Fair Value: Boon or Curse - Essay Example

FAIR VALUE: BOON OR CURSE Introduction Two terms used interchangeably in daily conversation: Value, and Price, one taken as a synonym for the otherwhen spoken as layman's terms. But the connotations assume a sharp distinction when these terms are used in the context of finance. An asset may be valuable because it may have a potential to generate income, or it may have substantial intrinsic value; however, it may have a low market price because the buyer may be unaware of its true worth, or the seller was in dire need of money and was willing to sell at a huge discount. An example of this may be an antique piece or jewellery which require the eye of an expert to discern true worth. It may also be the other way around, that an asset of low intrinsic value or poor income potential gets sold anyway at a high price, because the buyer did not know better but was induced by rumor or sales talk. A wise buyer will buy an asset at equal to or lower than its fair value, and a wise seller will sell at a price equal to or higher than fair value. The distinctions become more pronounced if what came under consideration was accounting value, or the worth of an asset according to financial records and the workings of generally accepted accounting principles. Theoretically, price should equal value, but since market efficiency is seldom a reality, if ever, in a transaction, buyers and sellers can exploit price and value inconsistencies to their benefit. Fair Value Defined The IASB definition of fair value has been described as "substantially similar" to the FASB revised definition, which are both consistent with the measurement objective. (IASB Fair Value Measurement). Under this definition, the fair value of an asset is the amount at which that asset could be bought or sold in a transaction between willing parties, other than in a liquidation. On the other hand, the fair value of a liability is that amount at which that liability could be incurred or settled in a current transaction between willing parties, other than in a liquidation. (Value-based Management) Drews (2000) gives the IRS and legal definition of "fair market value" as that price at which an asset would change hands between a willing buyer and a willing seller, neither being under compulsion to act and both having reasonable knowledge of all relevant facts. Representatives to the International Valuation Standards Committee (IVSC) made a presentation before the IASB. At that presentation the difference between 'price' and 'value' was articulated. 'Price' was defined at that mount agreed upon on in a transaction while 'value' is the outcome of a valuation process. In a majority of cases and for most common purposes, price and value result in almost the same number, the most recent transaction of a similar asset or liability being determinative of the fair value of the asset or liability subject of valuation. (IASB Fair Value Measurement) Fair Value vs. Market Price A quoted market price in an active market is considered the best evidence of what amount comprises the fair value, as a basis for measurement. In the absence of a quoted market price, the evaluators should be prepared to make an estimate of fair value, employing the best possible information which is available under the prevailing circumstances. (Value-based Management) As the term is commonly used, "fair value" can be easily distinguished from "market value" or "market price". It necessitates the assessment of the price that is considered fair by two specific parties, while taking into account the respective advantages or disadvantages that each will gain or suffer from the transaction. Usually, market value meets these criteria since it is the price at which transaction actually takes place; however, this is not necessarily always the case. Fair value is often used when regulators or assayers conduct due diligence in corporate transactions. During such occasions, because of particular synergies that exist between the two contracting parties, a price is arrived at that is fair between them, but at the same time is higher than the price that might be obtainable in the wider market. "In other words Special Value may be generated. Market Value requires this element of Special Value to be disregarded, but it forms part of the assessment of Fair Value." (Exposure Draft of Proposed Revised International Valuation Standard 2 - Bases Other than Market Value, June, 2006) Requirements of Valuation There are times, however, when the valuation exercise should be entity-specific, that is, the valuation procedure conducted is not for common or universal use but is particular to the parties involved and the purpose for which the value is sought to be determined. At this point it should be pointed out that the IVSC standards use three types of valuation procedures, two of which take a market view and one of them being entity-specific. These three methods, while grounded in principle, could conceivably result in different amount for the same valuation object. (Ibid) Drews (2000) makes an important observation. To use a fair market value standards, he opines, necessitates that a hypothetical transaction be conjured up, the price for which determines the assets's value. Furthermore, in order for this standard to be applicable across a wide variety of assets and situations, it is important that the price be determined on the basis of cash or cash equivalents. A transaction that assumes payment-in-kind or a similar barter arrangement would "compromise the universal utility of the standards". Also, the hypothetical transaction must also specify whether payment is made in a single, present, sum, or if the payment is the present value of future payments still to be realized. An important requirement in determining fair value is that neither party to the hypothetical transaction should be under no compulsion to act, that is, that neither the buyer nor the seller is required to enter into the transaction, or is under any pressure to do so, as in the case of a legal judgment or bankruptcy. Also, liquidation transactions are not included for the same reason (compulsion), and also because liquidation precludes any further productive use of the valuation object. If the apparent market-price data falls under any of these situations, then it should be ignored as a value equivalent. Also, it is necessary to filter out idiosyncratic behaviour on the part of specific buyers or sellers which may inconspicuously introduce driving factors that may not exist in the case of a typical buyer or seller. A transaction value, be it hypothetical or actual, is also always reflective of the prevailing economic environment in place at the time, that particular industry where the asset is deployed, and the type of asset in question. This is so because buyers and seller tend to act in their own best interests, which are circumscribed by the context under which the transaction takes place. The price arrived at should always be considered "fair" under the specific conditions surrounding the transaction. Advantages of Fair-Value Accounting vs Historical-Cost Accounting The long-standing debate about the appropriateness of the present accounting principles, which assigns the valuation of assets and liabilities according to the booked transaction costs. It is likely that the most important reason for a shift to fair-value accounting is that historical-cost financial statements do not provide information that is relevant to investors. As if to highlight this deficiency in the conventional historical-cost method, it was determined that the market value of publicly traded firms on the New York Stock Exchange is easily five times their asset values as recorded in the accounting books. The primary driver of this disparity was clearly illustrated by a comment by then-Federal Reserve Chairman Alan Greenspan: "[V]irtually unimaginable a half-century ago was the extent to which concepts