Good Bye Prudence

2.1 Among the questions being debated are : How fair is
fair value ? How does fair valuation measure up on the principles of
relevance and reliability ? How easy is it to audit fair value ? How will
fair value accounting work in practice and what are the implications for
performance measurement ? Furthermore, the profits arising from value changes
may not have been realised, and recognition of unrealised gains goes against
the traditional prudent approach to accounting. Worse, if the unrealised
gains get distributed as dividends, it may create major liquidity and
going-concern issues. This article is an attempt to provide a balanced
assessment of this controversial and multifaceted topic.

2.2 The IASBs Framework for the Preparation and
Presentation of Financial Statements adopted by the IASB in April 2001
stated that the objective of financial statements was to provide information
about the financial position, performance and changes in financial position of
an entity that is useful to a wide range of users in making economic decisions.
As per the Framework, the four principal qualitative characteristics ‘financial
statements’ should have are ‘understandability, relevance, reliability and
comparability’. Other qualitative characteristics are
materiality, faithful representation, substance over form, neutrality,
prudence and completeness. The Framework is now under revision. In the
Exposure Draft, relevance and faithful representation are identified as key
characteristics. The enhancing qualitative characteristics are comparability,
verifiability, timeliness and understandability. Interestingly, prudence and
reliability do not find any place in the proposed revised
Framework.

2.3 The International Accounting Standards Board (IASB) has
given significant importance to fair valuation in IFRS. IASB’s new and revised
standards are based, to a great extent, on an accounting model that focuses on
fair valuation for recognition, measurement and disclosure of assets and
liabilities and that income and expenses are determined by reference to
increases and decreases in assets and liabilities, rather than the reverse, as
in the case of the historical model. Besides financial instruments, other
standards that require use of fair valuation include business combination,
employee compensation, share-based payments, impairments, intangibles,
biological assets and investment properties.

2.4 However, at this point in time fair value is definitely
not well defined even in IFRS standards, and the determination of ‘fair
value’ can be highly subjective. Though many IFRS standards require fair
valuation, there is no single standard that prescribes how to determine ‘fair
value’. Some argue that in the preparation of financial statements, IASB has
placed too much emphasis on ‘relevant information’ and has given
inadequate consideration to reliability and understandability. The danger
to relevance, reliability and comparability of financial statements using
calculated, hypothetical, non-market-based fair values was well illustrated in
an exercise conducted by an 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
could vary as much as 40% to 155%.

2.5 Worse still, current IFRS standards include a variable
blend of both historical cost and ‘fair value’ measurement, for example :

2.6 With this hotchpotch, the understand ability prerequisite of financial statements prepared under IFRS has been compromised. Users are likely to be confused as financial statements have become an aggregation of apples and oranges.

3.1 We will now seek to understand the difference between ‘historical cost’ and ‘fair value’ accounting, how they measure up to the qualitative characteristics identified in the Framework and why prudence and reliability have lost their relevance in the changed scenario. Other alternative accounting models are: current cost, reproduction cost, replacement cost, net realisable value, value in use and deprival value. However, this article is restricted to a discussion between the historical cost and fair value approach.

3.2 Under historical cost, assets and liabilitiesare recorded at historical cost, followed by amortisation or depreciation. On the other hand in the ‘fair value’ model, assets and liabilities are recorded at the amount for which an asset or liability could be exchanged between knowledgeable and willing parties in an arm’s-length transaction. Historical cost gives no consideration to recoverability. It is only a measure of the amount expended. It has been observed that the value of an asset is represented by the future economic benefits expected to flow. The historical cost of an asset lacks this attribute, and therefore it must be supplemented by a measure of recoverable value to meet the ‘true and fair’ test. This aspect has been partly taken care of by requiring an impairment provision when recoverable amount falls below the historical carrying amount.

3.3 Some argue that a presumption of recoverability is implicit in the historical cost and amortisation, because it can be generally presumed that an entity will not pay more for an asset than it believes to be its value either in use or sale. However, the belief of asset cost recoverability may reflect entity-specific expectations that mayor may not be reasonable, and supported by observable evidence.

