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June 2010

Fair Value or Fear Value?

By Dolphy D’Souza | Chartered Accountant
Reading Time 10 mins

Accounting Standards

Fair value accounting is an integral aspect of International
Financial Reporting Standards (IFRS). In good times, everyone likes fair value
accounting, however, in bad times they are complaining. With the adoption of
IFRS from 2011 by India, the debate on fair value accounting has exacerbated.
Some argue that fair value accounting is procyclical and caused the recent
credit crisis. However subsequent research done by SEC indicates that financial
institutions collapsed because of credit losses on doubtful mortgages, caused by
sub-prime lending, and not fair value accounting.

Those criticising fair value accounting do not seem to
provide any credible alternatives. Do we take a step back to historical cost
accounting, wherein financial assets are stated at outdated values and hence not
relevant or reliable? Is there any better way of accounting for
, other than using fair value accounting ? For example, in the
case of long-term foreign exchange forward contracts there may not be an active
market. For such contracts, entities obtain MTM quotes from banks. In practice,
significant differences have been observed between quotes from various banks.
Though fair value in this case is judgmental, is it still not a much better
alternative than not accounting or accounting at historical price ?

Some years ago an exercise was conducted by a global
accounting firm to determine employee stock option charge. By making changes to
the input variables, all within the allowable parameters of IFRS, option expense
as a percentage of reported income was found to vary as much as 40% to 155%.
However, since then the IASB has issued an Exposure Draft on fair value
measurement, and overtime subjectivity and valuation spread is expected to
reduce substantially.

The next question is what kind of assets and liabilities lend
themselves better to fair value accounting. Whilst many non-financial assets
under IFRS are accounted at historical cost, biological assets are accounted at
fair value. Unfortunately many biological assets are simply not subject to
reliable estimates of fair value. Take for instance, a colt which is kept as a
potential breeding stock, grows into a fine stallion. The stallion starts
winning race events and is also used in Bollywood films. The stallion earns
substantial amount for its owner from breeding and other services. The stallion
gets older, his utility decreases. Eventually the stallion dies of old age and
the carcass used as pet food. At each stage in the life of the horse, the fair
value would change significantly, but estimating the fair values could be
extremely subjective and difficult. In many ways, the stallion reminds one of
fixed assets. Changes in fair value of fixed assets are not recognised in the
income statement, then why should the treatment be different in the case of
biological non-financial assets ?

In India the debate on fair value has got confused because of
lack of understanding of IFRS. For example, a common misunderstanding is that
all assets and liabilities are stated at fair value. However, the truth is that
under IFRS many non-financial assets such as fixed assets or intangible
assets are stated at cost less depreciation.
In the case of investment
properties, a company is allowed to choose either the cost option or fair value
option for accounting. The apprehension of using fair value accounting for
investment properties is driven by tax considerations. However, one may note
that IFRS financial statements are driven towards the needs of the investor and
not of any regulator. Therefore, the income-tax authorities should ensure that
IFRS is tax neutral.

Being an emerging economy, without deep markets in many
areas, India would have specific challenges. Many of the challenges in
determining fair valuation applicable to emerging economies may also apply to
any other developed economy. However, lack of expertise and experience in
emerging economies may amplify the problem. Additional education might be needed
on how to make estimates and judgments and the disclosure of fair value in
financial statements.

Many emerging economies do not have a deep and active market
for long-term maturities, and in the case of corporate bond there may not be an
active market at all. Valuation of such bonds would be difficult as there would
be no market to mark, and estimating discount rate for longer-term maturities
could be challenging. A country may have only one risk premium that covers all
maturities but not broken up for specific duration or industry sector — this can
compound the problem.

Any valuation that involves tax and foreign exchange as a
variable will add another dimension of complication in the case of emerging
This is because tax rates and regulations are not stable and
change quite frequently. Also, experience indicates that foreign exchange
reference rates announced by the central bank or a regulatory body may be
significantly different from the market. In the case of foreign exchange forward
contract, there may not be an active market beyond one year. Significant
differences have been observed in the MTM quotes from various banks on long-term
forward contracts.

