New Partnerships for Innovation in Microfinance_5

Microfinance Investments and IFRS: The Fair Value Challenge 95 the International Accounting Standards Committee,8 and IFRS issued by the IASB. Standards and topics range in scope and depth from the presentation of financial statements to financial reporting in hyperinflationary economies. The standard relevant to valuing investments in MFIs is IAS 39, entitled “Fi-nancial Instruments: Recognition and Measurement.” The objective of IAS 39 is “to establish principles for recognising and measuring financial assets, financial liabilities and some contracts to buy or sell non-financial items.” It requires that a financial asset or liability be recognised at fair value at initiation, including related transaction costs.9 Thereafter, equity instruments and embedded derivatives10 should be stated at fair value whereas debt instruments are usually held at amor-tised cost depending on their classification into one of the categories defined in IAS 39.9 (see box 3). There is an important exception that is relevant to microfi-nance: “equity investments that do not have a quoted market price in an active market and whose fair value cannot be reliably measured ….”11 Box 3: IFRS and Debt Investments Debt investments are usually classified as loans and receivables, and according to IFRS are therefore stated at amortised cost. When debt investments are held at amortised cost, the fair value of the investment may be referenced in the balance sheet notes for informational purposes. In certain circumstances IFRS does allow for the valuation of debt instru-ments at fair value (see IAS 39.9 for more detail). For example, if an investor holds both a debt investment and an equity investment in the same entity, or if the investor holds a convertible bond, it may make sense to report the debt investment at fair value, rather than amortized cost. This approach would treat both debt and equity in the same manner and any changes to the fair value of either the debt or equity investment at remeasurement would flow through the income statement. Whether held at amortized cost or at fair value, debt investments are subject to impairment tests. 8 The International Accounting Standards Committee is no longer in existence and has been effectively replaced by the IASB. Most of the standards issued by the International Accounting Standards Committee were adopted, either in original or revised form, by the IASB. See the IASB web site at www.iasb.org for more details. 9 IAS 39.43: Transaction costs are excluded in the case of financial assets or liabilities at fair value through profit or loss. 10 IAS 39.11. 11 IAS 39.46 ( c ). 96 Mark Schwiete and Jana Hoessel Aberle IASB states its mission as “developing, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require transparent and comparable information in general purpose financial state-ments.”12 Indeed, great progress toward this goal has been made: seventy-four countries, about two-thirds of which are developing countries, require domesti-cally-listed companies to report according to IFRS.13 Standard setters, including the IASB and FASB, have made significant efforts to align standards. A good example of recent efforts is the convergence of defini-tions of fair value, listed below. • IAS 39: The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length trans-action.14 • International Private Equity and Venture Capital Valuation Guidelines (IPEVCVG): The amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction.15 • Global Investment Performance Standards (GIPS): The amount at which an asset could be acquired or sold in a current transaction between willing parties in which the parties each acted knowledgeably, prudently, and without compulsion.16 • Financial Accounting Standards Board (FASB): An estimate of the price that could be received for an asset or paid to settle a liability in a current transaction between marketplace participants in the reference market for the asset or liability.17 In a November 2006 press release, the International Private Equity and Venture Capital (IPEV) Valuation Board reported that changes to its guidelines “will en- 12 From IASB’s web site, www.iasb.org. 13 See Deloitte and Touche’s IAS Plus web site: www.iasplus.com. 14 IAS 39, IN18, IAS 32.11. 15 IPEVCA were developed by the Association Français des Investisseurs en Capital (AFIC), the British Venture Capital Associate (BVCA) and the European Private Equity and Venture Capital Association with input and endorsement from numerous international private equity and venture capital associations. 1 January 2005. Available online at http://www.privateequityvaluation.com/documents/International_PE_VC_Valuation_ Guidelines_Oct_2006.pdf. 16 Global Investment Performance Standards. Revised by the Investment Performance Council and Adopted by the CFA Institute Board of Governors. February 2005. Available online at www.cfainstitute.org. 17 Financial Accounting Standards Board. Fair Value Team. Minutes of the June 29, 2005 Board Meeting – Definition, Transaction Price Presumption, and Hierarchy. Available online at http://www.fasb.org/board_meeting_minutes/06-29-05_fvm.pdf. Microfinance Investments and IFRS: The Fair Value Challenge 97 sure full consistency of the IPEV Guidelines with both FASB and IASB stan-dards.”18 Moreover, in the amended version IPEV explicitly notes that their defini-tion of fair value is “…congruent in concept with alternately worded definitions such as ‘Fair Value is the price that would be received for an asset or paid for a liability in a transaction between market participants at the reporting date’.” Yet much work remains: alternative accounting standards, such as U.S. GAAP, continue to be used around the globe. Though differences in standards are not as large or numerous as they once were, differences remain, and they create ambigu-ity for those responsible for financial reporting. The fair value case provides a salient example: while standard setters share similar views of the definition of fair value, the recommended methodologies which may be employed to calculate fair value for investments which lack an active market are inherently subjective and are specified differently among standards. These are discussed in detail below. Market Prices and Microfinance Investments Determining fair value at investment initiation – when the first funding transac-tion is made for a de nove entity – is usually a simple task: according to IFRS, the transaction price is normally considered the fair value of an investment. The initial transaction price for a debt, equity or mezzanine investment in an existing microfinance institution or the subscription price for an equity stake in a greenfield transaction would be considered fair value. At remeasurement, the determination of fair