How ‘fair’ is fair value?
Fair value accounting has come under a lot of criticism since the global financial crisis of 2008/ 2009 – how do you calculate the ‘fair’ value of an asset when no market exists for that asset? How accurate is an estimate of the ‘fair’ value likely to be when you are forced to calculate its selling price during unfavourable or volatile times? Moreover, does fair value accounting, being a market-based measurement, increase short-termism and volatility? Despite the many drawbacks of fair value accounting, Raymond Yuen Wai Pong CFA FCPA, Consultant, Creative Development International, argues that fair value continues to represent the best available methodology for determining and reporting the value of assets.
In 2005, Hong Kong adopted international accounting standards and moved from historical cost accounting to a ‘fair value’ accounting basis. This was Hong Kong’s ‘big bang’ in accounting. Before 2005, Hong Kong used the UK GAAP accounting basis where accounts were largely booked, prepared and reported using historical transaction values.
Under this system, a lot of off-balance sheet financial exposures were not accounted for or disclosed. The new Hong Kong Financial Reporting Standard (HKFRS) and Hong Kong Accounting Standard (HKAS) requirements are much more extensive and are designed to ensure company accounts measure and report not only the historical figures, but also the business realities behind those figures. There are currently 13 HKFRSs and 29 HKASs in effect amounting to over 2,500 pages of accounting/ reporting standards.
The advantages of fair value accounting
What is fair value accounting? Before answering this question, we need to know the definition of fair value from an accounting perspective. According to HKFRS, fair value is defined 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,’ (see HKFRS 13, Fair Value Measurement, Para 9).
This is further elaborated in HKFRS 13, Para 2, which states that fair value is a market-based measurement, not an entity-specific measurement. For some assets and liabilities, observable market transactions or market information might be available. For other assets and liabilities, this information might not be available. However, the objective of a fair value measurement in both cases is the same – to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market condition. That is, it represents an exit price at the measurement date from the perspective of a market participant who holds the asset or owes the liability.
This gives fair value accounting a notable advantage over historical cost accounting in that it better reflects the current situation of the company and is therefore more relevant and useful to the user of the financial statement. It also better reflects the temporal aspects of asset values, the associated risk aspects and it accounts for corporate actions with dilution effects. As a result, financial statements under HKFRS are more useful, especially to investors and potential shareholders of the company, as HKFRS has deepened and widened the disclosure requirements of financial statements.
The disadvantages of fair value accounting
Fair value accounting also has its drawbacks. The three big drawbacks are subjectivity, volatility and the high cost of preparation.
Under fair value accounting, asset values are calculated with reference to their market price. Where there is no open market for such assets, directors of the company have to resort to estimates for booking the fair value. Some of the estimates are prepared by third parties such as appraisers. Though still subjective, where the appraiser is professional and independent, the quality of the financial statements may not be compromised too much. However, if the estimates are prepared by the company itself, the subjectivity problem may become more acute. Figures may be subject to manipulation if the company is not honest.
Moreover, the fair value estimation of the assets may depend heavily on the intended usage of the asset by management. For instance, where management intends to dispose of the asset, it will be accounted for as a non-current asset held for sale. This is another part of fair value accounting where subjectivity comes into play.
There is also some confusion as to the meaning of ‘fair value’ – for example, should we base fair value on market price, economic value, replacement value, depreciated value, or intrinsic value? Of these values, I believe the intrinsic value concept is the most relevant one for most investors and users of financial statements. Clearly, where assets have an open market, the open market price will provide the most objective measurement, but where assets do not have an open market, the current fair value measurement methods required are best aligned with the intrinsic value concept such as using discounted cash flow, similar asset benchmark or even very advanced methods such as Black Scholes Model.
As fair value accounting is based on market-based measurements, asset values may be subject to big fluctuations, particularly where they are financial assets. For instance, during the recent financial crisis, the price of some bonds dropped in value by more than 60%.
Many have therefore criticised fair value accounting as encouraging short-termism in the users of the accounts.
