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Thursday, Nov 25, 2004

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Five things to fix before giving fair value a fair chance

D. Murali

SUSAN Schmidt Bies is a name to track if you are an accountant. She is a member of the Board of Governors of the US Federal Reserve System, serving a full term, and busy giving speeches on accounting and allied areas.

About a fortnight ago, she spoke on `financial supervision issues' at the Securities Industry Association Annual Meeting, in Florida, where `the first supervisory issue' was accounting for investment securities.

October end, her talk was on the Fed and the economy, at the American Association of Individual Investors Washington Chapter Meeting, virtually a 101 of the system, but not without a discussion of what goes into the `liability side of the household balance-sheet' and how business `repair' balance-sheets to reduce exposure to rising interest rates.

September end, talking in Texas, at the Bond Market Association's Regional Bond Traders and Sales Managers Roundtable, on developments in financial markets and financial management, Susan insisted that the auditors should fully understand "how modelling or other sophisticated techniques are used to determine fair value, and whether the assumptions used in the models are appropriate, and whether the data has integrity."

A couple of days before that, she was meeting the Cincinnati Chapter of the Ohio Society of Certified Public Accountants at their annual CPA Recognition Night, to speak on "challenges facing the accounting profession today".

Last week, it was on `fair value accounting' that Susan spoke on at the International Association of Credit Portfolio Managers General Meeting, in New York.

Susan's term is to end only in 2012, so I'm sure we would have many more such talks, couched in understandable language. Thus, in the latest lecture that touches on the recent `proposed standard on fair value measurements' issued by the Financial Accounting Standards Board (FASB), she asks: "Which is more appropriate — fair value or historical cost?" Fair value accounting is okay for assets and liabilities used in the business of short-term trading for profit, such as the trading account for banks, she opines, but hastens to counsel caution to the `accounting industry' when moving toward a more comprehensive fair value approach, "where all financial assets and liabilities are recorded on the balance-sheet at fair value and changes in fair value are recorded in earnings, whether realised or not."

Let not accounting add to existing hazards, is her message: "Whenever possible, the accounting framework should avoid providing a disincentive to better management of risk."

Five things to fix in fair value accounting

Fair value measurement problems that warrant further consideration are five, as the lecture explains. First comes the `reliability and measurement' issue; measurement is difficult when there is no `active market' for the asset or liability and so subjective inputs are resorted to.

Even if `multiple approaches' such as market, income, and replacement-cost methods were used, that would add little to reliability, if all these are based on the same underlying information, as would often be the case for financial instruments, points out Susan.

Second is `management bias'; this can lead to "misstatements of earnings and equity capital", commonly seen in historical cost scenario. "Without reliable fair value estimates, the potential for misstatements in financial statements prepared using fair value measurements will be even greater." To illustrate, Susan mentions of `significant write-downs of overstated asset valuations' that resulted in the failure of a number of finance companies and depository institutions. Not too different a scenario from our own financial institutions, one may say; it would be an understatement to say that they look rosy!

Third hitch is verification of fair value estimates. "Verification of valuations that are not based on observable market prices is very challenging," she notes, and one doubts if CAs are adequately equipped to handle the test.

Fourth quandary is presented by `compound values', as for example, as a servicing asset that can be considered to reflect two values, one financial, such as interest, and the other intangible, such as "value reflecting the contractual right to perform services over time in exchange for a fee."

The value arrived at can fall foul of the revenue recognition principle if "unearned revenue is not recognised up front".

Last is the disclosure hitch; "fair values reflect point estimates and by themselves do not result in transparent financial statements," states Susan. "Additional disclosures are necessary to bring meaning to these fair value estimates." Fair comes with its rough edges, therefore.

Indian `fair'

To be fair, Indian accounting pronouncements have long recognised the concept of fair value, as for instance, when defining `net realisable value' in AS-2, on inventories, as "the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale." Thus, inventories are to be valued at the lower of cost and NRV, though one may fault the Indian standard as being too conservative.

Again, in AS-10, the standard on accounting for fixed assets, `fair market value' is defined as "the price that would be agreed to in an open and unrestricted market between knowledgeable and willing parties dealing at arm's length who are fully informed and are not under any compulsion to transact." Somewhat on similar lines is the definition of `fair value' in AS-26 on intangible assets: "Fair value of an asset is the amount for which that asset could be exchanged between knowledgeable, willing parties in an arm's length transaction."

If value, like beauty, lies in the eyes of the beholder, fair is a complex matter, like complexion. What is fair in one context may seem `wheatish' elsewhere, and so with accounting too.

Yet, fair, if given a fair chance to meander in financial statements, can restore accounting to the status of a gentleman's game, with fewer shackling rules such as the millstone of historical cost to labour under. Betting too much on human goodness?

AccountSpeak@TheHindu.co.in

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