VideoThe countdown is on. The deadline for all EU-listed companies to adopt International Financial Reporting Standards (IFRS) — including controversial IAS 39 — is just around the corner. For the investor community seeking comparability of financial reports, that's good news. But for many CFOs that will mean grappling with one of the most contentious issues in accounting today — fair value.
Of course, banks and other financial institutions have found themselves squarely at the centre of the fair value debate thanks to IAS 39, which requires them to record a range of financial instruments such as derivatives and bonds at fair value on the balance sheet. Any changes in the value of those instruments must then be fed through a company's income statement, or else shown in shareholders' equity, depending on the instrument. The impact could be big, particularly given that, up until now, many financial assets and liabilities have been held at historical cost rather than fair value, or else not recorded on the balance sheet at all.
But other types of companies besides banks are likely to feel the growing influence of fair-value accounting in the years ahead. Take IAS 40 for investment properties. Although this standard gives real-estate developers the choice of recording their assets at historical cost, in reality it requires them to adopt a fair-value approach, with gains and losses recorded in the income statement or shown in the notes. Then there's IFRS 3 for business combinations, which prohibits "pooling of interest" accounting. The rule states that acquiring companies must measure the fair value of all acquired assets, including contingent liabilities, and the fair value of the amount paid, including equity, with the difference recorded as goodwill. IFRS 2 for share-based payments is a further example. The fair value of all employee stock options, for example, must now be determined at the grant date and expensed over the vesting period of the option. And so the list goes on. (See "Blast the Past" at the end of this article.) Indeed, the impact on the entire financial reporting "value chain" — from CFOs to auditors to investors and regulators — threatens to be far-reaching.
Marching Headlong
Martin Cubbon, group finance director of Hong Kong-based Swire Pacific, notes: "Fair value isn't just creeping into accounting, it's marching headlong. It seems to be the avowed intent of the IASB to pretty much standardise on fair value."
At Swire, a HK$17.6 billion ($2.26 billion) conglomerate that owns a large real-estate business, as well as 46 percent of Cathay Pacific Airways and other businesses, the introduction of IAS 40 for investment properties is set to have a major impact. With Hong Kong having adopted the standard effective in 2005, any changes in the value of the company's property portfolio will impact the profits of the whole group. In the past decade, annual swings in the value of the company's investment properties have been as high as HK$9 billion, a figure that would wipe out profits entirely in some years, while doubling them in others.
"As an old-fashioned 25-year qualified accountant, I think the move to greater fair value is very dangerous," says Cubbon. For one, he doesn't believe the volatility that fair-value accounting introduces to earnings is useful. But more than that, he worries that fair-value accounting is too subjective. Where liquid markets exist, determining the fair value of an asset or liability is simple enough. But when companies must make their own assessments of fair value using a discounted cash flow model or similar technique, then room for error, or even abuse, opens up.
"Historical cost accounting may be flawed, but at least it's objective; you know what you're getting," he observes. "With fair value, on the other hand, you're bringing in a great deal of assumptions and judgements about the future." As an example, Cubbon points to the flexibility managers have in setting the discount rate used in valuing a fixed asset. "These are highly judgmental areas," he sniffs.
Others share Cubbon's view. "Logically, all assets should go on the balance sheet," notes Robert Kirk, a professor of financial reporting at the University of Ulster in Ireland, "but assigning a value to assets that aren't bought or sold regularly — such as intellectual property — can't be an exact science."
Yet Rebecca McEnally, vice president of advocacy at the CFA Institute in Virginia, counters that accountants have been using estimates — such as guessing the useful life of a building — and models like straight-line depreciation for years. What's more, she points to a deeper issue. "If management finds such difficulty in determining the values of its assets, then what sort of decisions are they making in the absence of such relevant and useful information?" she asks.
How Fair Is Fair?
For their part, accounting standards setters acknowledge the increased use of fair value in recent years, but deny they're obsessed with it. "People have assumed that we're fanatics about fair value, but we're not," states David Tweedie, chairman of the London-based IASB.
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