Fair Value Accounting:

A Guide to Understanding the

Current Standards
Jefferson P. Jones and Sarah D. Stanwick

Will all financial assets and liabilities soon be measured at fair value? © 1999
John Wiley & Sons, Inc.

O ver the last several years, the Financial Accounting Standards Board
(FASB) has been concerned with the use of fair value as a measurement
attribute. For the most part, these efforts have focused on measuring and
accounting for financial assets and liabilities at fair value in the financial
statements. As a result of these deliberations, current U.S. generally accepted
accounting principles (GAAP) require companies to account for certain assets
and liabilities at fair value (e.g., trading and available-for-sale securities, derivative
instruments) and to disclose the fair values of other financial instruments in the
footnotes to financial statements.
Recently, suggestions have been made to have all financial assets and
liabilities (and possibly even nonfinancial assets and liabilities) recognized and
measured at fair value. For example, in December 1998, the International
Accounting Standards Committee (IASC) approved International Accounting
Standard (IAS) 39, which states that all financial assets and liabilities should be
recognized initially on the balance sheet at fair value and any subsequent
measurement should also be at fair value. In March 1999, the FASB issued an
Exposure Draft of a proposed statement of financial accounting concept in
which they suggest that fair value should be the measurement attribute of both
financial and nonfinancial liabilities.
In late 1997 and early 1998, a series of focus groups were conducted in an
effort to assess investor interest in the use of fair value as a measurement
attribute. One of the findings of these focus groups was the wide variation in
knowledge, particularly in the industry sector, of fair value accounting. Clearly,
with the increased interest in fair value accounting both in the United States and
internationally, it is important that corporate accountants and financial managers
be knowledgeable of the recognition, measurement, and disclosure issues
involved with the use of fair values. This article provides a review of current
pronouncements surrounding fair value and implications of the use of fair
values in the financial statements.
Jefferson P. Jones, Ph.D., CPA, and
Sarah D. Stanwick are assistant
professors in the School of Accoun- CCC 1044-8136/99/1101103-06
tancy at Auburn University. © 1999 John Wiley & Sons, Inc.

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Jefferson P. Jones and Sarah D. Stanwick

FAIR VALUE AS A MEASUREMENT ATTRIBUTE

Fair value is typically defined as the amount that an asset could be exchanged
for or by which a liability could be incurred or settled by knowledgeable, willing
parties in a current arm’s-length transaction. The FASB, in Statement of
Financial Accounting Concepts (SFAC) 5, describes several measurement
attributes used in accounting practice, including historical cost, current cost,
and current market value. These measurement attributes are consistent with the
above definition of fair value. For example, the use of the historical exchange
price to determine the initial value of an asset or liability is assumed to
approximate fair value.
The underlying idea behind the use of fair value as a measurement attribute
is that fair value represents a market price. Market prices capture the consensus
Market prices capture the view of all market participants about an asset’s or liability’s economic
characteristics, including assumptions about cash flows, profit margins, and
consensus view of all
risk. Because a market price incorporates all information available to market
market participants about participants in an effort to distinguish between assets and liabilities that on the
an asset’s or liability’s surface would appear similar (or, alternatively ensures that similar items do not
economic characteristics, appear to be different), the use of fair value should result in a better portrayal of
including assumptions economic reality. Therefore, the information provided by fair value should
about cash flows, profit provide financial statement users with more complete, relevant, and
margins, and risk. representationally faithful information that should result in an improved basis
for decision making.

THE USE OF FAIR VALUE IN CURRENT ACCOUNTING

PRONOUNCEMENTS
Current FASB and IASC pronouncements and deliberations relating to fair
value accounting involve three main issues: disclosures of fair value information,
initial recognition and measurement of assets and liabilities at fair value, and the
accounting for changes in fair value in subsequent periods. This review is not
meant to be a comprehensive review of any one area, but a general review of
areas in which the FASB or the IASC have addressed fair value measurements
and their conclusions.

Financial Instruments Project

In May 1986, the FASB added a project on the use of fair value in the
measurement and disclosure of financial instruments to its agenda. The first
phase of this financial instruments project focused on improving the disclosure
of information about financial instruments. Of particular relevance was the
issuance of Statement of Financial Accounting Standard (SFAS) 107, Disclosures
about Fair Value of Financial Instruments, in December 1991. This standard,
which did not address any recognition or measurement issues, required
disclosures of fair values of financial instruments and any assumptions used to
estimate these fair values. When it is not practicable to estimate fair value, SFAS
107 required information such as the carrying value and effective interest rate
that would be useful in estimating fair value, as well as the reasons why it was not
practicable to estimate fair value.
The next product of the FASB’s financial instruments project was SFAS 115,
Accounting for Certain Investments in Debt and Equity Securities. This statement

