Refelecting on the Fair Value Under IFRS for SMEs: Challenges and Perspectives

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1 Refelecting on the Fair Value Under IFRS for SMEs: Challenges and Perspectives IONICA HOLBAN (ONCIOIU) Tomis University from Constanta 5A Brizei Street, Constanta, bl. FB7A Abstract: -International Financial Reporting Standards (IFRSs) require or permit various assets, liabilities and equity instruments to be measured at faire value. There are two distinct dimensions to the consideration of alternatives to fair value. The first is to examine alternative current values, and the second is to consider historical costs. Discussions of fair value often fall in to the trap of debating the relative merits of fair value and historical cost while ignoring the existence of alternative current values. Thus fair value can, wrongly, be regarded as the only alternative to historical cost. In order to avoid giving this false impression, the current discussion will focus first on alternative measures of current value. The credibility regards a reasonable evaluation, the using of market information in all possible situations for evaluating and justifying the subjective arguments. Starting from these concepts, the users of the accountancy information of SMEs had demanded the elaborating of a model for a general appliance of the fair value. This paper analyses the answer of the question regarding on using the fair value under IFRS for SMEs, and also various controversial issues of the concept of fair value it as it is presented in the current project of the IASB and FASB. Key-Words: fair value, SMEs, IFRS 1 Introduction The accountancy of the XXI -st century requests a unique value. A solution for the amelioration of the accountancy information could be, after some of the specialist, the real value. This instrument was introduced by the accountancy-shapers as answer to degradation of the confidence into the financial measurements and regards a new system of evaluation for the assets and the debts of the entity. The accountancy has as essential finality the economic value-control of SMEs. From here comes out also the dependence of users decisions on then quality of the accountancy information and also the necessity that those have to reflect a real image upon the company s patrimony, based on the actual market- prices. To this adds the fact that the accountancy-write regards an economic medium without frontiers, where the accountancy information can be compared between the states and can be useful to all international users such as such her. It can be seen that the accountancy information has a more and more international character and the users are more and more sophisticated. In an uncertain world with imperfect and incomplete markets (financial crisis), no particular measurement objective should be regarded as having a monopoly, and different measurements should be regarded as complementing one another. 2 IFRS for SMEs - Advantages and Disadvantages It is already deeply embedded in IASB and FASB literature and there are growing calls from the user community to increase its use in financial reporting. Conceptual support for fair value under for SMEs is demonstrable and will be further underpinned in the revised conceptual framework. In general, the growing use of fair values in IFRSs and national accounting standards has prompted expressions of concern from all sectors of the accounting community, particularly small and medium-sized businesses and companies in developing countries. The well known evolution of the multinational companies during the last years, which affected almost every state, govern and person, the complexity of the business-management above the national frontiers (from the financial point of view, connecting to the reporting), means a dynamic change, with complex processes in different ISBN:

2 branches of a society and of course in book-keeping too. The variety of the book-keeping practices, of the financial auditor, of the fiscal norms and rules, can have a negative impact, not only on the companies ability in furnishing the needed and true financial information to the creditors and investors, but also on the capacity to analyse the future investment opportunities for SMEs, which are vital for the economic increment. Moreover, even if it were true that the managers of a smaller entity do not use faire values to manage the business, general purposed financial statements based on IFRSs are intended primarily for external users, including non-manager owners (such as outside investors and family members); existing and potential lenders and creditors; and credit-rating agencies. It is not surprising that there appears to be some consistency between the recent IASB statements discussed above and recent FASB comments. On 23 June 2004, FASB issued an Exposure Draft of a proposed Statement, Fair Value Measurements. This proposes a definition of fair value as the price at which an asset or liability could be exchanged in a current transaction between knowledgeable, unrelated willing parties, which definition seems at pains to preserve semantic differences between FASB and IASB, rather than to seek convergence. FASB proposes a hierarchy of the inputs which should be used to estimate fair value (note that this hierarchy is concerned with measurement estimations, not with definition). The new definition resolves two of the alternatives within fair value as follows: The reference to price rather then amount makes it clear that transaction costs are not included in fair value. If they are included in the measurement, the correct description would, in the case of assets, be fair value, less cost to