive assumptions concerning future cash flows from an external viewpoint and (2) employ one or more valuation techniques. Such measurements are less reliable than identifiable information or quoted prices in established markets. In general, companies should "maximize the use of observable inputs and minimize the use of unobservable inputs" to their valuation models [5: par. 21].

The fair value hierarchy prioritizes these observable and unobservable inputs into three categories, or levels, based on their degree of reliability. The components of the hierarchy are summarized below:

The Hierarchy and the Usefulness of Fair Value Information

Information Usefulness

The benefits of the fair value hierarchy to users of financial information can be assessed from different perspectives. In general, financial information is considered to be useful if it enhances one's ability to make investment and credit decisions [6]. Furthermore, such information is considered "better" (i.e., more useful) primarily if it has more relevance and reliability. Relevance refers to the capacity of information to "make a difference" in the decision-making process. While useful information must have both relevance and reliability to a minimum degree, neither is the paramount characteristic of accounting information [8].

Given the extent and complexity of existing fair value guidance, the benefits of the hierarchy should be evaluated by assessing whether it improves current theory and practice. Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Financial Information (CON 2), provides guidance helpful in making this assessment. First, the hierarchy should enhance the relevance and reliability of fair value information for users. Relevance is enhanced if the hierarchy improves a user's ability to make a decision involving fair values compared to existing practice. In other words, the information should help users to better assess a company's future outcomes, confirm the results of prior expectations, and be available on a timely basis. On the other hand, reliability is enhanced if users are provided with fair value measurements that are more verifiable, faithfully represented, and unbiased than they are under existing practices.

The benefits of the hierarchy can also be assessed by examining improvements in the comparability and consistency of fair value information, since both of these qualities impact the relationship between relevance and reliability [6]. Comparability is enhanced if the hierarchy better enables different companies to measure, report and disclose the fair values of assets and liabilities in a similar manner. Consistency is enhanced if an individual company is better able to measure fair values in a similar manner from period to period. An assessment of the hierarchy in light of these qualitative characteristics follows.

Relevance and Reliability: A Traditional Assessment

Accounting methods, such as some fair value measurement techniques, may increase the relevance of the information produced while simultaneously decreasing its reliability [6]. Though a longstanding debate continues, the FASB has concluded that improvements in relevance generated by the use of fair value information for assets and liabilities is often worth the trade-off of a reduction in the reliability of such information. Fair value better reflects current market conditions, and is more representative of a company's existing financial position than valuations using historical cost, although the latter is usually considered more reliable. A higher degree of usefulness is therefore achievable if fair value information causes better decisions, and thus increased relevance, without undo sacrifice as to its reliability. In an analysis of the trade-offs inherent in using fair value reporting, Ernst & Young [4] suggests that "reliability is a necessary precondition that must be met for information to be relevant."

An assessment of SFAS 157 suggests that financial statement users will be provided with more useful information and insights into the reliability of fair value measurements within the hierarchical structure in the following ways:

* Companies now have better guidance on the considerations in making assumptions for performing Level-2 calculations or, as a last resort, performing Level-3 calculations in those situations where quoted prices in active markets for identical assets or liabilities (Level- 1) are absent.

* Financial statement readers are more aware of the degree to which fair value measurements are derived from observable versus unobservable inputs.

* Disclosing the ranking of inputs provides better transparency and insights into the degree of subjectivity and judgment in a company's reported fair value measurements.

* Formal guidance is now available on the proper ranking when significant inputs are derived from more than one level of the hierarchy (i.e., use the lowest ranking).

* Having an established framework to derive fair values will improve the external auditor's ability to verify a company's fair value measurements, as discussed in more detail in the following section.

On the other hand, the hierarchy does not resolve issues that can potentially erode the reliability of fair value data, and therefore, its relevance for decision-making. Concerns will continue to exist, particularly with respect to the nature of Level-3 inputs, which are used to estimate fair value. By definition, these inputs are unobservable and are derived by company management. They may very well represent inputs based on hypothetical assumptions that would be made by hypothetical third parties (i.e., market participants), and are thus another form of an accounting estimate.

Some critics assert that such measurements may increase the likelihood of manipulation by opportunistic managements and may, in fact, be worse than using less relevant, but more reliable, historical costs. They also fear that this trend "has the potential for widespread deception of investors" [9]. Accordingly, Level-3 inputs will probably continue to be subject to management bias, susceptible to measurement error, and difficult to independently verify. In SFAS 157 (par. C87), the FASB acknowledges that some Level-3 inputs may be of such a hypothetical nature that they "would seem to be of questionable relevance to users of financial statements." However, given the general trend toward fair value reporting, the FASB believes that the hierarchy enhances the overall reliability of those measurements as well as its relevance to decision-makers.