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 Fair Value Accounting: A Guide to Understanding the Current Standards

extended the use of fair value accounting to investments in debt and equity
securities. Investments classified as available-for-sale or trading securities are to
be reported at fair value on the balance sheet. Additionally, any subsequent
changes in fair value would result in unrealized gains or losses that should be
included in either earnings (for investments classified as trading securities) or
as a separate component of shareholders’ equity (for investments classified as
available-for-sale securities). Notice that this standard results in fair value
accounting at initial measurement as well as for subsequent periods.
In response to requests for improved disclosures for derivative financial
instruments, the FASB issued SFAS 119, Disclosure about Derivative Financial
Instruments and Fair Value of Financial Instruments. This statement required
that entities that hold derivative financial instruments for trading disclose the
average fair value of these derivatives during the accounting period as well as the
fair value of the derivatives at the end of the period. Additionally, SFAS 119
amends SFAS 107 so that the fair value information with regard to derivatives
is presented separately from the fair value information of nonderivative financial
instruments. The FASB also provided guidance for transfers and servicing of
financial assets and extinguishment of liabilities in SFAS 125. Under the
provisions of this statement, fair value is used to initially measure liabilities or
derivatives incurred in a transfer of financial assets.
Later, the FASB established accounting and reporting standards for
derivatives in addition to the disclosure requirements. In SFAS 133, Accounting
and Reporting for Derivative Financial Instruments and Hedging Activities, all
derivatives are required to be recognized as either assets or liabilities that are
measured at fair value. Subsequent changes in fair value depend upon the
intended use of the derivative. For derivatives that are not designated as hedging
instruments or designated as fair value hedges, the change in fair value is
reported in current earnings. For derivatives designated as either cash flow
hedges of hedges of a foreign currency exposure of a foreign-currency-
denominated forecasted transaction, the effective portion of the hedge is
reported as a component of other comprehensive income, while the ineffective
portion of the hedge is reported in earnings immediately. The effective portion
As can be seen from the of the hedge is reclassified into earnings in subsequent periods as the hedged
above review of FASB transaction affects earnings. For hedges of a foreign currency exposure of a net
investment in a foreign operation, the change in fair value is reported as a
statements, the financial
component of other comprehensive income.
instruments project As can be seen from the above review of FASB statements, the financial
undertaken by the FASB instruments project undertaken by the FASB has as a central theme the use of
has as a central theme the fair value accounting. These standards encompass not only the use of fair value
use of fair value at initial measurement, but also the reporting of fair value changes in subsequent
accounting. periods and the disclosure of fair value information in situations in which it is
not practicable to estimate fair value.

Other FASB Pronouncements

In addition to the financial instruments project, the FASB has also issued
other guidance that incorporates the use of fair values. For example, in SFAS
110, Reporting by Defined Benefit Pension Plans of Investment Contracts, the
FASB requires that a defined benefit plan report investment contracts at fair
value. In SFAS 114, Accounting by Creditors for Impairment of a Loan, impaired

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Jefferson P. Jones and Sarah D. Stanwick

loans are required to be measured based on either the present value of the
expected future cash flows, the loan’s observable market price, or the fair value
of the loan’s collateral if the loan is collateral dependent. Similarly, in SFAS 121,
Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of, if a loan is considered to be impaired, the measurement of the
impairment loss should be based on the difference between the asset’s carrying
value and its fair value.

Proposed Concepts Statement

In March 1999, the FASB issued a revised exposure draft, Using Cash Flow
Information and Present Value in Accounting Measurements. In this exposure
draft, the FASB advocates the use of present value techniques as a means of
capturing the economic substance of a set of cash flows by incorporating the
risks and uncertainties of these cash flows in a manner similar to that of how the
market behaves. In other words, the use of present value techniques is an
attempt to measure assets or liabilities at their fair value. Paragraph 19 of the
proposed Concept Statements states that “the Board expects to adopt fair value
as the measurement attribute when applying present value techniques in the
initial and fresh-start measurement of assets and liabilities.” This statement
indicates a possible change of direction by the FASB, which previously has
shown no interest in taking fair value measurements beyond financial
instruments. This proposed Concept Statement establishes the foundation for
fair value estimate of any asset or liability for which reasonable cash flow
estimates can be made.

International Accounting Standards

In December 1998, the IASC approved IAS 39, Financial Instruments:
Recognition and Measurement, which states that all financial assets and liabilities,
including derivatives, should be recognized initially on the balance sheet at the
fair value of whatever was paid or received to acquire the financial asset or
liability. Any subsequent change in the fair value of such financial assets or
liabilities, with a few exceptions, should be measured at fair value. The company
will have the option either to recognize the entire adjustment in earnings of the
current period or to recognize only the changes in financial assets or liabilities
held for trading purposes in current earnings with the fair value changes of the
nontrading assets or liabilities reported in equity until sold. Additionally, IAS 39
provides for fair value accounting of transfers of financial assets or liabilities.
The most pervasive Clearly, the international community is proceeding along a similar path as that
of the FASB with respect to fair value accounting.
argument for the use of
fair values is that the IMPLICATIONS FOR FINANCIAL MANAGERS
usefulness of accounting As can be seen from the above discussion, there is a clear trend by standard-
disclosures will be setting bodies toward incorporating fair values in the measurements of assets
increased. and liabilities. The most pervasive argument for the use of fair values is that the
usefulness of accounting disclosures will be increased. Fair values are assumed
to be more helpful to investors and creditors in making decisions because fair
values, in effect, represent a market price for an asset or liability. Fair values,
therefore, better capture the economic characteristics of the asset or liability
than historical cost numbers because fair values incorporate market assumptions