sell. The reference to received to sell an asset and paid to transfer a liability clarify the choice of market, by specifying the exit market (disposal) rather then the entry market (acquisition). There are two distinct dimensions to the consideration of alternatives to fair value. The first is to examine alternative current values, and the second is to consider historical costs. Discussions of fair value often fall in to the trap of debating the relative merits of fair value and historical cost while ignoring the existence of alternative current values. Thus fair value can, wrongly, be regarded as the only alternative to historical cost. In order to avoid giving this false impression, the current discussion will focus first on alternative measures of current value. The term fair value subsequently became widely used to describe the measurement basis used in the revaluation exercise required by acquisition accounting for initial recognition of an acquired entity. This includes an entry value, current cost (subdivided into reproduction cost and replacement cost), two exit values (net realizable value and value in use) and one method that combines both entry and exit values (deprival value). For the sake of simplicity, the subsequent discussion is conducted in terms of measuring assets, although most but not all of it is equally relevant to liabilities. It is true to say that IFRS are placing much more emphasis on the use of fair values to record transactions and to allocate the initial amount of transactions among its constituent parts. This process began almost twenty-five years ago and reflects the practice in many national standards. The growth in such requirements also reflects the increasing complexity of many business transactions as well as the IASB s desire (and that of business entities and their auditors) to ensure that IFRS deal with a large proportion of these transactions. Fair values, or some other estimates of value, must be used; otherwise non-cash transactions will be omitted from the financial statements and compound transactions will not be disaggregated. If the use of fair values in such circumstances is new, the previous financial statements lacked relevant information. But, the definition of fair value in IFRS has remained unchanged for almost twenty-five years. It is therefore surprising that there is some uncertainty about its meaning and some confusion about what amounts are, and what are not, fair values. Another obvious conclusion is that, as explained in more detail below, the primary use of fair value has been for the measurement of transactions or the components of transactions on initial recognition. So, is likely that the IASB will continue to use fair values as the means of ensuring that transactions are represented faithfully in the financial statements and in impairment testing. Any significant extension of the use of fair values for the subsequent measurement of assets and liabilities is likely to meet strong resistance both in the IASB itself as well as its constituency Those who resist, however, should bear in mind that the current reliance on historical cost-based amounts provides less relevant information and omits some assets and, possibly, liabilities from the financial statements. And those who criticize the limited use of fair values in IFRS should question their application of national GAAP ISBN:

3 and whether previous financial statements really had the qualities they claimed. The implementation of International Financial Reporting Standards (IFRS) has led to frequent comments that it s present fair value-based standards. While IFRS have long required the use of fair value to measure the cost of assets or liabilities (in other words, the consideration paid or assumed), the IASB has begun to require that assets and liabilities should be measured at initial recognition at fair value even when this amount differs from cost (i.e. the fair value of the consideration given or received). So, some specialists bring into question the understanding and application of existing national GAAP and historical cost accounting. SMEs often say that it is too costly for them to apply faire value recognition or measurement principles relative to the benefit of the resulting information. They also say that in the absence of price quotations in an active market. In such cases, complex valuation techniques must be used. At the same time, they lack the resources to hire professional values. This is not cited as an issue for all of the assets and liabilities of smaller entities, but only for some. This is not cited as an issue for all of the assets and liabilities of smaller entities, but only for some. Bad debt recognition, for example, does not require professional values as much as it does knowledge of the debtors. Smaller companies worry that if accounting does not rely on an invoice price in an actual transaction, fair valuation is likely to increase the level of fraud and abuse. So, recent transactions do not necessarily provide reliable measures of faire values. Sometimes, formal exchanges with bid-asked prices are more like venues that bring buyers and sellers together. They do not have either dealers or brokers. As noted earlier, IFRSs that require fair value measurements also have reliability exceptions if fair value cannot be reliably measured. In the some time, smaller entities say that fair value information in financial statements adds significantly to auditing cost, because auditors are obligated to independently verify the entity s estimates of fair values. Smaller entities often say they do not use fair values to manage the business. While this may be true for certain types of assets and