and ideas would substitute for physical resources and human brawn in the production of goods and services." (Shortridge et al, 2006) In close relation to this is the consideration of the objectives for which fair value measurement is undertaken. The fair value measurement requirements in IAS 39 Financial Instruments: Recognition and Measurement are generally clear and well understood. The objective of fair value measurement in IAS 39 is to systematically compute for the price at which an orderly transaction would take place between market participants at the measurement date. To meet the objective of a fair value measurement, an entity measures the fair value of financial instruments by considering all relevant market information that is available at the time of valuation. When measuring fair value using a particular valuation technique commonly referred to as 'mark-to-model', an entity maximises the use of relevant observable inputs and minimises the use of unobservable inputs. The recent illiquidity in some financial markets has highlighted the following areas wherein contrary views support approaches that might not meet the objective of fair value measurement: (a) using management's estimates to measure fair value. (b) using prices in active markets versus inactive markets. (c) identifying forced transactions. (d) interpreting different estimates of fair value. (e) making valuation adjustments (IASB Expert Advisory Panel, 2008) Disadvantages in the use of Fair Value Estimates A skilled and well-informed underwriter or estimator will choose a valuation technique which is most relevant to the interested party, and in so doing make assumptions as they become necessary in the valuation model. He will also assess the reliability of such available pricing information, in order to estimate the price at which an orderly, unforced transaction would take place between contractual parties on the measurement date. Regardless of the valuation technique used, considerations pertaining to the entity will require appropriate risk adjustments that market participants would ordinarily make. This is essentially a subjective judgment; therefore, were two evaluators to conduct the valuation process, it is entirely likely that they might arrive at different estimates of the fair value of the same instrument even though both still meet the objectives of fair value measurement. This could happen even if the two evaluators use the same model, as the unobservable inputs used in each version of the model are bound to be different. This is the reason why fair valuation is essentially an art, dependent upon the skill and perception of the entity conducting the valuation process. Some seem to hold the view that if two estimates of fair value differ, then one or both estimates must be wrong. This is not necessarily the case. It is common for different analysts to arrive at different estimates of the fair value of the same instrument at the same measurement date, and both sets of valuation techniques and inputs used by both analysts can still meet the objective of fair value measurement and be in compliance with the accounting guidance. The fact that different estimates of fair value exist reflects the judgement and assumptions applied and the inherent uncertainty of estimating the fair value of instruments that do not have prices quoted in an active market. A single entity, however, applies judgement consistently (across time and by type of instrument) when measuring fair value. Because different analysts might arrive at different fair values, appropriate disclosures about the techniques used and judgements made are critical to users of financial statements. Special Considerations in the Valuation of Market-sensitive Instruments In the valuation of instruments transacted through what is supposedly an efficient market, the valuation is taken to be the latest transaction price of similar instruments, or the same instrument if such is of a fungible nature (e.g., stocks in the stock exchange). The problem arises if the market is seldom traded or is considered discontinuous or inactive. In such cases, the last transaction price may have taken place a long time ago, such that it is no longer representative of current fair value. For inactive markets, a thorough understanding of the instrument being valued allows the analyst to identify and evaluate the relevant market information available about identical or similar instruments. Such information to be considered includes, for example, prices from recent transactions in the same or a similar instrument, quotes from brokers and/or pricing services, indices and other inputs to model-based valuation techniques. An entity uses such information to measure the fair value of its financial instruments by assessing all available information and applying it as appropriate. There are a variety of valuation techniques which the accounting and finance profession recognizes, but no matter what model is used, an analyst takes into account current market conditions and includes appropriate risk adjustments that market participants would make, such as for credit and liquidity. Furthermore, as market conditions change, it might become imperative top either revise or adjust the model(s) used, or to change it entirely. An assayer or analyst makes adjustments to a estimation model when it results in a better assessment of the price at which an orderly transaction would take place between market participants on the measurement date. Finally, because a fair value measurement contemplates a transaction between market participants within the present context, an analyst should factor in the effect of market participants changing over time. For instance, the set of possible buyers for the instrument in an inactive market might differ from the set of possible buyers in an active market, their interest being essentially different. (IASB Expert Advisory Panel, 2008) Conclusion Market price and fair value are entirely different things, although one ideally should be the measure of the other. The differences are more pronounced between accounting value and market price, because accounting value is based on historical cost while market price is based on the dynamics between buyers and sellers in a market. The very choice of representative market is rendered more difficult when the asset or instrument has no direct market and must be approximated by the market for the closest approximate asset or instrument. Finally, in determining fair value, the analyst must be fully informed, factor in as much information as is available, be unbiased, or as close to it, as possible, and be sensitive to intangible factors that affect market action. In answer therefore to the question: Fair Value: boon or curse' The answer must be neither. Fair value exists not only in concept but in reality, because where there is a market there is always an awareness of value. Therefore, despite its difficulty of estimation and seeming subjectivity of application, fair value is an elusive concept that will continue to occupy the efforts of finance experts and analysts. Denying the existence of a "fair value" will only create disadvantages for the business entity, since the markets and, therefore, the opportunities in business are always forward, never backward, looking. But while an exact technique and absolute accuracy will continue to elude theorists, practitioners are comfortable with the fact that their familiarity with the markets can more than marginally equip them with a sense of fair value to serve them well. In time, it is doubtless that the accounting profession and regulatory authorities will move closer to incorporating these observations from industry into acceptable principles and policies. REFERENCES Basel Committee on Banking Supervision comments on IASB's discussion paper - fair value measurements, 4 May 2007 Bolton, L.E., Warlop L. (2003), and Alba, J.W. 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