By Nithea Nadarajah
“Fair value is the new mainstream basis of accounting,” observed Tan Khoon Yew, Partner, Learning & Professional Development, BDO in his presentation at the recent MIA MPERS Conference 2018.
Referring to an objective estimate of the current market value of an asset (or liability), fair value measurement is a paradigm shift away from the historical cost method of recognising the cost of an asset (or liability) upon its acquisition.
Under Section 2.34(b) of MPERS, fair value is defined as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s-length transaction.
Even thrashing out the semantics is challenging.
One, the contention that ‘an asset could be exchanged’ does not necessarily imply an outright cash or credit payment made for an asset. The asset exchanged could also fall within the ambit of barter transactions, which could evoke circular reference issues between the value of an asset given away versus the value of an asset received.
Two, ‘liability settled’ could also be perceived to include indirect settlement mechanisms such as debt novation agreements usually undertaken during de-gearing exercises. Should the fair value of the liability in question be measured at its carrying amount in the balance sheet or the amount payable to the third party assuming the liability?
Three, deciphering the context behind ‘knowledgeable, willing parties at an arm’s length transaction’. Willing parties at arm’s length transaction can be easily inferred to mean willing participation without any pressure or force amongst parties that are acting independently. However, in instances whereby the information required to accurately determine the fair value of an asset (or liability) is not readily accessible, are the parties deemed “knowledgeable”?
Measuring Fair Value
Fair value and historical cost are the two common measurement bases under MPERS. Section 2.46 of the MPERS specifies that at initial recognition, an entity shall measure assets and liabilities at historical cost unless another basis such as the fair value method is explicitly required.
MPERS requires that the fair value method be applied upon initial measurement of certain balance sheet items such as financial instruments, government grants, certain biological assets and service concession agreements. Additionally, revenue income under the profit and loss statement is also accorded the equivalent fair value basis treatment upon initial measurement.
Most non-financial assets are initially recognised at historical cost and subsequently measured using the fair value method. However, in relation to investment in associates and joint ventures, companies can apply either the cost method or the fair value method.
MPERS also introduced the concept of ‘undue cost or effort’ whereby an asset or liability is exempted from applying the fair value method should there be undue cost or effort suffered during the valuation process. However, this exemption is limited to only certain items identified under the MPERS e.g. financial instruments in Section 11 or investment properties in Section 16.
Applying Fair Value
Small and Medium Enterprises (SMEs) must maximise the use of observable inputs and reduce the use of unobservable inputs when measuring fair value. MPERS introduced a fair value hierarchy which prioritises the importance of observable inputs in the fair value measurement process.
- Observable market price or the current price of an identical asset in an active market is the best evidence of fair value.
- In the absence of observable market price, the next option will be the application of entity-specific observable market data which includes prices stated in a binding sales agreement or a recent transaction (provided there are no significant time lapses or undue changes in economic circumstances).
- If the market for the asset is not active and recent transactions are not good estimates of fair value, another method of measurement called the valuation technique is applied. The objective of using a valuation technique is to estimate what the transaction price would have been on the measurement date in an arm’s length exchange motivated by normal business considerations. The two most commonly acceptable valuation techniques are the discounted cash flow analysis and option pricing models.
- In the absence of asset market prices, it is reasonable to rely on the concept of determining the available market price for the transfer of an identical liability relating to that asset.
Regardless of the fair value technique adopted, the financial statements must adequately disclose the basis used to determine fair value, the observable or unobservable inputs relied upon, as well as the necessary assumptions made.
“MPERS does not prescribe beyond the general requirements, how fair value must be calculated for each type of asset or liability, especially in relation to non-financial assets,” cautioned Tan. SMEs are thus required to apply professional judgement in situations that lack clarity during the fair value measurement process.
Furthermore, MPERS does not provide guidance or specify the type of markets that SMEs are expected to rely upon, e.g. criteria for the most advantageous market. In reality, the existence of numerous financial markets and widely disseminated information present preparers with a surfeit of choice and their decisions could result in flawed and diverse fair value measurements.