Question

The trend toward fair value accounting
By J Russell Madray, CPA
The Debate
Critics contend that GAAP is seriously flawed. Some in the accounting profession go so far as to pronounce financial statements almost completely irrelevant to the financial analyst community. The fact that the market value of publicly traded firms on the New York Stock Exchange is an average of five times their asset values serves to highlight this deficiency. Many reformers, including FASB chairman Robert Herz, believe that fair value accounting must be part of the answer to making financial statements more relevant and useful.* Advocates of fair value accounting say it would give users of financial statements a far clearer picture of the economic state of a company.
But switching from historical cost to fair value requires enormous effort. Valuing assets in the absence of active markets can be very subjective, making financial statements less reliable. In fact, disputes can arise over the very definition of certain assets and liabilities.
The crux of the fair value debate is this: Each side agrees that relevance and reliability are important, but fair value advocates emphasize relevance, while historical cost advocates place greater weight on reliability.
Relevance versus Reliability
The pertinent conceptual guidance for making trade-offs between relevance and reliability is provided by FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information. It provides guidance for making standard-setting decisions aimed at producing information useful to investors and creditors. Concepts Statement No. 2 states:
The qualities that distinguish “better” (more useful) information from “inferior” (less useful) information are primarily the qualities of relevance and reliability … The objective of accounting policy decisions is to produce accounting information that is relevant to the purposes to be served and is reliable.
Critics of fair value generally believe that reliability should be the dominant characteristic of financial statement measures. But the FASB has required greater use of fair value measurements in financial statements because it perceives that information as more relevant to investors and creditors than historical cost information. In that regard, the FASB has not accepted the view that reliability should outweigh relevance for financial statement measures.
Some critics also interpret reliability as having a meaning that differs in at least certain respects from how that term is defined in the FASB’s Conceptual Framework. Some critics equate reliability with precision, and others view it principally in terms of verifiability. However, Concepts Statement No. 2 defines reliability as “the quality of information that assures that information is reasonably free from error or bias and faithfully represents what it purports to represent.” With respect to measures, it states that “the reliability of a measure rests on the faithfulness with which it represents what it purports to represent, coupled with an assurance for the user, which comes through verification, that it has that representational quality.” Thus, the principal components of reliability are representational faithfulness and verifiability.
Although there are reliability concerns associated with fair value measures, particularly when such measures may not be able to be observed in active markets and greater reliance must be placed on estimates of those measures, present-day financial statements are replete with estimates that are viewed as being sufficiently reliable. Indeed, present day measures of many assets and liabilities (and changes in them) are based on estimates, for example, the collectability of receivables, saleability of inventories, useful lives of equipment, amounts and timing of future cash flows from investments, or likelihood of loss in tort or environmental litigation.
Even though the precision of calculated measures such as those in depreciation accounting is not open to question since they can be calculated down to the penny, the reliability of those measures is open to question. Precision, therefore, is not a component of reliability under Concepts Statement No. 2. In fact, Concepts Statement No. 2 expressly states that reliability does not imply certainty or precision, and adds that any pretension to those qualities if they do not exist is a negation of reliability.
* Robert H. Herz’s remarks to the Financial Executives International Current Financial Reporting Issues Conference, New York Hilton Hotel, November 4, 2002.
Source: Excerpts from ‘The trend toward fair value accounting’, Journal of Financial Service Professionals, May 2001, pp. 16-113.

Questions:
1.How will the use of fair values affect the role of auditors and the audit function? Do you think it will affect the training of accounting students? How so?

Answer 1

Effect of Fair Value Accounting on the Role of Auditors and Audit Function

During this period of global markets, multinational corporations are demanding financial accounting standards with enhanced uniformity. In an effort to achieve this objective, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have been working together on the Convergence Project, aiming to develop accounting standards that closely correlate with international financial reporting standards.

In September 2006 and February 2007, the FASB issued two key fair value accounting (FVA) standards which focused on providing guidelines for fair value measurement (through a classification hierarchy), expanding disclosure requirements, and also allowing business entities to increase FVA's application. However, the recent financial crisis has placed increased scrutiny on estimates derived under FVA. Consequently, a spotlight has been placed on the auditing profession, as the effectiveness of an auditor's ability to test estimates derived under FVA has been questioned due to numerous firms approaching collapse in the midst of the credit crisis.