liabilities, or for certain types of management decisions, it is unlikely that this is uniformly true across the board for all decisions even within any one small business. The owner-manager is likely to: - consider fair value in deciding the price at which to sell an asset, or the amount at which to purchase fire insurance; - shop around for the best price (fair value) when making purchases; - consider competitors prices (quotations in an active market) in setting their own selling prices; - look very closely at the carrying amounts of assets on the books of another small business they are thinking of acquiring. Moreover, even if it were true that the managers of a smaller entity do not use fair values to manage the business, general purpose financial statements based on IFRSs are intended primarily for external users, including non-manager owners (such as outside investors and family members); existing and potential lenders and creditors; and credit-rating agencies. Entities in developing countries, in particular, often say that there is a shortage of skilled property values in the country or that there is a shortage of skilled actuaries. They do not have the skills to do the fair value measurements in-house, and those skills are not available externally. Smaller companies worry that if accounting does not rely on an invoice price in an actual transaction, fair valuation is likely to increase the level of fraud and abuse. SMEs do not have the sophisticated systems of internal controls and corporate governance that larger entities have. Even when an entity is willing, it is sometimes difficult to put effective corporate governance systems into place. In addition, it is easier for smaller entities to enter into side agreements that circumvent the fair value reporting requirements. Smaller entities tend to enter into a greater percentage of transactions with related parties. Such transactions may not be at arm s-length market prices. Value disclosures are competitively harmful. In some countries, mechanisms for enforcement of accounting standards are not in place or are inadequate. Without such mechanisms, there are likely to be problems with compliance with a standard, such as one that requires the fair value measurements whose implementation is subjective. Formal exchanges with bid-asked prices do not exist in many countries. Where they do exist, quoted prices are not always available. Sometimes, these exchanges are more like venues that bring buyers and sellers together. They do not have either dealers (who own the securities and establish their own price quotations) or brokers (intermediaries who try to match buyers and sellers but do not trade for their own account). As noted earlier, IFRSs that require fair value measurements also have reliability ISBN:

4 exceptions if fair value cannot be reliably measured. In small or developing countries, many markets are not active, i.e. transactions are infrequent and the bid-asked spread is large, and the market prices are likely to be affected by just a few market participants or a few transactions. Recent transactions do not necessarily provide reliable measures of fair values. Price quotations in the market are not based on norma1 market interactions due to strong government controls over the markets or government interventions in the markets. The IFRSs give only broad guidance for determining fair values. Smaller entities do not know whether to look for additional guidance. International valuation standards are just starting to be developed. Smaller entities express concern that application of a fair value measurement principle causes reported measures of earnings or assets or equity to be volatile. They view this reported volatility as undesirable - some would go so far as to say distortive - potentially affecting their access to capital or to customers. 3 The Using of the Fair Value and The Fundamental Request in the New Economy Context It has been glossed more and more intensely lately, regarding the using of the fair value under IFRS for SME s as a concept that determines a change, a transformation, so does the progress of the economic science determines a large reform in this field. So, the main problem of fair value adjustment is that many of the adjustments cause enormous fluctuations in earnings, assets, and liabilities that are washed out over time and never realized. The main advantage is that interim impacts that might be realized are booked. It is a war between might be versus might never be. The war has been waging for over a century with respect to booked assets and two decades with respect to unbooked derivative instruments, contingencies, and intangibles. On the other hand, the use of the faire value concept was favorized by the disadvantages using the historical cost from what we mention: 1. Does not eliminate or solve such controversial issues as what to include/exclude from balance sheets and does not overcome complex schemes for off-balance sheet financing (OBSF). It is too simplistic for complex contracting. For instance, many derivative financial instruments having current values of millions of dollars (e.g. forward contracts and swaps) have zero or negligible historical costs. For example, a firm may have an interest rate swap obligating it to pay millions of dollars even though the historical cost of that swap is zero. Having such huge liabilities remain unbooked may easily mislead investors. Historical cost accounting has induced game-playing when writing contracts (e.g. leases, employee compensation) in order to avoid having to book what are otherwise assets and liabilities under fair value reporting. 