The Financial Accounting Standards Board issued SFAS No. 157, Fair Value Measurements, in September 2006, and SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, in February 2007. These pronouncements may appear old news, but they remain fraught with risk for the unwary and are still being misunderstood and clarified.

SFAS No. 157 provided guidance on how relevance ("fair value") would be determined and disclosed. A few months later, FASB released SFAS 159, not to mandate the use of fair value, but rather to give reporting entities a "fair value option." SFAS 159 allows companies to go not only line by line on financial statements, but also "financial instrument by financial instrument" within a financial statement category.

The pronouncements permit treating some financial instruments according to fair value, while others still use historical cost accounting. The fair value option is elected when an eligible item is first recognized, but the decision is irrevocable once the election has been made.

FASB's stated objective in offering the fair value option was to improve financial reporting by giving entities the opportunity to mitigate reported earnings volatility caused by measuring related assets and liabilities differently without having to apply hedge accounting. However, this option provided an incentive for some entities to use fair value selectively. One unfortunate byproduct of the fair value option has been the lack of comparability of financial reporting and related analytics among otherwise comparable entities.

Both SFAS No. 157 and 159 took effect for financial reporting periods beginning after Nov. 15, 2007.

The FASB's July 1 Codification of U.S. GAAP has made references to SFAS obsolete. This article addresses the risks associated with U.S. GAAP Codification of Accounting Standards Topic 820, Fair Value Measurements and Disclosures, and Topic 825, Financial Instruments (formerly SFAS Nos. 157 and 159, respectively).

Topic 820 recognizes three valuation techniques (the market, income and cost approaches) to measure the fair value of assets and liabilities. These techniques represent long-established approaches.

Topic 820 also prioritizes observable inputs over unobservable inputs in determining the fair value of an asset or liability. Observable inputs represent the assumptions that market participants would consider when pricing an asset or liability based upon data obtained from independent sources (not data provided by the reporting entity). Unobservable inputs are the reporting entity's own assumptions regarding what market participants would consider in estimating the reporting entity's financial instruments.

Lastly, Topic 820 provides for a fair value hierarchy to assess the significance of particular inputs. The fair value hierarchy is broken into three input categories:

Level 1: Quoted prices in active markets for identical assets or liabilities on a specific date (e.g., the New York Stock Exchange, NASDAQ).

Level 2: These inputs involve data other than quoted prices and use comparables to determine the value of an asset or liability derived from prior transactions in similar assets or liabilities (e.g., Kelley Blue Book, real estate comparables).

Level 3: These are unobservable inputs and are based on management's assumptions about what market participants would consider to set fair value based on the best available data (the income approach using unobservable inputs).


When estimating the fair value of financial instruments, an entity shall disclose: the fair value of financial instruments for which it is practicable to estimate value, and the methods and significant assumptions used to estimate the financial instruments' fair value. A current proposal under consideration would require reporting entities to disclose information about the impact of "reasonably possible" alternative Level 3 inputs, additional disclosures regarding Level 3 fair value activity measurement, and additional disclosures regarding transfers in or out of Level 1 and 2 categories of inputs, as well as other disclosures about inputs and valuation techniques.


When it is not practicable (i.e., cost-prohibitive) for an entity to estimate the fair value of a financial instrument, the entity should disclose information pertinent to estimating the financial instrument's fair value and the reasons why it is not practicable to estimate its fair value.

Utilizing this exception to fair value reporting is a two-edged sword. While it is permissible to avoid the use of fair value in these instances, doing so could be problematic.


As a result of this complexity and confusion, accountants find themselves caught between lenders, the government, the rule-setters and the courts. It's not the first time we've been here, but it does present an environment of greatly increased risk and ethical murkiness.

CPAs performing audit, review or compilation services for clients with potentially significant fair value reporting implications should make certain that their clients are aware of the GAAP reporting requirements, and assess the fair value and historical cost reporting differences. The differences could be insignificant and merely require the disclosure of a GAAP departure. However, when potentially significant GAAP departures are apparent and when a client's valuations appear materially inaccurate, it is crucial to engage the services of a qualified valuation expert.

The CPA most at risk is the one who fails to potentially recognize the need for third-party valuation for engagements where fair value or other GAAP departures are contemplated. With the benefit of 20/20 hindsight, if an investor makes a decision based on your valuations and attestations and subsequently experiences significant losses, you would likely be accused of falling below professional standards and not exercising appropriate professional judgment.


For years, an expectation gap has existed between what clients expect and what CPAs deliver. Many accountants argue that the public, in the form of juries, aren't sophisticated enough to understand accounting complexities. They also argue that clients (not their CPAs) should be responsible when things go wrong - as long as the accountant followed professional standards.

When that mentality is pervasive, so is professional risk, especially when it is apparent that the profession already perceives inadequacies in the current GAAP reporting requirements. Liberally adding disclosures as necessary will help provide transparency and comparability when the application of GAAP could be misleading.

The best remedy is to increase your knowledge of risk and to become a better risk manager. This involves taking action to insulate yourself and your practice from legal trouble. Some of these action steps include:

1. Recognizing risk warning signs:

* Profits reported for periods when the statements of cash flows reflect negative cash flow from operating activities.

* Significant non-cash fair value gain adjustments within the statement of cash flows.

* Large fluctuations in intangible assets.

* Amortization expense is low in comparison to intangible assets.

* Real property acquired immediately before real estate downturns, with no reporting of impairment losses.

* Little or no impairment losses for goodwill or other intangible assets during economic downturns.

* Inadequate footnote disclosures for assets or liabilities accounted for using fair value.

2. Engage experts. Valuation experts are especially important where fair value and other departures from GAAP are concerned. Note that FASB Interpretation 101-3 indicates that independence would be impaired if a member performs an appraisal or valuation service for an attest client where the results of the service, individually or in the aggregate, would be material to the financial statements and the service involves substantial subjectivity.

3. Thoroughly assess prospective clients. Conduct a background check on prospective clients. Perform individual background checks on executives or partners. Consider requesting professional background investigations for all significant engagements and clients. Talk to their previous accountants. Understand the economics of the business category they are operating in and the inherent risks.

4. Know your existing clients. Systematically comb through your client base to look for potentially deteriorating situations. Here again, business category is a crucial factor. If there is growing stress in your client's business or markets, look deeper and start asking questions.

5. Understand your competencies. Be realistic about your own skills and abilities. Make sure they match or exceed the needs of prospective clients, the users of their financial statements, and existing clients whose practices have grown or changed.

6. Obtain management representations. Insist that client management provide explanations for requesting specific methods or techniques, or for any change in the treatment of specific transactions. Representation letters are not limited to audits and reviews.

7. Document all changes. Whenever you discover any change that might affect your responsibilities as detailed in your engagement letter, communicate those changes both orally and in writing. If the change presents additional risk, provide warnings to management in writing as well as orally.

8. Resign from the engagement if you see enough warning signs. Walk away from the engagement if your professional judgment determines that the risk has become too great.

9. Assume a risk-oriented mentality. There are too many pitfalls and complexities in the current economic environment to ignore risks in each engagement. If you are not aware of emerging risks, consult your attorney. If you can afford it, consider hiring a risk manager for your firm. Also consider taking CPE courses that focus on risk management for CPA firms.

In today's dynamic environment, accountants who apply strong risk management principals and techniques have a distinct competitive advantage over those who don't.

Duncan Will, CPA/ABV/CFF, CFE, is a loss prevention accounting and auditing specialist with Camico (

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