Fair Value Measurement free essay sample

The meaning of fair value Fair value is the price that would be received from the sell of an asset or will be paid to transfer a liability in an orderly transaction between the market participants and the measurement date [IFRS, 13 – A501]. However in accounting and economics, fair value is the rational and unbiased estimate of a possible market price of a good, service or an asset. Fair value takes into account many objectives and subjective factors such as: Objective Factors Supply and demand Acquisitions Distribution costs Replacement costs Cost of substitutes Subjective Factors Risks Cost of capital Returns of capital FAS 157 defines fair value as â€Å"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. † This definition reflects an â€Å"exit value†, meaning a value that firms can take the specific item through an orderly transaction with market participants. When the market price of an asset can not be determined, fair value is used as a certainty of the market value. Fair value is the amount at which the asset could be bought or sold in a current transaction between willing parties or transferred to an equivalent party. [GAAP] In terms of future markets, fair value is the equilibrium price for a future contract. This means that fair value will be equal to the spot price of the contract taking into account compound interest. In terms of consolidations, fair value is the estimated value of all assets and liabilities of an acquired company that will be used to consolidate the financial statements of both companies  in question. The application of fair value measurement Fair value measurement is for a particular asset or liability. [IFRS 13] For this reason, when measuring fir value an entity must take into account the characteristics of the asset or liability if the market participants would take those characteristics into account when determining the price of the asset or liability at the date of measurement. Then effect on measurement arising from the characteristics will differ depending on how the characteristics would be taken into account. Characteristics that should be taken into consideration are: The condition of the asset Location of the asset Sale restrictions Use of the asset An asset or liability that is measured at fair value might be either: A stand alone asset or liability (eg. a financial instrument) or A group of assets or liabilities (eg. a cash generating unit) Fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between participants in a market to sell the asset or transfer a liability at the measurement date under the conditions of the market. IFRS explains that a fair value measurement requires an entity to determine the following: The particular asset or liability has been measured For a non financial asset – determine if the asset was used as a stand alone or in combination with other assets. The market value in which a transaction would take place The appropriate valuation technique is used when measuring fair value. The valuation technique used should maximise the use of relevant inputs. To promote consistency and comparability in the measurement of fair values and their disclosure, IFRS established a fair value hierarchy that categorises into three levels. The highest priority is given to quoted prices, that being unadjusted prices. Level two is quotes prices that are observable directly or indirectly, while level 3 inputs are unobservable inputs. 4 3. Fair value measurement techniques An entity shall use valuation technique that are appropriate in the circumstances and for which sufficient data are available to measure fair value, maximising the use of relevant observable inputs and minimising the use of observable inputs [IFRS] Three widely used valuation techniques are used, they are: 3. 1 MARKET APPROACH This method of fair value measurement is based on the selling price of similar items in the market. The market approach is a business valuation method that can be used to calculate the value of property as a part of the valuation process for a business that is closely held. In addition to this the market approach can be used to determine the value of a business ownership’s interest in a security or an intangible asset. Regardless of what asset is being valuated, this approach studies the recent sales of similar types of assets and making adjustments for the difference in size, quality or even quantity. When taking into consideration the valuation of property, the value is estimated by looking at its comparables, such as recently sold properties sold that are of a similar size, features and located in a close proximity. 3. 2 COST APPROACH This approach states that a potential user of real estate would not or should not pay more for a property that what it would of cost to build an equivalent building. This means the cost of construction less depreciation plus the cost of the land. However there are some assumptions that are made. One of the most obvious being that there is a sufficient supply of buildable land and construction is a viable alternative to purchasing property. Other issues that can arise are the fact that the cost of constructing an obsolete building is not considered relevant to the market value, costs can not be estimated exactly, how exactly to estimate costs. There is also a chance that a project will only be feasible if the projected cost is less than its completed value. It is generally considered that the cost approach gives the best indication of market value when the property in question is new and an appropriate (highest and best) use. This is the third and final approach of the fair value measurement techniques, which is particularly common in commercial real estate appraisal and in business appraisal. This method is very similar to methods used for financial valuations, security analysis or even bond pricing. The income approach can be broken down to many sub-methods that fall into 3 categories that being: 3. 3. 1 Direct Capitalisation This is a simple quotient of dividing the annual net operating income by the appropriate capitalisation rate. For income producing estate, the net operating income is the net income of the property plus any interest expense and non cash items minus a reserve for replacement. The capitalisation rate may be determined in many ways such as market extraction, band of investments or the built up method. An assumption in direct capitalisation is that the cash flow is a perpetuity and the capitalisation rate is a constant. If either a cash flow or risk levels are expected to change, then the direct capitalisation fails and a discounted cash flow method must be used. Net income is capitalised by the use of market-derived yields. A capitalisation rate inherently includes the investment specific risk premium. 3. 3. 2 Discounted Cash Flow The discounted cash flow is similar to the net present value estimation in finance. However people often mistakenly use a market-derived cap rate and the net operating income as a substitute for the discount rate or the annual cash flow. The capitalisation rate equals the discount rate plus or minus a factor that anticipates growth. The net operating income may be used if the market value is the goal, but if investment value is the goal then other measures of cash flow would be more appropriate to use. 3. 3. 