Fair Value Measurement - Case Study Example

 IAS 16 defines fair value as the amount at which the asset can be exchanged between the parties having complete knowledge of the asset being transacted as an arm’s length transaction. The idea is that ‘that the fair value of the asset given up be used to measure the cost of the asset received, unless the fair value of the asset received is more clearly evident.’(Maria Davis, page 96)1 Under active markets it is easy to get quoted prices of assets and liabilities on a particular reporting date. But when active and liquid markets are not available for concerned asset or liability, the best way is to evaluate present value of future inflows in case of asset and future outflow of liabilities. If the fair value thus evaluated falls short of cost incurred / book value of the asset, the difference is treated as impairment and is written off to profit and loss. The problem of fair value measurement occurs when active market for the concerned asset or liability is not available on a reporting date. The entities may adopt varied ways to find out the fair value depending upon the nature of asset or liability involved, as no regulated procedure was available earlier under any GAAP before the pronouncement of SFAS 157 by FASB. IASB requires the use of fair value of assets and liabilities under different standards but the issue of fair value measurement has not been standardized so far. In order to provide consistency in the measurement of fair value and also for providing boost to convergence efforts between IASB and FASB, particularly after the appearance of SFAS 157, the IASB published a discussion paper seeking opinions from different sources in order to establish some sort of regulations for the measurement of fair value. It may be noted that recently issued SFAS 157 Fair Value Measurements has provided some guidance to IASB for further maneuvering on the subject matter. That is why in its pursuit to establish a unified code for measuring fair value for different assets and liabilities ISAB as per a press release (30 November 2006)2has made the decision of using single definition of fair value established by SFAS 157 Fair Value Measurements as the starting point of deliberation. SFAS 157 acknowledges that fair value is the exchange price of assets and liabilities in orderly transactions between buyers and sellers in the most advantageous market for such assets or liabilities. It also assumes a hypothetical transaction of sale and purchase in an orderly market to establish the fair value of asset or liability. Therefore the fair value measurement, as defined by SFAS 157 ‘reflects current market participant assumptions about future inflows of the asset and future outflows of the liability. It incorporates the attributes of particular asset or liability (e.g. location, condition).’ (Jae K Shim and Joel G Siegel, page 71)3 At the same time the fair value measurement as per SFAS 157 differs from the normal approach of fair valuation, as described above, in following two ways: First SFAS 157 follows an ‘exist approaches’. In other words there is no need of a willing seller and willing buyer to agree upon a price. Instead there must be a price where an entity could sell the asset. Suppose an entity has purchased an asset immediately before reporting date. If the entity could sell the asset at a price on reporting date that is different from its immediate purchase price, the ‘exist sale price’ would be the fair value of asset as per SFAS 157. Secondly SFAS 157 measures the fair value assuming a theoretical market purchaser, and it has nothing to do with the existence of an actual market for the concerned assets. Keeping the above information in the background, the issues raised in the assignment of establishing a single source of guidance for all fair value measurements, and fair value valuation of assets and liabilities at ‘exist price’ as stated in SFAS 157 are discussed and evaluated herein after for the purpose of an equitable decision to be made by IASB. It is observed that most of the contributors of the comment letters agree to single source of guidance for all fair value measurements required for IFRS. This is because only a single source will ‘not only reduce the complexities and improve the consistencies in measuring fair value, it also improve the ease and use and provide a broader view for financial statement preparers and users.’(CL 11, page 1)4 A single guidance source also improves the virtue of consistency in application of the guidelines. Practitioners find it handy to provide meaningful comparative information to the users of financial statements. But such a source has to be well documented that satisfy the needs of fair valuing of all types of assets and liabilities, and also provide different methods to suit different scenarios. It must be noted that IASB has sought fair valuation in a number of standards. Under the circumstances it may be difficult to produce a single document that satisfies the needs of fair valuation requirements of different standards under different circumstances. There is no doubt that single source provide consistency and comparability but single guidance may not entail the similar measurement for all types of assets. ICAEW is of the opinion, and rightly so in view of the complexities involved in the issue of ‘fair value measurement, that ‘it will often be necessary to apply a measurement concept in different ways. For example, a depreciating fixed asset, a purchased item of stock, and an item of stock manufactured by the reporting entity may all be measured at historical cost. But the relevant method of measurement will vary from one asset to another, and attempts to apply a common approach would be illogical.’