Sandra Minaburo Villar
Director of the Accounting Research Center
Instituto Tecnológico Autónomo de México

On August 15, 2016, the Mexican Financial Reporting Standards Board (CINIF, by its initials in Spanish) issued a new financial reporting standard, NIF B-17, “Fair Value Measurement,” and accepted comments on it up until November 15 of the same year. This new standard is part of the process of standardization undertaken by the CINIF since its founding in 2004, when the Mexican Public Accountancy Institute (IMCP) turned over responsibility for issuing accounting standards in Mexico.

This standard is important because of the historic connections between accounting and economics. In other words, as the economic climate continues to evolve, accounting will have the opportunity to change and adapt to these changes as well, and to play a role in its modifications and innovations. This creates an opportunity for accounting to transform itself by incorporating postulates from other disciplines (economics and mathematics). According to Carmona (1995), “the progress of accounting will not be achieved through introspection and the exhaustive use of its own methods, but rather by the application of methodologies from other disciplines to the accounting process.”
Other authors, such as Barlev and Haddad (2003) recognize the need for accounting to evolve from a historic value-based system to one based on fair value, since fair value accounting contributes greater value and relevance to the figures reported in financial statements than historic value, which conceals the true value of a company’s financial position and profits.

Barlev and Haddad (2003) measure relevance in terms of the closer correlation between fair-value-based accounting and the market, reduced agency costs, an increased commitment by company management to operating efficiency, and better information supplied to shareholders for decision-making. Similarly, fair-value-based accounting provides more complete and detailed rules for presentation, which help make the information more comparable and transparent.

Bleck and Liu (2007) show that market valuation can supply investors with a more timely alert mechanism than historic-cost-based valuation. These researchers prepared a model that explains various empirical discoveries, demonstrating the increased transparency that the use of fair value brings to accounting figures.

SFAS 157: Fair value measurements

The first predecessor of the new Mexican standard on incorporation of fair value into accounting comes from the U.S. Financial Accounting Standards Board (FASB).

In 1938, American banking regulators agreed to adopt historic cost as the primary method for reflecting the financial position of investors and lenders, because investments were long-term and interest rates were controlled and stable. The historic cost method worked very well in faithfully reflecting banks’ financial position.

But the world changed dramatically in the 1980s, when interest rates were deregulated and the economic climate became more volatile. Almost on a daily basis, when closing out their operations, banks had to seek alternatives for controlling and covering their exposure to interest rate fluctuations.

During the 1990s, the historic notion that investments were held until maturity was eliminated. The figures presented were no longer relevant when showing historic cost, because they did not faithfully reflect the banks’ financial position. So while historic cost was used to avoid artificial distortions in the reported figures, their use in the 1990s, in fact, distorted and obscured the true volatility. This meant that historic cost was no longer a realistic measurement for financial institutions. It became increasingly evident that market figures were more appropriate and readily available for making investment decisions.

The SEC supported the FASB’s 1986 draft of a standard on financial instruments, which would introduce market-value-based accounting. In drafting the standard, the FASB insisted on the relationship between accounting, economic theory and market forces.

In 2006, the FASB issued SFAS 157, “Fair value measurements,” because there were different definitions of fair value and few guidelines to clarify the concept. The guidelines were scattered throughout various standards, giving rise to confusion and, in some cases, inconsistencies.

The purpose of the standard was to improve the consistency and comparability of various fair value measurements, and to expand the disclosures reporting companies had to make in their financial information regarding these measurements.

NIF B-17: Fair Value Measurement

1. Definition

The draft of the standard issued by the CINIF for review and commentary this past year, in paragraph 30.1, defines fair value as “the price which, on the valuation date, would be received for selling an asset or would be paid to transfer or settle a liability in an orderly transaction between market participants; in other words, between independent, interested, willing and informed parties, in a free-market transaction.”

