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May 1, 2010
The use of fair value measurement in International Financial Reporting Standards (IFRS) is much higher than compared to that in Indian GAAP. However, it is a myth IFRS requires all assets and liabilities to be measured at fair value. For example, IFRS provides an option to an entity to use either the cost model or the revaluation model to measure fixed assets (property, plant and equipment (PPE) and intangible assets) subsequent to initial recognition.
An entity that selects the revaluation model measures items of fixed asset at fair value. Therefore, it is not mandatory for an entity to carry fixed assets at fair value. An entity may use cost model for one class of fixed assets (e.g. plant and equipment) and revaluation model for another class of fixed assets (e.g. land). Under IFRS the principle for valuation of inventories is the same as that in Indian GAAP. Inventories are valued at lower of cost or net realizable value (NRV).
IFRS uses fair value model for initial measurement of financial assets and financial liabilities. Subsequently, equity instruments and derivatives are measured at fair value. Loan and advances and debt instruments which the entity intends to hold till maturity are measured at amortized cost and not at fair value. Fair value is also used to record assets (including fixed assets) and liabilities acquired in a business combination. Fair value of those assets is considered the acquisition cost.
Fair value is an important and difficult concept in accounting. Determination of fair value involves judgement. IFRS defines fair value as “The amount for which an asset could be exchanged, or liability settled, or an equity instrument granted, could be exchanged, between knowledgeable, willing parties on an arm’s length transaction”. SFAS 157 (US GAAP) defines fair value as “Fair value is 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.” Although languages are different, in spirit both definitions are same. SFAS 157 provides detailed guidance on the measurement of fair value.
The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Thus fair value accounting is not the same as ‘mark-to-market’ accounting. In certain situations, for example, in the case of securities issued by a closely-held company, market value may not be available but fair value can be estimated. In certain circumstances, market value does not represent the fair value.
Fair value accounting should be viewed ‘mark-to-model’ accounting rather than ‘mark-to-market’ accounting. In estimating fair value entity uses ‘observable’ inputs, that is, assumptions based on market data from sources independent of the reporting entity. It also uses ‘unobservable’ inputs. Unobservable inputs are inputs that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances.
SFAS 157 provides a hierarchy of inputs being used to determine the fair value. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Examples of Level 2 inputs are quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active.
An active market for the asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. Examples of active market are the capital market and the commodity exchange. A quoted price in an active market provides the most reliable evidence of fair value and should be used to measure fair value whenever available. A fair value measurement assumes the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, in the most advantageous market for the asset or liability.
Suppose a company (say A) holds equity shares issued by its vendor (say B), which supplies critical components. The balance sheet date of A is March 31. Assume that the last transaction in the equity shares of B on March 30. Assume that the closing price on March 30 was Rs 80.
Does the price of Rs 80 per share represent the fair value as on March 31? If the price is determined in an orderly transaction (that is, in a normal business activity) in an active market and no significant event has occurred after the market closed on March 30, the price of Rs 80 represent the fair value as March 31. If a significant event (e.g. cancellation of a long term contract by a large global customer of B) occurred after the close of the market, the price should be adjusted to determine the fair value.
Price quoted in an active market does not represent fair value if the volume and level of activity have decrease significantly and there is no orderly transaction for the asset or liability. Therefore, if the volume and level of transaction for the shares of B have decreased significantly and the transaction is not an orderly transaction the share price of Rs 80 does not represent fair value.
On April 9, 2009 FASB has issued a Staff Position (FSP FAS 157-4) which provides additional guidance on how to determine whether there has been a significant decrease in volume and level of transactions for a particular asset or liability. The Staff Position stipulates that if the reporting entity concludes that there has been significant decrease in the volume and level of activity, significant adjustments to the quoted price might be required to determine the fair value.
For example, when the volume and level of activities in mortgage-backed securities decreased significantly due to sub-prime crisis, the market price failed to reflect the fair value. The FASB Staff Position provides significant flexibility to reporting entities to significantly adjust the market price in those situations. Some may criticise it, but I think the rule is appropriate. But it puts significant responsibility on the auditor to ensure the adjustment is reasonable.
Market price may deviate from the fair value due to speculation even if the volume and activity level have not been decreased. The FASB Staff Position does not cover this case, perhaps rightly so because it is difficult to objectively identify such deviations without the benefit of hind sight.