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

Review of Business, Oct, 2007 by James M. Fornaro, Anthony T. Barbera

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.