Thus, the purpose of this paper is to present the challenges auditors face when auditing FV estimates, and to discuss the profession's capability of adapting to FVA in the future. Keywords: auditing, fair value accounting, FASB, fair-value option, Convergence Project, financial/subprime crisis, level-three asset/liability, audit risk, earnings management, financial statement audit, financial asset/liability INTRODUCTION The historical cost principle has always been viewed as the foundation of accounting in the United States.

However, a combination of efforts by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) to converge US Generally Accepted Accounting Principles (GAAP) with International Financial Reporting Standards (IFRS), in addition to increased demands for more relevant financial data by investors, has created a transition towards valuation based accounting.

The first major set of GAAP standards issued that fully reflected the efforts of the Convergence Project was the creation of Statement of Financial Accounting Standards No. 157: Fair Value Measurements (FAS 157) and Statement of Financial Accounting Standards No. 159: The Fair Value Option for Financial Assets and Financial Liabilities (FAS 159). Both standards became effective for fiscal years beginning after November 15, 2007. While FAS 157 does not expand the use of fair value (FV), it is rendered as the first definitive U.S. accounting standard that defines FV accounting, provides a measurement hierarchy to value applicable assets and liabilities, and provides criteria for note disclosures with regard to valuation methods used.

Under FAS 157 a hypothetical exit price for an asset or liability should be determined. The "exit price" would be equal to an expected amount that a buyer would be willing to purchase the item from the owner (a business entity). FAS 159 (also referred to as the FV Option), on the other hand, allows companies, including not-for-profit organizations, the option to value certain classes of financial assets and financial liabilities at FV, that previously were not permitted by the FASB. The FASB's main purpose of expanding the use of FV was to increase transparency and the relevance of the data presented within the financial statements for external users. Nonetheless, the recent focus on FV accounting has created an assortment of difficult issues for auditors, which are twofold.

First, if the FV option has been elected and/or the FV framework disseminated by the FASB is not properly interpreted, an internal/external auditor's ability to assess the validity of management's asserted estimates may be impaired, and consequently, significantly increase audit risk. Second, the recent global financial crisis has further created complexities for auditors with respect to asserting that estimated prices reflect economic reality, especially for financial assets and liabilities mat do not have an active market. Recently, there has been an increased focus on how auditors have conducted their audit during engagements, in bom the current and pre-FAS157 era, with regard to testing and evaluating estimates derived under FV. These issues that auditors have faced will be addressed in subsequent sections of this paper.

FAIR VALUE ACCOUNTING:

BACKGROUND

While the notion that FV accounting is new may exist, this is not the case. The first accounting standard regarding FV, FAS 12: Accounting for Certain Marketable Securities, issued in 1975, allowed for marketable securities with significant declines in value (other than temporary), to be reported at the reduced market value as opposed to me acquisition price.1 Omer examples include FAS 107: Disclosures about FV of Financial Instruments, FAS 11 9: Disclosure about Derivative Financial Instruments and FV of Financial Instruments, and FAS 133: Accounting for Derivative Instruments &Hedging Activities, issued in December 1991, October 1994, and June 1998, respectively. In addition, under the requirements of FAS141R: Business Combinations (revised in 2007), assets acquired/liabilities assumed in business combinations are required to be written up or down to their respective FVs on me date of acquisition under the purchase method. Nonetheless, accounting for business combinations is not the focus of this article.

FAS157 defines FV and provide guidance as to its measurement, but does not expand its use. The FV hierarchy, consisting of Üiree-levels, provides the profession with a framework to determine or estimate FV for applicable assets and liabilities. When attempting a valuation, level one of the FV hierarchy should be used most frequently. An asset or liability that is categorized at mis level must be valued using available market prices for identical items. Items falling under this classification are considered to exist in a liquid market, (i.e., stock traded on me NYSE, U.S. Treasury Notes, futures contracts, etc). Level two indicates that "prices" can only be determined for inactively traded items or when market quotes can only be accessed for similar items (i.e. lightly traded preferred stock/corporate bonds).

