Fate of ‘fair' value

The Ministry of Corporate Affairs has announced the roadmap for adoption of converged accounting standards. These standards would require certain financial assets and liabilities to be recognised and measured at fair value to bring more relevance and reliability in the financial statements.

Since the determination of fair value requires appropriate models, consideration of the surrounding economic environment and exercise of judgment, the earnings and net-worth will be volatile from period-to-period, contrary to the prevailing practices.

Price discovery problem

The impact of fair value measurement on the financial statements of a company is a direct result of the market forces. For any financial instrument to derive its value, the “price discovery” mechanism is a unique and crucial process.

Valuers of OTC and structured products sometimes face the daunting task of valuing an instrument for which the price discovery mechanism either does not exist, or, is skewed due to excessive illiquidity for the instrument.

This problem, though existing to some degree in exchange-traded products, does not become an impediment for their valuation.

Exchange-traded products enjoy the price discovery mechanism embedded within the market microstructure.

It is important that the fair valuation methodology adopted is consistent with the current market conditions. The IASB (International Accounting Standards Board) identifies input parameters as fully observable (Level 1), directly or indirectly observable (Level 2) and unobservable (Level 3).

Fair valuation of instruments which use Level 1 and Level 2 inputs are comparatively aligned to the market expectations/consensus.

However, for illiquid instruments, Level 3 inputs make it more of a challenge. Therefore, it is pertinent for institutions with fair valuation obligations to have access to supplementary information sources.

Transparency in the valuation process can also be enhanced by making disclosures of the methodology and underlying market data inputs used.

Fair valuation, despite the debates in the academic and industry circles, is so far yet one of the best available tools for aligning the financial statements with the current market scenarios. Fair valuation benefits the investors immensely by disclosing the impact of market illiquidity in their financial reporting process. Is this always fair and true?

In the proposed Indian Accounting Standards, some of the financial assets and liabilities would be categorised as ‘fair value through profit and loss account.'

The gains or losses arising from changes in their fair value would be recognised in the income statement directly unlike in the existing Accounting Standards.

The fluctuations in the fair value will be reflected in the income statement. In 2009, considering the volatility in the foreign exchange rates, the Ministry of Corporate Affairs had issued a Notification making certain amendments to Accounting Standard 11 notified under the Companies (Accounting Standards) Rules, 2006.

As per the notification, exchange differences relating to acquisition of depreciable assets could be added to/deducted from the cost of the assets and depreciated over the balance life of the assets.

An illustration

The difference in the company's profitability can be summarised with an example: Let us assume that XYZ Ltd had taken a long-term loan of $100 million to acquire assets on January 1, 2011, and the repayment commences from January 1, 2014.

Applying the MCA notification, the company has (de)/capitalised the fluctuation and depreciated over the remaining useful life of the fixed assets.

If the MCA had not notified the above then the effect of fluctuation on the profit and loss account would be as shown in the Table.

The volatility in the rupee-dollar rate would have a significant impact on the profitability of the company, especially in Dec-11 and Mar-12 quarters when the company would have to recognise a loss of Rs 434 million in Dec-11 whereas by Feb-12 the loss would be wiped off.

The company may end up paying bonus to the management in the period of positive impact of foreign exchange movement on profitability and this would not be refunded in case of adverse movement in exchange rate.

This defies the sound logic of prudential accounting norms and not recognising unrealised gains. Therefore the MCA decision of allowing accounting of exchange directly to fixed assets or reserve appears appropriate during the period of volatility.

This impact will be more significant in the banking and financial sectors where the nature of the financial assets and financial liabilities are different and the existing valuation models are not similar with the proposed fair value. If fair value was always fair because it is reflective of economic realities, then why did the IASB/FASB make exceptions to the fair value accounting rules in 2008?

(Hemant M. Joshi is Partner, and Yogikumar Patel is Senior Manager, Deloitte Haskins & Sells. The views are personal.)