Fair value accounting: is it fair?
6th February, 2008
Fair value accounting: is it fair?When two academics from each side of the Atlantic publicly criticised fair value accounting as a “bubble-blowing accounting model� – accusing it of contributing to last year’s market crash and credit crunch – the debate about its value and also its fairness entered the public domain.
Stella Fearnley, from Bournemouth University, UK, and Shyam Sunder, from the Yale School of Management, US, said that the model is “built on sand�.
“Instead of informing markets through prudent valuation and controlling management excess, ‘fair’ values feed the prices back to the markets,� the academics wrote in the UK’s influential Financial Times newspaper.
“For example, a drop in the market value of the borrowings of a troubled company is reported as an increase in its income because the reduced liability flows through the income statement, thus obscuring the problem.�
The system needs a rethink, said the academics. But are they being fair?
Fair value definition
‘Fair value’ has been used in accounting standards for nearly two decades. Some advocates regard it as the ideal basis for measurement in financial reporting.
Definitions vary but, in substance, it is the same as market value – an estimate of the price a company would realise if it were to sell an asset, or the price it would pay to relieve a liability.
The term’s most common use is in acquisition accounting, where separable assets and liabilities are measured at fair value at the date of the acquisition. Effectively, it is a proxy for historical cost (original price paid or received). If, for example, a company decides to hold a bond to maturity, the bond can be shown at its original cost.
But fair value is also used as a form of current value measurement. In this case, if that same company buys another identical bond that it intends to sell soon, that bond can also be accounted for at fair value. Financial instruments, such as shares traded on an exchange, debt securities, and derivatives, are assessed in this way.
Companies also measure internal processes at fair value, such as making investing and trading decisions; managing and measuring risks; determining how much capital to devote to various lines of business; and calculating compensation.
Determining fair value
The process of valuing a financial instrument to its fair value depends on how easy it is to determine a price for that instrument. Because fair value is the price at which a willing buyer and seller agree to trade, finding the right price is the key to valuation.
In its simplest form, a company can find the price or value of an instrument in a newspaper or other quotation system. These prices typically reflect the last price reported to the secondary market. This usually works well because listed prices are generally available – but not for all financial instruments. In those cases, an auditor is required to determine fair value.
Auditors use valuation models to measure fair value that take into account various data, such as current economic forecasts, general market conditions, the price of similar financial instruments, etc. Auditors rely primarily on judgment only for the most complex instruments where market parameters and prices do not exist.
Measuring things at fair value is straightforward where there is an active market for them, but for most items in accounts there is often not an active market. So fair value is measured in various ways, including:
n Market value
n Replacement cost
n Depreciated replacement cost
n The lower of replacement cost and
net realisable value
n Market price adjusted if necessary for
unusual price fluctuations or for the size
of the holding
n By reference to market prices
n By discounting to present value.
International accounting standards state: “The best evidence of fair value is quoted prices in an active market. If the market for a financial instrument is not active, an entity establishes fair value by using a valuation technique…
“Valuation techniques include using recent arm’s length market transactions between knowledgeable, willing parties, if available; reference to the current fair value of another instrument that is substantially the same; discounted cash flow analysis; and option pricing models.�
Ensuring accuracy
Although judgment is involved in the fair valuation process, most companies need a robust internal control process for ensuring valuations are reasonable and consistent, points out Bill Charlton, UHY Haines Norton in Brisbane, Australia, one of UHY’s international specialists on valuation.
“Management review and oversight are key to ensuring accuracy,� he says. “Company directors must always subject valuation models to independent review as part of the internal control process to ensure that they reflect underlying market conditions; moreover, they must not be changed without appropriate approvals.�
In addition, estimates generated by the models are compared to actual trades to determine the reasonableness of the estimates, says Charlton. Companies also employ other means of independent verification, such as comparing estimates to the value of the instrument at termination.
Regardless of whether financial instruments are reported at fair value on the face of a firm’s balance sheet, financial statement footnotes provide details about the fair values of all financial instruments.
Fair value provides important information about financial assets and liabilities compared with values based on only their historical cost, says Charlton. Because fair value reflects current market conditions, it provides a comparison of the value of financial instruments bought at different times. In addition, financial disclosures that use fair value provide investors with insight into prevailing market values, further helping to ensure the usefulness of financial reports.
“However, without proper controls, the fair value, market regime provides company directors and others with the ability to overstate unrealised profits and understate unrealised losses,� says Charlton. “ That is what I consider to be the most important issue.�
Prospects for change
Using fair value as a proxy for historical cost can involve severe practical problems – both for preparers in arriving at reasonable measurements and for auditors in confirming that they are reasonable, says the Institute of Chartered Accountants (ICAEW) in the UK.
“But this use of fair value is relatively uncontroversial,� it says. “The real controversy arises over the increasing use of fair value as a measurement of current value, and it is primarily as a measure of current value that some wish to see it used more generally.�
Advocates of change argue that historical cost information is out of date and therefore necessarily irrelevant to any practical decision.
They also point to the degree of judgement involved in many historical cost measurements, which they regard as involving an unacceptable level of subjectivity.
Where fair values reflect active market prices, however, they embody the best available measure of the present value of risk-adjusted cashflows that the assets in question are likely to generate.
But there is also a case against fair value:
n A major practical problem is the lack of active markets for most assets and liabilities. This means that most fair value measurements are estimates. They are at least as subjective as historical cost measurements and, some would say, a lot more so.
n Assets in businesses generate cash flows jointly, not separately, so it is questionable just how useful information on the current values of individual assets will be in predicting the cashflows of a business as a whole.
n Fair value information can be costly. Even if it is worth obtaining for large listed companies whose accounts are pored over by armies of analysts, this does not necessarily mean that it is worth the money for privately owned companies.
n Recognising profits based on fair values means that unrealised profits are recognised. Some would doubt the prudence of this for the purposes of either dividend decisions or calculations of management bonuses, as well as its fairness for taxation.
The ICAEW’s position is a practical one. It says it does not have an ideological commitment to any single basis of measurement that it believes should be applied universally. Each basis has its uses, and fair value seems to be appropriate for many financial instruments.
But there are also many circumstances in which historical cost seems to work well, it says. For example, the International Accounting Standards Board (IASB) issued a discussion paper, Measurement Bases for Financial Accounting – Measurement on Initial Recognition, which proposed that assets and liabilities should preferably be measured at fair value on initial recognition.
The issue over fair value accounting is likely to arise in the context of the IASB’s work with the US Financial Accounting Standards Board as they converge international accounting standards and prepare a joint conceptual framework.
That framework will cover the question of measurement – and, say analysts, may well prepare the way for more extensive use of fair value that is both fair and valuable.
Contact: Bill Charlton
Email: w.charlton@uhyhn.com.au
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