Level three, however, refers to an asset/liability without an active market. In this regard, obtaining a market price is not possible (i.e. real estate, mortgage-backed securities). At this level, it is required that the entity provides adequate disclosures as to how the FV estimates were derived. Therefore, auditors have been relying mostly on judgment when evaluating estimates for these assets/liabilities. The FV Option, on the other hand, allows organizations to decouple from the historical cost principle with regard to certain financial assets and financial liabilities such as "stocks, bonds, [available-for sale equity/debt securities, held-to-maturity debt securities], loans, warranty obligations, and interest rate hedges," and use FV accounting on an instrument-by-instrument basis.

The Option, if applied, is permanent in nature, and can only be elected at the time when the entity "purchases the [permitted] financial asset or incurs a financial liability." According to Alfred King, author of Fair Value for Financial Reporting (2006), FV can be defined as "the price that would be received for an asset, or paid to transfer a liability, in a current transaction between marketplace participants in the reference market for the asset or liability." The chief issue that has existed for auditors is how to effectively assess and test "the price" in a hypothetical exchange when a "reference market" does not exist. Nonetheless, prior to the November 2007 adoption of FAS157 and FAS159, auditors were already experiencing an array of difficulties while attempting to assess managements' assertions during financial statement audits, which may have been a prelude to current issues.

DIFFICULTIES FOR AUDITORS WITH INTERPRETING FV ESTIMATES

As FV accounting has been slowly uprooting the historical cost principle, the Public Company Accounting Oversight Board (PCAOB), along with other accounting professionals have attempted to offer guidance. The PCAOB is a private sector organization that was created as a result of the financial scandals of the early-2000s with the passage of the Sarbanes-Oxley Act of 2002. One of the PCAOB's major roles in auditing is to enforce auditing standards for auditors. According to Mark Olson, PCAOB chairman cited by CFO Magazine author, Sarah Johnson, "FV accounting could put reliable auditing of financial reporting at risk," since the current market values for assets and liabilities may not be reflective of the true underlying worth of the asset or liability. King, on the other hand, indicates that while valuation specialists and management must project a FV for a specific asset or liability, testing these estimates is not an easy task for the auditor, especially in an inactive market, since a price can only be established if the asset or liability is sold.

Thus, the potential for an organization's management to be intentionally or unintentionally biased towards creating an over optimistic value for the asset, therefore, exists. In a June 2007, CFO Magazine article, Johnson, cited Rita Piazza, chairman of the SEC committee for the New York State Society of CPAs. Piazza declared, "Auditors will have little evidence for testing" values assigned to level three assets/liabilities where market values are based on managements' assertions, not factual acquisition prices or market quotes. Subsequently, after the effective dates of FAS 157 &FAS 159, in December 2007, the PCAOB, with the issuance of Staff Audit Practice Alert No. 2, sought to address potential issues with auditing financial instruments where the FV Option has been applied.

The Practice Alert indicates that auditors must be watchful that management has not misclassified assets/liabilities under the FV measurement hierarchy, and accordingly, disclosure requirements under GAAP have been met. In addition, estimates provided by pricing analysts and valuation specialists must now be thoroughly scrutinized by an auditor, thus increasing an auditor's responsibilities during an audit of internal controls over financial reporting. Additionally, auditors must be weary of earnings management, and fully understand the influence FV accounting can have on a client's balance sheet and income statement.

Earnings management occurs when corporate executives, who are seeking personal gain, intentionally interfere with the "earnings determination process." Effectively, an auditor's traditional framework for issuing an opinion or a disclaimer during the financial statement audits has now been modified. According to Johnson, auditors must become aware that the "internal controls surrounding FV may differ for those over typical business transactions," and base their assertions accordingly. However, material miscalculations on behalf of management and/or the auditor can result. Nevertheless, an error in the valuation of level-three assets and liabilities does not necessarily indicate fraud. "Auditors will need to look beyond the fact that a valuation was wrong to determine whether or not management made an appropriate judgment call," stated Johnson. Nonetheless, auditors must remain vigilant, assessing the degree of audit risk throughout the audit.

