Comment

It was sheer coincidence that within hours of my ordering two interesting titles —- Fair Value Accounting Fraud by Gerard M Zack and Company Valuation under IFRS by Nick Antill and Kenneth Lee —- I was called upon to assist a company with fair valuation of a host of financial instruments on their books. This was to facilitate migration to reporting under International Financial Reporting Standards (IFRS).

That little assignment indicates the complexities and difficulties to be encountered by corporate India as they plan their migration. I wonder if the authorities are aware of the difficulties in determining fair value in an environment where external information is shallow, external sources to assist in valuation hardly exist and markets are yet to fully develop. At the same time, corporates have entered into exotic structures with counterparties in the over-the-counter market.

Briefly, company M is listed and has a special purpose vehicle subsidiary Q executing a specific but significantly large project. Q entered the market to raise funds to meet its funding requirements in executing the project. Q is rated BBB+, while M enjoys a much higher AA-.

Q manages to issue deep discount convertible debentures with certain bankers.

The nomenclature, deep discount debenture, is more a misnomer than reflective of the structure. The bonds are issued at face value. They carry coupon of say 7% but require a yield of say 16%. The difference of 9% gets added to the principal amount akin to compounding. Hence, the final maturity payable is much higher than the initial face value.

The investor has an option to convert the bond into equity shares of the company as per prescribed formula for conversion. Presently, these debentures are classified as loans in the books of Q with a note disclosing the convertibility feature.

Under IFRS, the debt must be valued and accounted at its fair value, factoring the interest that would be paid without the conversion option. Since that rate would be higher, the present value (fair value) would be lower than the amount of loan.

The difference would be equity or liability on a conversion option granted by the company (writer of the option). In this case, it would be equity. The interest to be charged thereafter would be at this yield and not the contracted yield. The first problem and consequential difficulties of estimation of fair value comes from determination of the appropriate interest rate the company would have paid. The absence of a loan without any such feature around the same time makes the estimation subjective.

Further, the embedded structure permits the company to call the bond on the 3rd, 4th and 5th anniversary of the bond. This feature also would have a value that needs to be factored. Since this is a purchased option, it would increase the yield on the borrowed debenture. The banks will not share information as to the rates at which they would have subscribed to a debenture without any such feature. There is no other market information — like an index — from where one can derive the number. Hence, one has to rely on theory and other techniques.

Using theory means starting from a risk-free rate, adding a margin for credit risk, liquidity risk and premium for the call option purchased. Each one is beset with a valuer’s subjectivity and consequential estimation problems. The risk-free bond market is liquid only in specific maturities.

Credit spread details can be available from Crisil, but is a priced information and not available in the public domain. The call feature to repay the bond earlier is not easy to value since the call exercise on the subsequent dates are conditional upon non-exercise of the right on the previous exercise date.

With no history to understand the probability of such an exercise, the valuation of this right, applying conditional probability computations, is based on the valuer’s estimate of the probability of exercise. The choice of these subjective parameters could result in widely divergent valuation.

It was indeed a challenge to finally arrive at a valuation for the same. It was almost like a good structure designed for a time coming back to haunt the company with the introduction of IFRS.
Since the rating for Q is BBB+, the investor insists on and gets a put option on the debentures written by M the parent company. Under the terms of the put option, the investor had a choice to put the convertible debenture to M on the 3rd, 4th and 5th year. In exchange, M wrangles out a call option to buy the debenture on the same dates. By nature, the two options are not equal in value. Nevertheless, no consideration flows for the structure.

Non-payment of any consideration also poses challenges. Under IFRS, this contract is a naked derivative to be fair valued and accounted at inception.

Since there is no consideration paid or received, the asset or liability under the option would give raise to a corresponding liability or asset. The put option is mainly a protection against Q’s bankruptcy or its value being lower than the conversion price. It incidentally protects the investor against sudden raise in the interest rate in which the yield on the bond becomes less attractive, making the put valuable.

Value would be driven by probability estimates of exercise and the term structure of forward interest rates. Most western models may not fit the Indian market; nor is there adequate research on possible approaches. Different estimates of the probability of exercise would give different value for the option.

Once again, in the absence of the historical experience to predict the rate of exercise, one has to rely on gut, experience and logic. Value derived thus would be touted as determination of fair value as though it is as certain as an accomplished mathematical equation.
Other similar structures or instruments include a foreign currency convertible bond, put and call option on the shares of a joint venture company, etc.

Each instrument poses its own challenge in the absence of the required information to value the instruments. In the case of an FCCB, the option to convert is also a liability and not equity. ESOPs are another instrument to be valued and charged to remuneration. When there is no historical evidence of the exercise, estimating the life of the option in yet another subjective determination that goes into the valuation. This is the situation with a relatively medium market cap company.

What would be the situation in large companies with multiple structured instruments? Would readers of the accounts be better off with all these fair valuations? Will the authorities have a better understanding of the operations or finances of the companies? How would the tax department understand the accounts and tax them? It is mainly questions for the present. The answer must wait.

How is an auditor to rely on the estimates of fair value? There is absolutely no guidance from the Institute of Chartered Accountants or from Sebi. At the end of the exercise, we were left wondering in what way the readability of the accounts stands improved by this? In the absence of guidance, corporates are left to fend for themselves and therein lies the opportunity for what Zack calls the “fair value accounting fraud.”

As to when that fraud will unfold, your guess is as good as mine.
The writer is a chartered accountant and can be reached at rl@rlco.biz.