Problems With Reliability And Measurement Of Fair Value In Valuation Techniques Essay.

Valuation Techniques for Fair Value Measurement

Task 1.1: The various valuation techniques according to the IASB conceptual framework for financial reporting and specific international reporting standards (i.e. IFRS 13)

When transactions are clearly observable in the market such as, when quoted prices of identical liabilities or assets are prevalent in an active market, the ascertainment of fair value can be relatively straightforward. Nevertheless, valuation techniques can be utilized to measure fair value. IFRS 13 depicts three valuation techniques for fair value measurement. Firstly, the cost approach that highlights the amount required to replace the serviceability of an asset generally called current replacement cost. Based on this approach, the fair value is the cost to attain or establish an asset substitute of comparable utility, regulated for obsolescence that includes technological and external obsolescence (Paananen, 2009). This approach anticipates fair value by utilizing the economic principles that any buyer may expend for an asset that is not more than the expense to procure an asset of equivalent utility. Further, it is based on the methodology of substitution, which means that unless inconvenience, undue time, etc, are incorporated, the cost a buyer would be willing to expend for an asset being valued would not be greater than the cost to construct or assemble an equivalent asset. Secondly, the IFRS and IASB define income approach as the valuation method that converts future amounts to a single discounted amount. Fair value is measured based on the value depicted by the present expectations of the market about such future amounts. Valuation techniques based on such approach comprise of present value techniques like the discounted cash flow, option-pricing models like the binomial model, and multi-period aggressive earnings method utilized to value specific intangible assets. The most commonly used methods are the discounted cash flow method and the income capitalization method. Under income capitalization, a stream of income that is likely to remain stagnant is capitalized by utilizing a single multiplier.

Furthermore, the discounted cash flow method has several forms that can be utilized in practice. Besides, the general attribute is that the total income for a stated future period is adjusted to a current day value by utilizing a discount rate. Lastly, a market approach as defined by the IFRS 13 is a valuation technique that utilizes prices and other significant details generated by market transactions including comparable assets, liabilities, or a group of such liabilities and assets like a business. In simple words, under this approach, the fair market value is ascertained on the basis of comparable transactions. Moreover, the valuation techniques that are based on this approach are matrix pricing and valuation techniques by utilizing multiples of market ascertained from a set of comparables. Under the market multiples method, a market multiple expresses business value or another significant asset in terms of their ratio to an operating, financial, or physical standards (Botosan et. a, 2005). The multiples may be in ranges with a distinct multiple for every comparable liability or asset. Under Matrix Pricing method, different types of financial instruments like debt securities are valued without depending on the quoted prices for the particular securities, and instead depending on the relationship of securities to other benchmarked quoted securities as a whole.

Problems with Reliability and Measurement of Fair Value

Task 1.2: Discuss the problems associated with the reliability and measurement of using fair value technique

In the current volatile and dynamic markets, whether it is to sell or buy, what people really want to know is what an asset is worth to the present day. Measurement of fair value offers more transparency than the traditional cost-based measurements. However, there are several problems associated with the reliability and measurement of fair value.

Reliability implies that quality of information that ensures the information being free from any biases and errors. Fair value as a forecast of exit value under common conditions of the market is properly defined and non-controversial wherein there are effective liquid markets. However, there is a doubt whether there will or will not be a liquid market. When there is no such presence of a liquid market, a situation arises wherein the estimates of fair value will inevitably include anticipation of future flows of cash and selection of proper rates of discount. These estimations primarily rely on the assumptions and measurement error of the management (Johannesen, 2014). Moreover, this has the potential to disguise deliberate manipulation and improper computation of the numbers. The International Financial Reporting Standards and the IASB acknowledge that some of the relevant issues of measurement must be immediately resolved and moreover, these boards are operating to develop more guidance in relation to the estimation of fair value, thereby making ways for establishing proper control mechanisms to address the problems associated with the measurement and reliability of fair value. Nevertheless, it is notable that the utilization of fair value is also an important part of the preparation of company’s financial statements (Magennis et. al, 2008). Furthermore, there is also a problem in the likelihood of underlining the net company value at the cost of measuring the performance of the management. The other untold truth about the fair value is that constantly measuring the effects of movements of the market on the liabilities and assets of a company can play a key role in introducing massive volatilities into its financial statements (Pacter, 2015). However, several proponents of fair value believe that such volatility may be the cost of confidence of the investors. Nonetheless, the statement of financial accounting standards (SFAS) 157 has also reflected several problems associated with the reliability and measurement of fair value. It offers a hierarchy that ranks inputs to the estimation of fair value based on their measurement and reliability.

