Transparency in Financial Reporting. Ruth Ann McEwen

outflow required to settle the liability and they fairly reflect the intent of periodic revaluation.

      Level 2 inputs include:

       (a) quoted prices for similar assets or liabilities in active markets;

       (b) quoted prices for identical or similar assets or liabilities in markets that are not active;

       (c) inputs other than quoted prices that are observable for the asset or liability (e.g. interest rates and yield curves observable at commonly quoted intervals, volatilities, prepayment speeds, loss severities, credit risks, and default rates);

       (d) inputs that are derived principally from or corroborated by observable market data by correlation or other means (market-corroborated inputs). Level 2 inputs are more problematic. Use of “similar” prices invariably leads to subjectivity in determining exactly which prices are similar to the asset or liability being revalued. While current US GAAP requires extensive subjectivity, Level 2 estimation exacerbates what is already a well documented problem in US financial reporting: understatement of risk and manipulation of earnings.

      Level 3 inputs should be used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability. However, FAS 157’s emphasis that the fair value objective in Level 3 continues to be an exit price from the perspective of a market participant may diminish transparency and certainly increases the complexity of the financial statements.

      Under the guidance of FAS 157, entities must estimate these inputs not from an internal perspective, but from the view of an external party who would exchange for the asset, or assume the liability, at a fair price reflecting appropriate risk levels. The guidance provided by FAS 157 seems to suggest that external markets could or would price the risk of an asset retirement obligation in 2010 to decommission a nuclear power plant in 2030 and that an external party would be willing to assume the risk.

      FAS 157 uses the term ‘inputs’ to refer broadly to the assumptions that market participants would use in pricing the asset or liability, including assumptions about risk. It indicates that valuation techniques should maximize the use of observable inputs (Levels 1 and 2) and minimize the use of unobservable inputs (Level 3). Observable inputs are those that reflect assumptions market participants would use in pricing the asset or liability developed, based on market data obtained from sources independent of the reporting entity. Unobservable inputs are inputs that reflect the reporting entity’s own assumptions about the assumptions (emphasis added) market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. ^[14] Valuation under the Level 3 provisions of FAS 157 is based not on entity-specific estimates, but on estimates of what external parties would estimate. This uncertainty seems counterintuitive and is likely to diminish transparency.

      C. Hierarchy of inputs: example

      For example, assume that an entity must value an asset or liability using Level 3 inputs in a mathematical model. If a model such as present value is used, the entity must estimate:

       (a) future cash flows,

       (b) the variability in timing and amount of cash flows under differing circumstances and the likelihood of those circumstances,

       (c) the price that marketplace participants demand for bearing the uncertainty inherent in those cash flows, and

       (d) the time value of money.

      In determining these components, value is defined by the assumptions about estimated cash flows that the external parties would make. Level 3 inputs, then, require extensive estimates based on externally-based estimates.

      Consider valuation for contingent consideration under US GAAP and IFRS (FAS 141R and IFRS 3R). In certain settings, both require initial recognition at acquisition of the consideration at fair value and both require remeasurement at each reporting date until the contingency is resolved. Under US GAAP, fair value must reflect markets while IFRS entities may use entity-specific estimates. Thus, if Smith Company enters into a purchase agreement in which an earn-out clause will net Brown Company a $5 million payment and 5% of net sales for Product A contingent upon successfully defending a patent, then, at the acquisition date, Smith Company must estimate the fair value of the contingent liability. The fair value of the contingency is based on estimates of the likelihood that the defence will be successful and estimates of the cash flows from future sales of Product A.

      Under FAS 157, Smith should maximize the use of observable inputs when possible. In the current setting, estimating the liability requires Smith to estimate a subjective probability distribution for each of a series of questions addressing the likelihood of defending the patent and estimates of future cash flows. For example, Smith might estimate: (1) the probability of defending the patent, (2) market sales once the patent issue has been resolved, (3) the probability that Product A will become technologically obsolete, and (4) the probability that future patent actions may reduce sales.

      Smith must then use these probability weighted estimates in estimating future cash flows associated with Product A. Brown Company risks are included in the expected value of the cash flows. Since the earn-out will occur over several years, Smith must discount the expected cash flows by a risk adjusted discount rate. One choice for this rate might be the industry weighted average cost of capital. The liability would be the probability weighted cash flows (expected values) discounted at an industry cost of capital. Smith would need to remeasure the contingent liability at each reporting date.

      D. Entity-specific estimates

      CON 7 offers justification for using entity-specific estimates. Entities might expect to realize or pay cash flows that differ from those expected by external parties if:

       (a) the entity’s managers might intend different use or settlement than that anticipated by others;

       (b) the entity’s managers may prefer to accept risk of a liability (like a product warranty) and manage it internally, rather than transferring that liability to another party;

       (c) the entity might hold special preferences, like tax or zoning variances, not available to others;

       (d) the entity might hold information, trade secrets, or processes that allow it to realize (or avoid paying) cash flows that differ from others’ expectations;

       (e) the entity might be able to realize or pay amounts through use of internal resources.

      US GAAP does not allow entity-specific measurement. US entities rely extensively on mathematical models, some of which are extremely complex with subjective estimates that can introduce extreme volatility. Take, for example, the Black-Scholes model for estimating the value of employee share based payments. ^[15] Under the Black-Scholes model, estimates are required for the risk-free rate and the expected volatility of common stock. These estimates are considered to remain constant over the option’s term (not necessarily the case) and assumptions inherent in initial estimates can substantively affect the expense associated with the options, thus affecting income. For example, a Black-Scholes valuation of call options with an exercise price of $20 per share, a stock price at the date of the grant of $20 per share, an expected life of the option of 5 years, and no dividends would be $6.07 if the initial estimates of the risk-free rate and volatility are 6.5% and 15%, respectively. If the initial estimates are 5.0% and 10%, respectively, the valuation is reduced to $4.67, a reduction of 23% in employee compensation expense. Note that the Black-Scholes model requires assumptions that options are freely traded and that the option life is relatively short term. Neither of these assumptions is true for employee share-based payments, but the model is considered to be robust to violations of its assumptions.

      IFRS does allow entity-specific estimates and requires extensive disclosure about cash flows and other fair value estimates, especially when entity-specific measures have been used. Entities may well publish the assumptions underlying