The Hindu Business Line : Fair value accounting is fair

The International Accounting Standards Board (IASB) has given significant importance to fair valuation in the International Financial Reporting Standards (IFRS). Many IFRS standards require the use of fair valuation principles for recognition, measurement and disclosure. 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.

What’s fair value?

Certainly, to those who say that accounting should better reflect true economic substance, fair value, rather than historical cost, would generally seem to be the better measure. 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.

On the other hand, revenues, expenses, gains and losses are accounting constructs. Therefore most believe the starting point has to be assets and liabilities and the income statement should reflect movement in those assets and liabilities.

Fair value measure is to be preferred to the hundreds of rules underlying historical cost income. If we have to take control of the reported numbers out of the hands of corporate management, we do it by requiring that the reported numbers for assets and liabilities, to be reported on fair value basis.

Measurement problem

Whilst no one disputes the relevance of fair valuation over historical cost, the problem really starts when one has to measure fair value. For many financial assets and liabilities and some non-financial assets (for example, investment property), fair valuation may not be an extremely subjective or difficult exercise. However, for illiquid assets or liabilities, it may be necessary to use a model to derive the value.

The reliability of fair value estimates using models is dependent not only on how well a model replicates accepted market pricing processes, but also on the reliability of its data inputs. A fair value model should be based on inputs and assumptions that marketplace participants would use.

To cite an example, data inputs required by accepted stock option pricing models include 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 some of these inputs can be readily observed. For example, the risk-free interest rate can be derived from the observable prices 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, such as 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 current market expectations of future volatility. The dangers of using calculated, hypothetical, non-market based fair values was well illustrated in an exercise conducted by Ernst & Young. As per this exercise, by making changes to the input variables (but all within the allowable parameter of IFRS 2), option expense as a percentage of reported income could vary as much as 40-155.

Subjective, at times

Though fair valuation is at times subjective and displays a degree of potential unreliability to the values, they are still very useful to decision-making because they represent the economic reality as opposed to an accounting ‘fiction’ in the form of historical cost. Using fair values for decision-making, therefore, remains relatively difficult, but probably less difficult compared to the historical model. Giving up on fair valuation and going back to historical cost would certainly be a retrograde step.

One way of addressing the lack of reliability in cases where there is no market or other observable inputs, is to make valuation systems and processes more robust. Specificity and clarity on fair valuation techniques (either by IASB or other organisations like IVSC) will definitely help in churning out more reliable valuation numbers.

Another alternative is limiting the application of the fair value model to those assets and liabilities that have real or determinable market values, based on observable inputs. Where reliable fair values are not readily available, ranges of possible fair values (together with assumptions and sensitivity analyses) could be provided in the form of note disclosure.

A point to be noted is that users need financial statements that have predictive value in terms of providing a sound basis for decision-making, which is a quite different matter from supplying users with financial statements that give the impression that they are themselves predictions.

Unfortunately, IASB has so far chosen not to follow this path and neither has it considered it seriously.

(The author is Partner, Ernst & Young Pvt. Ltd. The views are personal.)

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