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. 157 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. 157 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...