Fair Value: Is It Fair Game For Critics? The Financial Accounting Standards Board (FASB), the accounting standard setters, issued Statement of Financial Accounting Standards No. 157 Fair Value Measurements that has set off a wave of controversy. Advocates, such as investors, support the idea of financial statements showing true value of a company’s assets and liabilities. Critics, on the other hand, think this pronouncement has caused volatile results in the current inactive market, blaming it for the current financial crisis. Also, fair value measurement has relevance, but another criticism is how much reliability the relevant information can provide. The purpose of Statement of Financial Accounting Standards No. 157 Fair Value Measurements (SFAS No. 157) is to provide guidance about how entities should determine fair value estimations for financial reporting purposes. SFAS No. 157 was issued to help investors and other decision-makers understand the accuracy of the estimates of a company’s assets.
Supporters of fair value accounting suggest it will offer users a clear picture of the real economic state of a company, but the change is not as simple as it sounds and there are disadvantages as well. Fair value, under Statement No. 157, is the current amount that an asset can be bought or sold, or a liability settled, between parties in a current transaction, assuming there is an active market. SFAS No. 157 clarifies the definition of fair value as: “…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.
Although there are no new requirements for using fair value, the new definition does introduce certain differences. Assets are now based on the price at which it would be sold, the exit price, instead of the price at which it would be bought. Also, SFAS No. 157 puts emphasis on fair value being market-based which could cause potential buyers to be unconvinced to acquire the asset. Fair value measurement should favor market participants and their assumptions about the price of an asset or liability, including risk, the highest and best use of an asset, and the nonperformance risk of a liability. Another provision of SFAS No. 57 is the fair value hierarchy that classifies the quality and reliability of information used in fair value measurements for disclosure purposes. The aforementioned assumptions of the market participants define the inputs used to measure fair value that are categorized in the following three levels. The most reliable valuation inputs, quoted prices in an active market, are at a higher rank in Level 1. A quoted market price in an active market is the best basis for the measurement of fair value. Items in Level 2 are inputs, other than quoted prices, that are observable in an active or inactive market.
Inputs based on unobservable data, in a situation of a market with little or no activity such as the existing credit crisis, are ranked in Level 3. The intention of the hierarchy is to enhance the use of observable market data and minimize the use of unobservable inputs. If a quoted market price is not available then financial statement preparers should estimate fair value using the best information available considering the circumstances, such as an inactive market. This could cause some difficulties when estimating fair value. The issuance of SFAS No. 57 requires new disclosures to be made for assets and liabilities measured at fair value in order to clear up how fair value is determined. It requires that there are disclosures about the methods a company uses to measure fair value, what fair value measures do to the earnings, and to what level does a company measure fair value. Also, further disclosure should be made for inputs that are classified in Level 3 of the hierarchy including the amount of total gains and losses held at the reporting date, and a description of where those losses and gains are reported in the income statement.
Finally, disclosures should be made for recurring fair value measurements, such as debt and equity securities mentioned under SFAS No. 115, as well as non-recurring measurements including impairment or disposal of assets under SFAS No. 144. Since the issuance of SFAS No. 157, there have been many disagreements about the movement towards fair value accounting. Several financial institutions have recently reported enormous losses which opened the debate over the requirements of SFAS No. 157 in situations when markets collapse and observable inputs are not easily available. Bankers would prefer a mix of air value and historical cost because of the numerous write-downs that affected companies’ income statements, but accounting standard-setters are trying to taper off historical cost altogether. Advocates of fair value say that “investors and analysts dispute bankers’ complaints about fair value; from the market’s standpoint, it actually helps them better understand the latest and truest worth of a firm’s assets and liabilities. ” The investors gain a clearer picture and the information is available to them about the risks of a financial institution, but decisions alter in an illiquid market like the current financial crisis.
As mentioned before, in an inactive market, financial statement preparers have to estimate fair value measurements based on unobservable information which is not very reliable according to the fair value hierarchy. The volatility of financial statements and the huge losses makes it easy for financial institutions to point fingers towards the new fair value measurement requirements. The debate between investors and bankers was settled when a study was performed by the Securities and Exchange Commission (SEC) in late 2008. In October 2008, Congress ordered the SEC to conduct a study on fair value accounting standards set in SFAS No. 57. This study focused on issues such as the effects the standards have on a financial institution’s balance sheet, the impacts it has on the bank failures in 2008, and the impact on the quality of financial information available to investors.  The SEC report to Congress on mark-to-market accounting states that “bank failures in the U. S. appeared to be the result of growing probable credit losses, concerns about asset quality, and, in certain cases, eroding lender and investor confidence. ” The study, prepared by the SEC, concluded that the reporting of the losses at fair value is not the reason for the 2008 bank failures.
Perhaps one of the strongest disputes about the switch to fair value accounting is the debate over relevance and reliability. Supporters of fair value encourage the movement because historical cost does not provide relevant information for investors and other decision makers. On the other hand, historical cost has the upper hand when it comes to reliability because of the balance sheets containing actual purchase prices and not estimated present values. Even though fair value does not provide the most reliable information, it is undeniably relevant for decision makers. Fair value accounting would produce balance sheets that are more representative of a company’s value. ” A company’s financial statements would include the true and current values of assets and liabilities if measured at fair value and historical cost could not provide that for investors and other users of the financial statements. “Relevant information that is unreliable is useless to an investor. ” When it comes to decision makers, reliability would clearly outweigh relevance which means that standard setters need to come up with solutions to provide reliability along with the relevant information of fair value measurements.