Definitions:

 FASB/ IAS/ IFRS - the price at which an asset or liability could be exchanged in a current transaction between
knowledgeable, unrelated willing parties in an arm’s length transaction.
 ED- 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.

Tradeoffs between relevance (fair value) and reliability (historical cost)

Benefits of fair value accounting

 Relevant information about entities’ financial health on a timelier basis than do historical costs
- Better insights of risk profile of firms currently in place so that regulatory intervention of troubled
institutions could be tackled more timely.
 Useful information- consistent and comparable among entities- asset and liability measures reflect current
economic conditions and up-to-date expectations of the future- more useful information for making
economic decision
 Minimize incentives for firms to manipulate asset sales to manage earnings- gains and losses are recognized
in income when assets are revalued.
 Reduce the complexity of financial reporting- investors are not necessary to study the choices made by
management to determine what basis of accounting is used.
 Intangible assets measurement- no physical substance- hardly measured by historical costs.

Costs of fair value accounting:

 Greater measurement error- implementation of a full value model for recognition yields unrecognized
gains/ losses- cause earnings to be more volatile than earning based on the current historical cost model.
 Managerial manipulation- subjective assessments involved in estimation due to the - asymmetric
information- absence of active markets
 High implementation costs- Hiring large amount of consultants and additional accounting staff to ensure the
uniformity in valuation policies such as policy format, content, valuation procedure across divisions.
 Indirect costs- investors devalue all companies when the information in the market lacks validity/ illiquid;
the volume of lawsuits could increase greatly when the fair value information is not precise and unreliable.
E.g. improper fair value accounting estimates were the foundation and catalyst of the fraud committed by
Enron.

Valuation techniques

 Market approach- uses price and other relevant info generated by market transactions.
 Income approach- uses valuation techniques to convert future amounts to a single present amount.
 Cost approach- based on the amount that currently would be required to replace the asset.
Measurement

Level 1: Observable market input that determined using quoted prices for identical asset/liability in an active market.

ED- no adjustment required.

Level 2: (1) Observable, quoted, and for identical asset/ liability in an inactive market.

(2) Observable, quoted, and for similar asset/ liability in an active/ inactive market.

(3) Observable but do not reflect quoted prices

(4) Not observable and derived through corroborated by other market data.

ED- Price must be objectively determined.

Level 3: Not observable and can’t be corroborated by other market data.

ED- multiple valuation techniques are required and evaluate its appropriateness based on the relevance and reliability of
the inputs used in deriving fair value estimates
Changes

• The guidance defines fair value as the price at which an asset or liability could be exchanged in a current transaction
between knowledgeable, unrelated willing parties.

• The proposed statement provides guidance on how to measure fair value and would apply to all existing and future
FASB pronouncements that require fair value measurement.

• The guidance would apply to fair valuation of financial as well as nonfinancial assets and liabilities.

• The ED establishes a three-tier hierarchy for choosing the inputs used in fair value measurements, ranging from
quoted prices of identical assets or liabilities to estimates based on internal valuation models.

• The ED provides guidance for disclosures when assets and liabilities are re-measured at fair value.

• The proposed statement shall be applied prospectively, with the exception of the effect of applying the guidance on
fair value measurements in active dealer markets where bid and asked prices are more readily and regularly available
than closing prices, which shall be reported as the cumulative effect of a change in accounting principle.

Differences of current practices

• For financial instruments traded in active dealer markets where bid and asked prices are more readily available than
closing prices, fair value must be estimated using bid prices for long positions and asked prices for short positions.

• Fair value of restricted securities must be estimated using the quoted price of an otherwise identical restricted
security, adjusted for the effect of the restriction.

• In the absence of quoted prices, fair value should be estimated using multiple valuation techniques consistent with the
market, income, and cost approaches.

• The proposed statement calls for expanded disclosures about the use of fair value to re-measure assets and liabilities,
how fair value