Review: Introduction of fair value accounting
Background
Harmonisation objective
During 2002-03 the Financial Reporting Council, the body responsible for establishing the strategic direction of the Australian Accounting Standards Board (the setter of accounting standards in Australia) announced the objective of harmonising Australian accounting standards with accounting standards issued by the International Accounting Standards Board (IASB) for reporting periods commencing on or after 1 January 2005.
IAS 39 / AASB 139 Financial Instruments: Recognition and Measurement
Australian Accounting Standard (AASB) 139 Financial Instruments: Recognition and Measurement (the Australian equivalent to International Accounting Standard 39) is the most important Australian equivalent international financial reporting standard to impact on the AOFM’s statutory financial reporting. The Standard, which applies to the AOFM from 1 July 2005, was issued as a pending standard in Australia in December 2003, revised in April 2004 and passed into law in July 2004.
In its 2003-04 audited annual financial statements (at Note 2, page 96), the AOFM disclosed that, in response to AASB 139, it had provisionally determined to adopt fair value accounting to its administered financial assets and financial liabilities from 1 July 2005. In its 2004-05 audited annual financial statements (at Note 2, page 97), the AOFM has confirmed the adoption of fair value accounting, together with an estimate of the (one-off) financial impact of the change in the accounting policy.
Fair value is synonymous with market value and represents the estimated exchange equivalent price using relevant inputs from reference markets and valuation techniques. Fair value is determined on the presumption that the reporting entity is a ‘going concern’ and is operating in an active market under normal market conditions, without any intention or need to liquidate, curtail materially the size of its activities or undertake transactions on adverse terms. Fair value is also determined without discounting for asset or liability positions that are larger than standard marketable parcels.
AOFM’s existing accounting policies
Since its establishment, the AOFM has applied an historic cost accounting methodology to its financial assets and financial liabilities, including derivatives. For fixed interest debt, this entails measuring a financial instrument at its issuance yield to maturity. The issuance yield is used to measure the financial instrument over its life, regardless of market yield movements. This constant yield to maturity approach produces a smooth and predictable interest cost/return outcome and valuation.
Example: The AOFM issues $500 million of its 7.5 per cent 15 September 2009 bond series on 1 July 2004. The market is willing to pay $552 million, an effective interest rate (or issuance yield to maturity) of 5.65 per cent to acquire the bond. This includes $11 million of accrued interest in relation to the next coupon payable on the bond (being $18.75 million on 15 September 2004).
Chart 1: Balance sheet under historic cost accounting
The value of the bond under historic cost accounting commences at its issuance price of $552 million, then smoothly and predictably amortises to $500 million, the maturity value on 15 September 2009. The value of the bond at any point in time reflects the net present value of future interest and principal flows discounted by the issuance yield to maturity (5.65 per cent in the example). Even though the yield applied to measure the bond is constant, its value will amortise steadily (due to the passage of time) to its face value. During 2004-05, for example, the bond’s value amortises by $7 million, from $552 million to $545 million.
Chart 2: Debt service cost under historic cost accounting
Debt service cost under historic cost accounting produces a smooth and predictable periodic debt service cost for the bond of around 5.65 per cent (or $30 million) in each financial year.
Fair value accounting
- value accounting requires a financial asset or financial liability to be measured on the basis of its current exchange equivalent price. The exchange equivalent price may change repeatedly during the life cycle of a financial instrument due to market forces. Accordingly, a fair value methodology has the potential to produce variable and unpredictable results.
- the purposes of the example, assume the quoted market yield for the 7.5 per cent 15 September 2009 bond at the end of each financial year is 30 June 2005: 7.5 per cent, 30 June 2006: 9.50 per cent, 30 June 2007: 9.00 per cent, 30 June 2008: 8.00 per cent and 30 June 2009: 6.00 per cent. The interest rate change from one year to the next is from 50 to 200 basis points, which represent realistic events.
- the term of a financial instrument is a key determinant of its price sensitivity to interest rate changes — the longer the term, the greater the price sensitivity. The example bond chosen has a term of around 5 years at the time of issuance (the Australian Government’s yield curve is around 13 years).
Chart 3: Balance sheet under fair value accounting
The value of the bond under fair value accounting commences at $552 million at the time of issuance and concludes at $500 million at the time of maturity — the same result attained under historic cost accounting. However, during intervening periods the value of the bond moves with market forces. For example, during 2004-05 the fair value of the bond fell $41 million due to two factors:
- amortisation — fall of $7 million due to the passage of time; and
- yield revaluation — fall of $34 million due to an increase in the market yield.
Historic cost accounting recognises only the amortisation component in determining the value of the bond, while fair value accounting recognises both components.
Chart 4: Debt service cost under fair value accounting
Given the variable and unpredictable changes in the market value of the bond, debt servicing cost under fair value accounting is also unpredictable and variable. For example, in 2004-05 the bond provides a return of $4 million, whilst it incurs a cost of $50 million in 2006-07.
