How fair is Fair Value Measurement?

For a company that earned R4.5 billion after tax in the year of the takeover and whose market capitalisation is currently close to R80 billion, this seems somewhat understated.

Incidentally, the bank employed the Relief from Royalty approach to estimate this value and used a royalty rate, before tax, of 1.5%, hence the low value. Barclays clearly did not buy Absa for the power of its brand.

The bank had to include this item in the balance sheet because of the International Financial Reporting Standard, IFRS 3 Business Combinations that came into effect at the start 2005. This new standard requires a company that buys another to account for all the costs involved in the purchase, both tangible and intangible, that can be reliably measured. In a reversal of its traditional standpoint, the accounting profession now believes that brands should be included in this collection of costs. They should no longer be lumped together with other intangibles under the heading of goodwill.

To the bank this is just an accounting entry, but it has far deeper implications.

Tangibles

For a start there was the rather strange sequence of events associated with this new standard which was issued by the London based International Accounting Standards Board (IASB).

The American equivalent of IASB, the Financial Accounting Standards Board (FASB) issued its Business Combinations standard in June 2001. The IASB version is not too different. They both require intangibles and other assets and liabilities to be valued, no longer at historic cost, but at fair value.

But neither new standard defines what Fair Value is or how it should be measured.
Because clarity was needed, FASB set about developing a set of guidelines that would plug this omission. This was initiated long after the standard that needed the explanation was put into practice. If the guideline is adopted, which now seems likely, fair value will be defined as: 'the price that would be received for an asset or paid to transfer a liability in a transaction between market participants at the measurement date'.

Even though the new standard is very specific that certain non-monetary intangibles, such as trademarks and brands, will be recognised, the phrasing of the standard is clearly aimed at the measurement of financial instruments.

This becomes clear in the hierarchy the standard writers have established to test the degree of admissibility of the candidate measurements inputs.

A Level 1 measure is observable and can be verified. It will almost certainly be a quoted price in a known and active market where identical instruments are regularly traded.

Financial assets

The guideline acknowledges that this will not always be possible and therefore Level 2 has been established to make provision for this. If quoted prices for identical assets are unavailable the next best comparison would be a quoted price, in an active market, for a similar type of asset. Failing that, there might be quoted prices available for assets that are either traded publicly occasionally or which feature in discrete principal to principal deals; but which are reported. Interest rates and yield curves are also acceptable as are unobservable inputs that are derived from inputs that are observable. This is complex stuff.

Finally there is Level 3, which is the bottom of the barrel. These are unobservable market inputs which cannot be corroborated. They will be acceptable if the assumptions are well grounded and fully published.

This is just the gist, but these three levels make it clear that the accountants are looking for the highest degree of accuracy they can get and this will be found mainly in the financial markets.

The problem is that fair value measurement must be applied to intangibles such as customer lists, trademarks and brands, among other assets. If these assets are to be valued with any level of certainly and if the values placed on the balance sheets are to be anywhere close to being realistic, these principles will not work. There are no markets in brands and customer lists.

The notion of brands as assets is very new to the accountants and it is going to take some time for them to understand that they differ quite drastically from what they are used to. They might need a special form of valuation approach for this group of intangibles. At the very least they should acknowledge that marketers have their own form of measurement and observable data such as market research, syndicated studies and expert opinion. If values are to make any sense, the accountants will have to admit at least some of these inputs at Level 2 and even Level 1.

Barclays used standard corporate finance methods to value the Absa brand and presumably, in the absence of a Fair Value measurement guidelines, tried to conform to common practice.

In my view what they came up with does not ring true.