The Hindu Business Line : Far from fair value

THE year 2005 could well be described as one in which the project for global convergence of accounting standards commenced. Parleys are on, draft papers are being circulated and projects are being undertaken globally with this single intent. However, the progress received a small setback when there was a huge hue and cry about IAS-39 (Financial Instruments - Recognition and Measurement), issued by the International Accounting Standards Board (IASB). Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. IAS 39 provides a hierarchy to be used in determining the fair value for a financial instrument

Quoted market prices in an active market are the best evidence of fair value and should be used, where they exist, to measure the financial instrument.

If a market for a financial instrument is not active, an entity establishes fair value by using a valuation technique that makes maximum use of market inputs and includes recent arm's length market transactions, reference to the current fair value of another instrument that is substantially the same, discounted cash flow analysis, and option pricing models.

An acceptable valuation technique incorporates all factors that market participants would consider in setting a price and is consistent with accepted economic methodologies for pricing financial instruments.

If there is no active market for an equity instrument and the range of reasonable fair values is significant and these estimates cannot be made reliably, then an entity must measure the equity instrument at cost less impairment.

Amortised cost is calculated using the effective interest method. The effective interest is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument to the net carrying amount of the financial asset or liability. Financial assets that are not carried at fair value though profit and loss are subject to an impairment test. If expected life cannot be determined reliably, then the contractual life is used.

Fair value option

IAS 39 permits entities to designate, at the time of acquisition or issuance, any financial asset or financial liability to be measured at fair value, with value changes recognised in profit or loss. This option is available even if the financial asset or financial liability would ordinarily, by its nature, be measured at amortised cost — but only if fair value can be reliably measured. Once an instrument is put in the fair-value-through-profit-and-loss category, it cannot be reclassified out.

Available for sale option

IAS 39 permits entities to designate, at the time of acquisition, any loan or receivable as available for sale, in which case it is measured at fair value with changes in fair value recognised in equity.

The impression was that IASB, whose standards would be the accepted standards when the convergence project is inked, was asking for too much in too short a time by suggesting the fair value option. In fact, a body has objected to using the term fair value suggesting current value or market value instead.

The Financial Accounting Standards Board (FASB), the US counterpart of the IASB, seems set to toe the line of the IASB as far as recognising financial assets and liabilities at fair value. Although it may seem too radical a measure, it may take time for us to accept the fact that in future the balance-sheet of the company would reflect the assets and liabilities of the company at street prices instead of having to use discounting factors to arrive at the true value.

The Institute of Chartered Accountants of India has issued an Exposure Draft on Financial Instruments which does not contain the fair value option. If issued as a standard in its present form, one could expect a limited revision soon using the present dreaded term, fair value.

(The author is a Hyderabad-based chartered accountant.)

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