Fair Value
accounting is now strongly entrenched in the accounting cannons after centuries
of following historical cost convention. It is a shift from ENTRY perspective
to EXIT perspective. Historical cost convention was perhaps the premium for
stability and long-term prudence, to cover the business from volatility of
business and market forces. That idea of measure of value – based on original
cost – was replaced by a measure defined as exchange value (of an asset)
between knowledgeable and willing parties in an arm’s length transaction.
Does fair
value (FV) inform the user of financials better? Does it improve upon true and
fair consideration? Are users happy to pay the price of volatility to get the ‘real’
picture? REALITY, what actually happened, has been the central pillar
accounting for centuries. FV, in a lighter vein could be augmented or virtual
reality which only time will test.
This
fourth VIEW and COUNTERVIEW aims to tells the story of how fair the fair value
is and although it has had a bumpy ride in times of turbulence, it is now an
accepted norm of accounting.
VIEW: WHY FAIR
VALUE SHOULD NOT HAVE FEAR VALUE?
Dolphy D’souza
Chartered
Accountant
Fair value
accounting is an integral aspect of Ind AS and all other global standards, such
as IFRS or US GAAP. Since Ind AS has
been in use for more than two years now, a discussion on this topic is probably
only academic. Most entities reluctantly or otherwise have accepted this
concept, though the debate when it was first introduced was highly exacerbated.
Of course, in good times, everyone likes fair value accounting, however, in bad
times they will be complaining.
Some argue
that fair value accounting is procyclical and caused the credit crisis a few
years ago. 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. Fair value accounting was
rather useful in highlighting the inherent problem and weaknesses of entities.
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financial assets are stated at outdated values and hence not relevant or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 derivatives, 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 judgemental, 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
valuation guidance on fair value measurement has been issued by IASB and
International Valuation Standards Council (IVSC), and overtime subjectivity and
valuation spread reduced substantially.
The next
question is what kind of assets and liabilities lend themselves better to fair
value accounting. Whilst many non-financial assets under Ind AS 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 values would change
significantly, but estimating the fair values could be extremely subjective,
difficult and make earnings highly volatile. 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 atleast some biological non-financial assets? Certainly, an invariable
application of fair valuation is not what the author recommends.
In India,
the debate on fair value has got confused because of lack of understanding of
Ind AS. For example, a common misunderstanding is that all assets and
liabilities are stated at fair value. However,
the truth is that under Ind AS many non-financial assets such as fixed assets
or intangible assets are stated at cost less depreciation (unless an entity
chooses to apply the revaluation model, subject to conditions being fulfilled).
The apprehension of using fair value accounting is driven by tax considerations
or legal legacy. However, one may note that Ind AS financial statements are
driven towards the needs of the investor and not of any regulator. Therefore,
the income-tax and other regulatory authorities should ensure that Ind AS is
tax or statute neutral.
Determining
fair value can be extremely excruciating in certain cases, such as biological
assets, contingent liabilities, unquoted equity shares, etc.
Notwithstanding the difficulty, determining fair value should not be an excuse
for abandoning the idea of fair valuation. Doing so would be throwing the baby
with the bath water. Fair valuation cannot be expected to provide, the same
result if different valuers were valuing it. This is because fair valuation is
not a science but an art and no guidance or methodology can ever make it a
science. IFRS 13 (Ind AS 113) and the IVSC valuation standards were certainly
helpful in bringing about clarity, consistency and in collapsing the valuation
spread between valuers.
In the
examples below, it is hard to imagine, a measurement basis other than fair
value.
|
S.No.
|
Particulars
|
Indian GAAP
|
Reason for fair value under Ind AS
|
|
1
|
Investment in equity and debt mutual funds
|
Long-term investments are carried at cost less provision for
other than temporary decline in the value of investment, if any.
|
Under Ind AS 109, Investments in debt and equity mutual funds
are measured at fair value with changes credited or debited to P&L
(FVTPL). This makes absolute practical sense.
Both retail and corporate investors evaluate their investment in
equity and debt funds (other than FMPs) on the basis of its fair value and
not historical cost. Even ordinary investors will consider historical cost as
being an outdated measure.
|
|
2
|
Investment in equity shares (quoted and unquoted)
|
Long-term investments are carried at cost less provision for
other than temporary decline in the value of investment, if any.
|
The reasons discussed in (1) above equally applies to investment
in equity shares (quoted and unquoted).
