BUS103: Introduction to Financial Accounting

Accountants must stay up to date with current issues in reporting and disclosures related to standards set by regulatory agencies.

Learning Objective

• Give some examples of current issues in reporting and disclosure that concern an accountant
  
  

Key Points

• Mark-to-market or fair-value accounting refers to accounting for the fair value of an asset or liability based on the current market price, or for similar assets and liabilities, or based on another objectively assessed "fair" value.
• Mark-to-market accounting can change values on the balance sheet as market conditions change.
• Stock option expensing is a method of accounting for the value of share options, distributed as incentives to employees, within the profit and loss reporting of a listed business.
  
  

Terms

• commodity

  Anything which has both a use value and an exchange value.

• fair value

  Fair value, also called "fair price" (in a commonplace conflation of the two distinct concepts) is a concept used in accounting and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset.

Current Issues in Reporting and Disclosure

Accountants must stay up to date with current issues in reporting and disclosures related to standards set by regulatory agencies.

Current Issues

Accountants must stay up to date with current issues in reporting and disclosure.

Mark-to-Market or Fair Value Accounting

Mark-to-market or fair value accounting refers to accounting for the fair value of an asset or liability based on the current market price, for similar assets and liabilities, or based on another objectively assessed "fair" value. Fair value accounting has been a part of Generally Accepted Accounting Principles (GAAP) in the United States since the early 1990s and used increasingly since then.

Mark-to-market accounting can change values on the balance sheet as market conditions change. In contrast, historical cost accounting, based on the past transactions, is simpler, more stable, and easier to perform, but does not reflect current fair value. Instead, it summarizes past transactions. Mark-to-market accounting can become inaccurate if market prices change unpredictably. Buyers and sellers may claim a number of specific instances when this is the case, including the inability to both accurately and collectively value the future income and expenses, often due to unreliable information and over-optimistic and over-pessimistic expectations.

SFAS No. 157

In September 2006, the U.S. Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards 157: Fair Value Measurement, which "defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements". This statement is effective for financial reporting fiscal periods commencing after November 15, 2007, and the interim periods applicable.

Fair Value GAAP vs. IFRS

Under GAAP, there is only one measurement model for fair value (with limited exceptions). GAAP defines fair value as the price that would be received to sell an asset or paid to transfer a liability (at the measurement date). Note that fair value is an exit price, which may differ from the transaction (entry) price.

Various IFRS standards use slightly varying wording to define fair value. Under IAS 39, fair value is defined as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. At inception, transaction (entry) price generally is considered fair value.

Sarbanes-Oxley Act

Following the Enron scandal, changes were made to mark to market via the Sarbanes-Oxley Act in 2002. Sarbanes-Oxley affected mark to market by forcing companies to implement stricter accounting standards. These included more transparency in financial reporting and stronger internal controls to prevent and identify fraud and auditor independence. Also, the Public Company Accounting Oversight Board (PCAOB) was created by the Securities and Exchange Commission (SEC) for the purpose of overseeing audits. This act also implemented harsher penalties for fraud, such as enhanced prison sentences and fines for committing fraud. Although the law was created to restore investor confidence, the cost of implementing the regulations caused many companies to avoid registering on U.S. stock exchanges.

Internal Revenue Code Section 475 contains the mark to market accounting method rule for taxation. It provides that qualified security dealers who elect mark to market treatment shall recognize gain or loss as if the property were sold for its fair market value on the last business day of the year, and any gain or loss shall be taken into account in that year. The section also provides that commodities dealers can elect mark to market treatment for any commodity (or their derivatives) which is actively traded (i.e., for which there is an established financial market providing a reasonable basis to determine fair market value by disseminating price quotes from brokers/dealers or actual prices from recent transactions).

Stock Option Expensing

Stock option expensing is a method of accounting for the value of share options, distributed as incentives to employees, within the profit and loss reporting of a listed business. On the income statement, balance sheet, and cash flow statement it should say that the loss from the exercise is accounted for by noting the difference between the market price (if one exists) of the shares and the cash received, the exercise price, for issuing those shares through the option.

Opponents of considering options as an expense say that the real loss–due to the difference between the exercise price and the market price of the shares–is already stated on the cash flow statement. They would also point out that a separate loss in earnings per share (due to the existence of more shares outstanding) is also recorded on the balance sheet by noting the dilution of shares outstanding. Simply, accounting for this on the income statement is believed to be redundant.

Currently, the future appreciation of all shares issued are not accounted for on the income statement but can be noted upon examination of the balance sheet and cash flow statement.

The two methods to calculate the expense associated with stock options are the "intrinsic value" method and the "fair-value" method. Only the fair-value method is currently U.S. GAAP. The intrinsic value method, associated with Accounting Principles Board Opinion 25, calculates the intrinsic value as the difference between the market value of the stock and the exercise price of the option at the date the option is issued (the "grant date"). Since companies generally issue stock options with exercise prices which are equal to the market price, the expense under this method is generally zero.

In 2002, another method was suggested–expensing the options as the difference between the market price and the strike price when the options are exercised, and not expensing options which are not exercised, and reflecting the unexercised options as a liability on the balance sheet. This method, which defers the expense, also was requested by companies.

FASB has moved against "Opinion 25", which left it open to businesses to monetize options according to their "intrinsic value", rather than their "fair value". The preference for fair value appears to be motivated by its voluntary adoption by several major listed businesses and the need for a common standard of accounting.