A fair definition of fair value

Source: Business Line, 13-07-2006

Mohan R. Lavi

Fair value is the amount at which an asset is exchanged or a liability settled between knowledgeable parties in an arm's length transaction.

There is a joke that defines GAAP as the difference between accounting theory and practice. This may no longer be the case, with accounting regulators sparing no effort to convince companies to reflect all assets and liabilities at fair value.

Accounting Standard 28, on Impairment of Assets and largely modelled on the International Accounting Standard, ensured that companies tested assets for impairment, thereby reflecting them at fair value. And to give a similar treatment to all the other items in the balance-sheet, International Accounting Standard 39 — on Financial Instruments — urged companies to value all their financial instruments at fair value.

While this did create an uproar in the accounting fraternity worldwide, the International Accounting Standards Board (IASB) decided to issue standards in a new avatar — International Financial Reporting Standards (IFRS) — which could become the rule rather than the exception as far as global standards go.

IFRS 7 — again on Financial Instruments — will be made mandatory from January 2007. This standard has given finality to the debate, by stating that all financial assets and liabilities be valued at fair value. But the all-important question that arose was: How to define fair value?

What's fair value?

Recently, the Reserve Bank of India (RBI) brought out a discussion paper on derivative and hedge accounting for banks. This, again, draws to a large extent on IAS 39, and gives a fair definition of fair value. It defines fair value as the amount at which an asset is exchanged or a liability settled between knowledgeable parties in an arm's length transaction.

The fair value of a derivative is the equivalent of the unrealised gain or loss from marking to market the derivative using prevailing market rates or valuation technique. The fair value should be measured reliably. The discussion paper also provides examples of sources from which one can obtain the fair value:

A published price quotation in an active market;

Prices available from most recent transactions; and

Results of a valuation technique that relies more on market inputs than entity-specific inputs.

The valuation technique should be calibrated regularly and tested for validity. The Institute of Chartered Accountants of India (ICAI) has announced that the present draft on Financial Instruments will be converted into an Accounting Standard in early 2007. In keeping with international trends, one can expect a change in the draft in that the standard would call for measurement of financial instruments at fair value instead of only a disclosure, as is the position now.

Internationally, the trend is to treat effective and `not effective' hedges separately. In principle, a hedge is highly effective if the changes in fair value or cash flow of the hedged item and the hedging derivative offset each other to a significant extent. With all these changes happening at a frenetic pace, it appears to be only a matter of time before balance-sheets reflect what is mentioned in audit reports — a true and fair view of the financial position of the company.