Ethical Implications of reporting fair value in financial statements.

Abstract

Statement of Financial Accounting Standards No. 157, Fair Value Measurements, issued by the Financial Accounting Standards Board (FASB) on September 15, 2006 provides enhanced guidance for estimating the fair values of assets and liabilities reported in financial statements. Prior to the issuance of this standard, methods for measuring fair value were diverse and inconsistent. The new standard establishes a fair value hierarchy that prioritizes the inputs that should be used when estimating fair value. Level-3 fair value estimates in the hierarchical structure, which involve the highest levels of management judgment and subjectivism, provide the greatest area of ethical concern.

Introduction

On September 15, 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157). This standard provides a single definition of fair value and enhanced guidance for estimating fair values of assets and liabilities to be reported in financial statements. Appendix D in SFAS 157 lists over 60 generally accepted accounting principles (GAAP) that require or permit entities to measure assets and liabilities at fair value. Prior to the issuance of SFAS 157, methods for measuring fair value were diverse and inconsistent, especially for items that were not actively traded. The new standard provides a hierarchical structure for measuring fair value, and also requires expanded disclosure of fair value measurements reported in financial statements, especially for those items measured using unobservable data. This Statement applies under other accounting pronouncements that require or permit fair value measurements; however, it does not require any new fair value measurements [2].

What the standard does do is to establish a fair value hierarchy that prioritizes the inputs (assumptions) that market participants will use when estimating the fair value of an asset or liability. The fair value estimates produced within levels one and two of the hierarchical structure use observable market inputs. However, the Level-3 fair value estimates involve the highest levels of management judgment and subjectivism, so they hold significant potentials for abuse and ethical concern.

Background of the Problem

There has long been resistance to fair value measurement replacement of the historical cost model by accounting professionals. Many professionals believe that historical cost gives the auditor a solid base upon which to form an opinion, thereby reducing the subjectivity in accounting. In contrast, they believe, for example, that the highly subjective pricing of long-term natural gas contracts was an open invitation to unethical, greedy people to manipulate earnings, which led to the great frauds of recent years. It was felt that the larger problem was with the execution of the accounting standards themselves, since they placed more and more pressure on the accountants and auditors to judge values without any solid basis for such an evaluation. This led to a threat of the reliability of accounting information [3].

Eugene H. Flegm, retired CFO of General Motors (GM) and former general auditor of that company, wrote a comment letter in which he outlined the origin of these accounting changes. He states his position on the need for reliable data and stewardship in accounting. Mr. Flegm represents the accounting professional's resistance to fair value measurement in place of a historical cost model. We cite the 1971 Trueblood Committee's conceptual framework for accounting, which proposed two radical shifts in financial accounting:

* The primary purpose of financial statements should be to provide investors and creditors with information to make rational decisions regarding their investments. (The longstanding stewardship function of accounting was relegated to a secondary position.)

* "Earnings" should be determined from an economist's rather than an accountant's view (historical cost model). In this approach, earnings for a given period could best be determined by the discounted change in the values of the beginning and ending balance sheet, ideally. However, determining the rate to be used was open to question. The debate on this has continued to this day, e.g., the radical shift in financial accounting to a balance sheet view of income, which was to lay the groundwork for a move from the historical cost model to a fair value one.

In short, Eugene Flegm believes that the many frauds committed by top management, the largest in history, can be traced not only to the general decline in values in the past 30 years, but also to the steady move to fair value accounting by the FASB. We concur; we believe that subjectivity in accounting must be reduced, and the way to do that is through maintenance of the historical-cost model [3].

