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Chapter 3: Measurement
The overall process for determining fair value under IFRS 13 can be illustrated by the following chart:
Step 1: Determine the asset or liability that is being measured. In doing so, it is essential to establish the unit of account.
Step 2: Determine the valuation premise. Different valuation premises exist for financial and non-financial assets and liabilities. The valuation premise is determined from a market participant’s perspective.
Step 3: Determine the market, either observable or hypothetical, in which the asset or liability is traded, to determine the value.
Step 4: Determine the valuation technique for measuring the fair value.
Step 5: Determine the fair value.
Use of International Valuation Standards
The International Valuation Standards Council (IVSC) is an independent organisation that produces and implements standards for the valuation of assets across the world.
International Valuation Standards (IVSs) are used for undertaking valuation assignments using generally recognised principles. The IVSC also promotes standards for the conduct and competency of professional valuers.
The IVSs consist of mandatory requirements that must be followed in order to state that a valuation was performed in compliance with the IVSs.
The standards cover the general principles on the valuation approaches to be followed, as well as reporting requirements. There are also standards capturing specific valuations, such as the valuation of businesses and business interests (IVS 200), intangible assets (IVS 210), plant and equipment (IVS 300), real property interests (IVS 400), development property (IVS 410), and financial instruments (IVS 500).
Step 1: Determine the asset or liability that is being measured Characteristics
A fair value measurement relates to a particular asset or liability. It should, therefore, incorporate the asset’s or liability’s specific characteristics, if market participants consider these characteristics when pricing the asset or liability. These characteristics could include condition, location, and restrictions, if any, on sale or use as of the measurement date.
How each of the characteristics might impact the fair value measurement depends on how market participants would consider each characteristic when acting in their best economic interest.
Unit of account
Fair value measurement might be applied to a stand-alone asset or liability (for example, an equity security, an investment property, an intangible asset, or a warranty liability) or a group of related assets and/or liabilities (such as a business), depending on the circumstances.
The unit of account drives the application of fair value measurement. The unit of account is the level at which the asset or liability is aggregated or disaggregated, by the IFRS requirements applicable to the particular asset or liability being measured. For financial instruments, the unit of account under IFRS 9 (IAS 39) is generally the standalone financial instrument. Consequently, in fair valuing financial instruments under IFRS 9 (IAS 39), adjustments for premiums or discounts related to size as a characteristic of the reporting entity’s holding are generally disallowed.
Offsetting positions in market or counterparty credit risk
If an entity manages a group of financial assets and financial liabilities based on its net exposure to either market risks or credit risks (as defined in IFRS 7), it can opt to measure the fair value of that group based on the net position. The net position is the unit of measurement for the fair value measurement, rather than the individual financial assets and liabilities.
The offsetting positions exception is permitted only if an entity:
- manages the financial asset/liability group based on its net exposure to market/credit risk by its documented risk management or investment strategy;
- provides information about the financial asset/liability group on a net basis to key management personnel, as defined in IAS 24; and
- measures those financial assets and liabilities at fair value in the statement of financial position regularly.
Broad risk management strategies, such as managing based on value-at-risk, might not be sufficient alone for a group to be eligible for the offsetting positions exception, because value-at-risk does not necessarily represent managing a portfolio to a net position.
How should exposure to market risk be considered when arriving at a net long or net short position?
When considering whether the portfolio exception is available for a group of financial assets and/or liabilities for a particular market risk, the degree of exposure (or offset) of market risk, to arrive at a net long or net short position, should be considered.
IFRS 13 does not prescribe how much of a long or short position is permitted to qualify for the portfolio exception. For example, assets in a portfolio would not have to be nearly 100% offset by liabilities for a certain risk. Rather, a reporting entity should assess the appropriateness of electing the portfolio exception, based on the nature of the portfolio being managed, in the context of its risk or investment management strategy.
We do not believe that bright lines or ‘percentages’ of the degree of offset of risk positions should be applied in determining whether there is sufficient offset in a group or portfolio. However, we believe that it would be inappropriate to apply the portfolio exception to an aggregated position without offset or hedging (for example, an aggregated block of equity shares). Such a position might relate to a trading strategy that is not managed on a net basis.
The offsetting positions exception applies only to financial assets, liabilities, and other contracts within the scope of IFRS 9 (IAS 39). The guidance applies to all contracts within the scope of IFRS 9 (IAS 39), regardless of whether they meet the definition of financial assets or financial liabilities. This includes contracts to buy or sell non-financial items that can be settled net in cash or another financial instrument.
The offsetting positions exception applies only to financial assets and liabilities that are exposed to identical (or, at least, substantially similar) market risks. If the risks are not identical, the differences should be considered when allocating the group’s fair value to component assets and liabilities, as explained.
The offsetting positions exception applies only to exposures of a similar duration. An entity that uses a 12-month futures contract against a five-year financial instrument measures the fair value of the exposure to 12-month interest rate risk on a net basis, and the remaining interest rate risk exposure (that is, years 2 to 5) on a gross basis.
Examples of mismatches
In applying the portfolio guidance, valuation of the net open risk position is required. Market participants might value a portfolio with basis risk differently from one that is perfectly hedged. The following are some examples of mismatches in the portfolio that affect the measurement of fair value.
Basis differences
Portfolios with basis differences might qualify for the portfolio exception. If there is any basis difference for dissimilar risks, that basis risk should be reflected in the fair value of the net position. For example, an entity might include financial instruments with different (but highly correlated) interest rate bases in one portfolio, provided that the entity manages its interest rate risk on a net basis. However, any difference in the interest rate bases (for example, LIBOR versus treasury) should be considered in the fair value measurement.
Duration differences
Portfolios containing offsetting positions with different maturities might qualify for the portfolio exception. Adjustments to the fair value of the net position of a portfolio should also be made for such duration mismatches. Therefore, unmatched (or unhedged) portions of the terms to maturity of the financial assets and liabilities that form part of the portfolio could result in an adjustment to the net position.
Exposure to counterparty credit risk
When applying the portfolio exception to a portfolio in which a specific counterparty’s credit risk is managed on a net basis, the entity must consider market participants’ expectations about whether any arrangements in place to mitigate credit risk exposure are legally enforceable in the event of default (for example, through a master netting arrangement). In a portfolio of financial assets and liabilities within a master netting arrangement, the adjustment for credit risk could be applied to the net exposure to the counterparty, rather than to each of the financial assets and liabilities separately. The adjustment will be applied to the net position based on the individual counterparty’s credit risk, in the case of a net asset position, or the reporting entity’s own credit risk in the case of a liability position. The portfolio exception does not change the requirement to incorporate a credit valuation adjustment (CVA) or debit valuation adjustment (DVA) on a net open asset or liability position, respectively.
The fair value of the net position is measured using IFRS 13 principles if the offsetting positions exception is applied. For example:
- For market risks, the fair value of the net position is the price within the bid-ask spread that is most representative of fair value in the entity’s circumstances.
- For credit risk, the fair value of such a group should consider credit enhancements (such as master netting agreements and collateral requirements) and market participant expectations about the legal enforceability of such enhancements.
The offsetting positions exception relates to measurement, and it does not permit the net presentation of assets and liabilities within the group. Presentation is dealt with in other IFRSs. Where gross presentation is required, the fair value of the group should be allocated to the assets and liabilities within the group on a reasonable and consistent basis (for example, using the relative fair value approach).
The use of the offsetting positions exception, along with any policies for allocating bid-ask and credit adjustments, is regarded as an accounting policy that should be applied consistently from period to period for a given portfolio.
Unit of account when applying the exception for offsetting positions in market or counterparty credit risk
If an entity has a portfolio of financial assets and liabilities that qualify for the offsetting positions exception, the unit of measurement is the net open risk or credit risk position. The portfolio, or net open position, becomes the asset or liability on which a reporting entity determines what a market participant would pay, or expect to pay, for it. Because the unit of measurement is the net position of the portfolio, size is an attribute of the portfolio being valued and, consequently, an adjustment based on size is appropriate, to the extent that it would be incorporated by market participants. However, where the instruments in the portfolio are quoted in an active market, the net position is measured based on the listed price multiplied by the number of instruments. No premiums or discounts are expected when measuring a portfolio at fair value. Therefore, use of P× Q without adjustments is considered appropriate.
Step 2: Determine the valuation premise
The transaction
Fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants under current market conditions at the measurement date.
A fair value measurement is based on information available at the date of measurement. Information that becomes known after the measurement date is only taken into account where reasonable and customary due diligence would have identified the additional information at the measurement date.
Impact of subsequent information in fair value measurement (1)
Entity A has two separate receivables (X and Y) from entity B, each with near identical terms and conditions.
Entity A intends, as it has from the time of their initial recognition, to sell receivables X and Y under a non-recourse factoring arrangement, which results in de-recognition. This intention existed at the time of initial recognition. Accordingly, receivables X and Y are considered held for sale and carried at fair value through profit or loss.
On 31 December, entity A sells receivable X and achieves de-recognition.
In early January, as part of beginning to prepare its financial statements for its 31 December year end, entity A uses a market approach, based on the near identical terms of receivables X and Y, and determines that the fair value of receivable Y on 31 December is the same as that indicated by the sale of receivable X.
On 31 January, before entity A has released its financial statements, entity B goes bankrupt. Entity A estimates the cash flows of receivable Y based on the bankruptcy of entity B to be less than originally expected.
Question:
Should entity A update its calculation of the fair value of receivable Y, based on the bankruptcy of entity B and the revised estimated cash flows?
Solution:
This depends on whether the impending bankruptcy of entity B was knowable (as opposed to actually known) at 31 December, as the result of customary and usual due diligence efforts. Entity A must decide whether the price at which receivable X was sold did not properly reflect the risk of impending bankruptcy and the assumptions that would be taken into account by market participants. If the price does indeed take this into account, as would be expected in a third-party transaction, the fair value of receivable Y should not be adjusted.
A market participant who would enter into a transaction for an asset or a liability is expected to undertake all reasonable efforts to become knowledgeable about the asset and the related risks at the time of the measurement.
Market participants
A fair value measurement should be based on the assumptions of market participants. It is not an entity-specific measurement.
Market participants are buyers and sellers in the principal (or most advantageous) market for the asset or liability that are:
- The transaction counterparties are not related parties, as defined in IAS 24. However, this does not preclude related-party transaction prices from being used as valuation inputs, if there is evidence that the transactions were on market terms.
- Transaction counterparties have 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.
- Able to transact in the asset or liability.
- Willing to transact in the asset or liability. Transaction counterparties are motivated but not forced or otherwise compelled to transact.
Market participants seek to maximize the fair value of an asset or minimize the fair value of a liability, in a transaction to sell the asset or to transfer the liability, in the principal (or most advantageous) market for the asset or liability. Market participants are presumed to act in their best economic interests.
The entity is not required to identify specific market participants; instead, it should develop a profile of potential market participants. The profile should consider factors specific to the asset or liability, the principal (or, in its absence, the most advantageous) market for the asset or liability, and market participants with whom the entity would transact in that market.
Fair value is determined by considering the characteristics of market participants who would enter into a hypothetical transaction for the asset or liability, in the absence of an observable market.
Determining a hypothetical market participant
Question:
What are the key considerations in determining a hypothetical market participant?
Solution:
Step 1: Determine the type of market participant If there is no knowledge of market participants in a particular market, management might need to make assumptions about the types of market participant that might be interested in a particular asset or liability. Market participants can include strategic investors and financial investors. Both types of market participant could be interested. The reporting entity will need to conclude which group is the appropriate market participant. In many sectors, financial buyers have become strategic buyers, and so the distinction between the two groups in those sectors has largely disappeared.
Step 2: Determine the market participant assumptions
Key considerations in developing market participant assumptions might include the specific location, condition, other characteristics of the asset or liability (for example, assumed growth rates and whether certain synergies are available to all market participants) and risk premium assumptions. For instance, there might be no apparent exit market for customer relationship intangible assets. Management might consider whether there are strategic buyers in the marketplace that would benefit from the customer relationships that are being valued. Most entities seek to build up their customer base as they grow their business, so the entity can look to potential participants in its industry that might be seeking additional growth and, from there, it can determine a hypothetical group of market participants.
Entry versus exit price
Fair value is based on the exit price and not on the entry price (transaction price). Exit price is the price that would be received to sell an asset or would be paid to transfer a liability. The entry price is the price that was paid for the asset or that was received to assume the liability. Conceptually, entry and exit prices are different. The exit price concept is based on current expectations about the sale or transfer price from the perspective of market participants.
Impact of credit risk on the fair value of derivatives
Question:
Does IFRS 13 require counterparty credit risk to be incorporated in the fair value of derivative instruments?
Solution:
Yes, to the extent that such credit risk affects the price that would be received to sell a derivative in an asset position (or paid to transfer a derivative in a liability position) in an orderly transaction between market participants. IFRS 13 states that, in determining fair values of the asset or liability which has a specified (contractual) term that use Level 2 inputs that are not quoted in an active market, credit risk would generally be built into a valuation model.
Counterparty credit risk typically arises where a derivative is in an asset position at the reporting date.
Fair value takes into account any restrictions on the sale or use of an asset if those restrictions relate to the asset rather than to the holder of the asset, and a market participant would take those restrictions into account in determining the price that he is prepared to pay.
Impact of restrictions on the sale of an equity instrument
This example has been reproduced from IFRS 13:
“An entity holds an equity instrument (a financial asset) for which sale is legally or contractually restricted for a specified period. (For example, such a restriction could limit sale to qualifying investors.) The restriction is a characteristic of the instrument and, therefore, would be transferred to market participants. In that case the fair value of the instrument would be measured on the basis of the quoted price for an otherwise identical unrestricted equity instrument of the same issuer that trades in a public market, adjusted to reflect the effect of the restriction. The adjustment would reflect the amount market participants would demand because of the risk relating to the inability to access a public market for the instrument for the specified period. The adjustment will vary depending on all the following:
a) the nature and duration of the restriction;
b) the extent to which buyers are limited by the restriction (for example, there might be a large number of qualifying investors); and
c) qualitative and quantitative factors specific to both the instrument and the issuer.”
Transaction costs when determining price
Transaction costs are: “the 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 an asset or the transfer of 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).”
Fair value should not be adjusted for transaction costs, which are accounted for by other IFRSs.
Considerations specific to non-financial assets: highest and best use
Meaning of ‘highest and best use’
A fair value measurement of a non-financial asset is based on its highest and best use (see below). This concept is not relevant for financial assets, liabilities, or an entity’s equity instruments because those items do not have alternative uses as contemplated in IFRS 13.
When measuring the fair value of a non-financial asset, an entity is required to take into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use.
The highest and best use of a non-financial asset is defined as “the use of a non-financial asset by market participants that would maximize the value of the asset or the group of assets and liabilities (e.g., a business) within which the asset would be used”.
The highest and best use takes into account the use of the non-financial asset that is: physically possible (taking into account the physical characteristics of the asset that market participants would consider when pricing the asset – e.g., the location or size of a property);
- legally permissible (taking into account any legal restrictions on the use of the asset that market participants would consider when pricing the asset – e.g., the zoning regulations applicable to a property); and
- financially feasible (taking into account whether use of the asset that is physically possible and legally permissible generates an adequate investment return that market participants would require from an investment in that asset put to that use).
For the final bullet above, the income or cash flows producing the investment return should take into account the costs of converting the asset to that use.
Meaning of ‘legally permissible’
In the context of IFRS 13, the question arises as to whether the term ‘legally permissible’ should be taken to refer to a use of the asset that is currently legally permitted, or should be more broadly interpreted to mean a use that may be permitted in the future.
This question is not specifically addressed in the body of IFRS 13, but it is referred to in the Basis for Conclusions, as follows.
“Some respondents asked for further guidance about whether a use that is legally permissible must be legal at the measurement date, or if, for example, future changes in legislation can be taken into account. The IASB concluded that a use of an asset does not need to be legal at the measurement date, but must not be legally prohibited in the jurisdiction (e.g., if the government of a particular country has prohibited building or development in a protected area, the highest and best use of the land in that area could not be to develop it for industrial use). The illustrative examples that accompany IFRS 13 show how an asset can be zoned for a particular use at the measurement date, but how a fair value measurement can assume a different zoning if market participants would do so (incorporating the cost to convert the asset and obtain that different zoning permission, including the risk that such permission would not be granted).”
This discussion clarifies that the term ‘legally permissible’ is not restricted to uses that are legal at the measurement date. For example, in the context of zoning regulations and depending on the rules in the particular jurisdiction, if a property is zoned only for commercial use at the measurement date, but market participants would take a potential change in use into account in pricing the property, the illustrative example set out in IFRS 13 indicates that such a potential change in use should be incorporated in the fair value measurement.
The key to determining whether a particular use should be considered to be legally permissible is set out in IFRS 13: “a use that is legally permissible takes into account any legal restrictions on the use of the asset that market participants would take into account when pricing the asset (e.g., the zoning regulations applicable to a property)”. In line with the general requirement under IFRS 13 to measure fair value using the assumptions that market participants would use, if market participants in pricing an asset would factor in the possibility that current legal restrictions might change in the future, then that potential for future changes in restrictions should be incorporated into the fair value measurement.
The example above deals with a scenario in which land currently used for industrial purposes could be developed as a site for residential use, and illustrates how to determine the highest and best use of the land by comparing the value of the land as currently used with its value as a vacant site for residential use. The example focuses on the determination of the highest and best use of the land – it does not address the implications for the measurement of any buildings on that land.
Highest and best use to be determined from the perspective of market participants
The highest and best use is determined from the perspective of market participants, even if the entity intends a different use. However, an entity’s current use of a non-financial asset is presumed to be its highest and best use unless market or other factors suggest that a different use by market participants would maximize the value of the asset.
IFRS 13 does not require an entity to perform an exhaustive search for other potential uses of a non-financial asset if there is no evidence to suggest that the current use of an asset is not its highest and best use. The Board concluded that an entity that seeks to maximize the value of its assets would use those assets at their highest and best use and that it would be necessary for an entity to consider alternative uses of those assets only if there was evidence that the current use of the assets is not their highest and best use (i.e., an alternative use would maximize their fair value).
There may be reasons why an entity intends not to use an acquired non-financial asset actively or according to its highest and best use (e.g., if an entity acquires an intangible asset solely to protect its competitive position by preventing others from using the intangible asset). Nevertheless, in such circumstances, the entity is required to measure the fair value of the asset assuming its highest and best use by market participants.
The requirements of IFRS 13, which are illustrated in the example below, are consistent with guidance already included in IFRS 3 regarding assets acquired in a business combination that the acquirer intends not to use or to use in a way that is different from the way other market participants would use them.
Example
Research and development project
An entity acquires a research and development (R&D) project in a business combination. The entity does not intend to complete the project. If completed, the project would compete with one of its own projects (to provide the next generation of the entity’s commercialised technology). Instead, the entity intends to hold (i.e., lock up) the project to prevent its competitors from obtaining access to the technology. In doing this, the project is expected to provide defensive value, principally by improving the prospects for the entity’s own competing technology. To measure the fair value of the project at initial recognition, the highest and best use of the project would be determined on the basis of its use by market participants. For example:
1. (a) The highest and best use of the R&D project would be to continue development if market participants would continue to develop the project and that use would maximise the value of the group of assets or of assets and liabilities in which the project would be used (i.e., the asset would be used in combination with other assets or with other assets and liabilities). That might be the case if market participants do not have similar technology, either in development or commercialised. The fair value of the project would be measured on the basis of the price that would be received in a current transaction to sell the project, assuming that the R&D would be used with its complementary assets and the associated liabilities and that those assets and liabilities would be available to market participants.
2. (b) The highest and best use of the R&D project would be to cease development if, for competitive reasons, market participants would lock up the project and that use would maximise the value of the group of assets or of assets and liabilities in which the project would be used. That might be the case if market participants have technology in a more advanced stage of development that would compete with the project if completed and the project would be expected to improve the prospects for their own competing technology if locked up. The fair value of the project would be measured on the basis of the price that would be received in a current transaction to sell the project, assuming that the R&D would be used (ie locked up) with its complementary assets and the associated liabilities and that those assets and liabilities would be available to market participants.
3. (c) The highest and best use of the R&D project would be to cease development if market participants would discontinue its development. That might be the case if the project is not expected to provide a market rate of return if completed and would not otherwise provide defensive value if locked up. The fair value of the project would be measured on the basis of the price that would be received in a current transaction to sell the project on its own (which might be zero).
Highest and best use as a stand-alone asset
If the highest and best use of the asset is on a stand-alone basis, the fair value of the asset is the price that would be received in a current transaction to sell the asset to market participants who would use the asset on a stand-alone basis.
Highest and best use as part of a group of assets or in combination with other assets and liabilities
If the highest and best use of the asset is in combination with other assets, or with other assets and liabilities, the fair value of the asset is the price that would be received in a current transaction to sell the asset assuming that the asset would be used with other assets, or with other assets and liabilities, and that those assets and liabilities would be available to market participants.
Therefore, in such circumstances, the price used would be the price for a sale to a market participant that has or can obtain, the other assets and liabilities needed to generate cash inflows by using the asset (i.e. its complementary assets and the associated liabilities).
When the highest and best use of a non-financial asset is in combination with other assets and liabilities, the liabilities associated with the asset and with the complementary assets include liabilities that fund working capital, but do not include liabilities used to fund assets other than those within the group of assets.
Assumptions about the highest and best use of a non-financial asset should be consistent for all the assets (for which highest and best use is relevant) of the group of assets, or the group of assets and liabilities, within which the asset would be used.
Even when it is considered that the highest and best use of a non-financial asset is in combination with other assets, or with other assets and liabilities, the unit of account for the fair value measurement is the unit of account specified in other IFRS Standards (which may be an individual asset). Specifically, the fair value measurement assumes that the market participant already holds the complementary assets and the associated liabilities and, therefore, that the non-financial asset is sold by itself.
It is assumed that the non-financial asset being measured at fair value is sold on its own (at the unit of account level) even if transactions in the asset are typically the result of sales of the asset as part of a group of assets or a business. Even when an asset is used in combination with other assets, the exit price for the asset is a price for that asset individually because a fair value measurement assumes that a market participant (buyer) of the asset already holds the complementary assets and the associated liabilities. Because the buyer is assumed to hold the other assets (and liabilities) necessary for the asset to function, that buyer would not be willing to pay more for the asset solely because it was sold as part of a group.
When measuring the fair value of a non-financial asset used in combination with other assets, or with other assets and liabilities, the effect of the requirements in IFRS 13 (as described above) depends on the circumstances. The fair value of the asset may be the same whether the asset is used on a stand-alone basis or in combination with other assets or with other assets and liabilities. That might be the case if the asset is a business that market participants would continue to operate. In such circumstances, the business should be valued in its entirety, thus reflecting the synergies that would be available to market participants.
