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Chapter 2: Fair value measurement at initial recognition
Definition of fair value – general
Fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”.
This basis for measuring fair value is commonly referred to as an exit price approach because it reflects the price at which a market participant who holds the asset or owes the liability could exit that asset or liability by selling the asset or transferring the liability to a third party.
Note that the definition assumes a hypothetical and orderly exchange transaction (i.e. it is not an actual sale a forced transaction or a distress sale).
Fair value as defined above is a market-based measurement (not an entity-specific value). It is therefore measured using the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk. Consequently, an entity’s intention to hold an asset or to settle or otherwise fulfill a liability is not relevant when measuring fair value.
IFRS 13’s definition clarifies that fair value should reflect current market conditions (which reflect the current expectations of market participants about future market conditions, rather than those of the reporting entity).
The extent to which market information is available can vary between different types of assets and liabilities. For some assets and liabilities, observable market transactions or market information may be available. For other assets and liabilities, observable market transactions and market information may not be available. However, the objective under IFRS 13 in both circumstances is the same – to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions. When a price for an identical asset or liability is not observable, an entity measures fair value using another valuation technique that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs.
A fair value measurement requires an entity to determine all the following:
- the particular asset or liability that is the subject of the measurement (consistently with its unit of account);
- for a non-financial asset, the valuation premise that is appropriate for the measurement (consistently with its highest and best use);
- the principal (or most advantageous) market for the asset or liability; and
- the valuation technique(s) appropriate for the measurement, considering the availability of data with which to develop inputs that represent the assumptions that market participants would use when pricing the asset or liability and the level of the fair value hierarchy within which the inputs are categorized.
Key elements of the definition of fair value are discussed in the following sections, namely:
- the asset or liability that is being measured;
- the market in which the transaction is assumed to occur;
- the market participants that are assumed to enter into the transaction; and
- the ‘price’ at which the transaction is assumed to occur.
Identifying the asset or liability
Determining the appropriate unit of account
The asset or liability is measured at fair value may be (1) a stand-alone asset or liability (e.g., an investment property), (2) a group of assets or a group of liabilities, or (3) a group of assets and liabilities (e.g., a cash-generating unit). The level at which fair value is measured will depend on the ‘unit of account’ (typically, the level at which the asset or liability is aggregated or disaggregated for recognition or disclosure purposes).
The unit of account is determined by the IFRS that requires or permits the fair value measurement, except as provided in IFRS 13.
IFRS 13 does not generally prescribe the unit of account. The Board concluded that IFRS 13 should describe how to measure fair value, not what is being measured at fair value. Other IFRS Standards specify whether a fair value measurement considers an individual asset or liability or a group of assets or liabilities (i.e. the unit of account). For example:
- IAS 36 states that an entity should measure the fair value less the costs of disposal for a cash-generating unit when assessing its recoverable amount. Therefore, the cash-generating unit is the unit of account for fair value measurement purposes; and
- under IFRS 9 (or, for entities that have not yet adopted IFRS 9, IAS 39, the unit of account is generally an individual financial instrument.
Fair value measurement when an investment entity holds both debt and equity shares in an investee – example
Entity A is an investment entity as defined in IFRS 10. Among other investments, it holds both a controlling interest in equity shares and a debt instrument issued by Entity B. The debt issued by Entity B includes a change of control provision such that, should Entity A lose its controlling interest, the debt becomes immediately repayable.
From a business strategy perspective, and in a manner consistent with standard practice in its industry, Entity A evaluates the performance of its investments in Entity B and makes acquisition and disposal decisions on an aggregate basis rather than by considering the shares and debt separately. When it holds both a controlling interest in the shares of a subsidiary and debt with a change of control provision issued by that subsidiary, Entity A rarely, if ever, disposes of one instrument without also disposing of the other as this ensures that its return on investment is maximised.
Neither the debt nor the equity shares are traded in an active market.
In the specific circumstances described above (subsidiary interest and debt with a change of control provision), measuring the interest in shares and debt as a single unit of measurement would be appropriate.