3.4 In contrast, ‘fair value’ stands on its own as the value could be exchanged between knowledge-able and willing parties dealing at arm’s length. Hence, the value of probable future economic benefit is reflected in the ‘fair value’. Further, ‘fair value’ of an asset needs no additional assessment of recoverable amount, because ‘fair value’ repre-sents the market’s measure of its recoverable value.

3.5 The historical cost-based accounting is premised on ‘cost-revenue matching’ objective. The ‘cost-revenue matching’ objective’ has its roots in the economic premise that costs are generally incurred to earn revenue. Business entities are set up with the objective of transforming various inputs of goods and services into outputs that can be sold for revenues that exceed the cost of inputs. The traditional accounting objective has been to recognise the cost of an asset as an expense when the revenues to which the asset is considered to contribute are recognised. Net income is then measured on the basis of matching costs with related revenues.

3.6 This traditional matching objective has undergone significant changes. It is now well accepted that an input must meet the definition of an asset to warrant capitalisation and that its cost should be carried forward only to the extent that it can be considered to be recoverable from future cash-generating activities or sale. Further, the market-place is the final arbiter in determining the recoverable value of an asset.

3.7 To carry forward an asset at historical cost that differs from its fair value results in wrong in-formation being given in later periods when the asset is ultimately realised (through sale or use) and would be violative of the basic accounting principle of cost matching revenue. It is reasoned that carrying an asset at ‘fair value’ is actually in line with the concept of ‘true and fair’.

3.8 Further, historical cost concept is not for-ward looking. In comparison, ‘fair value’ of an asset embodies market expectations and helps users to evaluate the risk and volatility dimension. In addition, financial disclosures that use ‘fair value’ provide investors with insight into prevailing market values, thereby enhancing the usefulness of finan-cial reports.

3.9 It is axiomatic that it is better to know what something is worth now than what it was worth at some time in the past. . . Historic cost data is never comparable on a firm-to-firm basis, because the costs were incurred on different dates by different firms or even within a single firm.

3.10 Today, investors are concerned with value, not costs. ‘Fair value’ accounting would in principle lead to better insight into the risk profile of the financial entities than is presently the case, more so in the light of the requirement to move many relevant off-balance sheet items onto the balance sheet. Financial stability could benefit if shareholders, uninsured depositors and other debt holders are in a position to readily identify a deterioration in the safety and soundness of an entity. In fact, their reactions either by directly interfering in managerial choices or by exiting from the investment could put pressure on the entity’s management to take early corrective action.

3.11 ‘Fair value’ accounting is timely because it brings economic reality into the balance sheet. With growing concern on ‘going concern’ of entities, a balance sheet prepared on ‘fair value’ basis will provide more relevant information as compared to a balance sheet prepared on outdated historical cost.

3.12 ‘Fair value’ balance sheet is a better representation of the net worth of an entity’s financial position than compared to a historical model. ‘Fair value’ measure of assets and liabilities is attractive because it meets many of the Framework’s qualitative characteristics of useful financial information. ‘Fair value’ can also be viewed as a better presentation of stewardship, as fair values are essential for determining performance ratios such as return on capital employed.

3.13 ‘Fair value’ of an asset or liability depends only on the characteristics of the asset or liability and not on the characteristics of the entity that holds the asset or liability or when it was acquired. ‘Fair value’ is a market-based measure that is not affected by factors specific to a particular entity; accordingly it represents an unbiased measurement that is consistent from period to period and across entities.

3.14 ‘Fair value’ is a solution to the accountant’s problem of income measurement: In accordance with the widely-accepted Hicksian definition of income is ‘a change in wealth – the change in fair value of net assets on the balance sheet yields income’. Hence, ‘fair value’ measure is to be preferred to the hundreds of rules underlying historical cost income. The issue is – how do we take control of the reported numbers out of the hands of corporate management? We do it by requiring that assets and liabilities be reported at ‘fair value’.

3.15 Whilst one could debate the use of fair valuation for non-financial asset and liabilities, there is little debate as regards valuation of financial assets and liabilities. The issue really is : how does one use historical cost to value stock options or derivatives ?

