B. Fair value measurement issues
5. Fair value measurement — methods and problems
A number of issues related to fair value measurement clearly are worth discussing. This article will focus on just two of them.
1. What to do in the absence of an active market?
39 See paragraph 198et seq. of the discussion paper.
40 The working draft of the FASB standard was discussed by the IASB during the November Board meeting and can be downloaded (together with the other agenda papers on this topic) from http://www.iasb.org/meetings/nov2005.asp.
41See IASB Update September 2005, p. 3.
To answer this question, it is necessary to analyse which items could have active markets. This evaluation depends of course, on the definition of an active market, or using the terminology of the FASB draft an “active reference market”.
With respect to current IFRSs, IAS 38 contains a definition and according to this definition, an active market needs three conditions to be present:
(1) homogenous items;
(2) buyers and sellers can normally be found at any time; and (3) prices available to the public.
The second condition that market participants may be found at any given point in time is actually a liquidity condition. Together with the homogeneity of the items, the existence of active markets is de facto almost reduced to securities or commodities exchanges. Consequently, items with an active market might include financial instruments in countries with developed capital markets, some agricultural produce, electricity, other commodities, emission rights under an environment protection scheme when publicly traded. The other side of this story is that an active market does not exist for a lot of items.
This will lead back to the question of the fair value measurement hierarchy.
Apart from differences in detail, some kind of valuation technique would be used to determine a fair value. This valuation technique will most likely be based on some kind of cash flow projection. Therefore, spot interest rates are needed (probably for longer maturities) and risk-related data. If this information is supposed to be only marked-based data, this would require sufficiently developed capital markets (see figure VI.5). To put it another way: Without at least sufficiently developed capital markets, fair value measurement is associated with some major problems, as even the data needed for the valuation technique may not be observed in the capital market.
Figure VI.5. What to do in the Absence of an Active Market?
Financial Instruments
(developed capital markets )
Agricultural Produce Electricity (?) other Commodities Emmission Rights (?)
no active market
valuation technique
• Interest rates for different maturities (currency -specific )
• Risk data (e.g . ratings )
• Estimated cash flows
{
active market
(liquid, frequent transactions, readily observable prices )
Inputs
2. Does fair value measurement introduce volatility?
Unlike a cost amount based on past cash flows, a fair value will vary through time. As the underlying information (or synonym, changes in the input parameters such as future cash flows, interest rates, risk premiums, prices for other items, e.g.
commodities) will vary continuously, so will a fair value based on these parameters.
This volatility is independent of the approach used to determine the fair value, i.e.
whether the fair value is determined by using the market participants’ estimation of the present value (market price) or by calculating it.
Consequently, if an entity chooses to invest in items whose fair values are volatile and if the accounting standards require the item to be measured at fair value and if changes in fair value are reported in profit or loss, the reporting entities’ net income will become more volatile over time when compared to entities using the cost- based measurement. However, it should be noted that although this volatility quite adequately reflects volatility in the economic environment of the entity. If the entity is a banking institution which deals with financial instruments in an economic environment primarily dominated by volatile capital markets, the financial statements may very well reflect this volatility.
However, there might be significant problems if not all balance sheet items whose fair values depend on certain parameters are measured at fair value. More precisely, the problem arises when some items are measured at fair value and someare measured at (amortized) cost, but still all the items’ fair values depend on the same parameter(s). Since changes in fair values cannot compensate each other, such a mixed measurement concept may results in distorted income figures.
This is due to an artificial accounting-induced volatility introduced to the profit or loss figures (see figure VI.6).
Figure VI.6. Economic and accounting volatility
Fair Values
• interest rates
• risk data
• estimated cash flows
• commodity prices influence
? Fair Value
Economic ("real") volatility Artificial("accounting") volatility
For illustration, consider a very simple example: the reporting entity invests in a straight bond, which is financed by a matching liability (fixed interest rates, matching notional amounts, matching maturities). If the bond (the reporting entities’
asset) is measured at fair value and the liability is measured at cost, every change in the interest rates will result in a change in the fair value attributable to the asset reported in profit or loss. As interest rates tend to be volatile, so will be the net income over time. The economic position of the entity with respect to interest rate risk is not reported faithfully, as there is no interest rate risk exposure. If the liability is also measured at fair value, the changes in its fair value would offset the changes attributable to the asset and both changes would compensate each other in profit or loss. If the liability is not measured at fair value, however, this mixed measurement concept will produce an artificial accounting-induced volatility, which could be
misleading to the users of the financial statement. The key question that needs to be discussed is therefore whether all items whose fair value depends on certain parameters are measured at fair value. There are a number of empirical studies which point out this problem.42