Fair Value Accounting

Moving from Facts to Opinion?

ASC 820 under US GAAP and IFRS 13 issued by IASB provide a principal based framework for fair value measurement. Though fair value measurement guidance in US GAAP and IFRS are substantially in the same line, some minor differences exist. This article discusses the IFRS 13 and challenges in its implementation.

Many years ago, Luca Pacioli introduced to the world the concept of double entry accounting.  Not much has changed since then—debits and credits form the basis of the world of accountants.  Accounting has been diligently following the golden rules since then recording past transactions and reflecting them into the financial statements.  Accounting standard boards and professional bodies of accounting all over the world have been attempting to increase consistency and comparability of financial statements and have issued accounting standards to guide the accountants on numerous complex issues.  While recognizing assets and liabilities on the financial statements, accountants have always had options to select from multitudes of measurement techniques ranging from historic cost, through value-in-use, to fair value, and many shades in between.

ASC 820 under US GAAP and IFRS 13 issued by IASB provide a principal based framework for fair value measurement.  Though fair value measurement guidance in US GAAP and IFRS are substantially in the same line, some minor differences exist, including:

• Quantitative sensitivity analysis disclosure for Level 3 financial instruments.
• Restriction on recognition of gains and losses at inception on financial instruments where the fair value has been determined using unobservable inputs under Level 3.
• Retirement benefit plan investments need not be fair valued.
• Derivative assets and liabilities that have been fair valued at Level 3 should not be presented on a net basis.
• Nonpublic entities to comply with the requirements of IFRS 13. Small and medium-sized entities require only select presentation and disclosures.

IFRS 13 defines fair value as: “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” (IFRS 13.9)  The fair value measurement is from the perspective of the market participant rather than the entity itself; it is the exit price of the asset or liability.  When an entity is fair valuing any asset or liability, the following factors would need to be considered:

• The asset or liability: Characteristics of an asset or liability that a market participant takes into account for pricing would need to be considered by the entity (e.g., condition, location, and restrictions, if any, on sale or use). A single asset or liability or a group of assets or liabilities may be fair valued.
• The market: Fair value would be based on a hypothetical transaction that would take place in the principal market, or in its absence, the most advantageous market.
• The market participants: Fair value measurement requires considering the same assumptions that market participants would use when pricing the asset or liability, assuming that market participants act in their best economic interest.
• The price: Fair value would be based on the exit price and not the transaction price or the entry price.

The standard also provides certain specific requirements for non-financial assets, liabilities, equity, and financial instruments.

• IFRS 13 requires the fair value of a non-financial asset to be measured based on its highest and best use from a market participant’s perspective.
• A fair value measurement assumes that a financial or non-financial liability or an entity’s own equity instrument is transferred to a market participant at the measurement date. It assumes that the liability/entity’s own equity instrument would remain outstanding and the market participant transferee would be required to fulfill the obligation and/or take on the rights and responsibilities associated with the instrument.
• When a quoted price for the transfer of a liability or the entity’s own equity instruments is not available but the instrument is held by another investor as an asset, management should measure fair value from the perspective of the investor.
• If a market is not available for the liability, a valuation technique is required to measure the fair value from the perspective of the liability issuer. The valuation techniques should be appropriate in the circumstances and have sufficient data available to measure fair value, maximizing the use of relevant observable inputs and minimizing the use of unobservable inputs.
• Based on the quality of the inputs, the standard established a fair value hierarchy: Level 1 for quoted price of identical assets; Level 2 for directly or indirectly observable inputs other than quoted prices; and Level 3 using unobservable inputs for valuation.
• The fair value of a liability reflects the effect of non-performance risk. Non-performance risk includes, but may not be limited to, an entity’s own credit risk.