Clarifying the Differences between Debt and Equity under IAS 32

Conclusion

However, in order to establish fair value accounting to possess reliable information for effective decision-making, the markets must also be transparent for all the liabilities and assets. Since many liabilities and assets do not pursue an active market, the measures of estimating the fair value become more subjective in nature, and hence, their valuation processes become less reliable as well. Furthermore, several critics have also drawn severe attention towards the reliability concept of fair value and its possible misuse. On a whole, the relevance and measurement of fair value are often held back with complications for publicly traded companies wherein few may require disclosing hundreds instead of thousands, of valuation presumptions and how they were ascertained.

Task 2.1: Discuss the key definition of terms used in clarifying the differences between debt and equity under International Financial Reporting Standard IAS 32, this should include financial asset, financial liability and equity instrument etc.

The standard IAS -32 is the guideline to classify the financial instruments into following three categories. They are:

1.Financial Assets

2. Financial Liabilities

3.Equity instruments

The main objective of the standard is to formulate principles. Based on these principles the financial instruments are classified as debt or equity. Offsetting of financial instruments i.e., liabilities and assets are another objectives of this standard. This also clarifies the basis of classification.

Before clarification of any matter, each item of discussion should be understood very well. Here the terms financial instruments, financial asset, financial liability and equity instrument etc. should be very clear so that classification can be made accurately (PWC 2009).  

By financial instrument, it means financial asset of a concern and financial liability of another concern forming by a contract.

A financial asset of an entity can be any asset as following:

1. Cash amount
2. Equity instrument that belongs to another concern
3. A contract between two parties regarding
4. i) Receiving of cash or financial asset from another party.
5. ii) Exchange of financial assets or liabilities with another party under favorable condition.
6. Equity instrument of the concern settled by the contract is
7. that entitled the concern to receive its equity instruments in varying number being a non-derivative;
8. that include equity instruments of the concern other than those are itself treated as contracts for receiving or delivering the equity instruments of the concern in the future and those which are exchanged being a derivative.

Financial liability of an entity can be any one of the following:

1. a) A contract between two parties regarding
2. i) Delivery of cash or any other financial asset to the other concern.
3. ii) Exchange of financial assets or liabilities with another party under favorable condition.

      iii) Puttable instruments classified as equity instrument by the standard IAS-32.

1. b) Equity instrument of the concern settled by the contract and that
2. i)    Entitled the concern to deliver its equity instruments in varying number being a non-derivative
3. ii) include equity instruments of the concern other than those are itself treated as contracts for receiving or delivering the equity instruments of the concern in the future and those are exchanged being a derivative.

• Puttable instruments classified as equity instrument by the standard IAS-32.

Equity instrument: A contract which determines the interest that remains in the assets of a concern after adjusting the entire liabilities of the concern (IAS Plus, 2012). 

Task 2.2: Discuss the key characteristics/criteria  used for the differentiate between debt and equity under International Financial Reporting Standard IAS 32 and discuss various type of financial instruments and how the financial instrument is recognized in the financial statements

As per the Standard IAS-32, financial statements should be classified as debt/liability or equity as per the definition or the nature of the contract. The decision regarding classification should be taken by the concern at the very beginning with the initial recognition of the instrument. It is not changed due to the change in the circumstances. There is an exception in the case of certain puttable instruments depending on criteria and obligation arising at the time of liquidation.

Recognition of Various Types of Financial Instruments in Financial Statements

The Standard IAS-32 denotes that a financial instrument can be equity if it fulfills the following conditions:

1. There is no contract to deliver cash  or any other financial asset to any other concern;
2. Equity instrument of the issuer that settled, is a
3. a) Non-derivative and there is no contract on the part of the issuer to deliver its equity instrument in varying amount.
4. b) Derivative and settled by the exchange of cash or financial asset with equity instrument by the issuer.

Different types of financial instruments and their recognition are discussed below.

Preference Shares: When these are issued under a condition that rate of dividend to pay is fixed and future redemption of shares is mandatory, these are recognized as a liability. This is because that there is an obligation to deliver case. On the other hand, if there is no obligation regarding fixed pay or maturity it is considered as equity. Based on the legal term associated with the preference share it is treated as liability or equity (PWC 2009) 

The issue of fixed amount of equity instruments: When there is a contract of receiving or delivering of equity instrument of a concern at fair value, there is an obligation of a fixed amount. In that case, the instrument is treated as a liability.

Choice of a party over the settlement of an instrument: When the party to a derivative financial instrument is given choice for its settlement, it is either financial asset or liability if not settled as an equity instrument.

Contingent settlement provisions: Where there is a provision of contingent settlement and the issuer has to settle by delivering either cash or any other financial instrument, then the instrument is a liability. There are certain exceptions:

• If there is question of originality of the contingent settlement provision
• Only at the time of the liquidation the matter of settlement of the obligation arises
• Instrument meets all the characteristics of puttable instruments under standards IAS-32, 16A and 16B.  

Obligation at liquidation in case of puttable instruments: The International Accounting Standards Board (IASB) made amendments in IAS-32 in the month of February 2008. In the case of classification of puttable instruments in the balance sheet when the obligation arises only at the time of liquidation, the instrument is treated as equity. In this case, the balance amount of interest is generated in the net assets of the concern. The amendment denotes that the instrument may match the characteristics of the financial liability but where the obligation is dependent on liquidation, it is classified as equity (IASB, 2007).

Right Issues: Regarding classification of right issues IASB made some amendments. Previously, right issues were accounted as liabilities. As it is issued to current stakeholders of a similar class of the concern on a pro-rata basis for a fixed rate of a currency, classification of right issues should be done as equity (ICAEW, 2009).

Compound instruments: Sometimes financial instruments hold the characteristics of both the liability and equity from the perspective of the issuer. In this case, the components to be presented and classified in part as liability or equity on the basis of the definition the parts attract (ICAEW, 2009). For example, convertible bonds have both the features of liability as well as equity. Where there is an obligation to pay cash, similarly these can be converted into shares.

Treasury Shares: In this case, the consideration for shares either paid or received is recognized and classified as equity.

There are also rules for offsetting financial assets and liabilities, prescribed by the standard IAS-32.This depends on the legal right of the concern to do so and the intention of doing settlement of liability and realizing the assets simultaneously (IAS Plus, 2012). 

Task 2.3: Discuss the issue surrounding the recognition of complex or hybrid financial instruments in the financial statements  

The accounting recognition of instruments of financial nature that contains a blend of debt and equity has led to immense issue and controversy among auditors, regulators, accounting standards, etc. there is a difference of opinion among different parties. One group is the view that the instruments, as well as securities,  must be differentiated from the traditional stocks, on the contrary, other believe that the instruments form a major part of backdoor equity finance that is utilized by the business (EY, 2016). To a major extent, this division of observance can be projected to the features that ascertain the issuance and the manner in which the contractual clauses projects the factors. As per IFRS (2012), the firms goes forward to issue the hybrid securities so that various advantages can be availed such as the cost of funding is low as compared to other instruments and lowering the financial leverage. Hybrids being a combination of debt and equity is unable to establish a rule that is capable of ascertaining how they should be taken into consideration on the pretext of a superficial analysis and in tune to this, the classification of account needs the consideration of various details such as remuneration, repurchase rights, debt and equity instruments subordination and maturity (Barsch, 2012).

Further, there are various instruments complex in nature and tagged as both equity and debt like the convertible loans or bonds with warrants detached. When it comes to convertible bonds or loans, they are mainly classified and taken into account for the continuous debt securities until the time the holder exercises the option for converting the bonds (Clor et. al, 2015). When converted such derivatives need to be accounted in a separate manner as compared to the bonds. The three issues that come to the forefront are as follows are the economic features of the derivative that is embedded derivative are not linked to the economic features of the host. Secondly, the hybrid instrument is not evaluated at fair value otherwise GAAP applicability with alterations in fair value reported in earnings (Cotter, 2012). Lastly, an instrument with the embedded derivative form is exposed to guidance that comes from hedging and derivative instruments. If any of the features are not observed then the bond is strike off from the books and the embedded derivative needs to be considered utilizing the accounting standards for derivatives, as well as hedging.

Conclusion

Going by the overall discussion it can be commented that the financial instruments can be segregated under debt or equity. Some have a clear identification while other differs and hence leads to complications. The instruments that are hybrid in the scenario are not assessed at fair value. Hence, there are many economic features that come to the forefront in the case of a hybrid instrument and hence, a difference is noted.  However, for the clarification IASB has provided a complimentary standard that is the IAS 32 and IFRS 9 that helps in classification.

Reference

Barsch, S.E 2012,  Taxation of Hybrid Financial Instruments and the Remuneration Derived Therefrom in an International and Cross-boarder Context. Manheim: Springer.

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Cotter, D 2012, Advanced Financial Reporting – A Complete Guide to IFRS, Harlow, England : Pearson Financial Times/Prentice Hall.

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Johannesen, N 2014, ‘ Tax avoidance with cross-border hybrid instruments’,  Journal of Public Economics, vol. 112, pp. 40-52.

Magennis, D., Watts, E., & Wright, S 2008,  ‘Convertible notes: The debt versus equity classification problem’, Journal of Multinational Financial Management, vol.8, no. 2,  pp. 303-315.

Paananen, M. & Lin, H., 2009.‘The development of accounting quality of IAS and IFRS over time: The case of Germany’, Journal of International accounting research, vol.8, no.1,pp.31-55.

Pacter, P 2015,  IFRS as Global Standards: a Pocket Guide,  International Financial Reporting Standards Foundation: London.

PWC 2014,   IFRS 9 – Classification and measurement. viewed 11 April, 2017 https://www.pwc.nl/nl/banken/assets/documents/in-depth-ifrs9-classification-measurement.pdf

PWC 2014,  Financial Instruments under IFRS:A guide through the maze,  viewed 11 April, 2017 https://www.pwc.com/gx/en/ifrs-reporting/pdf/financial_instruments_guide_maze.pdf