To better understand this definition, we must break down its elements. In the following paragraphs we will examine some of the characteristics and situations that should be taken into account to determine fair value.

a) Assets and liabilities

Companies must measure the fair value of each specific asset or liability. Therefore, the measurement must take into account attributes specific to the asset or liability. For example, the condition or location of the asset or liability, and any restrictions that might exist on the sale or use of the asset on the measurement date. The asset or liability could be an independent asset or liability (for example, a financial instrument or operating asset), or a group of assets or liabilities (for example, a set of assets, a reporting unit or a business). The unity of the asset or liability is determined by whether it is independent or part of a group of assets or liabilities. The accounting unit determines what is being measured by reference to the level on which the asset or liability is consolidated (or broken out) for the purposes of applying other accounting pronouncements.

b) Orderly transaction between market participants

The definition of fair value assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell an asset or transfer the liability on the measurement date. An orderly transaction is one that assumes exposure to the market or a period prior to the measurement date so that market activities are normal and usual for transactions involving those assets and liabilities. In other words, that it is not performed under duress (for example, a forced liquidation or foreclosure). The transaction to sell an asset or transfer a liability is a hypothetical transaction on the measurement date, considered from the perspective of the market participant that owns the asset or owes the liability. Therefore, the objective of fair value is to determine the price that would be received for selling the asset, or which would be paid for transferring the liability, on the measurement date–in other words, an exit price.

Similarly, measurement at fair value assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability, or, in the absence of a principal market, the most advantageous market for the asset or liability.

The principal market is the market on which the reporting entity would sell the asset or transfer the liability with the greatest volume and level of activity for the asset or liability.

The most advantageous market is the market in which the reporting entity would sell the asset or transfer the liability with the price that maximizes the amount that would be received for the asset or minimizes the amount that would be paid to transfer the liability, considering transaction costs in the respective market(s). In either of these two cases, the principal (or most advantageous) market is considered from the perspective of the reporting entity, which means different values may be reported by entities engaged in different activities.

If there is a principal market for the asset or liability, the measurement at fair value would represent the price from that market (whether the price is directly observable or otherwise determined by a valuation technique), even if the price on a different market were potentially more advantageous as of the measurement date.

The fair value of the asset or liability would be determined based on the assumptions the market participants would use to set the price of the asset or liability. In developing those assumptions, the reporting identity does not need to identify the specific market participants. Instead, the reporting entity must identify the characteristics that distinguish the market participants, generally considering factors specific to: a) the asset or liability, b) the main (or most advantageous) market for the asset or liability, and c) the market participants with which the reporting entity would trade in that market.

2. Valuation techniques

To measure fair value, the valuation techniques applied must comprise either the market approach, the income approach, or the cost approach. The main aspects of each one of these are as follow:

Market approach. The market approach uses prices and other material information generated by market transactions involving identical or comparable assets or liabilities (including a business). For example, valuation techniques comprising the market approach often use market multiples derived from a set of comparable metrics. Multiples may be presented in ranges, with a different multiple for each comparable. It may be that judgment must be applied in choosing where, within that range, the appropriate multiple falls, considering factors specific to the measurement (both quantitative and qualitative). Valuation techniques comprising the market approach include matrix pricing. Matrix pricing is a mathematical technique used primarily to determine the value of debt instruments without depending only on prices quoted for the specific securities, but rather relying on the securities’ relationship to other benchmark quoted securities.

Income approach. The income approach uses valuation techniques to convert future amounts (for example, cash flows or profits) into single present amounts (discounted). The measurement is carried out based on the value indicated by current market expectations regarding those future amounts. These valuation techniques include present value techniques; option pricing techniques like the Black-Scholes-Merton formula and the binomial model, which incorporate present value techniques, as well as the multi-period excess earnings method, which is used to measure the fair value of certain intangible assets.

