How fair is Fair Market Value?

The whole world seems to despise Fair Value or Mark-to-Market (M2M) accounting standard that is, what an asset would be expected to fetch right now in a sale. It’s when regulators enforced it, the banks had to expose their ugly underbelly that led to massive write downs. It now stokes a fear that whether the liquidity crisis will eventually lead to a solvency crisis. As holders of mortgage-backed securities (MBS) and the like revalue their assets at fire-sale prices, they are running short of capital—which can lead to further sales and more write-downs. Are the bean counters ensuring a crash? Asks the Economist.

So is historic cost accounting an alternative? Hardly. It could be worse. In a crisis prices fall until bottom-fishers start to buy. Yet when assets were booked at their original price, rather than at market price, banks could delude themselves—and investors—that dross was gold. Look at Japan, where the economy was sunk for most of the 1990s by stagnant loans to “zombie” companies. Historic-cost left investors in the dark about valuations; it was also prone to fraud and fraught with moral hazard, since sloppy lending went unpunished.

It would be perverse to ignore market signals when finance is increasingly based on broad capital markets. Fair-value accounting is indeed flawed. To paraphrase Winston Churchill, it is the worst kind of accounting, except for all the others. But one can be careful on selection of the benchmark.

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Sleight of hand or indifference?

Ah, well there you have it. Companies reporting financial results in ways as are most convenient.

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Under the Indian laws, Companies prepare accounts for two different purposes under two different set of regulations. The one under Schedule VI of the Companies Act, 1956 for statutory purposes and shareholder review. Another is in compliance of the Income Tax Act, 1961 that is recognized by the Income Tax authorities. While the former lays emphasis on disclosure and shareholder information, the latter stresses on revenue recognition and tax compliance. Often there are divergences between the two because of which the financial results are often at a variance.

For example, Schedule VI of the Companies Act permitted companies to adjust the exchange gain/loss to the cost of fixed asset. So if a company bought a fixed asset for $10 (Rs 400) with a forex loan and suffered an exchange loss of say Rs 30, it could add this loss to the cost of the fixed cost (Rs 400 + 30). They get to claim depreciation (read tax savings) on that inflated cost of the asset as well.

And then there is the accounting standards prescribed by ICAI that falls somewhere between the two. ICAI AS-11 calls for recognition of this loss of Rs.30 by charging it to P&L account without adjusting the actual cost of the asset (which is eligible for depreciation). The existing treatment allowed companies that had foreign currency borrowing for acquisition of assets to inflate their assets position on account of adjustment of exchange differences every year. The companies that did not resort to foreign currency borrowing for acquisition of assets had a disadvantage as they were required to write off their financing cost in the profit and loss account.

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As of now, the first-quarter results of several big companies such as Reliance Industries, Reliance Communications, Bharti Airtel and Jet Airways would have been a lot worse had they followed the Accounting Standards (AS) 11 rules prescribed by the Institute of Chartered Accountants of India (ICAI).

Even under the International Accounting Standards (IAS), Prior to the 2003 revision of IAS 21, an exchange loss on foreign currency debt used to finance the acquisition of an asset could be added to the carrying amount of the asset if the loss resulted from a severe devaluation of a currency against which there was no practical means of hedging. That option was eliminated in the 2003 revision. ICAI too followed suit in 2003.

But reading that news item gave me scope to laugh a lot. The excuses of Reliance Industries, Bharti, Jet, sound so flimsy. Most of them have taken refuge under legal opinions (many retired judges depend on it for their livelihood) that are available for a price. Reliance Communication chose not to respond. When you are living in denial and trying to fool yourself, silence is the best option.

Or is it indifference?

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