IFRS 13 states, in part “A fair value measurement assumes that market participants seek to maximise the fair value of a financial or non-financial asset or to minimise the fair value of a financial or non-financial liability by acting in their economic best interest in a transaction to sell the asset or to transfer the liability in the principal (or most advantageous) market for the asset or liability. Such a transaction might involve grouping assets and liabilities in a way in which market participants would enter into a transaction, if the unit of account in other IFRSs does not prohibit that grouping.” [Emphasis added]
Because IFRS 9 (or, for entities that have not yet adopted IFRS 9, IAS 39) does not specifically prohibit measurement of the instruments on an aggregate basis, it is appropriate to consider how fair value would be maximised. In the circumstances described, this may be through disposal of all of Entity A’s interests in Entity B if this is how market participants would transact.
If Entity A measures the fair value of its investments in Entity B on an aggregated basis, it may need to allocate that aggregate fair value to the individual financial instruments held to comply with the disclosure requirements of IFRS 7 and IFRS 13. Consistent with the requirement of IFRS 13, this allocation should be performed on a ‘reasonable and consistent basis using a methodology appropriate in the circumstances’.
In September 2014, the Board issued an exposure draft (ED/2014/4) Measuring Quoted Investments in Subsidiaries, Joint Ventures, and Associates at Fair Value. The ED considered the unit of account to measure the fair value of investments in subsidiaries, joint ventures, and associates when the investment is quoted in an active market. This issue is relevant in the following circumstances:
- an entity chooses to measure such investments at fair value by IFRS 9 (or, for entities that have not yet adopted IFRS 9, IAS 39) in its separate financial statements;
- an acquirer obtains control of an acquiree and remeasures its previously held equity interest at fair value or opts to measure the non-controlling interests at fair value;
- an entity loses control of its subsidiaries and remeasures its interest at fair value;
- an investment-entity parent measures its investments in subsidiaries (other than subsidiaries that provide investment-related services or activities) at fair value by IFRS 10; and
- an entity is required to measure the fair value of its investment in a subsidiary, joint venture, or associate as part of an impairment assessment by IAS 36.
In the ED, the Board proposed that the unit of account for investments in subsidiaries, joint ventures, and associates is the investment as a whole. However, in measuring the fair value of an investment that is composed of financial instruments quoted in an active market, the value should be the product of the quoted price of each instrument (P) multiplied by the quantity (Q) of instruments held (i.e. P × Q) without adjustments. This is on the basis that the quoted prices in an active market provide the most reliable evidence of fair value. The comment period for the ED ended in January 2015 and the Board started its re-deliberations in April 2015.
At its meeting in July 2015, the Board discussed potential directions for the project and based on the comments received, decided that further research should be undertaken concerning the proposals in the ED.
Following the post-implementation review of IFRS 13, the Board received feedback that this issue is narrow and affects only a limited population of entities and that the cost of any further work on the unit of account issue would exceed the benefits. Consequently, in March 2018 the Board decided not to pursue the matter further.
Unit of account for the purposes of measuring the fair value of investments in subsidiaries, joint ventures and associates when the investment is quoted in an active market Given the Board’s discussions on the matter of the unit of account for the purposes of measuring the fair value of interests in subsidiaries, joint ventures and associates when the investment is quoted in an active market, there are two acceptable approaches:
- Approach 1 – the unit of account is the individual financial instrument (e.g.,. an individual share) and, therefore, the fair value of the interest is measured as the product of the quoted price of the financial instrument (P) multiplied by the quantity (Q) of instruments held (i.e. P × Q); or
- Approach 2 – the unit of account should be considered as a whole and, potentially, the P × Q valuation can be adjusted to reflect the premium that would be paid for control, joint control or significant influence over an investee (or if applicable, a blockage factor (discount) reflecting how the market would absorb the transaction, if the investment was sold as a whole. It should be noted that any such adjustment would be unobservable (i.e. a ‘Level 3’ input). If significant, this would result in the entire fair value measurement being categorised as Level 3 and, therefore, additional disclosures stipulated by IFRS 13 with regard to Level 3 fair value measurement (for example, a description of the valuation process and inputs used and of sensitivity to changes in the unobservable input used) would be required.