CREDIT CRISIS / FV EVALUATION

Furthermore, with regard to the subprime/credit-crisis, audit firms have experienced many headwinds when attempting to address material mispricing of level three assets and liabilities. It is no secret that vast arrays of financial institutions have failed due to the economic debacle, (i.e. investment banks, hedge funds, and traditional banks). Though the failures of these firms may have been caused by poor corporate investment decisions, FV accounting has been blamed for amplifying the crisis. While errors or misjudgments related to the calculation of prices for illiquid assets may translate into auditor negligence, criminal allegations will most likely not be initiated against auditors, based on analyst assertions.

On the other hand, mortgage lenders and auditing firms will most likely endure a barrage of civil, as opposed to criminal lawsuits. For instance, in April 2009, KPMG was sued for $1 billion by "the trustee for bankrupt New Century Financial Corporation," for allegedly not issuing an adverse opinion when it should have been clear that the entity's financial position was deteriorating. Shareholders, who are foreseeable third parties, have suffered significant losses due to enormous write-downs of subprime assets and have been inclined to include these failed financial institutions' auditing firms in litigation proceedings.

AUDITOR FEEDBACK

Beyond the actual cases of alleged ordinary negligence, auditors themselves have expressed their concerns. Auditors have argued that risky credit securities, in the midst of the credit crisis, are underpriced compared to less risky financial instruments. In times of aggressive economic expansion, gains will be recorded on these securities under FVA. Essentially, market values for financial assets and financial liabilities are over optimistic in good economic times and excessively pessimistic during recessionary periods, creating the opportunity to manage earnings.

As a result, the illusion is created that the company was more profitable than it was in actuality. The main fear is that managed earnings may create material departures from economic reality, creating highly complicated engagements for the auditor. According to King, earnings mismanagement has been one of the lead reasons for the outbreak of financial scandals throughout the 2000s. Under the historical cost principle, an auditor would be able to validate me actual cost for a particular asset or liability by inspecting a receipt, cancelled check, invoice, contract, or title. Auditors may now need to abandon their experience with historical cost and utilize their own judgment in determining if management's assertions were correct. Yet, this can be very difficult since the FV for an asset or liability may, in reality, be 10% greater or less than management's estimate, according to King.

King asserts that if a scandal should occur, regardless of the auditor's belief that he/she rationally judged the projected market value for the asset or liability, the question, "why did you accept this value, this management assertion, this liability estimate?" would be asked to fhe internal/external auditor in the event of an investigation. Hence, while auditors are attempting to work their very best to authenticate the provided estimates from appraisers and management, it is near impossible to do so.20 Should auditors really be penalized for inaccurately testing the accuracy of an appraised value when no clear active market exists.

ISSUES IN FV EDUCATION

Others discuss how to address an auditors' lack of education in the realm of FV accounting, and how this aspect of accounting/auditing will become the new reality in the impending years and decades. According to King, within the not-too-distant future, FV accounting will replace historical cost education entirely. "It is only a matter of time until we have to go to history books to read about historical cost accounting because it will no longer be taught to students," claimed King. Johnson indicates that a greater focus should now be placed on educating auditors to learn valuation techniques. She asserts that the auditing industry and the PCAOB would be chief leaders in educating the profession.

Nonetheless, based on Johnson's reference to Arnold Hanish, the Chief Accounting Officer of Eli Lilly, the suggestion was made that it will take roughly a quarter century for fhe auditing industry to fully adapt to the changes. The potential deficiencies in education are also a concern for entry-level auditors mat did not receive adequate FV training in college. According the chief accountant for auditing and professional practice issues, Zoe-Vonna, members of SAG (The Standing Advisory Group) indicated that young, relatively inexperienced specialists and auditors are unable to "challenge management's assumptions for their FV calculations."

The major issue here is mat many auditing firms primarily rely on these individuals to conduct audits. Numerous professionals agree that auditors cannot always conduct a proper audit because of certain limitations. According to Wild, Halsey, and Subramanyam, auditors confront many challenges in attempting to value "insurance reserves, percentage of completion for large construction contracts, and the values of problem loans." The benefit of evaluating financial data must outweigh the cost, time, and effort an auditor must give to effectively test the reliability of me data, and to subsequently, issue an opinion. Nonetheless, in times of uncertainty, auditors are being forced to venture into unchartered waters.

