case study: Is 'fair value' good, bad or simply ugly? by Robert Bruce

Is 'fair value' good, bad or simply ugly? by Robert Bruce One of the cornerstones in the drive for a harmonised, global set of international finan- cial reporting standards is the use of 'fair value". This sounds disarmingly simple: assets and liabilities being carried in balance sheet should be shown at fair value. Indeed, the idea is persuasive when it con- cems the value of items that are traded on active markets. A fair value can simply be set by referring to the existing value of a comparable item in the market. a corporate

The problem comes when trying to value items- financial instruments, for example - where no obvious market value is available. Taking their cue from the financial ser- vices industry, the standard makers have, in such situations, opted for the mathematical calculation of a hypothetical market price. The trouble with this is that it is more arcane and less understandable. Even the best informed people start to lose the connection between value and its calculation. So it comes as no surprise that one of the Big Four accounting firms, Emst & Young. has just issued an attack on the concept in a paper called "How Fair is Fair Value?". Ultimately, the firm wants figures to be divided between those that are easily "fair valued", which should appear in the main financial statements, and those that are more complicated and so, as Emst & Young sees it, only relevant enough to be shown in the notes to the accounts. While outlining the difficulties the concept poses, Emst & Young does agree with elements of the underlying idea. *"Fair value" is a wonderfully powerful expression in the English language, it says. "It subliminally awakens all those feelings deep within us of wanting fair dealing and true worth to be recognised and appreciated." This is exactly what appeals about the concept in the complicated world of financial reporting. *On the face of it, therefore,' says Emst & Young. "it seems wholly sensible and appropriate to embrace "fair value" as the primary measurement attribute. On this the firm is in agreement with the International Accounting Standards Board, which runs the international financial reporting standards programme. It is where subjective assessments and calculations come in that Emst & Young has a problem. The firm has looked at the list of intangible assets, unquoted equity securities, derivatives, pension costs, share-based payments and asset valuations and impairments. It suggests that in many cases these are going to appear in the accounts as a hypo- thetical market price based on management assumptions about the future and using a valuation model. "We consider that it is inappropriate to refer to such calculated values as "fair value"", says the firm. Instead, it refers to such items as having been 'marked to model' rather than 'marked to market". At the root of this debate is the question of how far complexity in a company's financial structure needs to result in similar complexity in its financial reporting. Ken Wild, global leader of international accounting standards at accounting firm Deloitte, says: "Fair value has its limitations. It just gets progressively more difficult as you get to the more esoteric items.' In the end it comes down to whether it is more respon- sible to have some figures in the full accounts and some only disclosed in the notes to the accounts. "Emst & Young is right,' says Jim Leisenring, one of the more vociferous board members at the IASB. "It (fair value) becomes more difficult." But he doesn't see the Emst & Young solution of relegating the complex calculations to the notes as viable. I don't see disclosure in the notes as a substitute for recognition and measurement. Ie would mean gamemanship over what is in the notes and what isn't.' Allister Wilson, head of international reporting in the UK wing of Ermst & Young. and the driving force behind the paper's publication, argues that much of this type of accounting has simply become too complex to be comprehensible. I talk to boards and to CFOS and CEOS,' he says, "and increasingly they say they just don't understand their ng regulation and specific issues accounts.' Mr Leisenring rejects this, and indicates that the complexities of intangible assets and financial instruments were all freely taken up by the companies concerned. "Presumably the companies understood the transactions when they entered into them so they should be able to explain them." The Ernst & Young paper takes share-based payments as an example to show how the results of what it calls 'mark to model" can produce "very different results when quite small adjustments are made to the underlying assumptions and predictions'. This is at the heart of the firm's argument. "As the data indicate,' says the paper, 'cost or gains shown in the income statement could vary by a huge margin in any one year when using a calculated fair value, depending upon the choice made by modellers. "Furthermore...it is not generally understood that these "mark to model" calcu- lated values will directly affect reported profits and shareholders' equity, even though they bear little or no relation to cash flows, may cause confusion when unrealised gains are included and may produce valuations that fluctuate considerably year-on- year. But this is based on an assumption that users of accounts will not recognise this. "Analysts are rather better than that," says Mr Wild. "They know what figures are good and what figures are dodgy." The argument could seem arcane. But its consequences will be profound if confi- dence in accounts produced under international financial reporting standards starts to look shaky. Companies could use other less tightly prescribed and regulated avenues to put across what they see as their financial performance. The Operating and Financial Review, which has recently become mandatory for UK companies, for example, could offer such a route. The accounts become single compliance," says Mr Wilson, 'and the real reporting comes through the OFR with companies producing their own definitions of what information they want the market to see.

QUESTIONS 1. What is the concept underlying fair value? Why does a simple concept become difficult?

2. What approach to fair value is recommended by Emst & Young? What are the con- ceptual weaknesses of this approach?

3. Why does Ernst & Young say the fair value of items such as intangible assets, unquoted equity securities, derivatives, pension costs and share-based payments is measured by mark to model, rather than mark to market?

4. What are the risks associated with allowing preparers to select to value some items at fair value while providing only note disclosure in relation to fair value for other items?

5. What is Jim Leisenring's response to the claim that accounting for financial instru- ments and intangible assets has become too complex and is incomprehensible? What is the possible role of the Operating and Financial Review in an environment where financial reporting is complex?