It is a myth that the International Financial Reporting Standards (IFRS) are moving towards full fair value measurement. Rather, there are only a few fair value measurements in a typical IFRS balance sheet. However, the use of fair value in IFRS is more extensive than the use of the same in the Indian GAAP. Therefore, application of the fair value measurement principles in implementing IFRS will be an important challenge before the accounting fraternity in India. Understanding of the concept and the methods for estimating fair value should be understood by corporate accountants and managers and by auditors. Audit committee members should have an idea of the concept. In this and the next article we shall endeavour to provide an overview of the use of fair value in IFRS.
Current value and fair value
IFRS defines fair value as “the amount for which an asset could be exchanged, a liability settled or an equity instrument granted could be exchanged, between knowledgeable, willing parties in an arm’s length transaction’. The term ‘current value’ is used to refer to any value that reflects some aspects of economic conditions prevailing at the balance sheet date. Fair value is a measure of current value, but all current value measures do not represent fair value. In financial reporting some entity-specific current value measures are used to measure assets. For example, inventories are valued at the lower of cost and net realisable value (NRV). NRV measures the net amount that an entity expects to realise from the sale of inventory in the ordinary course of business. NRV is not fair value less costs to sell. NRV is an entity specific value.
Fair value of the same inventory reflects the value for which it could be exchanged between knowledgeable and willing buyers and sellers in the market place. Similarly, in he context of impairment accounting, recoverable amount is the lower of ‘value in use’, which is an entity-specific current value and fair value less costs to sell. Thus, fair value is a market value, which incorporates market assumptions/perceptions. Observable prices in an active market, when the trading volume is normal, are considered to be the best estimate of fair value. When such observable prices are not available at the valuation date, an entity has to estimate the fair value taking into consideration assumptions of buyers and sellers in the market where the asset is frequently traded or the market that is most advantageous to the entity.
Measurement of revenue
According to IFRS (IAS-18) ‘revenue shall be measured at the fair value of the consideration received or receivable’. Indian GAAP (AS-9) has no such stipulation. This is a significant difference between IFRS and Indian GAAP. Recognition of revenue from a credit transaction results in simultaneous recognition of revenue and receivable, which is a financial instrument. IFRS (IAS-39) requires that at initial recognition a financial instrument should be measured at fair value. Application of the principles stipulated in IFRS results in recognition of revenue and receivable at fair value. The fair value is lower than the nominal amount of consideration, when the payment is expected to be received after a considerable period of time from the date when the sale transaction is recorded in books. Although there is no stipulation in IFRS, it is the general opinion that if the receipt is deferred for six months or more, fair value should be estimated.
IAS-18 provides guidance on how to determine the fair value. If the entity sales the good or service both in cash and on credit, the cash sale price is the fair value. If, separate cash sale price is not available, the fair value of the consideration is determined by discounting all future receipts using the prevailing rate of interest for a similar instrument of an issuer with a similar credit rating.
Implementation of the accounting principle requires an entity to estimate, at the time of sale, the timing of the cash inflow and the incremental borrowing rate of the customer. The period for which the realisation is deferred depends on the past pattern of realisation from customers and not on the credit period allowed under the agreement. Estimation of the interest rate at which the customer can borrow with the same terms and conditions (e.g. borrowing without offering collateral) is judgemental and depends on the appropriate assessment of the customer’s credit rating. The difference between the nominal amount of consideration and the fair value is recognised as interest income (with corresponding increase in receivables) over the estimated credit period using the effective interest rate. Effective interest rate is the discounting rate used to estimate the fair value or the rate that equates the present value of nominal amount of the consideration to the cash sale price. The effective interest rate determined at the time of recording the sale transaction is not changed later.
In case the consideration, in full or part, is receivable, in a form other than cash, fair value is to be determined by using an appropriate method. SFAS-157 issued by Financial Accounting Standards Board (FASB) of USA provides the necessary guidance in this regard. International Accounting Standards Board (IASB) is in the process of issuing a standard that corresponds to SFAS-157.
Loans, advances and payables
Receivables, arising from revenue or otherwise, and payables are financial instruments. Therefore, they are to be initially recognised at fair value. If the fair value of the amount payable to a counter party is lower than the nominal amount, the difference is recognised as a part interest expense over the credit period using the effective interest rate. For example, if an entity is provided loan by a government agency at a concessional rate, the fair value of the amount borrowed is lower than the nominal amount and the loan should be recognised at fair value. Difficulties in estimating fair value may arise, for example, in case an entity engages with large number of small contractors who deposit small amount as earnest money/security deposit. Difficulty arises in estimating the time period over which the entity will hold the earnest money/security deposit. Each entity should establish a method to determine the fair value of payables.
If, the fair value of loan/advance (asset) is lower than the nominal amount because the interest rate at which the loan or advance is granted is lower than the market rate, the difference should be recognised as an expense in the income statement. For example, if the fair value of the loan of Rs 1,000 granted to an employee at a concessional rate is Rs 900, Rs 100 should be recognised as employee welfare expense or any other appropriate line item in the income statement and Rs. 900 should be recognised as loan. Moreover, the difference of Rs 100 should be amortised over the loan period using the effective interest rate and should be recognised as interest income. Similarly, advances or loans at concessional rate to vendors or other counter parties should be recognised initially at fair value.
Conclusion
Estimation of fair value is judgemental and the fair value depends on underlying assumptions. Therefore, there is a need for proper documentation delineating methods and assumptions. to satisfy the audit committee and the auditor.
