CFM80260 - Old rules: loan relationships: authorised accounting methods: authorised mark to market: meaning of fair value

Authorised MTM - fair value

This guidance applies to periods of account beginning before 1 January 2005

There is a definition of fair value in FA96/S85(6). In the case of an asset, fair value means the amount the company would get from an independent person for the rights under the loan relationship to future amounts - the expected income and the amount receivable on redemption. In the case of a liability, fair value is the amount the company would have to pay to an independent person for its release from all its future obligations under the loan relationship.

An independent person is defined in FA96/S101(3) as someone who is ‘a knowledgeable and willing party dealing at arm’s length’.

You would expect the fair value of a loan relationship to be affected primarily by interest rates. However, this is only one of a number of other factors, shown below, that may impact on fair value.

  • interest rate - all other things being equal, a security giving a high interest rate would be worth more than one carrying a low rate. However, if a security carries a fixed interest coupon, its fair value will decrease if commercial interest rates go up; a security yielding say 6% will be more valuable to an investor if he could get only 4% on a similar floating rate investment than if he could get 5.5%.
  • the ‘safety’ of the investment - loan stock in a speculative or high risk company, such as an Internet start-up, may be worth less than one issued by a long-established company, even if the interest rate offered by the start-up is higher to compensate for the risk.
  • the redemption price and date. Like interest, the discount can be set at different amounts. The longer the money is tied up the higher the risk. But the pricing of debt with different redemption dates will also depend on the expected future interest rates.
  • tradeability or liquidity. Some securities will not be easy to sell on, there may not be an active market in those types of securities, or there may be a lack of market demand.
  • default risk - has the credit rating of the issuing company deteriorated significantly. Is it already defaulting on some of its debts?