The yield revaluation component represents the cost or return of holding fixed interest debt in a changing interest rate environment. In 2004-05, a return was earned on the bond due to an increase in interest rates (there is an inverse relationship between yield and price). In 2006-07, a holding period cost was incurred due to a decrease in interest rates.
Comparison of historic cost accounting and fair value accounting
Chart 5: Comparison of debt service cost
The example discussed above related to bonds. The AOFM also holds substantial volumes of interest rate swaps and term deposits with the Reserve Bank of Australia. The same considerations apply to these instruments when held to maturity as for physical bonds. However, in the case of term deposits the differences between returns measured under the two accounting methodologies are relatively small because of the short term nature of the term deposits held by the AOFM. Interest rate swaps can be regarded as equivalent to two loan transactions, one with fixed interest rates and the other with floating rates. The accounting treatment of each of these loan legs may be analysed along the lines of physical bonds.
The full life debt service cost or return of a financial instrument will always be equal under both accounting methods. However, different accounting outcomes will usually arise from accounting period to accounting period.
In an issue and hold to maturity strategy the revaluation effect will net to zero over the life of a financial instrument. However, the revaluation effect would be relevant in circumstances where a financial instrument is closed-out prior to maturity. An entity may undertake early redemption for purposes of debt restructuring, profit realisation, out-performing a benchmark or anticipating future changes in market conditions.
Accordingly, the appropriate debt service cost measure for assessing performance is dependent on the objective of the entity. Performance measurement under a fair value methodology is most relevant for organisations that are focused on short term trading and profit outcomes. This methodology relates outcomes most closely to current market rates and removes the effects of events that occur in prior years from the current year’s outcome. Performance measurement under an historic cost methodology is most relevant for organisations that passively acquire or issue and hold to maturity without active trading.
The AOFM considers that historic cost accounting is the most appropriate measure for its debt issuance and management functions. However, fair value information is useful to financial statement users regardless of the reporting entity’s objectives. Fair value facilitates assessment of financial risk exposures (such as interest rate sensitivity and credit risk), changes in financial risk exposures, the value of transactions managed and the economic consequences of alternative strategies (such as portfolio restructuring or portfolio liquidation). Since establishment, the AOFM has disclosed in the notes to its audited annual financial statements fair value information on financial assets and financial liabilities. Whilst useful, this style of presentation has not fully integrated with the primary financial statements (which are prepared under historic cost accounting principles).
Comprehensive Income presentation
In adopting the new accounting standard AASB 139, the AOFM intends to present its financial statements from 2005-06 in a manner that gives appropriate balance to the two accounting regimes.
To this end, the AOFM proposes adopting a Comprehensive Income1 format for presenting its administered operating results for 2005-06 and onwards. Under a Comprehensive Income format Revenues and Operating Expenses are categorised into two components:
- Revenues and Expenses Before Remeasurements (such as interest on debt); and
- Revenues and Expenses from Remeasurements (such as unrealised revaluations on a financial instrument).
This style of presentation will allow the AOFM to give appropriate balance to the two results and explain each separately. The category ‘Revenues and Expenses Before Remeasurements’ records a financial result that is consistent with historic cost accounting principles and is most relevant to the AOFM’s role in managing its debt portfolio where debt and financial instruments are predominantly issued and held to maturity.
The category ‘Operating Result from Remeasurements’ will provide information on the unrealised changes in market valuation during the financial year, that are relevant in assessing financial risk exposures.
The AOFM has sought approval from the Department of Finance and Administration (Finance) to apply a Comprehensive Income format. Finance has agreed ‘in principle’ to the AOFM’s request and is currently working with the AOFM on the specific format to be adopted as an accounting standard on Comprehensive Income does not currently exist.
An illustration of the AOFM’s 2004-05 Administered Revenues and Expenses recast into a fair value accounting methodology and presented under Comprehensive Income principles is provided below. The illustration is consistent with an Exposure Draft issued by the Australian Accounting Standards Board on ‘Financial Reporting of General Government Sectors by Governments’ which addresses the harmonisation of Government Finance Statistics (GFS) and Generally Accepted Accounting Principles (GAAP) reporting.
Table 1: Illustrative comprehensive income presentation of AOFM’s 2004-05 administered revenues and expenses under fair value accounting
Note 1: Comprises interest received on swaps, interest on term deposits and interest on State and Territory loans.
Note 2: Comprises interest paid on gross debt and swaps and amortisation of net premiums and discounts and repurchase premia.
Note 3: Comprises net foreign exchange gains on cross currency swaps and foreign denominated debt.
Note 4: Comprises unrealised yield revaluations on all financial assets and financial liabilities measured at fair value.
1 The International Accounting Standards Board and the Financial Accounting Standards Board (the US standard setter) are currently conducting a joint project, the Reporting of Comprehensive Income. The project is dealing with the format and presentation of the Operating Statement on the basis of which items of revenues and expenses are categorised and ordered. It is expected that on completion of the project a new Profit and Loss Standard will be issued. Discussion papers are expected to be released in the 2006 calendar year.
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