Fair Valuations - can they propel the next bull run

FASB on April 9, laid to rest atleast a controversial subject on marking assets in distressed economic conditions.

The FASB via FSP157-4 issued its position on defining illiquid markets for assets and giving a leeway that the management can rely on their internal valuation models instead of using the external factors.

The rule revision applies to all assets and liabilities within the scope of accounting pronouncements that either require or permit fair value measurements.

The FSP provides that a reporting entity should evaluate a battery of factors to determine whether there has been a significant decrease in the volume and level of activity for the asset or liability when compared with "normal market activity" for the asset or liability. These factors include, but are not limited to, the following: 

• There are few recent transactions;
• Price quotations are not based on current information;
• Price quotations vary substantially either over time or among market makers;
• Indexes that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability;
• There is a significant increase in implied liquidity risk premiums, yields, or performance indicators for observed transactions or quoted prices when compared with the reporting entity's estimate of expected cash flows for the asset or liability;
• There is a wide bid/ask spread;
• There is a significant decline or absence of a market for new issuances for the asset or liability; and
• Little information is released publicly.

This move is a welcome step and will definetly aid a lot of banks in shoring up their balance sheets. No wonder, that post April 9, most of the markets are on a bull run and have started factoring this change in the swing in the balance sheets of various financial institutions.

The FASB must also be appreciated for relenting under pressure to delineate mark-market to accounting forever and has come out with the correct decision considering the economic scenario.

Will wait and wonder what will be FASB's position in a reverse scenario, when markets are in prime bull position and prices are overvalued, will they come out with a new FSP to FAS 157....????

Read all our earlier articles on Fair value accounting

Bond conversions now weigh on your EPS

With the change of an old accounting rule of APB 14-1 "Accounting for Convertible Debt Instruments That May Be Settled in Cash Upon Conversion" coming into effect this quarter, companies may start seeing a dip in the EPS reported. The rule which was amended last year, requires companies which settle their bonds (liabilities) in the form of part equity and part cash, now will have to take an additional charge to the income statement on account of interest expense, thereby lowering the EPS

The interest expense will be the differential between the value of the equity shares as on the date of the conversion and the maturity value of the debt.

This rule does not affect straight convertible debt that must be settled with the corporate issuer's stock, convertible preferred shares classified as equity, convertible debt with embedded options that are recorded as derivatives, and convertible bonds that require cash settlement for fractional shares when converted.

Separating the settlement into cash and shares requires the use of so-called split accounting to record the transaction. That is, the issuer must book the debt and equity components of the bond separately. It's the split that results in a higher interest expense on the income statement that tugs the EPS ratio down. Here's why.

A convertible bond is attractive to issuers because the interest paid to bondholders is lower than the market rate for most other borrowing. On the other hand, the low-interest bond attracts investors because of the conversion option, which allows the bondholder to turn the debt into equity if market conditions are favorable. For many, convertible bonds were seen as a win-win situation.

But FASB wanted to make sure that companies issuing convertible debt reflected the economic reality of the instrument — that is, the risk associated with the bond — on their financial statements. In the board's opinion, companies that issued convertible bonds had a tendency to inflate their EPS because the interest expense associated with the potential cash payout was under-reported.

The new rule, however, forces companies to record a higher interest expense — or a higher depreciation expense in the case of debt used for capital improvements — because the debt is calculated as if there were no conversion option, and will be settled in cash. That assumed cash payout includes the additional interest expense.

FASB also is requiring that the rule be applied retrospectively to 2008 financial statements. That means that if issuing companies report a material adjustment to their income statement, they must restate their financial results accordingly, going back two or three years, depending on how many years of comparison reporting they included in their 2008 filings.

Involuntary terminations - filling the GAAP

Layoffs are unpleasant and every accountant would wish they are never exercised for in his Company.

 At March 31, 20xx (year end), your company has approved a termination plan to exit a part of its operations. Under the plan,  the Company will close 2 of its branches, which will result in 100 employees being terminated in the next 60 days. 

 Your Company has announced a VRS scheme of Rs. 10lakhs per employee , given to employees on a first come first basis. In case, less than 100 employees opt for  theVRS, then the Company will involuntarily terminate the employment of the balance employees and give them Rs. 8lakhs each. 

 As the year end, what will be your accounting treatment.... 

• will you accrue for the entire liability of Rs. 10 crores (ie. 100* 10 lakhs) and take a P&L hit
• you will do nothing with it, the liabilty arises in the next year as employees will be terminated in the subsequent year
• you will disclose the liabilty in the notes to the accounts

On the Indian GAAP front, there have been no clear guidance on accounting for involuntary terminations, while on voluntary terminations or more popularly known as VRS schemes, the cost of such terminations  is recognized in the period in which the offer is accepted by the employee. So do we by the same principles account for costs on involuntary terminations, in the period in which the pink slip is handed over to the employee....

 

FAS 146 (earlier EITF 94-3) addresses this issue...

 FAS 146 requires managements to record liabilities at fair value in the period in which it is incurred. The following events should have occurred to conclude that a liability should be recorded and recognized immediately

 The board has approved the termination plan and has been adopted, in case shareholder approvals are required, then at the time of shareholder approval

1. The plan has identified the number of  employees, their job classification, their functions, location and expected completion date
2. The termination benefits are clearly documented stating the quantum for everydesignation of employee
3. The plan is communicated to the employees (not necessarily naming them specifically)
4. It is highly unlikely that points 1 to 3 will be withdrawn or there will major changes in the plan

Once all the above factors, exist the management will be required to account for the liability of involuntary termination benefits at its fair value.

 So going by the above guidance, our accounting treatment will be as under; 

• Take Rs.8 crores to P&L (i.e. 100 * Rs. 8 lakhs) being the value of termination benefits which the management has committed to as at March 31, 20xx
• Account for the increment liability of Rs. 2 lakhs in case of VRS in the period in which the employee opts for the scheme
• Disclose the facts in the notes to accounts.
• Disclose the facts to the actuary, so that provisions can be trued up to make for leaveencashment and gratuity accruals more accurate

PS  - In case a company knows that the profitability of the current accounting year is bad, and wishes to book a lot of expenses in the current year in order to make the next year look more profitable, all it needs to do, is to arrange for documentation, have a board resolution in hand and book the expense. All of this can be done in the last week prior to the year end.....  

On the contrary, a Company may have announced this in the last week of the year end and may just chose not to account for it...... if numbers are big.....and your auditor doesn't catch it...just hope nobody else does...