Cost approach. The cost approach is based on the amount that would normally be needed to replace the service capacity of an asset (also called current replacement cost). From the point of view of a market participant (seller), the price that would be received for the asset is determined based on the cost for a market participant (buyer) to buy or build a replacement asset of comparable profit, adjusted for obsolescence. Obsolescence incorporates physical deterioration, functional (technological) obsolescence and economic (external) obsolescence. It is broader than depreciation, for financial information purposes (an assignment of historic cost) or for tax purposes (based on a specified useful service life).

To measure fair value, the valuation technique selected must be the one most appropriate under the circumstances and the one for which there is sufficient information. In some cases, only one valuation technique will be appropriate; in others, multiple valuation techniques are preferred. If technical valuation multiples are used to measure fair value, the results should be evaluated and weighted, as appropriate, considering the fairness of the range indicated for those results.

Valuation techniques used to measure fair value must be applied consistently. However, if it is appropriate to change a valuation technique, or if its application results in a measurement that is equal to or more representative of fair value, a change in valuation technique is acceptable. This may be the case if, for example, new markets arise, new information becomes available, the information used formerly is no longer available, or valuation techniques improve.

a) Input data for valuation techniques

Input data refer generally to the assumptions that market participants will use to set the price of an asset or liability, including assumptions about risk; for example, the inherent risk in a specific valuation technique used to measure fair value (like a price setting model) or the inherent risk in the input data for valuation techniques.
Input data may be observable or non observable:

Observable input data reflect the assumptions that market participants would use to set the price of the asset or liability, developed on the basis of market information obtained from sources independent of the reporting entity.
Non observable input data reflect the assumptions of the reporting entity itself regarding the assumptions market participants would use to set the price of the asset or liability, developed on the basis of the best information available under the circumstances.

Valuation techniques used to measure fair value must maximize the use of observable input data and minimize the use of non observable input data.

3. Fair value hierarchy

To improve the consistency and comparability of fair value measurements, the fair value hierarchy prioritizes input data for valuation techniques used to measure fair value, on three broad levels. The fair value hierarchy assigns highest priority to quoted (unadjusted) prices on active markets for identical assets and liabilities (Level 1), and the lowest to non observable input data (Level 3).

The availability of relevant input data for the asset or liability, and the relative reliability of the input data, may affect the selection of appropriate valuation techniques. However, the fair value hierarchy prioritizes input data for the valuation techniques, not the valuation techniques themselves. For example, a fair value measurement that uses the present value technique may fall under Level 2 or Level 3, depending on the input data that are important to the measurement as a whole and the level on the reasonable value hierarchy those input data fall under.

a) Level 1 input data

Level 1 input data are quoted (unadjusted) prices in an active (liquid) market for assets or liabilities identical to those the reporting entity is capable of accessing on the measurement date. An active or liquid market for the asset or liability is a market in which the frequency and volume of trading in that asset or liability are sufficient to supply price setting information on a continuous basis. A quoted price in an active or liquid market supplies the most reliable information on fair value, and should be used to measure fair value whenever it is available.
In some situations, a quoted price on an active or liquid market may not represent the fair value on the measurement date. This may be the case if, for example, there are material events (principal-to-principal transactions or IPO announcements) after the close of a market and before the measurement date. The reporting entity must establish and apply a uniform policy for identifying the events that may affect fair value measurements. However, if the listed price is adjusted for new information, the adjustment drops to a lower level in the fair value measurement hierarchy.

b) Level 2 input data

Level 2 information is data other than quoted prices included in Level 1, which are observable for the asset or liability, either directly or indirectly. If the asset or liability has a specific contractual term, a Level 2 input data must be observable for substantially all of the term of the asset or liability. Level 2 input data include:
Listed prices for assets or liabilities in active or liquid markets.

Listed prices for identical or similar assets or liabilities on non-active markets; in other markets, markets where trading in that asset or liability is lighter, in which prices are not current, or price quotations vary substantially, or those for which little public information is released.