An Enhanced Fair Value Framework

Nevertheless, on September 15, 2006, the FASB issued SFAS 157. As mentioned earlier, SFAS 157 provides a new definition of fair value, which is:

* Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

In addition, SFAS 157:

* Retains the notion that the exchange price is that of an orderly transaction to sell an asset or transfer a liability in its principal or most advantageous market;

* Emphasizes that fair value is a market-based--not entity-specific--measurement, and that a fair value measurement should be based on assumptions market participants would use in pricing an asset or liability;

* Clarifies that assumptions include those about risk and about the effect of a restriction on the sale or use of an asset, and that a fair value measurement for a liability reflects its nonperformance risk;

* Affirms that the fair value of a position in a financial instrument that trades in an active market should be measured as the product of the quoted price for the individual instrument multiplied by the quantity held, with no adjustments for blockage factors;

* Expands disclosures about the use of fair value to measure assets and liabilities in interim and annual periods, subsequent to initial recognition.

SFAS 157 is generally effective for financial statements issued for fiscal years beginning after November 15, 2007, and related interim periods [5].

Fair Value Hierarchy

SFAS 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value estimate should be determined based on the assumptions that market participants would use in pricing an asset or liability. As a basis for considering market participant assumptions in fair value measurements, SFAS 157 establishes a fair value hierarchy that distinguishes between market participant assumptions developed from market data obtained from sources independent of the reporting entity (observable market inputs), and the reporting entity's own assumptions about market participant assumptions developed from the best information available in the circumstances (unobservable inputs).

This fair value hierarchical structure is aimed at increasing the consistency and comparability in fair value measurements, and related disclosures that are reported in financial statements, since it prioritizes the inputs to valuation techniques used to measure fair value into three broad levels, Level-1, Level-2, and Level-3, with Level-1 containing the best and most reliable form of market inputs and Level 3 containing virtually none. Although the availability of market inputs relevant to the asset or liability, and the relative reliability of the inputs, may affect the selection of appropriate valuation techniques, "the hierarchy is intended to convey information about the nature of the inputs (the assumptions, not the valuation techniques) used in creating the reported fair values)." [4].

Market inputs refer to the assumptions that market participants would use in making pricing decisions (that is, in estimating fair values). Market inputs are either observable or unobservable. Observable market inputs refer to inputs developed based on market data obtained from sources independent of the reporting entity. Unobservable market inputs refer to inputs that reflect the reporting entity's assumptions of market inputs.

Level-1 inputs are observable market inputs that reflect quoted prices for identical assets or liabilities in active markets that the reporting entity has the ability to access at the measurement date. An example is a quoted price on the New York Stock Exchange.

Level-2 inputs are inputs other than quoted prices included within Level-1 that are observable for the asset or liability, either directly or indirectly through corroboration with observable market data (market-corroborated inputs).

Level-3 inputs are unobservable inputs for the asset or liability; that is, inputs 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), developed based on the best information available in the circumstances. Assumptions about risk include the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model), and/or the risk inherent in the inputs to the valuation technique [2].

Fair Value Disclosures

SFAS 157 (paragraphs 32-35) requires disclosures about the fair value of assets and liabilities recognized in the statement of financial position in periods subsequent to initial recognition, whether the measurements are made on a recurring basis or on a nonrecurring basis. Quantitative disclosures using a tabular format are required in all periods (interim and annual). Qualitative (narrative) disclosures about the valuation techniques used to measure fair value are required in all annual periods.

Ethical Implications of Level-3's Fair Value Measurements and Audit Considerations

The Level-3 fair value estimates in the hierarchical structure are estimated with the most unreliable valuation inputs (assumptions), and therefore involve the most uncertainty and highest levels of management judgment and subjectivism. This is because market prices and other market inputs that would first be used to estimate their fair values are not available. Thus, management can employ their own assumptions about the inputs necessary to calculate fair values (such as future estimated cash flows and discount rates). Therefore, it is with the Level-3 fair value estimates reported in financial statements that the ethical problems will be the greatest, as managers try to over- or underestimate fair values to accommodate their own objectives.