FVS FUTURE

During the October 2008 hearings on Capitol Hill, relating to me financial crisis, senators and congressmen argued that FV has unfairly punished companies. Consequently, there has been a backlash from financial executives and political officials from around the globe calling for a modification to or an outright suspension of FAS 1 57 &FAS 159. While a suspension of FV accounting has not occurred, mere have been numerous updates and opinions released. In a November 2008 round-table discussion led by the SEC, FASB, IASB, and omer stakeholders, it was argued that modifications/updates must be made to FV accounting, in an effort to preserve the integrity of accounting and the overall financial system.

According to Johnson, one major suggestion was to make the FV Option revocable, which has yet not come to pass. Nonetheless, it may take years to fully debate and evaluate possible changes to FV accounting's application. Subsequently, in response to an ever deepening economic crisis, the FASB issued a flurry of pronouncements in April 2009 to provide further guidance on fair value in current market conditions. FASB Staff Position (FSP) No. FAS 157, Determining Whether a Market Is Not Active and a Transaction Is Not Distressed, provides guidance to determine Fair Value when a market is inactive and a transaction is not distressed.

FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments, increases the frequency of fair value disclosures from annually to quarterly. FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments (OTTI), provides guidance for recognizing when OTTI is established which portion impacts earnings and me remainder may impact other comprehensive income. Finally, on April 21, 2009, the PCAOB issued Staff Audit Practice Alert No. 4, as reinforcement to the aforementioned FSPs, which concentrates on auditor's approaches to test estimates for level three assets/liabilities.

The Alert discusses me fact that there is "a wide range of possible fair value measurements, from relatively simple to complex... [and] the auditors planned audit procedures can vary significantly in nature, timing, and extent." With regard to financial statement audits, the Alert states, "The auditors' substantive tests of the FV measurement may involve (a) testing management's significant assumptions, the valuation model, and the underlying data, (b) developing independent fair value estimates for corroborative purposes, or c) reviewing subsequent events and transactions. " Effectively, the Practice Alert provides a guide for an auditor faced with the challenge of auditing a FV estimate, and explains appropriate valuation approaches to take when conducting a financial statement audit. As the expanded use of FV accounting is merely in its infancy, the FASB and PCAOB are bound to continue to issue additional guidance in the future.

CONCLUSION

Though FV accounting was established to improve the usefulness of information in the financial statements, there is no doubt that a toll has been taken on auditors. Without properly understanding how to value inactively traded mortgage assets, some professionals believe that the auditors helped facilitate the credit crisis. While this accusation may be harsh, it again draws attention to the plethora of challenges facing the field. In the opinion of the authors, me FASB, the PCAOB, and me IASB did not fully anticipate the ramifications that expanded use of FV accounting could have on the auditing industry. The cases of alleged ordinary negligence prior to the enactment of FAS 157 &FAS 159 should have been a warning sign that it may be too soon to force the expanded use of FV on auditors and accountants alike.

While an outright IFRS adoption is not expected to occur in the U.S. until at least 2014, these difficulties have had ripple effects fhroughout the industry. Although increased transparency is positive in the long-term, adequate time for training should have been allowed. Based on me research results and the authors' opinions, the credit crisis was the financial industry's own doing and not the auditors! Major questions to consider are: Should the auditors have issued an adverse opinion or a disclaimer when there is no market for a particular asset or liability? Is the FV lower or higher than management claims? Was management deceptive? Should me FV of the asset be written to zero? While the concept of FV accounting is by no means new to the accounting field, it may take many years for all to build the appropriate skill set to deal with its complexities.

Ideally, the FASB 's and PCAOB 's guidance issued in April 2009, will lend additional direction and support to the profession. Over the next decade, as accountants and auditors become more familiar wifh the usability, application, and testing of FV accounting, a thorough set of international auditing standards could conceivably be issued. As time progresses, an auditor's ability to assess the degree of audit risk on a particular engagement will be improved if they first understand how to evaluate the new levels of inherent and control risks that FV presents. While both big and small firms will face many challenges in the years to come, with the proper education and guidance from standard-setters, there are enough skilled auditors to allow for an industry that will work in tandem with fair value, and a convergence between U.S. GAAP and IFRS.