Challenges of the Fair Value Approach (Part 1)

Just a few years ago, a German SAP Treasury and Risk Management user described the difference between International Accounting Standards (IAS) and Germany’s HGB (Handelsgesetzbuch, German Commercial Code) in valuating financial instruments like this: “With IAS you only need to calculate on the basis of market value. Apart from that, there’s no difference between the two.” Without a doubt, the IAS fair value approach has a tremendous impact on companies that still do their accounting according to domestic guidelines like HGB and are now poised to adopt IAS for the first time. Back then, as far as companies deploying treasury software were concerned, there initially didn’t seem to be any need for major adjustments.
According to Germany’s HGB standard, for instance, the lowest value principle needs to be applied. This means that on balance sheet key dates, calculations or write-offs are based on market value, with amortized costs considered as the upper value limit. On the other hand, IAS – and IAS 39 in particular – takes either fair value or valuation of amortized costs into consideration.
In recent years IAS has become increasingly important for publicly traded companies, so SAP has taken a closer look at IAS 39 from a treasury point of view. In this context, IAS requirements for fair value for solutions like SAP Treasury and Risk Management quickly became apparent.

Parallel worlds

For one thing, companies that decide to adopt the IAS method may continue to abide by domestic regulations, such as Germany’s HGB. The challenge posed to software solutions in this situation is to valuate the same financial instrument in two different ways – according to IAS and according to domestic regulations. In this context, various issues need to be addressed, such as whether data for the various transactions is stored using a complete or a delta approach. In addition to such content-related issues, software vendors need to decide whether to expand existing structures or to create a brand-new software solution from scratch.

SAP decided to create a totally new software solution. This approach resulted in parallel position management, which has been available since 2001 as SAP Corporate Finance Management 2.0 (SAP CFM 2.0), an add-on to SAP R/3 4.6C. From a valuation point of view, this led to coexistence with a previous software solution – operative valuation area – and the new position management solution. This coexistence ended in 2003 when SAP R/3 Enterprise Extension Set 2.00 was introduced, and the operative valuation area was completely integrated with the new position management solution. Terminating this coexistence also simplified customizing and improved ease of use. Furthermore, the new position management solution provides the architectural foundation to support IAS and its fair value approach.

Financial assets available for sale

According to IAS 39, at initial recognition, a financial instrument must first be grouped into one of four different categories. The appropriate grouping depends on the type of instrument and the intent of the company. Whereas a loan would typically be placed in the loans and receivables category, how long the bond is to be held is a key factor for acquired bonds. Accordingly, categories like held to maturity or financial assets available for sale are offered. In the financial assets available for sale category, in addition to the fair value approach, there is also a special requirement to recognize valuation results in equity (valuation not affecting net income) on balance sheet key dates. Valuation reserves that were reported in equity can only be recognized in the profit or loss statement (income statement-related valuation) when the asset is sold. For instance, if a bond is sold, the total of all previous valuation results must be rebooked, resulting in a charge-off from equity and a subsequent posting to an income statement account.
For instance, if a company purchases 1,000 shares at 120 Euro per share, this leads to a book value for this available-for-sale asset of 120,000 Euro. Suppose the stock price climbs to 140 Euro on the next balance sheet key date. Then the new book value of the assets would be 140,000 Euro according to the fair value approach. The difference between the two rates (20,000 Euro) is now booked as equity. Next, the company sells 500 shares after the stock price has risen even further, to 145 Euro, generating revenue of 72,500 Euro. However, the book value of the 500 shares is still 70,000 Euro. SAP Treasury and Risk Management’s new position management functions calculate a capital gain of 2,500 Euro. Because half of the stock is being sold, in a second step the solution automatically rebooks half of the valuation results received in the equity – in this case, 10,000 Euro. The total of capital gain and income statement-related recognition of the equity leads to an overall performance of 12,500 Euro from the original investment and the selling of 500 shares.
From a software point of view, it is irrelevant whether the results affect net income or not. However, users obviously expect the solution to automatically recognize the results in the income statement when assets are sold. At the same time, companies need to be able to check and evaluate every step the solution takes on its own regarding existing valuation reserves. This is especially important for year-end work, which is often carried out under tremendous time constraints. For this reason, this functionality is also featured in SAP Treasury and Risk Management’s new position management solution.

Further Information on mySAP ERP Financials:

Challenges of the Fair Value Approach Part 2
New General Ledger in mySAP ERP
What Hinges at Corporate Governance

Stefan Schmid