Available for sale investments

[idreesdurrani]

<font color="navy"></font id="navy"><font face="Verdana">I'd appreciate the senior members comments on a practical issue

A company is holding equity investments in listed securities which it has classified as Available for sale under IAS 39. The company recorded an impairment loss and fair value decrease of around 60 million and 13 million, respectively in the year 2006. Subsequently, in 2007, the market picked up and as at the year end for the 2007, the company's portfolio is depicting an increase of around 115 million. however, as we are aware,in 2008, the market prices again fell significantly, and the reversal is wiping all the fair value increase of 2007. Now while closing the books of accounts for 2007, can we book the fair value increase in the equity (fair value reserve), while we have substantial evidence of its reversal subsequently.

Best regards,</font id="Verdana">

[kamranACA]

Dear Idrees,

Your question is very thought provoking and in fact has to be elaborated / answered in detail. However, any such answer could not be a last word as all the background details and facts are not known.

First of all I must like to differentiate the concept of Impairment from the concept of Fair Valuation. Fair valuation has in fact nothing to do DIRECTLY with impairment although the absence of an active market for a financial asset could be one of the element to be considered while estimating the impairment. A simple decrease in fair value against the carrying value cannot necessarily require recognizing impairment.

I discuss the issues under different stages/heads to clarify the back ground and to focus on the question

MEASUREMENT OF AFS INVESTMENT

IAS 39 requires to account for/measure the investments (available for sale) initially at fair value plus any acquisition or incidental cost. Subsequently, these have to be invariably measured at fair value. Any increase or decrease in carrying value of AFS investment due to fair valuation has to be directly credited or debited in the reserves instead of routing through P/L account.

IMPAIRMENT OF AFS INVESTMENT

IAS 39 has stipulated a long list of factors which must be considered while assessing the impairment. Paragraphs 58 to 62 of IAS 39 discuss in detail how an objective evidence could be gathered to decide about the impairment. Among these paragraph 59 and 60 are most important. Please have a look on them.

It is likely to be kept on record that lack of active market solely is not a reason for charging impairment. Rather, paragraph 59 (e) states that "the disappearance of an active market of that financial asset because of Financial Difficulties" is an element to be considered. This has been further elaborated in paragraph 60 of IAS 39 as well.

By reading this part of IAS 39 we get to know that simply a downward trend of stock market prices does not require to charge impairment. This is in fact not objective evidence. At its own. Although it does not exactly suit but I quote the example of Nishat Mills Limited. Its EPS for latest year was almost Rs. 35 plus per share while the share (having face value Rs 10 each) was being traded on stock market at Rs 40 almost. As per stock market's general perception a share's market value could be almost 10 times of its EPS i.e. in case of Nishat Mills Limited the fair market value could have gone even to Rs 350 per share logically but it was not factually priced due to bearish and bullish market reasons. Still it was Rs 40 per share. Just suppose that depending upon the market condition if this price comes further down to Rs. 8 in stock exchanges, would there be any requirement to charge impairment? My answer is NO.

For impairment we have to look at so many factors including financial position/difficulties faced by investee, considerable reduction in profitability, loss of business, cash flows positivity, breaches of loan obligation contracts, earning per share, dividend pay out ratio, future cash flow projections, current position and net position of the investee, its break up value per share, solvency and many more factors.

In my view a "simple" reduction of share price in stock exchange is not a measure of impairment.

The impairment would be automatically reversed when investment will be stated at fair value and credit will be taken to reserves. In case of AFS investment already charged impairment will not be reversed in P/L account.

REQUIREMENTS OF IAS 10

Events after balance sheet date are of two types. Firstly, those that provide evidence of conditions that existed on balance sheet date and secondly, those that are indicative of conditions that arose after the balance sheet date. Only the first category is considered adjusting events by IAS 10.

If the stock market was fine as at balance sheet date and there were no issues of general collapse of stock markets worldwide (which is the case in my view with all accounts being finalized for 30 June 2008) or the worldwide financial recession then such downward price fall is not an adjusting event in the light of IAS 10 as no such condition was existing on balance sheet date.

