FAIR VALUE ACCOUNTING

2011-03-19T21:52:00.000-07:00

What is Fair Value?

In common parlance, Fair Value is the price at which an asset can be exchanged between two knowledgeable parties in an arm’s length transaction.

However, the Statement of Financial Accounting Standards issued by Financial Accounting Standards Board 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. It is not the price that would be paid to acquire an asset or received to assume the liability. The basic assumption of Fair value is that the firm has sufficient time to market the asset; it should not be estimated in a force liquidation or distress sale.

Why Fair Value Accounting? It will be much better to answer this question with an example. Suppose, Mr.X has purchased a building worth Rs. 2, 20,000 one year ago and he has to pay Rs.2, 60,000 to purchase an equivalent size of Building now. But using his special marketing skills he can sell the building for Rs. 3, 10,000 less Rs. 20,000 in various fees to finalize the sale. Let us assume the building is 13000 square feet and Rs.20 per square foot. Now, at what amount should the building be recorded? Now, we will analyze 4 options: a) Historical Cost: (Rs. 2, 20,000) this can be easily defined as the amount paid to acquire an asset adjusted for Depreciation and it is also very reliable. But if this is considered as the perfect method, then why the concept of Impairment arise? b) Replacement Cost: (Rs. 2, 60,000) is the amount that would have to be paid to acquire the same or an equivalent asset. This reflects the general rise in price; it might also include the influence of the parties involved.

c) Net Realizable value: ( Rs. 2,90,000) amount of cash into which an asset is expected to be converted in due course of business less direct costs, if any, necessary to make that conversion. It includes a profit element and as stated Mr.X’s special skill to sell the building at an increased price.

d) Fair Value: (Rs. 2, 60,000) It includes a profit element without any influence of the parties involved and it is also a hypothetical arms’ length price.

Difference between Fair Value and Fair Market Value: Many people believe that Fair value and Fair market value is same, At this juncture, i would like to highlight the difference between both;

Fair value of an asset is determined by using mathematical models in the finance theory. The fair value determined through these models can be substantially different from the fair market value of the same asset in certain cases. The fair market value is determined by the market forces and the demand and supply for a certain product or service. The inputs to the estimation of the fair value should be appropriately measured to arrive at the correct fair value for any asset. Analysts believe that assets will trade at their fair values in the long term and the fair market value may deviate from the fair value because of market anomalies. Market anomalies include financial barriers, mispricing or improper market expectations.

So, Here comes the next question, how to determine the Fair Value?

At least in theory all assets and liabilities should have a fair value, although it is not easy to determine them. Let us start from the idea that the best estimate of the Fair value is the Market price of the asset or liability, but this price does not exist for all items and even if it exits, it may not be reliable.

· When a published price in an active market exists, it should be used to value the financial asset or liability. A financial instrument is deemed to be quoted on an active market if the listed prices are easily and regularly available.

· If not, the fair value should be determined using a valuation technique incorporating all the factors that participants in the market would consider when establishing the price and which is consistent with accepted economic methods used to set the prices of financial instruments.

According to circular 4/2004, which has set out the criteria to determine fair value. These rules are:

· First of all, reliable values from active markets should be applied

· Failing this, valuation mechanisms should be used

· If neither of the above can be used, presumed value or objective criteria should be applied

The above said circular also states, a market is active when:

· The assets traded are uniform

· Buyers and sellers willing to trade the assets can be found at almost any time.

· Prices are public.

Valuation Techniques and Models:

Estimating fair value using valuation techniques and models aim to determine the price of a transaction for the measurement date in an arm’s length exchange between knowledgeable and willing parties. The application of valuation techniques and models necessarily implies the use of the directors 'judgment, which means it entails a certain degree of subjectivity. For this reason, the regulations establish a series of criteria in order to maximize the information from the market (to make maximum use of market inputs):

1. First of all, if the prices of the most recent market transactions between willing and duly informed parties acting independently are available, they should be used, provided there has not been a significant change in the economic conditions since the time of the transaction. If the economic conditions have changed (for example, a change in the risk-free interest rate), this price should be adjusted so that the fair view reflects this change. Similarly, the price of the most recent transaction should be adjusted if the institution can demonstrate that it is not the fair value (for example, because it is the result of a forced transaction, involuntary liquidation or urgent sale).

2. If the foregoing information is not available, references to the fair value of another, substantially similar, financial instrument should be used.