An entity should select its approach as an accounting policy choice and apply it consistently in fair valuing interests in subsidiaries, joint ventures and associates when the individual investment is quoted in an active market.
The following examples set out considerations for determining the appropriate unit of account for equity interests held by an entity in various scenarios and how the fair value of those interests should be measured.
Scenario Unit of account prescribed in the applicable IFRS Scenario 1 Entity A owns a 16 per cent equity interest in Entity B (160 million ordinary shares). Entity B’s ordinary shares are traded in an active market. The share price of each ordinary share at the measurement date is CU0.5. Entity A accounts for the 16 per cent equity interest at fair value at initial recognition and at the end of each reporting period in accordance with IFRS 9 (or, for entities that have not yet adopted IFRS 9, IAS 39). IFRS 9 (or IAS 39) is the applicable Standard that requires the fair value measurement. IFRS 13 specifically discusses a scenario where an entity holds a position in a single asset or liability (including a position comprising a large number of identical assets or liabilities) and the asset or liability is traded in an active market; in such circumstances, the unit of account is the individual financial instrument. The fair value of such a holding of financial instruments is required to be measured within Level 1 as P × Q. Therefore, in this scenario, the fair value of the 16 per cent equity interest in Entity B is measured as 160 million × CU0.5 = CU80 million. Scenario 2 Entity C owns a 54 per cent equity interest in Entity D (300 million ordinary shares). Entity D is a subsidiary of Entity C. Entity D’s ordinary shares are traded in an active market. The share price of each ordinary share at the measurement date is CU0.5. In its separate financial statements, Entity C has chosen to account for its investments in subsidiaries in accordance with IFRS 9 (or, for entities that have not yet adopted IFRS 9, IAS 39) at fair value at initial recognition and at the end of each reporting period.
Based on Entity C’s accounting policy, IFRS 9 (or IAS 39) is the applicable Standard that requires the fair value measurement in Entity C’s separate financial statements. If Entity C’s accounting policy for fair valuing interests in subsidiaries, joint ventures and associates is to consider the unit of account as the individual financial instruments (e.g.,. each individual share). Therefore, the unit of account for Entity C’s investment in Entity D is the individual share in Entity D, and the fair value of the 54 per cent equity interest in Entity D is determined as P × Q = 300 million × CU0.5 = CU150 million.
If Entity C’s accounting policy for fair valuing interests in subsidiaries, joint ventures and associates is to consider the unit of account as the investment as a whole, the P × Q valuation can be adjusted to reflect the control premium (or blockage factor) that would arise if the investment in Entity D was sold as a whole.
Note that this question concerns measurement in the separate financial statements of Entity C only. The accounting in the consolidated financial statements is specified in IFRS 10.
Determining the characteristics of an asset or a liability to be taken into account
Characteristics of an asset or a liability to be taken into account – general
When measuring fair value, the characteristics of an asset or a liability that should be taken into account are those that market participants would consider when pricing that asset or liability at the measurement date. Such characteristics could include, for example:
- the condition and location of an asset; and
- restrictions, if any, on the sale or use of an asset.
The effect on the measurement arising from a particular characteristic will differ depending on how that characteristic would be taken into account by market participants.
Restrictions on the sale or use of an asset
Following the principle set out in IFRS 13, a legal or contractual restriction on the sale or use of an asset should be incorporated in the asset’s fair value measurement if (1) the restriction is a characteristic of the asset, and (2) market participants would take the effect of the restriction into account when pricing the asset.
The following examples, reproduced from the illustrative examples accompanying IFRS 13, illustrate the effect of restrictions on the fair value measurement of an asset. Example below considers a restriction that is a characteristic of the asset being measured and that would transfer to market participants with the asset; such restrictions should be taken into account when measuring the fair value of the asset. Example below considers a restriction that is specific to the entity holding the asset and that would not transfer to market participants; such entity-specific restrictions should not be taken into account when measuring the fair value of the asset.
