ASEM IFRS SEMINAR Shanghai, 25-26 March 2006

1. ASEM IFRS SEMINARShanghai, 25-26 March 2006 Fair Value Measurement Dr Allister Wilson Technical & Audit Partner Ernst & Young, UK Senior Advisor to the EUROPEAN COMMISSION

2. Capital market activity: the balance is shifting

3. Approach to accounting is changing • ‘Traditional accounting’: • mainly historical cost • primary focus on the income statement • focus on transactions and their impact on earnings • matching and prudence concepts important • realisation principle central to revenue recognition • balance sheet much more of a residual

4. Approach to accounting is changing • IASB and FASB are shifting the emphasis: • primary focus now on assets and liabilities An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits

5. Approach to accounting is changing • IASB and FASB are changing the approach: • primary focus now on assets and liabilities • This means that the accounting process now revolves around the initial recognition, initial measurement, subsequent measurement and derecognition of assets and liabilities

6. Approach to accounting is changing • IASB and FASB are changing the approach: • conventional accounting concepts are being discarded: • matching, prudence and realisation • ‘fair value’ is replacing ‘historical cost’ • ‘relevance’ is more important than ‘reliability’

7. The introduction of fair value • We still have a mixed model • However, virtually all assets and liabilities are measured at ‘fair value’ • Only significant exceptions are property, plant and equipment, intangibles and inventory, although the impairment test periodically rebases these at fair value

8. Virtually the entire balance sheet is affected by fair value measurement • Investment property • Financial instruments • Biological assets (agriculture) • Commodity stocks • Employee benefits • Provisions • Share-based payments • Business combinations • Impairment

9. Approach to accounting is changing … but, what is fair value? Fair value is “the amount for which an asset or liability could be exchanged between knowledgeable, willing parties in an arm’s length transaction”

10. What is fair value? The IASB and FASB are exploring other options, such as: • Net realisable value • Replacement cost • Value in use

11. Approach to accounting is changing … something for you to think about How do you measure the ‘fair value’ of assets and liabilities – particularly when there are no observable active and liquid markets?

12. The IASB’s fair value hierarchy Level 1 Observable (quoted) market prices for identical assets or liabilities Level 2 if not available, use observable (quoted) market prices for similar assets and liabilities Level 3 if not available, use other valuation techniques

13. The introduction of fair value The result of this is that: • inevitably, substantial emphasis is being placed on the use of valuation models • which means that ‘fair value’ is really ‘calculated value’, ‘mark to model’ • ‘performance’ is essentially the change in balance sheet net assets from one period to the next

14. Fair valuation of own debt Base rate changes House of Lords decision Closes to new business

15. Performance Reporting Five primary financial statements: • Statement of financial position at the beginning of the year • Statement of financial position at the end of the year • Statement of recognised income and expense (SORIE) • Statement of changes in equity • Statement of cash flows

16. Impact on revenue recognition Current approach under IAS 18 – based on critical event theory and the realisation principle: • the entity has transferred to the buyer the significant risks and rewards of ownership of the goods; • the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold; • the amount of revenue can be measured reliably; • it is probable that the economic benefits associated with the transaction will flow to the entity; and • the costs incurred or to be incurred in respect of the transaction can be measured reliably

17. Revenue recognition Proposed new approach • based on changes in balance sheet assets and liabilities • realisation principle no longer relevant • revenue is the change in net contractual rights and performance obligations

18. The dangers of fair value The more fair is introduced as the primary basis of measurement: • Accounts will become more unreliable and less understandable • There will be an increasing disconnect between internal and external reporting • Accounts will no longer a means of market communication and companies will use non-GAAP measures to communicate with the market

19. Contact Information Allister Wilson Ernst & Young LLP +44 20 7951 1443 awilson@uk.ey.com www.gaap.co.uk