IFRS 13 – FAIR VALUE MEASUREMENTS
NEED FOR FAIR VALUE GUIDANCE & IFRS 13:
IFRS 13 provides a single source of guidance for all fair value measurements, clarifying the definition of fair value and enhancing disclosures requirements about reported fair value estimates.
IFRS 13, Fair Value Measurement was issued in May 2011 and defines fair value, establishes a framework for measuring fair value and requires significant disclosures relating to fair value measurement. The International Accounting Standards Board (IASB) wanted to enhance disclosures for fair value in order that users could better assess the valuation techniques and inputs that are used to measure fair value. There are no new requirements as to when fair value accounting is required but rather it relies on guidance regarding fair value measurements in existing standards.
The guidance in IFRS 13 does not apply to transactions dealt with by certain standards. For example share based payment transactions in IFRS 2, Share-based Payment, leasing transactions in IFRS 16, Leases, or to measurements that are similar to fair value but are not fair value – for example, net realisable value calculations in IAS 2, Inventories or value in use calculations in IAS 36, Impairment of Assets. Therefore, IFRS 13 applies to fair value measurements that are required or permitted by those standards not scoped out by IFRS 13. It replaces the inconsistent guidance found in various IFRSs with a single source of guidance on measurement of fair value
FAIR VALUE DEFINITION
Fair value is 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.
From the above definition, it can be inferred that fair value is an exit price. Consequently, fair value is focused on the assumptions of the market place, is not entity specific and so takes into account any assumptions about risk. This means that fair value is measured using the same assumptions used by market participants and takes into account the same characteristics of the asset or liability. Such conditions would include the condition and location of the asset and any restrictions on its sale or use.
An entity cannot argue that prices are too low relative to its own valuation of the asset and that it would be unwilling to sell at low prices. The prices to be used are those in ‗an orderly transaction‘. An orderly transaction is one that assumes exposure to the market for a period before the date of measurement to allow for normal marketing activities to take place and to ensure that it is not a forced transaction. If the transaction is not ‗orderly‘ then there will not have been enough time to create competition and potential buyers may reduce the price that they are willing to pay. Similarly if a seller is forced to accept a price in a short period of time, the price may not be representative. Therefore, it does not follow that a market in which there are few transactions is not orderly. If there has been competitive tension, sufficient time and information about the asset, then this may result in an acceptable fair value.
Unit of account
IFRS 13 does not specify the unit of account that should be used to measure fair value. This means that it is left to the individual standard to determine the unit of account for fair value measurement. A unit of account is the single asset or liability or group of assets or liabilities. The characteristic of an asset or liability must be distinguished from a characteristic arising from the holding of an asset or liability by an entity. An example of this is where an entity sells a large block of shares, and it has to sell them at a discount price to the market price. This is a characteristic of holding the asset rather than a characteristic of the asset itself and should not be taken into account when fair valuing the asset.
MARKETS – ACTIVE MARKET
A market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis
MARKETS – PRINCIPAL MARKET
Fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place in the principal market for the asset or liability or, in the absence of a principal market, in the most advantageous market for the asset or liability. The principal market is the one with the greatest volume and level of activity for the asset or liability that can be accessed by the entity.
IFRS 13 provides a new framework to estimate fair value in a consistent manner across standards. For a fair value measurement, an entity has to determine:
- The particular asset or liability that is the subject of the measurement
- For an asset, the valuation premise that is appropriate for the measurement
- The most advantageous market for the asset or liability and
- The valuation technique appropriate for measurement
MARKETS – THE MOST ADVANTAGEOUS MARKET
It is assumed that transactions take place in the most advantageous market to which the entity has access. This means that the entity is in a position to receive the maximum amount on sale of the asset or pay the minimum amount to transfer a liability after considering transaction and transport costs.
While transaction and transport costs are relevant to identify the market, they are not considered in determining the fair value.
Fair value measurement of an asset or liability should use the assumptions that market participants would use in pricing the asset or liability. These assumptions include:
- Buyers and sellers are independent of each other
- They have knowledge about the asset or liability
- They are capable of entering into a transaction
- They are willing to enter into a transaction, rather than being forced or otherwise compelled.
An entity uses valuation techniques 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.
Where fair value is determined using a valuation technique, IFRS 13 prescribes that the technique should be one of the following.
- Market approach: uses price and other relevant market information for identical or comparable assets or liabilities
- Income approach: converts future amounts to a single discounted present value amount or Cost approach: amount that would currently be required to replace the service capacity of the asset
When measuring fair value, the entity is required to maximise the use of observable inputs and minimise the use of unobservable inputs. To this end, the standard introduces a fair value hierarchy, which prioritises the inputs into the fair value measurement process.
FAIR VALUE HIERARCHY
IFRS 13 seeks to increase consistency and comparability in fair value measurements and related disclosures through a ‘Fair Value Hierarchy’. The hierarchy categorises the inputs used in valuation techniques into three levels.
Level 1 Inputs
Level 1 inputs are unadjusted quoted prices in active markets for items identical to the asset or liability being measured. As with current IFRS, if there is a quoted price in an active market, an entity uses that price without adjustment when measuring fair value. An example of this would be prices quoted on a stock exchange. The entity needs to be able to access the market at the measurement date. Active markets are ones where transactions take place with sufficient frequency and volume for pricing information to be provided. An alternative method may be used where it is expedient. The standard sets out certain criteria where this may be applicable. For example where the price quoted in an active market does not represent fair value at the measurement date. An example of this may be where a significant event takes place after the close of the market such as a business reorganisation or combination.
The determination of whether a fair value measurement is based on level 2 or level 3 inputs depends on (i) whether the inputs are observable inputs or unobservable and (ii) their significance.
Level 2 Inputs
Level 2 inputs are inputs other than the quoted prices in determined in level 1 that are directly or indirectly observable for that asset or liability. They are likely to be quoted assets or liabilities for similar items in active markets or supported by market data. For example interest rates, credit spreads or yields curves. Adjustments may be needed to level 2 inputs and, if this adjustment is significant, then it may require the fair value to be classified as level 3.
Level 3 Inputs
Finally, level 3 inputs are unobservable inputs. These inputs should be used only when it is not possible to use Level 1 or 2 inputs. The entity should maximise the use of relevant observable inputs and minimise the use of unobservable inputs.
However, situations may occur where relevant inputs are not observable and therefore these inputs must be developed to reflect the assumptions that market participants would use when determining an appropriate price for the asset or liability.
The general principle of using an exit price remains and IFRS 13 does not preclude an entity from using its own data. For example cash flow forecasts may be used to value an entity that is not listed. Each fair value measurement is categorised based on the lowest level input that is significant to it.
ASSET -SPECIFIC VALUATIONS
For a fair value measurement of an asset, it is assumed that the asset will be sold to a market participant who will use it at its highest and best use.
LIABILITY or EQUITY – SPECIFIC VALUATION
Fair value measurement of a liability, or owner‘s own equity assumes that the liability is transferred to a market participant at the measurement date. In many cases there is no observable market to provide pricing information and the highest and best use is not applicable. In this case, the fair value is based on the perspective of a market participant who holds the identical instrument as an asset.
Where there is no observable market price for the transfer of a liability, an entity would be required to measure the fair value of the liability using the same methodology that the counterparty would use to measure the fair value of the corresponding asset.
If there is no corresponding asset, then a corresponding valuation technique may be used. This would be the case with a decommissioning activity.
The fair value of a liability reflects the non-performance risk based on the entity‘s own credit standing plus any compensation for risk and profit margin that a market participant might require to undertake the activity. Transaction price is not always the best indicator of fair value at recognition because entry and exit prices are conceptually different.
IFRS 13 also sets out certain valuation concepts to assist in the determination of fair value. For nonfinancial assets only, fair value is determined based on the highest and best use of the asset as determined by a market participant.
Highest and best use is a valuation concept that considers how market participants would use a nonfinancial asset to maximise its benefit or value. The maximum value of a non-financial asset to market participants may come from its use in combination with other assets and liabilities or on a standalone basis.
In determining the highest and best use of a non-financial asset, IFRS 13 indicates that all uses that are physically possible, legally permissible and financially feasible should be considered. As such, when assessing alternative uses, entities should consider the physical characteristics of the asset, any legal restrictions on its use and whether the value generated provides an adequate investment return for market participants.
RULES IN BUSINESS COMBINATION:
IFRS 3 sets out general principles for arriving at the fair values of a subsidiary’s assets and liabilities only if they satisfy the following criteria:
- In the case of an asset other than an intangible asset, it is probable that any associated future economic benefits will flow to the acquirer, and its fair value can be measured reliably. Vice versa for liabilities
- In the case of an intangible asset or a contingent liability, its fair value can be measured reliably.
- The acquiree’s identifiable assets and liabilities might include assets and liabilities not previously recognised in the acquiree’s financial statements
- An acquirer should not recognise liabilities for future losses or other costs expected to be incurred as a result of the business combination.
- The acquiree may have intangible assets which can only be recognised separately from goodwill if they are identifiable. They must be able to be capable of being separated from the entity.
- The acquirer should measure the cost of a business combination as the total of the fair values at the date of acquisition
- If part of the consideration is payable at a later date, this deferred consideration is discounted to present value at the date of exchange.
- In case of equity instruments as cost of investment, the published price at the date of exchange normally provides the best evidence of the instrument’s fair value.
- Costs attributable to the combination, for example professional fees and administrative costs, should not be included: they are recognised as an expense when incurred.
- If an asset or liability has been recognised at fair value at acquisition, it must be recorded in the subsidiary‘s statement of financial position at fair value consequently also
- Some fair value adjustments are made on depreciable assets such as buildings, the assets with fair value adjustment must be depreciated at its fair value so there will be an adjustment, which flows through to profit or loss for this additional depreciation.
The guidance includes enhanced disclosure requirements that include:
- Information about the hierarchy level into which fair value measurements fall
- Transfers between levels 1 and 2
- Methods and inputs to the fair value measurements and changes in valuation techniques, and
- Additional disclosures for level 3 measurements that include a reconciliation of opening and closing balances, and quantitative information about unobservable inputs and assumptions used.