As we hit 31 December, many companies will need to put a fair value on assets, liabilities, derivatives and other financial instruments under IFRS rules. But the credit crunch has not only affected values, it has also in some cases made it more difficult to determine a fair value.

To help, a paper has just been produced by the Global Public Policy Committee (GPPC), which is comprised of the six largest international accountancy networks – the Big Four as well as BDO International and Grant Thornton International.

Welcoming the paper, the Association of British Insurers issued a statement in which Peter Montagnon, director of investment affairs, said: “ABI members have been concerned over the lack of transparency with regard to SIVs [special investment vehicles] and off balance sheet business and we look to audit committees, especially in the current situation, to ensure that relevant information is properly reported. This includes all facts needed for shareholders to have a proper understanding of the substance.”

The Investment Management Association said that the paper will “go some way to ensure that the current market turmoil does not result in inconsistent application of existing standards on fair value for 31 December year ends. The current credit crunch means that this is not a normal market and there are not necessarily going to be willing buyers and sellers to determine fair value.”

What does the GPPC paper say?
First of all, the paper makes clear that it simply “sets out the requirements of existing IFRS literature” so as to “enhance awareness”; it does not amend or interpret IFRS. (It helps that the document is just five pages long.)

In IAS 39 “fair value” is defined as “the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction”. It reminds readers that quoted prices in active markets provide the best evidence of fair values and so must be used when available.

When there aren’t any such quoted market prices, a valuation technique is to be used instead with the objective “to establish what the transaction price would have been on the measurement date in an arm’s length exchange motivated by normal business considerations”.

So far so good, but the paper acknowledges that it is possible that there might be situations where it was at one time thought that there was an active market for a particular financial instrument, but that such a market may now no longer exist, forcing the need to adopt a valuation technique.

An active market is one where quoted prices are readily and regularly available from an exchange, dealer, broker, industry group, pricing service or regulatory agency – and that these prices represent “actual and regularly occurring market transactions”. Note, however, that this does not mean there is a consistent number of market transactions from one period to another.

herefore, just because there is a significantly lower volume of transactions that is not evidence that there is not an active market – nor that the transactions taking place are “forced” transactions or “distressed sales”.

Furthermore, the presence of more sellers than buyers is not the same as a forced or distressed sale. Even if for a short period no trades take place it doesn’t necessarily mean that an active market has ceased to exist, though the paper does say that IAS 39 requires not only readily available prices, but also regularly occurring transactions.

What is meant by phrases such as “regularly occurring”, “forced transaction” and “distressed sale” is a matter of judgement in light of the particular facts and circumstances, however.

No active market
If there is no active market for a financial instrument then a valuation model is allowable. (But it is not acceptable to try to argue that market pricing is irrational and that a model-based measurement should therefore be used instead.)

A valuation technique must “incorporate all factors that market participants would consider in setting a price”. When there is evidence of a change in credit spread, liquidity or other perceived risks, IAS 39 requires the effects of the change to be considered in determining fair value (see box). Hence, a valuation model has to factor in current market conditions, including credit spreads and liquidity.

Determining fair value
An article in the most recent issue of the Bank of England Quarterly Bulletin attempts to “decompose” corporate bond spreads over government bonds, to determine whether the recent widening of spreads represents greater fears of default-related credit risk, or a greater illiquidity premium arising from increased risk that investors won’t be able to sell their holdings immediately except at a substantial price discount.

This may appear to be a fairly academic exercise. However, the article’s authors say that understanding why corporate bond spreads have widened recently will help provide an insight as to whether investors expect a worsening in the macroeconomy, have simply become more risk-averse, or whether there is information to be inferred about conditions in financial markets.
Its conclusion? Since mid-2007 there has been an increase in the risk premium arising from an increase in expected and unexpected default risk and an increase in the illiquidity premium, particularly for high-yield debt.

Useful links
The Association of British Insurers is at www.abi.org.uk
The US Center for Audit Quality (www.thecaq.org) issued a report on Measurement of Fair Value in Illiquid (or Less Liquid) Ma rkets for US GAAP, available at http://tinyurl.com /23udkt
The Bank of England Quarterly Bulletin is at www.bankofengland.co.uk