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

2. 2 Capital market activity: the balance is shifting 2005 20042003 Largest IPOChina Construction Bank BelgacomChina Life Number of 20 largest IPOs that are outside US191416 Number of 20 largest IPOs that are companies outside the US 19 1619 Japanese IPOs 157 171121 Chinese IPOs, cumulatively raising over $12 billion in each year 114 14294 Number of exchanges on which top 20 IPOs were completed 9 11

3. 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. 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. 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. 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. 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. 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. 9 … 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” Approach to accounting is changing

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

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

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

13. 13 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 The introduction of fair value

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

15. 15 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 Performance Reporting

16. 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. 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. 18 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 The dangers of fair value

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