Sometimes it is immediately clear whether a restriction is a characteristic of an asset and would transfer to market participants. In other circumstances, significant judgement may be required to make the assessment and it may be necessary to obtain expert advice.
Consistent with example below, when a restriction needs to be taken into account when measuring the fair value of the asset, this is achieved by adjusting the fair value of an identical unrestricted asset to reflect the ‘compensation’ that a market participant would require because of the restriction. The adjustment will vary depending on (1) the nature and duration of the restriction, (2) the extent to which buyers are limited by the restriction, and (3) qualitative and quantitative factors specific to the asset (including factors specific to the issuer of the asset, as appropriate).
When categorising the fair value measurement for the purposes of the fair value hierarchy under IFRS 13, an entity will need to evaluate the significance of any adjustment made to reflect a restriction on the sale or use of the asset.
Identifying the market in which to price the asset or liability
Principal market versus most advantageous market
IFRS 13 requires an entity to consider the market in which the sale of an asset or the transfer of liability will take place. The Standard introduces the concepts of a ‘principal market’ and a ‘most advantageous market’. Both terms are important in establishing the market in which the particular asset would be sold or the liability transferred and, consequently, in determining what price would be achieved if the sale or transfer occurred in that market at the measurement date.
To measure fair value, the transaction to sell the asset or transfer the liability is assumed to take place either:
- in the ‘principal market’ for the asset or liability; or
- in the absence of a principal market, in the ‘most advantageous market’ for the asset or liability.
The principal market is defined as “the market with the greatest volume and level of activity for the asset or liability”.
The most advantageous market is defined as “[t]he market that maximizes the amount that would be received to sell the asset or minimizes the amount that would be paid to transfer the liability, after taking into account transaction costs and transport costs”.
Note that, although transaction costs are not deducted (for an asset) or added (for a liability) when measuring fair value, they are considered when identifying the most advantageous market for an asset or a liability (see 3.5.3).
Identifying the principal (or most advantageous) market
The principal market should be identified on the basis of the volume or level of activity for the asset or liability rather than the volume or level of activity of the reporting entity’s transactions in a particular market. Therefore, the assessment as to which of two or more accessible markets is the principal market is made from the perspective of market participants rather than the entity.
Equally, in the absence of a principal market, the most advantageous market is identified using the assumptions that market participants would use.
A principal market may not exist, for example, when the volume or level of activity for the asset or liability is the same in two different markets to which the entity has access, or when there is no observable market for the asset or liability. In such circumstances, an entity needs to identify the most advantageous market or develop assumptions from the perspective of a market participant in a hypothetical most advantageous market.
IFRS 13 does not require an entity to conduct an exhaustive search of all possible markets to identify the principal market (or, in the absence of a principal market, the most advantageous market), but an entity is required to take into account all reasonably available information. In the absence of evidence to the contrary, the market in which an entity would normally enter into a transaction to sell the asset or to transfer the liability is presumed to be the principal (or most advantageous) market.
Therefore, an entity is permitted to use the price in the market in which it normally enters into transactions unless there is evidence that the principal market and that market are not the same.
Market in which an entity normally transacts is not the principal (or most advantageous) market
If there is evidence that the market in which an entity would normally transact is not the principal (or most advantageous) market, the principal (or most advantageous) market should be identified by:
- firstly, identifying other markets to which the entity has access; and
- secondly, when relevant, assessing which of two or more accessible markets is the principal (or most advantageous) market.
If there is a principal market for the asset or liability, the fair value measurement should reflect the price in that market, even if the price in a different market is potentially more advantageous at the measurement date.
