Notes on Fair Value in Accounting

Notes on Fair Value in Accounting

The International Accounting Standard, identified with number 13, defines Fair Value as the price that is received in an orderly transaction between market participants on the measurement date due to the sale of an asset or the transfer of a liability. Two assumptions apply to it: that the transaction takes place in the corresponding main market or in the most advantageous market for the asset or liability, and that the parties involved act in their best economic interest. The Fair Value evaluation is done with the help of adequate procedures that have sufficient data. Among them, we can mention the market focus, the cost approach and the income approach. The parameters used in the calculation of fair value can be classified hierarchically as follows:

• The first level parameters are the prices for identical assets or liabilities (market prices).

• The second level input parameters refer to directly or indirectly detectable prices for identical or very similar assets or liabilities (comparative values).

• The third level input parameters are the prices of assets or liabilities that can not be observed (estimates).

The norm indicate that companies are obliged to provide all information about the resulting Fair Value. It should be clarified what evaluation procedures and what input parameters were used, as well as presenting basic information about the assessed value of the asset or liability. Additionally, the impact of the valuations must be explained on the basis of the third level input parameters, that is, of the supposed benefits or losses. The Fair Value aims to assign greater objectivity, transparency and relevance to the information in the annual balance sheets. Since it is a commercial evaluation criterion, it does not incur fiscal consequences for companies. Its greatest advantage is relevance, resulting in the timely evaluation of active and passive values.

Historical data such as acquisition and production costs, which would otherwise serve as an indicator, do not enjoy such current information content. For current and future lenders and partners, fair values represent the best way to evaluate the chances of an investment's success. On the other hand, Fair Value serves as a basis to classify future cash flows. As a criterion of commercial evaluation, fair value plays an important role in both the initial and final assessment. Therefore, it is decisive when acquiring an asset or a liability, as well as when calculating it regularly in later stages, as long as there are losses or decisive gains that require it.

For the following assets and liabilities, Fair Value is an essential measurement requirement:

• All assets that are part of an asset plan (retirement pensions).

• Pension provisions, as long as their amount depends on fair value and is above the minimum guaranteed value.

• Assets, liabilities, accruals and special items that are connected to subsidiary companies - the exceptions are provisions and deferred taxes.

• The assets, liabilities, accruals and special items resulting from the investment in foreign companies (limited to the acquisition price). Here the exceptions are also provisions and deferred taxes.

As mentioned, there are three procedures for determining Fair Value. While the market approach aims at the reference market and can be included in the measurement of the fair value of the first and second level input parameters, the cost approach and the capital approach (income approach) are calculated on the basis of the third level evaluation criteria.

1) Market approach: Is a market-oriented calculation procedure. Here we can distinguish between the direct use of current market prices and the use of analogies to determine fair value. In the first case, the market price serves as a guide to calculate the fair value. The only condition that exists is that the market is active and complies with the following three points:

• The assets traded must be, to a large extent, homogeneous (independently of any spatial reference or market participants).

• As a general rule, it is always possible to find interested buyers and sellers.

• The prices of the goods or services exchanged are available to the public. In the second case there is no specific market price for the asset to be classified, which is why the fair value is determined on the basis of affordable assets.

For this purpose, the comparison values are modified, for example, through discounts or reloads. It also allows the use of multipliers that are coupled to sales or profits. Thanks to its traceability, the market approach is the preferred one when calculating Fair Value. However, its application is difficult if you do not have enough data, either because you do not know the specific market price nor the comparable values.

2) Capital approach (income approach): The capital approach, also known as the net present value method, is based on all the relevant cash flows (cash flows) with a risk interest rate until the valuation date. The Fair Value is determined using the values for the amount and duration of the payment flows. Some of the procedures are:

• Immediate cash flow method: the value is determined by the sum of future income that can be associated to each asset. This is done directly in the form of cash flow or cash.

• Royalty method: with this method the Fair Value is calculated on the basis of future royalties that will be paid to a third party for an asset. To this end, the royalty rate for sales is multiplied.

• Residual value method: the idea is that any residual income is assigned to the assets to be valued. For this purpose it is necessary to deduct the cash flows (tangible and intangible) of all other assets in the total revenues.

3) Cost approach: It brings together two approaches to determine Fair Value: the reproduction cost method and the substitution method. The first establishes the fair value of all the expenses necessary to replicate the asset in the event that identical resources and measures are used. The substitution is also aimed at the costs involved in the replication of an asset (with the same benefits), although, unlike the cost of reproduction method, the latter includes current resources and methods. Among the costs included in the evaluation are direct costs, such as cash flows, general and opportunity, such as the company's salaries. If the value object has been previously evaluated, the incurred loss of the economic value must be determined and deducted when calculating the final value. The strengths of the cost approach are the traceability and the verifiability of the valuation criteria, although for many items of intangible value, the replication process is hardly feasible. Another problem is the fact that the potential of future income is not shown.

Guillermo Souto