GAAP and IFRS: Reconciling Fair Value Measurements

GAAP and IFRS: Reconciling Fair Value Measurements

Understanding what’s to come with the adoption of IFRS will give internal auditors an opportunity to get involved with their company’s accounting conversion process.

Lawrence Metzger, PHD, CPA, CMA, CFM
Professor of Accounting
Loyola University Chicago

With support from important constituencies, the U.S. Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) have taken several steps toward what will be a major transition from the accounting and reporting framework currently in place in the United States to international financial reporting standards (IFRS). As part of this ongoing and complex cooperative effort, there is currently a joint project between the FASB and the IASB to develop a common measurement and reporting structure for fair value accounting. Fair value accounting, sometimes referred to as mark to market accounting, has been around for many years and has been applied to many types of asset and liability accounts. However, special emphasis has been placed on fair value reporting due to the ever expanding use (and misuse) of financial instruments, specifically derivatives. To this end, both the FASB and the IASB have issued recent exposure drafts aimed at reconciling the differences between international and U.S. generally accepted accounting principles (GAAP) with respect to fair value accounting. While some differences remain, there is a great deal of commonality between U.S. and international standards.

Under the FASB’s new Accounting Standards Codification System, fair value accounting has been categorized as Topic 820: Fair Value Measurement and Disclosures. Topic 820, formerly Financial Accounting Standard No. 157: Fair Value Measurement, and issued in September 2006, created a new standard definition of fair value. It also, among other provisions, provided a methodology for determining the fair value of assets and liabilities (including derivatives and hedging instruments) by using a hierarchy of inputs. Additionally, it required using valuation techniques consistent with conventional approaches (market, income, and/or cost), and provided some basic disclosure guidelines.

The IASB issued an exposure draft on Fair Value Measurement in May 2009 and is expected to issue a final standard in the first quarter of 2011. The FASB is waiting on responses to the Topic 820 exposure draft, Fair Value Measurements and Disclosures, issued in July 2010. This exposure draft (now referred to as an update) is a result of the continuing efforts by the FASB and the IASB to reconcile requirements for measuring fair value and for disclosing information about fair value measurements consistent with both U.S (GAAP) and international (IFRS) accounting principles.

Both Board’s objectives for publishing the proposed IFRS were to establish a single source of guidance for all fair value measurements required or permitted by IFRS to reduce complexity and improve consistency in their application, clarify the definition of fair value and related guidance to communicate the measurement objective more clearly, and enhance disclosures about fair value to enable users of financial statements to assess the extent to which fair value is used and to inform them about the inputs used to derive those fair values.

SIMILAR REPORTING RULES 
Both U.S. GAAP and IFRS have the same or very similar definitions for the following components of fair value:

Definition of fair value
Fair value is 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.

Valuation techniques
Income approach. The income approach uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present amount (discounted). 
 
Cost approach. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost).

Fair value hierarchy
Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.
 
Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. An example would be quoted prices for similar assets in active markets.
 
Level 3 inputs are inputs for the asset or liability that are not based on observable market data (unobservable inputs). Unobservable inputs shall be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date.

Disclosures
For assets and liabilities that are measured at fair value on a recurring basis in periods subsequent to initial recognition (for example, trading securities), the reporting entity shall disclose information that enables users of its financial statements to assess the inputs used to develop those measurements and for recurring fair value measurements using significant unobservable inputs (Level 3), and the effect of the measurements on earnings for the period.

DIFFERENT REPORTING RULES    
The Boards are working to ensure that, to the extent possible, their respective fair value measurement standards will be nearly identical. The following style differences will remain in the Boards’ respective standards:  

  • References. U.S. GAAP and IFRS will reference different documents. For example, regarding related party transactions, U.S. GAAP would refer to Topic 850: Related Party Disclosures, and IFRS would refer to International Accounting Standard No. 24: Related Party Disclosures. 
  • Style. For example, U.S. GAAP would refer to a reporting entity and IFRS would refer to an entity. 
  • Spelling. For example, U.S. GAAP would refer to labor costs and IFRS would refer to labour costs. 
  • Jurisdictions. For example, U.S. GAAP would refer to U.S. Treasury securities and IFRS would refer to government securities.

In addition, the U.S. GAAP and IFRS fair value measurement standards would have the following differences:  

  1. Different assets, liabilities, and equity instruments are measured at fair value. The standards in U.S. GAAP and IFRS that require or permit fair value measurements are different. As a consequence, an asset, liability, or equity instrument that is measured at fair value in U.S. GAAP might not be measured at fair value in IFRS and vice versa.
  2. The Boards have separate projects to address the measurement basis in other standards (for example, the projects to address the accounting for financial instruments and leases).
  3. There will be different accounting requirements in U.S. GAAP and IFRS for measuring the fair value of investments in investment company entities.
  4. Some of the disclosures about fair value measurements will be different for U.S. GAAP and IFRS. For example, IFRS do not distinguish between recurring and nonrecurring fair value measurements. In addition, because IFRS generally do not allow net presentation for derivatives, the amounts disclosed for fair value measurements categorized within Level 3 of the fair value hierarchy might differ.

The Boards believe that these differences would not result in inconsistent interpretations in practice by entities applying U.S. GAAP or IFRS.

WHAT'S AHEAD
The FASB and IASB are working together to ensure that the concept of fair value will have the same meaning in U.S. GAAP and in IFRS and that their respective fair value measurement and disclosure requirements will be the same, except for minor differences in wording and style. The Boards say their work will improve the comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with U.S. GAAP and IFRS.

Lawrence Metzger, PHD, CPA, CMA, CFM, is a professor of accounting at Loyola University Chicago.
 
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