Fair Value

FAIR VALUE:

Fair value for most financial instruments, while it has limitations, is the best available method to reflect market conditions when accompanied by appropriate disclosure.

Financial instruments currently reported using fair value includes:

• as assets most equity and debt securities held

• derivatives

Most assets and liabilities

While fair value information is generally relevant to investors, it is not always sufficiently reliable or practical to implement.

These three criteria—relevance, reliability, and practicality—need to be more fully understood prior to any proposed extension of fair value to assets and liabilities where it is not used today.

Examples:

Assets

trade receivables and most bank loans

inventories used in production

plant and equipment

Liabilities

trade payables

contingent liabilities

company-issued debt

insurance and other non-traded liabilities

Reporting what most financial instruments can be exchanged for in the market—their fair value—provides valuable insight to investors. Markets, and not the business operations of a company, determine the economic value of financial instruments like bonds or common stock. For the most part, such instruments (or derivatives of them) obtain their value from contractual or residual cash flows. The expected cash flows are reflected in their market prices. Even when market prices are difficult to determine, preparers rely on these cash flows to develop estimates of fair value.

The challenges of using fair value

While fair value yields a relevant measure for financial instruments, it presents a number of challenges. Changes in fair value introduce earnings volatility, which makes it more dif­ficult to forecast earnings.

There is a second challenge: Fair value has been criticized for producing inaccurate results in the unusual market conditions recently experienced. Such results, it is argued, hurt the company in the long run. Critics claim that recording losses in such an environment signals bad news to investors that may ultimately prove misleading.

Turmoil in the credit markets has spotlighted a third challenge: When market information is in short supply, companies are required to employ models. But at what point should companies turn from market prices to mod­els? There is no clear-cut answer, and com­panies often rely on judgment to make that call. The difficulty does not end there. Once the decision to use models has been made, management—and investors interested in understanding management’s judgment—must grapple with a host of other complexi­ties inherent in modeling.

As of today, fair value remains the best available method

Some argue that fair value for financial in­struments should be suspended or replaced when markets are severely distressed. But fair value increases the transparency of the impact of market forces on financial perfor­mance, which investors prefer. If fair value were replaced with some other method, investors would be left to their own devices to estimate the future cash flows of finan­cial instruments, and their estimates would likely be less reliable. At least for now, fair value remains the best available measure for most financial instruments. Its limitations can be mitigated by appropriate explanations from management.

The credit crisis has highlighted the challenges of reporting fair value for financial instruments. For nonfinancial assets and liabilities, those challenges become even more prominent.

Fair value is questionable for most nonfinancial assets . . .

The economic value of most nonfinancial assets is determined through their use in business operations, and not by markets. A manufacturing plant, for example, typically generates operational cash flows when used in conjunction with a business’s other assets and liabilities.

Although it is possible to determine fair value for these nonfinancial assets, doing so may be impractical for two primary reasons: (1) markets for these assets may be limited or may not exist, and (2) the value of these assets is often generated from their use as part of a larger group, not on a stand-alone basis.

. . . and for most liabilities

Where most of a company’s liabilities are concerned, investors are interested in the resources required to meet those obligations. Consider, for example, debt issued by a company. In many cases, the resources required to settle that debt provide the most meaningful information about a company’s future cash outlay and solvency, a key objective of financial reporting.

New fair value requirements will soon be effective for one type of liability: contingen­cies in mergers and acquisitions. This is an example where the relevance, reliability, and practicality of developing and reporting fair value is questionable. Contingencies tend to be company-specific and to have limited or nonexistent markets. As a consequence, esti­mates of their fair value could be unreliable.

Niche issues exist

From time to time, situations arise in which it is both meaningful and practical to provide investors with fair value information about nonfinancial assets and liabilities. Those situations tend to be company- or industry-specific and should be handled on a case-by-case basis. Examples include trading inventories (oil, agricultural commodities) and real estate. Severe and progressive declines in market values have converted fair value from a tech­nical issue into a public debate.

Impact on the banking system

The credit crisis has had a heavy impact on the banking system. As markets took a turn for the worse, banks were required to mark asset holdings down to their fair value. For some banks, this has meant significant reductions in available capital. To maintain compliance with existing capital regulations, these banks have recapitalized, sold assets in distressed markets, and restricted lending—thereby extending market turmoil into the broader economy.

Concerns about the capital adequacy of banks and the safety and soundness of the banking system have called into question whether regulations need to be fine-tuned or overhauled. They have also prompted calls for standard setters to retract or modify the use of fair value in the banking industry. In our view, these are separate issues that should be addressed separately; matters involving capital adequacy regulations should not be resolved by changing financial reporting.

Impact on the market: the procyclicality argument

Does reporting downward values drive deeper market declines and intensify market turmoil? Some think so, and as a quick fix they sug­gest revising reported market prices to reflect more stable circumstances. But this argument implies that bad news should be swept under the rug. It also ignores an important fact: Financial reporting does not create adverse market conditions; it captures market perfor­mance after it has occurred.

Looking forward: the move to IFRS

Indian companies aren’t the only ones facing the challenges of reporting at fair value in the near future. International Financial Reporting Standards (IFRS), the framework used by most of the world today encourages greater use of fair value, but generally in niche areas—for example, real estate. Today’s efforts to improve the use of fair value will benefit the world both now and well into the future.

It is impossible to predict how fair value will evolve over the next few years—how it will be affected by changes in investor needs, modeling techniques, the way markets monetize assets and liabilities, and legal and regulatory influences. Nonetheless, standard setters and companies can take actions to improve fair value as it exists today.