I must refer to paragraph 11 of IAS 10 which clarifies the entire situation. This goes

"An example of a non-adjusting event after the reporting period is a decline in market value of investments between the end of the reporting period and the date when the financial statements are authorized for issue. The decline in market value does not normally relate to the condition of the investments at the end of the reporting period, but reflects circumstances that have arisen subsequently. Therefore, an entity does not adjust the amounts recognised in its financial statements for the investments. Similarly, the entity does not update the amounts disclosed for the investments as at the end of the reporting period, although it may need to give additional disclosure under paragraph 21."


CONCLUSION

- Already provided impairment loss will not be reversed in profit and loss account. (Paragraph 69 of IAS 39).

- The entire amount of fair value gain will be recognised in equity as fair valuation reserve under IAS 39.

- Investment would be stated at fair value based upon the open market price in an active market as at balance sheet date.

- Management can consider disclosing subsequent to balance sheet date stock market conditions in a sub-note in notes to the accounts and any anticipated impact on financial position if this situation continues in the long run. {I hope this situation will not continue in the long run and things will start coming to right place within one and half year or so.}.


I think the above clarification would be beneficial for you. Tell me the address where I have to drop my advisory bill. Kidding!!!


Best regards,



KAMRAN.



Note Edited to correct impairment issue wrongly mentioned in this post.

[idreesdurrani]

Dear Kamran,

Thank you very much for your detailed reply. In fact my thoughts on this issue were pretty much the same as you mentioned except for one difference. I believe that the standard (IAS 39) does not permit the reversal of previously recognized impairment losses on equity instruments classified as available for sale. Therefore, all the fair value increase should be recognized directly in the fair value reserve (in equity), even though the company has previously recorded an impairment loss. As you mentioned a disclosure will be required for the subsequent market conditions as non adjustable event.

Regarding the impairment I agree with you to the extent that a temporary decline in the fair value or suspension of active trading cannot be an evidence of impairment, however, para 61 of the standard highlights that a significant or prolonged decline in the fair value of an investment in an equity instrument below its cost is also an objective evidence of impairment. Now what is “significant” and “prolonged” is again a subjective issue. There are some country specific guidelines on this, usually issued by the Central banks which establishes a threshold (for instance more than 20% decline below cost as significant & a decline for more than 6 months as Prolonged), but again these may not necessarily be accurate. The point you mentioned about the undervaluation of Nishat Mills probably is the result of market inefficiency, I believe. If the market is efficient (which is the assumption for most of the Accounting Principles), then the market value of a share is the best forecast of the fair value of that company.

Don't worry about the advisory bills....just as the doctors don't usually charge each other for fee, the practicing professionals of our community should also follow.....what do you think...thanks again for your participation.

Regards,

[kamranACA]

Dear,

In fact our market's fluctuations are so many times not supported by actual growth or decline in the actual value of shares. The purpose of quoting the shares of Nishat Mills was exactly the same. It is a blue chip company having nice growth in turnover, profit, EPS and DPO etc but the fluctuation in market value of shares is not reflective of what is actually going on.

Apart from such temporary situations where shares are not properly priced, of course the market value in active market is a good measure of fair value. If market value goes down significantly for longer periods this could be one element of objective eveidence of impairment but in circumstances like Pakistan it would be too earlier to declare the current situation as significant or persistent. We have seen such up and downs historically in our capital markets although the current one is larger specially in view of overall recession.

As far as longer periods are concerned, there had been a Technical Release (TR-23) issued by ICAP which has now been withdrawn due to more clarity and authority given by IAS 39. This TR-23 provided for a period of three years to decide for provision for permanent diminution in value of investments. This could be a guideline as to what period should be considered to decide about objective evidence that the decline in fair value is in fact accompnied by impairment.

In my personal view 3 years time (although not mentioned any where in IAS) is quite logical to take such decline as impairment. However, it is judgmental based upon subjective analysis.

Banks don't follow IAS 39, and normally state their investments under SBP circulars which being more prudent are normally more strict than the typical reporting frameworks.

Yes you are right as far as Reversal of Impairment of Available for Sale Investment is concerned. Such reversal does not have to be routed through from profit and loss account, as stated in paragraph 69 of IAS 39. All the increase in fair value will directly be taken to equity. Thanks for correcting me. Only the impairment of debt instruments clasified as available for sale has to be reversed through P/L.

Disclosure of subsequent market situation is optional and if you feel like giving it as per your judgment you can give it.


Regards,



KAMRAN.