Investors need fair value, not fake value

Equity investments currently reported at fair value could be measured at cost or some other ‘fake value’ in EU companies’ financial statements, depending on the outcome of a European Commission consultation.

There seems to be a never-ending debate in Europe about fair value measurement, particularly regarding equity investments. In our view any move to change the current financial reporting requirements would be detrimental for users of financial statements.

Since IFRS was introduced in Europe in 2005 there have been continuing objections to the use of fair value. IFRS 9 Financial Instruments, which has become effective in 2018, was somewhat reluctantly endorsed by the EU; in part because it reinforced the use of fair value for measuring equity investments. Related to this the European Commission recently asked EFRAG, its advisory body on financial reporting, to investigate alternative methods of measuring portfolios of equity investments instead of the currently required fair value.

The objections to fair value for equity investments are mainly related to where these assets are held by companies whose primary business model is to provide goods and services, such as insurance and utility companies. But we start by considering the less controversial use of fair value for separate investment funds.

Fair value measurement for investment portfolios

The financial reporting of a closed end investment fund is relatively simple and generally uncontroversial. Investors need to know the current market value (fair value) of the investments held and the change in value achieved during a reporting period. Other supplementary disclosures are also necessary, such as information about the composition of the underlying portfolio, any measurement uncertainty for assets that are not actively traded (where fair value measurement is not ‘level 1’) and the performance of the portfolio relative to a benchmark. Essentially this is how the accounting for separate investment funds currently works under IFRS, with little disagreement.

Fair value and fair value changes are key to evaluating a separate investment fund

Reporting the fair value of investments still means that individual investors can incorporate their own assessments when making decisions about investing in the fund. Also, the use of current market values is not inconsistent with the investors in the fund or the fund itself being ‘long-term’ investors. Even if an investor does not intend to sell in the short term, monitoring changes in fair value is essential to tracking the progress of the fund and assessing the performance of the management of that fund.

For an investment fund neither the original cost of assets in the portfolio nor the realisation of a gain or loss in an individual asset has much relevance to investors in the fund itself (assuming, as is generally the case, it does not have tax implications). Realisation of value may provide confirmatory evidence of fair values in the case of unquoted or illiquid assets, but this is covered by the measurement uncertainty disclosures and does not impact the fundamental principle of reporting fair values and value changes.

But what if not a separate entity?

So, if the use of fair values for investment funds is uncontroversial, you may be surprised to learn that this is far from the case when an investment fund is held by an entity whose primary business is to provide other goods and services. Many companies hold portfolios of investments as a result of their business model, but where the investments and investment management is not the primary or sole purpose of the enterprise.

For example:

  • A utility company faced with expensive decommission costs for power generating facilities at the end of their useful lives may build a dedicated investment portfolio over the working life of the asset.
  • An insurance company often receives premiums many years before claims are paid. Those premiums need to be invested.
  • Any company with a defined benefit pension scheme holding assets to fund future pension payments. Many such funds are ‘off-balance sheet’ and it is only the net funding position that is reported in the sponsor’s financial statements. However, even in this case, the reporting of the assets of the fund is still important.

In these examples the primary purpose of the business is to provide customers with other goods or services (such as power or insurance risk coverage), but the holding of an investment portfolio is essential to delivering that activity and to fund a particular liability.

Combining an operating business with an investment portfolio does not make fair value less relevant

But should the combination of holding an investment portfolio while undertaking another activity change the accounting applied to that portfolio? We think not. Fair values and change in fair value are still essential. However, in this case, the additional dimension is the existence of a related liability. But this merely requires appropriate accounting for the liability itself and the disclosure of how the investments relate to that liability, i.e. the approach to asset / liability management. In our view, this does not warrant a change to the accounting for the investment fund.

Of course, combining the accounting for a change in the value of an investment fund with reporting on the revenue and expenses for the business of providing goods and services does present challenges. If the change in value of an investment portfolio is reported in profit and loss and combined with revenue and expenses from, for example, power generation, then the resulting total profit would be difficult to interpret. However, this is why we have disaggregation of financial information, including subtotals, such as operating profit and further disclosures to help investors differentiate between different aspects of performance. As above, we do not believe it is a reason to change the measurement of the investment portfolio.

Objections to the use of fair value

Ever since IFRS was first applied in Europe in 2005 there have been objections to the use of fair value for the reporting of certain business activities under IFRS standards. Three arguments tend to be used against fair values:

  • Volatility: The use of fair value and the reporting of value changes in net income clearly increases the volatility of reported profits. Some see this as inherently undesirable in that it may confuse investors, resulting in inappropriate and/or excessively volatile stock prices. We do not think investors are that easily confused, even though politicians seem to think they might be! Any investor knows that profit may need to be disaggregated before being analysed.
  • Long-term investment: Volatile asset values and volatile profit is assumed to discourage the long-term investment in equities and encourage short-termism. Fair values are thought to be relevant for short-term investors, but not those who are willing and able to invest ‘through the cycle’. We think that reporting fair values is even more important for long-term investors. Not having fair values reported regularly would serve to discourage long-term investment simply because investors would be less well informed about what they are investing in.
  • Prudence: Valuing volatile assets at fair value and reporting gains in income is thought inconsistent with ‘prudent’ financial reporting. In particular, it is thought that it may encourage reckless dividend distributions or excessive management bonuses. In our view, the need to report relevant information to investors should not be compromised by a desire to influence dividends and bonuses. There are better mechanisms to achieve this end. Most jurisdictions, for example, restrict dividend payments beyond simple reported profits.

Those that object to fair value accounting for investments would either prefer not to use fair value measurement at all, or at least not to report value changes in net income. It is the first of these that is the subject of a recent request by the European Commission to EFRAG, its advisory body on financial reporting. (EFRAG is already investigating ways to avoid certain fair value changes being reported in net income, but that is perhaps an issue for another article).

Extract from the European Commission request for EFRAG to investigate alternatives to fair values
Source: EC letter to EFRAG dated 1 June 2018. Click extract to see full letter.

What alternatives to fair value might EFRAG consider? Essentially the choices are either cost, some sort of smoothed fair value or an alternative current value measure that is not the market price. We explain why we believe none of these would meet the needs of investors.

  • Cost: Whilst cost can be a sensible measurement basis for many assets (particularly those used in an operating business where the focus of investors is on the periodic flows that are generated) it is certainly not suitable for investment portfolios. It provides no relevant information for investor decision making. Cost is also difficult to compute where fungible investments are traded (one needs an arbitrary FIFO or average cost type rule) and it is difficult to decide when the cost should be written off if the asset value declines. The gains and losses under cost measurement are difficult to interpret, being based in realisation through sale rather than actual investment performance, and also easy for management to manipulate.
  • Smoothed fair value: Those that dislike fair value because of its volatility sometimes advocate using a smoothed value where the asset is measured at the average price over some selected period. Not only is the smoothing period arbitrary, but clearly this would not to provide a comprehensible or relevant valuation of the investment, being neither a current value nor a cost measure. Markets may well get things wrong from time to time, but a smoothed value is likely to be wrong all of the time.
  • Management valuation: Some believe that they can do a better job than the market in valuing equity investments. Of course, this applies to active investment management and fundamental analysis, but you all know how difficult it is to beat the market. Would you want the management of, say, a utility company to provide their valuation of equity investments or report the market price and let you decide whether you agree or not? We think the answer is clear, any move away from the anchor of fair value would reduce comparability, increase confusion and would be bad for investors.

Our view on measuring equity investments

The current measurement of equity investments at fair value, together with supporting disclosures, works just fine for investors, Let’s hope that nothing comes of the European Commission’s request.

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