3.16 ‘Fair value’ seems to be the only basis for valuing financial assets and liabilities. FASB be-lieves:

3.17 In case there is a well-defined and liquid market, defining ‘fair value’ is not problematic. However, for illiquid assets or liabilities it may be necessary to use a model to derive ‘fair value’, such as one based on the present value of ‘future cash flows’. But model’s assumptions, such as the r relevant discount rate, may vary widely between in-stitutions and types of assets/liabilities and such variations raise questions about reliability. As a result, some opponents of ‘fair value’ suggest that:

3.18  The counter argument is that even if there is a degree of potential unreliability as to the values, they are still useful to decision-making, because they represent economic reality as opposed to an accounting ‘fiction’ in the form of historical cost. A ‘fair value’ based balance sheet is a better representation of the net worth of an entity than one based on historical cost.

4.1 Having considered the superiority of fair valuation over the historical model, now let’s look at the pitfalls of fair value. Clearly ‘fair value’ is not a panacea for all ills. At this point in time ‘fair value’ methodology is definitely not well established in IFRS or US GAAP, and the determination of fair value can be highly subjective. In the absence of any specific guidance, ‘fair value’ raises a number of issues, such as:

4.2 The term ‘Fair value’ implies active and liquid markets with knowledgeable and willing buyers and sellers and observable arm’s-length transactions – not values calculated on the basis of hypothetical markets, with hypothetical buyers and sellers.

4.3 ‘Fair value’ also increases the risk of misunderstanding on the part of existing or potential investors. ‘Fair value’ might be the realisable market value, but it will not necessarily equate to the market value of the entity because of the existence of internally generated goodwill or other intangible assets. It cannot be denied that ‘Fair value’ brings balance sheet value closer to the market value. However, using fair values for decision-making remains relatively difficult, but probably less difficult when compared to the historical model.

4.4 In the absence of market value, a surrogate has to be used by regarding a mathematical calculation of a hypothetical market price as a fair value. This is illustrated in the following ‘fair value hierarchy’ that has been developed by the US FASB and embraced by the IASB. This indicates the process that should follow for determining ‘fair value’ :

4.5 The reality is that a Level 3 subjective assessment will be required to measure ‘fair value’ in many situations. This will apply to intangible assets acquired in a business combination, unquoted equity securities, equity securities quoted on illiquid markets, derivatives, pension costs, provisions for share-based payments, asset revaluations, impairments and biological assets during the growth phase.

4.6 The fundamental question is whether such hypothetical amounts are sufficiently understandable, reliable, relevant and comparable for financial reporting.

1.    Do the users understand how hypothetical and subjective ‘fair value’ can be?

2.    Can valuations that are not independently verifiable be considered reliable?

3.    Is information that is not reliable, relevant in the world of financial reporting?

4.7 ‘Fair value’ measurement models have been developed for some contractual assets and liabilities especially financial instruments. There seem to be fewer prospects for developing reliable fair value measurement models for non-contractual assets that are inputs to revenue-generating processes – assets that do not generate cash flows by themselves, but contribute along with other inputs to a cash-generating process – can present significant fair value measurement problems when there are no observable market prices for identicalor similar assets, for example, an equipment that is configured for a specialised use. It could be concluded that realisable value in the marketplace is nothing beyond its value as scrap, or the market value of unspecialised equipment less estimated costs to restore to its unspecialised condition. This view presumes that the market does not attribute any value to use. This would be an unreasonable presumption.

4.8 The reliability of fair value estimates is de-pendent not only on how well a model replicates accepted market pricing processes, but also on the reliability of data inputs and assumptions that marketplace understands – for example – data inputs required by ‘accepted stock option’ pricing model includes the current price of the underlying stock, the volatility of that price, the effects of vesting provisions, and the risk-free interest rate for the expected life of the option. The market prices of certain of these inputs can be readily observed, for example, the risk-free inter-est rate can be derived from the price of government bonds and the current price of the underlying stock can be observed if it is traded in a market. The market’s measure of some other inputs may not be so readily determinable, for example, the effects of vesting provisions and the appropriate measure of volatility. Further, the measure of volatility on pricing an option is commonly based on past volatility, which may not be fully indicative of future volatility. Consistency of such data with market expectations requires careful evaluation in the context of the particular circumstances and disclosure of the basis of such data, underlying assumptions and the extent of measurement uncertainty. It may not be out of place to quote Warren Buffet, who feels that ‘marking to market’ has changed to ‘marking to a model’ but is actually ‘marking to myth’.

