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| Fair Value must be based on observable market prices |
| Ashish K Bhattacharyya / New Delhi Dec 28, 2009, 00:33 IST |
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International Financial Reporting Standards (IFRS) uses fair value measurement more extensively than the Indian GAAP. The greatest challenge in applying IFRS in the preparation and presentation of financial statement is to estimate fair value of assets and liabilities in different situations. This is so because IFRS does not specify methods or processes for measuring items at fair value.
Rather, it indicates that fair values must be based on observable (for example, quoted) market prices. If observable market prices are not available, the techniques management uses for estimating fair value measurements should incorporate assumptions that individuals in the marketplace would use. If that information is not available, then IFRS permits an entity to use its own assumptions as long as there is no indication marketplace participants would use different assumptions.
Valuation of standing timber
IFRS requires entities to measure biological assets at fair value. Valuation of standing timber is highly judgemental. In absence of active market for standing timbers, discounted cash flow methods are used by companies to value standing timbers. This requires projection of future cash flows, both inflows and out flows, and the discount rate. Valuation is sensitive to estimated growth rate and log prices. It is often difficult to estimate those variables, particularly for forests with long rotation period, which may go up to 100 years.
Growth is dependent upon general climate conditions, soil, silvicultural practice, and quality of genetic material. Management performs a series of qualified judgments, assessments and field studies. Sometimes external specialists are engaged to establish growth rates during one cycle for various species taking into consideration local conditions. Usually current prices are not used to determine the log price. Prices are averaged based on price trend data that is periodically updated. Sometimes service of independent forestry experts are used to estimate the log price. Assumptions about climate change also impact the fair value. Estimation of discount rate is also an important issue.
Valuation of standing timber is a very complex exercise and is very difficult to verify. Although, in all situations, estimation of fair value is not as difficult as the valuation of standing timbers, ability to identify variables and to make reasonable assumptions are essential to arrive at a reasonable estimate of fair value.
Auditor’s approach
The first question that the auditor should consider is the significance of fair value to the company. She should assess the need of fair value in the context of the particular company.
The second question that the auditor should ask is how material is the fair value for the company. The auditor should assess the extent to which fair value measurement is likely to have an impact on the financial statements of the company. For example, the impact of ESOP valuation on the financial statements of a company depends on the extent of ESOP being used to compensate employees. The impact is lower for a company which issues ESOP only to the CEO as compared to a company that issues ESOP to large number of employees.
The assessment of the need and materiality is essential in forming the team (size of the ream and team capabilities) and preparation of the document delineating the issues relating to fair value which are present in the company.
The assessment should be based on the business knowledge, discussion with management and benchmarking with competing companies. At the next stage the auditor should satisfy herself that those who are responsible for estimating fair values have the requisite capabilities. She should assess whether she can rely on the valuation submitted by the management.
Valuation profession
Valuation is a science as well as an art. Valuation capabilities are developed by regularly valuing different kind of assets in different situations. Therefore, an auditor is more comfortable in relying on valuation by specialists, particularly where the valuation exercise is complex. Even companies will prefer to use the services of specialists rather than developing internal valuation capabilities. Therefore, successful implementation of IFRS will depend largely on the development of the valuation profession. Companies Bill 2009 has introduced the concept of registered valuer. Valuation Professionals Bill is under consideration of the government. Let us hope that the government and the accounting profession will join hands to develop the valuation profession for the benefit of companies and auditors.
Email: asish.bhattacharyya@gmail.com
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