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A fair definition of fair value
July, 13th 2006


Fair value is the amount at which an asset is exchanged or a liability settled between knowledgeable parties in an arm's length transaction.

There is a joke that defines GAAP as the difference between accounting theory and practice. This may no longer be the case, with accounting regulators sparing no effort to convince companies to reflect all assets and liabilities at fair value.

Accounting Standard 28, on Impairment of Assets and largely modelled on the International Accounting Standard, ensured that companies tested assets for impairment, thereby reflecting them at fair value. And to give a similar treatment to all the other items in the balance-sheet, International Accounting Standard 39 on Financial Instruments urged companies to value all their financial instruments at fair value.

While this did create an uproar in the accounting fraternity worldwide, the International Accounting Standards Board (IASB) decided to issue standards in a new avatar International Financial Reporting Standards (IFRS) which could become the rule rather than the exception as far as global standards go.

IFRS 7 again on Financial Instruments will be made mandatory from January 2007. This standard has given finality to the debate, by stating that all financial assets and liabilities be valued at fair value. But the all-important question that arose was: How to define fair value?

What's fair value?

Recently, the Reserve Bank of India (RBI) brought out a discussion paper on derivative and hedge accounting for banks. This, again, draws to a large extent on IAS 39, and gives a fair definition of fair value. It defines fair value as the amount at which an asset is exchanged or a liability settled between knowledgeable parties in an arm's length transaction.

The fair value of a derivative is the equivalent of the unrealised gain or loss from marking to market the derivative using prevailing market rates or valuation technique. The fair value should be measured reliably. The discussion paper also provides examples of sources from which one can obtain the fair value:

A published price quotation in an active market;

Prices available from most recent transactions; and

Results of a valuation technique that relies more on market inputs than entity-specific inputs.

The valuation technique should be calibrated regularly and tested for validity. The Institute of Chartered Accountants of India (ICAI) has announced that the present draft on Financial Instruments will be converted into an Accounting Standard in early 2007. In keeping with international trends, one can expect a change in the draft in that the standard would call for measurement of financial instruments at fair value instead of only a disclosure, as is the position now.

Internationally, the trend is to treat effective and `not effective' hedges separately. In principle, a hedge is highly effective if the changes in fair value or cash flow of the hedged item and the hedging derivative offset each other to a significant extent. With all these changes happening at a frenetic pace, it appears to be only a matter of time before balance-sheets reflect what is mentioned in audit reports a true and fair view of the financial position of the company.


Transfer pricing

Section 92 of the Income-Tax Act and its alphabetical successions were introduced with the sole intention of ensuring that international transactions occurred at `arm's length' prices (christened transfer pricing) and were not used as a conduit to siphon out money. The first glimpse of the law appeared to have been made for the "pure-play" software companies, which forced the Income-Tax Department to bring out a circular for the BPO sector a few years later. Judging from a recent decision of the Bangalore Tribunal, it appears that the transfer pricing law is not yet free from glitches.

The case involved Silicon Valley, a software company based in India, which had a subsidiary in Silicon Valley, US. The subsidiary was appointed as the marketing agent apart from performing onsite software development services. The Transactional Net Margin Method (TNMM) 10 per cent for marketing services and 5 per cent for software development was chosen as the ideal method for the subsidiary to earn its money using three-year averages of foreign databases.

A CBDT Circular mandates that all transfer pricing cases in excess of Rs 5 crore would need to be audited by a Transfer Pricing Officer (TPO). When the company's turn came, the TPO rejected the TNMM method, validating his point by saying that this should be used only as the last resort, the use of foreign databases was alien and that past averages could not be held to be representative of today's rates.

He mandated that Comparable Uncontrolled Price (CUP) should be used for the off-site software development services. Using data given by NASSCOM, he concluded that the subsidiary should charge $58 per hour for its services. He agreed with the company's choice of TNMM as the method for marketing activities and concluded his assessments.

The company chose to approach the CIT-Appeals for justice, which passed a rather radical order in favour of the company stating that:

Transfer pricing provisions are special provisions relating to income-tax;

The reference to the TPO should be made only when it is necessary and expedient to do so and not only on the basis of value;

The order of the TPO is not binding on the assessing officer; and

Industrial averages are not actual transactions for the purpose of compatibility.

Since the introduction of the transfer pricing audit mechanism, it is estimated that more than 800 cases have been audited and substantial sums added to the incomes stated.

It is nobody's guess that the number of such cases and additions are only going to increase further. Two fundamental questions that arise during any transfer pricing audit are the choice of methods and comparable data.

While the cost-plus method appears to be the favourite of the masses, justifying the choice of an alternative method and proving that comparable data suit the company's business model are proving to be bottlenecks.

Though largely modelled on OECD benchmarks the international norm the transfer pricing law in India needs some more clarity which could only be beneficial than irksome for both the taxpayer and the Department.

Mohan R. Lavi
(The author is a Hyderabad-based chartered accountant.)

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