IFRS 13 Implementation Challenges

During implementation data gathering, selection of the valuation technique, changing the mindset to an exit price orientation, and measuring risk premium are some common areas of deliberation.  Paucity of detailed knowledge is another major challenge.  I have provided a summary of select practical problems faced by industries across different verticals and would like to remind the readers that no single entity might have faced all of them:

• The identification of the appropriate market (i.e., the principal market and the advantageous market may not be as straight forward). Further, management may need to make assumptions about the type of market participants that may be interested in a particular asset or liability.  They would need to consider multiple factors such as the specific location, condition, and other characteristics of the asset or liability, growth rates, risk free rate and the risk premium, impact of inflation, and so on.
• Management may require considering alternative uses of those assets to determine whether the current use of the assets commands the highest price and is the best use.
• The price being based on an exit price brings in a hypothetical sale and requires adoption of an estimation methodology. The extent to which market data is available varies with different assets and liabilities.  A rigorous process would be required to study various market assumptions, key features of each transaction and their influencing factors to be able to determine a reliable fair value for an arms-length transaction.  Uncertainty and estimation is inherent in the entire process.
• The fair value of a liability should reflect non-performance risk and should take into account the effect of an entity’s own credit risk and the counterparty’s credit risk. Therefore, there were two implications: (1) that fair value measurements must take counterparty risk into account and thus a credit valuation adjustment should apply to the ‘risk free’ yield curve, and (2) a debit valuation adjustment would need to be made for the entity’s own credit status.
• A process in the entity would need to be established for periodically tracking and applying the movements in the credit value adjustment and the debit value adjustment.
• Apart from credit risk, a comprehensive risk assessment may be required by the entity while determining the non-performance risk. The entity must have a documented risk management strategy and risk quantification methodology established.
• The standard permits fair value measurement of a group of assets or liabilities. The portfolio impact in such cases needs to be determined.
• Use of the fair value hierarchy may become a data intensive and complex exercise. Availability of local data and statistical deficiencies has been an impediment resulting in usage of proxy values and resulting in many assets and liabilities being measured using unobservable inputs (i.e., at Level 3).
• Development and selection of the correct valuation technique is critical. The statistical-financial models developed for the valuation should be such that it can be consistently used in the future.
• Disclosures requirement are intensive, including the details of judgments, methodologies, and related issues.

Accountancy is not a subject of mathematical precision.  Estimates and judgments are an integral part of the subject.  The accounting standards, no doubt, provide transparency to the market and users of financial statements.  However, our accounting standards can now cause the same asset or liability to have multiple values.  It would depend upon the estimate of numerous factors and the choice of the valuation technique according to which they are being recognised.

Valuation is as much of an art as a science and we are fully aware of that.  Beauty is in the eye of the beholder, and so is valuation.  When the market is booming, assets valued at the exit price would be an overestimation and underestimated in case of market failures.  The value of the asset would oscillate with the market oscillations.

Fair value measurements would give rise to unrealized gains once recorded through profit and loss account.  Distribution of the unrealized gains may endanger the enterprise capital and pose a challenge to the maintenance of effective monetary capital.

Another challenge to fair value accounting is intangible assets.  Internally generated intangibles are no doubt valuable.  It may be Coke’s content formula or Facebook’s business concept, but these find no representation or fair value in accountancy.

Comparability is another feature of the financial statements.  It is a riddle how diverse accounting techniques, measurement methodologies, and varied accounting policies on fair valuation can result in truly comparative statements.

Every organization needs to sensitize their personnel on the impact that fair valuation would bring to the look and interpretation of their financial statement.  Even though the first challenge seems to be to have the computational framework ready, the real challenge will emerge once the first set of accounts is ready and its impact starts percolating down the profit and loss account of subsequent years.  Though alarming, fair valuation may not be fair to all entities.

Veena Hingarh is a Professor and Director in South Asian Management Technologies Foundation, a National State Board of Accountancy (NASBA) accredited training and research foundation. She is a professional corporate trainer in the area of finance and information system audit, and has rendered her sessions in India, South Africa, Dubai, Kuwait, Mauritius, Maldives, Bangladesh, Bahrain, Thailand, Sri Lanka, Malaysia, Indonesia, Philippines, etc. She also conducts the executive programs in Dubai affiliated to George Washington University, USA. She has been a consultant on World Bank Projects and to banks and corporates providing her services on IFRS, risk management, and information system audit. Prof. Hingarh can be contacted at: vhingarh@vsnl.net; or +919831090463.