The Standard provides the following examples of how an asset’s use in combination with other assets, or with other assets and liabilities, might be incorporated into a fair value measurement:
- It might be incorporated through adjustments to the value of the asset used on a stand-alone basis. That might be the case if the asset is a machine and the fair value measurement is determined using an observed price for a similar machine (not installed or otherwise configured for use), adjusted for transport and installation costs so that the fair value measurement reflects the current condition and location of the machine (installed and configured for use).
- It might be incorporated through the market participant assumptions used to measure the fair value of the asset. For example, if the asset works in progress inventory that is unique, and market participants would convert the inventory into finished goods, the fair value of the inventory would assume that market participants have acquired or would acquire any specialized machinery necessary to convert the inventory into finished goods.
- It might be incorporated into the valuation technique used to measure the fair value of the asset. That might be the case when using the multi-period excess earnings method to measure the fair value of an intangible asset because that valuation technique specifically takes into account the contribution of any complementary assets and the associated liabilities in the group in which such an intangible asset would be used.
- In more limited situations, when an entity uses an asset within a group of assets, the entity might measure the asset at an amount that approximates its fair value when allocating the fair value of the asset group to the individual assets of the group. That might be the case if the valuation involves real property and the fair value of improved property (i.e. an asset group) is allocated to its component assets (such as land and improvements).
The following example, reproduced from the illustrative examples accompanying IFRS 13, describes the measurement of the fair value of an asset that is used as part of a group of assets.
Example
Asset group
An entity acquires assets and assumes liabilities in a business combination. One of the groups of assets acquired comprises Assets A, B and C. Asset C is billing software integral to the business developed by the acquired entity for its own use in conjunction with Assets A and B (ie the related assets). The entity measures the fair value of each of the assets individually, consistently with the specified unit of account for the assets. The entity determines that the highest and best use of the assets is their current use and that each asset would provide maximum value to market participants principally through its use in combination with other assets or with other assets and liabilities (ie its complementary assets and the associated liabilities). There is no evidence to suggest that the current use of the assets is not their highest and best use.
In this situation, the entity would sell the assets in the market in which it initially acquired the assets (ie the entry and exit markets from the perspective of the entity are the same). Market participant buyers with whom the entity would enter into a transaction in that market have characteristics that are generally representative of both strategic buyers (such as competitors) and financial buyers (such as private equity or venture capital firms that do not have complementary investments) and include those buyers that initially bid for the assets. Although market participant buyers might be broadly classified as strategic or financial buyers, in many cases there will be differences among the market participant buyers within each of those groups, reflecting, for example, different uses for an asset and different operating strategies.
As discussed below, differences between the indicated fair values of the individual assets relate principally to the use of the assets by those market participants within different asset groups:
1. (a) Strategic buyer asset group. The entity determines that strategic buyers have related assets that would enhance the value of the group within which the assets would be used (ie market participant synergies). Those assets include a substitute asset for Asset C (the billing software), which would be used for only a limited transition period and could not be sold on its own at the end of that period. Because strategic buyers have substitute assets, Asset C would not be used for its full remaining economic life. The indicated fair values of Assets A, B and C within the strategic buyer asset group (reflecting the synergies resulting from the use of the assets within that group) are CU360, CU260 and CU30, respectively. The indicated fair value of the assets as a group within the strategic buyer asset group is CU650.
2. (b) Financial buyer asset group. The entity determines that financial buyers do not have related or substitute assets that would enhance the value of the group within which the assets would be used. Because financial buyers do not have substitute assets, Asset C (ie the billing software) would be used for its full remaining economic life. The indicated fair values of Assets A, B and C within the financial buyer asset group are CU300, CU200 and CU100, respectively. The indicated fair value of the assets as a group within the financial buyer asset group is CU600.
The fair values of Assets A, B and C would be determined on the basis of the use of the assets as a group within the strategic buyer group (CU360, CU260 and CU30). Although the use of the assets within the strategic buyer group does not maximise the fair value of each of the assets individually, it maximises the fair value of the assets as a group (CU650).
The highest and best use of a property is determined by reference to its use and not its classification. For example, if an entity uses the revaluation model in IAS 16 for its head office property, the determination of fair value will be based on whether the highest and best use of the property is as an office or for some other purpose, and not on whether the property is owner-occupied or investment property.
Management might presume that its current use of an asset is the highest and best use unless market or other factors suggest otherwise. An entity that seeks to maximize the value of its assets would use those assets at their highest and best use. Management considers alternative uses of those assets only if there is evidence that the current use of the assets is not their highest and best use. It would be unlikely for an asset’s current use not to be its highest and best use.
The highest and best use is determined from the perspective of market participants. It does not matter whether the entity intends to use the asset differently. For example, the entity could have made a defensive acquisition of a competing brand that it does not intend to use, to maintain or promote the competitive position of its brand. Despite its intentions, the entity measures the fair value of the competing brand, assuming its highest and best use by market participants.
The highest and best use of a non-financial asset might be on a stand-alone basis, or it might be achieved in combination with other assets and/or liabilities. In the latter case:
- Fair value is based on the use of the asset in such an asset/liability group. It is assumed that the asset would be used within such a group and that the other assets and liabilities would be available to market participants.
- The asset/liability group cannot include liabilities that are used to fund assets outside the asset/liability group.
- Assumptions about the highest and best use should be consistent for all nonfinancial assets in such an asset/liability group.
The fair value measurement assumes that the asset is sold in a manner that is consistent with the unit of account, and not as a group, because the market participant is assumed to have the other assets.
Where the highest and best use is in an asset/liability group, the synergies associated with the asset/liability group could be factored into the fair value of the individual asset in several ways.
Synergies in highest and best use
Synergies associated with an asset or liability group could be factored into the fair value of an individual asset in a number of ways, depending on the circumstances:
· Direct adjustments to fair value might be appropriate.
“If the asset is a machine and the fair value measurement is determined using an observed price for a similar machine (not installed or otherwise configured for use), adjusted for transport and installation costs so that the fair value measurement reflects the current condition and location of the machine (installed and configured for use).”
· Adjustment to market participant assumptions might be appropriate.
“For example, if the asset is work in progress inventory that is unique and market participants would convert the inventory into finished goods, the fair value of the inventory would assume that market participants have acquired or would acquire any specialised machinery necessary to convert the inventory into finished goods.”
· Adjustment via the valuation technique might be appropriate.
“When using the multi-period excess earnings method to measure the fair value of an intangible asset because that valuation technique specifically takes into account the contribution of any complementary assets and the associated liabilities in the group in which such an intangible asset would be used.”
· Allocation of fair value adjustments to individual assets might be appropriate.
“In more limited situations, when an entity uses an asset within a group of assets, the entity might measure the asset at an amount that approximates its fair value when allocating the fair value of the asset group to the individual assets of the group. That might be the case if the valuation involves real property and the fair value of improved property (i.e., an asset group) is allocated to its component assets (such as land and improvements).”
Considerations specific to liabilities and equity
Transfer of liabilities
The fair value of a financial or non-financial liability or an entity’s equity instrument assumes that the instrument is transferred to a market participant at the measurement date and not settled, canceled, or extinguished. The market participant transferee, in either case, is assumed to take on the rights and responsibilities associated with the instrument. Measurement on a settlement basis would probably be different from fair value at the measurement date. The likely timing, amount, and probability of settlement would be inputs into the fair value measure.
Difference between settlement and transfer value (1)
The previous IFRS definition of fair value required fair value for liabilities to be “the amount for which a liability could be settled, between knowledgeable willing parties …”. As liabilities could be ‘settled’ by extinguishing them or transferring them to another party, it was not clear whether settlement value referred to transfer value or the extinguishment value. IFRS 13 clarifies that the fair value is the transfer value rather than the extinguishment value.
Extinguishment value is generally not the transfer value. An additional risk premium above the expected pay-out might be required because of uncertainty about the ultimate amount of the liability (for example, asbestos liabilities and performance guarantees). The risk premium paid to a third party might differ from the settlement value that the direct counterparty would be willing to accept. In addition, the party assuming a liability might have to incur certain costs in order to manage the liability, or it might require a profit margin.
In practice, there might be significant differences between the settlement value and the transfer value. Among the differences is the impact of credit risk, which is seldom considered in the settlement of a liability.
For example, a financial institution transferee might be willing to assume nondemand deposit liabilities for less than the principal amount due to the depositors, because of the relatively low funding cost of such liabilities. In other instances, an additional risk premium above the expected pay-out might be required because of uncertainty about the ultimate amount of the liability (for example, unit-linked liabilities).
These factors might cause the transfer amount to differ from the settlement amount. In measuring liabilities at fair value, the reporting entity should assume that the liability is transferred to a credit-equivalent entity and that it continues after the transfer (that is, it is not settled). The hypothetical transaction used for valuation is based on a transfer to a credit-equivalent entity that is in need of funding and willing to take on the terms of the obligation.
Cost of settlement might only be one input when valuing a liability, because there might be other potential outcomes; for example, in the case of litigation, a party might challenge the claim or, in the case of an environmental liability, there could be multiple remediation approaches.
Liability and equity instruments held by other parties as assets
Observable active markets for liabilities and equities are much less likely to exist due to contractual and legal restrictions on liability and equity transfers. Even for quoted debt or equity securities, the market serves as an exit mechanism for the counterparty security holders rather than for the issuer. The quoted price, as a result, reflects the exit price for the investor rather than the issuer. When a quoted transfer price is not available for the issuer, but the instrument is held by another party as an asset, management should measure fair value from the asset holder’s perspective.
The fair value of the liability or equity instrument is derived by:
- Using the quoted price in an active market for the identical item held by another party as an asset (for example, actively quoted debt security prices).
- Using other observable inputs if the price in (a) is not available, such as the quoted price in an inactive market for the identical item held by another party as an asset (for example, quoted debt security prices in less active markets).
- Using another valuation technique if the observable inputs in (a) and (b) are not available, such as:
- an income approach − this approach uses a present value technique that takes into account the future cash outflows that a market participant would expect to receive from holding the liability or equity instrument as an asset.
- a market approach − under this approach, fair value is determined using quoted prices for similar liabilities or equity instruments held by other parties as assets.
Debt obligation measured at fair value using present value technique
On 1 January 20X1, entity C issues at par in a private placement a C2 million BBB-rated five-year fixed-rate debt instrument with an annual 10% coupon. Entity C designates this financial liability as at fair value through profit or loss.
At 31 December 20X1, entity C still carries a BBB credit rating. Market conditions, including available interest rates, credit spreads for a BBB-quality credit rating and liquidity, remain unchanged from the date when the debt instrument was issued. However, entity C’s credit spread has deteriorated by 50 basis points, because of a change in its risk of non-performance. After taking into account all market conditions, entity C concludes that, if it was to issue the instrument at the measurement date, the instrument would bear a rate of interest of 10.5%, or entity C would receive less than par in proceeds from the issue of the instrument.
The fair value of entity C’s liability is calculated using a present value technique. Entity C concludes that a market participant would use all of the following inputs (consistent with IFRS 13) when estimating the price that the market participant would expect to receive to assume entity C’s obligation:
· The terms of the debt instrument, including all of the following:
o coupon of 10%;
o principal amount of C2 million; and
o term of four years.
· The market rate of interest of 10.5% (which includes a change of 50 basis points in the risk of non-performance from the date of issue).
On the basis of its present value technique, entity C concludes that its liability’s fair value at 31 December 20X1 is C1,968,641.
Entity C does not include any additional input into its present value technique for risk or profit that a market participant might require for compensation for assuming the liability. Because entity C’s obligation is a financial liability, entity C concludes that the interest rate already captures the risk or profit that a market participant would require as compensation for assuming the liability. Furthermore, entity C does not adjust its present value technique for the existence of a restriction preventing it from transferring the liability.
An entity should adjust the quoted price of a liability or equity instrument held by another party as an asset only if there are factors specific to the asset that do not apply to the fair value measurement of the liability or equity instrument (for example, a restriction preventing the sale of the asset). There should be no separate inputs or adjustments to existing inputs for restrictions on the transfer of liabilities by the issuer of the liability in the measurement of the liability’s fair value. This is in contrast to the fair value from the perspective of the asset holder, which must take into account any restriction on the transfer of the asset by the asset holder.
Unit of account is also relevant. For example, a quoted debt security might be secured by a third-party guarantee. The quoted price of such a security would reflect the value of the guarantee. The issuer should exclude the effect of the guarantee from the quoted price, if the issuer is measuring only the fair value of its liability and the unit of account excludes the guarantee. If management uses the quoted price for a similar (but not identical) debt or equity instrument to value its debt, it would have to adjust for any differences in the characteristics between the debt or equity instruments. The price of the asset used to measure the fair value of the corresponding liability or equity instrument should not reflect the effect of a restriction preventing the asset’s sale. Factors that indicate that the price of the asset should be adjusted are:
- the quoted price relates to a similar but not identical asset, or
- the unit of account for the asset is not the same as for the liability.
Debt obligation with quoted price (a market approach)
On 1 January 20X1, entity B issues at par a C2 million BBB-rated exchange traded five-year fixed-rate debt instrument with an annual 10% coupon. Entity B designates this financial liability as at fair value through profit or loss.
On 31 December 20X1, the instrument is trading as an asset in an active market at C929 per C1,000 of par value, after payment of accrued interest. Entity B uses the quoted price of the asset in an active market as its initial input into the fair value measurement of its liability (C929 × (C2 million ÷ C1,000) = C1,858,000).
In determining whether the asset’s quoted price in an active market represents the liability’s fair value, entity B evaluates whether the asset’s quoted price includes the effect of factors not applicable to the fair value measurement of a liability. For example, the entity should consider whether the quoted price of the asset includes the effect of a third-party credit enhancement if that credit enhancement would be separately accounted for from the perspective of the issuer. Entity B determines that no adjustments are required to the asset’s quoted price.
Entity B concludes that the fair value of its debt instrument at 31 December 20X1 is C1,858,000.
Entity B categorises and discloses the fair value measurement of its debt instrument within Level 1 of the fair value hierarchy.
Liabilities not held by other parties as assets
Certain liabilities are not held by another party as an asset (for example, a decommissioning liability). The liability’s fair value is measured from the perspective of a market participant to whom the liability would be transferred. If a market is not available for the liability, a valuation technique is required to measure the liability’s fair value.
These valuation techniques can include a present value technique that considers either:
- the future cash outflows that a market participant would expect to incur in fulfilling the obligation, including the compensation that a market participant would require for taking on the obligation; or
- the amount that a market participant would receive to enter into or issue an identical liability, using the assumptions that market participants would use when pricing the identical item (for example, having the same credit characteristics) in the principal market (or, in its absence, the most advantageous market).
Present value calculations should reflect the future cash outflows that market participants would expect to incur in fulfilling the obligation. These cash outflows should include:
- market participants’ expectations about the costs of fulfilling the obligation; and
- the compensation that a market participant would require, which should include a return for:
- undertaking the activity − the market participant would expect compensation for fulfilling the obligation, as the participant will use valuable resources for this purpose; and
- assuming the risk associated with the obligation − for assuming the obligations, the market participant would usually require a risk premium to compensate for the risk that actual cash outflows might differ from those expected.
Risk premiums, to compensate for the risk assumed on the obligation, can be included by adjusting either the cash flows or the discount rate. However, the risk should not be double counted by adjusting both cash flows and discount rates for the same risk.
Non-financial liabilities might not have a contractual rate of return or an observable market yield. When measuring such liabilities at fair value, the various components of return might be indistinguishable (for example, when using the price that a third-party contractor would charge on a fixed fee basis). In other cases, the various components might require separate estimation (for example, when using the price that a third-party contractor would charge on a cost-plus basis). The objective is to determine what a potential market participant would require as compensation to take on the liability.
Decommissioning liability (1)
Assume that a factory is built on leased land that has to be returned to the owner in five years’ time without the factory building. The decommissioning liability would be the liability associated with the costs of demolishing the factory and making good the land. The decommissioning liability’s fair value might simply be the market rate that a demolition services provider would charge in order to agree, today, to take down the factory in five years’ time.
Non-performance risk
The liability’s fair value should reflect the effect of nonperformance risk, which is the risk that an entity will not fulfill an obligation. Non-performance risk includes the effect of credit risk, as well as any other factors that influence the likelihood of fulfilling the obligation. This applies to both financial and non-financial liabilities. Non-performance risk is assumed to be the same before and after the transfer of the liability. This concept assumes that the liability would transfer to a credit-equivalent entity.
Impact of credit risk on measurement of liabilities
Two entities might borrow the same amount of money for the same period. The fair value of those liabilities might well be substantially different, as illustrated below, because the fair value is significantly impacted by the credit risk of the borrower. That credit risk affects the interest rate that each entity will be charged.
Entities X and Y each enter into a contractual obligation to pay C500 in cash to entity Z in five years.
Entity X has an AA credit rating and can borrow at 6%.
Entity Y has a BBB credit rating and can borrow at 12%.
Entity X will receive about C374 in exchange for its promise (the present value of C500 in five years at 6%).
Entity Y will receive about C284 in exchange for its promise (the present value of C500 in five years at 12%).
The fair value of the liability to each entity (that is, the proceeds) incorporates that entity’s credit standing.
Elements of non-performance risk — risk associated with entity’s ability to deliver goods or perform services
The definition of non-performance risk clarifies that it encompasses an entity’s own credit risk (credit standing) and any other factors that might influence the likelihood that the obligation will be fulfilled. Therefore, in addition to an entity’s own credit risk, non-performance risk may include the risk associated with the entity’s ability to deliver goods or perform services.
For example, consider a contract for the delivery of a commodity (e.g. oil, natural gas or electricity) that is measured as a derivative liability at fair value in accordance with IFRS 9. When measuring the fair value of the liability, the entity is required to reflect its own credit risk (i.e. the risk that there will be financial loss for the counterparty because the entity fails to meet its financial obligation). In addition, there is the risk that the entity will not be able to obtain and deliver the commodity to the counterparty (e.g. because of supply issues for the commodity) which is also part of non-performance risk.
Such contracts may contain ‘make-whole’ or other default clauses to mitigate the risk of non-delivery because the entity would be required to compensate the counterparty for damages incurred if the entity is unable to deliver the commodity. The effect of such clauses will need to be considered in assessing the non-performance risk.
Impact of guarantee by acquirer on the fair value of an acquiree’s loan – example
Entity A acquires 100 per cent of Entity B from Entity C in a business combination. One of the identifiable liabilities of Entity B is a loan owed to a third party. The loan was originally guaranteed by Entity C as part of the loan terms. However, as a result of the business combination, the terms of the loan are revised so that Entity A becomes the guarantor of the loan (i.e. the guarantee by Entity A becomes part of the revised loan terms).
IFRS 3 requires that the third party loan is measured at fair value at the date of acquisition. The measurement requirements of IFRS 13 apply.
There are no quoted prices available for the transfer of an identical or a similar liability.
When measuring the fair value of the loan at the date of acquisition for the purpose of preparing consolidated financial statements, Entity A should take into account the effect of its own guarantee of the loan because the guarantee is part of the loan terms.
As discussed, IFRS 13 requires that when a quoted price for the transfer of an identical or a similar liability is not available, and the identical item is held by another party as an asset, an entity should measure the fair value of the liability from the perspective of a market participant that holds the identical item as an asset at the measurement date.
In the circumstances described, the loan is guaranteed by Entity A from the date of acquisition. From the perspective of a market participant holding the loan as an asset, the fact that the loan is guaranteed by Entity A would be taken into account when measuring the fair value of the loan receivable because the market participant would expect to recover the loan from Entity A if Entity B defaulted on the loan. Consequently, when measuring the fair value of the loan, a market participant would take into account (1) the credit standing of Entity B, and (2) the guarantee provided by Entity A.
This is also consistent with the requirement in IFRS 13 that an entity should take into account the effect of its own credit risk (credit standing) and any other factors that might influence the likelihood that the obligation will or will not be fulfilled.
Derivative liabilities and credit risk
Question:
How should credit risk be incorporated in the valuation of derivative liabilities?
Solution:
The entity’s own credit risk has to be incorporated into the derivative fair value when the derivative is in a liability position at the reporting date. This means that, under IFRS 13, an entity’s own credit risk will impact hedge effectiveness for both cash flow and fair value hedge relationships.
The counterparty close-out approach is prohibited. This approach reflects the amount that the entity would pay to settle the liability with the counterparty at the reporting date.
When using a valuation technique, entities need to take into account non-performance risk (for example, an entity’s own credit risk). IFRS 13 indicates that:
“the fair value of a liability reflects the effect of non-performance risk. Non-performance risk includes, but may not be limited to, an entity’s own credit risk. Non-performance risk is assumed to be the same before and after the transfer of the liability”.
Furthermore, IFRS 13 states that, for a liability, a fair value measurement using a present value technique captures elements from the perspective of market participants at the measurement date, such as the non-performance risk relating to that liability, including the entity’s (that is, the obligor’s) own credit risk.
The key principle is that fair value is the sale or transfer price from the perspective of market participants who owe the liability at the measurement date. It is based on the perspective of market participants rather than just the entity itself, so fair value is not affected by an entity’s intention towards the liability item that is being valued (for example, if the entity intends to settle the liability instead of transferring it to another party).
Derivative instruments have varying terms, and these terms need to be carefully evaluated in arriving at a valuation which complies with IFRS 13. Some of the factors that would reduce credit risk for a derivative might be:
· master netting arrangements that are effective on default;
· collateral arrangements; or
· termination provisions in derivative instruments.
The level of non-performance risk imputed into the fair value should be consistent with the unit of account. For example, the effect of third-party credit enhancements should be excluded if the credit enhancement is accounted for separately from the liability.
A third-party credit enhancement is excluded, because the liability issuer does not obtain the benefit of it, whereas the asset holder does. The issuer has to pay the entire liability unless it goes bankrupt, irrespective of the third-party credit enhancement. So, in certain circumstances, the asset holder is allowed to consider the enhancement in its fair value, whereas the liability issuer is not. However, IFRS 13 does not specify whether the credit enhancement should or should not be accounted for separately from the liability. That is determined based on other IFRSs.
Third-party enhancements: measurement of demand deposit liabilities
Question:
How should demand deposit liabilities be measured?
Solution:
A demand deposit represents a promise by the deposit-taking institution to deliver cash either to the depositor or to third parties designated by the depositor. It imposes a contractual obligation that is a financial liability. A typical example is a current account in a bank. The current account holder can demand settlement at any time, and the bank generally has the right to return the depositor’s money at any time (even though that right is seldom exercised). It is argued that the fair value of the financial liabilities with a demand feature is less than the demand amount, because not all depositors withdraw their money at the earliest opportunity. Often, there is a core of deposits (withdrawals replaced by new deposits) that is left outstanding for long periods of time.
The fair value of a financial liability with a demand feature cannot be less than the amount payable on demand, discounted from the first date that the amount could be required to be repaid. In many cases, the market price observed for such financial liabilities is the price at which they are originated between the customer and the deposit-taker (that is, the demand amount). Recognising such a financial liability at less than the demand amount will give rise to an immediate gain on the origination of such a deposit, which is inappropriate.
