Fair value must be the basis of measurement

ACCOUNTANCY

Financial reporting attempts to measure inherently abstract and debatable concepts such as profit and net assets. It has particular features that make it, to some extent, subjective and even arbitrary.

It also endeavours to portray a reality that is changing constantly. There is a growing controversy surrounding the question of measurement "" mainly because of a perceived movement away from the traditional basis of measurement (historical cost) towards a new basis (fair value).

Any change in the measurement basis will have a far-reaching effect. Measurement attributes result from conventions and differences in practice that have evolved over time.

Accounting profit or surplus is the difference between the net assets (total assets less total liabilities) recognised (in the balance sheet) at the beginning of the period and net assets recognised at the end of the period, other than changes arising from equity transactions.

Therefore, principles and methods that are used to recognise and measure assets and liabilities directly influence the measurement of profit, which many consider the single most important metric to measure the earning power of the company. Any change in measurement rules changes the measurement of profit and its interpretations.

This does not mean that accounting rules for the recognition and measurement should not change. In fact accounting rules evolve over time and therefore, change in accounting rules is a norm rather than an exception. Measurement in accounting is more a convention than a science.

At present, financial statement amounts are based on a variety of measurement attributes. These include historical cost (used for cash, held-to maturity investments, loans and receivables, and liabilities other than derivatives), modified historical cost (used for property, plant and equipment and receivables), fair value (used for derivatives, investments held for trading, available for sale investments and assets revaluation), and entity-specific value (used for impaired property, plant and equipment).

Ideally, all the assets and liabilities should be measured using a single attribute. The single attribute should be the fair value.

Fair value is defined as "the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction".

Observable prices in an active market present the best estimate of the fair value. In the absence of observable prices in an active market, fair value is determined using the present value model.

On the other hand, entity-specific value is determined using management expectations. Therefore, fair value and entity-specific value might differ. Fair value takes into account the market expectations about the future.

A question that is being debated is whether estimates of the future should be included in today's financial statements and whether that will improve the quality of financial statements.

A question that is being debated is whether estimates of the future should be included in today's financial statements and whether that will improve the quality of financial statements. Answer to the question may be derived from the definitions of assets and liabilities and from the objective of issuing financial statements.

The definitions of assets and liabilities clearly state that that assets and liabilities embody expectations of the future. Therefore, it is sensible to incorporate future expectations in the measurement of assets and liabilities.

The objective of financial reporting also supports incorporation of estimates of the future in the measurement of assets and liabilities.

The objective of financial reporting is to provide information that is useful in forecasting future cash flows that the company is expected to generate to enable investors to value the entity appropriately.

Information that incorporates estimates of the future based on the current business environment is more useful to investors, who value an entity in the context of the current business environment, than the historical cost information which fails to capture the effect of changes in the business environment.

Historical cost remains the predominant basis of financial reporting. It is usually the cheapest and the simplest basis of financial reporting measurement.

However, over the years pure historical cost has given way to new versions of historical cost, which incorporate estimates about future. For example, inventories are valued at the lower of cost or net realisable value. Net realisable value incorporates expectations about future.

Similarly, receivables are carried at the amount due from the counter party reduced by the uncollectible amount as estimated by the management. Property, plant, equipment (except land) and intangible assets, which have not been impaired, are carried at historical cost less accumulated depreciation.

The accumulated depreciation is based on the management's estimate of the period in future for which the company expects to use the asset. Modified historical costs reflect the belief that measurement of assets and liabilities should incorporate expectations about future.

Modified historical cost or entity-specific value is no substitute for fair value, which fully incorporates market expectations about future. Therefore, ideally all assets and liabilities should be measured at fair value.

But immediate shift to fair value will be difficult and may not be cost effective. For example, it is difficult to estimate the fair value of liabilities that are not traded in the market. Similarly, it is difficult to determine the fair value of intangible assets.

Therefore, those and similar items will be continued to be measured using some variety of the historical cost or entity-specific value. Companies may consider disclosure of fair value of those assets and liabilities which are measured using attributes other than fair value.

One argument against using the fair value is that it will increase the volatility of reported profit. The volatility will arise due to the volatility inherent in the fair value and also because of estimation error. Volatility by itself is not bad.

Rather, use of fair value will improve the quality of information. Net profit will more clearly reflect the likely impact of current economic events on the performance of the company and will help investors to assess the riskiness of the company. Therefore, increase in volatility cannot be an argument against the use of fair value.

However, use of fair value as a measurement attribute will require resolution of various issues. For example, total of fair values of assets determined separately for each individual asset is expected to be different from the fair value of all the assets taken together.

Issues relating to the determination of the fair value of liabilities are complex. Standard setters should resolve all the issues before mandating use of fair value for measuring all assets and liabilities.

The global debate on measurement has not created sufficient interest, may be due to lack of understanding the implications. ICAI may take initiatives to encourage its branches to hold workshops to develop understanding of the implications of the change in the measurement attribute.