4.9 As many assets and liabilities do not have an active market, the inputs and methods for estimating their fair value are subjective making ‘fair’ valuation less reliable. Federal Reserve research shows that ‘fair value’ estimates for bank loans can vary greatly depending on the valuation inputs and methodology used.

4.10    Banking  regulators    have observed  that  minor  changes in the  assumptions in a pricing model can have a substantial impact  and reliability can be a significant concern. However, FASB feels  that reliability can  be  significantly enhanced  if market inputs are used whilst valuing.

However, because management uses significant judgment in selecting market inputs when market prices are not available, reliability will continue to be an issue. Management’s use of judgment bias – whether intentional or unintentional in the valuation process, may result in inappropriate fair value also resulting in misstatement of earnings and capital. This is the case in the overvaluation of certain residual tranches in securitisations in recent years in the absence of active market. Significant write-downs of overstated asset valua-tions have resulted in the failure of a number of entities operating in the financial market.

4.11 It should be clear that the date and purpose of valuation is critical in establishing a ‘fair value’. A valuation determined at a particular point in time generally should not be relied upon for value on any other date. In the same vein, a valuation made for a particular purpose may not be appropriate for another purpose. Moreover, given the current state of the art, particularly with regard to credit risk models, reliability of financial statements could be negatively affected as fair values do not always convey precise information regarding an entity’s risk profile. Misjudgement can trigger overreaction, which can have a negative impact on the valuation of an entity.

4.12 We continue to read stories about earnings manipulation under the ‘historical cost’ model. The author believes that in the absence of reliable fair value estimates, the potential for misstatements in financial statements prepared using fair value measurements is greater. Moreover, valuations that are not based on observable market prices but on management judgments will be difficult to audit.

4.13 Volatility in earnings is another constant argument one hears against fair valuation.

1.    For assets and liabilities held to maturity, the volatility reflected in the financial statements is artificial and misleading as any deviations from cost will be gradually compensated during the life of the financial instrument, ‘pulling the value to par’ at maturity.

2.    An excessive reliance on fair values, including non-actively traded assets on illiquid secondary markets run the risk of embodying ‘artificial’ volatility, driven by: short-term fluctuations in financial market or caused by market imperfections or by inadequate de-velopment of valuation model.

4.14 The counter argument is that financial in-stitutions may have an incentive to take proactive measures in order to prevent this from occurring, by building additional reserves and thereby increas-ing their resilience in case certain binding finan-cial ratios are exceeded (e.g., capital requirements or ratios used in loan covenants that could trigger actions such as repayment).

4.15 Increased volatility is not necessarily a problem if investors correctly interpret the information disclosed. In particular, market analysts and institutional investors should try to extrapolate fair valuations from a variety of sources and mature financial markets would be in a position to appropriately interpret this increased volatility.

4.16 Implementation and maintenance of a fair value accounting system will cost time and resources. There may be other alternatives that may make more sense in a given situation. A case in point is one where biological assets are required to be fair valued by fAS 41. Other than questioning the need to fair value non-financial assets, the fact that biological assets are generally owned by small enterprises should not be ignored. These enterprises may find the whole process defeating, since fair value done at prohibitive cost may be completely useless for the purposes of decision making.

4.17 IAS 41 requires biological assets to be fair valued. IAS 41 met with severe criticism because many biological assets are simply not capable of reliable estimate of fair value. For example:

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, as 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 is used as pet food. At each stage in the life of the stallion, the ‘fair value’ would change significantly, but estimating the fair value would be extremely subjective and difficult. The issue is : if 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 assets?

