Mixed Measurement Model Could Trump Fair Value

PricewaterhouseCoopers has surveyed a group of investors and analysts to gauge their attitudes toward the different approaches taken by the accounting standards boards to account for financial instruments, including loans.

The International Accounting Standards Board and Financial Accounting Standards Board set out in late 2008, in a joint project, to reconsider all aspects of the accounting for financial instruments. However, the two boards have taken somewhat different approaches for the accounting treatment of some financial instruments, especially loans.

FASB’s approach proposes that all financial instruments be reported at fair value, including bank loans and deposits, while the IASB seeks to retain some of the existing financial instruments accounting model that used a combination of fair value and amortized cost, depending on the nature of the financial instrument, which is often referred to as a “mixed measurement model.”

PwC surveyed a geographically diverse sample of 62 investors and analysts to gain a better understanding of their perspectives on accounting and reporting for financial instruments. 

The report found that fair value information for financial instruments is considered relevant and valuable by most respondents, but is not necessarily the key consideration in their analysis of an entity. It is used in a variety of ways by respondents, but usually as they form their views on an entity's liquidity or capital adequacy or in an enterprise value calculation. It is seldom used as an indicator of future cash flow generation.

A majority of respondents favor a mixed measurement model, with fair value reporting for shorter-lived instruments and amortized cost reporting for longer-lived instruments (particularly bank loans and deposits) when the company intends to hold those instruments for the purpose of collecting the contractual cash flows. This view is held consistently across all the geographies and industry sectors included in the survey sample.

Respondents that favor the mixed measurement model think the information better reflects an entity's underlying business and economic reasons for holding an instrument. They also stress the importance of keeping net income free from fair value movements in instruments that are held for long-term cash flow, rather than for short-term trading gains.

Respondents voice a consistent desire for improved disclosure of fair value information. Specific improvements cited include detailed, but not excessive, information about portfolio composition and risk factors, valuation methods and assumptions, and sensitivity analysis for movements in key assumptions. 

There is widespread support for an impairment model based on expected losses, as opposed to one based on incurred losses. This preference is accompanied by a desire to define how an expected loss model would be applied. Respondents voiced concern that, if loosely defined, an expected loss model could lead to excessively subjective reserving in order to facilitate earnings management.