It is noted, however, that SFAS 157 requires the most detailed disclosures for the Level-3 fair value estimates reported in financial statements, to apprise readers of financial statements of managements' assumptions, and the reliability (or unreliability) of their fair value estimates. These requirements, combined with the expanded guidance of Statement on Auditing Standard No. 101, Auditing Fair Value Measurements and Disclosures (SAS 101), provide stakeholders with greater assurance about the reliability of the estimates. Specifically, SAS 101 provides a general framework for auditing fair value measurements and disclosure--providing guidance on understanding management's process for developing fair value estimates and evaluating whether the measurement conforms to GAAP.

The new guidance in SFAS 157 and the additional information reported in financial statements must also be considered during periodic audits. For example, the auditor must understand the new GAAP requirements for each type of fair value estimate and disclosure. The new GAAP does not specify methods or processes that should be used for measuring assets and liabilities at fair value. If observable market inputs are not available (i.e., a Level-3 valuation measurement), management techniques for estimating fair value should incorporate assumptions that individuals in the marketplace would use. If that information is not available without excessive cost and effort, then GAAP permits an entity to use its own assumptions as long as there is no indication that marketplace participants would use different assumptions [6].

Specifically, the auditor must evaluate the significant input assumptions, consider the appropriateness of the valuation model used, and test the underlying data and valuation estimates. The auditor does this even when management uses a valuation specialist to prepare the estimate. When management uses a qualified and objective specialist for the fair value measurement it uses for financial reporting purposes, it is still management that is responsible for the data that form the basis for the measurement, as well as the approach, methods, and assumptions the specialist used in arriving at the fair value of an item [6].

Implications for Academia and Corporate Governance

It has been suggested that investors and accountants will have to broaden their knowledge of fair value measurement methodologies, since there are already a large number of standards that require fair value estimates, and that academic programs at universities should provide joint accounting and finance programs that include courses on valuation techniques in financial reporting. There still remains the problem of greedy CEOs, CFOs, and challenged accounting professionals. Various approaches to address ethical lapses have been suggested. The Sarbanes-Oxley Act has been a boon. Business education could be a remedy. To improve corporate governance and mindful accounting professionals, it has been recommended that business schools focus on integrity at the individual, company and societal levels--that is, on business in society, not just business in economy [7].

In addition, it has been suggested that the principal problem that financial accounting should deal with is top management's fraud. Some authors have suggested that a cultural audit would provide a means for assessing the tone at the top and the attitude toward internal controls and ethical decision making recommended by the Treadway Commission almost two decades ago. A cultural audit would be a tool for creating ethical companies suggested by the authors Castellano and Lightle [1]. They propose that the board of directors, through the audit committee, retain an outside firm to conduct a cultural audit every three years. The authors cite three issues that need to be addressed:

* The degree to which preoccupation with meeting the analyst's expectations permeates the organizational climate;

* The degree of fear and pressure associated with meeting numerical goals and targets; and

* The compensation and incentive plans that may encourage unacceptable, unethical, and illegal forms of earnings management.

This means of assessment recognizes the critical role of internal controls over financial reporting for creating and maintaining ethical companies.

References

1. Castellano, J. and S. Lightle. "Using Cultural Audits to Access Tone at the Top," The CPA Journal, February, 2005. http://www.nysscpa.org/printversions/cpaj/2005/205/p.6.htm

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

3. Flegm, Eugene H. "On Solving the Problem, Not Being It," The CPA Journal, February 2005, 12-14.

4. Haldeman, Jr., R.G. "Fact, Fiction, and Fair Value Accounting at Enron," The CPA Journal, November 2006, 14-31.

5. Highlights, The CPA Journal, November 2006, 10.

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

7. Waddock, S. "Hollow Men and Women at the Helm ... Hollow Accounting Ethics?" Issues in Accounting Education, 20 (2), 2005, 145-150.

Teresa M. Danile, The Peter J. Tobin College of Business, St. John's University

Irene N. McCarthy, The Peter J. Tobin College of Business, St. John's University