(Third of four parts)
Peter Wallison of the American Enterprise Institute lamented, “Fair value accounting must be fixed, and quickly-not just because of its strongly adverse impact on financial institutions in today’s market but also because it is highly pro-cyclical... It may well be that fair value accounting was substantially responsible for the residential real estate bubble that collapsed with devastating consequences..” But none put it so bluntly than Steve Forbes, CEO and editor-in-chief of Forbes, “Fair value is an absurdity for financial institutions. If such rules have been in place during the Great Depression, we’d still be in it today...”
For these perceived reasons, the business community, in the United States and the rest of the world, eventually sought relief from fair value accounting. The response from the IASB and FASB was both swift and drastic. Unfortunately for its critics, fair value accounting wasn’t exactly sacked. The standard setters relaxed the application of the MTM rules through the Amendments to IAS 39. The FASB, on the other hand, made clarifications on the application of Financial Accounting Standard (FAS) 157 “Fair Value Measurements”, which allowed entities to make “internal assumptions” in measuring fair value in inactive markets. It stated that multiple inputs from different sources may collectively provide the best evidence of fair value. This spawned a new myriad of debates collectively trying to answer the question — How should fair value be determined?
How to determine fair value
The clamor against fair value accounting may not have been on the concept per se but more on finding an acceptable way to arrive at an acceptable amount. IAS 39 defines fair value as “the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction.” FAS 157, on the other hand, defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
While there is much to be done with respect to IFRS and US GAAP convergence, there is a lot of common ground in their definition of fair value. Both make reference to a price based on actual market transactions. In obtaining fair value, the use of observable market data is required, whether in the form of direct quotes or as an input to valuation techniques. Fair value is market-based rather than entity-specific. Thus, an entity is not allowed to adjust quoted prices just because it has access to more favorable prices than the market (e.g., an entity may have influence over certain potential counterparties because of its market power or because it is dealing with related parties).
Both IFRS and US GAAP explicitly mention “quoted prices in an active market” as the most reliable evidence of fair value. Quoted prices are usually expressed either as bid prices (offer to buy) or ask prices (offer to sell). The use of mid prices (the average of the bid and offer) is not a preferred approach under both IFRS and US GAAP since market transactions rarely happen at the mid price, if at all. Bid prices, particularly in the valuation of assets, should be used over ask prices because the former represents the “exit values” of the assets and are thus more conservative. Inasmuch as bid prices are essentially offers to buy, it is a reasonable assumption that an entity should be able to sell their assets at these prices at the minimum.
In the absence of an active market, an entity is allowed to use valuation techniques. There is a wide spectrum of valuation techniques to choose from. IFRS and US GAAP recommend a fair value hierarchy which ranks the quality and reliability of information used to determine fair values – quoted prices are the most reliable valuation inputs, whereas model values that include inputs based on unobservable data are the least reliable. Application Guidance (AG) 72 of IAS 39 stated that “in the absence of quoted market prices in an active market, the most recent transaction price provides evidence of fair value as long as there has not been a significant change in economic circumstances from the consummation of the transaction up to valuation date. If conditions are different or the risk characteristics of the underlying priced asset are different from the asset quoted in the market, the entity is allowed to make adjustments to the price obtained to arrive at a better estimate of fair value.”
Unfortunately, in spite of this hierarchy, with the abundance of available fair value sources, there remains a great deal of subjectivity not only in the choice of the technique but also on its application and use of inputs. For most financial instruments, there is no single universal valuation technique that may serve as the default approach in the absence of quoted prices. Assuming a valuation technique has already been selected, an entity is allowed to tweak the inputs and the model if circumstances indicate that such would more accurately reflect the “true value” of the asset. This is a nightmare for an investor who seeks comparability and uniformity, at least in terms of asset valuation, among potential investees.
Fair value in disorderly markets
Even the harshest critics of fair value accounting admit that quoted prices from an active market would be ideal for measurement purposes under normal market conditions. The fair value information determined under these situations would undeniably be objective and reliable. However, it’s a totally different scenario if “ab” is added in front of “normal”. The financial markets in the US and most of Europe are currently quoting prices for MBS and similar debt securities that are unbelievably low such that many consider these prices to be those of “fire sales.” As mentioned earlier, forced to inject liquidity into their balance sheets, panicking companies with exposures to these instruments are selling to buyers with so much “irrationality and fear.” Under these circumstances, transactions are consummated at very low prices — pulled downward by both despair on the supply side and fear on the demand side. In effect, when a company in financial distress begins “fire sales” of its assets to raise capital to meet regulatory requirements, the “market-bottom prices” at which its transactions are consummated, become the new standard for the valuation of all similar securities held by other companies that are marked to market. What makes matters worse is that between ask price and bid price, the latter is favored by both IFRS and US GAAP as a more reliable basis for asset valuation. Unfortunately, bid prices are never higher than ask prices and in a financial crisis, it has been observed that the bid-ask spread widens. Can these prices, just because they are quoted in an active market, still be construed as fair value? (To be concluded)
(Paul Bernard D. Causon is a Partner for Audit Services of Manabat Sanagustin & Co., CPAs, a member firm of KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. This article is for general information only and is not intended to be, nor is it a substitute for, informed professional advice. While due care was exercised to ensure the quality of the information contained in this article, readers should carefully evaluate its accuracy, completeness and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances. For comments or inquiries, please email manila@kpmg.com.ph or pcauson@kpmg.com).