One hundred academics and non-academics recently met in Sydney, Australia, for the 2018 IASB Research Forum, to discuss some of the latest research into financial reporting matters.
The Forum is organized annually by the IASB in collaboration with an academic journal to create a platform for presentations and discussions of new accounting research of relevance to the IASB’s work. We already looked at a couple of issues arising from Equity Financial Assets: A Tool for Earnings Management – A Case Study of the Youngor Group. Here’s another one.
The main body of IFRS 9 specifies that all investments in equity instruments and contracts on those instruments must be measured at fair value – it doesn’t mention using cost as a substitute (you’ll recall that the old IAS 39 allowed cost measurement for investments in equity instruments “that do not have a quoted market price in an active market and whose fair value cannot be reliably measured”). The application guidance, however, indicates that in limited circumstances, cost may be an appropriate estimate of fair value. This may be the case, it says, if insufficient more recent information is available to measure fair value, or if a wide range of possible fair value measurements exists and cost represents the best estimate of fair value within that range. It provides some indicators that cost might not be representative of fair value, including:
- A significant change in the performance of the investee compared with budgets, plans or milestones
- Changes in expectation that the investee’s technical product milestones will be achieved
- A significant change in the market for the investee’s equity or its products or potential products
- A significant change in the performance of comparable entities, or in the valuations implied by the overall market
- Internal matters of the investee such as fraud, commercial disputes, litigation, changes in management or strategy
- Evidence from external transactions in the investee’s equity, either by the investee (such as a fresh issue of equity), or by transfers of equity instruments between third parties
The guidance notes that this list isn’t exhaustive, and that an entity should use all information about the investee’s performance and operations that becomes available after the date of initial recognition.
This is all helpful, but of course there’s frequently a downside in such helpfulness. You might take the view that if original cost remains a reasonable approximation of a particular security’s fair value, then this will be indicated by the valuation technique applied, without any prodding by the standard. Taking the list above, it’s surely obvious that an investee’s fair value will be affected by (say) changes in its performance, and therefore debatable that the main impact of floating that concept will be to provide a basis for arguing the opposite: that since no such significant change is identified, then cost continues to represent a good estimate of fair value. And so on down the list.
This is how the study comments on that in the context of the Chinese market:
- (the new standard is) forcing companies to present at fair value low-holding equity investments or investments in equity instruments that are thinly traded in the relatively undeveloped Chinese capital market, where valuation techniques are unsophisticated as of yet. This potentially contributes to two consequences. First, the estimation may not be realistic, even while imposing significant costs on the company. Second, companies will choose from a variety of potentially unreliable measures to come up with an estimated number, resulting in managed earnings that serve the potentially short-term interests of managers. Neither consequence is intended by the new (standard), yet both are likely to happen.
The study concludes: “For a country like China where the market is not active and auditors are not sufficiently independent, an option for non-listed companies to measure investments at cost should be considered” (in context, this seems to mean “an option for (all) reporting entities to measure investments in non-listed entities at cost should be considered” – it’s a shame the wording leaves it a little unclear). Anyway, the implication seems to be that it may be better for a particular measurement to be consistently wrong in a sort-of-understandable way than to grapple with the complexities of getting it right (insofar as a fair value measurement can ever be assessed as such). But as the IASB’s basis for conclusions summed up:
- In the IASB’s view, the usefulness of information must be assessed against all four of the qualitative characteristics in the Framework: reliability, understandability, relevance and comparability. Thus, cost is a reliable (and objective) amount, but has little, if any, relevance.
Further, the reference to “for a country like China…” seems to envisage a system of exemptions based on the characteristics of individual jurisdictions, which it’s hard to imagine meeting the IASB’s approval. Overall, I think the IASB took the right course in asserting the primacy of fair value measurement, but I also think it’s vital that users treat “level 3” measurements with heightened skepticism, placing as much weight on the alternative ranges of valuations indicated by the accompanying disclosures as on the numbers that actually end up in the statements. And by that, I mean users in all countries, and investments in all countries…
The opinions expressed are solely those of the author