(CL71, page 4-5)5 Single source of guidance is a healthy process but it does not suit under all the circumstances where the assets and liabilities are required to be evaluated for different and varied purposes. Erick Mamelund6, the chairman of Norsk RegnskapsStiftelse, is of the view that though single source is a good solution for the sake of consistency and comparability, but such guidance need proper justification when situations regulated in different standards need departure from general guidance. Pierre de Lauzun (page 3)7 describes that single source of guidance for fair value measurement can be presented in two ways. Under first perspective the rules of fair value measurements may be put in one document and that document need not be a standard. It may be described as a generic term ‘fair value’ say part of conceptual framework of IASB. ‘This would reduce complexity and increase consistency by providing an overall picture of the family of measurements basis covered by the generic term ‘fair value’. In the second perspective fair value measurement can be treated as a moving definition that meets the requirements of all standards seeking fair valuation under different circumstances, but as per Pierre de Lauzun it ‘would neither reduce the complexities nor improve consistency, because, as it would not be relevant for all types of assets and liabilities.’ In other words for seeking consistency and avoiding complexities ‘fair value measurement’ rules should be placed separately in a document like conceptual framework for the general requirements of applications under different standards. ‘In theory an appropriate single source of guidance for all fair value measurements has the potential to reduce the complexities in measuring fair value.’(CL 136, page 3)8 but such resource need flexibilities to meet practical requirements. Let us now discuss the second issue whether a fair value measurement when defined as ‘exit price’ as in SFAS 157 would be consistent with definition of assets and liabilities in the IASB framework. Exit price denotes market value that can be transacted by seller when the seller decides not to use the asset for business purposes. Entry price is the cost of acquiring an asset for business purposes. Apparently the exist price notion adopted by SFAS 157 is in consistent with the objective of financial statements, as it reflects the cash generating ability of the entity. But that does not mean that fair value measurements as exist price are better than fair value measurements as entry price. So far as fair value is concerned ‘the existing IFRS definition implies a negotiated price and does not acknowledge that entry and exist market, and prices in those markets commonly differ.’(CL 50, page 3)9 It is not necessary that entry price or exit price is more indicative of current market expectations of inflow of an asset or outflow of a liability. They will differ only when they occur in different markets and not when prices are referenced in the same market. Accordingly the main issue is the market or transaction environments and not the entry and exist price for measuring the fair value. ‘Fair value measurement as exist price as per SFAS 157 makes sense when markets are functioning and liquid. In current environment when markets are highly illiquid, using process from distressed sales to value holdings often err on the side of over stating declines in asset values. Therefore, one of the consequences is that FAS 157 may overstate the magnitude of the problem and force more rapid adjustment than desirable.’(Nicholas P Sargen and others, page 5)10 The valuation of an asset or liability as per SEAS 157 is based on a process existed in an hypothetical market. That is why Joseph J Vella (page2)11, chairman of International Valuation Standard Committee (IVSC) is of the view that any conceptual framework should prepare basis and assumption for valuation of fair value and avoid setting of any methodology of valuation. As per Joseph J Vella the issue of exist price and entry price is not relevant from the point of fair valuation. Every price will be an exist price for the seller and entry price for the buyer. There are other important issues like consideration of cash flows and other economic benefits flowing to buyer or seller. Moreover, the SFAS 157 approach of exist is not suitable under all circumstances. It is suitable for well develop and actively traded markets, otherwise it is not possible to adopt in different scenarios. Even in developed markets exit price has to face pressure of market volatility. That is the reason SFAS 157 treats the exist price a hypothetical tool for fair value measurements. So far IFRS has kept market based approach and not the entity based approach or entry or exist price approach with regard to fair value applications; but its standardized solution depend upon its universal applicability. That is why it is suggested that the issue should be solved in a manner that provides maximum information to the users of financial statements. Under such circumstances EFARG (page 10)12 is of the view that ‘where no liquid market exists, the reporting entity will generally have better and more detailed information for determining the expected future cash flows than market participants, particularly when hypothetical transactions are involved. For these reasons IASB is to require the use of market- based exist value for its persuasive reasoning value.’ It is not important that fair value should be defined as exist price or entry price. The important factors are market realities that govern exist and entry prices. If exist price is considered fair value then it implies that entry price is also a fair value, provided both prices are transacted in orderly and similar markets. But that does not happen in realities. At the same time there is no second opinion that markets based exist prices provide best estimates of cash in flows and cash outflows. Therefore it is suggested that for the sake augmenting the process of convergence between FASB and IASB, the current market based exist price may be treated as the basis for fair value measurements with suitable adjustments pertaining to illiquid characteristics of the markets. Also this current exist price should be tested separately for different applications of fair value under different standards of IFRS. Fair value is not an economic based term. Therefore measurement of fair value should be relevant to realities of liquid or illiquid markets. Word Count: 2023 References Read More