The standards board issued IFRS 13 in 2011 to unify measurement requirements across various principles. With many organisations facing hurdles towards this transition, Veena Hingarh provides practical solutions to help overcome these obstacles…
Veena Hingarh, Director – South Asian Management Technologies Foundation
THE ACCOUNTING standard boards and the professional bodies of accounting all over the world are grappling to define and redefine various concepts of accountancy.
Post Luca Pacioli’s introduction of the double entry system not much has changed – debits remain debits and credits remain credits. Recording of past transactions, to reflect them faithfully, has been the motto of accounting ever since.
This could have remained a very routine and repetitive process, straightforward and problem free. Yet, over the years, accounting standards have been diverse across countries, dealing with numerous complex issues and many a times being economically and politically sensitive and even becoming controversial. What should have been straightforward ended being a meandering road to debate and doubt.
Perspective of the market
Accountants have always had options to select from multitudes of measurement techniques ranging from historic cost, through value-in-use, to fair value and many shades in between. The International Accounting Standards Board (IASB) issued International Financial Reporting Standards (IFRS) 13 on May 12, 2011 unifying the fair value measurement requirements across various IFRSs. It came into effect on January 1, 2013 and must be implemented in financial periods beginning on or after January 1, 2013.
IFRS 13 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.” (IFRS 13.9). The fair value measurement is from the perspective of the market participant rather than the entity itself, it is the exit price of the asset or liability. When an entity is fair valuing any asset or liability the following factors would need to be considered:
The asset or liability: Characteristics of an asset or liability that a market participant takes into account for pricing would need to be considered by the entity, for instance condition, location and restrictions, if any, on sale or use. A single asset or liability or a group of assets or liabilities may be fair valued.
The market: Fair value would be based on a hypothetical transaction that would take place in the principal market or, in its absence, the most advantageous market.
The market participants: Fair value measurement requires considering the same assumptions that market participants would use when pricing the asset or liability, assuming that market participants act in their best economic interest.
The price: Fair value would be based on the exit price and not the transaction price or the entry price.
The standard also provides certain specific requirements for non-financial assets, liabilities, equity and financial instruments.
IFRS 13 requires the fair value of a non-financial asset to be measured based on its highest and best use from a market participant’s perspective.
A fair value measurement assumes that a financial or non-financial liability or an entity’s own equity instrument is transferred to a market participant at the measurement date. It assumes that the liability/entity’s own equity instrument would remain outstanding and the market participant transferee would be required to fulfill the obligation/ take on the rights and responsibilities associated with the instrument.
Valuation techniques
When a quoted price for the transfer of a liability or the entity’s own equity instruments is not available but the instrument is held by another investor as an asset, management should measure fair value from the perspective of the investor.
If a market is not available for the liability, a valuation technique is required to measure the fair value from the perspective of the liability issuer. The valuation techniques should be appropriate in the circumstances and have sufficient data available to measure fair value, maximising the use of relevant observable inputs and minimising the use of unobservable inputs.
Based on the quality of the inputs the standard established a fair value hierarchy- Level 1 for quoted price of identical assets, Level 2 for directly or indirectly observable inputs other than quoted prices and Level 3 using unobservable inputs for valuation.
The fair value of a liability reflects the effect of non-performance risk. Non-performance risk includes, but may not be limited to, an entity’s own credit risk.
IFRS 13 implementation challenges
In this section I have discussed some of the challenges faced while implementing fair value measurement. Being the first year of implementation data gathering, selection of the valuation technique, changing the mind set to an exit price orientation, and measuring the risk premium have been some of the common areas of deliberation. Paucity of detailed knowledge is another major challenge. I have provided a summary of select practical problems faced by industries across different verticals and would like to remind the readers that no single entity might have faced all of them.
The identification of the appropriate market, that is, the principal market and the advantageous market may not be as straight forward. Further, management may need to make assumptions about the type of market participants that may be interested in a particular asset or liability. They would need to consider multiple factors such as the specific location, condition and other characteristics of the asset or liability, growth rates, risk free rate and the risk premium, impact of inflation and so on.
Non-performance risk
Every organisation needs to sensitise their personnel on the impact that fair valuation would bring on the look and interpretation of their financial statement.
Management may require considering alternative uses of those assets to determine whether the current use of the assets commands the highest price and is the best use.
The price being based on an exit price brings in a hypothetical sale and requires adoption of an estimation methodology. The extent to which market data is available varies with different assets and liabilities. A rigorous process would be required to study various market assumptions, key features of each transaction and their influencing factors to be able to determine a reliable fair value for an arms-length transaction. Uncertainty and estimation is inherent in the entire process.
The fair value of a liability should reflect non-performance risk and should take into account the effect of an entity’s own credit risk and the counterparty’s credit risk. Therefore there were two implications (1) that fair value measurements must take counterparty risk into account and therefore a credit valuation adjustment should apply to the ‘risk free’ yield curve, and (2) a debit valuation adjustment would need to be made for the entity’s own credit status.
A process in the entity would need to be established for periodically tracking and applying the movements in the credit value adjustment and the debit value adjustment.
Market transparency
Apart from credit risk a comprehensive risk assessment may be required by the entity while determining the non-performance risk. The entity must have a documented risk management strategy and risk quantification methodology established.
The standard permits fair value measurement of a group of assets or liabilities. The portfolio impact in such cases needs to be determined.
Use of the fair value hierarchy may become a data intensive and complex exercise. Availability of local data and statistical deficiencies has been an impediment resulting in usage of proxy values and resulting in many assets and liabilities being measured using unobservable inputs. That is, at Level 3.
Development and selection of the correct valuation technique is critical. The statistical –financial models developed for the valuation should be such that it can be consistently used in the future.
Disclosures requirement are intensive including the details of judgments, methodologies and related issues.
Accountancy is not a subject of mathematical precision. Estimates and judgments are an integral part of the subject. The accounting standards no doubt provide transparency to the market and users of financial statements. However, our accounting standards can now cause the same asset or liability to have multiple values. It would depend upon the estimate of numerous factors and the choice of the valuation technique according to which they are being recognised.
Effective monetary capital
Valuation is as much of an art as a science and we are fully aware of that. Beauty is in the eye of the beholder, and so is valuation. When the market is booming assets valued at the exit price would be an overestimation and underestimated in case of market failures. The value of the asset would oscillate with the market oscillations.
Fair value measurements would give rise to unrealised gains once recorded through profit and loss account. Distribution of the unrealised gains may endanger the enterprise capital and pose a challenge to the maintenance of effective monetary capital.
Another challenge to fair value accounting is intangible assets. Internally generated intangibles are no doubt valuable. It may be Coke’s content formula or Facebook’s business concept, but these find no representation or fair value in accountancy.
Comparability is another feature of the financial statements. It is a riddle how diverse accounting techniques, measurement methodologies, and varied accounting policies on fair valuation can result in truly comparative statements.
Every organisation needs to sensitise their personnel on the impact that fair valuation would bring on the look and interpretation of their financial statement. Even though the first challenge seems to be to have the computational framework ready, but the real challenge will emerge once the first set of accounts is ready and its impact starts percolating down the profit and loss account of subsequent years. Alarming though, but fair valuation may not be fair to all entities.
