Fair Value Accounting in Turbulent Times

On 6 May 2009 a workshop titled “Fair Value Accounting in Turbulent Times: The Role of International Financial Reporting Standards and the Accounting Profession” was organised by the Phillips College and PricewaterhouseCoopers with the financial support of the Cyprus Research Promotion Foundation.

The Panel discussion during the event was co-ordinated by Professor Andreas Antoniou, Professor of Economics at Phillips College. The Panel comprised the following:

• Yiangos Charalambous, First Vice Chairman, Hellenic Capital Market Commission;
• Theodoros Philippou, General Manager of the Institute of Certified Public Accountants of Cyprus;
• Professor Constantinos Karamanis, Associate Professor of Accounting, Department of Business Administration, Athens University of Economics and Business;
• Panayiotis Vroustouris, Certified Auditor and Accountant; and
• George C Kazamias, Director, PricewaterhouseCoopers.

The workshop through presentations by the panellists and questions and answers sessions covered areas such as the current status and impact of fair value accounting, recent developments in International Financial Reporting Standards in the area, challenges in the implementation of fair value accounting and expected future developments.

Current use of fair value accounting

Currently, most financial statements contain assets and liabilities that are measured using a variety of measurement methods, depending on the nature of asset. A typical set of financial statements prepared under IFRS might include for example, assets measured using historical cost, depreciated historical cost, net realisable value, market value, calculated fair value, valuations by actuaries and measurements modified by impairment tests.

It is already the case that a substantial portion of a reporting entity’s assets are stated in the balance sheet at fair value – including investments in shares, bonds, derivatives, investment properties, tangible and intangible assets that have been acquired in a business combination, impaired or revalued assets.

The supporters of the use of fair value primarily argue that fair value is the most relevant measurement basis. That is, it provides information that is most relevant to the users of financial statements, for the purpose of assessing the financial performance and financial position of a reporting entity. However, the worsening of the credit crisis in recent months has led to significant scrutiny on the use of fair values. Some have even gone so far as to blame financial reporting for the credit crunch. Some argued for example, that the standards forced them to report huge losses. On the other hand, it is argued that fair value accounting merely reported in the financial statements the underlying economic reality. Hence, it is argued that the use of fair values based on exit prices is the appropriate valuation approach for many financial instruments.

Fair value measurement considerations under International Accounting Standard (IAS) 39

IAS 39 is a mixed measurement standard whereby measurement depends on the classification of financial assets. Depending on the classification, measurement can be either at fair value or amortised cost.

Consistent with various other standards, fair value is defined in IAS 39 as the “amount for which an asset could be exchanged, or a liability settled, between knowledgeable willing parties in an arm’s length transaction”. Underlying this definition is a presumption that the reporting entity is a going concern without any intention or need to reduce significantly the scale of operations or enter into a transaction on adverse terms. Fair value is not, therefore, the amount that would be received in a forced transaction or a distressed sale.

For the purpose of determining an asset’s fair value, IAS 39 distinguishes between two main types of instruments – those for which quoted prices in an active market exist and those for which a quoted price in an active market does not exist. IAS 39 explains that the existence of published price quotations in an active market is the best evidence of fair value and that value should be used with no adjustments.

Guidance is included explaining what the term “quoted in an active market” means: quoted prices should be readily and regularly available for example from an exchange, dealer or broker and those prices should represent actual and regularly occurring market transactions on an arms length basis.

Hence, if observed arm’s length transactions are no longer regularly occurring even if prices might be available, or if the only observed transactions are distressed sales transactions, then the market would no longer be considered to be active. What is regularly occurring is a matter of judgement to be made in the light of the particular facts and circumstances.

If an instrument is not quoted in an active market, then under the fair value measurement hierarchy of IAS 39, fair value is to be determined on the basis of valuation techniques. If there is a valuation technique that is commonly used by market participants to price an instrument, and that technique has been demonstrated to provide reliable estimates of prices obtained in actual market transactions, then that technique should be used. The overriding objective of using a valuation technique is to establish what the transaction price would have been, on the measurement date, in an arm’s length exchange motivated by normal business considerations. In other words, valuation techniques should incorporate all factors that market participants would consider in setting a particular price.

Recent developments in response to the credit crisis

In response to the financial crisis, the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) undertook several initiatives, which also have an impact on fair value accounting, including the following:

1. Setting up of a Financial Crisis Advisory Group by IASB and FASB

This is a high level advisory group which considers financial reporting issues arising from the global financial crisis. The results of the work of the Financial Crisis Advisory Group will feed into the work of related projects by the two boards. The advisory group aims to consider how improvements in financial reporting could help enhance investor confidence in financial markets. The advisory group also aims to help identify significant accounting issues that require urgent and immediate attention by the boards, as well as issues for longer-term consideration.

2. Reclassification Amendment to IAS 39

In October 2008 the IASB issued an amendment to IAS 39 “Financial Instruments: Recognition and Measurement” that permits the reclassification of some financial instruments in certain circumstances. The amendment to IAS 39 introduced the possibility of reclassifications for companies applying IFRSs, which were already permitted under US generally accepted accounting principles (GAAP) in rare circumstances. The deterioration of the world’s financial markets that occurred during the third quarter of 2008 was referred to by the IASB as a possible example of rare circumstances which justified reclassification out of the trading category.

3. Guidance by the Financial Accounting Standards Board

On 2nd April 2009 the FASB published a Staff Position, FSP FAS 157-4 (FSP) Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That are Not Orderly.

This guidance has been characterised as a relaxation of the rules for fair value accounting by allowing more freedom to use own valuation models, rather than a current market price where markets have become illiquid. The Economist in its April 11th issue commented: “On April 2nd, after a bruising encounter with Congress, America’s Financial Accounting Standards Board (FASB) rushed through rule changes. These give banks more freedom to use models to value illiquid assets and more flexibility in recognising losses on long-term assets in the income statements … European ministers demanded that the International Accounting Standards Board (IASB) do likewise. The IASB says it does not want to be “piecemeal” but the pressure to fold when it completes its overhaul of rules later this year is strong.”

4. Six month timetable announced by the IASB to replace existing financial instruments standard

On 24 April 2009 the IASB announced a detailed six-month timetable for publishing a proposal to replace its existing financial instruments standard IAS 39. As per the announcement, the IASB’s comprehensive project on financial instruments responds directly to and is consistent with the recommendations and timetable set out by the Group of 20 (G20) nations at their meeting in April 2009. G20 called for standard setters to “reduce the complexity of accounting standards for financial instruments” and to address issues arising from the financial crisis.

With regards to fair value measurement, the IASB noted that the guidance on fair value measurement issued by the FASB is consistent with existing guidance on IFRS contained in the IASB’s Expert Advisory Panel report, Measuring and disclosing the fair value of financial instruments in markets that are no longer active. Therefore, the IASB noted, a level playing field exists in this area.

Conclusion

A lot of activity is expected until the end of 2009 with regards to amendments to International Financial Reporting Standards for financial instruments and fair value accounting. These changes are happening very fast and are in response to the credit and financial crisis.

While accounting standards cannot be blamed for causing the economic crisis, there is room for improvements and simplifications. The fair value model served to reveal quickly, to both investors and policy markets, deteriorating asset values and the associated economic implications. Fair value provides transparency to the users of financial statements about current market conditions. However, the current financial crisis has challenged many of the underlying assumptions in the current standards, and has highlighted the difficulty of the use of fair value in illiquid markets. Hence the decision to move quickly and amend the accounting standards for financial instruments by both the IASB and the FASB is a move in the right direction.

George C Kazamias
Director
Assurance Services
PricewaterhouseCoopers