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International Journal of Accounting & Business Management

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ISSN: 2289-4519

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Fair Value Accounting: Adoptability in Indian Corporate Financial Reporting Scenario

Dr. Pawan Jain

Institute of Management Technology Nagpur, India

pjain@imtnag.ac.in

Abstract This paper tries to examine the degree of adoptability of concept of Fair Value, as codified in the International Financial Reporting Standards (IFRSs), in Indian Accounting Standards. Indian Accounting Standards are the official set of corporate financial reporting standards of India, a major emerging economy on the world map. The paper examines the extent of adoptability of concept of Fair Value in Indian Accounting Standards (Ind A S), reasons for differences from International Financial Reporting Standards of International Accounting Standards Board and future road map for complete adoption of Fair Value for Indian Corporate Financial Reporting scenario. Data will be obtained from content analysis of Ind A S and IFRS, standards setters official reports & other documents and other academic research. The data examined in the paper has been extracted from government reports. The findings will be arrived at by examining the data so collected. The research examines the degree of adoptability of Fair Value concept in Ind A S. These findings can be used in future to find out their specific impact on companies’ financial statements. This research makes a timely, critical and relevant contribution in the area as it examines the degree of adoptability of Fair Value concept (as codified in IFRS) in Ind AS. Since India is one of the fast emerging economies of the world, the Paper tries to measure the extent of Fair Value adoption in Indian A S. It also provides insight on factors that can hinder the process of International Accounting Practices convergence in accounting practices followed in emerging economies with special reference to India.

Keywords—Accounting, International Financial Reporting Standards (IFRS), Fair Value Accounting 1. Introduction

This paper examines the extent of adoptability of concept of Fair Value by Indian Financial reporting scenario as part of its overall convergence with International Financial Reporting Standards (IFRS). This study is significant because (i) India is one of the top emerging economies in the world and (ii) Good number of studies, carried out in well functioning capital market and well developed economies, are available examining multiple issues relevant to Fair Value but a large gap exists when it comes to studying Fair Value concept with reference to an emerging economy. This study will try to fill this gap. During last decade, substantial number of studies has been carried out establishing the superiority of FV Concept over Historical Cost Concept. These studies were carried out in some of the well developed financial and economic environment concentrating in USA and European Countries. India, though one among the fastest emerging economies, have different economic, financial and social conditions. The adoptability of FV Concept is one of the essential elements for converging with IFRS.

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Currently, the companies registered in India prepare their Financial Statements (Income Statement and Balance Sheet) on the basis of Financial Reporting Standards issued by Institute of Chartered Accountants of India over last decade. These Standards were prepared on the basis of existing Accounting Practices in India and World. The standards setters while preparing these standards took into consideration globally existing best practices and Indian social, economic, financial & political conditions. Still these standards were not fully convergent with the International Accounting Standards (IAS)/ International Financial Reporting Standards (IFRS)i which were made mandatory for European Union members to follow since 2005 and subsequently adopted by a large number of countries across the globe.

To ensure a fully converged set of Standards, in 2010, Ministry of Corporate Affairs (MCA), Government of India prepared a roadmap in which, it was decided that there will be two sets of Corporate Financial Reporting Standards – one which are existing ones and being adopted by all companies; second which will be converged Indian Accounting Standards in the line of IFRS (Ind A S)ii and will be adopted by the companies in a phased manner. In the same roadmap, it was decided that Companies with a turnover of Rs 1000 Cr and listed on National Stock Exchange of India & Bombay Stock Exchange of India will prepare their Financial Statements as on April 01, 2011 as per converged Accounting Standards in the line of IFRS. But adoption was put off in the wake of issues related with concept of Fair Value and relevant tax-related issues.

