After the applicability of IAS 32 and IAS 39 in Pakistan, the concept of valuation of financial assets and financial liabilities at fair value is broadly followed. Consequently, equity investment in an unquoted company by a listed company, in most of cases, is measured at fair value being the break up value of the shares held, based on the latest financial statements of the investee.
Ours is a listed company which has short term investment in an unquoted insurance company XYZ Limited, a group company of MND Group. We hold approximately 9% of the equity of XYZ and have intentions to sell this investment within next few months. XYZ has significant investments in different listed companies including its own group companies. The accounting policy adopted for the valuation of these investments by XYZ and as stated in its audited financial statements for the year ended December 31, 2005 is setout below:
“Paragraph 4.6: Investments
The investments made by the company are classified for the purpose of measurement into the following categories:
a) Held to Maturity – Investments with fixed maturity that the management has the intent and ability to hold to maturity are classified as held to maturity and are initially recognized at cost being the fair value of consideration given and include transaction costs. At subsequent reporting dates these are measured at amortized costs using the yield method. Any premium paid or discounts availed on acquisition of such investments is deferred and included in income for the period on straight line basis over the term of investments.
b) Available for Sale – Investments classified as available for sale are initially measured at cost, being the fair value of consideration given and include transaction costs. Subsequent to the initial recognition at cost, these are stated at the lower of cost and market value, (market value being taken as lower if the fall is other than temporary), in accordance with the requirements of SRO 938 issued by the SECP in December 2002. The Company uses latest stock exchange quotations in an active market to determine the market value of its listed investments. The investment for which quoted market price is not available is measured at cost as it is not possible to apply any other valuation methodology.
At the subsequent reporting dates, the company reviews the carrying amounts of the investments to assess whether there is any indication that such investments have suffered an impairment loss. If any such indication exists the recoverable amount is estimated in order to determine the extent of the impairment loss, if any. Impairment losses are recognized as expenses.
This policy of stating available for sale investments at lower of cost and market value is not in compliance with IAS 39, which states that investments available for sale at subsequent reporting dates should be measured at fair value. The market value of available for sale investments as at December 31, 2005 is Rs. 4,061,132,654. Had the company complied with IAS 39, the carrying value of investments as at December 31, 2005 would have been higher by Rs.3,395,790,251”
The above non-conformity of compliance with IAS 39 is disclosed in audited financial statements of XYZ for the year ended December 31, 2005.
Our accounting policy for the valuation of investments available for sale is setout below:
These are stated at fair value and changes in carrying value are recognized as separate component of equity until investments are sold, disposed or until investments is determined to be impaired, at which the accumulated gain / loss previously reported in equity is included in income. For unquoted securities, fair value is determined considering the break up value of the securities.
You would appreciate that the break up value of XYZ is substantially understated as XYZ has not valued their investments in accordance with the measurement criteria provided by IAS 39 and accordingly is understating its available for sale investments and equity. Consequently the fair value of our investment in XYZ will not be stated at fair value in our books of account, if we adopt conventional method of valuing XYZ share at the break up value disclosed in its accounts.
Had XYZ valued its investments in accordance with the measurement criteria given in IAS 39, the carrying value of investments and equity of XYZ as at December 31, 2005 would have been higher by Rs. 3,395,790,251. Accordingly break up value used for the valuation of these investments in our company would also have been higher by the amount with which its equity would have increased. Our view in this regard is that while determining the fair value of our investment in XYZ, it is appropriate to adjust the equity of XYZ by the amount with which it is understated as at December 31, 2005.
You are requested to please let us have your comments on the above matter.
Your attention is drawn to the following paragraph 46 of IAS 39:-
46 After initial recognition, an entity shall measure financial assets, including derivatives that are assets, at their fair values, without any deduction for transaction costs it may incur on sale or other disposal, except for the following financial assets:
(b) ……………………….; and
(c) investments in equity instruments that do not have a quoted market price in an active market and whose fair value cannot be reliably measured and derivatives that are linked to and must be settled by delivery of such unquoted equity instruments, which shall be measured at cost (see Appendix A paragraphs AG80 and AG81).
Further your attention is also drawn to the paragraphs AG74 to AG75 and AG 80 to AG82 of IAS 39:-
No active market: valuation technique
AG74 If the market for a financial instrument is not active, an entity establishes fair value by using a valuation technique. Valuation techniques include using recent arm’s length market transactions between knowledgeable, willing parties, if available, reference to the current fair value of another instrument that is substantially the same, discounted cash flow analysis and option pricing models. If there is a valuation technique commonly used by market participants to price the instrument and that technique has been demonstrated to provide reliable estimates of prices obtained in actual market transactions, the entity uses that technique.
AG75 The objective of using a valuation technique is to establish what the transaction price would have been on the measurement date in an arm’s length exchange motivated by normal business considerations. Fair value is estimated on the basis of the results of a valuation technique that makes maximum use of market inputs, and relies as little as possible on entity specific inputs. A valuation technique would be expected to arrive at a realistic estimate of the fair value if (a) it reasonably reflects how the market could be expected to price the instrument and (b) the inputs to the valuation technique reasonably represent market expectations and measures of the risk return factors inherent in the financial instrument.
AG80 The fair value of investments in equity instruments that do not have a quoted market price in an active market and derivatives that are linked to and must be settled by delivery of such an unquoted equity instrument (see paragraphs 46(c) and 47) is reliably measurable if (a) the variability in the range of reasonable fair value estimates is not significant for that instrument or (b) the probabilities of the various estimates within the range can be reasonably assessed and used in estimating fair value.
AG81 There are many situations in which the variability in the range of reasonable fair value estimates of investments in equity instruments that do not have a quoted market price and derivatives that are linked to and must be settled by delivery of such an unquoted equity instrument (see paragraphs 46(c) and 47) is likely not to be significant. Normally it is possible to estimate the fair value of a financial asset that an entity has acquired from an outside party. However, if the range of reasonable fair value estimates is significant and the probabilities of the various estimates cannot be reasonably assessed, an entity is precluded from measuring the instrument at fair value.
In view of the above the Committee is of the opinion that instead of adjusting the equity of the Insurance Company in which you have an investment it would be appropriate to measure such investment at fair value by using the valuation technique referred to in paragraph AG 74 provided it can be measured reliably.
(November 4, 2006)