Fair value: Analysis of the impact for financial accounts

1. Introduction

The implementation of the IAS in the European Union will have an impact on data
collected from enterprises. The initial impact on financial accounts will only
be indirect through the wide range of elementary statistical sources used. Only
later there will be a methodological impact, through the various steps
necessary to make enterprise data comply with definitions and valuations of
the European System of National and Regional Accounts (ESA 95).

The most important issue of International Accounting Standards (IAS) from an ESA
95 financial accounts point of view is the ‘fair value’ requirement. The introduction of
fair valuation in the balance sheet of enterprises would largely increase the extent of
securities (debt securities and shares) that are recorded at fair value rather than at
book value and bring statistical reporting closer to what is required by the ESA 95
standard. However, fair valuation could also lead to a deviation from ESA 95, mainly
with respect to the valuation of deposits and to loans.

This paper analyses the conceptual impact on financial accounts of the introduction of
fair valuation. The analysis is conducted at the level of the relevant categories of ESA
95 financial assets and liabilities, and is line with the comparative analysis between
ESA 95 and IAS formerly carried out by Eurostat.

2. Valuation of financial assets and liabilities: ESA 95 and IAS

IAS 39 establishes principles for recognising, measuring (valuation), and disclosing

information about financial assets and liabilities. With some exceptions, financial
assets and liabilities are measured at fair ‘value’.

ESA 95 states as a general rule that all assets and liabilities are to be valued using
current market prices on the date to which the balance sheet relates (7.25). This
applies also to financial assets. Financial assets and liabilities should in principle be
valued at current prices. They should be assigned the same value whether they appear
as financial assets or liabilities (7.44). But as a matter of fact current market prices are
only applicable to assets that are marketable1. ESA 95 is rather silent on the definition
of “marketability”. However from a general point of view, a contingent asset is a
financial asset because it is tradable or can be offset on the market (7.22). Hence, as a
practical approach, the fact that the price of a financial asset is negotiable can be taken
as a prerequisite for marketability.

Given this definition the following financial assets have no current market prices:
a) Deposits: “the values to be recorded in the balance sheets are the amounts of
principal that the debtors are contractually obliged to repay the creditors under

1
That is, only financial assets within the categories AF.3 and AF.5 are to be valued at current market
prices
 the terms of the deposits when the deposits would be liquidated on the date the
balance sheet is set up. The values may include accrued interest (7.46).”
b) Loans” the values to be recorded in the balance sheets of both creditors and
debtors are the amounts of principal that the debtors are contractually obliged
to repay the creditors, even in cases where the loan was traded at discount or
premium (7.51).
c) Other accounts receivable/payable: “They are to be valued for both creditors
and debtors at the amount the debtors are contractually obliged to pay the
creditors when the obligation is extinguished”(7.61).

ESA 95 states that ideally, current market prices should be prices observable on the
market. When there are no observable prices an attempt has to be made to estimate
what the prices would be if the assets were acquired on the market on the date to
which the balance sheet relates (7.26). ESA 95 suggests also that current prices may
be approximated by re-valuing a) and accumulating acquisitions less disposals; or b)
by the present, or discounted, value of future returns (7.27).

Similarly, the best measure of fair value is a quoted market price in an open market.
However, IAS 39 recognises that ‘fair value’ cannot be readily determined for most
financial assets classified as available for sale or held for trading. And it provides
guidance for determining fair value in the absence of quoted prices. Hence, it can be
assumed that fair values are frequently the result of various estimation methods and
assumptions.

ESA 95 does not define the concept of fair value. Moreover, fair valuation may raise
some consistency problems between the valuation of assets and corresponding
liabilities of creditors and debtors. Nevertheless, in cases of absence of observable
market prices, the fair valuation may be derived, as a best approximation not far
removed from market valuation.

Valuation of individual categories of financial assets and liabilities

Currency and deposits

IAS 39 requires deposits to be recorded at cost value unless they are held for trading,
where they should be recorded at fair value. In fact, as deposits are not traded in the
same way as loans (unless negotiable instruments are issued), cost values will in
practice be equivalent to nominal values and fair values are unlikely to be adopted.
However, an extension of the fair valuation could have an impact on deposit liabilities
as it would permit the initial designation of deposits at fair value regardless of
whether they are traded or not.

ESA 95 recommends the use of principal amounts (see above). These values may
include accrued interest.

Holdings of negotiable securities

IAS 39 requires fair values to be used for all securities that are held for trading or are
available for sale. Securities that are held to maturity and unquoted shares are to be
valued at amortised cost. In ESA 95 it is recommended that holdings of securities be
recorded at fair (market) values regardless of the purpose for which they are held.

Issued negotiable securities

IAS 39 requires these to be recorded at amortised cost. However, an extension of fair

valuation would in some cases have an impact on debt securities issued. The ESA 95
recommends the use of market values in order to ensure consistency with the
valuation of the corresponding holdings of securities by creditors.

Financial derivatives (both assets and liabilities).

IAS 39 requires all derivatives to be recognised on the balance sheet at their fair
values, with the exception of those derivatives that are to be held to maturity that
should be recorded at cost. ESA95 only recognises those derivatives that have a
market value because they are tradable or can be offset on the market. ESA 95
recommends that all financial derivatives that are recognised on the balance sheet
should be recorded at fair (market) value. In the case that no quoted market price
exists, a financial derivative should be valued at either the amount required to buy out
or to offset the contract of the premium paid (7.50).

Loans

Under IAS 39, loans should be measured at amortised cost with the exception of loans
not originated by the enterprise and those held for trading purposes, which are to be
recorded at fair value.

An extension of fair valuation to loans would further increase the range of loans that
are recorded at fair value by permitting entities to measure any financial asset or
liability at fair value, by designating it at initial recognition as held for trading. In this
respect IAS 39 deviates from ESA 95 that recommends loans to be recorded at
principal value in the balance sheets of both creditors and debtors.

In the case of traded loans ESA 95 specifies that “where a loan becomes negotiable on
an organised market, it is to classify in the category securities other than shares”(5.79)
and thus valued at market price. In paragraph 6.62j, ESA 95 defines as securities other
than shares, “loans that have become negotiable de facto”.

Insurance technical reserves

ESA 95 makes reference to the Insurance Accounting Directive of December 1991

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that requires that, ‘current’ value of investments shall be disclosed in the accounts,
or in notes to the accounts (Article 46). The current value is defined as the market
value if there is a regulated market, and as the likely realisable value otherwise
(Article 48). However, it is not clear whether liabilities arising from insurance
contracts are financial instruments from an IAS point of view, and hence whether
these should be recorded at fair value.

2
Council Directive 91/674/EEC of December 1991 on the annual accounts and the consolidated
account of insurance undertakings.
Conclusions

• The categories of financial assets and liabilities that will be mostly affected by
the introduction of fair valuation are holdings of negotiable securities, deposit
liabilities and derivatives.

• If the extension of fair values is permitted for loans these are also likely to be
affected.

• The IAS requirement to recognise all derivatives on the balance sheet at their fair
values instead of off-balance sheet at historical cost would obviously have a
significant impact on balance sheets of enterprises.