The Chartered Institute of Financial Analysts (CFA) of USA, which represents financial analysts worldwide, published 'The Comprehensive Reporting Model' in 2007. According to the model, ‘fair value information is the most relevant information for financial decision making’. It argues that fair value measures reflect the most current and complete estimations of the value of the asset or obligation, including the amounts, timing, and riskiness of the future cash flows attributable to the asset or obligation. Such expectations lie at the heart of all asset exchanges.
Therefore, every financial analyst wants to know the fair value of individual assets and liabilities. CFA institute observes: ‘Opponents of fair value reporting argue that measuring and recognizing assets and liabilities at fair value in the financial statements introduces volatility into the financial statements. We argue to the contrary: If fair value measurement results in greater volatility, then the measurement has merely unmasked the true economic reality that was already there’.
It is difficult to argue in favour of historical cost measurement in situations where IFRS mandates fair value measurement. In the previous article we discussed some situations where IFRS mandates or provides a choice for fair value measurement of assets and liabilities. The following are some more examples where IFRS uses fair value measurement.
PPE and intangible assets Property, plant and equipment (PPE) and intangible assets acquired in a business combination or as government grant or in an exchange transaction are initially measured at fair value. Those assets acquired otherwise are initially measured at the acquisition cost. They are carried at fair value only if the entity chooses to use the revaluation model. Under the revaluation model the change in fair value is not recognised in profit or loss for the period. It is recognised in other comprehensive income. The accumulated balance of revaluation gain or loss is presented as a separated component of equity in the balance sheet as ‘revaluation reserve’. Even when an entity uses the cost model to measure items of PPE, it is required to use fair value in estimating the residual value.
Residual value is the amount that the entity would receive currently (that is, at the balance sheet date) for the asset if the asset were already of the age and in the condition expected at the end of its useful life. If the residual value is not material, it is preferable to estimate it at zero to avoid unnecessary cost of determining fair value at each balance sheet date. Thus, IFRS necessarily requires estimation of fair value of PPE and intangible assets acquired in a business combination for initially recording those assets in the books of the acquirer. There is no mandatory requirement in IFRS to carry items of PPE and intangible assets at fair value.
Active market is not available for most items of PPE and therefore market prices are not available. The fair value of items of PPE is usually determined by appraisal. However, if because of the specialised nature of an item of PPE, market based evidence is not available, the fair value is determined using income or a depreciated replacement cost approach. Usually income based approach is used to estimate the fair value of intangible assets.
Two income based approaches that are commonly used are Multi Period Excess Earnings Method (MEEM) and the Relief from Royalty Method. MEEM approach is effectively a residual cash flow approach. It is used in valuing the most important intangible asset. The Relief from Royalty Method is based on the concept that if an entity owns a right, it does not have to pay for the use of it, and therefore, is relieved from paying a royalty. This method is used for estimating the fair value of a trade mark or trade name.
Investment property
Investment property refers to items of land and building held to earn rental or capital appreciation, rather than for use in production or administration or for sale in the ordinary course of business. IFRS (IAS-40) permits an entity to choose between fair value model and cost model for measuring investment property. If an entity chooses the fair value model, the asset is measured at fair value at each balance sheet date and the change in fair value is recognised in profit or loss for the period.
The financial performance of any investment is measured by change in the fair value. Therefore, the most relevant measure for investment property is fair value. IFRS provides the choice for the cost model as a temporary measure. The Basis of Conclusion in IAS-40 observes that the choice is given for two reasons. The first reason is to give preparers and users time to gain experience with using of fair value model. The second reason is to allow time for countries with less-developed property markets and valuation profession to mature.
Finance lease
The measurement principle is the same as that in the Indian GAAP. A lessee measures the assets and liabilities at the lower of the fair value the fair value of the leased asset and the present value of the minimum lease payment.
Agriculture
IFRS (IAS-41) requires that a biological asset (living animal or plant) and agricultural produce at the point of harvest should be measured at each balance sheet date at fair value less cost to sell. The change in fair value is recognised in profit or loss for the period. Historical cost estimate for these assets is more unreliable than fair value estimate.
Share-based payment
IFRS (IFRS-2) requires share-based payment transactions (e.g. ESOP to employees) should be measured at fair value. At present Indian companies measures ESOP granted to employees at the intrinsic value of the option at the grant date. If the exercise price of the option is set at the share price at the grant date, the intrinsic value, which is the difference between the share price and the exercise price at that date, is zero. Usually, the fair value of the option at the grant date is higher than the intrinsic value. Adoption of IFRS will bring significant change in the current accounting practice of Indian companies.
Financial instruments
Fair value is the natural measurement attribute for financial assets and liabilities. Therefore, IFRS is moving towards full fair value measurement.
Reliability exceptions
Virtually every IFRS that requires a fair value measurement requires such a measurement only if the fair value can be measured reliably. Therefore, if the fair value estimate is so unreliable that it is misleading an entity may deviate from the requirement of fair value measurement. But then it has to defend its decision before the auditor and in published financial statements.
Conclusion
Almost every IFRS that requires fair value measurement provides guidance on how to estimate the fair value. The preparers of financial statements and auditors should develop the skill to apply those principles quickly. To question whether India is prepared to adopt IFRS from April 1, 2011 is to demean the accounting profession and the professional skills of analysts. It is true that the fair value measurement of assets and liabilities poses a challenge. The Indian accounting profession is capable of handling it.
E-mail: asish.bhattacharyya@gmail.com
