FAIR VALUE ACCOUNTING: LOVE IT OR HATE IT

Fair value can be defined as the price that would be received to sell an asset or paid to transfer a liability. A fair value measurement assumes that the transaction to sell an asset or transfer a liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market which maximises the amount that would be received or minimises the amount that would be paid.

IAS 39 Financial instruments: recognition and measurement requires an entity to use the most advantageous market in measuring the fair value of a financial asset or liability when multiple markets exist, whereas IAS 41 Agriculture requires an entity to use the most relevant market. Thus, there can be different approaches for estimating fair values. In addition, valuation techniques and current replacement cost could also be used.

If markets were liquid and transparent for all assets and liabilities, then fair value accounting would give reliable information which is useful in the decision making process. However, because many assets and liabilities do not have an active market, their valuations are less reliable. Fair value estimates can vary greatly, depending on the valuation inputs and methodology used. The use of significant judgement by management may result in inappropriate fair value measurements and consequently misstatements of earnings and equity capital.

Users of financial statements will need to place greater emphasis on understanding how assets and liabilities are measured and how reliable these valuations are when making decisions based on them.

A course for concern

The fair value option was generally introduced to reduce profit or loss volatility as it can be used to measure an economically matched position in the same way (at fair value).In addition, it can be used in place of IAS 39's requirement to separate embedded derivatives as the entire contract is measured at fair value with changes reported in profit or loss.

Although the fair value option can be of use, it can be used in an inappropriate manner thus defeating its original purpose. For example, companies may apply the option to instruments whose fair value is difficult to estimate so as to smooth profit or loss as valuation of these instruments may be subjective.

Also, if a company applied the option to financial liabilities, then the company may be recognising gains or losses for changes in its own credit worthiness.

Additional disclosures

Fair values reflect point estimates and do not result in transparent financial statements. Thus, additional disclosures are required to bring meaning to these fair value estimates. These include key drivers affecting valuation, fair value range estimates and confidence levels.

Another important disclosure relates to changes in fair value amounts. For example, changes in the fair values of securities can arise from movements in interest rates, foreign currency rates, credit quality and purchases and sales from the portfolio. Thus, for users to understand the fair value estimates, the financial statements should disclose the factors that caused the changes in fair value.

The disclosure of fair value information in the financial statements would also depend on the type of financial information required by investors. Some investors may desire both fair value and historical cost information.