Relevance and Reliability: Another View

Whether a specific trade-off between relevance and reliability is warranted also depends on the relative weights attached to each by a particular financial statement user. Accordingly, another (direct) relationship between relevance and reliability exists among the inputs used to derive fair values. Some believe that "information needs to pass a reliability threshold before it can be considered relevant at all" [4]. In other words, fair value measurements using Level-1 inputs can be viewed as being more reliable and more relevant than those using Level-2 and Level-3 inputs. Though this debate will continue, the FASB expects that the expanded disclosures required in SFAS 157 will enable users to "make more informed judgments" about the reliability of the accounting estimates and the method(s) used to derive them, and to identify fair value measurements that were estimated using "inherently subjective" input data and assumptions, which may not be very reliable (par. C98).

Comparability and Consistency

The fair value hierarchy should also enhance the comparability of information among companies, and improve the consistency from period to period of an entity's reported fair value estimates, because of the following changes in practices:

* All companies must follow the same framework to identify, rank, and then use the best inputs in their valuation techniques.

* Inputs to value specific assets and liabilities should be derived and ranked in a similar way using the new hierarchical structure.

* Pricing inconsistencies in certain Level-1 inputs have been eliminated, particularly with respect to instances when a company has a large holding of a particular asset (e.g., prohibition of blockage discounts) and adjustments to the values of restricted securities.

* Significant events or transactions that impact fair value (e.g., material announcements or large trades) may occur in "after-hours trading" on the measurement date. In such cases, SFAS 157 (par. 26) requires companies to "establish and consistently apply a policy for identifying those events" and how to classify the resultant fair value measurement in the hierarchy.

* Expanded required disclosures ensure a minimum level of clarity and similarity by having valuation information provided in a structured format, which will be more meaningful than existing disclosures.

* Expanded disclosures during interim periods of fair value measurements and related inputs will provide users with more current, and possibly more timely, information than in the past.

However, certain drawbacks to the comparability of fair value information are expected to persist despite the existence of the new hierarchy. This is due to the use of subjective management judgment at various points in the valuation process. For example, fair value measurements for many assets (e.g., intangibles, long-lived assets, etc.) are likely to require the use of present value techniques, and incorporate inputs from both Levels-2 and -3. In such cases, management must determine: (1) the principal (or most advantageous) market for the asset; (2) the underlying assumptions and inputs that market participants would use to value the asset; (3) the valuation technique(s) appropriate in the circumstances; (4) the significance of each input in determining fair value; and (5) the overall classification of the entire measurement within the hierarchy for disclosure purposes.

Accordingly, this degree of subjective judgment can lead to different fair value measurements and disclosures by different companies for substantially identical assets (and liabilities). Overall, however, the guidance and hierarchical structure provided in SFAS 157 will significantly improve the comparability and consistency of fair value measurements provided in financial statements in the future.

Considerations for External Auditors

An external auditor's main objective is to express an opinion on whether a company's financial statements are fairly presented in accordance with generally accepted accounting principles (GAAP). Auditors obtain sufficient appropriate audit evidence to form such an opinion by performing audit procedures. The appropriateness of evidence is measured by its relevance and reliability in determining whether the financial statements are fairly presented [1].

Statement of Auditing Standards No. 101, Auditing Fair Value Measurements and Disclosures (SAS 101), provides a general framework for auditing fair value measurements and disclosures [2]. When auditing values generated from Level-2 or -3 inputs, the process can be viewed as consisting of three steps [10]. First, the auditor must consider the significant management assumptions used to determine fair value, including their supporting documentation, development and application, monitoring of changes, and approval process. Second, the auditor must evaluate whether the valuation method used is appropriate in the circumstances, including whether it is in compliance with GAAP and whether it is appropriate given the client's business, industry, and environment. Lastly, the auditor must perform audit tests on the underlying data used to generate the fair value measurement.

Audit tests that could be performed include determining whether the data is accurate, complete, and relevant; verifying the source of the data; mathematical recalculations; and reviewing information for internal consistency [2]. In some cases, the auditor may develop an independent fair value estimate and compare it to the client's, and/or review events occurring after the balance sheet date that provide evidence supporting or refuting the client's fair value measurement. Furthermore, measuring fair value may be so complex that the client and/or the auditor will hire a valuation professional to assist in the calculation. In those cases the requirements of SAS No. 73, Using the Work of a Specialist, would apply [3].