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 Fair Value Accounting: A Guide to Understanding the Current Standards

about the asset or liability’s value and risk. Wide disagreement exists as to
whether fair values possess these characteristics, but one thing is for certain—
any attempt to incorporate fair value measurements is sure to be controversial.
The FASB and the Association for Investment Management Research
(AIMR), in conjunction with the Canadian Institute for Chartered Accountants
(CICA) conducted a series of focus groups in 1997 and 1998 to assess interest
in fair value accounting for financial instruments. While there was a wide range
of interest and knowledge about fair value accounting, the majority of the focus
group participants desired an increase in the quantity and quality of information
about fair values. However, no conclusion could be drawn as to whether the
current standards were inadequate or whether there was an unfamiliarity of the
participants with current standards and requirements. These results suggest
that the FASB or any other standard-setting body wishing to incorporate fair
values will face much criticism and lobbying in their efforts. In addition, if and
when fair value measurements are incorporated into accounting standards,
standard-setting bodies will be faced with a difficult effort in educating business
professionals as to the accounting requirements in place.
If fair values are incorporated into accounting standards, should the fair
values be recognized in the financial statements or would footnote disclosure
suffice? Based on responses by the focus groups, this issue will not be easy to
resolve. While many favored recognition of fair values, others expressed the
view that increased disclosures are desired. However, a majority of respondents
suggested an improvement in the method of presentation of information in the
disclosures, not just more extensive disclosures. Assuming that fair values will
be recognized in the financial statements, the use of fair values will certainly
require increased disclosure of underlying assumptions used in determining
fair value. Given the concern of the investment community, the FASB must
consider the nature, extent, and presentation of disclosures that will be required
if a move toward fair value accounting is made.
Another issue is whether assets and liabilities other than financial assets and
liabilities should be measured at fair value. The FASB’s conclusion in their
financial instruments project is that any asset or liability that is so closely related
to a financial instrument that it cannot be separated or distinguished should be
If the FASB wishes to
included in the project and, by implication, be measured at fair value. The FASB
extend the use of fair has also indicated, in the proposed Concepts Statement discussed above, an
value beyond financial interest in measuring nonfinancial as well as financial assets and liabilities at fair
assets and liabilities, they value. However, only a minority of focus group respondents agreed with
will surely face a great measuring nonfinancial assets at fair value. If the FASB wishes to extend the use
deal of opposition. of fair value beyond financial assets and liabilities, they will surely face a great
deal of opposition.
One concern with using fair value measurement deals with measurement
reliability. Focus group respondents were nearly unanimous in their concern
with this issue, but most felt that measurement reliability was something that
could be effectively dealt with in the standard-setting process. In a related
concern, the FASB must decide on how to reconcile different methods of
determining fair values. For example, should the price in a primary or secondary
market be used as a measure of fair value? Should the use of present value
techniques (as described in the FASB’s proposed Concepts Statement) that
use internally generated cash flow estimates be considered superior to

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Jefferson P. Jones and Sarah D. Stanwick

market-based techniques? Which more closely resembles fair value—entry or

exit price? The FASB has addressed these questions in their deliberations about
financial instruments. Generally, their conclusions suggest that market-based
information (e.g., quoted prices) is superior to other sources of information,
that fair value should be based on the market price that is most financially
advantageous to the entity, and that exit prices provide more relevant and useful
information to financial statement users that entry prices. As the use of fair value
accounting expands, many more implementation-related questions such as
these will have to be addressed.
Another concern with using fair value measurements is how they will affect
One of the concerns with financial reporting. One of the concerns with the requirement of fair value
the requirement of fair measurements is that the volatility of reported earnings will increase. This
value measurements is increase in volatility would occur as changes in the fair value of assets and
that the volatility of liabilities give rise to unrealized gains and losses that are recognized in periods
reported earnings subsequent to their initial recognition. The FASB is familiar with this concern—
will increase. it has been expressed with regard to the recognition of the pension liabilities and,
most recently, in discussions concerning the use of the purchase method of
business combinations. In dealing with this issue, the FASB must also consider
the method of presenting these unrealized gains and losses. Will these changes
in fair value be recognized in earnings or comprehensive income? Alternatively,
will the FASB require fair value financial statements to be presented side-by-side
with historical cost financial statements?

JUDGING THE EFFECT ON MANAGEMENT

Finally, the FASB must consider the effect of fair value accounting on
management. The use of fair values, while possibly increasing the usefulness of
the information provided, will certainly have associated costs that will be borne
by management. Focus group respondents were concerned not only with the
fact that management will bear additional costs in terms of preparation time and
money, but also with the possibility that fair value disclosures may affect a
company’s competitive position by forcing them to disclose what some may
consider proprietary information. Additionally, management may also spend
considerable time and effort in circumventing any fair value standard, thereby,
reducing the usefulness of any resulting financial information. ♦

108 The Journal of Corporate Accounting and Finance/Autumn 1999