MCA till date has notified 35 converged Indian Accounting Standards in line of IFRS. The ministry has finalized the date of adoption for these Accounting Standards as April 1, 2013 after much postponement of the same. The itinerary of the paper is as follows. Section II provides a brief literature review discussing various aspects of Fair Value examined by researchers globally A conceptual framework has been provided in Section III . Section IV examines the Indian Scenario with respect to adoption of Fair Value. Section V concludes the paper briefly suggesting the points helpful for a quick adoption of Fair Value in Indian Corporate Financial System. 2. Literature Review Globally, Companies have been using Historical Cost Concept for valuing their Assets & Liabilities for many years. This system is verifiable and based on reliable evidence. A period of economic instability and international inflation in early 1970s caused a severe criticism by economists, financial experts and other stakeholders of accounting profession regarding the inadequacies of valuations made by Historical Cost model. This also led the path to a movement globally and in particular, in USA to incorporate market and/or Fair Value reporting in Financial Statement rather than completely relying on Historical Cost Model. Accountants & Companies found Fair Value Model suitable more for valuing Financial Assets where valuation of assets was completely based on market price of the assets. International Accounting Standard Committee (IASC) in 1975 came out with an International Accounting Standard on Inventory IAS 2 in which concept of Fair Value was introduced first time. Subsequently, use of Fair Value concept was expanded into Property, Plant & Equipment; Revenues; Employees Benefits; Accounting & Reporting by Retirement Benefits Plan; Impairment of Assets; Financial Instruments : Recognition and Measurement; Intangible Assets etc (Shanklin et al, 2011) . With all these developments, it is still a debatable issue, which is a superior model with respect to valuation of assets & liabilities – Historical Cost Model or Fair Value Model. The debate between these Accounting Models is based on the issue of relevance versus reliability. The argument in favour of Fair Value Model suggests that reporting Financial Assets & Liabilities at Fair Value is more relevant than at historical cost. Fair Value reflects the current price at which an asset can be bought or sold and provides better insights to immediate risk. The argument in favour of Historical Cost Concept says that concept of Fair Value is less reliable. Valuation based on Historical Cost concept is more reliable as it is supported by documentary evidences like Bills/ Invoices. Fair Value Accounting leads to excessive volatility and short term

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fluctuations that don’t reflect the true value and fundamentals of the underlying Financial Assets and Liabilities. Several studies also blame the economic crisis happened over last decade on the concept of Fair Value. Lost in this controversy is the fact that the responsibility for failures falls on the management of companies that invested in high risk/high reward financial instruments which did not performed during volatile markets and created a crisis like situation. Many studies have been carried out blaming Concept of Fair Value for economic crisis during the last decade. Several other studies have proved otherwise and considered Concept of Fair Value as a model which is giving most relevant and current information about the asset valuation. Concept of Fair Value has been useful in providing the valuation for Financial Assets which are largely based on market conditions. During the last decade, globally, financial reporting standards setters have understood the significance of Concept of Fair Value in rapidly changing economic and financial scenario and have introduced the concept of Fair Value extensively in the corporate financial reporting standards. In USA, SFAS 157 allows the use of three valuation techniques for measuring fair value – Market Approach, Income Approach and Cost Approach. SFAS 157 establishes a three level fair value hierarchy whose major purpose is to prioritize the market inputs to valuation techniques used to measure fair value into three broad levels. The main purpose of these requirements is to increase transparency regarding how fair value is determined (Casabona & Shoaf, 2007). In India, the standards setters while converging to IAS/IFRS have also understood the importance of Fair Value Concept and adopted it in Accounting Standards wherever required. Fair Value is usually defined as a current market price. International Financial Reporting Standards (IFRS) define Fair value as “Fair Value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” The Financial Accounting Standard Board (FASB), USA, in its Fair Value measurement standard defines Fair Value as – “Fair Value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. Elena (2008) concluded the objective of Fair Value as to estimate an exchange price for the asset/liability being measured in the absence of an actual transaction for that asset/liability. Penman (2007) presented three notions of Fair Value – (i) Fair Value variously applied in a mixed attribute model where it is used along with alternatively with Historical Cost model; (ii) Fair Value continually applied as entry value; and (iii) Fair Value continually applied as exit value. Fair Value as defined by IASB and FASB is treated commonly as an exit value. Poon (2004) observed that Fair Values are the most relevant measures for financial assets and liabilities, and to deal with important conceptual & practical issues relating to the reliable determination of fair values, it is better to have complete information on Fair Value disclosures. According to a statement made by Robert Herz, chairman of FASB made at 2007 Annual Conference & Exposition of the Institute of Management Accountants (IMA), Fair Value is objective basis, impounds current information and is forward looking. Campbell et al (2008) in their study on implementation of SFAS no 157 (which is a framework for Fair Value definition, Measurement and disclosure) observed that SFAS 157 places great emphasis on the inputs used in fair value measurement and these inputs should specifically be (i) based on timely information; (ii) generated from independent sources; and (iii) used by market place participants in pricing decisions. Zhou & Ding (2009) in their study of Chinese Financial Reporting scenario concluded that China should apply certain degree of restrictions before Fair Value is adopted in Chinese financial reporting system. In another relevant study carried out by Peng & Bewley (2010), the authors found a high degree of adoption of IFRS FVA standards in China’s 2007 GAAP for financial instruments but many differences for non financial long term assets investments. This deviation was justified due to different fundamental characteristics of Chinese environment. Muller et al (2011) in their study of European Real Estate Industry observed that firms adopting IAS -40 mandatorily exhibited a larger decline in the information asymmetry which was reflected in lower bid-ask spread. They also found in their research that mandatory adoption firms continue to have

