Fair-Value Accounting
Analyzing the Changing Environment

By Rebecca Toppe Shortridge, Amanda Schroeder, and Erin Wagoner

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APRIL 2006 - FASB’s exposure draft, Fair Value Measurement, has brought renewed attention to the debate between historical-cost measurement and fair-value measurement in financial statements.

Perhaps the strongest argument for a move to fair-value accounting is that historical-cost financial statements do not provide information that is relevant to investors. The fact that the market value of publicly traded firms on the New York Stock Exchange is five times their asset values serves to highlight this deficiency. The primary driver of this disparity was clearly illustrated by then–Federal Reserve Chairman Alan Greenspan, as quoted in Cracking the Value Code: How Successful Businesses Are Creating Wealth in the New Economy (Richard E.S. Bolton, Barry D. Libert, and Steve M. Samek; HarperCollins, 2000). Greenspan said: “[V]irtually unimaginable a half-century ago was the extent to which concepts and ideas would substitute for physical resources and human brawn in the production of goods and services.”

The fair-value exposure draft would establish a framework for measuring assets and liabilities at fair value. Critics, however, have expressed concerns with the proposal.

Recent FASB Projects

FASB has issued numerous standards in recent years to require the use of or provide guidance for calculating fair-value measurements in financial accounting. This change from prior practice signifies to many a deliberate movement away from historical-cost financial statements and toward fair market value statements.

Statement of Financial Accounting Concepts 7. As FASB increases the items reported using fair value, determining how to actually measure value is critical. For example, how should a company establish the value of a customer list acquired in a business combination? Statement of Financial Accounting Concepts (SFAC) 7, Using Cash Flow Information and Present Value in Accounting, provides a framework for using the present value of future cash flows to establish fair value. According to SFAC 7, “the only objective of present value, when used in accounting measurements … is to estimate fair value. Stated differently, present value should attempt to capture the elements that when taken together would comprise a market price, if one existed.”

Essentially, SFAC 7 provides a discussion of present-value techniques that can be used to estimate fair value when a market-based value does not exist. By providing a method for establishing fair value, FASB extended the potential uses of fair-value accounting.

Statement of Financial Accounting Standards 141. FASB released Statement of Financial Accounting Standards (SFAS) 141, Business Combinations, in June 2001. This was a groundbreaking standard, because intangible assets that had never been recognized now had to be separately identified and reported in a business combination. FASB indicated that numerous users had indicated a desire for better information regarding intangible assets because they had become increasingly important in the U.S. “knowledge economy.”

Thus, SFAS 141 requires that all intangible assets acquired in a business combination “be recognized as an asset apart from goodwill if it arises from contractual or other legal rights … or if it is separable.” The intangible assets now required to be separately measured and recognized include such items as trade dress, customer lists, computer software, and employment contracts.

SFAS 141 further indicates that intangible assets acquired in a business combination “should initially be assigned an amount based on their fair value.” Fair value is defined as the amount at which the asset could be bought or sold in a current transaction between willing parties. The statement also notes that “judgment is required in estimating the period and amount of expected cash flows,” and that these judgments should be consistent with the objective of measuring fair value.

While assets required to be measured at market value in this standard are related to arm’s-length transactions, there was previously no requirement to separately identify intangible assets such as customer lists and employment contracts. This statement suggests that FASB is changing its focus from measuring only hard assets to also measuring the “soft” assets that are increasingly important in the current U.S. economy.

Statement of Financial Accounting Standards 142. SFAS 142, Goodwill and Other Intangible Assets, covers three topics: 1) the postacquisition accounting treatment for all intangibles, including those acquired through a business combination; 2) accounting for the acquisition of intangible assets in circumstances outside of business combinations; and 3) accounting for internally generated intangible assets.

First, SFAS 142 defines the requirements for postacquisition accounting of intangible assets. If the intangible asset has a definite useful life, amortization is required over the life of the asset. If the intangible asset has an indefinite useful life (e.g., goodwill), it is not subject to amortization and is instead tested annually for impairment. Second, SFAS 142 requires that intangible assets acquired outside of business combinations be recorded at fair value (see Rose Marie L. Bukics and J. Chapman Benson, “The Big Splash: Goodbye, Pooling; Hello, Goodwill Impairment Testing,” The CPA Journal, March 2002). Finally, SFAS 142 clearly states that the “costs of internally developing, maintaining, or restoring intangible assets that are not specifically identifiable, that have indeterminate lives, or that are inherent in a continuing business and related to an entity as a whole, shall be recognized as an expense when incurred.”