Vineyards and coffee and tea plantations have similar measurement issues. The relationship between the vines and coffee or tea plants and the land that they occupy is unique and integrated. The vine or plant itself has relatively little value. However, in conjunction with the land, they do have value. Determining the fair value for a vine-yard, coffee or tea plantation involves esti-mating production along with sales prices and costs for a number of years in the future, together with estimating a terminal value and the application of a discount rate to calcu-late the net present value – an enormously complex and subjective task. The value of the vines and plants would then have to be determined as a residual because it would be calculated by deducting the value of the un-improved land and the value of the infra-structure from the aggregate value. It is clear that the valuation in the above examples is based on subjective estimates and is open to substantial variability.

4.18 Pitfalls – of using ‘fair value’ for biological assets are:

4.19 Applying the ‘fair value’ option to the report-ing entity’s liabilities poses a particular problem, especially from a prudential point of view. As, under the fair value option, fair value measurement is not restricted to market developments (e.g., market interest rate fluctuations or changes in the exchange rate parities), but is all-encompassing, i.e., it also includes fluctuations caused by changes in the reporting entity’s credit rating – for example – a deterioration in the entity’s credit rating and the resultant devaluation of its own liabilities leads to an increase in its capital, for example, if an entity that has borrowed at 10%, credit worthiness goes down subsequently, and can now borrow only at 12%, it would record a fair value gain on the earlier loan reflecting the 2% gain on account of its own credit deterioration. From a prudential point of view, this is unacceptable.

4.20 In case of banks and financial institutions:

4.21 However, the flaw with the above argument is that:

4.22 The inadequacy of historical cost, transac-tion-based approach for dealing, in particular, with derivatives (which have little or no initial cost but can expose companies to very substantial financial risk) and diminutions in the value – impairments of assets, have encouraged standard-setters to espouse an asset/liability approach to recognition of income and a ‘fair value’ basis of measurement of assets and liabilities.

4.23 Although the recognition of unrealised gains and losses on financial assets is achieving wider acceptance, the IASB has not yet put forward any convincing arguments in favour of a ‘fair value’ model for non-financial assets. IAS 41 does not require the existence of active market for using fair value in case of biological assets. This approach is inconsistent with other international standards, for example – for valuing intangibles under IAS 38, the existence of an active market is a perquisite for using fair value.

5.1 The arguments for and against fair value accounting raise fundamental questions about core accounting issues, such as how performance should be measured, and the relative merits of the qualities of relevance versus reliability. Fair value accounting is a paradigm shift – it moves away from ‘historic focus’ to a ‘current perspective’ on value. However, the standard-setters now face a significant dilemma :

how can they continue to pursue their mark-to-model approach to asset/liability measurement and, at the same time, promul-gate accounting standards that will lead to a style of financial reporting that enables investorsto evaluatemanagement performance and assess enterprise value to make sound
investment decisions ?

5.2 The issues are:

5.3 The answer is :

5.4 The most interesting question in everyone’s mind is how long it will take for the full range of non-financial assets, and particularly internally generated goodwill, to be measured using ‘fair valuation’. That would make future balance sheet, a valuer’s balance sheet rather than an accountant’s balance sheet.

5.5 Using fair values to measure assets and liabilities is attractive because it meets many of the Framework’s qualitative characteristics of useful financial statement information. These criteria are to be applied in the context of the primary objective of financial reporting, which is to aid investors and other users of financial statements in making economic decisions. The criteria include relevance, comparability, consistency, and timeliness. Fair values are relevant because they reflect present economic conditions, i.e., the conditions under which the users will make their decisions. Fair values are comparable because the fair value of any particular asset or liability depends only on the characteristics of the asset or liability, not the characteristics of the entity that holds the asset or liability or when it was acquired. Fair values enhance consistency because they reflect the same type of information in every period. Fair values are timely because they reflect changes in economic conditions when those conditions change. In addition, fair values can be viewed as fulfilling a stewardship role for financial reporting because the financial statements reflect the values of assets at the entity’s disposal. Such values are essential for determining performance ratios such as return on capital employed. The author would conclude by stating that despite its faults, ‘fair value’ is here for good and as the valuation models become more established in future accounting standards, many of the criticisms on fair valuation would disappear. If marking to market is a myth, then historical cost accounting is rather a mystery. A return to full historical model would be a retrograde step. Investors are definitely not seeking financial statements that have outdated information. Change to ‘fair value’ is a challenge to our profession and I am sure we will meet the challenge.