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higher information asymmetry than voluntary adoption firms which is partially due to the lower reliability of fair values reported by the mandatory adoption firms. They concluded that common adoption of fair value even for long lived tangible assets, under a mandatory reporting regime can reduce, but not necessarily eliminate, information asymmetry differences across firms. In a qualitative study by Ying et al (2012) of global process of neoliberalisation and financialisation of political & economic systems, the authors concluded that introduction of Fair Value in Chinese Accounting System failed to transform the political & economic power in china. The process has changed the image of Chinese capital markets in the eyes of advanced capitalist economies which now see Chinese Accounting System as a strong system, but, as observed by the authors, lacks necessary regulatory and socio-political provisions to rationalize its relevance and reliability in the Chinese context. The study shows the Fair Value and IFRS adoption process in emerging economies in a new context. In his article on Commercial Banks O’Kelly (2008) argued that Fair Value might not be the best solution for measurement related problems for Banks. The Banks will not fair value the portfolio which they are holding for some time. Ratcliffe (2007) discussed some key accounting & reporting issues relevant while choosing Fair Value option by a reporting entity. The author highlighted the need of implementing Fair Value with the objective of improving financial reporting rather than to achieve a particular accounting result. So & Smith (2009) in their research of listed property companies observed that these companies have shown a significantly higher market reaction and returns association when revised value of investment property as per IAS 40/HKAS 40 is presented in Income Statement. Cairns et al (2012) through their study in UK & Australia observed that mandatory requirements related to financial instruments (IAS 39) and share based payments (IFRS 2) have increased comparability in policy choices. Increases in comparability for agricultural assets (IAS 41) were not significant. For optional use of Fair Value, comparability increased in relation to property (IAS 16) because some companies discontinued Fair Value Measurement. Trussel & Rose (2009) suggest that a hybrid system be followed for measuring assets and liabilities rather than following only Historical Cost Accounting or Fair Value Accounting. This hybrid system will incorporate both models depending on the nature of the financial instruments. Oncioiu (2012) concluded that Fair Value is conceptually strong. He also observed that markets which exist are of imperfect nature and no particular measurement objective should be regarded as having monopoly. There should be more than one measurement systems complementing each other. 3. Conceptual Framework for Fair Value The concept of Fair Value has undergone a sea change over last 50 years. In 1960s, current value was seen as a replacement of Historical Value. Replacement Value, Net Realizable Value and Deprival Value were some other concepts which were adopted by practitioners and theoreticians as an alternative to Historical Cost. American Standard Setters in late 1980s first used the term “Fair Value” which was then taken up by UK and International Accounting setters. Though the terms were different but connotations are same. Loosely all these terms were giving a market based current value as opposed to traditional historical cost value. Over the last decade, the precise application of Fair value has varied from standard to standard which caused practitioners and theoreticians in misusing and misunderstanding the concept (Oncioiu, 2012). Recently, IASB came out with IFRS 13, which suggests a uniform method of calculating Fair Value. FASB had also developed SFAS 157 which deals with Fair Value. In SFAS 157, FASB has provided single definition of Fair Value and prescribes a framework for performing fair value measurement using a three tiered hierarchy of inputs. IASB, working on its convergence programme, followed similar manner of defining and measuring Fair Value as provided in SFAS 157 and announce IFRS 13. IFRS 13 follows similar hierarchical structure in categorizing the inputs used in measurement of fair value. This is significant to note that India has converged its accounting standards with IAS/IFRS and will follow the same Accounting standards as prescribed by IASB. The three level hierarchical structures are as follows (IASB, 2013):

Level 1 input are Quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date.