3 Gross Income Multiplier The gross income multiplier also referred to as the gross rent multiplier is simply the ration of the monthly or annual rent divided into the selling price. If many properties of a similar kind are sold recently in the market, then the gross income multiplier will be computed for those and will be applied to the 6 anticipated monthly rent for the property in question. The gross income multiplier is useful for rented houses, duplexes and simple commercial properties. An entity shall use valuation techniques consistent with one or more approaches to measure fair value. In some cases a single valuation technique will be appropriate, such as when valuing an asset or liability using quoted prices in an active market for assets or liabilities that are identical. In other cases multiple valuations can be done. 4. Challenges facing fair value reporting Many would agree that fair value measurement yields a more relevant measure than historical cost. With regards to an article by Price Waterhouse Coopers, titled â€Å"Fair value accounting: is it an appropriate measure to value for today’s financial instruments? † It identifies implications that arise due to fair value such as: Where models are use to determine fair value Even though investors in general believe that fair value is an appropriate measure for financial instruments. However some investors as well as companies are more concerned about the use of fair value when it is unclear on how to determine the market pricing. Fair value measures require applying the market prices regardless of how volatile the market may be, and referring to prices of similar securities. When neither of the two are present or exist, the company involved would have to employ models to determine fair values. This is an extra cost that would have to be burdened by the company that could pose possible risks. Volatility of Earnings The volatility of earnings generally occurs when the market becomes illiquid and the prices are no longer available. When the methods of determining fair value are applied, the effect on earnings may be as unpredictable as the market is. Financial instruments fluctuate as a result of market realities that are revealed in the assessment of fair values. Effect of fair value measurement on long term value This is of a particular concern, as whether any particular application of fair value measurement accurately reflects long term value, it can only be decided in the long term. 7 Pieter van der Zwan CA(SA) stated in his article- â€Å"Pushing fair value accounting to its limits† a number of possible challenges or issues that could later arise due to fair value measurements such as: Disclosure Recent amendments to the requirements of disclosure of financial instruments have brought on the questioning of the fairness and reliability of the disclosure of financial statements. The issue arose from the way that fair value is being calculated in practise. Zwan brings up the fact that entities in South Africa find that determining fair value when required by IFRS is harder done than said. Unobservable subjective fair value Zwan predicts that the use of unobservable and subjective fair value accounting would most likely increase over the years. In most of these times these fair value measurements will provide information that is more useful for the financial statements than the alternative of measuring the cost of the item. However this is unsatisfactory as knowing the cost of the item would be more beneficial in times of sales. Auditor responsibility The increased use of fair value accounting places greater responsibility on auditors and those who help prepare financial statements. Auditors need to be able to assess all subjective and unobservable inputs to express an opinion. Auditors would need to be able to verify the inputs be being able to rely on the fair value of the information set out in the financial statements. 8 INTRODUCTION Fair value accounting is a financial reporting approach in which companies are required to or permitted to measure and report on an ongoing basis, the estimates of prices they would receive for certain assets and liabilities if they were to sell the assets of would have to pay to be relieved of the liability. Under accounting in a fair value basis, a company would report a loss when the fair value of the assets decreases or value of liabilities increase. Generally accepted principles and fair value measurement have played a major role for more than 50 years. In September 2006, the Financial Accounting Standard Board , the FASB had issued a controversial yet important new standard that they called, the Statement of Financial Standards no 157 – FAIR VALUE MEASUREMENT (FAS 157), which provided more significant and comprehensive guidance to assist companies in the estimation of fair values. The practical applicability of this standard was tested during the most extreme market conditions during a credit crunch that was ongoing. Some parties criticized fair value accounting, including the FAS 157 measurement guidance techniques. Some of the criticism included; reported losses were misleading, fair values were difficult to estimate, reported losses have adverse affects on the market prices and so on. In South Africa, International Financial Reporting Standard number 13 is dedicated to Fair Value. This standard defines fair value, briefly explains the measurement of fair value, the recommended disclosure and the standards and rules that need to be followed. Through this essay I will try to answer the most asked question with regards to fair value, that being – â€Å"Does Fair Value Accounting provide more useful information to investors and businesses? † 2 CONCLUSION It is only fair to say that fair value measurement benefits both companies and investors. Some of these benefits include: Requires and permits companies to report amounts that are more accurate, timely and are comparable under the existing market conditions. Allows companies to report amounts that can be updated on a regular and on going basis. Limits companies ability to manipulate their net income, or value of their assets or liabilities of a specific period. Gains and losses resulting from changes in fair value must be additionally disclosed so that it can be found easily. The Council of Institutional Investors stated that â€Å"the goal of fair value measurement is for firms to estimate as best as possible the prices at which the position they currently hold would change hands in orderly transactions based on current information and conditions†. This goal was met by firms, companies and investors as they incorporated their current information about their future cash flows and the current risk adjusted discount rates into their fair values and their measurement. Fair value measurement and its disclosure have taken on a greater importance over the more recent years, with this form of measurement being the most used valuation in financial statements. Even though management expects the use of the fair valuation they do not specify which of the three may be used, the company will have to use the technique that best suits the asset or liability needed to be valued. Fair value accounting benefits investors as well unlike other methods of measurement accounting such as amortisation costing. Fair value accounting is the best platform for mandatory or voluntary disclosure so that investors will be able to answer any questions that management poses to them with regards to their choice of valuation and its respective outcome. It is in my opinion that the fair value method is more beneficial than any other method; it produces an outcome that is more appropriate and can be understood more easily by those analysing financial statements.