Some companies were against fair value in the case of investments in
unquoted shares. However, Ind AS
implementation has revealed that in many cases unquoted equity shares were
either impaired or had a very high valuation. Accounting at fair value will
reflect the real value of the shares and the entity that holds such
shares. Such information is absolutely
critical for any reader of financial statements, for making a sensible
assessment of the true worth of an entity.
|
|
3
|
Investment in debt instruments
|
Carried at amortised cost by banks and financial institutions.
Other entities carry Long-term investments at cost less
provision for other than temporary decline in the value of investment, if
any. Interest is recognised on accrual basis at contractual rate.
|
Such investments if they meet certain conditions are accounted
on an amortised cost basis. However,
the fair value disclosure with respect to such instruments is required. Factors such as change in interest rate,
credit rating, inflation rate, etc. plays an important role in
determination of fair value disclosure with respect to such instruments is
required. Factors such as change in
interest rate, credit rating, inflation rate, etc. plays an important
role in determination of fair value.
|
|
|
|
|
Consider an example on why fair value disclosure of loans given
by a financial company is critical to understanding the financial position of
the entity.
Example: A finance company gives loan at competitive rates let
say @ 8% and subsequently interest rate goes up; say 10%. Fair value of the
loan is impacted significantly, resulting in a huge hair cut (but not under
Indian GAAP). Further, an entity may
have liability at floating rate, so there is clear mismatch between assets
and liabilities, which will impact its future profitability and
viability. This will get reflected
under Ind AS but not under Indian GAAP.
|
|
4
|
Interest free loans between parent and subsidiary
|
Both parent and subsidiary recognise loan at amount paid/
received.
|
On day 1, the parent will recognize loan at fair value and debit
the differential amount to investment in subsidiary. Subsequently, interest
income is recognised in P&L at market rate. The subsidiary will also recognise loan at
fair value and credit differential amount to capital reserve (investment by
parent). This will result in interest expense recognition at market
rate. Some may argue that this is
notional accounting. However, this
accounting will reveal the hidden cost in the group transactions. Further, it will eliminate transaction
structuring by treating all loans whether interest bearing or non-interest
bearing equally for accounting purposes. It will also bring transparency in
related party transactions.
|
|
5
|
Redeemable and convertible instruments, for example, redeemable
or convertible preference shares
|
Instrument is accounted for based on their legal form. Redeemable and convertible preference
shares are presented as equity share capital
|
Redeemable preference share is treated as a liability. Convertible preference shares are split
into equity and liability or derivative and liability. Fair value principles
are applied in split accounting in case of convertible instruments and in
determining the fair value of liability and interest expense. This, will fairly present the amount of
liability and embedded equity/derivative.
|
|
6
|
Share based payment
|
Gives an option to account for ESOP expenses using either the
fair value or the intrinsic value method over the vesting period.
|
It requires expenses of share based payment to be measured using
the fair value method only. The fair
value of an ESOP is estimated using an option pricing model like the Black
Scholes Merton or a Binomial Model. Under Indian GAAP, very often the
intrinsic method did not result in any ESOP cost for an entity. This is undesirable, since it makes a
distinction between remuneration that is paid in cash vs that which is paid
through an ESOP scheme. The form in
which remuneration is paid should not determine the expense charge to the
P&L.
|
|
7
|
Foreign Parent issues ESOP to employees of Indian subsidiary
(there is no settlement obligation on subsidiary)
|
The parent generally recognizes ESOP expense and no expense is
recognised by the subsidiary.
|
The expense will need to be recognised by subsidiary since its
employees are receiving remuneration by way of ESOP. No expense can be
recognised by the parent. Who provides the ESOP is not relevant to this
assessment; rather, who receives the benefit is relevant. Fair value
principles are applied in determining the ESOP cost.
|
|
8
|
Acquired contingent liabilities in business combination
|
Contingent liabilities do not form part of acquisition
accounting.
|
The acquired contingent liabilities are recognised at the
acquisition date at fair value, provided it can be measured reliably. By
putting a value to contingent liabilities, the consequential goodwill amount
is fairly reflected.
|
|
9
|
Sales Tax deferral/loan
|
Sales tax loan is accounted for at the undiscounted value.
|
Ind AS requires that on initial recognition, sales tax loan
should be accounted for at fair value, i.e., present value of future cash
flows. Difference between amount deferred and fair value of loan is correctly
treated as government grant under Ind AS 20.