If one has to value a corporate bond that is not actively
traded, the discount rate would be the base rate plus a credit rating-based
credit spread. There are various discounting curves available such as the
zero-coupon interest rate, yield to maturity rate, MIBOR, Fixed Income Money
Market and Derivative Association (FIMMDA) rate, etc. FIMMDA issues credit
rating-based credit spread on a monthly basis. Reuters issues credit spread on a
daily basis but only for AAA rated instruments. The reliability of the valuation
of the bond would depend upon (a) the reliability of the base rate used (b) the
availability and reliability of the credit rating for the instrument, and (c)
the reliability of the credit spread. If a company uses a particular curve to
discount a corporate bond (say, YTM curve) which is different from the
acceptable practice in the market (say, FIMMDA), then the value would differ
from how the market determines it.

Similar issues would also arise in the case of valuation of
government bonds. Many of them may be very illiquid, particularly the state
government bonds. Quotes from different brokers often differ significantly. Also
it is difficult to know if the brokers are acting as principal or agents and
whether the broker will fulfil the deal at the committed price. Valuing them in
the absence of a market may yield different results, as risk premium for state
governments may not be available and would certainly not be the same as that of
the central government. As per RBI requirements state government securities are
valued applying the YTM method by marking it up by 25 basis point, above the
yields of the central government securities of equivalent maturity. However,
IFRS this approximation may not work, as it is clear that
different states have different risk profiles, which impacts their valuation.

Under IFRS a company may have to fair value its foreign currency convertible bond listed on a foreign securities exchange. However, in many instances at the reporting period there may be no trade as it may not be actively traded. This could lend itself to potential abuse as insignificant trades at the reporting date may inaccurately determine the fair value of the bonds. The appropriate thing to do in such situations is to make an adjustment to the quoted price based on a detailed analysis so as to measure the bond at its fair value.

It is also common in an emerging economy that an entity is required to estimate fair value of an unquoted instrument, without the benefit of detailed cash flow forecasts, management budgets, or robust multiples. An entity may own an insignificant amount, say, 10% of another entity, and therefore may not be legally entitled to obtain that information from the investee. In many cases, local benchmark companies or their financial information may simply not be available on which to base the valuation. It may be noted that RBI requires unquoted equity instruments to be valued at break-up value from the company’s latest available balance sheet, and in its absence, at Re.1 per company. Such valuations would not be acceptable under IFRS.

When estimating fair value in an emerging economy, modelling a non-financial variable could be extremely difficult. For example, under IFRS, acquisition accounting requires fair valuation of contingent liabilities of the acquiree. If the contingent liabilities were with regard to tax, in many developed economies there is a settlement system and past experience on which an estimate can be based. However, in emerging economies the litigations tend to be very long-drawn and uncertain, eventually resulting in a full liability or no liability at all. The tax authorities that influence the variable may change their behavior rapidly, thereby making the historical behaviour an inaccurate basis on which to predict future behaviour.

Sometimes market dynamics work in a very complicated manner in emerging economies. It may be difficult to determine the principal or most advantageous market due to regulatory or political circumstances. For example, a commodity market may have been cornered by a few selected players, and though in legal terms, all market participants can trade in the market, in actual terms it may be restrictive. Whether such a market should be considered in determining the fair value, if the market participant is not entirely clear whether it will be allowed entry and trade without any restriction ? Such questions would be more common in emerging economies.

Highest and best use is a concept that underscores fair valuation. As people are supposed to act rationally, a fair value measurement considers a market participant’s ability to generate economic benefit by using the asset in its highest and best use. However, highest and best use is subject to the restrictions of what is physically, legally and financially feasible. This could be a difficult area particularly in emerging economies, in the absence of clear laws or the manner in which they are implemented. For example, a builder that owns a piece of land, may not be clear, whether he will be allowed to construct 10 floors or 20 floors and whether the property development is restricted by laws in terms of its usage, for example, only for residential or commercial purposes, etc. This could make the valuation of the land a difficult task.

The above are issues that emerging economies may face more prominently than developed economies. In any system or methodology, fair valuation cannot be expected to provide, the same results if different valuers were valuing it. This is because it is not a science but an art and no guidance or methodology can ever make it a science. However, some additional guidance from the IASB on the above issues will certainly be helpful in bringing about clarity and consistency on how these issues are handled and in collapsing the range within which the fair value should fall. Issuance of guidance that specifically deals with fair valuation issues in emerging economies, will also reduce the resistance in these economies towards fair valuation.

To sum up, fair value accounting does not create good or bad news; rather it is an impartial messenger of the news. However, IASB should look at improvements in terms of providing guidance on a regular basis to reduce judgment and subjectivity as well as restricting the use of fair value accounting only to those assets and liabilities that lend themselves better to fair value accounting. IASB should also focus on providing specific guidance on the fair value challenges that emerging economies such as India would face.

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