Access to the market
To use the price in the principal (or most advantageous) market as the basis for measuring fair value, an entity must have access to that market at the measurement date. Because different entities (and businesses within those entities) with different activities may have access to different markets, the principal (or most advantageous) market for the same asset or liability might be different for different entities (and businesses within those entities). Therefore, the principal (or most advantageous) market should be considered from the perspective of the entity, thereby allowing for differences between and among entities with different activities.
Example 7 of the illustrative examples accompanying IFRS 13 illustrates a scenario in which two entities measure the same instrument differently because each identifies its principal market based on the market to which it has access.
Although an entity must be able to access the market, the entity does not need to be able to sell the particular asset or transfer the particular liability on the measurement date to be able to measure fair value based on the price in that market.
For example, as discussed in the example above, an entity may be restricted from selling a particular asset at the measurement date. Nevertheless, if the entity has access to the principal market at that date, the entity could measure the asset’s fair value using observed prices for sales of similar (but unrestricted) assets in that market. If the restriction is a characteristic of the asset (i.e., it would transfer with the asset in a hypothetical sale), an entity should adjust the observed market prices for similar (but unrestricted) assets to reflect the restriction.
Measuring fair value when no apparent exit market exists
Even when there is no observable market to provide pricing information about the sale of an asset or the transfer of a liability at the measurement date, a fair value measurement should assume that a transaction takes place at that date, considered from the perspective of a market participant that holds the asset or owes the liability. That assumed transaction establishes a basis for estimating the price to sell the asset or to transfer the liability.
When an observable market for an asset or a liability does not exist, an entity must assume a hypothetical transaction at the measurement date. This is consistent with the fair value objective in IFRS 13 to measure fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”.
Factors indicating a change in the principal (or most advantageous) market
While it is presumed that the market in which an entity normally transacts is the principal (or most advantageous) market, an entity should reassess the principal (or most advantageous) market for an asset or a liability at each measurement date based on reasonably available information. Factors indicating that there may have been a change in the principal (or most advantageous) market include the following (the list is not exhaustive):
- a significant change in market conditions;
- a decrease in the volume or level of activity relative to other markets;
- the development of a new market (see below);
- a change in the entity’s ability to access particular markets (e.g.,., an entity loses access to a market or gains access to a market to which it did not previously have access); and
- when there is no principal market, a change in value such that the price for the asset or liability in a market previously considered most advantageous is no longer the most advantageous.
Events such as those listed above may indicate that there has been a change in the principal (or most advantageous) market for the asset or liability, or that circumstances have changed such that there is no longer a principal market for the asset or liability (in which case the entity should refer instead to the most advantageous market).
When a market first develops (e.g.,., for a new form of securities), it may operate primarily as a principal-to-principal or over-the-counter market. However, the volume and level of activity in the exchange market may increase over time. As the volume and level of activity change, and the balance of market activity shifts, an entity should take this into account when reassessing the principal (or most advantageous) market for an asset or a liability.
Market participants
Definition of market participants
Market participants are defined as “buyers and sellers in the principal (or most advantageous) market for the asset or liability that have all of the following characteristics:
(a) They are independent of each other, i.e., they are not related parties as defined in IAS 24, although the price in a related party transaction may be used as an input to a fair value measurement if the entity has evidence that the transaction was entered into at market terms.
(b) They are knowledgeable, having a reasonable understanding of the asset or liability and the transaction using all available information, including information that might be obtained through due diligence efforts that are usual and customary.
(c) They can enter into a transaction for the asset or liability.
(d) They are willing to enter into a transaction for the asset or liability, i.e., they are motivated but not forced or otherwise compelled to do so”.
Use of assumptions that market participants would use
IFRS 13 requires an entity to use the assumptions that market participants would use when pricing the asset or liability, assuming that market participants act in their economic best interest.
In developing those assumptions, an entity is not required to identify specific market participants, but is expected to identify characteristics that distinguish market participants generally, considering factors specific to:
- the asset or liability;
- the principal (or most advantageous) market for the asset or liability; and
- market participants with whom the entity would enter into a transaction in that market.