Sales tax loan is a funding by the government to an entity. Ind AS accounting truly reflects that
underlying substance.
|
In many
areas, fair valuation is simply inevitable. Fair value accounting does not
create good or bad news; rather it is an impartial messenger of the news.
counterview:
WHEREFORE FAIR VALUE?
Ashutosh Pednekar
Chartered
Accountant
A common misconception is
that wherefore means where; it is occasionally so used in
retellings of Romeo and Juliet — often for comedic effect. The meaning of “Wherefore
art thou Romeo?” is not “Where are you, Romeo?” but “Why are
you Romeo?” i.e. “Why did you have to be a Montague” i (the
family name of Romeo).
One may wonder, why in an
article that is meant to be defiant to current trends of accounting I am
quoting Shakespeare. Well, the fact remains that English as she is spoken is
not necessarily understood in the same manner by everyone. That is the bane with
Fair Value (FV) accounting too. My concept of FV could be different from your
concept. Hence, the users of financial statements could possibly, get different
perspective of financial statements. Accounting permits or requires (based on
specific conditions) different bases of measurement. The two main bases are
historical cost and current value, with current value having bases such as FV,
value in use for assets or fulfilment value for liabilities and current cost.
The IASB in March 2018 has issued the revised Conceptual Framework of
Financial Reporting. Chapter 6 describes various measurement bases and
discusses factors to be considered when selecting those. Our Indian Accounting
Standards (Ind AS) will need to follow this framework.
It is said that double
entry book keeping was first codified in a treatise 1494 in by Luca Pacioli.
Prior to that, there are records of double entry book keeping by Jews and
Koreans. The Bahi-Khata system of accounting in India was prevalent too. These
would have been times when traders of different regions and languages did
business with each other and to settle the trades needed a uniform language of
accounting acceptable to all. Double entry system of book keeping served the
purpose. Trade practices, technology and methods of transacting evolved but the
cardinal rules of accounting remained the same. Ever since Pacioli’s treatise
those rules (debit what comes in, credit what goes out, et al) have remained
consistent for more than 600 years!
_________________________________________________
Twentieth century saw
multiplication of world trade; money becoming more fungible, businesses
regulated, stakes increasing, higher gains, deeper losses. This led the users
of financial statements question accounting and financial statements. The
persons who were making decisions of providing resources to an entity relied on
the financial information that was available and they realised that the
financial information was inadequate – if an entity had acquired an asset fifty
years ago and it was carried at historical cost less depreciation, then that
information was not relevant to the user who wanted to take a decision of
providing resources. These decisions were made on an elaborate combination of
what price a similar asset / business fetches in an open market and / or a
calculation of future cash flows, discounted at an appropriate rate reflecting
the risk of the entity i.e. at FV. However, accounting continued on historical
cost measurement basis.
Since 1980s there was a
demand to have the needs of resource providers addressed in the financial
statements. Consequently, the concept of FV gained prominence and eventually
accounting standards included it and the concept of exit price emerged.
Along with that came in the complex arithmetical computations, statistical
assumptions & probabilities requiring use of significant estimations.
India is in the process of
converging to IFRS since April 2016 in a phased manner. The entities that are
applying Ind AS are of different sizes and structures even amongst listed
entities The experience of two years of Ind AS of preparers and auditors has
been educating as well as exasperating. The questions that promoters and many
preparers ask of accountants and auditors are:-
– Why
my entity needs to be evaluated on an “exit price”.
– Am
I selling my entity as on the balance sheet date?
– What
has happened to the concept of going concern?
– My
balance sheet used to be prepared for me and my shareholders and my bankers and
my business partners and they know how healthy or otherwise I am.
– By
having my financial statements at an exit price am I telling the world that my
business is up for grabs at the values presented in the financial statements?
– I
do not want to and I have no intentions of selling my business, either in parts
or as a whole, then why should I increase my costs of compliance by undertaking
valuation exercises based on various inputs that standards themselves say can
be “unobservable” So, be definition they are abstract and unreal.
– So
am I placing a picture of my state of affairs based on presumptions, statistics
and estimations rather than at the values at which the transactions have taken
place?
Answers anyone?
The standard gives a three
level hierarchy for specific facts and circumstances. The hierarchy ranges from
simple to complex calculations. An entity is required to replicate the above at
each measurement date. If it is presenting financial results on quarterly
basis, then all these steps have to be done each quarter. The cost of
compliance with FV computations, recognition and measurement is indeed
significant. Not to mention the volatility that can enter the financial
statements. If the markets are erratic then it would get reflected in the
financial statements. Compare this with
the stability provided by historical cost measurement, where one is certain
that the amounts at which assets and liabilities are presented are the values
that are a result of transactions that have already occurred.
