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Total Number of Subscribers: 467 |
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Date:22nd December 2008 |
Compiled by Mr. M. Sathya Kumar |
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Fair Value
Accounting Fair value accounting is a concept that has
attracted worldwide debate as to its appropriateness in financial statements.
Terms such as ‘mark to myth’ and one based on
judgmental aspects which tend to demean the very concept of prudence are
slated as arguments for the same. It is also true that most of the criticism
comes from the ‘old guard’ who have always
believed that historical cost is one of the most verifiable concepts in
accounting. The fact is that the world has moved on and fair valuation is a
measure by itself. The accounting profession needs to wake up to this reality
and take necessary steps to make sure fair valuation (now a big element of
the ‘true and fair’ opinion) is
well understood. Our profession needs to be well equipped to make
sure we use it appropriately and not expose it to abuse the way it is feared
to be. The issue is : what is Prudence.
‘Prudence is the inclusion of a degree of caution in the exercise of the
judgments needed in making the estimates required under conditions of uncertainty,
such that assets or income are not overstated and liabilities or expenses are
not understated. However, it completely ignores assets or liabilities that
expose an entity to market-related risks. The issue is : Is that
prudent ? Especially in today’s times when in free
markets, entities are exposed to market risk (intentional or unintentional). Fair value accounting envisages accounting
for unrealised gain to reflect a ‘true and fair’
view of the state of affairs.Fair valuation has brought to the notice of an
investor the true profits in companies like Enron, WorldCom and Waste
Management in the past and a host of financial services companies in the
current credit market meltdown. This is mainly because over the years, the
masters of business have been under acute pressure to show results and the
masters of finance have helped them achieve it at any cost. This has led to
the use of financial and other instruments in our financial statements,
making fair valuation a very important aspect of today’s financial statements. Also, the use of derivative instruments has
been genuinely necessitated as we globalise businesses and as countries open
up to free trade. Let’s now examine
what are the flaws with fair value accounting. The biggest issue to fair
value is that of illiquidity and its related concern that in both boom
and bust time market values are not real. Firstly, India does not have any
traded benchmarks except government securities, and secondly,
over-the-counter products are very difficult to measure. Accordingly, we
prefer not to record any perceived market losses unless we believe they are
permanent. Gains are a complete no unless realised. Unfortunately we judge
losses with the same parameters as we assess gains, but only record the
former should the diminution be permanent. How fair is that from a ‘true and fair’ perspective ? The reality is that companies have certain
investments of a permanent nature (HTM held to maturity) and some of a
trading nature (short-term investments or positions taken which do not
actually hedge any underlying transaction). The former is normally
treated as a long-term asset where values would be realised over the period
to maturity with any diminution being recorded should there be a perceived
risk. The trading assets and derivates which do not necessarily hedge
an underlying transaction are effectively hexposures to market risk and
hence, are not intended to be held to maturity. Accordingly, these should be
marked to market at any accounting period to bring into the results and
perceived gain or loss from the asset. The fact that such gain is permanent
or temporary is not of concern. The financial statements should reflect the
results of the market risk position taken by an entity. Our legacy accounting
principles completely ignore this concept, as these did not exist in India
until the recent past when our economy opened up as part of our reforms. Another example where we completely ignore
fair valuation is in while recording debt with equity conversion features.
We seem to completely ignore the optionality to convert in financial
statements today. And the only way to record these is through fair valuation.
Take FCCBs for instance. Our corporates have been recording the FCCB as if
the conversion is not an option but a definite event. In the present
situation where stock prices have fallen and conversions are unlikely to
happen, companies are faced with cash redemptions and huge back-ended
interest costs. Fair value accounting would have valued the options at fair
value and treated the balance as a debt. The option value would tend to
become zero near redemption should conversion price and market price of stock
converge. This would ensure an equitable profit or loss and the optionality
clearly being recorded on the balance sheet. Our traditional cost system
records the consequence of conversion as an unlikely contingent event which
ends being ignored by investors and analysts alike. A key understanding that most accountants,
bankers and CFOs alike tend to get confused with is the difference between
hedging and hedge accounting. This is where most transactions get confused as
hedges and hence are not fair valued. Hedging is a dynamic measure where a
decision-maker consciously performs a correlation exercise to identify how an
underlying market risk can be hedged. Hedge accounting is a measurable
principle which provides guidelines as to when a derivative instrument can be
regarded as a hedge to an underlying. For example, if someone sees a
correlation between the price of apples and the price of oil, he could
effectively buy oil futures to hedge against moving apple prices. That would
make his P&L immune should his hypothesis be correct. However, this would
not qualify for hedge accounting as it may not meet the criteria of commonality
of risks. However, if the hypothesis is true, then whether hedge accounting
is followed or not, the impact on the profit and loss account would be
similar. We also seem to have mixed issues of fair
value accounting with capital adequacy norms (especially in the financial
services sector). The issues revolve around certain companies not reflecting
pension costs in line with AS-15 or transferring of securities initially
purchased as trading to HTM. These are artificial coverages to maintain
adequate capital. However, there should be a distinction made in special
situations between regulatory and financial capital adequacy. We tend to
break or amend the financial thermometer, but do not succeed in improving the
health of the patient. Instead we make the doctor’s task more difficult as the problems do not go away through accounting
solutions. Having considered fair valuation as a bane
in most situations, India is possibly one of the few countries which allow
asset revaluations which completely goes against the historical cost concept
or prudence and is a way to fair valuation of assets provided the increase
is of a permanent nature (which only restates balance sheets at replacement
costs, a completely un-verifiable proposition). However, as this is an
age-old practice we continue it. While it is easy to point the faults
inherent in fair value accounting, it is less easy to identify an alternative
method which would better fulfil the features of relevance, reliability,
comparability and understandability. Reference to historical prices would
provide less comparable and much less relevant information given that the
company itself views the underlyings at fair value (e.g., options).
Illiquid financial instruments are a challenge, but even there the idea of
reducing the scope of fair value has not resulted in credible options. An
alternative is to ‘mark to model’. Models have been widely
used and may aid transparency if backed by detailed disclosures about
underlying instruments and mark to model assumptions. Another issue debated is the relevance of
fair valuation in the present markets. Should assets be marked down to
reflect losses as these are not the values at which companies may sell ?
My own argument is that if a company sold its assets at the balance-sheet date,
fair value is what it would receive for the assets, regardless of whether
such values are artificially low in current markets. Irrespective of the
company’s intention to hold this until markets improve, the lack of
liquidity in current markets can, and has, forced companies to sell assets at
these ‘artificially’ low values. In the current market situation, any
accounting which fails to highlight liquidity risk in the way that fair value
accounting does, would fail to capture the risk appropriately. Fair value
accounting reflects the reality that investors are faced with as far as
trading assets are concerned. In the final analyses, fair value accounting
as prescribed internationally and in AS-30 can best be described in the same
breath as Churchill’s portrayal of democracy, "It’s the worst system with the exception of all others". Though
there is a lot of judgment involved and there is enough potential to abuse it
especially in an illiquid environment, there is a lack of any other credible
alternative. Though there is a need to have a vigorous debate around fair
value, the fact remains that as a profession we need to clearly understand
the concept and see how we could challenge the interpretations taken by our
industry and banking colleagues. Article by Abizer Diwanji Chartered Accountant |
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