2. Historical cost accrual accounting assumes a going concern. Under current US GAAP, historical cost is the basis of accounting for going concerns. If the firm is not deemed a going concern, the basis of accounting shifts to exit (liquidation) values. For many firms, however, it is difficult and/or misleading to make a binary designation of going versus non-going. Many firms fall into the grey area on a continuum. Personal financial statements seldom meet the going concern test since they are generally used in estate and divorce settlements. Hence, exit (liquidation) value is required instead of historical cost for personal financial statements. 3. Historical cost is perpetuated by a myth of objectivity when there are countless underlying subjective estimates of asset economic life, allocation of joint costs, allocation of indirect costs, bad debt reserves, warranty liabilities, pension liabilities, and so on. The fundamental measurement issue is not application guidance and the choice of evidence to support measurement, but rather it is to determine the guiding objective of the measurement process. The primary objective of account, and therefore of measurement in accounts, is, according to the conceptual framework of the IASB and the FASB, relevance to the need of users. Those needs are assumed to arise from the economic decisions that users have to make. These decisions are assumed to be primarily those made by an investor, and they therefore relate primarily to the prediction of future cash flows. However, prediction does not imply merely forecasting, and the concerns of stewardship are also assumed to be included in the objective. Stewardship implies accountability by management to investors. The feedback that this provides is relevant to future cash flows because it will affect the future conduct of management and confidence which investors will place in the entity s prospects. Many academic writers have advocated that a single measurement method be applied to all assets. ISBN:

5 This would have the obvious benefit of enabling different types of asset to be compared without having to allow the changes in valuation method and would also remove possible errors or bias arising from different classification methods being used by different entities or at different times. However, it seems likely that, in practice, cost or benefit considerations may justify the use of different measurement methods for different categories of asset (e.g. when market evidence is unavailable or expensive). In the latter case, it may still be helpful to users to have a common valuation objective, imposing consistency of purpose, even if the techniques used to achieve it may vary according to asset type. Moreover, it may be preferable to choose techniques by reference to specific circumstances rather than asset type: thus, it would be the actual absence of market information, rather then asset type that would justify the use of an alternative technique, so that the measurement objective would always be followed as closely as was permitted by the available evidence. This is the approach adopted by the fair value hierarchy discussed above. 4 Conclusions To conclude, there are a number of plausible alternatives to fair value and that the choice will depend upon the specific circumstances in the context of SME s of the entity and the needs of the user of accounts. In an uncertain world with imperfect and incomplete markets, no particular measurement objective should be regarded as having a monopoly, and different measurements should be regarded as complementing one another. Among the advantages of the real value there can be named: Utility, relevance, transparency and superior accuracy of the results and cash-flow of the company, it brings more clearance to the financial statements, it does a total accounting of the comparable value and it gives more liability to the manager. The credibility regards a reasonable evaluation, the using of market information in all possible situations for evaluating and justifying the subjective arguments. The neutrality presumes evaluations that were done in an adequate context and without a selective presentation. Fair value is here to stay. It is already deeply embedded in IASB and FASB literature and there are growing calls from the user community to increase its use in financial reporting. Conceptual support for fair value is demonstrable and will be further underpinned in the revised conceptual framework. Users, auditors and regulators will become more comfortable with the use of fair value as time passes. Moving from theory to practice, the question perhaps becomes: What are the informational advantages and disadvantages of the practicable proxies to fair value, SME s value, both when applied consistently, and when applied pragmatically on an item-by item basis? This takes us back to the academically traditional debates on the pros and cons of the various theories of income measurement and asset valuation. Many academics have strongly held view on these issues. References: [1] FASB, Fair Value Measurements, Statement of Financial Accounting Standards No. 157, [2] McConnell, P., Response to Fair Value Accounting, Financial Economics, and the Transformation of Reliability. Accounting and Business Research, 2010, Vol. 40, No. 3. [3] Arya, A. and A. Reinstein, Recent Developments in Fair Value Accounting. The CPA Journal, 2010, August. [4] IASB, International Financial Reporting Standard for Small and Medium-sized Entities, London, International Accounting Standards Foundation, [5] Lamoreaux, M. G., AICPA Expresses Concern on FASB Financial Instruments Proposal. Journal of Accountancy, 2010, October. [6] IASB, IFRS 13 Fair Value Measurementwww.ifrs.org, 2011 ISBN: