Lecture 3 The Fair Value Debate

1. Lecture 3The Fair Value Debate

2. Lecture Overview • What are the key arguments for fair value versus historical cost measurement and why is it so important now? • What is Fair Value? • Arguments For & Against • Role of market prices • Fair value in action: AASB 139, AASB 141, AASB 9 and the GFC • Why is it important now?

3. What is Fair Value? • “the amount for which an item could be exchanged between knowledgeable, willing parties in an arms length transaction” AASB139 definitions. • Fair value is a type of exit value or sales value

4. Do you know what fair value means? Sometimes Fair value ≠ market price There are 3 tiers!!!! Fair value = value-in-use BUT only in ideal conditions • Observable • Only public info…so any information content? • More subjective, open to bias & assumptions but ironically • incorporates private info so may have more information value!

5. Theoretical foundations underpinning the use of market prices Market price Rational investors Information aggregation hypothesis Efficient market hypothesis (Fama)

6. Value • Value reflects marketprices…but ONLY if we’re talking about actual prices quoted in an active market i.e. there are buyers and sellers • Many assets/liabilities are valued on a less reliable basis (using what the US term tier 2 or 3 fair values). Inactive markets or similar products. Market proxies • These lower level valuations raise different assessments of relevance and reliability. Market models.

7. Arguments ‘For’ Fair Value • Reliable – market price set by forces outside the entity…for tier 1. • Relevant – useful, how much we pay or receive for an item now is relevant to decision to buy or sell… Timely • Understandable – easy concept, amount to be received if item was sold. Not so easy for tiers 2 and 3. • Comparable – between entities, determined at the same point in time (particular day). Again, is it truly comparable?

8. Arguments ‘Against’ Fair Value • Ignores going concern assumption – measures values as though the entity was intending to sell off all assets and liquidate • Value depends on circumstances. e.g. current market conditions • Specialised assets – not bought and sold on an active market, unique with no value to other entities: CDS (Credit Default Swap), CDOs (Collateral Debt Obligation) • Measured at current date – influenced by short term fluctuations

9. Arguments ‘Against’ • Subjectivity – for items not regularly traded in an active market, we form an estimate of fair value • NPV – estimated future cash flowsdiscountedto present value • Present value – identification of cash flows, management expectations, predictions & assumptions • Market prices – represent expectations, expectations based on predictions, predictions may or may not be correct = volatility in market prices caused by market corrections • Wording: some commentators have criticised the language used, and what is implied by the term “fair”

10. Arguments against • Behavioural finance: • if we prove investors are not always rational, are market prices relevant and reliable? • We’ll examine this later when we look at capital markets • Some key areas: • Over-representation • Herding • Heuristics • Overconfidence

11. AASB 139: Financial Instruments • So you buy a financial instrument. • Pre Oct 08 (when they moved the goal posts in “rare circumstances”) you chose: • Fair value through profit and loss Fair Value, with gains and losses through profit and loss, includes held for trading and others designated as fair value at the time of acquisition 2. Available-for-sale Fair value, gains and losses to other comprehensive income (i.e. equity, no profit effect) – Not a “clean surplus” per Ohlson! 3. Held to maturity Amortised cost (cost to settle) and subject to impairment testing. We have to show an ability to hold the asset in terms of solvency and liquidity 4. Loans and Receivables Amortised cost, impairment testing

12. Examples of AASB139 disclosures: Wesfarmers 2010 Annual Report (extract from notes) CONSOLIDATED Restated Restated 2010 2009 $m $m 13: Available-for-sale investments Shares in listed companies at fair value 2 1 Shares in unlisted companies at fair value 17 17 19 18 Available-for-sale investments consist of investments in ordinary shares, and therefore have no fixed maturity date or coupon rate. The fair value for listed available-for-sale investments has been determined directly by reference to published price quotations in an active market. There are no individually material investments at 30 June 2010. The fair value of the unlisted available-for-sale investments has been estimated using appropriate valuation techniques based on assumptionswhere the fair value cannot be determined by observable market prices or rates. Management believes the estimated fair value resulting from the valuation techniques and recorded in the balance sheet and the related changes in fair values recorded in reserves are reasonable and the most appropriate at balance sheet date. Management also believes that changing any of the assumptions to a reasonably possible alternative would not result in a significantly different value