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Inputs other than quoted market prices included within level 1, that are still observable for the asset or liability, either directly or indirectly.

Unobservable inputs for the asset or liability – These are used to measure fair value to the extent that relevant observable inputs are not available.

Changing Business scenario which grew complex with the passage of time post WWII era forced for measurement system capable of capturing the most relevant value for assets & liabilities. Practitioners, Academicians and Regulators also started experimenting with multiple concepts and during last decade, the concept of “Fair Value” assumed shape. The reasons which were cited for advent of concept of Fair Value are – lack of reliability while valuing firms’ value as per existing Historical Cost System; increasing significance of Intangible Assets like Brand, Goodwill, Intellectual Property etc where it was difficult to find the value as per Historical Cost System; dissatisfaction among investors over valuation method being followed while valuing firms; new financial instruments like options, future etc. Once the concept of “Fair Value” came into practice, standard setters globally started laying down the conceptual guidelines regarding definition, measurement and interpretation of “Fair Value”. IASB came out with IFRS 13 and FASB with SFAS 157. This helped practitioners, Academicians and regulators to deal with complex issues involving Fair Value. Academicians and Standard Setters identified certain areas where Fair Value can be used for measurement purpose -

Investment in securities in a trading portfolio and derivative instruments on such securities; Pension Assets; Investments by an Insurance Company; Real Estate held for speculation with no plan for developing or utilizing the real estate; Options that give the counter party (but not the firm) the call rights (Penman, 2007)

Accounting for Lease; Employers’ Accounting for Pensions; Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Terminal Benefits; Employers’ Accounting for Postretirement Benefits other than Pensions; Disclosures about Fair Value of Financial Instruments; Share Based Payments; Accounting for Derivative Instruments and Hedging Activities; Accounting for Transfer and servicing of Financial Assets and Extinguishments of Liabilities; Business Combinations; Goodwill and other Tangible Assets; Accounting for Asset Retirement Obligations; Accounting for the Impairment of Disposal of long lived Assets; Accounting for Costs associated with exit or disposal activities; Fair Value option for Financial Assets and Financial Liabilities etc (Casabona & Shoaf, 2007 , FASB)

Loans receivables and Payables; Investments in Equity securities, including investments accounted for using the equity method; Rights and Obligations under Insurance Contracts; Written Loan Commitments. (Ratcliffe, 2007)

Expensing Share Options; Assets acquired in takeover; Surplus Assets; Carrying Amount on Balance Sheet; Measurement of lease assets and liabilities; Impairment Reviews; Measurement of embedded reviews; Agricultural Assets; Property Plant & Equipment and Investment Property - Optional adoption of Fair Value (Elena, 2008, IASB)

Initially, firms were dealing with above mentioned areas using limited guidelines available on Fair Value. After the pronouncements of SFAS 157 and IFRS 13, a conceptual clarity is there helping the practitioners, academicians and regulators to deal with fair value. 4. Fair Value – The Indian Scenario In India, Firms have been using Historical Cost Model for measuring assets & liabilities due to multiple reasons. According to Ministry of Corporate Affairs, India, the country will adopt IFRS from April 01, 2013. The adoption of IFRS/Converged Ind AS will ensure a speedy shift from Historical Cost Accounting to Fair Value Accounting. Currently, in India, this shift is gradual and limited to certain areas only. The following paragraphs will explore the areas where the concept of Fair value Accounting can be used in India. 4.1 Real Estate Sector

