Companies provide financial information to shareholders and creditors through financial statements. Shareholders use the same to value the equity of the company and to evaluate the management in its stewardship function. Creditors, including lenders, use the same for evaluating credit risk. The objective is to provide financial information that is relevant in predicting the stream of cash flows, which the enterprise will generate in future. Information is relevant if it improves the estimate of amount, timing and risk of future cash flows. Accounting standard setters always balance relevance and reliability. Earlier the emphasis was on reliability. Now, it is shifted to relevance. International financial Reporting Standards (IFRS) uses fair value more extensively than the use of fair value in Indian accounting standards (AS) on the presumption that for certain assets and liabilities, the fair value attribute is more relevant than the historical cost. It might be interesting to examine whether those presumptions are logical. Let us examine the relevance of the information on the fair value of fixed asset.
Enterprises use fixed assets to produce and sell products and services. They do not intend to realise cash by selling them.
Items of fixed assets are initially measured at acquisition cost. As per AS, enterprises use the cost model to measure fixed assets for the purpose of presentation in the balance sheet. The initial acquisition cost is reduced by the accumulated depreciation and accumulated impairment loss. Impairment loss is recognised and the carrying amount of an item of fixed asset is reduced when the management estimates that the asset will not be able to recover its carrying amount either through use or sale.
IFRS allows companies to choose either the cost model or the fair value model to measure items fixed assets. Fair value model can be used for measuring intangible assets only if an active market exists and it is expected that the same will continue to exist at the end of the useful life of the asset or some party has committed to buy the asset at the end of its useful life. Those conditions can be met rarely. IFRS does not allow cherry picking. A company has to decide once for all that whether it will use the fair value model for a particular class of asset (e.g. land). US GAAP mandates the use of the cost model and does not allow revaluation. AS mandates use of the cost model but allows revaluation of tangible assets. It does not allow cherry picking. Both the IFRS and AS require the company to recognise the revaluation gain outside the net profit.
Analysts value enterprises based on the estimated free cash flow (FCF) stream that the enterprise will generate in future. FCF is the operating cash flow available for distribution to all the investors, including debt holders, after meeting internal demand for incremental investment in fixed assets and working capital. The market value of non-operating assets is added to the present value of FCF to estimate the enterprise value. Fair value of the operating assets is not relevant in valuing an enterprise.
It may be argued that the fair value of fixed assets might be useful in evaluating the management in its stewardship function. For example, if the price of the land on which the factory is situated has gone up manifold and it benefits shareholders if the management unlocks the value of the land by shifting the factory to another site where the price of the land is much cheaper. Disclosure of the market value of land might trigger discussion among analysts and shareholders and they might solicit the management’s response. This argument might be valid. But if the market value is readily available every one shall have ready access to it. If market inputs are not available, the fair value will be much less reliable and shareholders and analysts will not attach any value to that information. Therefore, use of fair value in measuring fixed assets does not enhance relevance of the financial information even from this perspective.
There is consensus that wherever possible, a number of alternative accounting principles and methods should be reduced to enhance comparability. Allowing enterprises to choose between the cost model and the fair value model in measuring fixed assets is against this fundamental principle. The ICAI and government should consider withdrawing the option to revalue fixed assets.
E-Mail id: asish.bhattacharyya@gmail.com Affiliation: Chairperson, Riverside Management Academy (www.riversidemanagement.in)