Consistent with SFAS 141, this standard requires recognition of intangible assets that were previously not reported in historical-cost financial statements. This standard also recognizes that the value of assets may not decline equally over time, thus they should be measured for impairment. This requires companies to establish methods for assessing value for individual assets and operating units.

Statement of Financial Accounting Standards 144. SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, uses fair-value measurements to assess whether long-lived assets are permanently impaired. This standard, issued in August 2001, states that impairment “is the condition that exists when the carrying amount of a long-lived asset (asset group) exceeds its fair value.” This statement again requires using fair-value measurements to determine the appropriate accounting treatment.

SFAS 144 provides “traditional” guidance on assessing fair value. In particular, it indicates that the fair value of an asset is the amount that the asset could be purchased or sold for in a third-party transaction. Paragraph 22 dictates that actively quoted market prices are the best measure but that prices of similar assets may be used when necessary. Paragraph 23 provides that it may be necessary to use the present value of discounted cash flows technique presented in SFAC 7 when a market value cannot be used to establish a reasonable value.

Interestingly, in numerous scenarios (SFAS 144, lower of cost or market for inventory, and others) FASB believes it is appropriate to use fair-value measurements to record asset impairments. Supporters of fair-value accounting could use these scenarios to support the use of fair-value accounting for all assets and liabilities on the balance sheet. The question arises: If fair value can be used to develop relevant and reliable measures of impairment, then why aren’t fair-value measures relevant and reliable measures of appreciation?

FASB Exposure Draft, Fair-Value Measurements. In June 2004, after more than five years of work, FASB issued an exposure draft on fair-value measurements. This proposal provides guidance for valuing assets and liabilities that are required to be measured at fair value under other pronouncements. The ultimate goal of the fair-value project is to improve comparability, consistency, and reliability of fair-value measurements by creating a model that can be broadly applied to financial and nonfinancial assets and liabilities. The framework would also remove policies that disagree with SEC guidelines for investment funds, and clarify the use of fair-value measurements in other authoritative pronouncements.

The exposure draft would not replace, but instead would expand upon, current disclosures relating to the use of fair-value measurements for assets and liabilities. Disclosures would include information about fair-value amounts, how they are determined, and the effect of any remeasurement on earnings, including unrealized gains and losses (see Joseph V. Carcello and Jan R. Williams, “Fair Value Measurement,” in Miller GAAP 2004). These new disclosures would apply to securities that are perpetually measured at fair value and to assets that are periodically measured for impairment. Carcello and Williams note that this standard would have broad implications, affecting or amending more than 30 accounting standards.

In summary, this exposure draft does not expand the assets or liabilities to be measured at fair value. Instead, it provides a consistent framework for measuring these assets and liabilities and for disclosing information about their valuation. Although the standard does not increase the assets and liabilities currently measured at fair value, it provides a format that FASB could use in the future to measure additional assets and liabilities at fair value.

Relevance Versus Reliability

Perhaps the root of the disagreement over a shift to fair-value measurement is the philosophical debate over relevance versus reliability. Proponents of fair-value accounting argue that historical-cost financial statements are not relevant because they do not provide information about current values. The fair-value dissenters argue that the information provided by fair-value financial statements is unreliable because it is not based on arm’s-length transactions. They contend that if the information is unreliable it should not be used to make financial decisions. This trade-off should be at the core of any discussion about the use of fair value in financial statements.

Relevance. Proponents of fair-value accounting argue that this measurement is more relevant to decision makers even if it is less reliable. First, fair-value accounting would produce balance sheets that are more representative of a company’s value. Specifically, unless the values of fixed assets are assumed to remain the same over time, historical-cost information is relevant only upon obtaining the asset. Furthermore, because historical-cost measures remain unchanged over time, users do not get valuable feedback about appreciation or depreciation following the purchase of the asset.