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Real estate Sector is playing a critical role in the development of the Indian economy. Over the next decade, the real estate sector is expected to grow by 30 per cent. By 2020, The Indian real estate market size is expected to touch US$ 180 billion. The Private Equity Funds invested around US$ 1,700 million in this sector during 2011. The sector attracted heavy foreign direct investment (FDI) inflows also in 2011-12 (April-January) amounting to US$ 492.50 million. With this exposure to international funding and investors, the Real estate sector must have a sound financial reporting standard in place. Ind AS 11 on Construction along with Ind AS 17 on Lease provides guidelines on multiple issues relevant to Real Estate Sector. Since the sector is opening up for foreign investment and getting organized, the concept of fair value is fast catching the attention of players in the Industry and the use of concept of Fair Value in increasing. 4.2 Future & Options Sector Future & Options Market in India is growing at a fast pace. The Table below gives a picture of transactions carried out during last five years (2008-09 to 2012-13) in National Stock Exchangeiii, India. The table shows annual turnover for Index Futures & Stock Futures and Notional Turnover for Index Options & Stock Options. The amount is in Billion Rs.

Year Index Future Stock Future Index Option Stock option Total 2012-13 20502.11 32897.07 175433.62 14911.00 243743.81 2011-12 35779.98 40746.70 227200.31 9770.31 313497.31 2010-11 43567.54 54957.56 183653.65 10303.44 292482.21 2009-10 39343.88 51952.46 80279.64 5060.65 176636.64 2008-09 35701.11 34796.42 37315.01 2292.26 110104.82

The table shows the trade almost tripling in just 5 years. The Foreign Institutional Investors and other entities are active players in Derivatives Securities Market in India. To report the transactions in Financial Statements, Ind AS 32 on Financial Instruments - Presentation, Ind AS 39 on Financial Instruments – Recognition & Measurement and Ind AS 107 on Financial Instrument - Disclosures provide set of guidelines for reporting the transactions in financial statements. 4.3 Employee Benefits India is one of the fastest growing economies on the World map. With GDP over Rs 75 Trillion, economy growth rate close to 8%, forex reserve standing at UD $ 290 Billion (all data for 2012), Indian Economy is playing a significant role among the global players. With so much of activities on economic and Industrial front, the work force in India is growing multifold. According to a report by Goldman Sache a demographically young India will be the largest contributor to the global labour force in the coming decades, and will add about 110 million workers by 2020. With all these variables, a global level Employee Benefits reporting system should be in place. Ind AS 19 on Employee Benefits addresses the issues relevant to Employee Benefits. In India, amount collected by companies for employee benefits is handled by Employees Provident Fund Organization (EPFO)iv. Companies are required to make sufficient provisions for future obligations payable to Employees and the guidelines for such provisioning and other relevant issues are to be provided by Ind AS 19. The concept of Fair Value is relevant here due to the various provisioning of future obligations. A clear set of guidelines will help while reporting the relevant transactions in financial statements. 4.4 Other Sectors The other relevant sectors which will be benefitted with adoption of IFRS/Ind AS include Leasing business which stands close to Rs 200 Billion for which guidelines have been provided in Ind AS 17 on Lease; Impairment of Assets which is a newer concept for Indian Corporate Financial Reporting for which the guidelines have been provided by Ind AS 36; Intangible Assets, a concept which is gaining momentum due to fast changing business scenario

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valuing not only the Plant & Machines of the Business but Brand, Licenses, trademarks etc also, the guidelines for which have been provided in Ind AS 38. In above paragraphs, we have tried to explain the utility of Ind AS (a converged set of corporate financial reporting standards with IFRS) in general and fair Value in particular with respect to reporting of financial transactions carried out by Indian Firms. There are other areas also for which concept of Fair Value is equally significant and Indian Corporate Financial Reporting system will adopt it or in the process of adopting. 5. Conclusions The concept of Fair Value is here to stay. Despite all its misgivings, the standards setters and practitioners are embracing the concept. Researchers (Baluch et al, 2011) proposed a hybrid system to deal with the shortcomings of Fair Value Accounting. Wagner & Garner (2010) argued that if there is a mismatch between provisions of Fair Value Accounting and regulatory provisions, Fair Value Accounting will fail to serve its purpose. In Indian Context, following are some of the recommendations which may be useful for adoption of Fair Value Accounting which will result in fast developing economy, growing capital markets, access to cheap cross border funds etc.

i. The regulatory environment has to be readjusted considering the concept of fair value. Tax Laws which are a major hurdle in adoption of Fair Value should include the concept of Fair Value for valuation purpose of assets & liabilities.

ii. There are many practitioners in India which are not comfortable with the concept of Fair Value and how it is to be used. Training will make them adept for using Fair Value.

iii. Fair Value itself requires some clarity on definition and measurement methods. Recently introduced IFRS 13 will address these issues.

iv. It is also feared in the Indian Corporate sector that adoption of concept of Fair Value may reduce the value of assets held by these firms. An awareness programme should be carried by the Standard setters to remove this misunderstanding.