13. Example of disclosure Extract from notes to the Financial Statements Fairfax Media Limited and Controlled Entities for the period ended 27 June, 2010 M) AVAILABLE-FOR-SALE INVESTMENTS Available-for-sale financial assets are investments in listed equity securities in which the Group does not have significant influence or control. They are stated at fair value based on current quoted prices and unrealised gains and losses arising from changes in the fair value are recognised in the asset revaluation reserve. The assets are included in non-current assets unless management intends to dispose of the investment within twelve months of the balance sheet date.........Results as part of OCI

14. Extract from notes to the Financial StatementsFairfax Media Limited and Controlled Entities for the period ended 27 June, 2010 (N) INVESTMENTS AND OTHER FINANCIAL ASSETS The Group classifies its investments in the following categories: financial assets at fair value through profit or loss, loans and receivables, held to maturity investments and available for sale financial assets. The classification depends on the purpose for which the investments were acquired. Management determines the classification of its investments at initial recognition and, in the case of assets classified as held to maturity, re-evaluates this designation at each reporting date. The consolidated entity classifies and measures its investments as follows: (i) Financial assets at fair value through profit and loss This category has two sub-categories: financial assets held for trading and those designated at fair value through profit and loss on initial recognition. The policy of management is to designate a financial asset at fair value through profit and loss if there exists the possibility it will be sold in the short term and the asset is subject to frequent changes in fair value. These assets are measured at fair value and realised and unrealised gains and losses arising from changes in fair value are included in the income statement in the period in which they arise. (ii) Loans and receivables (iii) Other financial assets (iv) Held to maturity investments

15. AASB 139 • Measurement dependent upon intention. The same asset can be categorised differently by different entities. • Which categories are measured at fair value? • How do we measure fair value of financial assets?

16. How do the categories meet the measurement approach to decision usefulness? 1. Fair value through profit and loss Current values, profit measured including fair value “income” 2. Available-for-sale Current values Fair value effect on income has delayed recognition until realisation…mixed measurement? Income lags “real economic performance” because of late recognition 3. Held to maturity Not current / market values Do not affect income in a fair value sense 4. Loans and Receivables No active market values Valued at a kind of value in use (NPV of future cash flows if this number falls below book value)

17. Accounting Standards using fair value • Measurement at Fair Value • How can fair value be determined? • Talk to the person next to you for 1 minute. Discuss 3 standards with Fair value in them.

18. Global Financial Crisis • Did fair value accounting contribute to the global financial crisis? OR • Play the role of the messenger? • Are the standards the source of the problem? • Implementation problems in practice? • The institutional framework • Flexibility, necessary in times of crisis, also opens door for manipulation

19. YES! Fair values contributed to the GFC

20. No! FVA just revealed underlying risk, allowing earlier correction • Blaming FVA for the GFC is like blaming your petrol gauge when you run out of fuel! • FVA recognises gains and losses earlier: problems cannot be hidden as they can with Historical cost (no hidden reserves) • Maybe we should be looking at prudential regulation, off balance sheet vehicles and securitisation instead?

21. Global Financial Crisis The issues? • Did prices deviate significantly from fundamental values during the crisis? • When should we deviate from market prices in determining fair values – relevance vs. reliability. Is it easy to decide when you’re in an active & liquid market? • Volatility in financial statements becomes normal – so, when do we act? How do we know when something looks odd? • Contagion effects – financial stability vs. transparency

22. Why is it important right now? The GFC has MADE it important! • Standard setting is moving towards more use of fair value. Interesting to consider this in light of US GAAP / IFRS convergence. • Current Accounting Standards allow a range of measures – mixed measurement system. This is likely to change. • As future accounting professionals, it is important we are aware of the strengths & weaknesses of fair value accounting, as the increased adoption of FVA is likely to affect our future careers