Of course, the fall in value will usually be remedied after the financial crisis, and the value of the bond does not always have to be ‘marked-to-market’ – it may be based on an amortised cost where the holder intends to hold the bond for investment rather than trading. This will reduce the ‘short-termism’ in the accounts.
Furthermore, the reporting standard will be further refined in the coming HKFRS 9 Financial Instruments, which will replace HKAS 39 Financial Instruments: Recognition and Measurement. The major change will be to replace the scattered criteria for measuring with fair value or amortised cost under HKAS 39 with a coherent single approach under HKFRS 9, which has to be applied by January 2013 with the option of early adoption.
The high cost of preparation
Fair value accounting requires companies, from time to time, to employ an appraiser to estimate the value of assets and this naturally raises the administrative cost of the preparation of financial statements. Furthermore, the measurement and disclosure of HKFRS is much more complicated and extensive than the pre-2005 accounting standards. This increases the cost of preparation of the financial statements. For instance, measurement of the value of hybrid bonds with convertible features that split the bond into fixed interest components and equity components will involve the use of complicated models to split the value.
Disclosure requirements of HKFRS are also much more extensive as compared with pre-2005 HK GAAP. For instance, in addition to giving the figures, a quantitative and qualitative information on a hybrid bond would be required for the user to appreciate the risk of the hybrid bond to the company. However, all this information is very important to appreciate the financial performance and financial position of a business.
Is fair value the best available method?
Despite the disadvantages of fair value accounting listed above, it is worth asking whether there is a better method available to us. In my view, despite the many controversies surrounding this method, particularly after the recent financial crisis, fair value accounting is still the best available method to account for the financial performance of businesses.
Consider a moment what a return to historical cost accounting would mean for the accounting of derivatives. Derivatives involve hidden leverage, off-balance sheet exposures and expose companies to sometimes highly volatile financial markets. According to Wikipedia, the global derivatives market was valued in June 2007 at over US$500 trillion, which is equal to more than eight times the total GDP of the world, or over 30 times the GDP of the world’s biggest economy – the US. Furthermore, while the growth rate of the derivatives market has slowed in OECD countries in recent years, the growth rate in developing countries like the PRC is still in double digits.
Historical cost accounting fails to account for financial products like derivatives, which could be a make or break for many businesses. For instance, the Hong Kong listed company First Natural (HKEX Code: 1076) went into provisional liquidation in September 2010 because of its exposure to a huge amount of derivatives products. The company was still suspended from listing when this article went to print.
Furthermore, there are provisions to deal with the most obvious drawback of fair value accounting – namely how to estimate the value of assets in the absence of an open market for them. in my view… fair value accounting is still the best available method to account for the financial performance of businesses
Under HKFRS 13 Fair Value Measurement, for example, the fair value estimates are cascaded into a three-level hierarchy, as reported by Deloitte in their IAS Plus Update (March 2009).
Level 1 is based on quoted prices (unadjusted) in active markets for identical assets or liabilities.
Level 2 is based on inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly (that is as prices) or indirectly (that is derived from prices).
Level 3 is based on inputs for the asset or liability that are not based on observable market data (unobservable inputs).
Extensive disclosure and reconciliation are required for any transfer between these levels. As the HKFRS and HKAS requirements are very extensive and are beyond the scope of this article, readers interested in understanding more about this should refer to the IAS Plus Update issued by Deloitte in March 2009, or refer directly to HKFRS 13, Fair Value Measurement.
In conclusion I would argue that, despite the drawbacks of fair value accounting, it remains a great improvement in the accounting standards of the business world. Fair value accounting:
- provides more relevant information to the user by referring to the market value, or estimates of the market value, of assets
- provides more extensive disclosure to the user, including information on risk exposures and the business rationale behind the figures, and
- raises the quality of information in the financial statements by including a very important class of financial assets – derivatives – which can be subject to great fluctuations in value and which would otherwise be offbalance sheet exposures.
Raymond Yuen Wai Pong CFA FCPA
Consultant, Creative Development International
The opinions expressed are the author’s and do not necessarily reflect those of Creative Development International.