value can be more complicated and a fair value hierarchy, discussed below, must be applied. Market prices, when available, are considered the best gauge of fair value. Ac-cording to IFRS, “The existence of published price quotations in an active market is the best evidence of fair value and when they exist they are used to measure the financial asset or liability.”19 Usually the current bid price in the most advanta-geous market is used as a basis, adjusted for necessary considerations such as differences in the credit risk profile of the counterparty. Yet market prices require active financial markets, which creates a problem in valuing MFI Investments. Markets for MFI investments are neither active by any definition, nor do transactions occur on an arm’s length basis. (See below for more detail on microfinance secondary markets.) According to IFRS, “A financial market is quoted in an active market if quoted prices are readily and regularly available from an exchange, dealer, broker, industry group, pricing service or regulatory agency and those prices represent actual and regularly occurring market transactions on an arm’s length basis,”20 this term referring to independent third-party transactions. 18 International Private Equity and Venture Capital Valuation Board Press Release, “Valuation of Private Equity Investments: Changes Ensure Consistency with Recent Fair Value Standard”, Brussels, November 15, 2006. http://www.privateequityvaluation.com/. 19 IAS 39.71. 20 IAS 39.7. 98 Mark Schwiete and Jana Hoessel Aberle KfW’s internal definition of a market price in an active market provides addi-tional guidance: • Investment shares are available from a stock exchange, or through a broker or trader. • The share price reflects the arm’s length principle (e.g that parties to the transaction are equal and independent and there is a market price). • The free float of the shares comprises a minimum of 5% of total share capital. • There are no restrictions on the maximum turnover or trading volume of the shares. • On at least one-third of the trading days in the last year trades were registered, and on at least five days in each calendar month shares were traded.21 In cases where current market prices are unavailable, the task of determining fair value becomes more complicated. In such a case, the starting point for determin-ing fair value is the price of the most recent transaction – providing that no “sig-nificant change in economic circumstances” has taken place since that transac-tion’s settlement.22 If such a change has occurred, or if the reporting organisation can prove that the price of the most recent transaction does not accurately repre-sent fair value, then the market price is adjusted accordingly to arrive at fair value according to IAS 39. The initiation price of the investment itself may be used as the fair value, or the price of a recent investment in the same entity by a different investing party may be used. The International Private Equity and Venture Capital Valuation Guide-lines (IPEVCVG) provide specific guidance as to events which may materially reduce current fair value in relation to the investment initiation value: (1) the per-formance or prospects of the underlying business has significantly deteriorated relative to expectations at investment initiation; (2) a significant adverse change in the underlying business or business milieu has occurred; (3) market conditions have declined; and (4) the underlying business is raising capital and evidence ex-ists that future financing will take place under conditions materially different from the investment in question.23 KfW has chosen to define the “recent” prices which may be used under IAS 39 as prices of transactions taking place within one year of the valuation date. In order to use the price of the last transaction as the “fair value,” none of the follow-ing conditions can be true: 21 KfW Internal Draft Document. “Konzernvorgaben zur Bewertung von Finanzinstrumenten (‘Investments’) durch Geschäftspartner der KfW-Bankengruppe für den Bereich Beteili-gungsfinanzierung” (“KfW banking group valuation directives for investments in partici-patory financing”). 22 IAS 39.72. 23 Paraphrased from IPEVCVG. Page 15. Microfinance Investments and IFRS: The Fair Value Challenge 99 • Parties to the transaction were exclusively management or employees of the investment entity investing their own funds. • A minimum of one investor is a related party of the investment entity. • Restructuring financing has been undertaken by existing investors. • The last transaction was a strategic financing round (defined below). KfW guidelines also provide for extraordinary events which alter the value of the investment and preclude the use of the last market transaction as a basis for deter-mining fair value.24 The above caveats to the use of recent transaction prices are loosely based on those of IPEVCVG: 1. “a further Investment by the existing stakeholders with little new Investment; 2. different rights attached to the new and existing Investments; 3. a new investor motivated by strategic considerations; 4. the Investment may be considered to be a forced sale or ‘rescue package;’ or 5. the absolute amount of the new Investment is relatively insignificant.”25 The third point is of particular importance to microfinance investments and is relevant to both new and existing investors. Many microfinance investors are mo-tivated by strategic considerations, including sustainable development and more specific social goals in addition to profit. If, as pundits predict, MFIs tap into pri-vate capital markets in the future, more profit-oriented investors may join the ranks of the current social/mixed or dual objective investors in MFIs. In the future, profit-driven equity holders in a particular MFI may have to adjust for the dual or mixed goals of other investors in the same MFI when considering using the most recent transaction price as the fair value. Markets for MFI investments are neither active by any definition, nor do trans-actions occur on an arm’s length basis: though the number of microfinance inves-tors is growing, the number remains limited and many transactions take place between “related parties”. Data on transactions among related parties, clearly vio-lating the “arm’s length” principle, cannot be used as a basis for determining the fair value of a “comparable” transaction. The lack of an active secondary market for MFI investments precludes the use of published price quotations or recent transactions as a basis for calculating fair value. 24 KfW Internal Draft Document. “Konzernvorgaben zur Bewertung von Finanzinstrumenten (‘Investments’) durch Geschäftspartner der KfW-Bankengruppe für den Bereich Beteiligungsfinanzierung.” 25 Quoted directly from IPEVCVG, Page 14. ... - tailieumienphi.vn