Effect of collateral on fair value measurement of liabilities
When an entity has provided collateral in respect of a liability, this will affect the fair value measurement of the liability under IFRS 13. As discussed, IFRS 13 requires that the fair value of a liability should reflect the effect of non-performance risk, and that non-performance risk is assumed to be the same before and after the transfer of the liability. The definition of non-performance risk in IFRS 13 clarifies that it encompasses an entity’s own credit risk (credit standing) and any other factors that might influence the likelihood that the obligation will be fulfilled. One factor specifically mentioned in IFRS 13 is “the terms of credit enhancements related to the liability, if any”.
Collateral is a form of credit enhancement that is contractually linked to a liability (i.e. the terms of the obligation require a lien on the collateral until settlement of the obligation). The fact that an entity has provided collateral typically means that the stated terms of the liability (e.g. the interest rate charged) differ from the terms of an identical liability that is not supported by collateral. The collateral is a characteristic of the liability and, consequently, it should be reflected in the fair value measurement of the collateralised liability.
For example, on 1 January 20X1, Company A borrows CU10 million repayable in five years. The fixed interest rate is 1-year LIBOR plus 125 basis points. Company A is required to pledge specified property interests as collateral. Management estimates that Company A could have arranged a similar loan with no collateral at a 200 basis point spread to LIBOR. On 1 January 20X1, the 1-year LIBOR rate is 1.5 per cent. For simplicity, transaction costs are ignored.
At 1 January 20X1, the fair value of the loan (including any impact from the collateral) is CU10 million. The present value of the loan’s contractual cash flows, discounted at Company A’s unsecured borrowing rate of 3.5 per cent (i.e. 1.5 per cent LIBOR plus 200 basis points), is CU9.7 million.
This example illustrates that the effect of an issuer’s credit standing as well as the effect of credit enhancements should be taken into account in measuring the fair value of the liability. If Company A ignored the reduction in the interest rate attributable to the collateral, it would mistakenly conclude that the fair value of its debt was CU9.7 million rather than CU10 million.
Effect of a decline in the fair value of collateral – example
On 1 January 20X1, Company B issues CU100 million of bonds collateralised by a portion of its aircraft fleet. On 30 September 20X3, there has been a substantial decline in the fair value of the aircraft that serve as collateral for the bonds. Assume that Company B’s credit standing remains unchanged and all other stated terms of the bonds represent current market conditions for the remaining term of the obligation.
When measuring the fair value of the bonds at 30 September 20X3, Company B must do so from the perspective of a market participant that holds the bonds as an asset (i.e. a bondholder). A market participant would reflect the reduced level of collateral in the price at which a transfer of the bond would take place.
Company B determines that the hypothetical market participant would be willing to transfer the liability for only CU80 million. In other words, the fair value of the bonds has decreased by CU20 million due to the decline in value of the collateral even though Company B’s credit standing remains unchanged.
Effect of a decline in the borrower’s credit standing – example
The facts are the same as, except that, at 30 September 20X3, the fair value of the aircraft pledged as collateral remains unchanged. Instead, the credit standing of Company B has declined from AAA to AA-.
When measuring the fair value of the bonds at 30 September 20X3, Company B is required to consider the effect of the decline in its credit standing but also the fact that the fair value of the collateral has not changed.
Company B observes that the wider credit spread for uncollateralised AA- corporate bonds suggests that the fair value of the bonds has declined by 10 per cent (i.e. to CU90 million). However, because the fair value of the collateral has not changed, the note remains well collateralised. Consequently, the fair value of the note may not have declined by as much as 10 per cent. Company B determines that the increase in non-performance risk arising from the decline in its own credit standing is partially offset by the collateral. Based on credit spreads observed for similar, collateralised bonds, Company B concludes that the fair value of the notes has decreased by CU7 million to CU93 million.
Shareholders’ equity
The principles in IFRS 13 also apply to shareholders’ equity. An example of this is where equity interests are issued as consideration in a business combination. The valuation model of instruments classified within shareholders’ equity has become consistent with the requirements for measuring the fair value of liabilities. The guidance specifies that an entity should measure the fair value of its equity instruments from the perspective of a market participant who holds the instrument as an asset. Similar to the application to liabilities, where equity instruments are not held by other parties as assets, an entity should use a valuation technique using market participant assumptions.
Step 3: Determine the market
Management determines fair value based on a transaction that would take place in the principal market or, in its absence, the most advantageous market.
Management should evaluate the level of activity in various markets. The entity does not have to undertake an exhaustive search of all possible markets to identify the principal or most advantageous market. It should take into account all readily available information. The market in which an entity normally transacts is presumed to be the principal market or, in its absence, the most advantageous market, in the absence of other evidence.
Principal market
The principal market is the market with the greatest volume and level of activity for the asset or liability.
If there is a principal market, the price in that market must be used, even if prices in other markets are more advantageous. The transactions to which management refers, in establishing the price in that market, could be actual or hypothetical.
Most advantageous market
The most advantageous market is the 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.
Determination of most advantageous market for convertible debt
An entity holds a convertible debt that is carried at fair value. The convertible debt is not quoted in an active market, but the equity securities of the issuer are.
In determining the convertible debt’s fair value, it is necessary to consider both the redemption of the debt and the conversion into equity securities of the issuer.
If the convertible debt is out of the money, the most advantageous market might be based on redemption of the debt for cash. If the convertible debt is in the money and can be exercised, the most advantageous market might be to assume conversion and sale of the underlying shares.
An adjustment might be necessary to reflect the probability of exercise. The entity should also consider the convertible debt’s value, which might be at a premium to the ‘if converted’ shares, due to the combination of the convertible debt’s yield and the option value of the conversion feature.
Principal or most advantageous market
In a territory, there are two available markets for soya bean:
a. Export: this is the market where the higher prices would be available for the producer. There are limitations in the volumes that can be sold in this market, because the government sets a limit on the volume of exports. Each producer needs to obtain an authorisation to export its production. It is rare for the government to authorise more than 25% of production for export.
b. Domestic: the prices are lower in this market than in the export market, but there are no restrictions in terms of volume (other than the demand for the product by purchasers).
Producers intend to sell all of the production that they can in the export market. When they do not have any further authorisation to export, they sell the remaining production in the domestic market.
The domestic market is the principal market for the producers, in terms of volume, and so it is the one which should be used to determine fair value.
The export market is the most advantageous market, because this is the one that gives the higher benefits to the producers. If no principal market could be identified, the prices in this market would need to be used.
Management evaluates all potential markets in which it could reasonably expect to sell the asset or transfer the liability, to determine the most advantageous market. For non-financial assets, identifying potential markets will be based on the ‘highest and best use’ valuation premise, from the perspective of market participants. To determine the highest and best use of a non-financial asset, the reporting entity might need to consider multiple markets. Most non-financial assets are already employed in their ‘highest and best use’, so this requirement is not as onerous as it might seem.
Producer has access to more than one market
Question:
An entity is in the business of growing and harvesting sugar cane. Along with other local growers, it sells the harvested cane to the local mill. There are other mills located throughout the country. However, it is uneconomic to transport the sugar cane to other mills, although they often pay higher prices for the cane. Which market price should the entity use to establish fair value?
Solution:
IFRS 13 presumes that the market in which the entity would normally sell its assets is the principal market for those assets. Unless there is clear evidence to the contrary, the local mill would be considered the principal market for the harvested sugar cane, and the entity should use the local market price as the basis for determining fair value.
Transaction costs when determining the most advantageous market
Fair value should not be adjusted for transaction costs. Transaction costs do not include transport costs under IFRS 13. Fair value should be adjusted for transport costs if location is a characteristic of the asset (for example, a commodity). Transaction costs are considered only in determining the most advantageous market.
Impact of transaction and transport costs on fair value
An entity has an asset that can be sold in two different markets, with similar volume of activities but with different prices. The entity enters into transactions in both markets, and it can access the price in those markets for the asset at the measurement date. There is no principal market for the asset.
Market A (C) Market B (C) Price 27 25 Transport costs (3) (2) 24 23 Transaction costs (3) (1) Net amount received 21 22 1. Determine the most advantageous market
A principal market for the asset does not exist, so 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 (that is, the net amount that would be received in the respective markets).
Therefore, market B is the most advantageous market, since the entity would maximise the net amount that would be received for the asset in market B (C22).
1. Determine the fair value in this market, after transport costs
The fair value of the asset is measured using the price in market B (C25), less transport costs (C2), resulting in a fair value measurement of C23.
Transaction costs are not considered when estimating the fair value.
If market A had been the principal market for the asset (that is, the market with the greatest volume and level of activity for the asset), the asset’s fair value would be measured using the price that would be received in that market, after taking into account transport costs (C24). The same applies for market B (C23).
Impact of transport costs when determining fair value
Entity A purchased cattle at an auction on 30 June 20X8.
Purchase price at 30 June 20X8 C100,000 Costs of transporting the cattle back to the entity’s farm C1,000 Sales price of the cattle at 31 December 20X8 C110,000 The company would have to incur similar transportation costs if it were to sell the cattle at auction, in addition to an auctioneer’s fee of 2% of sales price.
Initial recognition Fair value less costs to sell (C100,000 – C1,000 – C2,000) C97,000 Cash outflow (C100,000 + C1,000+ C2,000) C103,000 Loss on initial recognition C6,000 Measurement at year end Fair value less costs to sell (C109,000 – (2%*110,000)) C106,800 By 31 December 20X8, the cattle should be measured in entity A’s financial statements at C106,800 (that is, fair value of C109,000 less the estimated auctioneer’s fee of C2,200). The estimated transportation costs of getting the cattle to the auction of C1, 000 are deducted from the sales price in determining fair value.
Market accessibility
Eligible markets are restricted to those that the entity can access at the measurement date. Because different reporting entities might have access to different markets, the principal or most advantageous markets could vary between reporting entities. Also, an entity might have several different activities that use different markets for the same assets or liabilities. There is no need to identify one principal, or most advantageous, market for the whole entity; each different business unit within the entity could have its principal or most advantageous market.
Although an entity must be able to access the market, it 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.
Access to principal market
A commodities trader has a reporting date of 31 December 20X0, which falls on a Saturday. The commodities trader holds commodity X. The trader has access to both retail and wholesale markets for commodity X.
The principal market is the wholesale market, because that is the market with the greatest volume and level of activity for the commodity. However, the retail market selling prices are usually higher. The wholesale market only trades on weekdays, whereas the retail market trades also on Saturdays.
What value should the commodities trader use as the fair value of the commodities?
The commodities trader is not allowed to use the higher retail price as the fair value of the commodities merely because the wholesale market (that is, the principal market) does not trade on the measurement date.
There might be no known or observable market for an asset or liability. Management should first identify potential market participants (for example, strategic and financial buyers) and then develop a hypothetical market based on the expected assumptions of those market participants.
Step 4: Determine the valuation techniques for measuring fair value
There are three main approaches to measuring the fair value of assets and liabilities: the market approach, the income approach, and the cost approach. These approaches apply to both financial instruments and non-financial items.
Selection of valuation techniques
The valuation technique selected should:
- Be appropriate in the circumstances.
- Be a technique for which sufficient data is available.
- Maximize the use of relevant observable inputs and minimize the use of unobservable inputs.
Definition of inputs
Inputs are defined as “the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk, such as the following:
(a) the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model); and
(b) the risk inherent in the inputs to the valuation technique”.
Inputs may be observable or unobservable. Valuation techniques used to measure fair value are required to maximize the use of relevant observable inputs and minimize the use of unobservable inputs.
Observable valuation inputs are more reliable than those that are unobservable (sometimes referred to as ‘entity-specific’ because these inputs are derived by an entity rather than by the ‘market’).
The inputs used should be consistent with the characteristics of the asset or liability that market participants would take into account in a transaction for the asset or liability.
Observable inputs
Examples of markets in which inputs might be observable for some assets and liabilities include the following:
- Exchange markets In an exchange market, closing prices are both readily available and generally representative of fair value (e.g., the London Stock Exchange).
- Dealer markets In a dealer market, dealers stand ready to trade (either buy or sell for their account), thereby providing liquidity by using their capital to hold an inventory of the items for which they make a market. Typically, bid and ask prices (representing the price at which the dealer is willing to buy and the price at which the dealer is willing to sell, respectively) are more readily available than closing prices. Over-the-counter markets (for which prices are publicly reported) are dealer markets. Dealer markets also exist for some other assets and liabilities, including some financial instruments, commodities, and physical assets (e.g., used equipment).
- Brokered markets In a brokered market, brokers attempt to match buyers with sellers but do not stand ready to trade for their account. Brokers do not use their capital to hold an inventory of the items for which they make a market. The broker knows the prices bid and asked by the respective parties, but each party is typically unaware of another party’s price requirements. Prices of completed transactions are sometimes available. Brokered markets include electronic communication networks, in which buy and sell orders are matched, and commercial and residential real estate markets.
- Principal-to-principal markets In a principal-to-principal market, transactions (both originations and re-sales) are negotiated independently with no intermediary. Little information about those transactions may be made available publicly.
Applying a premium or discount
In some cases, the characteristics of an asset or a liability that market participants would take into account in a transaction for the asset or liability result in the application of an adjustment, such as a premium or discount (e.g., a control premium or non-controlling interest discount). However, a fair value measurement should not incorporate a premium or discount that is inconsistent with the unit of account in the IFRS that requires or permits the fair value measurement.
Premiums or discounts that reflect size as a characteristic of the entity’s holding (specifically, a blockage factor that adjusts the quoted price of an asset or a liability because the market’s normal daily trading volume is not sufficient to absorb the quantity held by the entity) are not permitted in a fair value measurement.
For example, an investor holding one share that is quoted in an active market may receive a different amount of consideration per share compared to an investor that sells 15 percent of the total equity shares. The difference between the two holdings is simply the size of the investor’s holding, which is typically not a characteristic of the financial asset and thus is not considered in the fair value measurement in this circumstance. For both investors, the fair value measurement of the shares is the price for disposing of a single share multiplied by the quantity held.
In contrast, when measuring the fair value of a controlling interest, it is appropriate to incorporate a control premium because IFRS 13 regards the control premium as a characteristic of the asset or liability.
In all cases, if there is a quoted market price in an active market for an asset or a liability, the entity should use that price without adjustment when measuring fair value, except as specified in IFRS 13.
Markets where input can be observable
Examples of markets in which inputs might be observable include exchange markets, dealer markets, brokered markets and principal-to-principal markets, which are explained in IFRS 13:
“a) Exchange markets.
In an exchange market, closing prices are both readily available and generally representative of fair value. An example of such a market is the London Stock Exchange.
b) Dealer markets. In a dealer market, dealers stand ready to trade (either buy or sell for their own account), thereby providing liquidity by using their capital to hold an inventory of the items for which they make a market. Typically bid and ask prices (representing the price at which the dealer is willing to buy and the price at which the dealer is willing to sell, respectively) are more readily available than closing prices. Over-the-counter markets (for which prices are publicly reported) are dealer markets. Dealer markets also exist for some other assets and liabilities, including some financial instruments, commodities and physical assets (for example, used equipment).
c) Brokered markets. In a brokered market, brokers attempt to match buyers with sellers but do not stand ready to trade for their own account. In other words, brokers do not use their own capital to hold an inventory of the items for which they make a market. The broker knows the prices bid and asked by the respective parties, but each party is typically unaware of another party’s price requirements. Prices of completed transactions are sometimes available. Brokered markets include electronic communication networks, in which buy and sell orders are matched, and commercial and residential real estate markets.
d) Principal-to-principal markets. In a principal-to-principal market, transactions, both originations and re-sales, are negotiated independently with no intermediary. Little information about those transactions may be made available publicly.”
Effect of credit risk on the fair value of financial instruments
Question:
How should entities measure the effect on fair value of credit risk?
Solution:
IFRS 13 states that the best evidence of fair value is quoted prices in active markets and, if such a quoted price is available, it should be used. However, it is rare for such quoted prices to be available for derivatives, because they are rarely transferred from one entity to another.
In the absence of quoted prices in active markets, the entity uses a valuation technique. The objective is to establish what the transaction price would have been on the measurement date in an orderly transaction between market participants. Hence, the valuation includes adjustments for credit risk that market participants would make. It should be noted that the size of such adjustments might vary between different kinds of derivatives, and between markets or jurisdictions, and is a matter for audit judgement. In estimating the size of the adjustment for any particular derivative, the entity considers all relevant market information that is available. This includes factors such as:
· Information about the pricing of new derivatives that are similar to the one being valued and the extent to which the pricing of such derivatives varies with the credit risk of the parties to it.
· Whether market participants are taking other actions to mitigate credit risk (for example, requiring collateral to be posted).
· The results of models and how they correspond to observed prices for actual transactions.
· The extent to which credit risk is already reflected in the valuation model and assumptions. For example, if a derivative valuation uses a LIBOR discount rate, this will incorporate the credit risk inherent in LIBOR. However, it might be the case that this differs from the credit risk inherent in the derivative being valued. Also, some derivative valuations use discount rates other than LIBOR (for example, overnight indexed swap) that have less credit risk inherent in them.
(i) The effect of the entity’s own credit risk from the perspective of market participants, and any other factors that might influence the likelihood that the obligation will or will not be fulfilled. That effect might differ, depending on the terms of credit enhancements related to the liability, if any. The following factors are considered: (i) the liability is transferred to a market participant at the measurement date and the liability would remain outstanding; (ii) the market participant transferee would be required to fulfil the obligation; (iii) the liability would not be settled with the counterparty or otherwise extinguished at the measurement date; and (iv) non-performance risk is assumed to be the same before and after the transfer of the liability.
Where a derivative is in a large asset position relative to future reasonably possible changes in its fair value, the instrument tends to act more like a loan than a newly transacted on-market derivative. In such cases, an appropriate spread to include in the valuation is likely to tend towards the credit default swap (‘CDS’) rate of the derivative counterparty (or, if not available, then use whatever the best information is available that reflects the credit risk, such as bond spreads, ratings, comparable instruments or other published information). On the other hand, where the derivative is in a relatively small asset position, the instrument tends to act more like a newly transacted derivative than a loan. In such cases, it would be more appropriate to use the spread applied in pricing new on-market derivatives that are similar to the one being valued. Similar considerations would apply to derivative liabilities.
Credit risk adjustments on a portfolio basis
Question:
Can the credit risk adjustment be calculated on a portfolio basis?
Solution:
Multiple contracts, involving a single counterparty, can be grouped together in determining the credit risk adjustment, to the extent that the contracts are covered under one master netting agreement. The netting agreement results in a credit risk exposure based on the ‘net’ position rather than at the contract level. In such cases, the credit risk adjustment should be calculated on a portfolio basis, including all exposures under the ISDA master agreement, and then allocated to each transaction. The allocation method used should be appropriate for the entity’s fact pattern – potential methods might be relative fair value approach, relative credit adjustment approach, or in-exchange/ ‘full credit’ approach. The method selected should be consistently applied and clearly disclosed.
The valuation technique should be consistent 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.
It might be appropriate to use multiple valuation techniques; in which case, the reasonableness of the results of the various measurement techniques will have to be evaluated. The valuation result or point within the range of values that is most representative of fair value in the circumstances is used.
Valuation techniques should be applied consistently year on year unless alternative techniques provide an equally or more representative indication of fair value. This also applies to any weightings which might be applied to the results of multiple valuation techniques. Any changes are regarded as changes in accounting estimates, although the IAS 8 disclosures are not required.
The following events might necessitate changes in techniques/weightings:
- new markets develop;
- new information becomes available;
- information previously used is no longer available;
- valuation techniques improve; or
- market conditions change.
Valuation techniques
Valuation techniques required to maximize the use of observable inputs
An entity is required to use valuation techniques that are appropriate in the circumstances and for which sufficient data are available to measure fair value, maximizing the use of relevant observable inputs and minimizing the use of unobservable inputs.
Meaning of valuation ‘technique’
When the price for an asset or a liability cannot be observed directly, it must be estimated using a valuation technique. When used in the context of fair value measurement, ‘valuation technique’ is a generic term and its application is not limited to complex fair valuation models. For example, valuing an asset or a liability using quoted prices in an active market for identical assets and liabilities is a valuation technique. In other cases, when prices cannot be observed directly and more judgement is required, it will be appropriate to use more complex valuation techniques.
Observable inputs are defined as “[i]nputs that are developed using market data, such as publicly available information about actual events or transactions, and that reflect the assumptions that market participants would use when pricing the asset or liability”.
Unobservable inputs are defined as “[i]nputs for which market data are not available and that are developed using the best information available about the assumptions that market participants would use when pricing the asset or liability”.
Widely used valuation techniques
IFRS 13 refers to three widely used valuation techniques:
- the market approach;
- the cost approach (sometimes referred to as ‘replacement cost’); and
- the income approach
Any valuation technique used to measure fair value should be consistent with one or more of the above approaches.
Selecting an appropriate valuation technique
IFRS 13 does not set out a hierarchy of valuation techniques; this is because particular valuation techniques may be more appropriate in some circumstances than in others.
Each valuation technique has its own merits and may or may not be suitable for measuring the fair value of a specified item or items in particular circumstances. In practice, different valuation techniques can give rise to different estimates of fair value and, therefore, it is important to select the most appropriate methodology for the particular circumstances.
Choosing a valuation technique requires judgement and involves the selection of a method, formulae and assumptions. The reliability of a fair value measurement derived from a valuation technique is dependent on both the reliability of the valuation technique and the reliability of the inputs used. Consequently, when selecting a valuation technique, it will be important to consider the availability of reliable inputs for that valuation. In addition to selecting a technique that maximises the use of relevant observable inputs and minimises the use of unobservable inputs, an entity must also ensure that the best possible evidence is used to support unobservable inputs.
In assessing the appropriateness of each valuation technique, an entity should also evaluate all available inputs significant to the valuation technique and compare the technique with other valuation techniques. For example, in a given situation, an entity may conclude that it is appropriate to use a market approach rather than an income approach because the market approach uses superior market information as inputs.
An entity should consider using a valuation specialist, when appropriate.
Selecting an appropriate valuation technique or techniques for unquoted equity securities – example
Company A holds equity investments in two entities – Company B and Company C. Company A measures these investments at fair value on a recurring basis.
- Company B is a clothing retailer that operates in the niche market of the baby clothing industry. Quoted prices are not available for Company B’s shares. Most of Company B’s competitors are either privately held or are subsidiaries of larger publicly traded clothing retailers. Company B is similar to two other organisations, whose shares are thinly traded in an observable market.
- Company C is a retailer that operates in the competitive consumer electronics industry. Although quoted prices are not available for Company C’s shares, Company C is comparable to many entities whose shares are actively traded.
Because the prices of Company B’s and Company C’s shares cannot be observed directly, Company A must measure the fair value of these investments using a valuation technique (or techniques).
Company A is considering a market approach, an income approach or a combination of these two approaches. The market approach and the income approach are common valuation techniques for equity investments that are not publicly traded. Under the market approach, entities use prices and other relevant information generated by market transactions involving identical or comparable securities. Under the income approach, future amounts are converted into a single present amount (e.g.,. discounted cash flows model). Company A is not considering the cost approach to value its equity securities because it is not considered relevant.
Company A should select the valuation technique (or techniques) that is (are) appropriate in the circumstances and for which sufficient data are available to measure fair value, maximising the use of relevant observable inputs and minimising the use of unobservable inputs.
Investment in Company B
Using a market approach, the fair value measurement of Company A’s investment in Company B would involve an analysis of market prices and other relevant information for the two similar organisations that are traded (albeit thinly) in an observable market. It is likely that the observable market data would need to be adjusted to reflect differences between Company B and the two similar organisations that are traded. For example, Company A might consider that market participants would incorporate significant entity-specific adjustments into the valuation of Company B’s shares (e.g.,. adjustments to reflect the relative illiquidity of Company B’s shares, profitability, net assets, unrecognised assets such as internally generated intangible assets, and differences in business model between Company B and the two traded organisations). These adjustments would be made using Company A’s own assumptions. Consequently, in such circumstances, a market approach would rely on unobservable inputs that are significant to the fair value measurement.
Using an income approach based on discounted cash flows, the fair value measurement of Company A’s investment in Company B would also be based on significant entity-specific assumptions in forecasting Company B’s future cash flows. As a result, the income approach would also rely on unobservable inputs that are significant to the fair value measurement.
Based on the above information, it is likely that Company A would conclude that both the market approach and the income approach are appropriate techniques for measuring the fair value of its investment in Company B. In making its selection, Company A would consider the reliability of the evidence supporting the inputs used in each of the valuation techniques. Provided that relevant and reliable inputs are available, and there are no other factors indicating that one of the approaches is superior, it would seem appropriate to use a combination of both approaches, even if one approach is used only to corroborate the results of the other.
Investment in Company C
When selecting an appropriate approach to measure the fair value of its investment in Company C, Company A should perform an analysis similar to that outlined for Company B.
Using a market approach, it is more likely that market participants would incorporate fewer unobservable adjustments into the valuation of Company C’s shares because of the large number of comparable traded entities and the high trading volume of the shares of those comparable entities. However, Company A should consider whether to make an adjustment for illiquidity to reflect the fact that Company C’s shares are unquoted whereas those of comparable entities in the same sector are listed and actively traded.
Using an income approach based on discounted cash flows, the fair value measurement of Company A’s investment in Company C would be based on forecasted future cash flows. This forecast would include projections of future profitability and, therefore, would be likely to include entity-specific assumptions that are not observable.
As a result, it is likely that Company A would conclude that it is appropriate to measure the fair value of its investment in Company C using the market approach because it uses more observable inputs (i.e. in terms of the hierarchy described, ‘Level 2’ inputs rather than ‘Level 3’ inputs) with a significant effect.
Valuation techniques – market approach
The market approach is a valuation technique that uses prices and other relevant information derived directly from publicly available information about relevant market transactions. Those market transactions should involve identical or comparable (that is, similar) assets, liabilities, or businesses. The market approach might also be relevant for non-financial assets, such as unlisted equities or land and buildings. Some unquoted equity securities might be fairly valued using earnings per share multiples derived from comparable quoted equity securities. Land and buildings might be fairly valued by reference to prices achieved in sales of comparable properties.
Examples of market approaches include:
- Valuation techniques using market multiples derived from comparable transactions.
- Matrix pricing – a mathematical technique used principally to value some types of financial instruments, such as debt securities, without relying exclusively on quoted prices for the specific securities, but rather relying on the securities’ relationship to other benchmark quoted securities.
Valuation techniques – income approach
The income approach uses a cash flow model, discounted to present value to a single amount. The model is constructed using current market expectations about those future cash flows.
Examples of the income approach include:
- Present value techniques.
- Multi-period excess earnings method (MEEM).
- Option pricing models. These include the Black-Scholes-Merton formula and binomial models that incorporate present value techniques and reflect both time value and an option’s intrinsic value.
Use of discounted cash flows; present value techniques
Present value techniques are a type of income approach whereby future amounts, such as expected future cash flows, are linked to the present value using an appropriate discount rate. An entity generally determines expected cash flows relating to an asset/liability and adjusts these cash flows using an appropriate discount rate. IFRS 13 neither prescribes the use of one single specific present value technique nor limits the use of present value techniques to measure fair value, instead indicating that a reporting entity should use the appropriate technique, based on facts and circumstances specific to the asset or liability being measured and the market in which it is transacted.
The following key elements, from the perspective of market participants, should be captured in developing a fair value measurement using present value:
- an estimate of future cash flows; expectations about possible variations in the amount and timing of cash flows;
- the time value of money, based on the risk-free rate for monetary assets with maturity dates or durations that coincide with the period covered by the cash flows and that pose neither uncertainty in timing nor the risk of default to the holder (that is, a ‘risk-free’ interest rate);
- a risk premium due to uncertainty and illiquidity; other factors that market participants would take into account in the circumstances; and
- for a liability, the risk of non-performance, including the reporting entity’s own credit risk.
The general principles that govern the application of all present value techniques are:
- Cash flows and discount rates should reflect assumptions that market participants would use when pricing the asset or liability.
- Cash flows and discount rates should take into account only the factors attributable to the asset or liability being measured.
- To avoid double counting or omitting the effects of risk factors, discount rates should reflect assumptions that are consistent with those inherent in the cash flows. For example, a discount rate that reflects the uncertainty in expectations about future defaults is appropriate if using the contractual cash flows of a loan (that is, a discount rate adjustment technique). That same rate should not be used if using expected (that is, probability-weighted) cash flows (that is, an expected present value technique) because the expected cash flows already reflect assumptions about the uncertainty in future defaults; instead, a discount rate that is commensurate with the fact that the cash flows have been adjusted for risk should be used.
- Assumptions about cash flows and discount rates should be internally consistent. For example, nominal cash flows, which include the effect of inflation, should be discounted at a rate that includes the effect of inflation. The nominal risk-free interest rate includes the effect of inflation. Real cash flows, which exclude the effect of inflation, should be discounted at a rate that excludes the effect of inflation. Similarly, after-tax cash flows should be discounted using an after-tax discount rate. Pre-tax cash flows should be discounted at a rate consistent with those cash flows.
- Discount rates should be consistent with the underlying economic factors of the currency in which the cash flows are denominated.
Components of a present value measurement
Present value is a tool used to link future amounts (e.g., cash flows or values) to a present amount using a discount rate. A fair value measurement of an asset or a liability using a present value technique captures all of the following elements from the perspective of market participants at the measurement date:
- an estimate of future cash flows for the asset or liability being measured;
- expectations about possible variations in the amount and timing of the cash flows representing the uncertainty inherent in the cash flows;
- the time value of money, represented by the rate on risk-free monetary assets that have maturity dates or durations that coincide with the period covered by the cash flows and pose neither uncertainty in timing nor risk of default to the holder (i.e. a risk-free interest rate);
- the price for bearing the uncertainty inherent in the cash flows (i.e. a risk premium);
- other factors that market participants would take into account in the circumstances; and
- for a liability, the non-performance risk relating to that liability, including the obligor’s own credit risk.
Components of a present value measurement – income tax deductions for depreciation or amortisation expense
When using post-tax cash flows (and a post-tax discount rate) to measure the fair value of a depreciable asset, an entity should include all relevant cash flows. These would include cash inflows resulting from future tax deductions for the asset’s depreciation or amortisation expense that a market participant would expect to receive. A market participant would expect to receive the future tax deductions if the depreciation or amortisation is deductible for tax purposes in the jurisdiction in which the transaction is entered into. Judgement will be required to determine which jurisdiction should be considered from a market participant perspective.
This conclusion is consistent with the following guidance in IVS 210 Intangible Assets issued by the International Valuation Standards Council.
“In many tax regimes, the amortisation of an intangible asset can be treated as an expense in calculating taxable income. This “tax amortisation benefit” can have a positive impact on the value of the asset. When an income approach is used, it will be necessary to consider the impact of any available tax benefit to buyers and make an appropriate adjustment to the cash flows.”
General principles underlying present value measurement
Present value techniques differ in how they capture the elements listed. However, all of the following general principles govern the application of any present value technique used to measure fair value:
- Cash flows and discount rates should reflect assumptions that market participants would use when pricing the asset or liability.
- Cash flows and discount rates should take into account only the factors attributable to the asset or liability being measured.
- To avoid double-counting or omitting the effects of risk factors, discount rates should reflect assumptions that are consistent with those inherent in the cash flows. For example, a discount rate that reflects the uncertainty in expectations about future defaults is appropriate if using contractual cash flows of a loan (i.e. a discount rate adjustment technique). That same rate should not be used if using expected (i.e. probability-weighted) cash flows (i.e. an expected present value technique) because the expected cash flows already reflect assumptions about the uncertainty in future defaults; instead, a discount rate that is commensurate with the risk inherent in the expected cash flows should be used.
- Assumptions about cash flows and discount rates should be internally consistent. For example, nominal cash flows, which include the effect of inflation, should be discounted at a rate that includes the effect of inflation. The nominal risk-free interest rate includes the effect of inflation. Real cash flows, which exclude the effect of inflation, should be discounted at a rate that excludes the effect of inflation. Similarly, after-tax cash flows should be discounted using an after-tax discount rate. Pre-tax cash flows should be discounted at a rate consistent with those cash flows.
Care should be taken in determining a pre-tax discount rate by adjusting a post-tax rate. Because the tax consequences of cash flows may occur in different periods, the pre-tax rate of return is not always the post-tax rate of return grossed up by the standard rate of tax.
- Discount rates should be consistent with the underlying economic factors of the currency in which the cash flows are denominated.
Risk and uncertainty
Risk and uncertainty – general
A fair value measurement using present value techniques is made under conditions of uncertainty because the cash flows used are estimates rather than known amounts. In many cases, both the amount and timing of the cash flows are uncertain. Even contractually fixed amounts, such as the payments on a loan, are uncertain if there is a risk of default.
Market participants generally seek compensation (i.e. a risk premium) for bearing the uncertainty inherent in the cash flows of an asset or a liability. A fair value measurement should include a risk premium reflecting the amount that market participants would demand as compensation for the uncertainty inherent in the cash flows. Otherwise, the measurement would not faithfully represent fair value. In some cases, determining the appropriate risk premium may be difficult. However, the degree of difficulty alone is not a sufficient reason to exclude a risk premium.
Present value techniques differ in how they adjust for risk and in the type of cash flows they use. For example, the discount rate adjustment technique described uses contractual, promised, or most likely cash flows and a risk-adjusted discount rate.
Expected present value techniques incorporate the effects of risk and uncertainty in one of two ways. The calculation either uses risk-adjusted expected cash flows and a risk-free rate to discount them or uses expected cash flows that are not risk-adjusted and a discount rate adjusted to include the risk premium that market participants require. That rate is different from the rate used in the discount rate adjustment technique.
Discount rate adjustment technique
The discount rate adjustment technique uses a single set of cash flows from the range of possible estimated amounts, whether contractual or promised (as is the case for a bond) or most likely cash flows. In all cases, those cash flows are conditional upon the occurrence of specified events (e.g., contractual or promised cash flows for a bond are conditional on the event of no default by the debtor). The discount rate used in the discount rate adjustment technique is derived from observed rates of return for comparable assets or liabilities that are traded in the market. Accordingly, the contractual, promised, or most likely cash flows are discounted at an observed or estimated market rate for such conditional cash flows (i.e. a market rate of return).
The discount rate adjustment technique requires an analysis of market data for comparable assets or liabilities. Comparability is established by considering the nature of the cash flows (e.g., whether the cash flows are contractual or non-contractual and are likely to respond similarly to changes in economic conditions), as well as other factors (e.g., credit standing, collateral, duration, restrictive covenants, and liquidity). Alternatively, if a single comparable asset or liability does not fairly reflect the risk inherent in the cash flows of the asset or liability being measured, it may be possible to derive a discount rate using data for several comparable assets or liabilities in conjunction with the risk-free yield curve (i.e. using a ‘build-up’ approach).
Example
Deriving a discount rate using a build-up approach
Assume that Asset A is a contractual right to receive CU800 in one year (i.e. there is no timing uncertainty). There is an established market for comparable assets, and information about those assets, including price information, is available. Of those comparable assets:
(a) Asset B is a contractual right to receive CU1,200 in one year and has a market price of CU1,083. Thus, the implied annual rate of return (i.e. a one-year market rate of return) is 10.8 per cent [(CU1,200/CU1,083) – 1].
(b) Asset C is a contractual right to receive CU700 in two years and has a market price of CU566. Thus, the implied annual rate of return (i.e. a two-year market rate of return) is 11.2 per cent [(CU700/CU566)^0.5 – 1].
(c) All three assets are comparable with respect to risk (i.e. dispersion of possible pay-offs and credit).
On the basis of the timing of the contractual payments to be received for Asset A relative to the timing for Asset B and Asset C (i.e. one year for Asset B versus two years for Asset C), Asset B is deemed more comparable to Asset A. Using the contractual payment to be received for Asset A (CU800) and the one-year market rate derived from Asset B (10.8 per cent), the fair value of Asset A is CU722 (CU800/1.108).
Alternatively, in the absence of available market information for Asset B, the one-year market rate could be derived from Asset C using the build-up approach. In that case, the two-year market rate indicated by Asset C (11.2 per cent) would be adjusted to a one-year market rate using the term structure of the risk-free yield curve. Additional information and analysis might be required to determine whether the risk premiums for one-year and two-year assets are the same. If it is determined that the risk premiums for one-year and two-year assets are not the same, the two-year market rate of return would be further adjusted for that effect.
When the discount rate adjustment technique is applied to fixed receipts or payments, the adjustment for risk inherent in the cash flows of the asset or liability being measured is included in the discount rate. In some applications of the discount rate adjustment technique to cash flows that are not fixed receipts or payments, an adjustment to the cash flows may be necessary to achieve comparability with the observed asset or liability from which the discount rate is derived.
Expected present value technique
The expected present value technique uses as a starting point a set of cash flows that represent the probability-weighted average of all possible future cash flows (i.e. the expected cash flows). The resulting estimate is identical to the expected value, which, in statistical terms, is the weighted average of a discrete random variable’s possible values with the respective probabilities as the weights. All possible cash flows are probability-weighted; consequently, the resulting expected cash flow is not conditional upon the occurrence of any specified event (unlike the cash flows used in the discount rate adjustment technique).
In making an investment decision, risk-averse market participants would take into account the risk that the actual cash flows may differ from the expected cash flows. Portfolio theory distinguishes between unsystematic (diversifiable) risk, which is the risk specific to a particular asset or liability, and systematic (non-diversifiable) risk, which is the common risk shared by an asset or a liability with the other items in a diversified portfolio. Portfolio theory holds that in a market in equilibrium, market participants will be compensated only for bearing the systematic risk inherent in the cash flows. In markets that are inefficient or out of equilibrium, other forms of return or compensation might be available.
IFRS 13 describes two methods for applying the expected present value technique.
- Method 1 adjusts the expected cash flows of an asset for systematic (i.e. market) risk by subtracting a cash risk premium (i.e. risk-adjusted expected cash flows). Those risk-adjusted expected cash flows represent a certainty-equivalent cash flow, which is discounted at a risk-free interest rate. A certainty-equivalent cash flow refers to an expected cash flow (as defined), adjusted for risk so that a market participant is indifferent to trading a certain cash flow for an expected cash flow. For example, if a market participant were willing to trade an expected cash flow of CU1,200 for a certain cash flow of CU1,000, the CU1,000 is the certainty equivalent of the CU1,200 (i.e. the CU200 would represent the cash risk premium). In that case, the market participant would be indifferent to the asset held.
- Method 2 adjusts for systematic (i.e. market) risk by adding a risk premium to the risk-free interest rate. Accordingly, the expected cash flows are discounted at a rate that corresponds to an expected rate associated with probability-weighted cash flows (i.e. an expected rate of return). Models used for pricing risky assets, such as the capital asset pricing model, can be used to estimate the expected rate of return. Because the discount rate used in the discount rate adjustment technique is a rate of return relating to conditional cash flows, it is likely to be higher than the expected rate of return relating to expected or probability-weighted cash flows.
Example
Present value techniques: discounting risk-adjusted expected cash flows by the risk-free rate versus discounting unadjusted expected cash flows by a risk-adjusted discount rate
Assume that an asset has expected cash flows of CU780 in one year determined on the basis of the possible cash flows and probabilities shown below. The applicable risk-free interest rate for cash flows with a one-year horizon is 5 per cent, and the systematic risk premium for an asset with the same risk profile is 3 per cent.
Possible cash flows Probability Probability-weighted cash flows CU500 15% CU75 CU800 60% CU480 CU900 25% CU225 Expected cash flows: CU780 · In this simple illustration, the expected cash flows (CU780) represent the probability-weighted average of the three possible outcomes. In more realistic situations, there could be many possible outcomes. However, to apply the expected present value technique, it is not always necessary to take into account distributions of all possible cash flows using complex models and techniques. Rather, it might be possible to develop a limited number of discrete scenarios and probabilities that capture the array of possible cash flows. For example, an entity might use realised cash flows for some relevant past period, adjusted for changes in circumstances occurring subsequently (e.g.,. changes in external factors, including economic or market conditions, industry trends and competition as well as changes in internal factors affecting the entity more specifically), taking into account the assumptions of market participants.
· In theory, the present value (i.e. the fair value) of the asset’s cash flows is the same whether determined by discounting the risk adjusted expected cash flows by the risk-free rate (Method 1) or by discounting the unadjusted expected cash flows by the risk-adjusted discount rate (Method 2).
· Using Method 1, the expected cash flows are adjusted for systematic (i.e. market) risk. In the absence of market data directly indicating the amount of the risk adjustment, such adjustment could be derived from an asset pricing model using the concept of certainty equivalents. For example, the risk adjustment (i.e. the cash risk premium of CU22) could be determined using the systematic risk premium of 3 per cent (CU780 – [CU780 × (1.05/1.08)]), which results in risk-adjusted expected cash flows of CU758 (CU780 – CU22). The CU758 is the certainty equivalent of CU780 and is discounted at the risk-free interest rate (5 per cent). The present value (i.e. the fair value) of the asset is CU722 (CU758/1.05).
· Using Method 2, the expected cash flows are not adjusted for systematic (i.e. market) risk. Rather, the adjustment for that risk is included in the discount rate. Thus, the expected cash flows are discounted at an expected rate of return of 8 per cent (i.e. the 5 per cent risk-free interest rate plus the 3 per cent systematic risk premium). The present value (i.e. the fair value) of the asset is CU722 (CU780/1.08).
· When using an expected present value technique to measure fair value, either Method 1 or Method 2 could be used. The selection of Method 1 or Method 2 will depend on facts and circumstances specific to the asset or liability being measured, the extent to which sufficient data are available, and the judgements applied.
Use of multiple valuation techniques
In some cases, it is appropriate to use a single valuation technique (e.g., when valuing an asset or a liability using quoted market prices in an active market for identical assets or liabilities). However, in other circumstances, it is appropriate to use multiple valuation techniques.
When multiple valuation techniques are used to measure fair value, the results (i.e. the fair value measurements) should be evaluated taking into account the reasonableness of the range of values indicated by those results. A fair value measurement is the point within that range that is most representative of the fair value in the circumstances.
Single cash flow versus probability-weighted cash flows
Cash flow models will use either conditional or expected cash flows; and other valuation inputs need to be consistent with the approach chosen.
Conditional cash flows are based on a single outcome that is dependent on the occurrence of specific events. For example, the cash flows might reflect a ‘most likely’ or ‘promised’ cash flow scenario, such as a zero-coupon bond that promises to repay a principal amount at the end of a fixed time period.
Expected cash flows represent a probability-weighted average of all possible outcomes. Since expected cash flows incorporate expectations of all possible outcomes, expected cash flows are not conditional on certain events.
The discount rate applied to measure the present value of the cash flow estimate should be consistent with the nature of the cash flow estimate. In principle, conditional and expected approaches consider many of the same risks, but an expected cash flow reflects the risks of achieving the cash flow directly in the cash flow estimates, while a conditional cash flow requires an adjustment to the discount rate to reflect the conditional nature of the cash flow estimate. Conceptually, both methods should result in consistent valuation conclusions.
For example, a discount rate that reflects the uncertainty in expectations about future defaults is appropriate if using contractual cash flows of a loan (that is, a discount rate adjustment technique). That same rate should not be used if using expected (that is, probability-weighted) cash flows (that is, an expected present value technique), because the expected cash flows already reflect assumptions about the uncertainty in future defaults; instead, a discount rate that is commensurate with the risk inherent in the expected cash flows should be used. The discount rate adjustment concept is difficult to apply when contractual cash flows do not exist.
Projected cash flows are subject to specific (or unsystematic) risk and systematic risk. Present value techniques differ in how they are adjusted for risk and the type of cash flow that is used.
Specific risk is a risk that only a single entity or industry is subject to, and it can usually be eliminated, or at least substantially reduced, by diversification. Systematic risk is the risk arising from the general market, economic or political risk and cannot be reduced by diversification. Adjusting the cash flows to reflect systematic risk is often difficult. Usually, the discount rate that is applied to cash flows would incorporate systematic or non-diversifiable risk, represented by a weighted average cost of capital that would be required by a market participant.
Measuring fair value when the volume or level of activity for an asset or a liability has significantly decreased
IFRS 13 notes that the fair value of an asset or a liability might be affected when there has been a significant decrease in the volume or level of activity for that asset or liability about normal market activity for the asset or liability (or similar assets or liabilities).
The consequence of a significant decrease in the volume or level of activity could be that a transaction price or a quoted price for that item is not representative of fair value. However, a decrease in the volume or level of activity on its own may not indicate that a transaction price or quoted price does not represent fair value or that a transaction in that market is not orderly.
The following are examples of factors that can help determine whether, based on the evidence available, there has been a significant decrease in the volume or level of activity for the asset or liability:
- there are few recent transactions;
- price quotations are not developed using current information;
- price quotations vary substantially either over time or among market-makers (e.g., some brokered markets);
- indices that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability;
- there is a significant increase in implied liquidity risk premiums, yields, or performance indicators (such as delinquency rates or loss severities) for observed transactions or quoted prices when compared with the entity’s estimate of expected cash flows, taking into account all available market data about credit and other non-performance risk for the asset or liability;
- there is a wide bid-ask spread or a significant increase in the bid-ask spread;
- there is a significant decline in the activity of, or there is an absence of, a market for new issues (i.e. a primary market) for the asset or liability or similar assets or liabilities; and
- little information is publicly available (e.g., for transactions that take place in a principal-to-principal market).
In assessing whether there has been a significant decrease in the volume or level of activity, an entity should evaluate the significance and relevance of factors such as those listed above.
Note that the presence of one or more of the factors listed in IFRS 13 alone is not sufficient to conclude that a market is not ‘active’.
If it is concluded that there has been a significant decrease in the volume or level of activity for the asset or liability about normal market activity for the asset or liability (or similar assets or liabilities), further analysis of the transactions or quoted prices is needed. If it is determined that a transaction or quoted price does not represent fair value (e.g., there may be transactions that are not orderly), an adjustment to the transactions or quoted prices will be necessary if those prices are to be used as a basis for measuring fair value. The adjustment can be significant to the fair value measurement in its entirety.
Adjustments may also be necessary for other circumstances (e.g., when a price for a similar asset requires significant adjustment to make it comparable to the asset being measured, or when the price is ‘stale’). IFRS 13 does not prescribe a methodology for making significant adjustments to transactions or quoted prices. Consistent with valuation techniques, as discussed, appropriate risk adjustments should be applied, including a risk premium reflecting the amount that market participants would demand as compensation for the uncertainty inherent in the cash flows of an asset or a liability. Otherwise, the measurement does not faithfully represent fair value. In some cases, determining the appropriate risk adjustment may be difficult. However, the degree of difficulty alone is not a sufficient basis on which to exclude a risk adjustment. The risk adjustment should be reflective of an orderly transaction between market participants at the measurement date under current market conditions.
If there has been a significant decrease in the volume or level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate (e.g., the use of a market approach and an income approach, respectively). When weighing indications of fair value resulting from the use of multiple valuation techniques, an entity should consider the reasonableness of the range of fair value measurements. The objective is to determine the point within the range that is most representative of fair value under current market conditions. A wide range of fair value measurements may be an indication that further analysis is needed.
Even when there has been a significant decrease in the volume or level of activity for the asset or liability, the objective of a fair value measurement remains the same. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (i.e. not a forced liquidation or distress sale) between market participants at the measurement date under current market conditions.
Estimating the price at which market participants would be willing to enter into a transaction at the measurement date under current market conditions if there has been a significant decrease in the volume or level of activity for the asset or liability depends on the facts and circumstances at the measurement date and requires judgment. An entity’s intention to hold the asset or to settle or otherwise fulfill the liability is not relevant when measuring fair value because fair value is a market-based measurement, not an entity-specific measurement.
Quoted prices provided by third parties
IFRS 13 does not preclude the use of quoted prices provided by third parties, such as pricing services or brokers if it is determined that the quoted prices provided by those parties are developed by IFRS 13.
However, if there has been a significant decrease in the volume or level of activity for the asset or liability, an entity is required to evaluate whether the quoted prices provided by third parties are developed using current information that reflects orderly transactions or a valuation technique that reflects market participant assumptions (including assumptions about risk). In weighting a quoted price as an input to a fair value measurement, an entity should place less weight (when compared with other indications of fair value that reflect the results of transactions) on quotes that do not reflect the results of transactions.
Further, the nature of a quote (e.g., whether the quote is an indicative price or a binding offer) should be taken into account when weighing the available evidence, with more weight given to quotes provided by third parties that represent binding offers.
Broker or pricing service quotes determinative of fair value
Broker or pricing service quotes are not necessarily determinative of fair value if an active market (as defined in IFRS 13) does not exist for the item being measured. In assessing whether a broker or pricing service quote appropriately represents fair value, an entity needs to understand how the broker or pricing service has arrived at the quoted price, and the inputs and other information used.
Quote based on information from an active market
Consistent with IFRS 13, when a broker or pricing service quote represents the unadjusted price quoted for an identical asset, liability or equity instrument in an active market to which the entity has access at the measurement date, the entity is required to use the quoted price without adjustment when measuring fair value, subject to limited exceptions as discussed in IFRS 13. Such a quote represents a Level 1 input.
If any adjustment is made to the broker or pricing service quote in the circumstances specified in IFRS 13, or in the absence of an active market, a broker or pricing service quote does not represent a Level 1 input. However, it may nevertheless be determinative of fair value.
Quote based on valuation technique(s)
If a quote is based on a valuation technique that is used by market participants and uses market-observable or market-corroborated inputs that reflect the assumptions of market participants, it is determinative of fair value if no significant adjustment to the quote is needed. If a significant adjustment is needed, the quote is not determinative of fair value but it could represent a relevant observable input into the entity’s fair value measurement.
General considerations
In assessing whether a quote is determinative of fair value, the entity should consider all relevant circumstances, including the following questions (the list is not exhaustive).
- Are there differences between the asset or liability being measured and the item for which a quote is available (e.g.,. differences in the terms or risk attributes)? Such differences may necessitate adjustments to the price quoted by the broker or pricing service.
- Does the quote reflect currently occurring orderly transactions for the asset or liability being measured? That is, are market participants currently transacting in the asset or liability at the price quoted by the broker or pricing service or does the quote reflect ‘stale’ information or transactions that are not orderly? IFRS 13 (see above) provides specific guidance for circumstances in which there has been a significant decrease in the volume or level of activity for the asset or liability.
- Is the broker or pricing service using a valuation technique that complies with the fair value measurement principles in IFRS 13? For example, does the valuation technique used by the broker or pricing service (1) reflect market participant assumptions, including assumptions about risk, (2) maximise the use of relevant observable inputs, and (3) minimise the use of unobservable inputs? If the valuation technique does not reflect the assumptions market participants would use in pricing the asset or liability, the price quoted by the broker or pricing service may need adjustment or may not be relevant to the entity’s fair value measurement.
- Is the quote provided by the broker or pricing service an indicative price or a binding offer? That is, does the broker or another market participant stand ready to transact at the price quoted by the broker or pricing service? As noted above, IFRS 13 indicates that more weight should be given to quotes based on binding offers. Typically, a quote obtained from a broker or pricing service is an indicative price and not a binding offer (unless the broker is a market-maker).
- Does the quote come from a reputable broker or pricing service that has a substantial presence in the market and the experience and expertise to provide a representationally faithful quote for the asset or liability being measured? An entity may place more weight on a quote from a broker or pricing service that has more experience and expertise related to the asset or liability being measured.
As the number of market transactions decreases, brokers or pricing services may rely more on proprietary models based on their own assumptions to arrive at a quote. The entity should evaluate how the quote has been arrived at and whether it reflects market participant assumptions, including assumptions about risk. This information may be difficult to obtain if quotes are based on proprietary models that brokers or pricing services may not be willing to share. However, even when brokers or pricing services do not wish to share detailed information about their models, it may still be possible to obtain information about the nature of the assumptions and the inputs used in the model. If the quote does not reflect assumptions that market participants would use in pricing the asset or liability, the quote will most likely not be determinative of fair value because adjustments may be required. In such cases, the quote may be an input to the entity’s fair value measurement, but other indications of fair value may be equally or more useful when estimating fair value (e.g.,. a valuation based on the entity’s own estimates of the inputs that market participants would use in pricing the asset or liability).
Multiple quotes
An entity may need to perform additional analysis when quotes for an individual asset or liability are obtained from different brokers or pricing services. Multiple quotes within a narrow range constitute stronger evidence of fair value than multiple quotes that are widely dispersed. IFRS 13 states that a wide range of measurements may be an indication that further analysis is needed. The entity should consider the reasonableness of the range of fair value measurements, with the objective of determining the point within the range that is most representative of fair value under current market conditions.
In addition, if an entity’s own estimate of fair value is outside the range of broker or pricing service quotes, the entity should understand the reason(s) for such a difference. If the range of quotes provides strong evidence of fair value, the entity may need to make adjustments to its valuation technique to reflect current market information.
Impact on fair value of an entity’s unwillingness to transact at current prices
If an entity is unwilling to transact at a price from an external source (such as a quoted market price or a price provided by a broker, pricing service or potential buyer), the entity’s unwillingness to transact at that price is not sufficient evidence for the entity to disregard that price in measuring fair value. If the best information available in the circumstances indicates that market participants would transact at a price from an external source, an entity is not permitted to disregard that price simply because it is not willing to transact at that price.
The following examples explore this issue further.
Example 1
Entity A is using a valuation model to measure the fair value of its investment in privately placed corporate debt securities issued by Entity X. No quoted price for identical securities is available. Entity A’s valuation model uses assumptions about default rates and discount rates. Default rate assumptions can be readily derived from current observable market data for actively traded credit default swaps on publicly traded bonds of Entity X. When measuring the fair value of its investment, Entity A cannot disregard this market data even if Entity A would not be willing to transact at a price consistent with this market data.
Example 2
Entity A holds distressed debt securities. Transactions in the securities occur infrequently and there is no active market for the securities, but there are active markets for similar securities. Entity A’s own valuation model, which is based on observable Level 2 inputs current at the measurement date, indicates that market participants would be willing to buy and sell the debt for CU30 at the measurement date. Entity A has calibrated the model to the best information available at the measurement date (including transaction prices in similar securities and risk premiums).
At the measurement date, a potential buyer provides an unsolicited bid to buy the securities for CU20. When measuring the fair value of the debt securities, Entity A can neither disregard this bid price simply because it is not willing to transact at that price, nor can it assume that the bid price provides better evidence of fair value than its own model. Although the bid price is the price one potential buyer would be willing to pay for Entity A’s asset, it may not necessarily be the price at which market participants (buyers and sellers) would be willing to transact on the measurement date.
Valuation techniques to measure fair value should maximise the use of relevant observable inputs (i.e. Level 1 and Level 2 inputs that do not require significant adjustment) and minimise the use of unobservable inputs (Level 3 inputs). If the bid price is classified as a Level 3 input, it may be appropriate for Entity A to place less weight on the bid price in measuring the fair value of its debt securities given that Entity A’s own model is based on Level 2 inputs. However, if Entity A obtains several bid prices and the fair value indicated by the valuation model is not in the range of the bid prices obtained, Entity A may need to consider whether its model is valid and identify the reasons for the discrepancy between the model amount and the bid prices.
Calibration of valuation techniques
If the transaction price is fair value at initial recognition and a valuation technique that uses unobservable inputs will be used to measure fair value in subsequent periods, the valuation technique should be calibrated so that at initial recognition the result of the valuation technique equals the transaction price. Calibration ensures that the valuation technique reflects current market conditions, and it helps an entity to determine whether an adjustment to the valuation technique is necessary (e.g., there might be a characteristic of the asset or liability that is not captured by the valuation technique). After initial recognition, when measuring fair value using a valuation technique or techniques that use unobservable inputs, an entity should ensure that those valuation techniques reflect observable market data (e.g., the price for a similar asset or liability) at the measurement date.
Calibration of models or model inputs
Some IFRS Standards require or permit assets or liabilities to be recognised initially at fair value. When an asset is acquired or a liability assumed in a market transaction, it cannot be assumed that the price paid to acquire the asset or received to assume the liability (i.e. transaction or entry price) is the same as the fair value of the asset or liability in accordance with IFRS 13 (an exit price).
IFRS 13 deals specifically with circumstances in which:
- a valuation technique that uses unobservable inputs is used to measure the fair value of an asset or a liability in subsequent periods; and
- the transaction price for the asset or liability is an appropriate measure of fair value at initial recognition in accordance with IFRS 13.
In such circumstances, IFRS 13 requires that the valuation technique should be calibrated (i.e. adjusted) so that, at initial recognition, the result of the valuation technique equals the transaction price. Calibration ensures that the valuation technique reflects current market conditions, and it helps an entity to determine whether an adjustment to the valuation technique is necessary (e.g.,. a characteristic of the asset or liability may not be captured by the valuation technique).
If the transaction price is fair value at initial recognition, calibration of an entity’s pricing model eliminates differences between the transaction price and the model’s output (the ‘inception difference’). IFRS 13 does not prescribe any specific method for the calibration of pricing models. Therefore, an entity should select the most appropriate method for the particular circumstances.
Factors to consider when selecting the calibration method include:
- the valuation technique used;
- the availability of information about market participant assumptions (e.g.,. relevant observable inputs, estimated timing of when unobservable inputs may become observable);
- the complexity involved (i.e. complexity in different calibration methods, or in the identification of the causes underlying differences between transaction price and fair value estimates based on the entity’s pricing model);
- the terms of the instrument; and
- the nature of the entity’s portfolio.
In outline, calibration might be approached in the following manner.
- Step 1 Identify the source of the inception difference.
- Step 2 Adjust the unobservable inputs or establish valuation adjustments such that the adjusted model result equals the transaction price at inception (i.e. the inception difference is eliminated).
- Step 3 Changes in fair value measured using the entity’s pricing model will be recognised subsequent to initial recognition. The adjustments identified at Step 2 may be reversed or modified when (1) unobservable inputs become observable, or (2) unobservable inputs or valuation adjustments are adjusted to reflect new information (e.g.,. through subsequent calibration of the model or model inputs to reflect new transaction data).
Step 2 may result in either direct adjustment to model inputs or an adjustment to the model’s output (a valuation adjustment).
When calibration is achieved through direct adjustment to model inputs, an entity should consider the impact of such adjustments on the valuation of other instruments in its portfolio (e.g.,. instruments valued using the same or similar pricing inputs). The calibration may affect the valuation of other instruments because the calibrated inputs may replace or supersede the assumptions previously used for unobservable inputs.
When calibration is achieved through a valuation adjustment, the entity should review the valuation adjustment periodically to ensure that the adjustment reflects any new information and that it is consistent with the exit price notion in IFRS 13.
Calibration of models or model inputs – example
Entity X enters into an electricity forward contract to purchase 100 megawatts of electricity (daily) for a 10-year term. The electricity forward contract is within the scope of IFRS 9 (or, for entities that have not yet adopted IFRS 9, IAS 39 and is measured at fair value.
No cash is exchanged between the parties at the inception of the forward contract. Using the guidance in IFRS 13, Entity X determines that the transaction price equals the exit price (i.e. the fair value of the forward contract equals zero at inception).
Entity X develops its own valuation technique to measure the fair value of the forward contract at subsequent reporting dates. At inception, there are three years of observable forward prices available in the relevant market. Entity X’s model uses estimated forward electricity prices beyond three years. At inception, and prior to calibration, the pricing model values the forward contract as an asset of CU1 million. Consequently, Entity X needs to calibrate its model so that the model result at inception equals the transaction price of zero.
In this simple scenario, Entity X might calibrate its model as follows.
- Step 1 Entity X establishes that the only unobservable input that significantly affects the model value is forward electricity prices. Consequently, Entity X attributes the inception difference of CU1 million (i.e. the difference between the model’s result and the fair value of zero) to its estimate of unobservable forward electricity prices for Years 4 to 10 of the contract.
- Step 2 Entity X adjusts the unobservable forward price points at Years 4 to 10 on the forward price curve such that the model produces a fair value of zero.
Because Entity X attributed the inception difference solely to the unobservable electricity prices in the relevant market, any calibration adjustment represents a calibration of these unobservable electricity prices to the most recent available information (the forward contract’s transaction price). As a result, if Entity X owns a portfolio of contracts whose fair values are estimated using long-dated electricity prices in the same market, the calibration adjustment to the electricity forward prices would most likely also affect the fair value of those other long-dated contracts.
Similar considerations are also relevant when a calibration results in valuation adjustments to the pricing model’s output. In general, calibration adjustments provide updated information about assumptions used by market participants in assessing unobservable inputs or valuation adjustments. Therefore, calibration adjustments may have an effect beyond the recently executed transaction.
- Step 3 Assuming no other calibration adjustments are made and that observable forward prices remain available for the next three years, the calibration adjustments would be removed as the inputs for Years 4 to 10 become observable. (For example, at the end of Year 1 of the contract, observable forward prices would be available for Years 2 to 4, and unobservable inputs for Years 5 to 10 would be used. As a result, the calibration adjustments for Year 4 should be removed from the valuation as this input has become observable.) All calibration adjustments should be removed once all the unobservable inputs become observable (e.g.,. in the last three years of the contract). In addition, no calibration adjustments should remain in the model in a period in which settlement has occurred.
Changes in valuation techniques
Once a valuation technique has been selected, it should be applied consistently. A change in a valuation technique or its application (e.g., a change in its weighting when multiple valuation techniques are used or a change in an adjustment applied to a valuation technique) is only appropriate if the change results in a measurement that is equally or more representative of fair value in the circumstances.
IFRS 13 provides the following examples of events that might appropriately lead to a change in valuation technique:
- new markets develop;
- new information becomes available;
- information previously used is no longer available;
- valuation techniques improve; or
- market conditions change.
Change in valuation technique that uses unadjusted quoted prices
If a valuation technique does not use unadjusted quoted prices, and in a subsequent period a quoted price in an active market becomes available, the quoted price should be used because IFRS 13 states that “a quoted price in an active market provides the most reliable evidence of fair value and shall be used without adjustment to measure fair value whenever available”, with limited exceptions.
Depending on the particular circumstances, a change from a valuation technique that uses unadjusted quoted prices to a different valuation technique (such as a discounted cash flow technique) may be appropriate when:
- quoted prices for an identical asset or liability are no longer available; or
- quoted prices are available, but the market is no longer active. Note, however, that prices from relevant observable transactions must be considered in determining fair value even if the market is not active; or
- the entity no longer has access to the market in which the prices are quoted. The entity must be able to access the market in order to use a quote from that market without adjustment to reflect the lack of access, but the entity does not need to be able to sell the particular asset or transfer the particular liability on the measurement date (see 3.3 for further details); or
- quoted prices are no longer based on relevant observable market data and do not reflect assumptions that market participants would make in pricing the asset at the measurement date. As discussed, an entity cannot necessarily assume that a price provided by an external source is representative of fair value at the measurement date.
A decrease in the volume or level of activity in a market does not necessarily mean that the market is no longer active and, consequently, that a change in the valuation technique is warranted.
In selecting another valuation technique, when appropriate, an entity should maximise the use of relevant observable inputs (e.g.,. quoted prices for a similar asset or liability with adjustments as appropriate) and minimise the use of unobservable inputs.
If there is a change in the valuation technique used or its application, any resulting difference should be accounted for as a change in accounting estimate by IAS 8 however, the disclosures generally required under IAS 8 regarding a change in accounting estimate are not required for revisions resulting from a change in a valuation technique or its application.
Valuation techniques – cost approach
The cost approach is often referred to as current replacement cost. It is a valuation technique that attempts to determine the amount required to replace the service capacity of an asset. The cost approach assumes that fair value is the cost to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence – including physical deterioration, functional (technological) obsolescence and economic obsolescence. The cost approach is usually applied to specialised facilities, buildings or equipment where use of the income or market approach would not produce a sensible outcome, or to corroborate another approach.
Inputs based on bid and ask prices
Bid and ask prices are common within markets for financial instruments. Dealers stand ready to buy at the bid price and sell at the ask price. If an input within the fair value measurement is based on bid prices and ask prices, the price within the bid-ask spread that is most representative of fair value in the circumstances is used to measure fair value. The use of bid prices for long positions (assets), and ask prices for short positions (liabilities), is permitted but not required. The fair value of the liability might not be the same as the fair value of the corresponding asset where the pricing includes a bid-ask spread. The most representative fair value for assets and liabilities within the bid-ask price could be different.
The use of mid-market pricing, or other pricing conventions that are used by market participants as a practical expedient for fair value, are not precluded.
Appropriateness of the mid-market pricing convention
Question:
When is the mid-market pricing convention deemed appropriate?
Solution:
Pricing inputs with bid-ask spreads could be Level 1, 2 or 3 inputs; however, there is no guidance on when it is appropriate to use the mid-market practical expedient. Election of the mid-market practical expedient is presumed appropriate for pricing inputs within a bid-ask spread that fall within Level 1 of the fair value hierarchy (that is, unadjusted observable quoted prices for identical assets or liabilities). In these cases, a reporting entity does not need to evaluate mid-market pricing against expectations of where it actually would trade within the bid-ask range.
The mid-market practical expedient is appropriate for inputs from markets in which stand-ready, dealer-based bid-ask pricing exists. In addition, it might be applicable in other circumstances in which a bid-ask pricing protocol is used by market participants in valuation and measurement. Generally, the less observable the input, the less probable that it is subject to a bid-ask spread and, therefore, the less likely that use of a mid-market convention would be appropriate. For example, it might not be appropriate to apply a mid-market convention where the bid-ask spread is wide, indicating the inclusion of a pricing element other than transaction costs (for example, a liquidity reserve).
Treatment of bid-ask spread on initial recognition
An entity purchases an equity financial asset and irrevocably elects to present its subsequent changes of fair value in other comprehensive income (FVTOCI), paying the ask (offer) price of C104 and a brokerage commission of C3. The entity has established that mid-market prices are most representative of fair value. The entity uses the mid-market price to remeasure the financial asset and to recognise changes in fair value in other comprehensive income. The following details are relevant:
Reference price Acquisition Balance sheet date (C) (C) Bid price 100 110 Mid-market price 102 113 Ask or offer price 104 116 Financial assets at fair value through other comprehensive income (FVTOCI) should be initially recognised at fair value, plus transaction costs paid to acquire the asset.
The ask price represents the amount at which a dealer is willing to sell and, therefore, the price that the entity would have to pay to acquire the asset. The difference between the mid-market price that represents the asset’s fair value and the ask price is a transaction cost. The commission paid to the broker is also a transaction cost.
The asset is designated at fair value through other comprehensive income (that is, not at fair value through profit or loss), so the transaction costs are included in the asset’s initial carrying value. Therefore, the asset will be recorded at its fair value of C102 (mid-market price) plus the mid-ask spread (C2) plus commission (C3), giving a total of C107. At the balance sheet date, the asset will be valued at the mid-market price (C113) at that date, and any difference between this price and the amount recognised initially (C107) will be recorded in other comprehensive income.
Therefore, the appropriate accounting entries on initial recognition and at the balance sheet date are as follows:
Dr Cr C C At acquisition FVTOCI asset (mid-market price inclusive of transaction costs) 107 Cash 107 At balance sheet date FVTOCI asset 6 Gain in other comprehensive income 6 If the asset is a debt instrument measured at amortised cost, the bid-ask spread, brokerage commission and any premium or discount are subsequently amortised and recognised as part of interest income over the asset’s life, using the effective interest method.
Treatment of bid-ask spread not included in initial carrying value of a financial asset
An entity purchases an equity financial asset that it classifies as at fair value through profit or loss, paying the ask (offer) price of C104 and a brokerage commission of C3. The entity has established that mid-market prices are most representative of fair value. The entity uses the mid-market price to remeasure the financial asset and to recognise changes in fair value through profit or loss. The following details are relevant:
Reference price Acquisition Balance sheet date (C) (C) Bid price 100 110 Mid-market price 102 113 Ask or offer price 104 116 Financial assets classified as at fair value through profit or loss should be recognised initially at fair value. Transaction costs arising on a financial asset classified as at fair value through profit or loss (FVTPL) are immediately recognised in profit or loss, and they do not form part of the asset’s initial carrying value. Hence, the asset is measured on initial recognition using the mid-market price (C102). At the balance sheet date, the asset will be valued at the mid-market price (C113) at that date, and any difference between this price and the amount recognised initially (C11) will be recorded in profit or loss.
The appropriate accounting entries, on initial recognition and at the balance sheet date, are as follows:
Dr Cr C C At acquisition FVTPL asset (mid-market price) 102 Profit/loss (mid-ask spread of C2 + commission of C3) 5 Cash 107
Bid-ask pricing – mid-market pricing and other pricing conventions as a practical expedient – example
Entity X and Entity Y hold the same debt security as an asset. Entity Y, a broker-dealer, is a market-maker in the debt security. Entity X is not. The debt security is traded in an active market by Entity Y (and other broker-dealers) using bid and ask prices.
Even though Entity X would most likely sell the debt security at or close to the bid price, Entity X may select a policy to use the mid-market price as the fair value of the debt security as a practical expedient. However, it would not be appropriate to use the ask price for the debt security because this would be inconsistent with the objective of fair value being an exit price.
Even though Entity Y may be able to exit at a price greater than the bid price, Entity Y may choose as its policy to measure the debt security by using the bid price as a practical expedient.
Changes in the use of bid, ask or mid-market pricing or other pricing conventions
When an entity has in the past complied with the requirements of IFRS 13 and measured fair value at the price within the bid-ask spread that is most representative of fair value in the circumstances, it is not generally appropriate for the entity to change its accounting policy to using the practical expedient of mid-market pricing or another pricing convention as permitted by IFRS 13.
Once a valuation technique has been selected, it should generally be applied consistently. A change in a valuation technique is only appropriate if the change results in a measurement that is equally or more representative of fair value in the circumstances.
Having established a policy of measuring fair value at the price within the bid-ask spread that is most representative of fair value in the circumstances, a change to using a practical expedient such as mid-market pricing or another pricing convention would generally be inappropriate because it would not typically result in a measurement that is equally or more representative of fair value.
Valuation premiums and discounts
Valuation adjustments might be necessary to reflect certain characteristics of the asset or liability being fair valued. Examples are control premiums or non-controlling interest discounts. There are two caveats to consider when including such adjustments:
- adjustments are not permitted for premiums or discounts that are inconsistent with the unit of account for the asset or liability being measured; and
- adjustments are permitted only where they reflect a characteristic of an asset or liability (for example, control premium). Adjustments are not permitted for premiums or discounts that reflect size as a characteristic of the entity’s holding. Specifically, IFRS 13 prohibits adjustments for blockage factors that adjust the quoted price of an asset or a liability because the market’s normal daily trading volume is not sufficient to absorb the quantity held by an entity.
If there is a quoted price in an active market (that is, a Level 1 input) for an asset or a liability, management should use that price without adjustment when measuring fair value.
Adjustments for size of holding: investments measured under IFRS 9 (IAS 39)
Question:
An entity has a holding of shares that are traded in an active market. If the entity sells its entire holding in a single transaction, the market’s normal daily trading volume would not be sufficient to absorb the quantity held. That single transaction would affect the quoted price, and it would result in the entity receiving a lower selling price. Should the entity adjust the fair value of that share to reflect this?
Solution:
No. The unit of account, based on other IFRSs, is a single share, and not the overall holding. Therefore, the fair value of the asset or liability should be measured as the product of the quoted price for a single share and the quantity held by the entity.
The flow chart below illustrates the above requirements:
Adjustments for illiquidity and size of holding: investments measured under IFRS 9 (IAS 39)
Question:
Investor X holds a 10% investment in private entity Y. The investment is classified as a financial asset at fair value through profit or loss under IFRS 9 (IAS 39). Investor X fair values private entity Y using a market multiple of comparable listed entity Z. Should this valuation be adjusted for:
· Illiquidity of private entity Y’s shares, as compared to listed entity Z?
· The lower price that investor X is likely to receive if investor X sold the entire 10% investment in a single transaction, rather than if it sold its shares in entity Y in smaller batches?
Solution:
Investor X should adjust for private entity Y’s illiquidity, because this is a characteristic of private entity Y’s shares. Private entity Y’s shares are not listed; entity Z’s shares are listed. However, investor X should not adjust the valuation to reflect the likely outcome that, if it sold all of its investment in private entity Y in a single transaction, it might receive a lower price. This is because the unit of account in IFRS 9 (IAS 39) is a single instrument. The fair value in IFRS 9 (IAS 39), therefore, reflects the fair value of each financial instrument in private entity Y.
Measuring the fair value of listed entities: associates
Question:
Entity C holds 25% of the equity of listed entity D, which it treats as an associate under IAS 28, and its equity accounts for the investment. In testing the investment for impairment, entity C wishes to use discounted cash flow methodology. Is this appropriate?
Solution:
Entity C could use discounted cash flow methodology to measure value in use under IAS 36, but it should use the listed price multiplied by the number of shares held to measure fair value less costs of disposal, or an appropriate model that would take into consideration any premiums or discounts – for example, the existence of significant influence.
Measuring the fair value of listed entities: subsidiaries
Question:
Entity C holds 75% of the equity of listed entity D, which it treats as a subsidiary. In testing the investment for impairment, entity C wishes to use discounted cash flow methodology. Is this appropriate?
Solution:
Entity C could use discounted cash flow methodology to measure value in use under IAS 36, but it should use the listed price multiplied by the number of shares held to measure fair value less costs of disposal or an appropriate model that would take into consideration any premiums or discounts, for example, for the existence of control.
Unit of account under other IFRSs
Question:
Entity A holds 100% of the shares in an unlisted entity, B. Unlisted entity B is a cash-generating unit (CGU) that is being tested for impairment under IAS 36, using the fair value less costs of disposal (FVLCD) method.
Entity A fair values entity B using a market multiple of a comparable listed entity. If entity A assumes the sale of unlisted entity B’s shares in a single transaction, it is likely to receive a different price, due to the size of the sale, compared to selling the shares in smaller portions (say, in units of 1,000 each time).
For the purpose of determining FVLCD, should entity A assume the sale of unlisted entity B’s shares in a single transaction or multiple transactions?
Solution:
The unit of account being fair valued is the CGU under IAS 36, and the shares of entity B are not traded in an active market, so the fair value that should be considered is the aggregate fair value of the CGU. Entity A should, therefore, assume the sale of unlisted entity B’s shares in aggregate. Since the valuation input is a market multiple from a comparable listed entity, a premium for control and a discount for lack of marketability (listing) will be considered where appropriate.
Inclusion of a control premium
Question:
Entity C holds 100% of the shares in entity D, which is a cash-generating unit being tested for impairment under IAS 36, using fair value less costs of disposal. Entity C fair values entity D using a discounted cash flow method, based on entity D’s underlying cash inflows (for example, from sales) and outflows (for example, from expenses), and the industry cost of capital.
Should entity C adjust the output of the discounted cash flow valuation model for a control premium?
Solution:
Entity C should not make this adjustment. The control premium has already been imputed by the use of the business cash flows discounted at the industry cost of capital. This method of valuation implicitly assumes control. No further adjustment for a control premium is required.
Status of IASB work on use of P × Q for investments in associates, joint ventures and subsidiaries measured at fair value
The IASB has debated whether to amend IAS 27, IAS 28, IFRS 10 (for investment entities) and IAS 36, to clarify the unit of account as either the investment as a whole or an individual unit in these investments.
In September 2014, the Board issued an exposure draft which clarified that, although the unit of account for associates, joint ventures and subsidiaries is the investment as a whole, the fair value measurement of a listed investment quoted in an active market will remain the product of the number of shares held and the share price at the date of measurement. This would not take into consideration any premiums or discounts on controlling or non-controlling shareholdings.
In January 2016, the Board decided to consider the findings from the 2014 exposure draft, and subsequent research during the post-implementation review of IFRS 13 and the Request for Information which was published in May 2017, to further assess the extent and effect of the issue, as well as current practice.
In March 2018, the Board decided not to perform any work in the area of prioritising the unit of account or Level 1 inputs as follow-up work of postimplementation review of IFRS 13, because the costs of such work would exceed its benefits.
Diversity in practice has developed in this area. Entities can use either P × Q for valuing their shareholdings in investments in associates, joint ventures or subsidiaries, or an appropriate model that would take into consideration any premiums or discounts arising, for example, for existence or lack of control.
Entities should disclose clearly in the financial statements the fair value model that they have used. Significant implied premiums or discounts are likely to be scrutinised by regulators.
Fair value hierarchy
There is a fair value hierarchy in IFRS 13 equivalent to the hierarchy established under IFRS 7. The highest priority is given to Level 1 inputs; Level 3 inputs get the lowest priority.
A fair value measurement is categorised, in its entirety, at the same level of the fair value hierarchy as the lowest-level input that is significant to the entire measurement. An input is significant if that input can result in a significantly different fair value measurement. Factors specific to the asset or liability should be considered. Determining the significance of a particular input to a fair value measurement is a matter of judgement. A starting point is to consider the inputs that factor into the fair value measurement, the relative significance of each of the inputs, and whether those inputs are externally verifiable or are derived through internal estimates. Adjustments that are not part of fair value, but which other literature requires management to include in the measurement (such as costs of disposal in a fair value less cost of disposal valuation), are not considered when determining the hierarchical level.
Determination of significance of an input in fair value measurement
Question:
How should the significance of an input in fair value measurement be determined?
Solution:
There are no bright lines for determining significance; two different entities might reach different conclusions from the same fact pattern. We believe that management should consider the impact of lower-level inputs on the fair value measurement at the time when the measurement is made, as well as their potential impact on future movements in the fair value.
In assessing the significance of unobservable inputs to an assets or a liability’s fair value, management should:
· consider the sensitivity of the assets or the liability’s overall value to changes in the data; and
· re-assess the likelihood of variability in the data over the life of the asset or liability.
The assessment should be performed on both an individual and an aggregate basis, where more than one item of unobservable data (or more than one parameter) is used to measure the fair value of an asset or liability. This assessment will depend on the facts and circumstances specific to a given asset or liability, and it will require significant professional judgement.
Given the level of judgement that might be involved, management should document its rationale where it is not straightforward to determine the classification of inputs in the fair value hierarchy. In addition, management should develop and consistently apply a policy for determining significance.
The fair value hierarchy ranks fair value measurements based on the type of inputs; it does not depend on the type of valuation techniques used.
Level 1
Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.
An active market is defined in IFRS 13 as one in which transactions for the asset or liability take place with sufficient frequency and volume that prices are readily available on an ongoing basis.
Level 1 measurements should emphasise on the principal (or, if unavailable, the most advantageous) market. The transacting entity should be able to transact in the chosen market at the measurement date.
The quoted price should be used without adjustment whenever available, except in the following situations:
- A practical expedient exists for the fair value measurement of a large number of similar assets or liabilities (for example, debt securities) for which quoted prices in active markets are available but not readily accessible. A reporting entity could measure fair value by using an alternative pricing method (for example, matrix pricing), instead of obtaining quoted prices for each individual security. If an alternative pricing method is used as a practical expedient, the resulting fair value measurement will be at a lower level (usually, Level 2).
- Where significant events (for example, principal-to-principal transactions, brokered trades and announcements) occur after the close of a market but before the measurement date, a quoted market price might not be representative of fair value on the measurement date. Management should establish and consistently apply a policy for identifying and incorporating events that might affect fair value measurements. If management adjusts the quoted price, the resulting measurement will not be classified in Level 1, but will be a lower-level measurement.
- An entity is measuring the fair value of its quoted liability or equity instrument using the quoted price for the identical item traded as an asset. If the quoted value is used, this would be a Level 1 measurement. However, the quoted price might reflect factors that do not apply to the liability or equity instrument. The fair value should be adjusted for these factors, and the resulting fair value measurement would be classified in a lower level.
Classification in fair value hierarchy of single price source or quote
Question:
How should a single price source or quote be classified within the fair value hierarchy?
Solution:
Management might only have access to a single price source or quote. Apart from where transactions on an exchange constitute the source, a single source would not generally be a Level 1 input, because a single market-maker would, almost by definition, suggest an inactive market. However, in some rare cases, a single market-maker dominates the market for a particular security, such that trading in that security is active but all the activity flows through that market-maker. In those limited circumstances, a Level 1 determination might be supported if the broker is standing ready to transact at that price.
In all cases other than the above fact pattern, management should determine if the single broker quote represents a Level 2 or a Level 3 input.
Key considerations in making this assessment include the following:
· Level 2: a single broker quote might be supported as a Level 2 input if there is observable market information on comparable to support the single broker quote and/or the broker stood willing to transact in the security at that price.
· Level 3: a single broker quote is frequently a Level 3 input if there are no comparable and the quote was provided as an indicative value, with no commitment to actually transact at that price (for example, information obtained under an agreement to provide administrative pricing support to a fund for a security purchased from that broker). Such information will require additional follow-up or due diligence procedures when used in financial reporting.
Management should specifically consider the underlying facts associated with each valuation input, in assessing the appropriate classification in the fair value hierarchy.
Level 2
Level 2 inputs are inputs, other than quoted prices included within Level 1, that are observable for the asset or liability, either directly or indirectly.
Level 2 inputs include:
- Quoted prices for similar assets or liabilities in active markets.
- Quoted prices for identical or similar assets or liabilities in markets that are not active.
- Inputs other than quoted prices that are observable for the asset or liability, for example:
- Interest rates and yield curves observable at commonly quoted intervals.
- Implied volatilities.
- Credit spreads.
- Market-corroborated inputs.
Level 2 inputs
The following are examples of Level 2 inputs:
“1) Receive-fixed, pay-variable interest rate swap based on the London Interbank Offered Rate (LIBOR) swap rate. A Level 2 input would be the LIBOR swap rate if that rate is observable at commonly quoted intervals for substantially the full term of the swap.
2) Receive-fixed, pay-variable interest rate swap based on a yield curve denominated in a foreign currency. A Level 2 input would be the swap rate based on a yield curve denominated in a foreign currency that is observable at commonly quoted intervals for substantially the full term of the swap. That would be the case if the term of the swap is 10 years and that rate is observable at commonly quoted intervals for 9 years, provided that any reasonable extrapolation of the yield curve for year 10 would not be significant to the fair value measurement of the swap in its entirety.
3) Receive-fixed, pay-variable interest rate swap based on a specific bank’s prime rate. A Level 2 input would be the bank’s prime rate derived through extrapolation if the extrapolated values are corroborated by observable market data, for example, by correlation with an interest rate that is observable over substantially the full term of the swap.
4) Three-year option on exchange-traded shares.
A Level 2 input would be the implied volatility for the shares derived through extrapolation to year 3 if both of the following conditions exist:
1. Prices for one-year and two-year options on the shares are observable.
2. The extrapolated implied volatility of a three-year option is corroborated by observable market data for substantially the full term of the option.
In that case the implied volatility could be derived by extrapolating from the implied volatility of the one-year and two-year options on the shares and corroborated by the implied volatility for three-year options on comparable entities’ shares, provided that correlation with the one-year and two-year implied volatilities is established.
1) Licensing arrangement.
For a licensing arrangement that is acquired in a business combination and was recently negotiated with an unrelated party by the acquired entity (the party to the licensing arrangement). A Level 2 input would be the royalty rate in the contract with the unrelated party at inception of the arrangement.
2) Finished goods inventory at a retail outlet.
For finished goods inventory that is acquired in a business combination, a Level 2 input would be either a price to customers in a retail market or a price to retailers in a wholesale market, adjusted for differences between the condition and location of the inventory item and the comparable (i.e. similar) inventory items so that the fair value measurement reflects the price that would be received in a transaction to sell the inventory to another retailer that would complete the requisite selling efforts. Conceptually, the fair value measurement will be the same, whether adjustments are made to a retail price (downward) or to a wholesale price (upward). Generally, the price that requires the least amount of subjective adjustments should be used for the fair value measurement.
3) Building held and used.
A Level 2 input would be the price per square metre for the building (a valuation multiple) derived from observable market data, e.g.,., multiples derived from prices in observed transactions involving comparable (i.e., similar) buildings in similar locations.
4) Cash-generating unit.
A Level 2 input would be a valuation multiple (e.g.,., a multiple of earnings or revenue or a similar performance measure) derived from observable market data, e.g.,., multiples derived from prices in observed transactions involving comparable (i.e., similar) businesses, taking into account operational, market, financial and non-financial factors.”
If the asset or liability has a specified (contractual) term, a Level 2 input must be observable for substantially the full term of the asset or liability.
Adjustments to Level 2 inputs should include factors such as the condition and/or location of the asset or the liability on the measurement date, and the volume and level of activity in the markets within which the inputs are observed. Adjustments are also required to the extent that inputs do not fully relate to items that are comparable to the asset or liability.
Level 2 inputs for similar but not identical instruments
On 1 January 20X5, entity A acquires a bond issued by entity B through a private placement. The consideration paid is C1 million, which is the bond’s fair value at initial recognition. The entity classifies the bond as at fair value through profit or loss. The bond has no observable market price. At 31 December 20X5, the entity is able to identify actively traded corporate bonds that are similar to its bond.
The bond being fair valued is not identical to the traded bonds, so adjustments to the observable price of the traded bonds might be required. The traded bonds are not identical, so the measurement will be Level 2.
In carrying out the evaluation, the major elements of the two bonds that should be compared are as follows:
· The amount and timing of the contractual cash flows, including prepayment expectations.
· The currency in which the bonds are payable.
· The credit risk rating and the factors on which changes in the credit risk rating are dependent. For example, the fair value of bonds issued by entities with different industry and geographical bases would be expected to respond differently to changes in the market factors.
· Any other terms and conditions that could affect the bond’s fair value.
An adjustment that is significant to the fair value measurement might place the measurement in Level 3 in the fair value hierarchy.
Certain inputs derived through extrapolation or interpolation might be corroborated by observable market data (for example, extrapolating observable one- and five-year interest rate yields to derive three-year yields) and would be considered Level 2 inputs.
Corroboration by market data (1)
Question:
Assume that:
· the Argentinian interest rate yield curve is correlated to the Chilean interest rate yield curve;
· the Argentinian yield curve is observable for three years; and
· the Chilean yield curve is observable for only two years.
How can management determine the third year of the Chilean yield curve?
Solution:
Management could determine the third year of the Chilean yield curve based on the extrapolation of the Chilean yield curve from years 1 and 2 and the correlation of the third-year Argentinian yield curve.
In this example, the Chilean yield for year 3 would be considered a Level 2 input. However, extrapolating short-term data to measure longer-term inputs might require assumptions and judgements that cannot be corroborated by observable market data and, therefore, might represent a Level 3 input.
Corroboration by market data (2)
Question:
Assume that: the Argentinian interest rate yield curve is correlated to the Chilean interest rate yield curve; the Argentinian yield curve is observable for three years; and the Chilean yield curve is observable for only two years. Assume that the entity prepares its fair value measurement based on interpolation of observable market data. How would the fair value measurement of a foreign exchange contract be classified in the fair value hierarchy if it is based on interpolated information?
Solution:
Key considerations in determining the appropriate classification within the fair value hierarchy include the following:
· A spot foreign exchange (FX) rate that can be observed through market data as being active is a Level 1 input.
· A fair value measurement that can be interpolated using externally quoted sources would generally be a Level 2 valuation. For example, assume that there are forward prices available for 30- and 60-day FX contracts that qualify as Level 1 inputs and the entity is measuring a 50- day contract. If the price can be derived through simple interpolation, the resulting measurement is a Level 2 valuation.
However, if the contract length is three years and prices are only available for the next two years, any extrapolated amount would be considered a Level 3 valuation (on the assumption that this is significant to the valuation) if there was no other observable market information to corroborate the pricing inputs in the third year. Unlike the Chilean interest rates which were corroborated by the Argentinian yield curve, the FX rate for the third year is not corroborated by any observable market information in this case.
Level 3 inputs are unobservable inputs for the asset or liability.
Level 3 inputs
Examples of Level 3 inputs are as follows:
“a) Long-dated currency swap. A Level 3 input would be an interest rate in a specified currency that is not observable and cannot be corroborated by observable market data at commonly quoted intervals or otherwise for substantially the full term of the currency swap. The interest rates in a currency swap are the swap rates calculated from the respective countries’ yield curves.
b) Three-year option on exchange-traded shares. A Level 3 input would be historical volatility, i.e., the volatility for the shares derived from the shares’ historical prices. Historical volatility typically does not represent current market participants’ expectations about future volatility, even if it is the only information available to price an option.
c) Interest rate swap. A Level 3 input would be an adjustment to a mid-market consensus (non-binding) price for the swap developed using data that are not directly observable and cannot otherwise be corroborated by observable market data
d) Decommissioning liability assumed in a business combination. A Level 3 input would be a current estimate using the entity’s own data about the future cash outflows to be paid to fulfil the obligation (including market participants’ expectations about the costs of fulfilling the obligation and the compensation that a market participant would require for taking on the obligation to dismantle the asset) if there is no reasonably available information that indicates that market participants would use different assumptions. That Level 3 input would be used in a present value technique together with other inputs, for example, a current risk-free interest rate or a credit-adjusted risk-free rate if the effect of the entity’s credit standing on the fair value of the liability is reflected in the discount rate rather than in the estimate of future cash outflows
e) Cash-generating unit. A Level 3 input would be a financial forecast (for example, of cash flows or profit or loss) developed using the entity’s own data if there is no reasonably available information that indicates that market participants would use different assumptions.”
Level 3 inputs should be used only when observable inputs are not available. The fair value measurement objective is to derive an exit price at the measurement date, from the perspective of a market participant, that holds the asset or owes the liability. Fair value measurements should, therefore, reflect the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk.
Both the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and the risk inherent in the inputs to the valuation technique should be considered in a Level 3 measurement.
Level 3 inputs should be developed using the best information available in the circumstances, which might include an entity’s own data. However, the entity’s own data should be adjusted if reasonably available information indicates that other market participants would use different data. For example, an entity should not factor in entity-specific synergies that are not available to market participants. An entity need not undertake exhaustive efforts to obtain information about market participant assumptions.
IFRS 13 permits the use of prices quoted by third parties (for example, pricing services and brokers), subject to the following:
- The reporting entity should determine that these prices are developed in accordance with IFRS 13 requirements, including those requirements regarding significant decrease in the volume/level of activity.
- Less weight is placed on quotes that do not reflect the result of transactions.
- The nature of a quote (for example, whether it is an indicative price or a binding offer) should be considered; more weight is given to binding offers.
Use of third-party pricing quotes
Question:
How should third-party quotes be considered in estimating fair value?
Solution:
Many reporting entities obtain information from pricing services − such as Bloomberg, Interactive Data Corporation, Loan Pricing Corporation, Markit’s Totem Service, broker pricing information and similar sources − for use as inputs in their fair value measurements. The information provided by these sources could be any level in the fair value hierarchy, depending on the source of the information for a particular security. Classification within the hierarchy is discussed below.
Level 1 inputs
For a price or other input to qualify as Level 1 in the fair value hierarchy, management should be able to obtain the price from multiple sources. Level 1 inputs relate to items traded on an exchange or an active index/market location.
Level 2 and Level 3 inputs
Reporting entities might rely on pricing services or published prices that represent a consensus reporting of multiple brokers. It might not be clear whether the prices provided can be transacted on. In order to support an assertion that a broker quote or information obtained from a consensus pricing service represents a Level 2 input, management should perform due diligence to understand how the price was developed, including understanding the nature and observability of the inputs used to determine that price. Additional corroboration could include:
· discussions with pricing services, dealers or other companies to obtain additional prices of identical or similar assets to corroborate the price;
· back-testing of prices, to determine historical accuracy against actual transactions; or
· comparisons with other external or internal valuation model outputs.
The level of due diligence performed is highly dependent on the facts and circumstances, such as the type and complexity of the asset or liability being measured, as well as its observability and liquidity in the marketplace. Generally, the more unique the asset or liability being measured and the less liquid it is, the more due diligence will be necessary to corroborate the price, in order to support classification as a Level 2 input.
When performing due diligence, management should clearly document the assessment performed, in arriving at its conclusions. Without additional supporting information, prices obtained from a single or multiple broker source or a pricing service are indicative values or proxy quotes; we believe that such information generally represents Level 3 inputs.
Further, management must have some higher-level (that is, observable) data to support classification of an input as Level 2. A broker quote for which the broker does not stand ready to transact cannot be corroborated by an internal model populated with Level 3 information, or with additional indicative broker quotes, to support a Level 2 classification. There might be other instances where pricing information can be corroborated by market evidence, resulting in a Level 2 input.
Ultimately, it is management’s responsibility to determine the appropriateness of its fair value measurements and their classification in the fair value hierarchy, including instances where pricing services are used. Therefore, reporting entities that use pricing services will need to understand how the pricing information has been developed, and they will need to obtain sufficient information to be able to determine where instruments fall within the fair value hierarchy and that the measure was computed in a manner that represents an exit price.
A pricing service could provide quoted prices for an actively traded equity security, which would be Level 1 inputs if corroborated by the reporting entity. The same pricing service might also provide a corporate bond price based on matrix pricing, which could constitute a Level 2 or a Level 3 input, depending on the information used in the model.
In another example, a reporting entity might obtain a price from a broker for a residential mortgage-backed security. The reporting entity might be fully aware of the depth and liquidity of the security’s trading in the marketplace, based on its historical trading experience.
In addition, the pricing methodology for the security might be common and well understood (for example, matrix pricing), and so less due diligence might be required. However, a similar conclusion might not be appropriate in all instances (for example, a collateralised debt obligation that is not frequently traded and does not have liquidity in the marketplace).
Impact of models on classification in the fair value hierarchy
Question:
How does the use of models in a valuation impact the classification within the fair value hierarchy?
Solution:
Reporting entities commonly use proprietary models to calculate certain fair value measurements (for example, some long-term derivative contracts, impairments of financial instruments, and illiquid complex financial investments). The level within the fair value hierarchy is determined based on the characteristics of the inputs to the valuation, and not on the model’s methodology or complexity. However, certain valuations might require the use of complex models to develop forward curves and other inputs; therefore, the models and inputs are frequently inextricably linked.
The use of a model does not automatically result in a Level 3 fair value measurement. For example, a standard valuation model that uses all observable inputs is likely to result in a measurement that is classified as Level 2. However, to the extent that adjustments or interpolations are made to Level 2 inputs in an otherwise standard model, the measurement might fall into Level 3, depending on whether the adjusted inputs are significant to the measurement. Further, if a reporting entity uses a valuation model that is proprietary and relies on unobservable inputs, the resulting fair value measurement will be categorised as Level 3.
Consider the measurement of a financial asset that is not actively traded. The valuation is performed using a proprietary model, incorporating unobservable inputs. However, while the financial asset is not actively traded, assume that the broker providing the inputs to be used in the model is standing ready to transact at the quoted price and/or sufficient corroborating data is obtained. Provided that the model does not include management assumptions used to make adjustments to the data, it might be reasonable to conclude that the inputs, and thus the measurement, would be classified as a Level 2 fair value measurement. However, if the entity is required to develop a forward price curve, because the duration of the contract exceeds the length of time that observable inputs are available, or is otherwise required to make adjustments to observable data, the valuation is relying on Level 3 inputs, and so it would be classified as a Level 3 fair value measurement if those inputs are significant to the overall fair value measurement.
Classification of funds invested in actively traded securities
Question:
How should funds invested only in actively traded securities be classified?
Solution:
Entities might invest in funds (an alternative investment) that invest primarily in exchange-traded equity securities. Such funds might not necessarily qualify for Level 1 classification in the fair value hierarchy.
The reporting entity should first determine the appropriate unit of account (that is, what is being measured). As discussed, the unit of account is determined based on other applicable IFRSs.
We would expect the unit of account for interests in mutual or alternative fund investments to be the interest in the investee fund itself, rather than the individual assets and liabilities held by the fund. The categorisation within the fair value hierarchy should be assessed based on the investment security of the fund itself, and not the securities within the fund. The investment would be classified as Level 1 if the fair value measurement of the interest in the fund (not the underlying investments) was determined using observable inputs that are quoted prices (unadjusted) for identical assets in active markets. The assessment should be based on the individual facts for each investment, and it should reflect the considerations discussed above.
An investor cannot ‘look through’ an interest in an alternative investment, to the underlying assets and liabilities, to estimate fair value or to determine the classification of the fair value measurement within the fair value hierarchy. The reporting entity should consider the inputs used to establish the fair value and whether they were observable or unobservable.
Active versus inactive markets
Determining whether a market is active focuses on the trading activity for the individual asset or liability being measured and not on the general levels of activity in the market in which the asset or liability is traded. For example, a security listed on the FTSE in London or HKEx in Hong Kong could be considered to be traded in an inactive market if the security itself is traded infrequently.
IFRS 13 sets out a list of factors that may indicate that there has been a significant decrease in the volume or level of activity for an asset or a liability relative to normal market activity for that asset or liability (or similar assets or liabilities). The presence of one or more of the factors listed in IFRS 13 alone is not sufficient to conclude that a market is not active. An entity should evaluate the relevance and significance of these factors to the individual asset or liability measured at fair value in order to determine whether the market for that asset or liability is inactive. A market is not deemed inactive simply because of insufficient trading volume relative to the size of an entity’s position.
The characterisation of a market as ‘active’ or ‘inactive’ may change as market conditions change. However, a decline in the volume of transactions for a particular asset or liability does not automatically mean that the market has become inactive. A market would still be considered active as long as the frequency and volume of relevant transactions are sufficient to provide ongoing pricing information.
Further, quoted prices from a market affected by a decline in the volume or level of activity should not be ignored unless the price is associated with a transaction that is not orderly. It is not appropriate to conclude automatically that all transactions occurring in a market exhibiting a significant decline in volume or level of activity are not orderly. IFRS 13 sets out a list of factors that may indicate that a transaction is not orderly. Very little weight should be given to prices observed for a transaction that is not orderly; more weight may be given to a price observed for an orderly transaction. However, the entity should evaluate carefully whether an adjustment may be needed to that price to ensure the fair value measurement is consistent with the objectives in IFRS 13.
When an asset or a liability could be exchanged in a number of markets (e.g.,. a financial asset or a financial liability that could be exchanged on a number of exchanges), the entity will need to consider which market is the most relevant for measuring fair value. IFRS 13 states explicitly that the emphasis within Level 1 is on determining both of the following:
- the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability; and
- whether the entity can enter into a transaction for the asset or liability at the price in that market at the measurement date.
When a quoted price in an active market is available, it should not be adjusted except in the circumstances listed below:
- When an entity holds a large number of similar (but not identical) assets or liabilities (e.g.,. debt securities) that are measured at fair value and a quoted price in an active market is available but not readily accessible for each of those assets or liabilities individually (i.e. given the large number of similar assets or liabilities held by the entity, it would be difficult to obtain pricing information for each individual asset or liability at the measurement date). In such circumstances, as a practical expedient, an entity may measure fair value using an alternative pricing method that does not rely exclusively on quoted prices (e.g.,. matrix pricing). However, the use of an alternative pricing method results in a fair value measurement categorised within a lower level of the fair value hierarchy.
- When a quoted price in an active market does not represent fair value at the measurement date. That might be the case if, for example, significant events (such as transactions in a principal-to-principal market, trades in a brokered market or announcements) take place after the close of a market but before the measurement date. An entity should establish and consistently apply a policy for identifying those events that might affect fair value measurements. However, if the quoted price is adjusted for new information, the adjustment results in a fair value measurement categorised within a lower level of the fair value hierarchy.
- When measuring the fair value of a liability or an entity’s own equity instrument using the quoted price for the identical item traded as an asset in an active market and that price needs to be adjusted for factors specific to the item or the asset. If no adjustment to the quoted price of the asset is required, the result is a fair value measurement categorised within Level 1 of the fair value hierarchy. However, any adjustment to the quoted price of the asset results in a fair value measurement categorised within a lower level of the fair value hierarchy.
If an entity holds a position in a single asset or liability (including a position comprising a large number of identical assets or liabilities, such as a holding of financial instruments) and the asset or liability is traded in an active market, the fair value of the asset or liability should be measured within Level 1 as the product of the quoted price for the individual asset or liability and the quantity held by the entity. That is the case even if a market’s normal daily trading volume is not sufficient to absorb the quantity held and placing orders to sell the position in a single transaction might affect the quoted price.
Published net asset values for open-ended investment funds as Level 1 inputs
Some open-ended investments funds not listed on a stock exchange may publish daily quotations of their net asset values (NAVs) at which redemptions or purchases of units occur without any adjustments to the published NAV. The redemptions and unit purchases may take place regularly at the quoted NAVs and there is no secondary market for the units because they are not transferrable (i.e. the sole transactions are issuances and redemptions of the units by the fund). These quoted NAVs may meet the definition of a Level 1 input provided that all of the elements of the definition in IFRS 13 are met.
Consequently, the following criteria must be satisfied:
- the price must be quoted in an active market;
- the price must be unadjusted;
- the price must be for an asset or a liability that is identical to the asset or liability being measured; and
- the entity must have access to the price at the measurement date.
For the price to be classified as a Level 1 input, it is not required that there be an active market between the holders of the financial instrument and other potential holders that are not the issuer of the financial instrument; it is possible that the financial instrument does not have an active market other than between the holders of the financial instrument and the issuer of the financial instrument.
Careful analysis is required when assessing whether such prices meet the definition of a Level 1 input. In particular, the assessment should include (1) whether quoted prices are readily and regularly available, (2) whether transactions occur regularly, and (3) whether the regularly occurring transactions take place at the quoted (unadjusted price) on an arm’s length basis.
Using quoted prices for a ‘similar’ asset or liability
Under IFRS 13 (see above), when an entity measures the fair value of an asset or a liability and no Level 1 inputs are available, it may use quoted prices for ‘similar’ assets or liabilities in active markets as a Level 2 input. Equally, under IFRS 13, entities holding a large number of ‘similar’ assets or liabilities for which a quoted price is not accessible for all of the assets and liabilities being measured, may measure fair value using alternative pricing (e.g.,. matrix pricing) as a practical expedient.
IFRS 13 does not provide any specific guidance as to what is meant by ‘similar’ in this context. The identification of a similar asset or liability involves the exercise of judgement and requires both:
- an understanding of the terms and other factors that affect the fair values of the asset or liability being measured and the asset or liability for which the quoted price exists; and
- an identification and assessment of any differences in the terms and other factors that affect the fair values of these assets or liabilities.
Specifically in relation to financial instruments, the Board’s Expert Advisory Panel’s October 2008 report Measuring and disclosing the fair value of financial instruments in markets that are no longer active provides additional material for consideration.
Determining how an input is classified when the item being measured has a specified contractual term – example
Company X enters into a fixed-price six-year agreement to sell 50 megawatts (MW) of on-peak electricity for delivery at location ABC beginning on 1 January 20X1 and continuing through to 31 December 20X6. On 31 March 20X1, Company X is measuring the fair value of the fixed-price agreement. Active market quotes are available for forward contracts to sell electricity at location ABC for two years (31 March 20X1 to 31 March 20X3). Accordingly, Company X will use the two years of observable forward pricing data and develop an expectation for the remaining three years and nine months (i.e. 1 April 20X3 to 31 December 20X6) using a model that relies on pricing data and weather patterns from the previous four years. The model also incorporates all relevant physical constraints (capacity of existing power plants and power plants expected to be completed near location ABC, projected supply and demand etc.).
In the circumstances described, the five-year and nine-month forward price curve represents a Level 3, rather than a Level 2, input.
An input for an item with a specified contractual term falls within Level 2 of the hierarchy only if it meets both of the following criteria:
- as required by IFRS 13 (see above), the input must be observable for substantially the full term of the asset or liability; and
- the impact of the unobservable period must not be significant to the fair value of the asset or liability. The guidance set out should be applied when evaluating whether the effect of the unobservable period is significant.
IFRS 13cites as an example an interest rate swap with a term of 10 years and for which the fair value is determined using a swap rate based on a yield curve that is observable at commonly quoted intervals for nine years. The swap rate input is a Level 2 input provided that any reasonable extrapolation of the yield curve for Year 10 would not be significant to the fair value measurement of the swap in its entirety.
In contrast, in the circumstances described, Company X can observe forward prices for only 24 months of the remaining 69-month term of the agreement (i.e. 35 per cent of the term). Because this does not represent substantially the full term, the first criterion above is not met. An analysis of the second criterion is unnecessary; the forward price curve is considered a Level 3 input. However, if the forward price curve had been observable for substantially the full term, Company X would need to consider the second criterion (i.e. whether the effect of the unobservable term is significant to the fair value of the agreement) to determine whether the forward price curve is a Level 2 or Level 3 input.
Determining whether adjustments are required to quoted prices for a similar asset or liability
An entity should consider whether adjustments to the quoted price for a similar asset or liability are necessary to reflect differences between the terms of the items being compared and other factors that may affect the fair values of those items. For example, the entity may need to make adjustments to reflect differences in the condition, location or risks (including non-performance risk and liquidity risk) of the items being compared.
Under IFRS 13, when a quoted price for the transfer of an identical or similar liability is not available and the identical item is held by another party as an asset, the fair value of the liability is measured from the perspective of a market participant that holds the identical item as an asset at the measurement date. The value should only be adjusted for factors specific to the asset that are not applicable to the fair value measurement of the liability. IFRS 13 provides a number of examples of such factors.
In addition, if an entity uses a quoted price for a similar item in its valuation technique, the entity may need to make adjustments to reflect differences in risk, including liquidity differences. For example, the item being measured may be in shorter supply (relative to demand) than the similar item for which a quoted price exists. In this situation, a liquidity risk premium exists for the item being measured that should be factored into the fair value measurement as an adjustment to the quoted price of the similar item.
Using quoted prices for a similar asset or liability – example
Sales of genetically modified wheat are increasing globally. However, there are no separate markets for genetically modified wheat and wheat that is not genetically modified. Thus, when measuring their agricultural produce at the time of harvest at fair value less costs to sell under IAS 41, sellers of genetically modified wheat use quoted prices for wheat that is not genetically modified. Because the quoted price is for a similar asset, that price would generally represent a Level 2 input. However, because genetically modified wheat has different characteristics to the wheat for which a quoted price exists, an adjustment should be made to reflect market participant assumptions about the price that would be received for selling genetically modified wheat. If the adjustment is significant to the entire measurement and based on unobservable data, the entire measurement would be classified as a Level 3 measurement.
An adjustment to a Level 2 input that is significant to the entire measurement might result in a fair value measurement categorised within Level 3 of the fair value hierarchy if the adjustment uses significant unobservable inputs.
IFRS 13 provides the following examples of Level 2 inputs for particular assets and liabilities:
- Receive-fixed, pay-variable interest rate swap based on the London Interbank Offered Rate (LIBOR) swap rate A Level 2 input would be the LIBOR swap rate if that rate is observable at commonly quoted intervals for substantially the full term of the swap.
- Receive-fixed, pay-variable interest rate swap based on a yield curve denominated in a foreign currency A Level 2 input would be the swap rate based on a yield curve denominated in a foreign currency that is observable at commonly quoted intervals for substantially the full term of the swap. That would be the case if the term of the swap is 10 years and that rate is observable at commonly quoted intervals for nine years, provided that any reasonable extrapolation of the yield curve for Year 10 would not be significant to the fair value measurement of the swap in its entirety.
- Receive-fixed, pay-variable interest rate swap based on a specific bank’s prime rate A Level 2 input would be the bank’s prime rate derived through extrapolation if the extrapolated values are corroborated by observable market data, e.g.,. by correlation with an interest rate that is observable over substantially the full term of the swap.
- Three-year option on exchange-traded shares A Level 2 input would be the implied volatility for the shares derived through extrapolation to Year 3 if both of the following conditions exist:
- prices for one-year and two-year options on the shares are observable; and
- the extrapolated implied volatility of a three-year option is corroborated by observable market data for substantially the full term of the option.
In that case, the implied volatility could be derived by extrapolating from the implied volatility of the one-year and two-year options on the shares and corroborated by the implied volatility for three-year options on comparable entities’ shares, provided that correlation with the one-year and two-year implied volatilities is established.
- Licensing arrangement For a licensing arrangement that is acquired in a business combination and was recently negotiated with an unrelated party by the acquired entity (the party to the licensing arrangement), a Level 2 input would be the royalty rate of the contract with the unrelated party at inception of the arrangement.
- Finished goods inventory at a retail outlet For finished goods inventory that is acquired in a business combination, a Level 2 input would be either a price to customers in a retail market or a price to retailers in a wholesale market, adjusted for differences between the condition and location of the inventory item and the comparable (i.e. similar) inventory items so that the fair value measurement reflects the price that would be received in a transaction to sell the inventory to another retailer that would complete the requisite selling efforts. Conceptually, the fair value measurement will be the same, whether adjustments are made to a retail price (downward) or to a wholesale price (upward). Generally, the price that requires the least amount of subjective adjustments should be used for the fair value measurement.
- Building held and used A Level 2 input would be the price per square metre for the building (a valuation multiple) derived from observable market data, e.g.,. multiples derived from prices in observed transactions involving comparable (i.e. similar) buildings in similar locations.
- Cash-generating unit A Level 2 input would be a valuation multiple (e.g.,. a multiple of earnings or revenue or a similar performance measure) derived from observable market data, e.g.,. multiples derived from prices in observed transactions involving comparable (i.e. similar) businesses, taking into account operational, market, financial and non-financial factors.
Determining the level within the fair value hierarchy when broker or pricing service quotes are used
IFRS 13 allows the use of quoted prices provided by brokers or pricing services if the entity has determined that the quoted prices provided by a broker or pricing service are developed in accordance with IFRS 13.
When quoted prices are provided by a broker or pricing service, and are used by an entity in measuring the fair value of an asset or a liability, the following considerations are relevant for the entity’s assessment of the level within the fair value hierarchy in which the quoted prices fall.
Level 1 inputs
Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities. If the quote provided by a broker or pricing service relies solely on unadjusted quoted prices in an active market for an identical instrument that the entity can access at the measurement date, the quoted price should be used to measure the fair value of the asset or liability without adjustment, subject to limited exceptions as discussed in IFRS 13.
If an adjustment is necessary in accordance with IFRS 13, or if the quoted price originates from a market that is not active, the broker or pricing service quote does not represent a Level 1 input.
Level 2 inputs
Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Observable inputs are defined in IFRS 13 as “inputs that are developed using market data, such as publicly available information about actual events or transactions, and that reflect the assumptions that market participants would use when pricing the asset or liability [or own equity instrument]”.
If a quote from a broker or pricing service meets any of the following criteria, it represents a Level 2 input.
- The entity can determine that the broker or pricing service quote itself represents a quoted price for similar assets or liabilities in active markets.
- The entity can determine that the quote is based on quoted prices for identical or similar assets or liabilities in markets that are not active, from transactions that are orderly and for which adjustments are based only on information that is (1) observable, or (2) market-corroborated, or (3) unobservable, but insignificant to the measurement.
- The entity can determine that the quote was established using a valuation technique and that the inputs the broker or pricing service used to arrive at the quoted price are observable or market-corroborated and any unobservable inputs do not have a significant effect on the measurement.
- The entity can corroborate the broker or pricing service quote or inputs using prices (1) from orderly transactions in an active market, or (2) from orderly transactions in an inactive market for which any adjustment needed to ensure the price is representative of fair value is insignificant to the measurement.
In some circumstances, adjustments to the Level 2 inputs may be necessary, for example if the quoted price is based on a similar (but not identical) asset or liability. If an adjustment is required, an entity should determine whether the adjustment is significant to the entire measurement and whether it is based on unobservable inputs. If this is the case, the entire measurement will be categorised within Level 3.
Level 3 inputs
Level 3 inputs are unobservable inputs for the asset or liability. Broker or pricing service quotes meeting any of the following criteria are categorised in Level 3 of the fair value hierarchy.
- The entity can determine that the quote is based on a Level 1 or Level 2 input but an adjustment is required that is significant to the measurement and based on unobservable inputs.
- The entity can determine that the quote is based on unobservable inputs with a significant effect.
Regardless of whether the entity determines that the broker or pricing service quote is based on observable or unobservable inputs, it is not appropriate for an entity to accept, without further analysis, that the inputs used are appropriate in the circumstances. The entity must gain sufficient understanding of the inputs to be able to conclude that they reflect assumptions market participants would use, including assumptions about risks inherent in a particular valuation technique and the inputs used. Further, an entity must be able to conclude that the inputs used are based on the best information available. Adjustments should be made if reasonably available information, including the entity’s own data, indicates that other market participants would use different inputs.
Other considerations
Depending on the asset or liability being measured at fair value, a quote from a broker or pricing service may be the only input, or one of many inputs, into an entity’s fair value measurement of that asset or liability. All inputs must be considered before determining the level within the fair value hierarchy for measurement of the asset or liability.
Other factors indicating that a broker or pricing service quote may be given more weight in the fair value measurement include that:
- the quote is binding on the entity making the quote; or
- the quote is available from more than one broker or pricing service.
IFRS Interpretations Committee agenda decision – January 2015
The IFRS Interpretations Committee considered the application of the fair value hierarchy when prices provided by a third party are used. In an agenda decision reported in the January 2015 IFRIC Update, the Committee concluded that “the classification of those measurements within the fair value hierarchy will depend on the evaluation of the inputs used by the third party to derive those prices, instead of on the pricing methodology used”. Consequently, as discussed above, the inputs used by the broker or pricing service in determining a quotation must be assessed to determine the classification of the asset or liability within the fair value hierarchy.
Disclosure
IFRS 13 in the illustrative examples accompanying IFRS 13 suggests that, in order to comply with the disclosure requirements in IFRS 13, an entity may disclose “how third-party information such as broker quotes, pricing services, net asset values and relevant market data was taken into account when measuring fair value” as part of the entity’s additional information about significant unobservable inputs. Further, IFRS 13 suggests that, in order to comply with the disclosure requirements in IFRS 13, an entity may disclose how the entity determined that third-party information, such as broker quotes or pricing services, used in the fair value measurement was developed in accordance with IFRS 13 as part of the entity’s description of its valuation process for Level 3 fair value measurements.
Use of historical transaction prices in determining the fair value of real estate properties
Although there may be circumstances when properties are sufficiently similar that the sales price of one is considered as indicative of the value of another, historical prices for sales of similar properties are not always an appropriate measure of fair value.
IFRS 13 requires entities to maximise the use of relevant observable data and minimise the use of unobservable data; consequently, an appropriate, publicly available comparable transaction price should be used in preference to, for example, an unobservable estimate of the reversionary yield on a property.
However, evidence of historical market transactions should not be followed without question. Trends in value and the market evidence available (whether for directly comparable transactions or otherwise) should be taken into account and, when appropriate, the valuation should be adjusted for such evidence to reflect the fair value definition. Judgement should also be applied in attaching more or less weight to various sources of evidence.
Market trends and the time elapsed since historical transactions occurred will also dictate whether those transactions are relevant to the valuation of the property concerned. For example, when, at the measurement date, there is evidence that the market has changed significantly since the most recent transaction in similar property, and/or a significant period has passed since that most recent transaction, historical transactions will not necessarily reflect those subsequent market changes. It would not be appropriate to take into account historical transaction prices which are not indicative of market conditions at the measurement date.
In a depressed market, when a significant proportion of sales may be made by vendors such as liquidators or receivers, historical transaction prices may still be relevant in measuring the fair value of investment property. However, care should be exercised to ensure that such transaction prices reflect exchange prices in an orderly transaction.
Application of Level 1 classification criteria – examples
Based on the definition in IFRS 13, for a fair value measurement to be categorised in Level 1 of the fair value hierarchy, the following criteria must be satisfied:
- the only input used must be a price (or prices) quoted in an active market;
- the price must be unadjusted. IFRS 13 requires that any adjustment to a fair value measurement (regardless of its significance) that would otherwise meet the Level 1 criteria results in the fair value measurement being categorised as a lower-level measurement;
- the price must be for an asset or a liability that is identical to the asset or liability being measured; and
- the entity must have access to the price at the measurement date. For example, an entity has access to the price if it has the ability to transact at that price in an exchange market. In addition, an entity has access to the price if there are dealers who stand ready to transact with the entity at that price. However, broker quotes by themselves are not sufficient evidence that the entity has access to the price if the brokers do not stand ready to transact at that price. Any adjustment made to a quoted price in an active market because the entity has limited or no access to that market results in a Level 2 or a Level 3 measurement, depending on the nature of the adjustment. Further, although a quoted price in an active market may be available, such pricing may not be readily accessible for all of the assets and liabilities being measured, if an entity holds a large volume of similar (but not identical) instruments. As a result, the entity may measure fair value using alternative pricing (e.g.,. matrix pricing) as a practical expedient, which would result in a lower level measurement in the fair value hierarchy.
Application of Level 1 classification criteria: debt security – example
Entity P holds a debt security that is traded in a dealer market in which bid and ask prices are available. The market is an active market and it is the principal market for the security. The market is accessible by Entity P. No adjustments have been made to the quoted price.
If the quoted price used to measure the fair value of the debt security is for a debt security identical to that held by Entity P, the measurement of the debt security should be classified within Level 1 of the fair value hierarchy. The fact that a price is derived from a dealer market (rather than an ‘exchange’ market) does not in itself preclude classification as a Level 1 measurement because such dealer markets may be active and accessible to the entity.
Application of Level 1 classification criteria: issued debt security with identical instrument traded as an asset – example
Entity Q has issued an exchange-traded debt security. Entity Q has elected to account for this instrument using the fair value option under IFRS 9 (or, for entities that have not yet adopted IFRS 9, IAS 39). A quoted price for the transfer of an identical or a similar liability is not available; however, an identical instrument is currently trading as an asset in an active market. Entity Q uses the quoted price for the asset as its initial input for the fair value measurement of the issued debt security. Entity Q also evaluates whether the quoted price for the asset requires adjustment for factors, such as third-party credit enhancements, that would not be applicable to the issued debt security. Entity Q determines that no adjustments are required to the quoted price of the asset.
Because the quoted price used to measure the fair value of the issued debt security is for an identical debt security (e.g.,. the identical ISIN*) traded as an asset, and no adjustments to the quoted price of the instrument are required, the resulting measurement of the issued debt security should be classified as a Level 1 measurement in the fair value hierarchy.
*ISIN refers to the International Securities Identification Number, a 12-character alpha-numerical code that does not contain information characterising financial instruments but serves for uniform identification of a security at trading and settlement.
Application of Level 1 classification criteria: ‘look-alike’ forward contract – example
Entity R holds an over-the-counter (OTC) ‘look-alike’ forward contract (i.e. it mirrors another contract). The counterparty to this contract is contractually obligated to settle it on the basis of the quoted price for a similar futures contract traded on an active futures exchange. The forward contract meets the definition of a derivative and is therefore measured at fair value.
While the look-alike forward contract mirrors the exchange-traded futures contract, and the value of the look-alike forward contract is intended to approximate the quoted price for the exchange-traded futures contract, the forward and futures contracts are not identical. Even if the parties to the forward contract both have the highest credit quality (resulting in the same level of credit risk as the exchange-traded futures contract), the forward contract is not considered identical because (1) the counterparties are different, and (2) Entity R cannot sell the forward contract on the futures exchange (i.e. the forward contract has different levels of counterparty and liquidity risk when compared to the futures contract). While the quoted price for the futures contract may be a Level 1 input (when the market for it is active), the fair value measurement of the look-alike forward contract can only be classified as Level 2 or Level 3.
Application of Level 1 classification criteria: interest rate swap – example
Entity S is a party to an interest rate swap that is transacted on an over-the-counter (OTC) market. The OTC market does not quote prices for interest rate swaps. Entity S would determine the fair value of the swap by using either (1) a discounted cash flow approach based on market-based yield curves, or (2) the price at which a similar swap was exchanged on the OTC market. While similar swaps may have been exchanged on the OTC market, the similar swaps would have different counterparties and would, therefore, not be identical to the swap held by Entity S.
The price at which Entity S would be able to sell the swap would result from a negotiated transaction contemplating the credit standings of the two parties to the swap as well as the terms of the specific swap. Because the swap held by Entity S is not identical to any similar swap for which there may be transactions on the OTC market, the measurement of the swap by Entity S would be classified as a Level 2 or a Level 3 measurement, depending on the inputs that are significant to the measurement.
Classification of fair value measurements within the fair value hierarchy – example
Entity I holds an investment in equity instruments that are not traded in an active market (e.g.,. equity instruments issued by a private entity). In accordance with IFRS 9 (or, for entities that have not yet adopted IFRS 9, IAS 39), the investment is measured at fair value subsequent to initial recognition.
The examples below illustrate the application of the guidance in IFRS 13 on the classification of measurements within the fair value hierarchy.
Note that, because the equity instruments are not traded in an active market, Level 1 inputs are not available.
Scenario 1 – Fair value is estimated based on recent transactions
If Entity I estimates the fair value of its investment based on recent transactions between independent third parties (e.g.,. quoted prices in an inactive market, privately negotiated acquisitions or disposals of the equity instruments etc.), these transaction prices would be considered Level 2 inputs if they meet the definition of fair value. This would be the case if the price represents an exit price for the equity instruments at the date of the transaction, the transaction is executed at terms that are consistent with how other market participants would transact, and the transaction is not executed under duress.
Similarly, prices based on recent transactions between Entity I and third parties may be considered Level 2 inputs if they meet the criteria above. For example, Entity I owns a 5 per cent equity investment in Entity X and measures that investment at fair value. Entity I acquires an additional 10 per cent of Entity X. If the transaction price for the additional 10 per cent meets the definition of fair value, Entity I may use that price as a basis for valuing its entire 15 per cent investment at the next reporting date.
In either case, it may be necessary to adjust the recent transaction price to measure the investment appropriately at fair value at the reporting date. For example, the recent transaction price should be adjusted for events or changes in the entity’s financial position that have occurred since the date of the transaction that would affect the value of the equity investment in the entity. Unobservable adjustments to a Level 2 input that are significant to the entire measurement would change the categorisation to Level 3.
Scenario 2 – Fair value is determined based on a discounted cash flow technique
IFRS 13 cites as an example of a Level 3 input “a financial forecast (eg of cash flows or earnings) developed using the entity’s own data if there is no reasonably available information that indicates that market participants would use different assumptions”. While certain information used in the model may be observable (e.g.,. interest rate curves), the entity’s projected cash flows (which are not observable) would probably be significant to the entire fair value measurement. Therefore, the measurement of the investment would probably be classified as Level 3.
Scenario 3 – Fair value is determined based on a market-based multiple applied to a financial measure
IFRS 13 cites as an example of a Level 2 input “a valuation multiple (eg a multiple of earnings or revenue or a similar performance measure) derived from observable market data, eg multiples derived from prices in observed transactions involving comparable (that is, similar) businesses, taking into account operational, market, financial, and non-financial factors”. The market-derived multiple may thus be considered a Level 2 input. However, the historical financial measure (i.e. earnings or EBITDA) and any adjustments needed to reflect differences between the entity and comparable entities would probably be Level 3 inputs because they are entity-specific and are not considered market-observable data. Therefore, the measurement of the investment would probably be classified within Level 3 of the fair value hierarchy.
Determining the ‘significance’ of an input or an adjustment
To determine the level in which the fair value measurement should be categorised, an entity should aggregate the inputs to the measurement by level and determine the lowest level of inputs that are significant to the fair value measurement in its entirety. For example, a measurement that includes inputs with significant effect from Levels 2 and 3 would be classified in its entirety in Level 3, because Level 3 is the lowest level input with a significant effect.
Entities should establish a methodology for determining whether an input or aggregated inputs are significant to the measurement in its entirety. The methodology should be applied consistently.
In some cases, a qualitative assessment of the inputs used may be sufficient. For example, changes in discount rates generally have a significant effect on fair value measurements determined using a discounted cash flow model.
In other cases, a quantitative analysis of the inputs may be required. One quantitative approach might involve the following steps.
- Step 1 Select a threshold or percentage of the overall fair value measurement as a benchmark for significance.
- Step 2 Perform a sensitivity analysis, calculating the percentage change in the fair value measurement arising from reasonably possible changes to each input.
- Step 3 Compare the percentage change in the fair value measurement for each input calculated under Step 2 to the benchmark selected under Step 1. If the percentage change in the fair value measurement for a particular input exceeds the selected benchmark, that input would be considered significant. If none of the individual Level 3 inputs are considered significant, the combined effect of all the Level 3 inputs should be considered to determine whether they have a significant effect in aggregate on the fair value measurement.
When this approach is used, the benchmark should represent a percentage of the overall measurement and not a percentage of a particular component of the fair value measurement. In addition, the threshold should not represent a percentage of total assets, total liabilities, gains or losses, or other line items in the statement of financial position or the statement of comprehensive income because this would not be specific to the fair value measurement.
Determining the significance of an input – example
Entity A holds a hybrid instrument which includes an embedded option. Entity A is measuring the instrument at fair value in its entirety. One of the inputs to its valuation model is the volatility of the embedded option for which market data are not available (i.e. it is unobservable and, consequently, a Level 3 input).
Entity A is evaluating whether the unobservable volatility input is significant to the overall fair value measurement for the hybrid instrument. In making its assessment, Entity A considers the significance of the volatility in relation to the hybrid instrument in its entirety and not solely in relation to the embedded option.
Entity A uses a quantitative methodology and selects a threshold or percentage of the overall fair value measurement of the hybrid instrument as a benchmark for significance. Entity A then performs a sensitivity analysis to determine how the volatility input affects the overall fair value of the hybrid instrument within a reasonably possible range of values for the volatility input.
If reasonable changes in the volatility input cause the percentage change in the fair value measurement of the hybrid instrument to exceed the selected threshold, Entity A would conclude that the unobservable volatility input is significant to the measurement in its entirety. In that case, the fair value measurement of the hybrid instrument would represent a Level 3 measurement within the fair value hierarchy.
Observable transactions in inactive markets
The level of market activity does not affect the IFRS 13 measurement objective, i.e. fair value is the price in an orderly transaction between market participants at the measurement date under current market conditions.
Observable transactions are relevant inputs to a fair value measurement when they reflect market participants’ assumptions in orderly transactions and, thus, are representative of fair value. Relevant observable inputs should be given priority when measuring fair value in accordance with IFRS 13. IFRS 13 states that “valuation techniques used to measure fair value shall maximise the use of relevant observable inputs and minimise the use of unobservable inputs”. Further, IFRS 13 states, in part, that “unobservable inputs [Level 3] shall be used to measure fair value to the extent that relevant observable inputs [Level 1 and Level 2] are not available…”.
However, when the volume and level of activity in a market have significantly decreased and the market is not active, observable transactions may not be representative of fair value because of increased instances of transactions that are not orderly (e.g.,. forced liquidations or distress sales). Consequently, an entity should perform further analysis of the transactions or quoted prices available to determine whether they represent fair value. In some circumstances, a change in valuation technique or the use of multiple valuation techniques may be appropriate, as discussed below.
Transactions are not orderly
If the observable transactions are not orderly, IFRS 13 states that “the entity shall place little, if any, weight (compared with other indications of fair value) on that transaction price”. If an entity previously used quoted prices to measure fair value, and quoted prices from orderly transactions are no longer available, the entity may need to change its valuation technique or use multiple valuation techniques. If the entity measures fair value by using the price from a transaction that is not orderly, the price should be adjusted to reflect the assumptions that market participants would use in pricing the asset or liability in an orderly transaction. The resulting measurement would generally be classified as a Level 3 measurement.
Transactions are orderly
If the observable transactions are orderly, the entity should consider the transaction price when estimating fair value. However, the entity may also need to adjust the transaction price when measuring fair value to meet the measurement objective. IFRS 13 states that the “amount of weight placed on that [orderly] transaction price when compared with other indications of fair value will depend on the facts and circumstances”.
If an entity determines that it does not need to make any significant adjustment to the transaction price using unobservable inputs to arrive at the fair value of the asset or liability, the transaction price represents a relevant observable input and the measurement would be classified as a Level 2 measurement. However, if the entity determines that it needs to make a significant adjustment to the transaction price using unobservable inputs, the measurement would be classified as a Level 3 measurement.
Insufficient information to determine whether transactions are orderly
If an entity is unable to obtain, without undue cost and effort, sufficient information to determine whether the transaction is orderly, the entity must consider the transaction price in determining fair value; however, the transaction price may not be the ‘sole or primary’ basis for estimating fair value. In such circumstances, because the transaction price may not reflect the assumptions that market participants would use, a fair value measurement that has this price as its principal input would most likely represent a Level 3 measurement. As above, the use of multiple valuation techniques may be appropriate in this case.
Relationship between the quality of a valuation and its classification in the fair value hierarchy
The classification of a fair value measurement within the hierarchy specified by IFRS 13 is not indicative of the ‘quality’ of that valuation. The hierarchy differentiates between inputs to a fair value measurement on the basis of their observability, not their quality. As stated in IFRS 13, the purpose of the hierarchy is to increase the consistency and comparability of fair value measurements, an aim which is achieved by giving priority to more observable inputs. It is clear from IFRS 13, however, that if a market participant would take account of a less observable factor then that must be incorporated into a fair value measurement.
In particular, it is important to note that the fact that a fair value measurement incorporates significant unobservable inputs and is, therefore, classified as ‘Level 3’ does not mean that the fair value measurement is of low quality or is not reliable. IFRS 13 acknowledges that unobservable inputs by necessity include some degree of subjectivity, but concludes that this is best addressed by requiring enhanced quantitative and qualitative disclosures (e.g.,. details of valuation techniques and inputs being used and sensitivity analysis as required by IFRS 13) for fair value measurements incorporating such inputs. As noted in IFRS 13, these disclosures give the user information about inputs for which limited or no information is publicly available and, as such, exist to address the lack of observability of Level 3 inputs rather than because such inputs are not deemed to be of sufficient quality.
Classification of fair value measurements of real estate properties within the fair value hierarchy
In practice, the majority of fair value measurements for real estate properties are likely to be classified as Level 3 because the underlying valuation techniques use significant unobservable inputs. Less commonly, the appropriate classification of the fair value measurement of a real estate property could be Level 2 if sufficient observable data are available and no significant adjustments to the observable data are required.
Given that no two properties are identical in terms of location, condition, specification and other factors, it would be extremely rare for Level 1 inputs to be available for the valuation of real estate properties.
The following examples illustrate contrasting scenarios.
Example 1
Entity A owns a completed commercial building in Hong Kong which is classified as an investment property in accordance with IAS 40 and is currently leased out to tenants. Buy-and-sell transactions in the same market for similar properties are infrequent. Consequently, Entity A engages a valuer who uses a valuation technique requiring the estimation of future rental income and yield for the property (e.g.,. an income capitalisation approach when the fair value of the property is arrived at by discounting (1) the contracted annual rent at a capitalisation rate over the existing contractual lease period, and (2) the current market rent at a reversionary yield over the period beyond the existing contractual lease period).
In such circumstances, the contracted annual rent may be observable, but the capitalisation rate and the reversionary yield are unlikely to be so, particularly when sale and leasing transactions for similar properties in the same market are not frequent. Use of a significant unobservable input (such as the capitalisation rate or reversionary yield) will result in the property being classified as Level 3.
Example 2
Entity B owns a residential apartment unit in Hong Kong that is classified as an investment property in accordance with IAS 40. The fair value of the apartment unit can be measured based on publicly available information regarding the average of recent transaction prices for similar properties (e.g.,. located in the same or a similar building with similar size and facing), and no significant adjustments are required to be made to the average transaction price.
In such circumstances, it would be appropriate to classify the fair value measurement as Level 2. In contrast, if adjustments are required to the observable data that are (1) based on unobservable data, and (2) significant to the fair value measurement as a whole, the fair value measurement should be classified as Level 3.
In the case of properties under development (e.g.,. investment properties under construction that are measured at fair value at each reporting date in accordance with IAS 40), the measurement of fair value will generally require the use of valuation methodologies with significant unobservable inputs because buy-and-sell transactions for similar properties under development are infrequent. Consequently, the fair value measurements will generally be classified as Level 3. For example, the residual approach to measuring the fair value of properties under development takes into account the expected completion value of the property, less the expected future development costs, with adjustments for profit and risk. The estimated costs to develop the property and the adjustments for risk are specific to the property and are unobservable inputs.
Inactive markets and non-orderly transactions
The following flow chart highlights the considerations in determining the level of reliance on market prices, assuming that the transaction price was fair value before the decline in activity:
Factors that should be considered in determining whether there has been a significant decrease in the volume or level of activity are (relative to the normal market activity):
- There are few recent transactions.
- Price quotations are not developed using current information.
- Price quotations vary substantially, either over time or among market-makers (for example, some brokered markets).
- Indices that were previously highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability.
- There is a significant increase in implied liquidity risk premiums, yields or performance indicators (such as delinquency rates or loss severities) for observed transactions or quoted prices when compared with the entity’s estimate of expected cash flows, taking into account all available market data about credit and other non-performance risk for the asset or liability.
- There is a wide bid-ask spread or significant increase in the bid-ask spread.
- There is a significant decline in the activity of, or there is an absence of, a market for new issues (that is, a primary market) for the asset or liability or similar assets or liabilities.
- Little information is publicly available (for example, for transactions that take place in a principal-to-principal market).
If there has been a significant decrease in the volume or level of activity, further analysis is needed. The entity might conclude one of the following three things:
- The transaction or quoted price still represents fair value (assuming that it did in the first place). A decline in volume/activity, on its own, might not indicate that the quoted price does not represent fair value.
- The transaction or quoted price does not represent fair value. In such cases, an adjustment is required if:
- those prices are still used as the basis for measuring fair value, and the adjustment might be significant to the fair value measurement; and
- other circumstances necessitate the adjustment – for example, where a price for a similar asset requires significant adjustment to make it comparable to the asset being measured or where the price is stale.
- The transaction is not orderly.
Where the decrease in volume/activity necessitates an adjustment:
- Appropriate risk adjustments should be included for the uncertainty inherent in the cash flows, even where such adjustments are difficult to determine.
- A change in valuation technique or the use of multiple valuation techniques might be appropriate. Where multiple techniques result in a wide range of fair values, further analysis might be required.
- The objective of a fair value measurement remains the same − that is, to determine 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 under current market conditions. However, IFRS 13 does not specify a methodology for making such adjustments.
An entity’s intention to hold an asset or settle a liability is not considered in measuring fair value, because fair value is a market-based measurement and not an entity-specific measurement. Management intentions could be different from what a market participant would expect.
Identifying transactions that are not orderly
It is inappropriate to conclude that all transactions in a market are not orderly simply due to a significant decrease in volume/level of activity. Indications that transactions are not orderly include:
- There was inadequate 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 under current market conditions.
- There was a usual and customary marketing period, but the seller marketed the asset or liability to a single market participant.
- The seller is in or near bankruptcy or receivership (distressed).
- The seller was required to sell to meet regulatory or legal requirements (if the seller was forced; not all requirements to divest result in a forced sale; many are made in circumstances which allow sufficient time and marketing effort to result in an orderly disposal).
- The transaction price is an outlier when compared with other recent transactions for the same or a similar asset or liability.
Exhaustive efforts are not required to determine whether a transaction is orderly, but reasonably available information should not be ignored. If the entity is a party to a transaction, it is presumed to have sufficient information to conclude whether the transaction is orderly.
Little, if any, weight is given to the transaction price for transactions that are not orderly. The amount of weight placed on an orderly transaction price will depend on transaction volume, comparability of the transaction to the asset or liability being measured, proximity of the transaction to the measurement date, and other facts and circumstances. If there is insufficient information to conclude whether or not a transaction is orderly, the transaction price is considered but given a lower weighting than prices from other, orderly, transactions. This is also illustrated in Example 14 in the Illustrative examples accompanying IFRS 13.
Determining whether a transaction is orderly – example
Entity A is acting as an administrator on behalf of the creditors of Entity B, which is subject to bankruptcy proceedings. The administrator’s role is to seek to maximise the return to Entity B’s creditors. As part of Entity A’s responsibilities, it auctions a portfolio of Entity B’s financial assets. Entity A promotes the auction to interested parties with the expectation of receiving bids for the financial assets over a specified period.
Even though the financial assets are being sold as part of bankruptcy proceedings, the auction process may be considered to be an orderly transaction provided that all of the necessary conditions are met.
IFRS 13 defines an orderly transaction 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 (eg a forced liquidation or distress sale)”.
In the circumstances described, it seems possible that the auction process may be considered to be an orderly transaction because the sale is not immediate and there is sufficient (i.e. usual and customary) time to market the assets to other market participants.