Use of assumptions that market participants would use – example
Entity F uses a discounted cash flow model to measure the fair value of a financial asset. Entity F has obtained information about the assumptions that market participants would use to measure the fair value of the asset. However, Entity F believes that some of those assumptions are not appropriate.
Entity F is not permitted to rely on its own internal data rather than use the assumptions that market participants would use. A fair value measurement is a market-based measurement and not entity-specific. IFRS 13 requires that the fair value of an asset or a liability should be measured using the assumptions that market participants would use when pricing the asset or liability, assuming that market participants act in their economic best interest.
When using a discounted cash flow model to measure the fair value of a financial asset, Entity F should incorporate relevant observable inputs whenever available. Any unobservable inputs used in the fair value measure (e.g.,., estimated future cash flows or risk adjustments incorporated into the discount rate) should be based on management’s estimate of assumptions that market participants would use in pricing the asset in a current transaction at the measurement date. If market data from transactions involving comparable assets indicate, for example, that a significant liquidity discount applies at the measurement date to compensate for the difficulty in selling assets under current market conditions, Entity F should incorporate that information in its cash flow model (e.g.,., through an adjustment to the discount rate) even if management’s internal data would not result in such a liquidity adjustment.
The price at which a transaction is assumed to occur
Characteristics of the price at which a transaction is assumed to occur
The price at which a transaction is assumed to occur in the principal or most advantageous market is the price:
- in an ‘orderly’ transaction; and
- under current market conditions at the measurement date.
The price may be directly observable or estimated using another valuation technique.
The price should not be adjusted for ‘transaction costs’, but it should be adjusted for ‘transport costs’ in specified circumstances.
An ‘orderly’ transaction
A fair value measurement assumes that the asset or liability is exchanged in an ‘orderly’ transaction in the principal (or most advantageous) market. An orderly transaction is defined as “a transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (e.g., a forced liquidation or distress sale)”.
Transaction costs and transport costs
Transaction costs are defined as “[t]he costs to sell an asset or transfer a liability in the principal (or most advantageous) market for the asset or liability that are directly attributable to the disposal of the asset or the transfer of the liability and meet both of the following criteria:
(a) They result directly from and are essential to that transaction.
(b) They would not have been incurred by the entity had the decision to sell the asset or transfer the liability not been made (similar to costs to sell, as defined in IFRS 5)”.
Transaction costs do not include transport costs. Transport costs are defined as “[t] the costs that would be incurred to transport an asset from its current location to its principal (or most advantageous) market”.
IFRS 13 specifies that, when measuring fair value, the relevant market price should not be reduced (for an asset) or increased (for a liability) for transaction costs. Because such costs are specific to a transaction and will differ depending on how an entity enters into a transaction for an asset or a liability, they are not considered to be a characteristic of the asset or liability.
The appropriate treatment for transaction costs should be determined by other relevant IFRS Standards.
In contrast, the price in the principal (or most advantageous) market used to measure the fair value of an asset is adjusted for any transport costs (as defined above) if the location is a characteristic of the asset (which might be the case, for example, for a commodity).
The appropriate treatments for transaction and transport costs are illustrated in the following example, which is reproduced from the illustrative examples accompanying IFRS 13.
Example
Level 1 principal (or most advantageous) market
An asset is sold in two different active markets at different prices. An entity enters into transactions in both markets and can access the price in those markets for the asset at the measurement date. In Market A, the price that would be received is CU26, transaction costs in that market are CU3 and the costs to transport the asset to that market are CU2 (i.e., the net amount that would be received is CU21). In Market B, the price that would be received is CU25, transaction costs in that market are CU1 and the costs to transport the asset to that market are CU2 (i.e., the net amount that would be received in Market B is CU22).
If Market A is the principal market for the asset (i.e., the market with the greatest volume and level of activity for the asset), the fair value of the asset would be measured using the price that would be received in that market, after taking into account transport costs (CU24).
If neither market is the principal market for the asset, the fair value of the asset would be measured using the price in the most advantageous market. The most advantageous market is the market that maximises the amount that would be received to sell the asset, after taking into account transaction costs and transport costs (i.e., the net amount that would be received in the respective markets).