As inputs used in fair value measurements shift from observable to unobservable (i.e., from Level-1 to Level-2 to Level-3), the measurements are more difficult for the auditor to verify using independent sources. In fact, these measurements become more of a management estimate containing much uncertainty, due to such factors as the length of the forecast period, the number of significant and complex assumptions, the degree of subjectivity associated with the assumptions, the degree of uncertainty associated with future outcomes, and the lack of objective data [2]. The introduction of the fair value hierarchy and related expanded disclosures will alert auditors to those measurements that require extra care due to their low reliability. Such disclosures will also alert financial statement users as to fair value estimates that may be relevant but are less reliable, even after having been audited.

Conclusion

SFAS 157 represents an important milestone in the evolution of fair value measurement and reporting. In particular, the introduction of the hierarchy is consistent with the FASB's objective that fair value information assist users in making more informed business decisions. The prioritization of inputs to these measurements and expanded disclosures will provide users with additional insights into the composition and relative reliability of a company's fair value measurements as well as the consistency and comparability of such information.

Indeed, the new guidance will impact the methods by which management derives these measurements and the external auditor's approach in assessing the fairness of the information. Looking forward, the FASB has established a foundation upon which it can provide future guidance concerning fair value measurements for additional types of assets and liabilities. All parties will need to pay particular attention to future developments as fair value reporting remains high on the agenda of the FASB and other standards setters, especially the SEC.

References

1. American Institute of Certified Public Accountants (AICPA). "Audit Evidence," Statement on Auditing Standards No. 106, New York, NY: AICPA, March 2006.

2. American Institute of Certified Public Accountants (AICPA). "Auditing Fair Value Measurements and Disclosures," Statement on Auditing Standards No. 101, New York, NY: AICPA, January 2003.

3. American Institute of Certified Public Accountants (AICPA). "Using the Work of a Specialist," Statement on Auditing Standards No. 73, New York, NY: AICPA, July 1994.

4. Ernst & Young. "How Fair is Fair Value?" IFRS Stakeholder Series, May 2005.

5. Financial Accounting Standards Board (FASB). "Fair Value Measurements," Statement of Financial Accounting Standards No. 157, Norwalk, CT: FASB, September 2006.

6. Financial Accounting Standards Board (FASB). "Qualitative Characteristics of Accounting Information," Statement of Financial Accounting Concepts No. 2, Stamford, CT: FASB, May 1980.

7. Financial Accounting Standards Board (FASB). "Recognition and Measurement in Financial Statements of Business Enterprises," Statement of Financial Accounting Concepts No. 5, Stamford, CT: FASB, December 1984.

8. Financial Accounting Standards Board (FASB). "Using Cash Flow Information and Present Value in Accounting Measurements," Statement of Financial Accounting Concepts No. 7, Norwalk, CT: FASB, February 2000.

9. Haldeman, Jr., R.G. "Fact, Fiction, and Fair Value Accounting at Enron," The CPA Journal, November 2006, 14-21.

10. Menelaides, S.L., L.E. Graham and G. Fischbach. "The Auditor's Approach to Fair Value," Journal of Accountancy, June 2003, 73-76.

Additional/Further Reading

Deloitte & Touche. "FASB Issues Standard on Measuring Fair Value," Heads Up, Vol. 13, Issue 12, September 27, 2006.

Ernst & Young. "Summary of FASB Statement No. 157, Fair Value Measurements," October, 2006.

Fink, R. "Will Fair Value Fly?" CFO Magazine, September 2006, 54-62.

King, A.M. "New Rules for Fair Value," Valuation Strategies, Sept/Oct. 2004, 20-23.

McCarthy, P. D. "Unnecessary Complexity in Accounting Principles," The CPA Journal, March 2004, 18-19.

PriceWaterhouseCoopers. "FASB Standard On Fair Value Measurements: An Overview of the Standard's Key Provisions and Its Implications," Dateline 2006-25, September, 2006.

Shortridge, R.T., A. Schroeder and E. Wagoner. "Fair-Value Accounting," The CPA Journal, April 2006, 37-39.

James M. Fornaro, School of Business, SUNY-College at Old Westbury

Anthony T. Barbera, School of Business, SUNY-College at Old Westbury Exhibit 1. COMPONENTS OF THE FAIR VALUE HIERARCHY Degree of Reliability Level Source of Information Example Higher 1 Unadjusted quoted Investment in the

prices in active common stock of a

markets for identical company traded on

assets or liabilities. the NYSE or

NASDAQ.

2 Unadjusted quoted Investment in

prices of assets and corporate debt

liabilities that are: securities that

(1) similar and traded are not traded in

in active markets, or an active market.

(2) traded in less Fair value is

liquid markets, and determined by

other observable reference to

inputs. equivalent bonds

traded on the

NYSE. Lower 3 Market-based data is Specialized

not sufficiently machinery where

available. Fair value little market-

is computed using based data exists.

unobservable inputs Fair value is

that reflect expected measured using

assumptions made by present values of

market participants projected future

and one or more cash flows.

valuation techniques.