3. Valuation techniques and models (discounted cash flows, option pricing models such as Black-Scholes, etc.) will be used when the information enumerated above is not available. It is considered that a valuation technique offers a realistic estimate if the variables used are a reasonable representation of the expectations of market agents about this financial instrument and the risk/return factors inherent in it have been taken into account.

Characteristics of valuation techniques:

(I) The techniques used to estimate fair value must be appropriate and consistent with economic methodologies and financial theory. They must incorporate observable market data and any other factors that participants in the market would take into account when estimating the fair value of the financial instrument concerned.

(II) If a valuation technique is in common use by market participants, and it has been demonstrated to give reliable and more realistic estimates of the prices obtained in recent market transactions, this technique should be used.

(III) The valuation technique must maximize the use of market inputs and limit as far as possible the use of own estimates and non-observable data.

(IV) The choice of a valuation method or technique implies an exercise of judgment by the directors when deciding the fundamental principles and underlying theoretical assumptions.

For this reason, the regulations require that there be a wide range of documentation available on the chosen valuation method and that the reasons for choosing one alternative rather than the others be reported where appropriate.

(V) Once a particular valuation technique or model has been chosen, this should be used over time, unless there are changes to the assumptions that led to its being chosen. It needs to be borne in mind that the valuation technique may be modified if this would result in a more reliable estimate of fair value, such as, for example, if a new technique or an improvement in an existing technique has been developed. In such cases, these variations will be treated as changes in the estimates and applied prospectively.

(VI) The valuation technique must be reviewed periodically to confirm its validity.

(VII) The use of any valuation technique or model implies a risk known as "model risk". This risk covers the possibility that the chosen technique or model is incorrect, that it is based on erroneous assumptions or does not adequately reflect normal market behavior. This risk always exists as there is no model or technique that is a perfect substitute for a market transaction.

The estimated fair value of a financial instrument will be based on one or more of the following factors:

1. The time value of money. On analyzing the discounted expected cash flows the observable risk free interest rate will be used for the period in which it is expected that each flow be produced. It is usually possible to deduce this interest rate from observable public debt prices. However, in most emerging countries, public debt is not free of credit risk. Therefore in these cases it may be more appropriate to use rates of interest on private fixed income securities, provided they are issued in the same currency and are traded on highly liquid markets between counterparties with good credit quality.

2. Credit risk. The effect of credit risk on fair value is shown in the premium on the risk-free interest rate. This may be inferred from the observable market prices of negotiable instruments with different credit qualities, or from observable interest rates applied by lenders to borrowers with different credit ratings. If there is insufficient information to determine the level of credit risk the market participants would consider when setting the price of the financial instrument, in the absence of evidence to the contrary, there have been no variations in the credit risk differential compared to that existing on the date of registration. Notwithstanding the foregoing, it is to be expected that the institution will make reasonable efforts to determine if there is any evidence of a change in these factors. When such evidence exists, the institution will consider the effects of the change when calculating the fair value of the financial instrument.

3. Foreign currency exchange prices for transactions in different currencies.

4. Commodity prices (for example, in the case of derivatives on commodities).

5. Equity prices. For unlisted instruments, the fair value may be estimated from valuation techniques (ratio-based models, updating of free cash flows, multiple price approach, etc.)

6. Volatility. This may be estimated from historical market data, or using volatilities implicit in current market prices.

7. Liquidity, understood as the ease with which transactions involving particular financial instrument may be undertaken. For instruments listed on relatively inactive markets, liquidity is estimated depending on the time necessary to perform the transaction without a significant variation in prices occurring; for unlisted instruments, liquidity may be estimated in relation to the unique

Characteristics of the instrument (necessary size of the transaction, etc.)

8. Risk of early cancellation (prepayment risk and surrender risk and risk of redemption). The estimate of the coincidence or not between the real maturity and contractual maturity may be estimated using historical data. On this point it should be noted that in any case, the fair value of the financial liabilities that may be cancelled on sight may not be less than the present value of amount that may be demanded calculated from the date on which its repayment may be demanded.

9. Servicing costs. These costs may be estimated from the commissions required by other market participants.

INFORMATION DISCLOSURE REQUIREMENTS:

As regards fair value, the management's responsibility mainly takes the form of informing users of financial statements of the hypotheses adopted and assumptions made when they value financial instruments and the fair value of those financial instruments valued at cost in financial statements. To do so, the institution must group together all its assets and liabilities into classes and it may only offset them when their book values can be offset on the balance sheet. Additionally, information will be given on:

1. The fair value of each portfolio of financial assets and liabilities compared with its corresponding book values shown on the balance sheet. Also, the fair value of the financial assets on the various portfolios must be disclosed.

