Use of fair value accounting

K.S. Welivita

Although fair value accounting has been a part of generally accepted accounting principles (GAAP) since early 1990s, the use of fair value measurements has increased steadily over the past decade, primarily in response to investor demand for relevant and timely financial statements that will aid in making better informed decisions.

Fair value accounting (also known as mark-to-market accounting) is a financial reporting approach in which companies are required to measure and report on an on going basis certain assets and liabilities (generally financial instruments) at estimates of the prices they would receive if they were to sell the assets or would pay if they were to be relieved of the liabilities.

Accounting

Under fair value accounting, companies report losses when the fair values of their assets decrease or liabilities increase. Those losses reduce companies’ reported equity and may also reduce companies reported net profit. International Accounting Standards Board (IASB) defines fair value as “the amount for which an asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged, between knowledgeable, willing parties in an arm’s length transaction”.

Fair value accounting is not limited to financial assets or financial businesses. It can apply to any business, and with respect to a wide variety of assets, liabilities and activities. Accountants presently use a wide array of accrual and deferral methods in preparing financial statements. Those methods are essentially mathematical calculation even to a minute cent to get the precision. Nevertheless, Accountants who continue to seek more precision are to be admired and encouraged.

The goal of fair value measurement is for firms to estimate as best as possible the prices at which the positions they currently hold would change hands in orderly transactions based on current information and conditions. To meet this goal, firms must fully incorporate current information about future cash flows and current risk-adjusted discount rates in to their fair value measurements. The rationale for this requirement is market price should reflect all publicly available information about future cash flows, including investors’ private information that is revealed through their trading as well as current risk-adjusted discount rates. When fair values are estimated using unadjusted or adjusted market prices, they are referred to as mark-to-market values. If market prices for the same or similar positions are not available, then firms must estimate fair values using valuation models. When fair values are estimated using valuation models, they are referred to as mark-to-model values.

The main issue with fair value accounting is whether firms can and do estimates fair value accurately and without discretion. When identical positions trade in liquid markets that provide unadjusted mark-to-market values, fair value generally is the most accurate and least discretionary possible measurement attribute, although even liquid markets get values wrong on occasion. Fair values typically are less accurate and more discretionary when they are either adjusted mark-to-market values or mark-to-model values. In adjusting market-to-market values, firms may have to make adjustments for market illiquidity or for the dissimilarity of the position being fair valued from the position for which the market price is observed. These adjustments can be large and judgmental in some circumstances.

Valuation

In estimating mark-to-model values, firms typically have choice about which valuation models to use and about which inputs to use in applying the chosen models. All valuation models are limited, and different model capture the value-relevant aspects of positions differently. Firms often must apply valuation models using inputs derived from historical data that predict future cash flows or correspond to risk-adjusted discount rates imperfectly. The period’s firms chosen to analyze historical data to determine these inputs can have very significant effects on their mark-to-model values.

In principle, fair value accounting should be the best possible measurement attribute for including firms’ management to make voluntary disclosure and for making investors aware of the critical questions to ask managements. When firms report unrealized gains and losses, their management are motivated to explain in the Management Discussion and Analysis sections of financial reports and elsewhere what went right or wrong during the period and the nature of any fair value measurement issues. If a firm’s management does not adequately explain their unrealized gains and losses, then investors at least are aware that value-relevant events occurred during the financial period and can prod management to explain further.

Some financial institutions believe that fair value accounting forces them to write down certain financial assets to a level below the value they expect to recover in the long term. Further, they assert that these write-downs compel them to curtail lending activities, preserving capital solely to meet certain regulatory requirements.

Other stakeholders, including investors and auditors, believe that properly applied fair value accounting provides the most transparent picture of the relative financial condition of an organization. This level of transparency enables investors to compare more effectively similarly situated organizations.

Stock Exchange

To increase consistency and comparability in fair value measurements and related disclosures, IASB establishes a fair value hierarchy for assets or liabilities that prioritizes the inputs, or assumptions, used in valuation techniques. Level 1 input are unadjusted quoted market prices in active markets for identical items, such as quoted company shares that trades on the Colombo Stock Exchange.

Market

Mark-to-market financial instruments are relatively easy if they are actively traded in liquid markets. The problem becomes more complicated if active markets do not exist. Particularly if a financial instrument does a compound instrument comprise several embedded option like features, values for which depend on inter-related default and price risk characteristics. Moreover, in the absence of active liquid markets, fair value is not well defined in the sense that an instrument’s acquisition price, selling price, and value-in-use to the entity can differ from each other.

Fair values may be used as an analytic tool in the lending process and are compared with historical cost values. This historical cost information, along with associate disclosures, contains reliable information that provides insights into a firm’s cash flows.

Under the generally accepted accounting principles, credit derivatives are generally required to recognize as an asset or liability and measured at fair value, and gain or loss resulting from the change in fair value must be recorded in earnings. Most credit derivatives do not qualify for hedge accounting treatment, which would permit the gain or loss on the credit derivatives to be reported in the same period as the gain or loss on the position being hedge, assuming hedge is effective. Therefore, the use of credit derivatives can result in earnings volatility. It is also important to consider that the tax laws governing purchase price allocations in taxable business acquisitions or in certain asset exchanges may not follow applicable book principles. There may be different valuation approaches or models that are permitted under tax laws.

The alternative to fair value accounting generally is some form of amortized cost accounting. In its pure form, amortized cost uses historical information about future cash flows and risk-adjusted discount rates from the inception of positions to account for them throughout their lives on firms’ balance sheets and income statements.

Gains And Losses

Unlike under fair value accounting, unrealized gains and losses are ignored until they realized through the disposal or impairment in value, of positions or the passage of time. When firms dispose of positions, they record the cumulative unrealized gains and losses that have developed since the inception or prior impairment of positions on their income statements.

The fair value regime represents an evolving accounting system which has now permeated the regulatory environment and made its way into social landscape. With the globalization of capital markets and advent of complex financial instruments in use today, it has become apparent that fair values of assets and liabilities are of greater interest to investors than their historical costs.