Wednesday, September 16, 2009

Fair value accounting unfair?

Don't worry about this particular entry. I've been examining the issue of "mark-to-market" and "fair value accounting" for some time. These accounting rules are being debated heatedly in the U.S. and Europe. I've done some previous posts on this under the label "Mark-to-Market Rule". It is something you can click on if you have lingering symptoms of insomnia and, if you find that Perry Como and Mantovani isn't able to cure your predicament. I am just pasting this piece by Stephen Oong from Ernst & Young as published in The Star for my own reference. You will find this matter becoming more and more prominent in the coming months because the accounting profession in Malaysia has determined that from January 1, 2010 (that would be some 3 months away), Malaysian corporates must adopt this rule in measuring the value of their assets.

FAIR value accounting has been the subject of intense scrutiny and debate in the uncertainty of the current economic times. Under such conditions, the fair values of certain assets and liabilities are more volatile, causing the income statements of some companies to be more volatile too. Certain quarters are of the view that fair value accounting is the main culprit behind the poor performance of many of the worst affected companies. Or is fair value accounting a mere bearer of the bad news?

Fair value accounting is a financial measurement methodology whereby companies are permitted or required to measure certain assets and liabilities at fair value or market value. Under fair value accounting, companies report losses when the fair values of their assets decrease or liabilities increase. The gains or losses are reflected directly in the income statements or sometimes in the statement of equity changes.

Companies in Malaysia are very familiar and comfortable with using fair value accounting. For many years, Malaysian companies have been applying fair value accounting in the measurement of certain permissible items and transactions in their financial statements. Such applications are allowed for by our Malaysian accounting standards. Why then the sudden spate of criticism on fair value accounting? Could it be that fair value accounting is not fair?

Fair value accounting is accused of being pro-cyclical. In periods of growth and during downturns, fair value accounting accentuates the volatility of the financial statements. When assets are measured at their respective fair values, rising or falling values will be reflected in the financial statements of the company and such swings could move in a cyclical fashion.

Fair value accounting appears harsh when prices are going down; yet no one complains when asset values are rising. However, fair value accounting is merely reporting and reflecting the outcomes of market forces at play, not causing them.

When market conditions result in volatility in values and earnings, users of financial statements benefit when companies transparently report these circumstances and their impact on financial reporting. Users of financial statements would like to know the financial position of a company based on its current value rather than some old historical costs.

Although the information contained in the balance sheet is reliable (because it is based on verifiable historical costs) and not subjective, it is irrelevant, and accordingly not useful, for decision-making purposes.

Assets acquired years ago and newly-acquired assets do not have the same costs and hence have different carrying values, even though their respective current values may be the same. To account for such assets in the financial statements of different entities at their respective historical costs would make comparisons between companies almost impossible.

Historical cost information for assets has no economic relevance to the buy, sell, hold decisions that management must make each day. However, making economic decisions using fair values may also be inappropriate because the fair values used may not be reliable, but at least they may not be totally wrong all the time.

The support for the use of the fair value approach is principally grounded on relevance. The adoption of fair value as the primary basis of measurement should be tested explicitly against the four attributes that make information in financial statements useful to users: understandability, relevance, reliability and comparability. However, information needs to pass a reliability threshold before it can be considered relevant.

In this respect, fair values based on prices quoted in an active market will pass both the reliability and relevance attributes. However, a source of discomfort among the fair value dissenters is when assets and liabilities are not quoted in an active market; or when there are infrequent or no transactions for the kind of assets or liabilities held by the entity.

Under FRS, in such illiquid market situations, companies are to use adjusted mark-to-market measurements based on observable market prices for similar assets and liabilities. Where such market observable data is not available, FRS suggests the use of acceptable valuation models to estimate fair value (mark-to-model measurement). Such adjusted mark-to-market and mark-to-model basis of determining fair value is what users of financial information are not comfortable with.

In any adjusted mark-to-market models and valuation models, the output is only as relevant and reliable as the input. Because the assets are in an illiquid market, input using market observable data is hard to come by. Companies would therefore have to rely heavily on the estimation of future cashflows and to use input based on non-observable best estimates and best judgments.

So can valuations that are not independently verifiable be considered reliable? And is information that is not reliable relevant in the world of financial reporting? Under such circumstances, the financial statements produced using fair values may be more relevant (vis-à-vis historical costs) but one cannot be so sure about its reliability either.

Relevance and reliability are the two key attributes of financial reports that are useful to readers. However, these attributes could be compromised by the use of adjusted mark-to-market and mark-to-model calculated fair values.

That is why it is important that companies make adequate and robust disclosures in their financial statements as to the valuation processes and methods used in determining fair values, what the significant estimates are and the assumptions used as inputs.

The balance sheet prepared using fair value as a basis of measurement gives a better reflection of the actual worth of the company. Until and unless another better basis of accounting measurement can be identified, fair value accounting is still the fairest option available.

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