Because the entity would maximise the net amount that would be received for the asset in Market B (CU22), the fair value of the asset would be measured using the price in that market (CU25), less transport costs (CU2), resulting in a fair value measurement of CU23. Although transaction costs are taken into account when determining which market is the most advantageous market, the price used to measure the fair value of the asset is not adjusted for those costs (although it is adjusted for transport costs).
IFRS 13 requires entities to reflect characteristics specific to the asset or liability being measured when measuring fair value. Consequently, if location is a characteristic of an asset, an entity should adjust the price in the principal (or most advantageous) market for transport costs when measuring the fair value of the asset.
The following two examples illustrate how transport costs may be a subtractive input or an additive input as an adjustment to an observable market price for an asset.
Transport costs are a subtractive input – example
Company A has agricultural produce ready for harvesting at Location 1. As required under IAS 41, the agricultural produce is measured at fair value less costs to sell at the point of harvest. The fair value less costs to sell at that date will subsequently be used as the cost when applying IAS 2 to the harvested produce.
Company A has identified Location 2 as the principal market for sale of its produce. The quoted price for the produce in Location 2 is CU100 per unit. Company A determines that transport costs of CU5 per unit would be incurred to move the produce from Location 1 to Location 2. Therefore, the fair value of the produce at its current location would be CU95 per unit (i.e., CU100 per unit quoted price at Location 2 less CU5 per unit to transport the produce to the principal market at Location 2). Note that this represents the fair value before deduction of costs to sell in accordance with IAS 41.
Potential for difference between the transaction price and fair value at initial recognition
Some IFRS Standards require or permit assets or liabilities to be recognized initially based on ‘fair value’. If the asset has been acquired, or the liability assumed, in a market transaction, it might be assumed that the transaction price (i.e., the price paid to acquire an asset or received to assume a liability) can be taken to be the fair value of the asset or the liability. However, the price paid to acquire an asset, or received to assume a liability, is an entry price and, consequently, it is not necessarily the same as the fair value of the asset or liability for IFRS 13 purposes (which is an exit price). The Standard notes that entities do not necessarily sell assets at the prices paid to acquire them; nor do they necessarily transfer liabilities at the prices received to assume them.
Indicators that the transaction price differs from fair value at initial recognition
When determining whether the fair value at initial recognition equals the transaction price, an entity should take into account factors specific to the transaction and the asset and liability.
IFRS 13 lists several factors that may suggest that the transaction price is not the fair value of the asset or liability at initial recognition.
Indicators that the transaction price is not representative of fair value at initial recognition – examples
The following table repeats the factors listed in IFRS 13 and provides examples for each. Note that this list of indicators is not exhaustive, and other factors may exist that should be considered in evaluating whether a transaction price represents fair value.
Factor (IFRS 13) Example The transaction is between related parties, although the price in a related party transaction may be used as an input into a fair value measurement if the reporting entity has evidence that the transaction was entered into at market terms. An entity purchases a portfolio of troubled loans from an unconsolidated investee. The parties meet the definition of related parties under IAS 24. The fact that the parties are related may indicate that the transaction price does not reflect fair value. However, this alone would not be determinative. Evidence that the transaction was entered into at market terms may include:
- the appointment of third parties to negotiate or measure fair value; or
- the terms of the transaction are consistent with available market data for similar transactions between unrelated parties; or
- there is no evidence that one of the parties to the transaction is under duress (see the next factor).
