David Green: All the fun of fair value
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Debt valuation is about to change for local authorities who need to take care of the details, according to David Green.
31st March 2016 will be the first date that local authorities are required to value their debt and investments according to the new accounting standard IFRS 13 Fair Values.
Fair, of course, has nothing to do with bumper cars and candy floss, even if we are in a bit of a merry-go-round of accounting rule changes at the moment. Fair in this context means an arm’s-length transaction where no-one is doing anyone a favour, or penalising them, just dealing at a fair price.
The valuation of investments will be little changed by the new rules. Authorities have always valued their bonds and pooled funds at the price they can be sold for. And the fair value of short-term cash investments will not be materially different to the principal plus accrued interest, given that short-term interest rates have not changed much over the past year.
Fair but different
But for many authorities there will be significant changes this year to how they value their borrowings and other financial liabilities. Fair value is now defined as the price that would be paid to transfer the liability, i.e. how much would you have to pay someone to take the debt off your hands, or how much the lender would receive to sell your loan to another bank.
This may be quite different to the penalty charged by the lender for early redemption. And IFRS 13 is very clear that the valuation must assume that the debt remains outstanding, rather than being cancelled.
In previous years, many authorities have valued their PWLB loans at the cost of early repayment. The board even publishes these figures on its website to assist.
But PWLB calculates these values by discounting the loan cash flows at an interest rate below gilt yields. No other investor would accept such a low rate of return to take the loans off the board’s hands. A higher discount rate, such as the market rate for local authority borrowing, should now be used instead, which will lower the fair value.
A fair value calculation must take into account all factors that the entity taking on the liability would take into account. So if the lender has the option to increase the interest rate, such as with a LOBO loan, this will increase the transfer value.
An option pricing model, loaded with market data, should be used to value this element. Local authorities that have ignored this feature in previous years will find their fair values rather higher this time round as a result.
No excuses
You can’t use the excuse that there is no market as a reason not to calculate a fair value. The concept of paying someone else to take on your PFI liabilities, while you retain the assets is a little strange, but you can estimate the price of such a theoretical transaction.
Again, this will be by discounting the principal and interest elements of future unitary charge payments at a suitable market interest rate.
Given the sharp fall in long-term yields over the past years, and the fact that the risk in the project will be much lower once the construction is completed, the market rate is likely to be well below the contractual rate (the implicit rate of return) and so the fair value may be much higher than the figure reported on the balance sheet.
Authorities whose debt comes under regular scrutiny from elected members, local taxpayers or national pressure groups will want to have their explanations for high fair values prepared in advance. A clear and concise paragraph in the statement of accounts discussing the rollercoaster ride of interest rates that we’ve been on should deter some queries. On the other hand, a bland set of numbers with no context showing that some liabilities have doubled in value could attract a flurry of unwelcome attention making you feel like you’re on the wrong end of a coconut shy. And that wouldn’t be very fair at all.
David Green is Client Director at Arlingclose Limited.