One typical example of the
complexity of FV accounting is the interest free or concessional interest loans
given to employees. An entity is required to determine the FV of such loans, by
discounting the cash flows at an appropriate rate of interest and documenting
the rationale of appropriateness and then presenting the difference between the
FV of the loan and the amount of loan as employee benefits and which would be
recycled over the tenor of the loan, making it PL neutral over multiple years.
When one explains this to business owner the reaction is flabbergasting. When
one explains the rationale of this charge, then there is a reluctant nodding of
head followed by, “but when I gave the loan, this was not my intention.
Sometimes the intent was to keep my employees satisfied and that cannot be an
accounting rule / requirement”. He
reacts by saying, “for me it is the amount of loan to employee that is
critical – on employee leaving the organization I will recover the absolute
amount and not its fair value.”
If a simple business transaction
of loan to employee causes such difficulties in FV accounting, one can only
imagine what could be the case in complex business transactions.
Some standards require
disclosure of FV of items that are carried at amortised cost! This defies logic
to some preparers as the business model permits those items to be carried at
amortised cost but disclosure requirements requires determining FV, implying
going through the grind of estimations & computations and justifying it to
all users of financial statements.
The user now has to read
the voluminous disclosures to understand the impact of the numbers in the
financial statements. Will they have the expertise of understanding the devil
in such detailed? Isn’t it fine that an entity provides such detailed information
on a need to know basis, sat, to a potential investor to whom “FV at exit
price” is more relevant rather than “historical cost”
The reaction of other
stakeholders & users of financial statements viz. bankers, lenders,
vendors, current & potential investors, tax authorities is awaited to be
seen in public domain. Reactions and responses of users of financial statements
and their impact on businesses will tell us whether FV accounting has achieved
what it had set out to; whether the benefits indeed exceeded the costs. Only
then, perhaps, we will know the answer to wherefore art thou fair value
accounting?
India is part of a global
business community and standards of performance have to be comparable. Hence,
India decided to converge with IFRS. But, is it fair that every Indian entity
that is not comparable with an international entity in terms of size and
structure is required to go through this grind of fair value and its
disclosures? Can one not look at a model of the IFRS for SMEs? For less complex
entities IFRS for SMEs give limited options w.r.t recognition & measurement
principles and disclosures are significantly less too. It would make the
financial statements more relevant and reliable.
It has taken the world six centuries to move
from historical cost measurement bases to FV measurement bases. We all
experience that lifecycle of new technologies is much short lived. Likewise,
can we equate FV as new technology prone for obsolescence a decade or five from now? And thereafter do we move to
a new technology or do we revert to historical cost.
An alternate proposition
would be that only those entities that frequently raise resources from local
and international markets, who have international investors, who have a mass
that matters or are comparable with the Fortune Global 500ii can be
required to have FV accounting. To understand where India stands, we have only
7 companies in this global list with the highest at 168th position. The 500th
company on the global list has revenues of US$ 21,609 Mniii
(INR 1,44,780 Crore). It would be worthwhile to do an analysis around this
figure and determine what would be the right size for an entity to get involved
in determination of FV and recognizing it in its financial statements. For
others (excluding sectors such as banking, insurance & lending),
historical cost could continue. FV will be need-based information, not
necessarily part of financial statements.
One size fits all is a good
dictum. However, if the size of an average Indian business entity that applies
FV accounting is much smaller than the average size of a global entity that
applies FV accounting, aren’t we justified in having something simpler commensurate
with our size and nature of business?
This debate shall certainly
not end with this article but may at the least trigger a thought process, and
for that I would like to end with apologies to William Shakespeare by a bit
rephrasing of Marallus speaking to two rejoicing commoners in Julius Ceaser,
Act 1, Scene 1iv :-
Wherefore
rejoice
What
conquest brings fair value home?
What
levels of hierarchy follows him to the statement of financial position to grace
in probability weighted estimates
You measurement
blocks, you recognition principles, you worse than senseless disclosure
requirements
Oh you
hard hearts, you cruel men of accounting
Knew you
not historical accounting.
________________________________________________
iv http://www.shakespeare-monologues.org/monologues/612