Summarily, infrastructure to support understanding, provide oversight, enforcing proper application of the concept, providing training & awareness programme are some of the essential elements for successful implementation of Fair Value Accounting. 5.1 Recommendation for Future Research The Paper examines the degree of adoption of concept of “Fair Value” in Ind Accounting Standards. Future Research may track the impact of adoption of Fair Value on Financial Statements of Indian Firms. 5.2 Limitations of the Study The paper has been written considering the qualitative information available as government reports, standards setters’ documents and existing material on Fair Value. The quantitative analysis of data has not been carried out to judge the degree of adoption of Fair Value in Ind Accounting Standards. The conclusion has been arrived at by examining the qualitative information only. References Arya, Avinash, Reinstein, Alan, 2010, ‘Recent Developments in Fair Value Accounting’, The CPA

Journal, LXXX, (8), pg 20.

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Baluch, Catherine, Cohen, Reuben, Soto, Henry, Tucker, Pamela, Volkan, Ara, Wright, Gail, 2011, ‘Fair Value Accounting: Current Status And A Proposal For Convergence’, International Business & Economic Research Journal, 10, (4), pg 17.

Cairns, David, Massoudi, Renee, Dianne, Taplin, Ross, Tarca, Ann, 2012, ‘IFRS Fair Value Measurement and Accounting Policy Choice in the United Kingdom and Australia’, SSRN Working Paper Series.

Campbell, L, Ronald, Owens-Jackson, A, Lisa, Robinson, R, Diana, 2008, ‘Fair Value Accounting – from Theory to Practice’, Strategic Finance, pg 31.

Casabona, Patrick, Shoaf, Victoria, 2007, ‘New Requirements for Measuring and Reporting Fair Value in GAAP’, Review of Business, 27, (4), pg 10.

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Cheng, Kang, 2009, ‘Fair Value’s ‘How’ Meets ‘When’ – The Complications of Applying Mark-to-Market Accounting in an Inactive Market’, The CPA Journal, LXXIX, (8), pg 26.

Lhaopadchan, Suntharee, 2010, ‘Fair value accounting and intangible assets: Goodwill impairment and managerial choice’, Journal of Financial Regulation and Compliance, 18, (2), pg 120.

MacDonald, A, Linda, 2010, ‘Fair Value Changes Ahead’, The CPA Journal, LXXX, (1), pg 24. Muller, A, Karl, Riedl, J, Edward, Sellhorn, Thorsten, 2011, ‘Mandatory Fair Value Accounting and

Information Asymmetry: Evidence from the European Real Estate Industry’, SSRN Working Paper Series.

O’Kelly, Brian, 2008, ‘Commercial Banks – How Fair is Fair Value’, Accountancy Ireland, 40, (3), pg 30.

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Trussel, M, John, Rose, C, Laura, 2009, ‘Fair Value Accounting and the Current Financial Crisis’, The CPA Journal, LXXIX, (6), pg 26.

Wagner, Andrew, Garner, Don, 2010, ‘Fair Value Accounting – Fact Or Fancy?’, Journal of Business & Economic Research, 8, (11) pg 35.

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i International Financial Reporting Standards comprise of IFRS issued after 2001; International Accounting Standards(IAS) issued before 2001(after 2001, all financial reporting standards issued by IASB are known as IFRS, before 2001, these were issued by IASC and were known as IAS); Interpretations originated from International Financial Reporting Interpretation Committee issued after 2001; Standing Interpretation Committee issued before 2001. ii Ind Accounting Standards are the standards which are converged with IAS/IFRS. These Accounting Standards will be adopted by Indian Firms since April 01, 2013. iii National Stock Exchange is the biggest Stock exchange (volume wise) of India. iv EPFO is an organization in India responsible for collecting Provident Fund Contribution from Indian Government owned and privately owned companies.