The transaction takes place under duress or the seller is forced to accept the price in the transaction (e.g., if the seller is experiencing financial difficulty). A hedge fund must sell all of its non-marketable assets in response to a spike in redemptions that may lead to a liquidity crisis. A liquidity crisis may be an indicator of financial difficulty. The factors in IFRS 13 indicating that a transaction is not orderly may also indicate that the transaction price does not represent fair value. The unit of account represented by the transaction price is different from the unit of account for the asset or liability measured at fair value. For example, this might be the case if the asset or liability measured at fair value is only one of the elements in the transaction (e.g., in a business combination), if the transaction includes unstated rights and privileges that are measured separately in accordance with another IFRS, or if the transaction price includes transaction costs. IFRS 13 requires that the unit of account for an asset or a liability should be determined in accordance with the IFRS that requires or permits the fair value measurement, except as provided in IFRS 13. The following example illustrates a scenario in which the unit of account for the asset is different from the unit of account represented by the transaction price.
On 30 June 20X1, Company A acquires a 3 per cent equity interest (3 million shares) in Company B from an independent third party. Quoted prices in an active market are available for Company B’s shares. Company A pays CU100 million for the entire 3 per cent equity interest (the transaction price is determined based on a negotiated arm’s length price for the entire 3 per cent equity interest). The quoted price for Company B’s shares on 30 June 20X1 is CU36 per share. Company A needs to identify the unit of account in order to measure the fair value of the 3 per cent equity interest on initial recognition.
In identifying the unit of account for fair value measurement purposes, IFRS 9 (or, for entities that have not yet adopted IFRS 9, IAS 39) is the applicable Standard. IFRS 13 states, in part, that “in IAS 39 and IFRS 9… the unit of account is generally an individual financial instrument”. This guidance is also consistent with the guidance set out in IFRS 13 which states that “if an entity holds a position in a single asset … and the asset … is traded in an active market, the fair value of the asset … shall be measured within Level 1 as the product of the quoted price for the individual asset … and the quantity held by the entity”. Therefore, notwithstanding the fact that Company A paid a transaction price of CU100 million for the entire 3 million shares, the unit of account in this example is each individual share, not the entire 3 per cent equity interest acquired. Specifically, the fair value of the 3 per cent equity interest in Company B is measured as the product of the quoted price for each individual share and the quantity held (‘P × Q’) (i.e., CU108 million = 3 million shares × CU36 per share). The market in which the transaction takes place is different from the principal market (or most advantageous market). For example, those markets might be different if the entity is a dealer that enters into transactions with customers in the retail market, but the principal (or most advantageous) market for the exit transaction is with other dealers in the dealer market. Entity A (a retail counterparty) enters into an interest rate swap in a retail market with Entity B (a dealer) for no initial consideration (i.e., the transaction price is zero). Entity A can access only the retail market. Entity B can access both the retail market (i.e., with retail counterparties) and the dealer market (i.e., with dealer counterparties). From the perspective of Entity A, the fair value at initial recognition is zero because Entity A does not have access to the dealer market.
From Entity B’s perspective, the transaction price of the interest rate swap (i.e., zero) does not represent fair value at initial recognition if prices observed or market participant assumptions in the dealer market (i.e., Entity B’s principal market) indicate that fair value is something other than zero. Note: This final scenario is a summary of Example 7 from the illustrative examples accompanying IFRS 13.
Recognition of ‘day 1 p&l’
In many cases, the transaction price and the fair value will be equal (e.g., when the transaction date is the same as the measurement date and an asset is acquired in the market in which it would be sold). However, when the amounts are not equal, the asset or liability should be measured at fair value and the difference between the transaction price and fair value (generally referred to as a ‘day 1 gain or loss’, ‘day 1 profit or loss’, or ‘day 1 p&l’) is required to be recognized as a gain or loss in profit or loss unless the relevant IFRS specifies otherwise.
For example, IFRS 9 and IAS 39 state that an entity cannot recognize a day 1 gain or loss for a financial instrument unless the instrument’s fair value is evidenced by a quoted price in an active market for an identical asset or liability or based on a valuation technique that uses only data from observable markets. In contrast, IFRS 3 and IAS 41 require the recognition of day 1 gains or losses even when fair value is measured using unobservable inputs.
When, by the relevant IFRS, a day 1 gain or loss is not recognized, the asset or liability should be measured at fair value and the day 1 gain or loss deferred and accounted for separately under the relevant Standard.