HOW FAIR ARE FAIR VALUE GAINS?

What are fair value gains / losses?

Fair value can be defined as the amount of consideration agreed upon in an arm’s length transaction between knowledgeable, willing parties who are under no compulsion to act. Fair value is a market-based measurement and is generally used for assets whose carrying value is based on mark-to-market valuations and not for assets carried at historical costs.

Fair value gains /losses is to be reflected in the income statement of the company and is a non-cash item. It refers to the changes in fair value of the entities assets and liabilities over the course of the year.

For financial assets, it’s very much an accounting practice than a fundamental shift in the underlying assets.

A case in point would be Haw Par (SGX: H02). For FY2005, the Group’s quoted and unquoted equity investments were designated as available-for-sale “AFS” and carried at fair value and accounted in approximately S$668mil (net of tax) in unrealised gains in the Group’s equity. On an underlying fair value basis, the year on year gain from the AFS was 10% but due the accounting conversion from the low historical cost base to AFS reflected at fair value, the fair value gain was calculated to be over 180% (Over the historical cost).

Which entities would be affected by fair value changes?

Example of companies with a significant portion of their assets in:

1)    Listed equity investments – Haw Par

2)    Agricultural (Upstream operations) – Golden Agri-Resources (SGX: E5H)

3)    Investment properties – Suntec Real Estate Inv Trust (SGX: T82U)

Potential benefits of fair value accounting:

1)    Better reflection of current market information

2)    Tend to self-correct over time (Due to gains and losses over the years)

3)    Better comparability for certain portfolios (i.e. Involving financial assets)

Potential downsides of fair value accounting:

1)    Markets have to be liquid for fair value to be measure reliably

2)    Fair value provided by sources other than liquid markets are unverifiable and might be subject to accounting “sleight of hand”.

3)    Divergence between net income in the income statement and net operating cash flow form the cash flow statement

Value In Action

At the end of the day, investors have to assess the business based on underlying fundamentals and not purely based on changes in accounting conventions. Given the appropriate companies under the right circumstances, relevant fair value changes would be more than welcomed as it would result in greater disclosure for investors.

 

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The information provided is for general information purposes only and is not intended to be any investment or financial advice. All views and opinions articulated in the article were expressed in Cheong Mun Hong’s personal capacity and do not in any way represent those of his employer and other related entities. Cheong Mun Hong doesn’t own shares in any companies mentioned above.

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