Article
Fair value accounting is a concept that has attracted
worldwide debate as to its appropriateness in financial statements. Terms such
as ‘mark to myth’ and one based on judgmental aspects which tend to demean the
very concept of prudence are slated as arguments for the same. It is also true
that most of the criticism comes from the ‘old guard’ who have always
believed that historical cost is one of the most verifiable concepts in
accounting. The fact is that the world has moved on and fair valuation is a
measure by itself. The accounting profession needs to wake up to this reality
and take necessary steps to make sure fair valuation (now a big element of the
‘true and fair’ opinion) is well understood. Our profession needs to be well
equipped to make sure we use it appropriately and not expose it to abuse the way
it is feared to be.
The issue is : what is Prudence. ‘Prudence is the
inclusion of a degree of caution in the exercise of the judgments needed in
making the estimates required under conditions of uncertainty, such that assets
or income are not overstated and liabilities or expenses are not understated.
However, it completely ignores assets or liabilities that expose an entity to
market-related risks. The issue is : Is that prudent ? Especially in today’s
times when in free markets, entities are exposed to market risk (intentional or
unintentional).
Fair value accounting envisages accounting for unrealised
gain to reflect a ‘true and fair’ view of the state of affairs.
Fair valuation has brought to the notice of an investor the
true profits in companies like Enron, WorldCom and Waste Management in
the past and a host of financial services companies in the current credit market
meltdown. This is mainly because over the years, the masters of business have
been under acute pressure to show results and the masters of finance have helped
them achieve it at any cost. This has led to the use of financial and other
instruments in our financial statements, making fair valuation a very important
aspect of today’s financial statements. Also, the use of derivative instruments
has been genuinely necessitated as we globalise businesses and as countries open
up to free trade.
Let’s now examine what are the flaws with fair value
accounting. The biggest issue to fair value is that of illiquidity and its
related concern that in both boom and bust time market values are not
real. Firstly, India does not have any traded benchmarks except government
securities, and secondly, over-the-counter products are very difficult to
measure. Accordingly, we prefer not to record any perceived market losses unless
we believe they are permanent. Gains are a complete no unless realised.
Unfortunately we judge losses with the same parameters as we assess gains, but
only record the former should the diminution be permanent. How fair is that from
a ‘true and fair’ perspective ?
The reality is that companies have certain investments of a
permanent nature (HTM held to maturity) and some of a trading nature (short-term
investments or positions taken which do not actually hedge any underlying
transaction). The former is normally treated as a long-term asset where
values would be realised over the period to maturity with any diminution being
recorded should there be a perceived risk. The trading assets and
derivates which do not necessarily hedge an underlying transaction are
effectively hexposures to market risk and hence, are not intended to be held to
maturity. Accordingly, these should be marked to market at any accounting period
to bring into the results and perceived gain or loss from the asset. The fact
that such gain is permanent or temporary is not of concern. The financial
statements should reflect the results of the market risk position taken by an
entity. Our legacy accounting principles completely ignore this concept, as
these did not exist in India until the recent past when our economy opened up as
part of our reforms.
Another example where we completely ignore fair valuation is
in while recording debt with equity conversion features. We seem to
completely ignore the optionality to convert in financial statements
today. And the only way to record these is through fair valuation. Take FCCBs
for instance. Our corporates have been recording the FCCB as if the conversion
is not an option but a definite event. In the present situation where stock
prices have fallen and conversions are unlikely to happen, companies are faced
with cash redemptions and huge back-ended interest costs. Fair value accounting
would have valued the options at fair value and treated the balance as a debt.
The option value would tend to become zero near redemption should conversion
price and market price of stock converge. This would ensure an equitable profit
or loss and the optionality clearly being recorded on the balance sheet. Our
traditional cost system records the consequence of conversion as an unlikely
contingent event which ends being ignored by investors and analysts alike.
A key understanding that most accountants, bankers and CFOs
alike tend to get confused with is the difference between hedging and hedge
accounting. This is where most transactions get confused as hedges and hence are
not fair valued. Hedging is a dynamic measure where a decision-maker consciously
performs a correlation exercise to identify how an underlying market risk can be
hedged. Hedge accounting is a measurable principle which provides
guidelines as to when a derivative instrument can be regarded as a hedge to an
underlying. For example, if someone sees a correlation between the price of
apples and the price of oil, he could effectively buy oil futures to hedge
against moving apple prices. That would make his P&L immune should his
hypothesis be correct. However, this would not qualify for hedge accounting as
it may not meet the criteria of commonality of risks. However, if the hypothesis
is true, then whether hedge accounting is followed or not, the impact on the
profit and loss account would be similar.
We also seem to have mixed issues of fair value accounting with capital adequacy norms (especially in the financial services sector). The issues revolve around certain companies not reflecting pension costs in line with AS-15 or transferring of securities initially purchased as trading to HTM. These are artificial coverages to maintain adequate capital. However, there should be a distinction made in special situations between regulatory and financial capital adequacy. We tend to break or amend the financial thermometer, but do not succeed in improving the health of the patient. Instead we make the doctor’s task more difficult as the problems do not go away through accounting solutions.
Having considered fair valuation as a bane in most situations, India is possibly one of the few countries which allow asset revaluations which completely goes against the historical cost concept or prudence and is a way to fair valuation of assets provided the increase is of a permanent nature (which only restates balance sheets at replacement costs, a completely unverifiable proposition). However, as this is an age-old practice we continue it.
While it is easy to point the faults inherent in fair value accounting, it is less easy to identify an alternative method which would better fulfil the features of relevance, reliability, comparability and understand ability . Reference to historical prices would provide less comparable and much less relevant information given that the company itself views the underlyings at fair value (e.g., options). Illiquid financial instruments are a challenge, but even there the idea of reducing the scope of fair value has not resulted in credible options. An al-ternative is to ‘mark to model’. Models have been widely used and may aid transparency if backed by detailed disclosures about underlying instruments and mark to model assumptions.
Another issue debated is the relevance of fair valuation in the present markets. Should assets be marked down to reflect losses as these are not the values at which companies may sell? My own argument is that if a company sold its assets at the balance-sheet date, fair value is what it would receive for the assets, regardless of whether such values are artificially low in current markets. Irrespective of the company’s intention to hold this until markets improve, the lack of liquidity in current markets can, and has, forced companies to sell assets at these ‘artificially’ low values. In the current market situation, any accounting which fails to highlight liquidity risk in the way that fair value accounting does, would fail to capture the risk appropriately. Fair value accounting reflects the reality that investors are faced with as far as trading assets are concerned.
In the final analyses, fair value accounting as prescribed internationally and in AS-30 can best be described in the same breath as Churchill’s portrayal of democracy, “It’s the worst system with the exception of all others”. Though there is a lot of judgment involved and there is enough potential to abuse it especially in an illiquid environment, there is a lack of any other credible alternative. Though there is a need to have a vigorous debate around fair value, the fact remains that as a profession we need to. clearly understand the concept and see how we could challenge the interpretations taken by our industry and banking colleagues.