2. If the fair values of the financial instruments have been determined in whole or in part by direct reference to quoted prices published by an active market, or if on the other hand, they have been obtained using some or other valuation technique, and the percentage each of these groups represents.

3. The main methods and hypotheses adopted by the company's managers to

determine the fair values of the most significant classes of financial assets and

liabilities for which there are no observable prices on an active market (proportions of early payments, estimated rate of losses on loans, interest rates, discount rates, etc.)

4. The fair value of the financial instruments that have not been valued in the financial statements using this criterion (portfolio of investments to maturity, credit investment, etc.)

5. When different fair value could be derived, if the hypotheses used in the estimate of the fair value of the financial instruments included in the financial statements were changed, in whole or in part, then the institution must disclose the effect of possible alternatives to this fair value.

6. Investments in unlisted equity instruments or the derivatives linked to them which are valued on a historical cost basis as their fair value cannot be measure reliably.

Similarly, a description of the financial instruments should be given, with their main characteristics, book value, reasons why the fair value could not be determined reliably, and if possible, the range of values between which it is highly likely this value is located; whether the institution intends to sell or dispose of them, and the procedure for this. In the case of the sale of these instruments the book value will be indicated at the time of the sale and the amount of the profit or loss recognized, along with any information about the market for them.

7. In the case of assets that are available for sale, the amount of the profit or loss recognized in the equity during the financial year and the amount that has been withdrawn from the equity and recognised in the profit and loss account of the year must be reported.

8. The effect on the profit and loss account caused by the changes in fair value.

However, for certain financial instruments such as short-term receivables or payables no information is required about their fair value provided that their book value is a good approximation to it.

General points regarding Fair Value:

a) Although it does not say so expressly, underlying definition of fair value is the assumption that the company is a going concern. Overestimates or underestimates due to special circumstances are excluded

b) Fair value is determined for a specific date. At this moment certain information is available and particular market conditions and expectations exist which may change over time. Thus, the fair value on one date may not be appropriate for another. That is to say, the fair value at a given moment may not be a good estimator of the fair value in the future.

Advantages of Fair Value:

Fair Value V/S Historical costs which literally means relevance V/S Reliability.

Fair-value accounting provides relevant information, capable of making a difference in a decision. It is relevant because it offers:
1. Predictive Value- Fair-value is more relevant to investors and creditors as it reflects the current prices of assets, thus capturing a better exposure to the future.
2. Feedback Value- Relevant information allows the firm to conform or rethink their decisions.
3. Timeliness- Decision making is based on all the information available to investors and creditors. Fair-value accounting reports changes in value and components of that change to date, so all the information needed will be readily available, in time to make the right decision.

4. Valuing all financial instruments by their fair value will allow users of financial statements to obtain a truer and fairer view of the company's real financial situation as only fair value reflects the prevailing economic conditions and the changes in them. By contrast, historical cost-based accounting shows the conditions that existed when the transaction took place and any possible changes in the price do not appear until the asset is realized.

5. Book earnings are brought closer to financial earnings, which are considered a positive outcome for the efficient functioning of the market and for the use of accounting information in the valuation of companies.

Disadvantages of Fair Value Accounting:

1. It is notoriously less reliable. Unless an asset is exchanged in an arm's length transaction, fair value has to be based on an estimate. No matter how scientific, all methods involve judgments that can have an enormous effect on the final sum. Auditors generally are against fair value accounting because of this lack of reliability and the fear that in a company failure the value will turn out to have been unduly optimistic. Basing accounting values on historic cost means they are founded on a certain figure.
2. The second major disadvantage is that fair values can fluctuate significantly over a short time and thus produce major swings in reported results. Historical cost accounting generally produces smoother patterns of profit over time.

Conclusion: Even though Fair Value has got its own limitations, it has got enormous advantages which can’t be over sighted. For these reasons the regulations, and in particular Banco de España Circular 472004 on Financial Reporting Standards for credit institutions, encourage the use of fair value when it facilitates solid risk management, limiting its application in the case of balance sheet items for which there is no deep market and when the estimate of fair value is not sufficiently reliable. The aim is to allow institutions to manage risks correctly and avoid artificial accounting volatility in the balance sheet and profit and loss statement, with the consequent negative impact this would have for shareholders and depositors.

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FAIR VALUE ACCOUNTING