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Chapter 2:55 of the Bhagvad Gita introduces the concept of Stitha-prajna — the ideal human being who can do no wrong and is fair in all situations. When enunciated, the concept of Fair Value (FV) was touted to be the equivalent of Stitha- Prajna for accounting.
The collapse of Lehmann Brothers and its collateral impact on the global economic environment forced regulators to take a hard look at the concept. While the yes-men advocated the concept stating that one cannot manage what one cannot measure, the nay-sayers ridiculed the concept stating that one measurement cannot fit all. After working with the Financial Accounting Standards Board (FASB) in the US, the International Accounting Standards Board (IASB) has finally come out with an Accounting Standard IFRS-13 on Fair Value Measurements the effects of which are slated to reflect on financial statements prepared on or after January 1, 2013.
From project to culmination stage, IFRS 13 has taken about five and a half years. Retaining the essence of FV, the standard defines it to mean 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.
Three levels
Similar to the erstwhile US GAAP standard on FV SFAS 157, IFRS 13 creates three levels of hierarchy for FV. Level 1 inputs are quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date. There are very limited circumstances when one can make adjustments to the quoted market price. The all-encompassing nature of a quoted market price is evident when IFRS 13 mandates using this price even if there is a single asset/liability and the market's normal daily trading volume is not sufficient to absorb the quantity held and placing orders to sell the position in a single transaction might affect the quoted price.
Investments in unlisted and thereby unquoted entities would fall under Level 2 which are inputs other than quoted market prices included that are observable for the asset or liability, either directly or indirectly and are typified by quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active or non-quoted prices such as interest rates and credit spreads.
If the Level-2 test fails due to lack of comparable companies, the residuary Level-3 category would apply which are unobservable inputs for the asset or liability. Unobservable inputs are used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. Once the input levels are frozen, the standard recommends three valuation methods — the market approach which uses prices and other relevant information generated by market transactions involving identical or comparable assets, liabilities, or a group of assets and liabilities; the income approach which discounts future amounts to arrive at a single current amount; or the cost approach wherein the amount that would be required currently to replace the service capacity of an asset would be considered. As expected from any IFRS standard, a host of disclosures are warranted.
Issues
The standard has not set the accounting world on fire due to the existence of a look-alike under US GAAP. As any standard on FV has to be fair to both sides of the balance sheet, IFRS 13 permits the measurement of liabilities at FV which includes non-performance risk, including credit risk. It is expected that the earlier guidance of the IASB to present credit risk in the guarded other comprehensive income category would continue to prevent entities from presenting credit defaults to be shown as normal income. Level 2 and 3 inputs would depend on the judgement of and data with the management. It would probably be a good practice to share this with the auditor and obtain his prior approval to avoid audit alarms later. IFRS 13 attempts to alleviate concerns of the shareholders by exhorting exhaustive disclosures on the inputs, methods and assumptions on FV. The true impact of IFRS-13 would be known once the medium-sized entities move over to the standard as the large ones could have the cushion to bear any adverse impacts.
(The author is a Bnagalore-based chartered accountant.)
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