Adjustments to Level 2 input data may vary depending on factors specific to the asset or liability. These factors are the condition or location of the asset or liability, the degree to which the input data relate to concepts comparable to the asset or liability, and the volume and frequency of activity in the markets where the input data are observed. A substantial adjustment to the fair value measurement as a whole could cause the measurement to fall to Level 3, depending on the fair value hierarchy level under which the input data used to determine the adjustment fall.

c) Level 3 input data

Level 3 input data are non observable data for the asset or liability. Non observable input data may be used for measuring fair value to the extent that observable input data are not available. Therefore, at this level situations are permitted in which there is little or no market activity in the asset or liability on the measurement date. The purpose of fair value measurement remains the same, however; in other words, an exit price from the point of view of a market participant who owns the asset or owes the liability. Consequently, non observable input data should reflect the assumptions used by the reporting entity itself regarding the assumptions that market participants would use for setting the price of the asset or liability (including risk assumptions). Non observable input data must be obtained based on the best information available under the circumstances, which may include data from the reporting entity itself. The reporting entity must not, however, ignore information on the assumptions of market participants that is readily available without undue cost or effort.

4. Conclusions

Given the history and the background of the accounting discipline, the combination and mutual dependence of economics, mathematics and accounting information is inevitable, so fair value measurement may be a response to this combination, or rather the response that regulators have adopted to solve this problem and provide more accurate accounting information.

The evidence compiled in recent academic research by various authors shows that the fair value of assets and liabilities obtained through an observable market (Level 1) relate closely to the relevance and reliability that financial statement information. But for the fair values obtained by other means or markets (Level 2), the results are mixed and indicate that the reliability of the estimates is limited to certain assets and liabilities.

As was proven by Benston (2006) in his paper on Enron, a Level 3 fair value measurement is neither as reliable nor as representative of a company’s situation. Enron had been valuing its energy contracts using Level 3 techniques, and all of those figures had been backed up by the accounting firm Andersen Consulting. The problem was that the financial information was unable to quickly absorb the volatility of those markets, which eventually resulted in a series of explosive ethical and valuation scandals that erupted at the start of this century.

Other difficulties in fair value measurement relate to the following aspects:

• Inefficient markets, or no markets at all.
• When there is no active market, fair value is not representative of prices, so many assumptions must be made to determine it.
• When a market is inefficient, the value of the assets or liabilities may be over- or under-estimated.
• Lack of data.
• Market volatility.
• The implicit shortcomings of valuation techniques.

Finally, there is still no general or widely accepted agreement in the global accounting community regarding the proposal that all financial information be presented at fair value, even though international regulators like the International Accounting Standards Board (IASB), the Financial Accounting Standards Board (FASB) and now the Mexican Financial Reporting Standards Institute CINIF) have made considerable progress in line with this trend.

References:

• Barlev and Haddad. “Fair value accounting and the management of the firm.” 2003. Elsevier Sciences. Journal of Critical Perspectives on Accounting 14.
• Benston, George. “Fair value accounting: a cautionary tale from Enron.” 2006. Journal of Accounting and Public Policy. No. 25.
• Bleck y Liu. “Market transparency and the accounting regime.” 2007. Journal of Accounting Research, Vol. 45, No. 2.
• Carmona, S. 1995. Por los límites de la contabilidad, cited in Tua, J., Evolución y situación actual del pensamiento contable, p. 120.
• CINIF. 2016. NIF B-17: Determinación del Valor Razonable, in <http://www.cinif.org.mx/uploads/NIF_B-17.pdf>.Viewed November 5, 2016.
• FASB. 2016. ASC Topic 820: Fair Value Measurement, in <https://asc.fasb.org/>. Viewed November 5, 2016.
• IASB. 2016. IFRS 13: Fair Value Measurement, in <http://eifrs.ifrs.org/eifrs/bnstandards/en/2016/ifrs13.pdf>. Viewed November 5, 2016.