For example, if ABC Corporation purchased a two-acre tract of land in 1980 for $1 million, then a historical-cost financial statement would still record the land at $1 million on ABC’s balance sheet. If XYZ purchased a similar two-acre tract of land in 2005 for $2 million, then XYZ would report an asset of $2 million on its balance sheet. Even if the two pieces of land were virtually identical, ABC would report an asset with one-half the value of XYZ’s land; historical cost is unable to identify that the two items are similar. This problem is compounded when numerous assets and liabilities are reported at historical cost, leading to a balance sheet that may be greatly undervalued. If, however, ABC and XYZ reported financial information using fair-value accounting, then both would report an asset of $2 million. The fair-value balance sheet provides information for investors who are interested in the current value of assets and liabilities, not the historical cost.

Reliability. Despite the advantage of having more-relevant information, the change to fair-value accounting has met with much resistance. The primary argument against fair-value accounting is that it is not reliable. According to Colleen Cunningham, president and CEO of Financial Executives International (FEI), in “Fair Value Accounting: Fair for Whom?” (Financial Executive, March/April 2004): “Relevant information that is unreliable is useless to an investor. We must, therefore, be clear about the nature of the claim being made for an accounting number described as reliable.”

One advantage of historical-cost financial information is that it produces earnings numbers that are not based on appraisals or other valuation techniques. Therefore, the income statement is less likely to be subject to manipulation by management. In addition, historical balance sheet figures comprise actual purchase prices, not estimates of current values that can be altered to improve various financial ratios. Because historical-cost statements rely less on estimates and more on “hard” numbers, proponents believe that historical-cost financial statements are more reliable than fair-value financial statements.

Furthermore, fair-value measurements may be less reliable than historical-costs measures because fair-value accounting provides management the opportunity to manipulate the bottom line. Continuing the example from above, ABC could argue that its tract of land is undervalued by $1 million and that it should record a gain in the financial statements. What if ABC argued that its tract of land was worth even more because it had a slightly better location? Therefore, instead of a $1 million gain, ABC could choose to report a $1.5 million gain, recognizing an additional $500,000 gain on the income statement.

Developing reliable methods of measuring fair value so that investors trust the information reported in financial statements is critical if FASB continues its movement toward fair-value accounting. This is no easy task, especially in light of recent scandals in financial reporting.

The Debate Continues

FASB’s recent activities with SFAC 7, SFAS 141, SFAS 142, SFAS 144, and the fair value exposure draft are steps toward fair-value measurement that will no doubt result in countless debates in the business world. SFASs 141 and 142 require companies to record acquired intangible assets at fair value. However, intangible assets that are internally developed are expensed immediately. Because of this type of inconsistency, investors will likely remain uninformed regarding the true measure of many intangible assets. As Baruch Lev said in his “Remarks on the Measurement, Valuation, and Reporting of Intangible Assets” (Economic Policy Review, Federal Reserve Bank of New York, September 2003), fair-value information that is provided regarding intangible assets is largely inconsistent, partial, and confusing, and prevents boards of directors and investors from intelligently allocating resources.

Undoubtedly, valuing tangible and intangible assets at fair value is extremely difficult and time-consuming. Current financial accounting standards, however, require the use of estimates every day; for example, the allowance for doubtful accounts, contingent liabilities, projected pension obligations, and goodwill impairment. It is not a significant leap to require companies to provide some measurement of the fair market value of both tangible and intangible assets, even if this information is reported only in the footnotes.

The debate surrounding historical-cost and fair-market values will not end soon. If anything, this discussion is likely to intensify given FASB’s interest in the topic. One hopes the debate will provide insight into a more efficient system for presenting financial information and economic transactions to boards of directors, analysts, and investors.

Rebecca Toppe Shortridge, PhD, CPA, is an assistant professor in the department of accountancy at Northern Illinois Univeristy, DeKalb, Ill.
Amanda Schroeder is a staff accountant in the Indianapolis office of Deloitte & Touche.
Erin Wagoner is a staff accountant with the CPA firm of Katz, Sapper, & Miller, Indianapolis, Ind.




















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